The Annotated Feature is a new concept from CIO Canada. In this edition, we asked Linda Tuck Chapman,
a Canadian outsourcing expert, to go over this article from our sister publication and offer her take on what was right, what was wrong and what was left out. Negotiating outsouring contracts: Beware of mimimum commitments
by Stephanie Overby
Once upon a time, IT service providers demanded exclusivity from customers. As those early outsourcing deals wore on, clients grew weary of being locked in to a "one and only" provider. To keep their customers happy, outsourcing vendors began offering minimum volume and revenue commitment clauses, which gave customers some room to breathe while insuring a certain level of return for IT service suppliers.
Minimum commitments—which can take many forms, including revenue, service volume, or full-time employee levels—oblige an IT services buyer to consume no less than a certain level of business with the vendor, either annually or over the life of the contract. Such clauses are typically contained in a special section of the master service agreement or in the contract's pricing schedule.Savvy customers know that the higher the risk, the higher the cost. Totally eliminating minimums increases risk for your service provider and therefore can quickly translate into higher costs.
This is particularly true in a smaller market such as Canada where service providers have a smaller customer base across which to spread their risks and costs. Linda Tuck ChapmanOutsourcing advisor
For a time, IT executives were all too happy to sign on the dotted line, deeming minimum commitments a reasonable demand. Fast forward to today and—while IT service providers of all stripes continue to press for minimum commitments—savvy customers are pushing back.
The Drawbacks of Minimum Commitments
"There is no benefit to the customer from a minimum volume clause," says Atul Vashistha, chairman of offshore outsourcing consultancy neoIT. Indeed, minimum requirements deter clients from seeking services from alternate providers even when the current vendor is not performing. They also make it difficult to respond to major events like business downturns, changes in strategy, and mergers and acquisitions.
"The inclusion of minimum commitments creates an underlying encumbrance that limits client flexibility," explains Marc
Tanowitz, principal at outsourcing consultancy Pace Harmon.
Switching providers means lots of cost, time and switch risk. First try to resolve issues, particularly since fault is rarely one-sided. Eliminating minimums may reduce termination penalties, but there are many means to achieve this goal.
--Linda Tuck Chapman,Outsourcing Advisor
Outsourcing providers have their reasons for asking clients to commit to a certain level of business—some more defensible than others. Minimum commitments can enable vendors to recoup upfront investments, better plan staffing decisions, and ensure a certain level of revenue or profit.
"The suppliers have legitimate concerns," says George Kimball, partner in the San Diego office of law firm Baker & McKenzie's global IT and telecommunications practice. "Pricing and margins may be based upon some assumed combination of skills, facilities and other resources that might be skewed by drastic reductions or 'cherry picking'."
For example, in large infrastructure deals where the providers are compelled to acquire significant client assets, minimum commitments are not uncommon, says Tanowitz. Outsourcing vendors are also more likely to negotiate for strong minimum commitments from a client if the contract is put together quickly with less time for due diligence, says Vashistha. Putting a floor on the minimum amount of business the deal will generate provides some risk mitigation for the provider, should the work prove more difficult or costly than it seemed.
Agreed. On-boarding costs can be enormous, including deal pursuit, infrastructure setup and transition effort. Your deal should be fairly priced and allow your service provider to recover costs and make a fair profit. -LTC
But many of today's outsourcing deals require less significant up-front investment by the vendor, particularly application development and maintenance contracts or newer "infrastructure light" deals. Customers who place a bigger premium on flexibility see little to like in minimum commitments clauses.
Agreed, providing you approve sub-contracting and let them outsource and/or offshore at their discretion. Keep your focus on outcomes, not inputs, once the deal is signed. -LTC
"In today's economic conditions, no client can safely and accurately predict longer term departmental budgets and thus there is no clear vision on outsourcing budgets," explains Vashistha. "Keeping up with minimum volume commitments can become very challenging."
A counter-argument is that CIOs must ensure they have the skills to help customers turn financial forecasts into accurate volume and usage forecasts. -LTC
Alternatives to Minimum Commitments
Despite vendor pressure, some outsourcing customers are successfully pushing back on minimum volume commitments, says Tanowitz. They're finding other ways to satisfy an outsourcing vendor's need for ROI:
1.The client compensates the vendor for documented costs that cannot be reduced, eliminated or mitigated should they terminate the contract. Client and provider agree to a tiered discount structure. The vendor captures a bigger (but reasonable) margin at lower volumes while the customer reaps lower costs when work increases.
2. The client, rather than the provider, funds any upfront investment necessary for the deal.
3. The customer opens up its strategy book to the supplier, offering insight into future opportunities, business conditions, and other factors that give the vendor confidence in the long term value of the deal.
4. The client offers to go public about the deal, improving the vendor's marketing position, or enlists as an "active referral" for the provider.
5. In most cases, IT executives will find it in their best interest—and entirely achievable—to steer clear of minimum commitments. Still, there will continue to be circumstances which necessitate minimums, particularly if the vendor makes a significant financial, operational or technical commitment in return for the deal, says Tanowitz.
There are excellent points, all of which should be a part of any outsourcing contract negotiations.-LTC
IT leaders who agree to minimum commitments must remember, as always, the devil is in the details. Watch out for the following customer unfriendly terms that can show up in minimum commitment clauses. If you find them in your contract, read them carefully and understand their implications to your bottom line or negotiate for better terms before you finalize the outsourcing arrangement. A best practice is to implement a Supplier Risk Governance program, a repeatable process that ensures relationships are formally reviewed on a periodic basis.
The intensity and frequency of the review should be commensurate with the level of risk and contract value. -LTC
Minimum commitments as a percentage of total spend or demand
They're less desirable because they increase as the business grows.
Major termination charges
If termination charges are modest, says Kimball, convenience termination is a realistic option and the customer enjoys considerable leverage if the parties have to revisit pricing on account of reduced consumption.
. . . but tough to negotiate-LTC
Minimum monthly commitments
Avoid at all costs, says Tanowitz. They reset each month and do not allow the client to normalize any seasonal spikes or troughs in demand.
Minimum annual commitments
Not as bad as the monthly option, but minimum term commitments (i.e., over the life of the deal) allow shortfalls to be made up over time. The longer the averaging period, the less likely you are to fall short of commitments.
And commitments should be reset over time. -LTC
Minimum commitments tied to a particular service or component
Providers may prefer service-specific commitments (in addition to aggregate commitments) because they may be operationally and financially independent or performed by different business units. A customer may prefer to forego the aggregate commitments, in these cases, or peg per-category minimums well below the aggregate percentage in order to maximize their flexibility, says Kimball.
Minimum commitments that are too high
The lower the threshold, the less likely consumption is to fall below that threshold.
Harsh penalties
If, for example, the customer must pay the full cost of a shortfall over the term of the agreement, minimum commitments can prove very costly. That would amount to "paying full price for services not being received," says Tanowitz. Alternately, vendors could ask for a percentage of the shortfall or take back pricing discounts on volumes that were not met. Which is why commitments must be made on a rational basis that allows your service provider to recover their startup investment and make a fair return.
I've seen some one-sided clauses that allow the service provider to earn all expected profits, regardless.-LTC
No end-of-contract provisions
Disengagement or termination assistance provisions will permit phased reductions in scope and volume or even eliminate minimum commitments in the months before the contract expires, Kimball says.
Most termination provisions dramatically decline over time. If you agree to minimums in your contracts, don't forget to step down or suspend them during the termination and switch phase. -LTC