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.
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.
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.
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.
Minimum commitments as a percentage of total spend or demand
They’re less desirable because they increase as the business grows.
Major termination charges
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
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.
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.
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.