Let’s begin with a conceptual understanding of service-level credits. The purpose of service-level credits (i.e., penalties, at-risk amounts) is two-fold:
• Provide the vendor with an incentive to achieve the minimum expected level of performance
• Establish an inherent link between performance and fees.
When negotiating an outsourcing agreement, it is essential to understand that service-level credits are a tool to guide rather than transform vendor behavior. Under most circumstances, even significant credits will not result in major changes to a service provider’s standard operating model.
A case in point involved a $75 million outsourcing transaction for data-center services. The vendor, a leading global provider, had made significant over-commitments when negotiating the agreement. The result was continuous and undisputed credits totaling 15% of fees or $11 million over the term of the contract. Despite the substantial credits, it was not in the vendor’s interest to re-structure its standard-delivery approach to fully meet the terms of a single contract. Instead, the service provider simply paid the credits and ultimately offered the customer significant price reductions in exchange for revised service levels.
While the impact is limited, service-level credits can be an effective tool for correcting non-structural operational deficiencies. There are numerous instances where outsourcing vendors will make limited operational changes such as improved quality controls or more detailed procedures in a bid to maximize their revenue stream. Thus, the principal-negotiating objective with service-level credits is to ensure the rapid and permanent correction of day-to-day operational problems. Structural delivery problems, in contrast, are best addressed through termination for cause provisions based on repeated failure to perform.
Key Negotiating Issues
The following set of key issues can significantly influence the extent of service-level credits, and should be carefully monitored during the negotiation process:
Dilution of Credits. At-risk levels are typically
10%–15% of monthly fees in most outsourcing transactions. When structuring the at-risk methodology, outsourcing customers should be attentive to a common vendor approach known as “the penalty dilution strategy.” Although vendors may readily agree to 10%–15% at-risk, they may also attempt to spread the risk across so many service levels that there are in effect no service-level credits. For example, a diluted credit of 0.5% of monthly fees for a given performance failure is unlikely to result in any meaningful operational changes when vendor margins are typically in the range of 20%.
Depending on the circumstances, the inclusion of a minimum credit amount for any performance failure can be a significant way of addressing the situation. Minimum credits typically range from 1%–3% of total monthly fees and can drive vendors to take notice of each performance failure.
Earn Back of Credits. As part of their negotiating strategy, vendors will commonly argue that there should be an opportunity to earn back service-level credits for exemplary performance. The argument is typically based on a matter of “fairness.”
The central issue that outsourcing customers should assess is whether the value of over-performance is adequate compensation for performance failures. When viewed from this perspective, the customer-vendor balance is uneven and earn back should not be permitted.
As an example, a major automotive-parts manufacturer had a large-scale data-center outsourcing agreement with a leading services provider. Given the just-in-time inventory approach of the automotive industry, application availability was critical to the success of the parts manufacturer as any significant outage would have led to the shutdown of major automotive assembly lines. The result would have been significant financial penalties to the parts manufacturer and strained customer relationships. Any over performance by the outsourcing supplier would never have compensated for negative consequences of a significant outage.
Timeliness of Credits. Another important negotiating issue is when service-level credits are imposed following a performance failure. A standard strategy among outsourc-ing vendors is to propose an annual tallying and assessment of credits. With this approach, it is not uncommon for outsourcing customers to lose track of credits or fail to conduct the annual assessment. As a result, some or all of the credits may never be assessed.
To ensure meaningful impact and prompt correction of a performance deficiency, service-level credits should typically be assessed immediately following the performance failure.
Re-distribution of the At-Risk Percentage. The right to re-distribute the total at-risk percentage across the existing service levels can add considerable flexibility to an outsourcing agreement. During the life of the contract, business priorities and the vendor’s ability to deliver in specific areas can change significantly. The customer’s right to redistribute the total at-risk percentage, often with 30 days notice, can be useful in targeting issues under changing circumstances.
Exchange of Service Levels and Service-Level Objectives. Additional flexibility can be created through the use of both service levels (with associated credits) and service-level objectives (without associated credits). The key mechanism is the ability to exchange service levels for service-level objectives during the term of the agreement.
Although service-level objectives are important, they do not carry the same degree of criticality as service levels at the outset of the agreement. Over time, however, a given service-level objective may become more important than a given service level due to changing business requirements or vendor-delivery issues. The ability to re-assess priorities during the term of the agreement and make exchanges from one group to another can significantly enhance the customer’s ability to target critical areas.
Escalating At-Risk Percentages for Consecutive Failures.
The importance of escalating at-risk percentages for consecutive monthly failures can increase the pressure on vendors to correct repeated problems. This can be accomplished through the use of increasing factors that are multiplied by the at-risk percentage assigned to a given service level.
For example, if 3% of the monthly fees were assigned to a given service level, the following factors would escalate the at-risk percentage with each consecutive month of performance failure.
| | | | | | | | | | | | | |
| Assigned | | | Months of | | | | Factor | | | | Adjusted | |
| 3 | | | 1 | | | | 1.1 | | | | 3.3 | |
| 3 | | | 2 | | | | 1.3 | | | | 3.9 | |
| 3 | | | 3+ | | | | 1.5 | | | | 4.5 | |
Understanding the limits of service-level credits is the starting point for effective negotiations. To guide vendors toward optimal performance, outsourcing customers should adhere to the following guidelines:
| • | | Avoid the dilution of credits |
| • | | Prohibit the earn back of credits |
| • | | Assess credits in a timely manner |
| • | | Re-distribute the total at-risk percentage as needed |
| • | | Exchange service levels and service-level objectives when required |
| • | | Utilize increasing factors for consecutive failures. |
These universal methods can ensure that maximum value is derived from service-level credits under any outsourcing agreement.
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