IT Outsourcing Contracts: Practical Implications of the Incomplete Contract
Theory ... Heckmann has found that formal contract management for the
purchase of ...
IT Outsourcing Contracts: Practical Implications of the Incomplete Contract Theory Dr. Erik Beulen – Atos Origin/Tilburg University Prof. dr. Pieter Ribbers - Tilburg University
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Abstract This article deals with IT outsourcing contracts. Contract amendments are often necessary, either because of changing client needs, or because the contracts themselves are incomplete. In some cases, requests for changes give rise to disputes and even litigation. Also market conformity is a hot topic for IT outsourcing contracts. Dissatisfied clients may wish to repatriate the service as a result, which may be very costly or even impossible. This results in the issues that are addressed in this paper: the transition to another supplier. The approach we used includes desk research involving six European IT outsourcing situations, including one that was worldwide in scope. A senior lawyer and contract managers with the IT supplier were interviewed on the basis of this desk research. This paper will present a series of propositions related to the management of IT outsourcing contracts derived from this research.
1. Introduction The IT services outsourcing market is still growing every year. Trend analysts such as Morgan & Chambers and IDC predict annual growth figures of approximately 10% [28] [17]. This growth is also confirmed by publications such as the OutsourcingProject [31]. Furthermore, the contracting period for most outsourcing contracts is more than one year [38] [6] and an increasing number of outsourcers are making use of more than one external IT supplier [23] [10]. Based on these observations, it is essential that the outsourcing contracting domain be subjected to careful review. After all, many organizations are entering into long-term commitments with one or more external IT suppliers. The outsourcing contract plays an important role during the period of time that the outsourcing relationship is in effect. Lacity and Hirschheim formulated an important principle for IT outsourcing: “If a company decides to outsource, the contract is the only mechanism to ensure that expectations are realized.” [22]. However, the basic premise must be that the IT supplier
and the outsourcing company are always ready to help one another and are willing to cooperate together to develop solutions: “the willingness to cooperate on all organizational processes” [3]. Heckmann has found that formal contract management for the purchase of information technology can make an important contribution to the management of purchasing processes. Heckmann observes, however, that many organizations have not implemented any purchasing processes at all, or have not implemented them adequately [16]. Furthermore research into outsourcing contracts to date is still very limited. This article attempts to provide insight into three important areas of interest for outsourcing contracts: the incompleteness of contracts, market conformity and transition to another supplier. These are all areas that require attention when purchasing IT services and they are further elaborated here on the basis of Transaction Cost Theory and Incomplete Contract Theory. This research is based on six case studies, three interviews with contract managers and an interview with a legal expert in the field of outsourcing contracts. The insights developed in this article should assist outsourcing organizations and IT suppliers in formulating and managing their outsourcing contracts. Section 2 of this article describes the research framework, while Section 3 describes the structure of this research project. The basis used for the analysis is formulated in Section 4. It includes the general observations associated with the six contracts studied for this research project. The analysis based on the interviews and the six contracts is contained in Section 5. Section 6 contains the conclusion.
2. Research Framework IT outsourcing can be defined as the transfer of responsibility for the execution of an IT service to one or more IT suppliers. This definition is based on the work of Lacity [21], Willcocks and Chio [37] and Currie [10]. The outsourcing reality must be seen as a success by both the outsourcing organization and the IT supplier. This is referred to as the Success of the IT Outsourcing
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Relationship in this article. The Success of the IT Outsourcing Relationship is adversely affected by the incompleteness of contracts. The negative effect of the incompleteness of contracts can be offset through contract management. The incompleteness of the contracts themselves can be mitigated with the help of proper contract management. In addition, proper contract management makes a positive contribution to the Success of the IT Outsourcing Relationship. The contract management aspect will be developed further in this article on the basis of a series of propositions. Contract Management
(+)
Incomplete Contracts
(-)
IT Outsourcing Relationship Success
Figure 1: Research Framework An outsourcing contract constitutes the foundation for transferring responsibility. These contracts include the agreements that form the basis for executing the IT service. A distinction can be made here between the general conditions of the contract and agreements concerning the scope and the service levels associated with the specific IT services to be provided [8] [34]. In developing this research framework, a link with Transaction Cost Theory and as a further extension of this, a link with the Incomplete Contract Theory was made. These theories offer a point of departure for addressing issues related to outsourcing contracts. Transaction Cost Theory is based on a comparison of costs associated with the in-house development of products or services – indicated by a “make-decision: insourcing” and the purchase of products or services – indicated by a “buy-decision: outsourcing”. When services are purchased, the acquisition costs involved must also be taken into account [9] [35]. When they outsource their IT services, the outsourcing organization is taking a “buy-decision”. In addition to the invoices that the outsourcing organization receives from the IT supplier, the outsourcing organization must also take the costs associated with managing the IT supplier and with preparing and maintaining the contract into account [2] [18]. Incomplete Contract Theory is based on situations in which the parties that wish to enter into an agreement together are not able to predict all of the future situations that may occur as a result of the transaction they wish to conclude. As a consequence of this, they are not able to describe all possible future scenarios as part of the contracts they wish to negotiate. This does not concern
questions of uncertainty in relation to the contracting parties involved, but uncertainties concerning the transaction itself [14] [33] [15]. In the IT outsourcing literature, the Incomplete Contract Theory has been developed by Nam et al. [29]. The future information needs of the outsourcing organizations, driven by the dynamics of the marketplaces in which these organizations operate, or changes in strategies due to the emergence of new technologies, are elements, which cannot be defined when a contract is signed. Based on these theories, there are three areas of interest in relation to IT outsourcing contracts that can be differentiated: the incompleteness of outsourcing contracts [15] [32], market conformity [4] and transition to another supplier [30] [1]. These three areas of interest are further analyzed in sections 3 and 4 on the basis of contract case studies and interviews. Incompleteness of IT Outsourcing Contracts Attempts to include all possible future scenarios into an IT outsourcing contract requires intense efforts from both the outsourcing organization and the IT suppliers and may well be an impossible task. The cost of preparing an IT outsourcing contract is considered a coordination cost by Transaction Cost Theory [18]. When preparing IT outsourcing contracts, the question really is to what extent both parties are prepared to attempt to be complete. The degree to which this is possible for IT outsourcing contracts depends on the following factors: asset specificity, uncertainty and measurement, and frequency of the transaction [2]. In many outsourcing situations, the opportunity to include details into the contract is very limited. This is related to the time pressures that often exist to come to an agreement and the costs associated with the preparation of the IT outsourcing contract. Management may deem it essential for certain IT services to be quickly available. In this case the parties often agree on a procedures for dealing with changes that lead to situations that are not covered by the contract [12]. Burnett uses the Liaison Model to describe this aspect [8]. This procedure is used as a basis for formulating agreements between both parties that complement the signed IT outsourcing contract. Hart and Segal use the concept of expost negotiations to describe this aspect [15] [32]. Market Conformity Many outsourcing companies fear that they pay the IT supplier too much for the IT services provided [26] [38]. Furthermore, the realization of cost savings is still the most important motivating factor for the outsourcing of IT services [28]. The duration of most IT outsourcing contracts is such that the contract must include clear agreements about potential changes in costs and the process to be used for making such changes. There is no consensus in the literature concerning the desirability of entering into IT outsourcing contracts of long duration. Lacity and Willcocks conclude that contracts of short duration lead to cost savings for outsourcing organizations. Short here is defined as less than 4 years. The arguments used by Lacity and Willcocks to substantiate their position is that a shorter timeframe leads to a reduction in uncertainty, and therefore a lower risk exposure, and provides an increased incentive for IT suppliers to maintain the appropriate level of IT service. After all, the contract is coming up for renewal within a shorter period of time. Furthermore, the literature indicates that it is possible to modify the contents of contracts of shorter duration more easily, which means that the contents of the contract can be adapted more easily to changing circumstances [24]. On the other hand, contracts of shorter duration lead to the possible scenario that the IT services may need to be transferred to another IT supplier. This scenario of course carries additional costs with it. For this reason McFarlan and Nolan assign preference to contracts of longer duration. These are designated as alliances by McFarlan and Nolan [27]. It is not possible to indicate which of these two scenarios exercises the greatest influence on the basis
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of this initial exploratory research alone. The contract duration for the case studies that were analyzed varied from 1 – 5 years. The mechanism used to change the costs of the IT services provided may be based on a public index, or may consist of periodic benchmarks [8]. The costs associated with the use of periodic benchmarks are of course much greater than the use of a public index. However, market conformity is greater when a periodic benchmark is used. Transition to Another Supplier Responsibilities are transferred not only when an IT outsourcing contract is initially signed, but also when the IT outsourcing contract is assigned to an IT supplier other than the IT supplier currently performing the IT services. This also involves costs that may be considered as coordination costs. A transfer demands much attention from the outsourcing organization, the current IT supplier and the new IT supplier [30] [1]. In particular, the knowledge that the current IT supplier has built up over the years, also referred to as tacit knowledge, will need to be transferred to the new IT supplier. The only interests that the current IT supplier has in carefully transferring this knowledge are the preservation of its reputation [6]. The IT outsourcing contract must therefore include agreements concerning the transfer process at the end of the contract.
3. Structure of this Research Project This article explores three specific areas of interest – incompleteness of contracts, market conformity and transition to another supplier – related to outsourcing contracts on the basis of Transaction Cost Theory, Incomplete Contract Theory and the literature on outsourcing. Desk research involving six outsourcing case studies was applied to develop these three areas further. Interviews with three contract managers with
responsibility for one of the six case studies, numbers 1, 4 and 6 respectively, were conducted to complement this desk research. This is reflected in Table 1. Each case study included one or more contracts that were analyzed. These contracts are included in Table 2. The outsourcing relationship involved in case study number 3 had been previously analyzed by the authors [7]. A legal expert was furthermore interviewed in order to discuss the legal aspects involved in outsourcing contracts. The same analysis techniques for collecting data were used for all case studies. All interviews were recorded, fully transcribed and further developed. The results were approved by the interviewees and constituted the basis for the analysis. Interviewees were asked to identify the important issues in relation to the management of outsourcing contracts using open questions. Closed questions were then used to explore each of the three areas of interest in further detail. Propositions have been formulated for each of the three areas of interest to outsourcing contracts on the basis of the desk research and the interviews. Altos Origin is the IT supplier, which carries responsibility for providing the IT services for all contracts reviewed. Atos Origin is the seventh largest IT supplier in Europe.
No.
Sector Utilities
Geographic Coverage Europe
Yearly Contract (Mil. of Euros) 5
Contract Duration 5 years
Extension Yes/No Yes
1 2
Utilities
Europe
20
3 years + option to extend by 2 years
3
Processing Industry
N/A
Worldwide
90
5 years
N/A
4
Media
Europe
1
1 years
Yes
5
Discrete Manufacturing
Europe
6
3 years
Yes
6
Telecommunications
EMEA
Confidential (> 20) 5 years (framework agreement) & 3 + 2 years options to extend (Chunks) No
Table 1: Overview of the case studies analyzed. No.
Contracts Analyzed
1.1
Framework Agreement
1.2
Supplementary agreement to Framework Agreement
1.3
Windows NT server services (SLA) – contract within Framework Agreement Mainframe Service Level Agreement – contract within Framework Agreement
1.4
1.5
1
Service Level Agreement for trouble shooting support and
Description of IT Services1 Generic IT Services Specific IT Services Management and maintenance of server Management and maintenance of mainframe and environment. trouble shooting service in support of workplace equipment. Management and maintenance of server Management and maintenance of mainframe and environment. trouble shooting service in support of workplace equipment. Windows NT server services: configuration Windows NT server services: operational management, software management and distribution. management, incident management, problem management, and change management. Management and maintenance of mainframes: Management and maintenance of mainframes systems operation (batch jobs processing, backup (hardware, network and print definitions, data and recovery), application management, incident and management, infrastructure, software, disaster problem management, change management and recovery, space management). consultancy & projects. Trouble shooting services: corrective maintenance, Trouble shooting support services: preventive supply of parts, technical purchasing procedure, maintenance.
The subdivision into generic and specific services shown here was made on the basis of the authors’ own professional judgement.
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2.1
NT hardware – contract within Framework Agreement Framework Agreement2
2.2
Transfer Agreement3
3
Concern Framework Agreement4
4.1
Application Facility Management Agreement Service Level Agreement – contract within Application Facility Management Agreement Facility Management Service Agreement
4.2
5.1 5.2
6.1 6.2
Service Level Agreement – contract within Facility Management Service Agreement EMEA Framework Agreement3 Geographical Chunk G1
6.3
Enterprise operations and Unix distributed computer Chunk
6.4
Administration of supply chain/back-office and technical applications Chunk
warranty support, and equipment replacement. The service delivery is documented as part of an The service delivery is documented as part of an interim SLA: application maintenance. interim SLA: operations (mainframe, midrange, networks and print and mail), desktop services. This agreement documents the transfer of the internal IT division. This involves a transfer of shares since the IT division is a legal entity. In addition, the execution of a transition project is specified, including the identification of projects together with the associated plans and a fixed price for executing these projects. Dedicated midrange computer services, e-Business IBM mainframe service, network & generic services, SAP services and miscellaneous services services, desktop hardware & software services, (helpdesk + assets charging services + application LAN management services. management for custom-developed applications). Management and maintenance of information Projects systems and support to users of these systems. Management and maintenance of information Projects systems and support to users of these systems. Data processing and communications services and products: mainframe services, communication services, publishing services. Data processing and communications services and products: mainframe services, communication services, publishing services.
Data processing and communications services and products: customer support services. Data processing and communications services and products: customer support services.
This is a framework contract, which does not include the provision of services. It only addresses how the parties intend to work together. IMACs + voice & video + special services. Helpdesk services + desk-side support services + software upgrades and distribution + LAN services (including LAN servers). Performance management + capacity management + Operations management + systems administration + incident/problem management + environment backup and recovery management + physical management. database administration + configuration management + asset management + security management + software distribution to workstations. Supply chain (order management + order fulfillment + service management) and back-office & technical applications Chunk (product creation + product configuration + shop floor MES systems).
Table 2: Summary of case studies analyzed.
4. Characteristics of the Case Studies Investigated Based on the six case studies analyzed, there are a number of things that stand out. This includes the objectives and the structure of the contracts and its characteristics.
4.1 Objectives The general picture that emerges is that in all case studies analyzed, the contracts include objectives that are linked to the costs associated with delivering the IT services. This is consistent with the observations made by Morgan & Chambers and by Giarte. Their research
identifies objectives that are linked to the cost of delivering IT services as the most important objectives [11] [28]. It is worth noting that the IT outsourcing contracts associated with case studies 1, 2 and 5 are based on the delivery of IT services in conformance with market norms. This approach is typical of a partnership agreement between an outsourcing organization and an IT supplier. The other case studies are more focused on reducing the costs of the IT services. This approach is typical of a purchasing relationship. In addition, the contracts also include other objectives. The most striking here are objectives aimed at getting access to new technologies. Given the speed at which new developments are coming out these days, such as e-
2
This Framework Agreement includes an Interim SLA. During the course of the IT outsourcing contract this Interim SLA was replaced with a large number of service level agreements. These new service level agreements were not included in the analysis. 3 A subdivision into generic and specific services was not applicable for this transfer agreement. 4 A large number of contracts with the divisions and business units of the outsourcing organization fall under the Concern Framework Agreement. These include the actual agreements between the outsourcing organization and the IT suppliers. These contracts were not analyzed as part of this research project.
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Business and ASPs, it is difficult for the internal IT divisions of outsourcing organizations to properly incorporate these new developments into their
operations [5]. This is consistent with the core business motives for outsourcing IT services [21].
Objectives Costs Managing costs Service delivery in accordance with market norms Improving price/performance ratio Reducing costs Others Shorter T-T-M Access to new technologies Anticipation of organizational change Increasing customer satisfaction (Customer satisfaction was not defined as part of the contract, however, IT suppliers conduct annual surveys to determine the level of customer satisfaction.)
Case 1
Case 2
X
X
Case 3
Case 4 X
X
X
Case 5
Case 6 X
X X X
X
X X X
Table 3: Summary of the objectives associated with the case studies analyzed.
4.2 Contract Structures The structure and contents of the IT outsourcing contracts associated with all of the case studies analyzed were essentially the same and they all included a framework agreement. The framework agreements included all of the general terms and conditions, including the operational domain, the contract duration and the conditions for termination. The framework agreements serve as an umbrella for service level agreements which document the actual services to be delivered and the associated service levels. The uniformity of these contracts could be explained by the fact that the IT supplier associated with all of these contracts is one and the same supplier. In actual practice, however, most IT outsourcing contracts have a similar structure and content [36] [19]. Furthermore, it is worth noting that the method used for grouping SLAs was different for the larger case studies analyzed (case studies 2, 3 and 6). In case study 3 and 6 the grouping was first based on the geographic distribution and business units of the outsourcing organization and only then on the nature of the IT services provided. In case study 2 they were solely grouped on the basis of the nature of the IT services provided. It may be possible to attribute this distinction to the much greater geographic dispersion of the business units belonging to the outsourcing organizations in case studies 3 and 6. For the smaller case studies analyzed (case studies 1, 4 and 5) this method of grouping SLAs did not apply and the SLAs were simply grouped according to the type of IT service provided. By linking the method of grouping the SLAs to the geographical location and the business units of the outsourcing organization, it is possible to attain a much higher degree of contract effectiveness. This is due to the fact that this approach makes it possible to align the IT services included in the contract with the local information needs of the business units of the
outsourcing organization [6]. The grouping of SLAs by the type of IT service makes it possible to build greater efficiency into the contracts. This is so because this approach makes it possible for the IT supplier to standardize the IT services, which in turn enables the IT supplier to realize economies of scale, including the inherent cost savings [21].
4.3 Characteristics Using Kraljic’s Purchasing Portfolio as a basis, it is possible to characterize the purchase of IT services as the purchase of strategic products. The parties will need to enter into a partnership in order to accomplish this [20]. This does not imply that there will be an equal relationship between the parties. What is important here is the observation that the case studies analyzed in part included the delivery of generic IT services. This strengthens the position of the outsourcing organizations, because it makes it easier for them to transfer to another IT supplier. Furthermore, the balance of power between the outsourcing organization and the IT supplier can be ascertained from the manner in which the degree of exclusivity, liability - Liability here is solely meant to include liabilities that arise from the execution of IT services by the IT supplier. This expressly excludes liabilities for outsourcing organizations that are related to the transfer of the employees of internal IT divisions, service level agreements, hardware or other assets. - and termination conditions are formulated as part of the outsourcing contract. This is detailed in Table 4. The price paid by the outsourcing organization for the IT services provided is also an important indicator. If the IT supplier has a strong position of power, the outsourcing organization will pay a higher price for the IT services provided. The current research structure does not lend itself to be able to explore this specific point in further detail, however.
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Indicators for measuring the relationship between the outsourcing organization and the IT supplier Degree of Exclusivity Sole supplier for activity domain and preferred – Degree of supplier for other remaining new services exclusivity as defined Preferred supplier for activity domain (including in the Framework turnover guarantee) Agreement. Preferred supplier (excluding turnover guarantee) Liability Direct damages Direct and indirect damages Termination Bankruptcy/Force Majeure/Default Conditions Change in the IT supplier’s ownership Business needs
Case 1
Case 2
X
X
Case 3
Case 4
Case 5
X
X
Case 6
X
X
X
X
X
X
X X
X X X
X X
X X
X X
X X X X X
Table 4: Relationship between the outsourcing organization and the IT supplier. Exclusivity Most of the contracts associated with the case studies analyzed stipulated that the IT supplier was to be the sole supplier within the agreed upon domain of activities for the duration of the contract (case studies 1, 2, 4 and 5). This is consistent with Wheeler’s alliance approach [34]. The contract associated with case study 3 includes a preferred position for the IT supplier. The IT supplier is required to negotiate agreements concerning the provision of IT services with the divisions and business units of the outsourcing organization. Contracts were already in place between the internal IT division taken over and the divisions and business units of the outsourcing organization when this contract was signed. These contracts were also transferred to the IT supplier and constituted the basis for providing services to the divisions and business units of the outsourcing organization. Case study 6 only includes a provision for a preferred position and agreements concerning the delivery of IT services come into effect only once an SLA has been agreed upon. It is possible to conclude that the larger case studies analyzed included a more limited degree of exclusivity compared to the smaller case studies. There may be a possible connection here to the balance of power between the outsourcing organization and the IT supplier. Liability It is possible to make a distinction between direct damages and indirect damages caused the performance of work activities [36]. It is striking that in the case studies considered, the contractual agreements only covered direct damages. The IT supplier does not assume any liability for indirect damages. This is generally not a common practice within the IT industry either [19]. Other than this, the maximum amount to be paid for each occurrence in the case of damages is the same for all contracts. This is generally inconsistent with the IT industry, however, where most outsourcing contracts are linked to the size of the contract. 10% of the total yearly contract value is often used as the upper limit in these instances [36] [19]. The size of the maximum compensation for damages included in the case studies considered cannot be disclosed in this article for reasons of confidentiality. The fact that the absolute amounts used in each case study were identical is remarkable considering the large discrepancies in the scope of the case studies analyzed. This is related to the IT supplier’s liability policy. The liability insurance coverage obtained by IT suppliers plays an important role in this regard. It is of course possible for an IT supplier to obtain additional insurance in order to be able to increase the maximum amounts paid for direct damages. This in turn of course has an impact on the cost of the IT services provided. Furthermore, all contracts analyzed contained a waiver to indemnify the outsourcing organization against all liabilities arising from transferred IT services, employees and assets. Termination Conditions Bankruptcy, force majeure and default are standard contract termination conditions [8] [34]. After all, these all disrupt the IT service delivery. All of these termination conditions were consequently found in all of the case studies. Change in ownership was furthermore also one of the conditions found in all case studies, although different contracts specified different limits. Some contracts
allowed the outsourcing organization to terminate the contract if 40% of the IT supplier’s shares were transferred to another party. In yet other contracts, this percentage was set at 80%. This has major implications for the IT supplier operating in a marketplace where mergers and takeovers are the daily norm. Long-term IT outsourcing contracts determine a significant portion of the value of IT companies in instances of mergers or takeovers. Furthermore, many takeovers and mergers are financed through the transfer of (newly to be issued) shares [13]. If the long-term IT outsourcing contracts include clauses that constitute a basis for outsourcing organizations to terminate their contracts this can have a major impact on the value of the IT supplier and consequently on the proposed transaction. This is particularly tricky for the management of IT suppliers listed on a stock exchange. Taking a prior pulse of their larger clients to determine if they intend to terminate their IT outsourcing contracts in case the proposed merger or takeover proceeds is not something that can simply be assumed to be fully permissible within the context of the different national laws and regulations to which organizations that are listed on a stock exchange are obliged to adhere. Only the largest outsourcing organizations are capable of forcing IT suppliers to conclude framework agreements without contracting for the actual delivery of IT services. This only occurred in case study 6. Empty framework agreements of this type are, however, a frequent occurrence in dealing with governmental organization. The question this raises, is whether the preparation and conclusion of this type of contract is actually of benefit to the parties involved. Case study 3 included an additional termination condition, which allows the contract to be terminated for business needs. This condition was supported by proper agreements governing the consequences of terminating the contract, however. In addition to compensating the IT supplier for the costs incurred in terminating the delivery of its IT services, the outsourcing organization also agreed to compensate the IT supplier for a significant portion of lost profits. This stands in contrast to case study 6. The contract for this case study only included agreements to cover the costs incurred by the IT supplier for terminating the delivery of its IT services. The actual duration of the framework agreement will be reduced from 5 years to 180 days. In case studies 3 and 6, the dynamics of the marketplace were such that it became essential for the outsourcing organization to include this type of clause in the outsourcing contract. The outsourcing organization related to case study 3 was involved in the privatization of the energy market. The outsourcing organization in case study 6 was involved with new technologies, such as UMTS, to be implemented for telecommunication enterprises. In general it can be stated that the position of the outsourcing organization is stronger when the size of the contract is larger [20]. This conclusion is supported by the analysis of the case studies.
5. Model-based Analysis The three areas of interest, incompleteness of contracts, market conformity and transition to another
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supplier, are analyzed in this chapter on the basis of the IT outsourcing contracts associated with the case studies and on the basis of the interviews and an inventory of the literature.
5.1 Incompleteness of Contracts The contracts must of course clearly specify the IT services to be provided and the costs associated with the delivery of these services. In addition, the legal expert interviewed indicated that the contract must include agreements concerning intellectual property rights (IPR). This is a very specific subject, in which clear agreements, read indemnifications, are important for the IT supplier in cases where licenses are transferred from the outsourcing organization. IPR is also important for software developed by the IT supplier on behalf of the outsourcing organization during the course of the contract. The IPR in principle belongs to the outsourcing organization. However, developments, such as Processing Outsourcing and Business Process Outsourcing make it essential for IT suppliers to acquire the IPR. But in the case of a transfer to another IT supplier, the outsourcing organization must be able to continue to use the software licenses whose IPR remains with the “old” IT supplier. This requires separate agreements between the outsourcing organization and the IT suppliers. These agreements should be prepared ahead of time on a case-by-case basis. For all contracts analyzed, the contract managers interviewed indicated that significant dynamics are taking place on the side of the outsourcing organization. For example, in case study 4 there was a strong move towards the centralization and standardization of IT services in order to achieve more cost-effective business operations. The revenues of the outsourcing organization were under pressure: fewer subscriptions and less advertising income. All contracts analyzed included the objectives of both the outsourcing organization and the IT supplier. Only in case studies 1 and 5, were the objectives stated in the contract modified during the course of the contract. The expectation in case study 1 was that the load on the mainframe would decrease during the course of the contract. In case study 5, the expectation was that the mainframe load would be transferred to BAAN during the course of the contract. Due to the fact that the outsourcing organization was taken over by an American company before the expiration of the contract, this migration did not materialize. This is why it is important that regular meetings take place, at the right level, between the outsourcing organization and the IT supplier. A distinction can be made in this regard between the operational, tactical and strategic levels, as described by Burnett in his Liaison Model [8]. The contracts that were reviewed contain
agreements about both the frequency of meetings, as well as the subjects to be addressed. In actual practice it was apparent that in case studies 1 and 4, the meetings at a strategic level between the outsourcing organization and the IT supplier did not take place for a long period of time due to frequent management changes on the part of the IT supplier. The contract managers interviewed indicated that both the temporary suspension of strategic meetings, as well as the frequent changes in management, had a negative impact on the Success of the IT Outsourcing Relationship. All contracts also included a procedure for dealing with disputes. The starting point is that disputes are in principle to be resolved at the proper level on the basis of discussions. If this does not resolve the issue, the dispute is discussed at a higher level. If the parties are not able to reach an agreement at the strategic level, the contracts reviewed included a provision for mediation. An independent expert makes a decision about the dispute that is binding on both parties. This results in rapid problem resolution, saves costs and helps ensure that any damage to the IT supplier’s image is minimized. One of the parties may express a preference for submitting the dispute to a legal court. This option is also left open in the contracts that were reviewed. The contract manager involved in case study 5, made the following observation about this: “If you end up resolving a dispute in front of a judge, you may as well terminate the contract right then and there. You’ll lose far too much time before you can expect to receive a verdict. Furthermore, exposing your dirty linen in public is not a great way to protect your reputation. It is important to work your way through any problems together.” The legal expert interviewed indicated that it is essential to take minutes during all meetings. These minutes constitute a supplement to the contractual agreements and can be very useful for helping to address matters that are not specified in the contract. This is why it is important that only authorized officers are involved in these meetings. The legal expert: “The minutes of meetings constitutes a supplement to the contractual agreements. As soon as the parties are in agreement about the minutes, any agreements they include become binding on all parties.” Proposition 1.1: The inclusion of the objectives, meeting structures and escalation procedures for the resolution of contract disputes contributes to minimizing the negative impact of the incompleteness of contracts on the Success of the IT Outsourcing Relationship. [36] [25] Proposition 1.2: The resolution of disputes concerning the provision of IT services at the right level, makes a positive contribution to the Success of the IT Outsourcing Relationship. [19] [6]
5.2 Market Conformity
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In order to guarantee conformity to market conditions as part of the contract, it is possible to formulate agreements concerning the costs of the IT services provided during the course of the contract. This may be accomplished by linking costs to an index (case studies 4 and 6) or to a previously agreed upon cost savings program (case studies 1 and 5). In the latter instance, the IT supplier reorganizes the IT services function for the outsourcing organization and is able to realize cost savings on this basis. Based on an understanding of market conditions and developments, the parties enter into agreements about the costs involved. Another option for guaranteeing market conformity is to formulate agreements about costs on the basis of periodic benchmarks (case studies 2 and 3). Costs are usually adjusted on a yearly basis in these instances. This approach implies that the parties must come to an agreement each year about the rates to be used for the coming year. It is of course also possible for the parties to opt for a combination of these two alternatives. Both alternatives were part of the contracts reviewed. The provision of continuous and more specific services, such as application management, in particular are usually contracted for on the basis of a previously agreed upon cost savings program or indexation. The provision of continuous and generic services, such as desktop services, is usually contracted for on the basis of benchmarks. The rates for staff assigned to an organization were automatically adjusted on a yearly basis in the contracts reviewed. The outsourcing organizations are given the right to register an objection to these rate increases. A benchmark is then used to determine if the rates proposed by the IT supplier are justified. It is important that the parties are able to come to an agreement as to who will carry out the benchmark. The contract should also stipulate who is responsible for incurring the costs of the benchmark. Three of the contracts included a provision for the IT supplier to incur these costs. The other contracts included a provision for the outsourcing organization to absorb these costs provided that the results of the benchmark confirmed the rates charged by the IT supplier to be in conformance with market rates. The contract manager responsible for case study 5 and the legal expert both indicated that it is important for the proper interpretation of the benchmark results that the IT supplier be closely involved in conducting the benchmark. The legal expert interviewed indicated that it is sufficient to include a benchmarking clause into the contract. The inclusion of a detailed description of the benchmarking process does not make any sense, certainly not in cases where the nature of the IT services delivered during the course of the contract are expected to change significantly. The interviews did not yield a clear picture of how to change pricing levels in the case of a previously agreed
upon cost savings program or indexation, where the agreed upon prices turned out to be higher than the pricing levels prevalent in the marketplace. The contract managers responsible for case studies 1 and 4 thought that the IT supplier should adjust the pricing levels downwards in these instances. The legal expert adopted the standpoint that a contract is a contract and the outsourcing organization should continue to adhere to the agreements entered into. The contracts reviewed did not contain any additional arrangements concerning this subject. In view of the fact that the contract managers for case studies 1 and 4 indicated that in those instances where the pricing is below the pricing levels prevalent in the marketplace, prices are not adjusted upwards, it seems justified in all cases not to revisit any contractual commitments that have already been made. Aside from this, there are outsourcing organizations who will attempt to arrive at market-conforming rates for their IT services through means of multiple sourcing. Only the outsourcing organizations involved in case studies 3 and 6 entered into a contract with multiple IT suppliers. These case studies also involve the larger contracts. One of the contract managers interviewed indicated that a certain size is essential for the implementation of multiple sourcing. The contract manager responsible for case study 1: “The minimum size for an outsourcing contract is 20 FTEs. For contracts of a smaller size it is impossible to offer the services as you would like to offer these, let alone that you would then also be forced to work together with another supplier to provide these services.” The legal expert interviewed raised yet another concern against multiple sourcing. This is the question of confidentiality. This affects the pricing levels, as well as the technologies to be deployed. The outsourcing organization will have to build in security measures for its IT suppliers. Finally, the set up of a multiple sourcing arrangement will also require greater effort and maturity from the outsourcing organization itself. The contract manager responsible for case study 1, indicated that his client’s contract management capacity had not yet reached a stage of maturity that would enable it to manage multiple outsourcing relationships. Finally, the contracts that formed part of case study 6 included a preferred customer clause. This obliges the IT supplier to use the same pricing structure used for other customers in cases where similar services are provided to the preferred customer within the same geographical region. This means that the IT supplier’s lowest rates are not only applicable to the services provided to the customer with whom direct contractual agreements were negotiated, but also to customers who have a preferred customer clause in their contracts. This type of clause originated from within the industry [20]. It is not easy to integrate a clause like this into IT services contracts. Legal expert interviewed: “The real
Proceedings of the 36th Hawaii International Conference on System Sciences (HICSS’03)
0-7695-1874-5/03 $17.00 © 2002 IEEE
issue is that you must have a system in place to monitor your costs. If you don’t have such a system in place you will be in breach of contract from the very first day.” Aside from this, the objectives for different contracts may vary. This may affect costs. The parties interviewed also cast doubts on the comparability of contracts. Contract manager interviewed: “It is a subjective benchmark. The circumstances are always different. It is impossible to compare one contract with another contract. I am happy that my contracts do not contain a clause like that.” This would appear to justify the provisional conclusion that the inclusion of a “most preferred customer clause” into IT outsourcing contracts is not desirable. Proposition 2.1: The formulation of agreements concerning the development of future pricing scenarios must be based on the nature of the IT services: for continuous generic services preference should be given to a benchmarking-based approach. [6] [19] Proposition 2.2: The formulation of agreements concerning the development of future pricing scenarios must be based on the nature of the IT services: for continuous specific services preference should be given to the formulation of an agreed upon approach before the outsourcing contract is signed. [8] [1] Proposition 2.3: Multiple sourcing only contributes to the provision of services in conformance with market conditions and to the Success of the IT Outsourcing Relationship when the scope of the IT services is sufficiently large and the outsourcing organization is able to assure confidentiality for the IT suppliers involved. [10] Proposition 2.4: Multiple sourcing can only be implemented by the outsourcing organization on the proviso that care is taken to ensure that it has a contract management division of sufficient strength and experience. [10] Proposition 2.5: The inclusion of a “most preferred customer clause” into outsourcing contracts does not contribute to the Success of the IT Outsourcing Relationship. [8] [1]
5.3 Transfers To Another Supplier Following the expiration of a contracting period, it is conceivable that an IT supplier may have to transfer responsibility for the IT service to another IT supplier, or that the outsourcing organization will repatriate the execution of the IT services to its own organization. It is important in this regard that the knowledge concerning the execution of the IT service is transferred. The IT supplier must take care to anchor this so-called tacit knowledge within its organization during the course of the contract. This requires the preparation of documentation and the setup of processes to maintain this documentation. Contract manager: “We are audited every year by an external party and they pay particular attention to the degree to which our knowledge of the applications is anchored within the organization and is transferable.” The legal expert interviewed indicated that the loss of reputation and fear of claims are the two most important incentives for the IT supplier who is required to transfer responsibility. In all of the case studies reviewed, the contracts identify the process that the parties must
follow in the case of a transfer. Contract manager: “This contract is almost coming to an end. I am not sure that it will be extended once again. I am already thinking about the resources that are available for the preparation of a transition plan and for the execution of that plan. The current resources that carry responsibility for the delivery of the IT service play an important role in this regard, but a strong project manager and a few consultants are essential for ensuring that this effort proceeds along the proper lines. Obviously I am hoping that it will not come to this and that we will be able to sign an extension of a few more years.” Furthermore, the contracts include provisions for the IT supplier to be reimbursed by the outsourcing organization for all costs incurred on the basis of a transition plan that has received prior approval from the outsourcing organization. This allows the outsourcing organization to control its costs. The transition plan also identifies the point in time at which the transfer of responsibility for the execution of the IT services takes effect. The new IT supplier then discharges the current supplier of all responsibility. Proposition 3.1: Contracts must include a description of the transition process in terms of responsibilities and financial implications. [36] [30] Proposition 3.2: The IT supplier must develop documentation concerning the execution of the IT services and must set up a process for maintaining this documentation. [25] Proposition 3.3: The transfer of responsibility for the execution of the IT services must occur on the basis of a transition plan that has received prior approval from the outsourcing organization. [19]
6. Conclusions The preparation and management of IT outsourcing contracts involves a large number of aspects that require attention from the outsourcing organization and IT suppliers. It is not possible to include everything in a contract. Using a process of mutual consultation, it becomes possible to resolve any unforeseen circumstances. In relation to market conformity, the parties must make some fundamental choices before the contract is signed: cost adjustments throughout the course of the contract or the inclusion of clauses that govern the entire duration of the contract before the contract is signed. The basic premise is that both the outsourcing organization and IT suppliers benefit from the application of costs that are in conformance with prevailing market conditions. When a contract is terminated, the current IT supplier is required to transfer its knowledge. This requires attention and care from the current IT supplier. As part of the further development of the contracting topic, it may be of interest to devote attention to IPR, in light of the emergence of Processing Outsourcing and Business Process Outsourcing, as well as to multiple
Proceedings of the 36th Hawaii International Conference on System Sciences (HICSS’03)
0-7695-1874-5/03 $17.00 © 2002 IEEE
sourcing which is also becoming clearly visible as a trend within the marketplace. Further research into the development of a contract management capability is another area that requires attention. Lacity and Hirschheim have indicated that the delivery of IT services should be managed as a portfolio: selective sourcing – which treats IS as a portfolio – is the key to rightsourcing [22]. This places a heavy demand on the contract management capacity of the outsourcing organization, since it requires multiple IT suppliers to be managed [6]. Among the case studies that were analyzed, only case study 6 incorporated true portfolio management. An external consulting bureau is providing contract management support to the outsourcing organization in this instance.
7. Acknowledgement We thank Atos Origin for the possibility to take interviews within their organizations and the anonymous HICSS referees for their critical comments.
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Proceedings of the 36th Hawaii International Conference on System Sciences (HICSS’03)
0-7695-1874-5/03 $17.00 © 2002 IEEE
