Addressing Uncertainty in Outsourcing Contracting: Lessons Learned in Big Deals

Uncertainty is inherent in outsourcing complex business functions. Over the three-, five- and even ten-year deal terms common in outsourcing, business, market, and technology changes are both inevitable and difficult to predict. In recent decades, this uncertainty appears to have been increasing and remains well above levels prevailing during the 1990s.¹ Uncertainty creates both risk and opportunity.

This chapter describes contracting approaches now being used to address uncertainty in large outsourcing transactions. Uncertainty is a major factor in those big deals because success relies on numerous factors, decisions become increasingly difficult to reverse as the deal progresses, and a failure can damage the prospects and reputation of the entire company. As a result, both parties invest more time, effort, management attention, and other resources to put together a deal that addresses uncertainty. However, though big deals require greater investments to address uncertainty, many of the lessons learned can be applied across a wide range of outsourcing contracts.

CLARITY

Clarity is an essential problem to solve in building and maintaining long-term business relationships.² Without clarity as to the promises being made, the parties cannot reasonably evaluate whether those promises are credible before signing and have been kept after signing.

Clarity is difficult to achieve for many reasons. Achieving clarity through negotiations requires decisions and agreement on topics that are often difficult to discuss. Access to facts is often limited by objectives such as maintaining a small circle of knowledge and reducing due diligence costs. Drafting clear contract language requires time and skill. Also, some negotiators use ambiguity as a strategy, both as to the present facts and how they will act in the future.

Companies drive clarity in big deals using processes that can be applied in any deal. They start with a steering committee of executives committed to building a firm foundation for a successful long-term relationship. They prioritize a shared understanding of the deal, including the required due diligence, discussions and drafting. They create a culture of collaboration across companies, working to document a deal aligned to what a single enterprise would do to maximize value and avoid costly pitfalls. Lawyers are involved from deal shaping to crafting language that works not just for the team at the table but also for the people who will use that language to run operations and resolve disputed points. That language should include commitments, options and incentives.

COMMITMENTS, OPTIONS, AND INCENTIVES³

Commitments are the core of any outsourcing contract. The company seeks commitments from the supplier to provide specified products and services at or above necessary levels of quality and performance using specified technologies, locations and other resources. In managed services outsourcing, the supplier’s commitment often extends to taking responsibility for performing an existing company function the way it is being performed at signing. In exchange, the company makes commitments to pay stated amounts when due and provide access to relevant resources. To some degree, commitments can include evolution and continuous improvement for readily foreseeable change.

To address known uncertainties, companies seek options to change the commitments at reasonably firm prices. For example, the contract might allow the company to obtain out-of-scope services at reasonable time-and-materials rates, to reduce scope, or to change the technical or operational requirements as technologies and markets evolve. Options increase agility by allowing the company to change outsourcing arrangements to match changing needs. In addition, options create savings because they may limit what the supplier can charge for a change—even a critical change where the company has little leverage—and reduce the risk of over-sized commitments. However, to craft useful options, the company must anticipate what products and services the company will need to produce future desired outcomes.

When companies value certain outcomes but cannot specify what commitments might drive those outcomes, they create incentives for the supplier to act in the customer’s best interest. Service levels and contractual damages are common examples, but, in big deals, companies use a broad array of business metrics. Their goal is to have financially motivated suppliers to find creative solutions to improve those metrics. However, agreeing on effective incentives can be difficult because suppliers generally have limited control over the outcomes.

GOVERNANCE BY RELATIONSHIPS

Even highly-detailed commitments, options and incentives cannot address all of the uncertainty in outsourcing. Instead, companies fill the gap between the formal written contract and what actually happens during the term, creating an informal relational contract that operates alongside the formal written contract. Companies use the formal contract to support the relational contract through approaches such as:

• Transparency. A party might be required to provide reports, provide access to monitoring systems, or allow audit of its books or operations by the other party. What the party learns can be used informally or formally to monitor and manage the relationship. Similarly, the parties might regularly exchange general information about their goals, challenges, capabilities and constraints. Exchanging that information can allow the parties to work more effectively to solve unanticipated problems and seize unanticipated opportunities.
• Teams. Some contracts designate small teams, perhaps one specialist from each party, to jointly solve classes of problems. More sophisticated contracts might specify required skills for the team members and possibly provide for advance approval rights over designated key personnel. Management specialists can help in contracting for high-functioning teams.
• Committees. Other contracts create one or more committees, often with three to six members from each party, to discuss and resolve issues. There may be committees on topics, such as service delivery or cybersecurity, and committees at different levels, such as operational, managerial or executive. The contract may provide times and agendas for meetings, and might also permit a party to require a meeting upon the occurrence of certain events. If the decisions of a committee are in some way legally binding, there may be notice, quorum and voting provisions akin to corporate bylaws.
• Decision Rights. Each party might be given the right to make certain decisions. For example, a party subject to regulations might have the right to interpret those regulations for the purposes of the contract.

MANAGERIAL PROVISIONS

In some big deals, the company uses contractual provisions that allow it to manage suppliers in ways similar to how it manages its internal operations. These provisions are referred to as “managerial provisions.”⁴ Managerial provisions are of particular value if success depends on the employees of the company and the supplier working together as they would if they were part of a single enterprise with a single set of goals. Often, the company requires suppliers to follow company standards that were written for and also apply to internal operations.

For example, integrated product manufacturers require the use of very similar techniques in their component outsourcing arrangements as in their own operations. For example, they specify details of supplier plant floor operations and have their engineers on-site to observe and to help solve problems in supplier plants. A key benefit for the manufacturers is in their ability to verify process quality at every step, avoiding the difficulties of determining quality of finished products.

The tighter adherence to company management practices created by managerial provisions may help reduce the risk of uncertainty. There is considerable research indicating that those management practices work well within companies. For example, the World Management Survey (WMS) compiled remarkably comprehensive information about managerial practices and firm performance.⁵ Studies using the WMS data found that “differences in management practices account for about 30% of total . . . productivity differences.”⁶

Using managerial provisions to flow down company management practices intensifies the need for the clarity, commitments, options, incentives and relational contracts described above, with a focus on how work is to be done. The company would need to invest in continuing to deeply understand functions that it has outsourced, which can be contrary to the objectives of many companies in outsourcing non-core functions. Thus, companies in big deals tend to use managerial provisions only where the supplier’s adherence to the company’s standards is important to the company’s larger business and the company is confident that its standards are superior to those that the supplier would otherwise implement.

MODULARITY

Companies also seek to address uncertainty through modular deal structures, essentially structuring a big deal as a set of smaller deals. Extensive data supports the proposition that “modular is faster, cheaper, and less risky” in a variety of scenarios.⁷ Modularity explains the successful economics of, for example, cloud computing, which is based on immense numbers of individually low-powered devices.

The modular approach has many variations. Some companies divide a large scope into modules and contract for them separately, allowing them to be reduced or added as needed and containing the risk of particular uncertainties within a module. Others take a modular approach across time; for example, structuring a transition in many waves and using an agile process for learning from each transition wave to make the next transition wave more successful. Still others divide modules by deal structure. For example, a function might be divided into modules priced on inputs, modules priced on outputs, and modules priced on outcomes. This allows the company to leverage the best approach for each scope.

Using a modular approach also helps to make the approaches described earlier in this article more feasible. A group of specialists on a module can optimize clarity, commitments, options, incentives, relationships, and managerial provisions for that module. They can govern that module knowledgeably through teams, committees, and decision rights. Companies can apply managerial provisions to modules where the benefits justify the investment (and omit managerial provisions from other modules). In parallel, an overall deal structure with cross-module governance and cross-module services can help to optimize value across modules and shared functions.

CONCLUSION

In big outsourcing deals, companies use various approaches to securing and delivering value amid rising levels of uncertainty. These approaches generally involve better coordination across enterprise boundaries and building flexibility into contracts to be more prepared for a larger range of conditions. When they fit the deal, these approaches can help to reduce the risks and capture the benefits of having critical functions performed by outside suppliers in increasingly uncertain times. These big deals have paved the way for ever-wider use of these approaches to maximize value and avoid costly pitfalls.

¹ See more generally the World Uncertainty Index at https://worlduncertaintyindex.com/.

² See Robert Gibbons, Rebecca Henderson, Relational Contracts and Organizational Capabilities, ORGANIZATION SCIENCE 23(5), 1350-1364 (2011).

³ See Brad Peterson, Estimating the Value of Contract Terms in Sourcing Agreements, Contract Management, Apr. 2012, available at https://www.mayerbrown.com/-/media/files/news/2012/04/estimating-the-value-of-contract-terms-in-sourcing/files/contractmanagement4-12/fileattachment/contractmanagement4-12.pdf.

⁴ Lisa Bernstein and Brad Peterson, Managerial Contracting: A Preliminary Study, 14 JOURNAL OF LEGAL ANALYSIS 1, 176–243 (2022), https://doi.org/10.1093/jla/laac007.

⁵ See CENTRE FOR ECON. PERFORMANCE, World Management Survey, https://worldmanagementsurvey.org/. See also, Chad Syverson, What Determines Productivity?, 49 J. ECON. LITERATURE 326, 329, 336-338 (2001) (discussing the design of the WMS and the “steps [taken] to enhance the accuracy and consistency of the survey.”).

⁶ Nicholas Bloom, Raffaella Sadun & John Van Reenen, Management as a Technology? (Nat’l Bureau of Econ. Rsch., Working Paper No. 22327, 2017).

⁷ Bent Flyvbjerg, How Big Things Get Done: The Surprising Factors that Determine the Fate of Every Project (Random House, 2023), at 173.