Exclusivity and best service pricing in outsourcing
Outsourcing and managed network services contracts are typically longer term arrangements that run for terms of four to seven years. Often customers agree to an exclusive or part-exclusive relationship with a supplier in order to secure the supplier’s best pricing. In return, the customer is usually ‘locked in’ to one supplier and must acquire all of their technology and telecommunications needs from that supplier.
As technology is improving and evolving so rapidly, the hardware and software that the customer agrees to acquire at the start of the relationship and which is listed in the contract, may be out-dated after three or four years. This means that the pricing agreed in the contract may also not reflect the current market price. However, as the relationship may, to some extent, be exclusive, the customer is not permitted to acquire products outside of the agreement on the open market. The lack of market pressure may mean what was a good deal at the beginning now results in the customer is paying significantly over the odds mid-way through the relationship and unable to avail of services and products from other supplier or new market entrants.
What is a benchmarking clause?
A benchmarking provision allows a customer itself, or through a third party benchmarking company, to compare the price, services and service levels in the contract against those of competitor suppliers and comparator customers. Essentially, a benchmarking provision is a market comparison clause that allows a customer to understand the competitiveness of its services are and ensure it is not trapped in an out-of-date arrangement where the charges are too high and the services deliver too little.
A well drafted benchmarking provision will identify key misalignments in the customer and supplier relationship and uncover where the services are not meeting best practice. Recommendations arising from the benchmark may be as straightforward as incorporating a lower price or adjusting a service level metric found to be inadequate or out of alignment with the market. In other situations, benchmarking might lead to the re-negotiation of some or all of the contract. Either way, the purpose of the benchmarking provision is to provide examples of better services and drive beneficial change in the customer and supplier’s arrangement.
Issues when negotiating a benchmarking clause
Negotiating a benchmarking clause can be contentious. Suppliers like to forecast fixed revenue across the whole term of a contract. A benchmark in the middle of the term that ratchets-down the contracted prices is not in the supplier’s commercial interests. The supplier will also be loath to let a third-party benchmarking company have access to and store the supplier’s confidential pricing information for the purposes of performing the benchmarking exercise and for use in other benchmarks.
Other issues that can arise when negotiating a benchmark clause include:
- How often should the benchmark occur? – annually, at the half-way point of the term or any time at the customer’s request?
- Who should perform the benchmark? – the supplier, the customer, or a third-party benchmarking company, such as Bain?
- Which party will pay for the benchmark? – should the supplier have to pay for the benchmark as a ‘penalty’ if the benchmark exercise finds its prices are higher than the market average?
- Who will be compared against whom? – are there enough valid comparators in the customer’s market? Should international competitors that are subject to different market forces be allowed in the comparison? If the customer is a bank can its services be compared to those acquired by a company in a completely different market, like a mining company?
If a supplier is resisting a benchmarking provision or not agreeing to defined outcomes after the benchmarking exercise is complete, a customer may try to include a shorter contract term to allow for the re-tender of the services after one or two years. This will open the service provision up to competition and can be used as leverage to argue for a mid-term benchmark. Although, it should be remembered that any re-tender comes with the added cost of the customer’s procurement department having to carry out the re-tender.
Comparing ‘apples with apples’
What are the appropriate pricing and service metrics to use in the comparison? The supplier will argue that it is difficult to accurately compare complex, client specific or unique outsourcing or managed services against the market as they are dependent on the unique characteristics of the customer’s environment, internal processes and risk allocation in the contract. Also, the volume of services that a customer acquires will directly affect the price as often a high volume of services over a longer term provides the biggest discounts. But it becomes more difficult when trying to compare high volume/low margins services against low volume/high margin services.
Should the customer be allowed to ‘cherry pick’ what it compares against?
One of the key questions when negotiating any benchmarking provision is whether the benchmarker compares the services and prices against other suppliers’ offerings to other customers as a whole, or simply against the best price in the market for individual services. What the parties agree here has enormous consequences for the outcome of the benchmark. For example, if Competitor A has low pricing for one service but higher pricing for another service that Competitor B has lower pricing for, should the customer be able to ‘cherry pick’ the best pricing in the market, where no single supplier could offer such competitive prices across its whole range of services?
What next? The conclusion of the benchmark exercise
If the benchmarking exercise finds that the supplier’s price is too high compared to other similar suppliers or the service metrics or performance levels do not meet the market standard, the question becomes ‘what next’?
Customers will often push for a contractual mechanism that automatically adjusts the price or service metric so that it is in line with the comparators recommended in the benchmarking report (or at least within a certain percentage of the best market rate available). Suppliers will try to soften the obligation and request that the parties simply talk about the results of the benchmark or that the supplier performs its own internal review. In extreme cases, a customer may ask for a termination right for an individual service if the supplier if not able to adjust the benchmarked service in line with the market.
On balance, a customer entering a long-term contract should always try to include a benchmarking provision to help it achieve best value for money and quality of service over the term. However, when used cleverly, benchmarking provisions do more than offer leverage for customers, they can give the customer a strategic advantage and drive beneficial change into the parties’ relationships and contracts.
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