AI moves the dial on addressing tech change in outsourcing contracts

Although cost savings driven by technology change is not a new issue in outsourcing, the rapid pace of technology change recently has brought this into sharp focus, particularly when considered against the fact that long-term strategic outsourcing contracts can last for 10 years or more. It is difficult to predict what the technology landscape will look like in two years, let alone a decade.

Suppliers may contend that if they are investing in the technological innovation, they should enjoy the rewards of that investment, but with the possibility that technological advances will lower the supplier's cost of delivering outsourced services during the lifetime of their contract, customers will want to ensure they do not end up paying above the market rate for the services or that the supplier profits disproportionately.

In addition to having joint innovation projects in the outsourcing deals that need them, it is also important to consider the situation where the customer is not directly involved in the innovation, but the supplier is using it for its service delivery “behind the scenes”.

A possible way to provide the customer benefit in this situation is to use a gainshare arrangement where the customer gets some of the savings from improvement when the supplier makes very high profits. However, the difficulty will be in finding out when continuous improvement affects the services within the scope, whether the level of very high profits has been achieved, and whether the customer can access enough financial information from the supplier to check the profits made – probably a touchy issue for most suppliers.

Technology upgrade requirements are usually similar – they may require the supplier to provide yearly plans that show how it will update the systems and software that it is using to offer the outsourced services, but they will not normally require changes to the pricing under the outsourcing contract, unless this is decided on a case-by-case basis or under change management clauses.

Benchmarking is the customer's chance to "check the market" regularly. If the supplier agrees to benchmarking, it is usual to set some rules for it, such as, for example, that the customer can do it every few years, and that the supplier or contracts that the outsourced contract will be compared to are "similar". Restrictions on the frequency of benchmarking are reasonable, but with technology changing so fast, customers may need to review how often they can benchmark. It is fair to the supplier that it is compared to "similar" suppliers or services, but it is also crucial that the criteria for what is similar are not so strict that the benchmarking cannot happen in reality. In complex outsourcing deals, this can be solved by splitting up the services into different parts and running a series of benchmarks across different service lines.

A related challenge can arise around the final outcome of a benchmarking process. Sometimes suppliers will accept benchmarking but the result of the benchmarking exercise is not enforceable. Instead, the conclusion of the process can open up commercial discussions between the parties, which weakens the effect of the benchmarking. If benchmarking becomes more significant in the context of a long-term outsourcing agreement, customers may be inclined to push for the exercise to have more of a mandatory outcome. One way to do this, would be to include mandatory benchmarking as part of the customer’s original ‘request for proposal’ (RFP).

Some customer clients take the view that they do not want to spend their budget on negotiating benchmarking provisions, because they are convinced they will never use them. That might change in the future, but in any case, benchmarking provisions can help to initiate a conversation with the supplier. If both the customer and the supplier are reluctant to do a formal benchmarking exercise, it could nevertheless prompt a commercial discussion that results in a price adjustment that both are happy with, avoiding the need for benchmarking.

Suppliers might claim that when an outsourcing deal is not exclusive, the customer can compare prices with other options. In reality, though, most customers would say that running RFP processes and negotiating complex outsourcing deals are not worth the time and cost just to test the market. Customers might try to look for better prices for some parts of the services and use the non-exclusivity or even partial termination rights in the contract to switch to a better offer. However, they also need to think about the possible costs and difficulties of having different suppliers deliver the services – customers will need to consider how the services depend on each other and interact.

Some customers may use “most favoured customer” (MFC) clauses to try to get the best price over the duration of an outsourcing contract. MFC clauses aim to prevent the supplier from offering the same or similar services to other customers at a lower price than the most favoured customer. However, MFC clauses are usually subject to equally strict normalising provisions as benchmarking, which may make them difficult to apply in practice. Moreover, they can raise competition issues, depending on the market share of the customer.

Some outsourcing contracts are based on cost-plus models – where the supplier's cost to deliver the services is paid by the customer, along with a fair and agreed-upon margin. This can deal with the potential that technology enhancements lower the delivery cost of the services for the supplier, letting the customer also enjoy this benefit. However cost-plus models will usually depend on "open book" principles, where the supplier shares data on its costs to deliver the services with the customer. Suppliers may be hesitant to reveal internal resourcing costs, which they may view as confidential business information.

Customers should also be aware that, in a cost-plus model, while they may benefit from lower costs of doing business, they may also face higher charges if the costs of delivering the services go up, which is possible in the current economic situation. A possible solution would be to negotiate with the supplier that it takes on some of the risk of rising costs and lowers its profit margins if costs exceed a certain limit. Another issue with cost-plus models is that the supplier may have no incentive to cut its costs by innovating, since it can pass costs on to the customer – this would need to be addressed by requiring continuous improvement from the supplier.

Often outsourcing agreements are entered into with lengthy terms of 10 or even 15 years, which has been a way for suppliers to offer savings, knowing that they have a commitment from the customer. However, it may be that customers are less willing to commit to long-term outsourcing contracts against the background of rapid technology change and its impact on pricing.

Another possibility is to insert "break" clauses in a lengthy outsourcing deal every couple of years. This would allow the customer to bargain for better prices, but it might also result in suppliers hiking up the initial annual prices because of the reduced commitment. Customers will have to weigh the pros and cons of paying more at the start versus having the power to adjust the prices when the contract is up for review.

AI has been driving technology forward at a rapid pace, especially in the last couple of years. Customers should consider adding clauses to their long-term outsourcing contracts that ensure they also benefit from the supplier's tech innovations.

Co-written by Madeleine Barratt of Pinsent Masons. Pinsent Masons is hosting a webinar on the topic of how to contract for AI, on Wednesday 10 April 2024. The event is free to attend – registration is open.