Adolfo Kunz
Adolfo Kunz

The Ultimate Guide to Service Levels in Outsourcing Agreements: Part 4

Introduction

In the previous article, we discussed the importance of building Service Level Management processes that incentivize the right behavior from third-party vendors, including key concepts that are used to properly manage the services and prevent value erosion. Third-party vendors need to show confidence and commitment in the quality of the products and services they deliver, assume accountability, and be incentivized to take action to prevent/correct any issues.

In this final article, we will do a deep dive on the type of actions that can be triggered by a well-defined Service Level Management process and how to deal with risks and third-party vendor concerns. These actions can deliver added value to both the third-party vendor and the organization beyond the measurement of performance.

 

Balancing Risk

In outsourcing deals, third-party vendors share risks with clients by providing a defined set of products or services, for an established price, with a minimum committed level of service.

During the term of the agreement, the in-scope products or services and associated pricing remain relatively unchanged (without a change order). Likewise, with Service Levels, the minimum performance target doesn’t change. However, actual performance can vary due to multiple circumstances within or out of the control of the parties, impacting third-party vendor revenues and/or client business results.

In outsourcing contracts, some provisions sought by third-party vendors to mitigate risk and protect their interests include:

Risk Mitigation Strategy
Minimize the At-Risk Amount
Use a fixed At-Risk Amount (not linked to contract value over time)
Avoid or minimize the Allocation Pool
Avoid or minimize the use of Multipliers for multiple or recurring misses
Avoid or limit Service Level Metric adjustments (committed performance improvements) over time
Baseline Service Levels based on historical performance
Use formulas that minimize the risk of missing a Service Level
Incorporate caps for individual Service Level Metrics
Incorporate Earn-back terms and conditions
 
 

These provisions have been discussed in our previous articles or will be discussed later in this article.

While it is understandable for a third-party vendor to protect their interests and minimize risk, clients, as part of the contract negotiation strategy, equally need to make sure their interests are protected. To reach a fair and balanced agreement, they need to understand and be ready to negotiate in some or all of these contract provisions.

Common mistakes that organizations make when defining their Service Level Management processes include:

  • Being over-aggressive / under-aggressive with Service Level requirements
  • Over-engineering of the Service Level Management processes
  • Underestimating the value of the Service Level Management processes
A
Being over-aggressive / under-aggressive with Service Level Requirements

The Service Level methodology and the metrics defined need to be realistic and fair, should align with business needs, and be achievable by the third-party vendor using a combination of the tools and capabilities that both the organization and the third-party vendor provide.

The lack of or low Service Level targets and/or a poorly designed Service Level methodology will undermine the value to the organization, while aggressive Service Level targets and/or Service Level methodology will add unnecessary complexity and cost.

Organizations hire suppliers to improve the service performance at least to market standards and expect incremental performance at a lower cost, but additional capabilities or significant increases can only be achieved through investments. Organizations need to clearly state their expectations during the development of the requirements and definition of the Service Level targets and the methodology to be used.  In turn, third-party vendors, as part of the proposal and contract development process, must be transparent and include any investments and timing required to meet those Service Levels targets.

It is not infrequent for third-party vendors to deliver proposals with the assumption that Service Levels are to be maintained as-is, or that all capabilities to be delivered to client-defined expectations are in place, rather than assess and design the solution as initially requested, and if necessary, challenge the client’s thought process.

B
Over-engineering of the Service Level Management processes

An over-engineered Service Level Management process adds complexity and cost and can deteriorate value. Organizations add complexity by trying to (i) measure minute metrics rather than understanding the services from an end-to-end perspective, (ii) use data that is difficult to collect, inaccurate or ambiguous, (iii) create complicated algorithms and formulas, and (iv) establish complex governance structures and processes to monitor, validate, and attempt to make decisions with the data provided.

Service Level Management processes need to be designed to consider the value they will deliver to the organization. Best practice is to focus on establishing only those metrics and processes that provide meaningful information and drive actions to help the business improve.

C
Underestimating the value of the Service Level Management processes

To think about the Service Level Management process only as a dashboard to monitor the performance of any group of third-party vendors against a set of agreed or targeted minimum performance standards, deteriorates the value received.

As described in other articles and later in this document, in addition to any punitive actions, a well-defined Service Level Management would include processes that will help organizations:

  • Proactively identify:
    • Potential service issues or risks by looking into trends (risk mitigation)
    • Opportunities for improvement
  • Measure the impact of:
    • Preventive / corrective actions
    • Continuous improvement initiatives
    • Innovation initiatives
 

Actions Triggered by the Service Level Management Process

Within an outsourcing relationship, the consequences of missing a defined target or presenting a negative trend over time can vary significantly. In most instances, these take the form of punitive actions that can range from service credits to more severe sanctions, such as contract termination.

It is very important to understand that organizations have the right, but not the obligation to enforce any or all the consequences established in a contract. Sometimes the organization may decide not to take action to maintain a healthy relationship, which is usually the result of the perceived commitment and response from the third-party vendor.

The consequences of a missed Service Level should be linked to the business impact associated with an appropriate metric. For example, consequences on metrics associated with business performance are more severe than those associated with non-production environments, continuous improvement, or innovation.

The following table shows the typical actions taken:

Event Type Potential Actions(s) Triggered
Missed Service Level target Service Level Credits For all Critical Service Levels (CSL) a percentage of the At-Risk Amount (Service Credit) is paid by the third-party vendor to compensate for the impact caused to the organization business.
Root Cause Analysis (RCA) / Action Plan For specific Critical Service Levels (CSL) and/or Key Performance Indicators (KPI) the third-party vendor needs to perform a formal RCA to identify the cause of the miss, and/or design and implement an action plan to prevent it from happening again.
Termination Event For high-impact Service Levels, the organization can have the option to terminate the contract (full or partially) for cause.
Negative Trend on a Service Level Root Cause Analysis (RCA) / Action Plan For all Critical Service Levels (CSL) and/or Key Performance Indicators (KPI) that are showing a negative trend over a period (e.g., 3 consecutive months), third-party vendor needs to perform a formal RCA to identify the cause, and/or design and implement an action plan to prevent a miss.
 

Other actions triggered by Service Level Management processes

As mentioned previously, comprehensive Service Level Management processes should be considered as part of the contract with a third-party vendor, and should be used to:

  • Identify Potential Risks / Issues
    Identify and analyze negative trends or events having a major impact on a specific metric to discover potential service delivery issues or risks.
  • Identify Opportunities of Improvement
    Assess if a Service Level metric or target remains relevant for the organization over time–these may become inadequate or insufficient to meet business demands. Organizations should continuously assess the service components and activities involved in achieving an established Service Level target and identify those areas where the service can be optimized and the performance improved. In many instances, the improvement activities will require investments that need to be justified in light of the value delivered.
  • Measure impact of Preventive / Corrective actions
    Assess the impact of actions implemented to prevent or correct an identified issue through the Service Level metrics. Organizations should be able to see changes in performance through a correction or positive trend in the Service Level and the mitigation of potential risks.
  • Measure impact of Continuous Improvement initiatives
    Assess the impact of the implementation of Continuous Improvement initiatives in the performance of the services being measured (e.g., responsiveness, availability, etc.). These initiatives may trigger the need to update the Service Level targets or their definition (e.g., increased automation may help reduce response times and/or reduce downtime) or to establish new Service Level metrics.
  • Measure impact of Innovation
    Assess the impact of the implementation of Innovation initiatives in the performance of existing Service Level metrics or through the implementation of new Service Level metrics. These initiatives may also trigger the need to update existing Service Level metrics, targets or their definition, or to establish new Service Level metrics.
 

Dealing with Special Situations

There are other situations that need to be considered when establishing an agreement with a third-party vendor. Understanding the issues and the way to address them can help reduce conflicts and improve the value received by the organization and the end-users of the products or services.

 
A
Reporting of Service Levels Metrics

End-users often complain about the misalignment that exists between the reported Service Level metrics and the actual performance perceived. This is usually the consequence of poorly designed governance processes and a lack of communication.

While the intent is to outsource end-to-end services, these are frequently not fully controlled or managed by a single third-party vendor (e.g., network carriers aren’t solely responsible for user-perceived response times). To prevent this, organizations can:

  1. Seek for the third-party vendor to assume end-to-end accountability for the services, by having them subcontract (assume) all the required service components and actively negotiate and manage all associated software/support contracts; and/or,
  2. Build a Service Level reporting structure that provides transparency into:
    1. The actual performance of the services delivered to the end-users, clearly identifying the impact caused by all parties involved, and,
    2. The actual performance of the services reflecting only the impact caused by the third-party vendor.

Service Levels are useless if they are perceived as inaccurate by end-users or unreliable to support business decisions.

B
Multiple / Recurring Service Level Misses

There are situations where more than one Service Level target is missed by the third-party vendor during a given measurement period or a single Service Level target is missed recurrently. These situations may be the result of a poor Service Level design or a larger operational issue and need to be addressed accordingly.

Organizations need to consider these types of situations as part of the contract, as they may have a significant impact on the business if not addressed promptly.

  1. Considerations for multiple Service Level targets missed during a measurement period:
    1. To the extent possible, use Service Level metrics and targets that are mutually exclusive.
    2. Define the number of multiple misses that would be considered unacceptable.
    3. Establish the provisions to be used when multiple Service Level targets are missed due to a single event (e.g., apply the consequences linked to the most impactful Service Level target missed).
    4. Establish the provisions to be used when multiple Service Level targets are missed during a measurement period (e.g., apply a multiplier to the Service Level credits associated with the Service Level targets missed).
  2. Considerations for recurring failures of a single Service Level target:
    1. Define what “recurring” means within the contract, establishing the number of times a Service Level target is missed over a discrete number of measurement periods (e.g., 3 consecutive misses, 3 misses in 6 measurement periods)
    2. Establish the provisions to be used for recurrent failures of a Service Level target, as defined in the contract (e.g., apply a multiplier to the Service Level Credits associated to subsequent Service Level targets missed, conduct a root cause analysis, develop an action plan, etc.).
C
Excused Performance

There are situations where the third-party vendor may have a valid argument to excuse themselves from failing to perform to the Service Level targets committed. But these situations need to be addressed before the contract is signed.

Some of these situations include:

Situation Description Issue Mitigation
Inaccurate information / assumptions provided by client prior to service Information provided to the third-party vendor to prepare the proposal is incomplete or inaccurate.

Third-party vendors will condition Service Levels to the verification of initial assumptions.
Service Levels targets set post-contract negotiations are harder to agree with and do not align with business needs. Focus initial Service Levels on market standards as a minimum, to be met and priced accordingly by the third-party vendor.

Conduct due diligence to confirm data and assumptions and get commitment from the third-party vendor before the contract is executed.
Non-performance by the client organization The third-party vendor is unable to meet the Service Level targets because of a decision/ action or the lack of it by the client team. Potentially creates dissatisfaction with end-users and conflict between the parties as Service Level targets are not met and the “blame game” is played. Clearly identify roles and responsibilities between client and the third-party vendor.

Have the vendor assume end-to-end responsibility of services, sub-contracting / assuming responsibility for all service components.

Create a reporting structure that accurately reflects the performance of services for the end-users, and the performance of each party involved.
Non-performance by another client third-party vendor The third-party vendor is unable to meet the Service Level targets because of a decision/ action or the lack of it by a client managed third-party vendor.
Force Majeure An extraordinary event that is not under the control of the client or the third-party vendor. Impact to the client business and its end customers for an undetermined period. Clearly define what constitutes a Force Majeure event.

Have a documented and tested Business Continuity / Disaster Recovery plan for critical solutions that mitigates the risks and enables the third-party vendor to recover the client business operations within established timeframes.
 

Conclusion

In this article, we discussed the different actions that are triggered by a well-defined Service Level Management process, the main third-party vendor concerns and how to address them, and recommendations for handling special situations.

The right Service Level Management processes and metrics can be powerful tools for organizations: they not only enable the organization to monitor and manage the performance of third-party vendors, but also help identify and manage potential risks (by sharing risks with the third-party vendor and proactively identifying potential issues through trend analysis). They can be used as a tool for continuous improvement (by setting performance targets and measuring results against those targets).

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Adolfo Kunz
Senior Specialist

Adolfo Kunz has more than 33 years of experience in IT sourcing, strategy, operations, transformation, cost optimization, service management, vendor management, IT due diligence, and planning for mergers and acquisitions, business development, program management, and project management. He has worked with Fortune 500s in a variety of industries, including energy and resources, oil and gas, consumer packaged goods, retail, transportation, financial services, healthcare, and manufacturing.

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