The contract is the key instrument controlling an enterprise's relationship with its
vendors. Service contracts are becoming increasingly complex due to service
diversification, multisourcing, and offshore outsourcing.Develop and manage
contracts effectively in order to maximize the returns from vendor and service
provider relationships.
This article was originally published by Info-Tech Research Group. Copyright (c) 1998-2008 Info-Tech Research Group. All rights reserved. Reprinted with permission.
Contracts are binding agreements between two parties that are legally
enforceable and fall within the domain of contract law. Each contract has three
basic components: offer, acceptance, and consideration.
The offer is the proposal itself that is communicated to the contracting
party.
Acceptance is acknowledgement that the offer was accepted.
Consideration is the bargained exchange, in this case generally cash.
In order for a contract to be valid, it must be worded correctly, legally valid, and
agreed to by a competent person who has the authority to make the agreement
on behalf of his or her firm.
Business contracts must be reviewed by the legal department to ensure that the
language is correct, that the contract is valid, and that its clauses fall within the
law. This can be important, because there are numerous hidden obstacles here,
such as limitations to liability, consumer guarantees, and the like that might not
be immediately apparent. Likewise, contracts should be reviewed by the finance
department, since expenditures will need to comply with company policy, and
there may be financial "tests" such as Return on Investment (ROI) that need to be
applied or differing approvals required at different cost levels.
Contracts perform two basic purposes:
1. Create a record of the terms of the agreement between two parties, and
2. Protect the legitimate interests of those parties.
The contract determines the ground rules and describes how the relationship
should operate. Maintaining flexibility is important. The key to avoiding conflicts
is to anticipate as many contingencies as possible. Contracts need to be flexible
and provide for change in the environment. Service contracts also need to be
backed by an adequate service-level agreement and metrics to adequately
measure compliance.
Contract provisions also must be geared to meeting the specific needs of the
business. This means setting a reasonable period during which the contract is to
run, and ensuring that service levels meet company objectives.
This Research Report will offer information and insight about how to effectively
manage IT contracts. It will look at long-term service, equipment, and outsourcing
contracts. Smaller items tend to fall within the range of general procurement
where contracts, if they exist at all, tend to be considerably less complex than
those for large products and ongoing service contracts.
Essential Contract Components
A contract is a complex legal document containing clauses that might include
a high degree of technical detail. Contracts for the purchase of goods are
relatively simple because the purchase is a one time event. Contracts for
services, or which include a service component, are considerably more difficult
because they may include a wide range of intangibles as well as requirements for
ongoing activity.
Basic components of a service contract are the following:
Agreement to provide services.
Conditions and controls.
Service level agreement.
Penalties, remedies, and termination clauses.
Agreement to Provide Services
This is the basic structure of the
agreement, laying out the services that
are to be provided and the rate to be
paid. This needs to be as specific as
possible, and forms the basis from which
service levels can be agreed upon.
Conditions and Controls
This is the general category in
which details are set up to enable
the contracted services to work. If
infrastructure components are involved,
their ownership and control must be
established, as well as what will happen
to them if the agreement should be
terminated. A management structure
needs to be put in place for services, and the interface between buyer and
supplier must be established. Areas of responsibility need to be established, and
there also need to be agreements as to how the service and service levels will be
monitored. To ensure that the contracted service remains at satisfactory levels,
contract details and services need to be monitored on a regular basis.
Issues to consider here include those which are specific to a particular contract
and the established general structures and procedures under which a firm is handling service contracts, such as contract centralization, Vendor Management Offices (VMOs), and required contract provisions.
Service Level Agreeent (SLA)
The SLA lists specific levels of service that are to be provided by the supplier. The
cost of the contract is generally geared to the level of service required, so it is
important to get this right. Too much service can be expensive, while too little can
fail to support the business processes for which the service is required.
The SLA is important because it's generally linked to incentives and penalties that
ensure the required business objectives are achieved. If the service provider falls
too far behind in meeting the SLA's provisions, it may be considered cause for
terminating the contract, with significant penalties to the service provider. SLAs
ensure accountability on the part of the service provider and also determine the
price of the service.
Setting an appropriate service level specification is important because it guides
the measurement process, and is also used by the service supplier to determine
the price of the contract. To set an appropriate service level, it's important to
review the entire process and determine reasonable benchmarks and how they
can be measured. The following is a process for making this decision:
1. Determine the service to be measured, whether it's the objective to be
achieved, the process itself, or the product.
2. Choose the attribute to measure, determining the most critical
components of the service and relationships
3. Select the precision of measurements to be used.
4. Determine the current in-house service levels and costs sustained for that
service level. Compare these to industry standards, and determine how
much improvement is required.
Each service-level specification should contain a definition of the metric and
what's being measured; a description of the reason for measuring the metric; a
description of the method and process for capturing the data; and a statement
of the timing interval for measurement.
Penalties, Remedies, and Termination
Penalties and remedies are set up to ensure that the service level specified in
the SLA is met, and that the buyer is compensated for negative effects of service
below agreed levels. Conditions under which the contract can be terminated
must also be specified. This will generally include conditions such as inability of the
vendor to meet SLAs; merger or acquisition of the vendor; merger or acquisition
of the buyer; large scale change in technology or requirements; and so forth. In
general, the easier it is to break the contract, the more expensive the contract
will be.
Penalties are generally financial, and need to be high enough that the vendor
does not simply account for them as a standard charge; however, they need to
be low enough that continuing to provide the service will remain viable.
In the event of continuous breaches of service levels or other conditions that
make the contract untenable, there must be an exit or termination clause clearly
specifying the conditions under which the contract will end. If the contract ends,
it is important to remember that this, too, requires careful planning in transitioning
to an in-house operation or to another supplier. Break ups can be extremely
expensive.
Termination clauses are of two varieties: For Cause and For Convenience.
For Cause is the most common, and requires a breakdown in service
provision triggering a no-penalty end to the contract. Otherwise, a
penalty is paid by the client for terminating the relationship.
For Convenience termination clauses permit arbitrary contract
termination. In most cases, such a clause is extremely expensive, but it can
be useful in short-term trials and other situations where the length of the
contract is indeterminate.
Following are examples of key termination clauses that should be included in
an outsourcing contract. Note that these are intended for information purposes
only, and contract provisions and language should never be added without the
advice of a lawyer.
Termination for Cause. (BUYER) may terminate this contract for
cause based upon the failure of the Service Provider to comply with
the terms and/or conditions of the contract; provided that (BUYER)
shall give the Contractor written notice specifying the Contractor's
failure. If within thirty (30) days after receipt of such notice, the
Contractor shall not have either corrected such failure and thereafter
proceeded diligently to complete such correction, then (BUYER)
may, at its option, place the Contractor in default and the Contract
shall terminate on the date specified in such notice. The Contractor
may exercise any rights available to it under (STATE/PROVINCE) law
to terminate for cause upon the failure of (BUYER) to comply with the
terms and conditions of this contract; provided that the Contractor
shall give (BUYER) written notice specifying (BUYER)'s failure and a
reasonable opportunity for the (BUYER) to cure the defect. 1
Termination for Convenience. (BUYER) may terminate the Contract
at any time by giving thirty (30) days written notice to the Contractor.
The Contractor shall be entitled to payment for deliverables in
progress, to the extent work has been performed satisfactorily. 2
