Today’s Win-Win Approaches for Outsourcing Contracts

Today’s changing business environment continues to create new win-win opportunities through new outsourcing models. This Legal Update provides examples of those new models and potential benefits to both the companies and their suppliers.

New Innovation Opportunities

The business environment has changed in two key ways. First, advances in artificial intelligence (AI) and other automation technologies have created new opportunities to replace human labor with digital labor. Those advances allow suppliers to offer companies unprecedented levels of operational savings, premised on automation, while deals premised on automation may offer other benefits as well. Automation can go beyond human capabilities—certainly in speed and accuracy—and in other forms of value.

Second, companies are increasingly concerned about risks and uncertainties, such as supply chain disruptions, cyberattacks, new regulations, and force majeure events. Companies are thus more willing to pay suppliers a premium to mitigate more risks. For example, companies are more willing to invest in designing, building, testing, and maintaining fail-over processes and redundant systems.

Thus, in this new business environment, suppliers can offer services that are not only cheaper, but better, faster, safer and cheaper. However, the supplier’s ability to do so may depend on cooperation by the company. For example, the supplier may need to build, maintain, and run AI and other automations on the company’s systems, and work closely with the company to update those automations as the company updates its systems and processes.

Limits of Traditional Deal Structures for New Innovation Opportunities

These benefits do not arise naturally under traditional outsourcing deal structures. For example, a pricing model based on full-time-equivalent resources (FTEs) or other inputs provides limited incentive for the supplier to innovate, because the supplier’s revenue will be reduced if the supplier successfully automates away the need for FTEs or other inputs. Similarly, the fixed-price-with-volume-adjustments approach (such as “ARC/RRC pricing”) provides little incentive for the company to collaborate because there is no benefit for the company in reducing the supplier’s costs. In both cases—presumably to reduce cost—companies have accepted a great deal of risk that suppliers could mitigate through force majeure and other exculpatory clauses.

One approach to aligning the parties’ incentives in traditional outsourcing arrangements has been to agree on projects to perform specific innovations on a time-and-materials (T&M) or fixed fee basis. For example, an agreement might include a “Transformation Plan” with contractually required “Transformation Milestones” or an “Innovation Fund” to be spent on agreed projects. Alternatively, the agreement might provide that the parties simply agree from time to time on projects and their funding.

Unfortunately, innovation has been notably difficult to obtain through traditional T&M or fixed-price transformation projects. On T&M projects, suppliers increase profit by increasing the size of the project instead of the value of the innovation delivered. With fixed-price projects, suppliers increase profit by completing the originally scoped work at the lowest possible cost, leaving innovation opportunities for future projects,—because the supplier does not directly benefit from better innovation. Thus, neither approach aligns the supplier’s interests optimally, or even particularly well, with the company’s goal of maximizing efficiency and effectiveness.

Another approach in traditional outsourcing arrangements has been to include general commitments to innovate. These include both clauses specifically calling for “innovation” or “continuous improvement,” and clauses requiring performance in accordance with contemporary market standards and practices. These have been difficult to enforce in practice. More specific criteria, such as obligations to use reasonably current (e.g., “n-1”) software, have been more enforceable, but also are more limited in value. As a result, companies are often disappointed to find that the pace of innovation actually slows down after outsourcing.

A third approach has been for the company to transform functions on its own, separate from outsourcing. However, that approach foregoes the strengths of external service providers. External service providers have vastly more experience with automating non-core functions. They can leverage solutions over many customers, spreading the costs. They generally have more ability to hire talent in AI and other transformative technologies. And, done well, contracting with external service providers can allow the company’s management to focus on its core business.

New Win-Win: Optimizing Alignment for Innovation

Optimal alignment between a company and its supplier is difficult in practice because each party seeks to maximize its own profits. In theory, however, the optimal level of alignment is what would result if the company and the supplier were wholly owned by the same ultimate parent company. That parent company, as a single owner, could optimally combine the company’s unique skills and market opportunities with the supplier’s economies of scale, expertise, and tools for innovation efforts. Those combined efforts would adapt to changing circumstances efficiently, not hindered by separate teams pursuing separate profit-and-loss objectives.

The difference between that single-owner optimum and traditional outsourcing agreements motivates many companies to use internal shared services organizations instead of outsourcing. Those companies see acting outside of their core competencies as being more efficient than traditional company-supplier outsourcing contracts. Other companies, however, are more directly aligning incentives with better contracting approaches for outsourcing. The following is an example with three levels of investment and benefit.

Level 1: Allow Supplier to “Own” the Innovation Opportunity

Companies often have work performed by people that is repetitive enough to automate, but too company-specific for any one-to-many product available on the market. Often, a business-case analysis shows that automation with internal resources would be a win for the company, but automation by a specialist supplier would be a bigger win. There is tension, however, in that the company would need to share that bigger win with the supplier, along with control over the “what,” “how,” and “when” of automation. As noted above, traditional outsourcing models do not align incentives well for success.

One solution is to structure the outsourcing deal so that the supplier essentially bears the full cost but also receives the full benefit of the innovation opportunity. For example, a contract might provide that:

• Typical managed services terms apply, including a commitment by the supplier to provide “like-for-like” services scope and service levels.
• The supplier’s charges are based on the volume of work done, not the inputs used to do the work, and reflect the benefits to the supplier of the innovation opportunity.
• In addition to the transformation and technology obligation in its technical solution, the supplier has the right to automate the work. That right is subject to specified constraints designed to reduce the risk and the cost of the automation to the company. Foremost among these constraints might be requirements to comply with the company’s relevant policies, build on agreed platforms using agreed tools, avoid steps that would increase fees under or violate the company’s agreements with third parties, implement guardrails and monitoring to address known AI risks, implement only after approval by the company, and immediately suspend and correct malfunctioning AI bots.
• The supplier agrees to update its automations as the company’s operations change. All updates would be subject to the same constraints described above. Pricing would be provided for discretionary changes requested by the company.
• The company agrees to support the supplier’s automation of the work. For example, the company might agree to provide third-party licenses as requested by supplier for customer-approved AI bot platforms, documentation on customer systems, access to the company’s systems and data for approved AI bots, assistance in testing AI bots, and advance notice of future changes that may affect the operation of its AI bots.
• The company also agrees to make certain types of changes in the company’s people, processes, and technology. These changes would be managed in a manner consistent with how the company manages similar internal changes, such as adherence to the company’s technical change control procedures and obtaining approvals from the company’s change control board.
• The performance standards that apply to the work—often speed and accuracy in copying data—are modified following automation to reflect the value and risk of the work as automated. For example, if the automation will use generative AI (GenAI) to respond to customers, the contract might introduce metrics based on the customers’ self-reported satisfaction or the average number of “hallucinations” found in a review of the responses from the GenAI solution.
• The contract provides the company with sufficient rights to the automations to allow the company to continue use after exit, and to smoothly transition to another provider or internal processing.

By having a single “owner” for an innovation opportunity, this deal structure facilitates efficient and effective investments in transforming service delivery. The win-win in this “Level 1” structure is a reduction in cost for both parties.

Level 2: Pay for Innovation

The second approach uses pricing to drive innovation that improves the output of the work, such as by making that output better, faster, cheaper (to use), or safer. It achieves this by having the company “pay for performance.” For example, if speed is a primary objective, the pricing for outputs might be higher for faster instead of slower work. As another example, if reliability is a primary concern, there could be bonuses for rapid recovery in test or actual business continuity events. In this approach, the win-win is in creating a profitable investment for the supplier while providing net business gains for the company.

This approach is more difficult for the company to analyze and value than a traditional outsourcing model or the “Level 1” approach. In those cases, the supplier is agreeing to provide the company with the same benefits for less money. The company thus analyzes whether the savings justify the loss of control, difficulty of exit, and other risks of outsourcing. With this “Level 2” approach, the company must estimate the value of the innovation, net of unintended consequences.

In addition to the “Level 1” terms described above, a “Level 2” contract might define, for example:

• How the parties will measure how much better, faster, or safer the work has become.
• How much the company will pay for each unit of quality, speed, or risk reduction.
• What fee reductions will apply if the work becomes worse, slower, or otherwise harmful to the company.
• Termination charges or other pricing if, after the supplier has invested in the innovation, the company decides not to use it.

To optimize these provisions, the parties would involve relevant stakeholders. For example, the company would involve the business users who will benefit from the innovation, the operational teams that will integrate with the innovation, the compliance and risk teams governing the work, the technical teams that will integrate the innovation with existing technology, and the financial team working on the business case. While contracting for this approach will be more complex for the reasons stated above, this approach, in the right circumstances, has the potential for value far beyond paying less for the same services.

Level 3: Partner for Innovation

Partnering for innovation offers opportunities for better alignment by creating new profit to share between the company and the supplier—by “partnering,” we mean sharing the risks and rewards of a shared endeavor within a commercial contract, rather than a legal partnership. Thus, in a “Level 3” model, both the company and the supplier would agree to innovate. In addition to agreeing to cooperate with the supplier’s innovation, the company would agree to innovate in ways that facilitate the supplier’s innovation and achievement of “Level 2” rewards.

As an example, imagine that the opportunity is to use GenAI to provide a chatbot to respond to inquiries from customers and market additional products. In a “Level 1” approach, the supplier could simply train its GenAI model on the company’s playbook and perhaps transcripts from call center discussions. In a “Level 2” approach, the supplier might also be compensated on sales revenue or customer satisfaction metrics. Under a “Level 3” approach, however, the contract might, in addition, require the company to:

• Develop new “best practice” responses and risk “guardrails” to be used in training the GenAI model.
• Develop secondary databases, application program interfaces (APIs) or other technology to make the company’s data more readily available to the supplier’s GenAI-based automations.
• Dedicate resources and funds to market the supplier’s chatbot to its customers, thus increasing uptake and potential revenues to the supplier from the “Level 2” pricing.
• Assign a team to test, monitor and develop continuous improvement recommendations.

A “Level 3” pricing structure could also provide monetary incentives for the company to make these facilitating innovations. For example, if the “Level 2” pricing rewards the supplier based on the revenue from its chatbot’s suggestions on additional products, the company might receive a discount based on the amount of data available to the supplier’s chatbot through the new APIs, or the number of the company’s customers who engage with the chatbot. As another example, the company’s completion of a facilitating innovation might trigger an obligation for the supplier to deliver the facilitated innovation.

The benefit of the “Level 3” approach is leveraging the innovative capabilities of both parties. The win-win here is in improving both the company’s business results and the revenue to the supplier.

Conclusion

New opportunities for value creation and new levels of risk both increase the value of innovation in outsourcing agreements. However, traditional outsourcing deal structures are not well-suited to fostering innovation, either to capture value or to mitigate risk. As a result, new win-win approaches serve to align incentives for innovation. These approaches include giving a single-party ownership on an innovation opportunity, modifying pricing to provide incentives for innovation, and partnering for innovation. These and other models better align incentives, maximize possible joint gains by allocating work to the party most capable of performing, and reduce integration challenges by using the customer’s management methods for its internal work and ecosystem. Together, these approaches can help companies and their suppliers work more effectively together to maximize value, and to avoid costly pitfalls in today’s changing business environment.