The outsourcing landscape is only getting more complex, with more providers, options, and services than ever before. For many, that means the task of simply understanding what’s available itself is daunting.
But once you’ve understood your own needs and selected the perfect outsourcing partner, there’s still a vital step: the contract. While it’s easy to see this as a simple formality, the outsourcing contract can easily make or break the relationship.
So let’s dive into why outsourcing contracts are so important, what you should look for in them, and see some examples you can use for reference. Armed with all this information, you’ll be ready to create an effective contract and kick off a successful partnership.
Why Is a Good Outsourcing Contract Important?
Good working relationships are built on alignment, mutual understanding, and effective collaboration. Outsourcing contracts are so important because they set you up for success on all three fronts.
Let’s start with the first example: alignment. Any outsourcing provider you work with is going to have to make countless decisions over the course of your working relationship. You don’t want to have to micromanage them through them all, so alignment becomes vital. By gaining a solid understanding of your expectations, goals, priorities, ways of working, etc. your provider can better ensure all are addressed.
This can begin with your outsourcing contract. The negotiations over its terms offer an excellent opportunity to discuss what both parties want, how they prefer to work, and what should happen if things go wrong. While it’s easy to view this process simply as a hassle, it’s really a chance to build alignment around your shared goals.
Mutual understanding and effective collaboration are likewise benefitted by contracts that clearly lay out all of these details. For complex projects like custom software development, one of the most common outsourced services today, these are essential ingredients for success.
What are the three types of outsourcing contracts?
The three basic types of outsourcing contracts are built around three models for services and pricing. Each is suited for specific types of relationships and projects, so be sure to familiarize yourself with all three. Also be sure to consult with any prospective outsourcing partners to understand their preferences and experiences with each type.
Fixed price contracts
These are the most straightforward types of outsourcing contracts. Here, the vendor reviews the proposed scope of work from the client and gives a single fixed price. But why are these basic contracts less common than you may assume?
In short, the lack of flexibility creates some degree of risk for both parties. If the lender underestimates the difficulty of the work, they may not be able to complete it for the agreed upon price. Or, they may simply need to take a loss on the project.
On the other hand, if the client’s needs change or evolve, it may not be possible to easily adjust the project scope later. This is why fixed price contracts are generally used for very simple and straightforward projects. If you’re looking to hire an outsourcing company, fixed price contracts will strongly discourage them from taking on any project that seems complex or at all risky.
So bear this in mind when considering the right type of outsourcing contract for your needs.
Target cost contracts
These contracts attempt to address some of the risk issues present in fixed price contracts. To do this, the client and provider negotiate prior to the contract being drafted to determine the expected costs for the project. This will include the base fees, contract fees, and be adjusted based on the expected risk.
Together, all of these elements make up the target cost. If the ultimate cost of the project comes in below this number, the provider and the client split the resulting savings. On the other hand, if it comes in above that number, the provider and client will split the costs. This is called gainshare and painshare.
The idea then is for both parties in the outsourcing contract to evenly share the risks involved. These contracts also help align the parties, ensuring everyone has a strong incentive to ensure the project comes in under the target cost. This explains why this type of outsourcing contract is particularly popular for IT and software development outsourcing.
Time and materials contracts
This is another very straightforward and predictable type of outsourcing contract. Time and materials contracts establish a price for the time and materials that go into a project. The vendor then charges the client based on how much of each was used.
These contracts can be useful when the scope of a project is too difficult to estimate, as they can be scaled up or down very easily. But for those same reasons, this model pushes quite a bit of risk onto the customer because they are not guaranteed any specific results based on the time and materials expended. This means costs can rise quickly and become a problem if the project is not carefully managed and monitored.
So if your project has an unknown scope but you’re confident in your ability to manage the time and materials that will go into it, this can be a great option. Its transparency as a “you get what you pay for” model can make it appealing for cases where that is prioritized.
How do you structure an outsourcing contract?
The structure of an outsourcing contract matters far less than its contents. Whether a particular clause is at the beginning or the end does not impact its legal weight. That said, it is beneficial to structure your contracts in a way that makes sense and highlights the most important elements for both parties.
Service Level Agreements (SLAs) vs Contracts
You may have heard companies talk about signing SLAs with vendors, so what’s the difference between these agreements and traditional contracts? The first thing to understand is that SLAs are a type of contract. That said, they tend to be less formal and may or may not be legally enforceable.
For this reason, SLAs are often used within an established relationship or to define a project within a broader working relationship. But why would you want to use an SLA in the first place then?
Because SLAs are less formal and often not legally enforceable, they don’t generally require input from a lawyer. A project manager or other leader can fairly easily draw up an SLA themselves, saving time and money.
So you can think of SLAs as a helpful tool for creating alignment and ensuring both parties have a shared understanding of what needs to happen. They’re not a replacement for traditional outsourcing contracts, but can be a very helpful tool to have on hand.
What Should Be Included in our contract
With all of that out of the way, what elements should you consider including in your contracts?
Description of Services
It shouldn’t come as a surprise that any outsourcing contract should contain a list of the services a provider is expected to deliver. The question is usually the amount of detail to include.
On the one hand, a highly detailed description of services can help set expectations, create alignment, and ensure clarity between the parties. On the other hand, this can be time-consuming and wasteful, particularly with complex projects that are guaranteed to evolve during their execution.
For that reason,
To help account for anything unexpected, many descriptions of services also include a clause outlining anything not specified.
Intellectual Property (IP)
Oftentimes outsourcing providers will have access to important elements of your IP. In other cases, the project may itself involve developing new valuable pieces of IP. Both cases necessitate clear rules about how your IP can be used and who owns it. Within outsourcing contracts, IP protection clauses are often called “retained rights.”
For example, a provider may be willing to offer a lower price if it can retain the right to use a particular function or feature it develops for you. Or you may want to be specific that everything created within your partnership belongs to you exclusively. Either way, being clear about these rules from the start helps avoid misunderstandings and problems down the line.
Non-Disclosure Agreements (NDAs)
These clauses can help protect both parties and their sensitive information from getting into the wrong hands. Usually, an NDA will specify that parties to the contract are not allowed to discuss certain things in public. Sometimes these may be time limited or they may be indefinite. If you have concerns about sensitive details aside from personal data or IP being leaked or otherwise used against you, NDAs can offer invaluable protection
Data protection
Data security and privacy has never been more important. This applies both to increasing government regulations over the storage and use of data, and the PR implications of data breaches.
For these reasons, it’s extremely important that outsourcing contracts lay out how data will be stored, where it will be stored, how it can be accessed, who has such access, etc. It’s important to be specific about what rules should be followed and the consequences of any breaches. These clauses should ensure that all relevant regulations are followed and that sensitive data is protected.
Duration
Ask yourself: is it extremely important that the terms of your contract be fulfilled by a specific date or is the date flexible? This can have an enormous impact on the quality of work done, its cost, and the ultimate scope of the project.
For this reason, it’s important to consider how you want to balance these factors in your outsourcing contract. Remember that you’re never going to get the highest quality work at the cheapest price and quickly. Every working relationship involves compromises, so understanding which of those elements is most important to you and reflecting that in your contract is critical.
Your duration clause may specify a hard end date, or even provide monetary incentives for meeting certain milestones on time. The way you structure it is up to you, just be sure it helps align both parties towards achieving your goals.
Dispute resolution
While it may be easy to assume the best, you always need to be prepared for when things go wrong. Including a clause for dispute resolution is absolutely essential for any outsourcing contract. These clauses lay out in detail precisely how disputes should be addressed.
The advantage this brings is that it’s clear to both parties exactly how disputes will be handled. For example, this may involve arbitration. These clauses may also specify when and how disputes may be raised. Overall, clarity in this area makes dealing with any problems that arise far easier for both parties.
Payment terms
Detailed payment terms are a standard part of outsourcing contracts for good reason. It’s important both parties have a shared understanding of when and how goods and services should be paid for.
These terms generally include the payment method, how long the client has to pay invoices, and how costs are calculated. For example, you may have a fixed price contract, payment in advance, or even payments based on performance.
Finding the best payment terms for both parties is a key way contracts can create alignment. Methods like payment based on performance ensure both sides have a mutual interest in ensuring the work done produces genuine value for the client.
Scope
Contract scope may seem like an obvious and basic element to include, but the reality is a bit more complex. True, an easy way to approach this is simply to have the scope of the project be clearly laid out in the original contract, but there are alternatives you may want to consider.
A common issue here is scope creep, where the scope of a project gradually increases as it progresses. This can throw off many other elements of the contract like the duration, payment terms, etc.
This is why it can be beneficial to consider scope adjustments from the outset. One way to think about this is by looking at the classic “iron triangle” of project management. Here, scope is fixed while resources and time are merely estimated. In other words, you tell the provider what you want and they figure out what’s required to achieve it.
But you can also use the Agile project management triangle to frame your work instead. Here, the time and resources are fixed while the scope is flexible. That means you give your provider a set time and budget along with a prioritized list of objectives and they accomplish as much as they can within those constraints.
Whichever approach you use, it’s important to be aware of the tradeoffs and choose a scope that will help you achieve your goals.
Transfer of assets
Often in order for a provider to do its work they will require some assets from the client. A transfer of assets clause lays out how and when such transfers will occur. It may also specify who will cover the resulting costs and how long the transferred assets may be accessed.
Performance monitoring and auditing
It’s exceptionally important to monitor progress and occasionally audit work that’s being done through an outsourcing contract. Generally, you want to avoid treating an outsourcing provider like a black box with no visibility into their processes as this introduces substantial risk.
This is why most outsourcing contracts have clauses detailing how performance monitoring and auditing will be conducted. For example, who will perform these tasks, how often they will be performed, how they will occur, and what will happen if problems are identified. Overall this is an important way to tackle problems early and prevent them from snowballing into more substantial issues.
Force majeure
It’s important to appreciate the reality that no outsourcing contract can account for all possibilities. Sometimes things outside the control of you and your provider will have a major impact on your work. A recent example is the war in Ukraine, which had a massive impact on many outsourcing companies operating in that country.
Force majeure clauses lay out what happens if circumstances like this make it impossible to fulfill the contract. This may be a rare occurrence but it’s helpful to lay out what happens so everyone has clarity in a worst case scenario.
Also note that these clauses may be included within a broader category of Business Continuity and Disaster Recovery (BCDR). As such, they may also include issues like legal changes, illnesses or resignation from employees, supply chain issues, or even malware attacks.
Termination
Like with force majeure, a termination clause is one you hope never to use but which is useful to have. These clauses lay out exactly what happens if either party in the contract decides to terminate. This would include how much notice they should give, for example the contract can only be terminated with one month’s notice, penalties or fees that should be paid, arbitration, etc.
The idea is that if either party is dissatisfied with the partnership, they know what their options are. This clarity helps ensure that even if things don’t go according to plan, all the parties have an agreed upon understanding of what can happen to address the situation.
How long are outsourcing contracts?
There’s no single answer to this question, but finding the ideal length is always a challenge. Including too many details can create unnecessary delays and unneeded complexity. But short contracts with too few details can fail to address many of the key points mentioned above.
This is why it’s so important to work with lawyers with experience drafting outsourcing contracts in your specific field. Their expertise is invaluable as even small mistakes or oversights can easily create significant problems in the right circumstances.
