The pros and cons of output-based contracting

Proponents of output-based contracting say it enables more efficient service delivery, innovation and an improved customer experience. But it needs to be approached with care

Agreeing key service parameters should bring greater delivery certainty and improved relationships

An output-based contract will describe the required business deliverable or output, rather than how such outputs should be delivered.

A simple example of an input/resource-based contractual requirement could be: “The supplier shall provide 20 Dell Blade servers at its Northampton datacentre, with two web servers, a clustered Microsoft SQL Server database, two firewalls and a load balancer, connecting to the customer with two 20Mbit/s links.”

An output-based contract might express the same requirements as: “The supplier shall provide a web hosting environment, including a database and appropriate connectivity, sufficient to meet the application availability and response service levels set out in the service levels schedule.”

Output-based contracting has a number of perceived benefits. Customers can focus on developing contract requirements that specify the outputs its business needs. The Office of Government Commerce (OGC) notes that an output-based approach to requirements “allows providers scope to propose innovative solutions that might not have occurred to the procurement team”.

Suppliers have more flexibility to provide the best solution for the customer’s requirements, rather than being tied to a specific set of technical specifications. Customers get the supplier’s commitment to the specified business outputs they want, while looking to benefit from supplier innovation and efficiency in its delivery across the life of the contract.

It sounds good, but has output-based contracting proved such a panacea in practice?

Innovation
Having consulted numerous client contacts in IT procurement and delivery, it is apparent that where customers invite bids on output-based requirements, suppliers often propose innovative delivery solutions. But after that there is little direct connection between the use of output-based contracting and innovation.

Dynamic change to delivery solutions under output-based contracts is, in fact, relatively unusual. This is especially so where reasonable service stability has been achieved. Consistent with the findings at the National Outsourcing Association’s recent Innovation in Outsourcing event, real post-procurement innovation – that is, delivering significant cost reduction and/or service improvement – primarily depends not on the approach to expressing contract requirements but other factors, including involvement of an engaged, experienced and skilled customer function.

Certainty of output/delivery
Output-based contracting has too often been used at the cost of a real understanding between the parties of what is being paid for and will be delivered.

Areas exemplifying this are disaster recovery, technology refresh and what are called innovation teams.

Customer requirements for disaster recovery have often been expressed in extremely high-level output-based terms. Many corresponding supplier solutions are scarce on specific delivery detail. It could be argued that it is output-based contracting, so the lack of specification of solutions is OK, as the customer can count on the outputs.

But this leap of faith is a risky strategy for customers and can present ancillary difficulties even if disaster does not strike. For example, what if the customer wishes to accept more risk and downscale their disaster recovery provision? If the output-based description is lacking detail, on what commonly understood delivery and pricing basis do the parties begin discussing changes, impact on costing and so on?

Times of change
Currently, contract renegotiations and extensions are rife, especially in the public sector. This stocktaking of past performance highlights the difference of opinion between the customer’s output-based expectations and actual delivery.

And the lack of a clear and mutually understood contract baseline in many output-based arrangements has undoubtedly led to frustration and mistrust when assessing the impact of service changes required as part of renegotiations.

The pros and cons of output-based contracting

Proponents of output-based contracting say it enables more efficient service delivery, innovation and an improved customer experience. But it needs to be approached with care

Alternative approaches
Can a different approach to output-based contracting better address these issues? The strategy adopted in the OGC Model ICT Services Agreement is worth considering. That contract stipulates that the supplier must satisfy a set of requirements and must employ its specified solution in doing so. This allows contracting to output-based requirements, while the customer retains the certainty of knowing the supplier’s technical solution will be used.

Unfortunately, a common issue is that suppliers intend technical detail in the solution document (such as a specified connectivity bandwidth) as a limit to the service. Yet, under the model contract’s terms, the supplier must still satisfy the service description, regardless of what the solution document provides. This can lead to protracted disagreement between the two parties.

Furthermore, the solution is a contractual document generally setting out key delivery components, so any significant innovative changes to its content will require the customer’s agreement – therefore the contract structure itself may not necessarily facilitate innovation and dynamic delivery models.

Single reference point
In some recent renegotiations involving OGC Model ICT Services Agreement-based deals, the parties have abandoned the separate service description and solution documents approach. Additional effort has been invested in producing a more detailed and consolidated single service document, more clearly identifying parameters to what will be delivered for the contract charges.

This consolidation has much to recommend it, including reduced risk of conflicting contract statements. However, these customers’ willingness to adopt this approach was supported by an established delivery infrastructure and an operational track record between the parties. In other words, the risk of the solution significantly failing to satisfy the service description had diminished.

Certainly, public sector customers using the OGC ICT terms for new procurements are likely to maintain the model contract’s separate service description and solution approach – not least as it supports the competitive procurement process of differing bidders proposing solutions against a common set of customer requirements.

Which way now?
Large-scale abandonment of output-based contracting is not advocated. It clearly lets customers contract for what they care about: business solutions. But both sides would be well advised to face facts regarding output-based contracting.

Customers’ risk aversion has, at times, stretched output-based requirements beyond appropriate limits and failed to reflect the practical and financial limits of the supplier’s solution. Further, the role of output-based contracting in supporting innovation beyond the bid stage seems questionable. Consequently, parties should not be too concerned that a more detailed and mutually agreed contract baseline will itself stifle service improvement.

By investing the time and effort to understand, agree and contractually reflect key service parameters, the rewards should be greater delivery certainty, a more effective contract baseline and improved supply relationships.

For example, one customer recently benefitted by moving from higher-level, output-based print requirements based on a maximum printer-to-user ratio and blended estate price to a granular printing solution with a range of specific printer models with differing functionality available at different prices. This allowed business units to directly assess their local printer needs and make economies where it was right for the local customer.

Conclusion
Speaking to the attendees at a PA Consulting Group networking event, Fiona Spencer, director of Shared Services at the Home Office, noted that customer/supplier partnership and innovation were key ingredients for meeting current budget constraints.

This is correct but it should not be assumed that detailed contract requirements of themselves hinder such relationships and innovation. Those engaged in establishing new procurements or re-negotiating existing arrangements should challenge over-emphasis on an output-based approach and focus efforts on appropriately reflective contract requirements. This is hardly a revolutionary message, but it is an important one.

Michael Horn is a technology contracts expert at international law firm Pinsent Masons