Sourcing Inside Out: Benchmarking Clauses that Work

Benchmarking clauses have been getting a lot of attention in the media recently. Are they really necessary? Do they work? Do viable alternatives exist?

Despite some flaws and challenges, Compass believes benchmarking clauses remain the most effective mechanism clients can use to periodically gauge the value being delivered by their service provider and to adjust contract terms to reflect market changes and to adhere to industry standards.

No doubt, implementing benchmarking clauses can be a contentious process. Service providers – often with good reason – seek to avoid executing the benchmark by offering upfront discounts in lieu, by imposing unrealistic requirements and conditions, or by unreasonably challenging the findings. But it doesn’t have to be that way.

I recently conducted a webcast on benchmarking clauses together with Rob Finkel, a partner in the New York office of the international law firm Milbank, Tweed, Hadley & McCloy LLP, and a member of the Strategic Sourcing and Technology Group. Rob and I brought our different perspectives to the discussion to outline some general principles and specific tactics that can help ensure that benchmarking clauses are a win/win proposition for all parties, and that they contribute to keeping an outsourcing relationship on track and moving in the right direction.

The Benchmarking Big Picture

Rob and I violently agreed that a key to an effective benchmarking clause is that it be part of a broader, strategic appraisal of the outsourcing relationship. According to Rob, “In the past, there was more of a notion that you could outsource functions and not worry too much about the day to day management of the relationship. There’s been a recognition that thinking like that is too simplistic. Our clients now recognize that the more they manage the relationship, and the more they set up rules to manage the relationship, the better the results will be. And benchmarking is part of that general process of governance; part of setting up the rules that ensure that the relationship will be successful.”

Put differently, the client organization shouldn’t view the benchmarking exercise as an opportunity to beat 10 percent off the price, but rather as a constructive review of performance and a way to investigate all aspects of the relationship and to draw conclusions that can drive positive change. This requires a future-looking perspective. While the benchmarking process is a review of past performance, the context and the outcome should focus on future goals and objectives.

If both parties take this approach, and view the benchmark exercise as a way of building the relationship over the long term, the process will be constructive and strategic in nature – and vendors will be much more likely to support it enthusiastically.

So, what can clients do to make the benchmarking process a strategic discussion, rather than an exercise in nickel-and-diming? One key is to take a 360 degree view of the outsourcing relationship and not to focus on cost issues alone. In other words, the client organization must view the relationship as a valuable asset that must be nurtured and developed. To this end, a governance assessment should be conducted as part of the yearly financial benchmark. Not only will this assessment uncover the source of many service and cost challenges, it will also bring a forward-looking component to the engagement, enabling the parties to set in motion improvements that will benefit both in terms of lower costs and higher quality

Devil in the Details: the Legal Perspective of Benchmarking

Perhaps ironically, a strategic, big picture approach to benchmarking requires diligent attention to detail. From a contractual perspective, says Rob Finkel, “Benchmarking clauses have become more detailed and more specific, with more matters open to negotiation. I think that’s a good trend. In general, I would advise a client to negotiate a clause with more detail rather than less.”

Two areas where those details are critical, Rob adds, concern how the clause will operate in the future, and how it will be implemented. Flexibility is important. “You want to avoid provisions that constrain the process. Avoid geographic or industry reference groups. It’s generally better to have broad access to as much relevant data as possible.”

Perhaps the most important issue surrounding a benchmark clause is: What do you do with the findings? At Compass, we’ve seen situations where clients undertake a rigorous assessment of cost and quality, apply lots of detailed metrics, and at the end of the process, the two parties agree to sit down and have a chat.

Rob agrees that it’s essential to spell out in detail how the results of the benchmark will be acted upon. “This is perhaps the most important part of the clause,” he says. “My preference is to have a provision stating that the results lead to some adjustment in the contract – an automatic price reduction or an adjustment in service levels.”

Contracts are becoming increasingly specific about how price adjustments are carried out. Many vendors are insisting on deadbands, which state that adjustments kick in only at a certain point, and caps, which limit the total amount of a potential adjustment. Rob says that deadbands can be useful if both parties agree, while he generally advises against caps on adjustments that are too low.

We also agree that termination clauses are not highly effective. In Compass’ view, a benchmark analysis won’t sway a client’s decision to terminate one way or another; Rob points out that termination is often too expensive for a client to be a viable option.

As far as frequency goes, Rob says most clients seek to benchmark every 12 to 18 months. He also says most clients frequently prefer to pay for benchmarking themselves. “If the vendor bears the cost, they’ll just pass it on. Many of our clients prefer to pick up the cost themselves. Since they’re not sure they’ll use benchmarking in the future, they want to control the mechanism.” In terms of selection, he says it generally works best to have the client and vendor agree on a list of potential benchmarkers and allow the client to select from that list.

At Compass, we advise our clients that an independent third party is essential to executing an effective benchmarking initiative, in terms of defining the metrics and the comparative groups, normalizing the reference data, and ensuring a meaningful and relevant apples-to-apples comparison. We advise that legal expertise is similarly essential to crafting the contractual terms of the agreement.

Finally, during contract negotiations, don’t accept any watered-down substitute to the benchmarking clause – there is no effective alternative to the traditional benchmark. The future financial health of your outsourcing agreement is riding on this clause.

Useful Links

Compass
http://www.compassmc.com/index.htm

Listen to the Compass Webinar on benchmarking here:
http://www.compassmc.com/North_America/Sourcing_Focus.htm

Milbank, Tweed, Hadley & McCloy LLP
http://www.milbank.com/en

Strategic Sourcing and Technology Group
http://www.milbank.com/en/PracticeAreas/StrategicSourcingAndTechnology_alpha.htm