As the global economy becomes more competitive, companies of all sizes are considering outsourcing their non-core functions to service providers that specialize in these functions. Successful outsourcing allows a company to focus on becoming more competitive in the performance of its core capabilities and to delegate other aspects of its operations to one or more service providers who can reduce costs and improve performance in these non-core functions. However, improvements and cost reductions typically require transforming the way in which the outsourced functions are performed, and the impact of such transformation is one of the greatest challenges facing the parties to an outsourcing transaction.Veterans of numerous outsourcing transactions recognize that the very changes that are necessary components in transforming an outsourced function inevitably create issues that are common to most, if not all, outsourcing transactions. The ability to identify and resolve these issues creates the power to manage the outsourcing transaction in a manner that both fosters the necessary changes and mitigates the issues that a transformation creates.During the last two years, the word governance has become the buzzword for the most effective strategies for resolving issues that seem endemic to outsourcing transactions. Dictionaries equate governance with management and control, but like most buzzwords, governance means different things to different people. An effective approach to governance in an outsourcing transaction requires that the parties address in the outsourcing contract, at a minimum, the following four areas: communications management, performance management, change management and dispute management.I. Communications ManagementAn outsourcing contract can facilitate communications management by creating procedures for exchanging information and communicating issues first within the internal organizational structure of the outsourcing service provider and the customer and then between the parties. Military chain-of-command procedures long predate outsourcing transactions but they provide a valuable model for dealing effectively with information and events. Organizations operate most efficiently when matters are dealt with at the lowest possible level in the operations and management hierarchy. The parties need to escalate any issue that is not resolved at the level where it originates, together with all relevant information, to the next higher level, where it can be processed and resolved or further escalated as appropriate. With effective internal communications procedures in place, the parties to an outsourcing contract can create, and invest in the personnel time necessary to implement, structured communications procedures between them.II. Performance ManagementThe greatest performance management challenge is isolating a realistic subset of all of the outsourced functions whose performance is truly critical to the customers success. Once critical functions have been identified, procedures for measuring the performance of these functions must be put in place and performance standards, which are commonly referred to as service levels, can be attached to them.In order to create an incentive for the outsourcing service provider to achieve the service levels, all outsourcing contracts must establish remedies for failure to meet service levels. The most common remedies are service credits, self-help and termination. Service credits are reductions in the fees or charges that are payable to the service provider for the outsourced services. Self-help provisions permit the customer to step in with its own personnel or outside contractors to assist the service provider in rectifying one or more performance failures or to take complete responsibility for performance in the event of a serious failure. Termination is a remedy of last resort, since transition to another service provider or return to in-house performance of the services is time-consuming and costly. Nevertheless, a customer must retain the ability to fire a service provider if it experiences serious and repeated service deficiencies.III. Change Management The parties to an outsourcing contract have a shared need for cost reliability. The customer enters into such a contract based, in large part, on the savings it believes it will achieve, while the service provider has tried to calculate carefully the costs it will incur to provide the requested services so as to preserve its own profit margin.Two factors invariably undermine the reliability of each partys cost calculations: scope creep and demand creation. Scope creep occurs when a customer insists that particular services that are not specifically identified in the outsourcing agreement are nevertheless service provider obligations. Such services typically relate to services that are specifically identified as service provider obligations and are often minor in nature. Demand creation occurs when a service provider seeks to increase the scope of services that the customer has outsourced, with a corresponding increase in charges. Employees of the customer may well find additional services proposed by the service provider to be appealing.An outsourcing contract needs to include a carefully structured change management procedure with practical guidelines for distinguishing between additional services that are included in existing fees and additional services that justify additional fees. The contract needs to establish clear procedures by which service provider personnel are permitted to introduce new or additional services to customer personnel.In addition to changes that have a cost impact, long-term service relationships will inevitably require performance changes over time, and events will arise that impact the service outcomes. Some changes will be required by the customers business needs, while other changes may be mandated by law. Not all such changes will require a change to the pricing, but they may require a change to performance schedules or service levels. For example, due to recent highly publicized breaches of security resulting in the disclosure of customer data, many companies are increasing their internal data security requirements. These additional requirements may directly increase the service providers scope of work, or they may indirectly impact the service providers ability to achieve the service levels. Even changes that impact the services, but do not contemplate a change in scope or pricing, need to be managed through the change control procedure.To ensure that a comprehensive change management process is followed, it must also be practical. Not all changes need to rise to the highest level of approval within the change management chain. The change control managers need to have the ability to appoint lower level designees to approve specified categories (or thresholds) of changes, and the change control managers need the authority to agree upon certain changes that are not subject to the formal change control process. With deliberate thought and consideration, a change management process can be structured to efficiently, effectively and fairly implement changes to the services and to take into account changes that otherwise impact the performance outcomes.IV. Dispute ManagementDisputes in any contractual relationship signal a breakdown in the good faith and cooperative spirit that are necessary components of the relationship. Procedures for managing and resolving disputes need to be established before a dispute arises. An outsourcing contract needs to encourage the parties to acknowledge and address disputes as they arise, rather than sweep them under a carpet where they often become more serious.Ordinarily, disputes that are not resolved at the operational level are escalated to the project managers and, if not resolved by the project managers within a specified period, may be escalated to a steering committee. If a dispute cannot be resolved by the steering committee within a specified time, the typical alternatives are the top executives of the customer and the service provider, alternative dispute resolution procedures such as mediation and arbitration, and litigation.Because outsourcing transactions require the customer to cede control of critical aspects of its operations to a third party and the customers competitive success depends on proper performance of those services, there are numerous threats to the success of these transactions. Procedures need to be built into every outsourcing contract that facilitate the resolution of the types of problems that commonly arise in outsourcing transactions.About the AuthorsPhilip D. Porter ([email protected]) is a partner and Robin Everett ([email protected]) is counsel in the Northern Virginia office of Hogan & Hartson L.L.P.