Outsourcing Contracts: The Case for Fresh Thinking

1. Service Credits: Worth the Money? 

How we got here

Service levels were introduced because buyers needed an objective way to measure whether they were getting what they paid for. Once service levels were established, the logic seemed inescapable: without financial consequences, no supplier would take them seriously. Hence the service credit - a pre-agreed monetary deduction triggered by a missed service level, which has since become so universal that it is practically unthinkable to draft an outsourcing contract without one.

The problem with the logic

The mechanism rests on a behavioral assumption: that the prospect of financial penalty will motivate a supplier to perform. In practice, there is good reason to doubt this.

Suppliers are sophisticated businesses with extensive performance data. They know, statistically, how often they are likely to miss any given service level. That probability and the associated service credit is factored into the bid as a risk premium, meaning the customer is, in effect, already paying for the credits before any breach occurs. The deduction when it arrives is not a punishment that changes behavior; it is simply the settlement of an insurance premium already baked into the price.

"There is no relationship between the credits and behavior. It is just a financial item that you pay for as a customer anyway."

Most customers can accept that failure to meet service levels happens from time to time. The real issue at stake is whether the supplier is able to identity the root cause, learn, amend and adapt delivery processes or technology and ensure that the same root cause will not create outages again. Do financial penalties support what is often referred to as “the learning organization" and are the people on the floor – those delivering the services – incentivized or even affected by service credits? The engineers, the programmers, and other technical subject matter experts are typically motivated by collaboration, trust, the sense and purpose making, associated with service work and serve a business purpose. It is rare that a contract is able to foster that feeling of connectedness between those actually delivering the services and customer’s business purpose.

What service credits are not

It is worth noting that service credits and liquidated damages, though they share a common philosophical lineage, are treated quite differently across jurisdictions. In many Anglo-Saxon legal systems, service credits are understood as exhaustive remedies: accept the credit, forfeit the right to claim actual loss. In most other legal systems, no such exhaustive quality is implied. This distinction has significant practical consequences that practitioners frequently underestimate.

The path forward

None of this means that financial accountability for performance should be abandoned. The underlying goal - to have a supplier that learns from mistakes and does not repeat them - is entirely legitimate. But the mechanisms to pursue that goal deserve to be rethought:

• Escalating penalties for patterns of repeated failure, rather than flat per-incident credits, would better reflect what customers actually care about.
• Positive incentives for sustained excellence, structured to share in the value created, would align supplier motivation with customer outcomes.
• Automatic rights of renegotiation as the engagement matures would prevent service levels from becoming fossilised at inception-era assumptions.
• Outcome-based contracting, where the supplier shares in the consequences of the business result, rather than just the technical out put, offers a fundamentally different model — though it demands clarity about outcomes that many customers find difficult to provide, and requires the commercial flexibility to absorb changes in the parameters that drive those outcomes.

The honest conclusion is that a contract clause which drives no behavior and whose cost is simply passed back to the customer is not neutral: it is an unnecessary cost with the illusion of protection. Maybe it is time just to give up service credits and work on alternatives in earnest.

2. Governance: The Unrealised Opportunity

The cost nobody sees

Governance is expensive in ways that are rarely visible to customers. From a supplier's perspective, the cost of staffing governance meetings, preparing reporting packs, maintaining compliance with contractual governance obligations, and attending forums at multiple levels of seniority, can represent a substantial proportion of total delivery cost. Much of that reporting is never read. Many of those forums make no meaningful decisions.

This is not a marginal inefficiency. It is a systemic one.

What governance is supposed to do

The purpose of governance is straightforward. It should enable strategic decisions to be made when circumstances change. It should provide a structured channel for escalating operational disputes so that the people doing the day-to-day work are not permanently mired in conflict. It should ensure that the relationship has the institutional resilience to absorb shocks — changes in volume, technology, regulation, economics — without defaulting to confrontation.

Why it so often fails

In practice, governance structures are usually drafted by one party — a lawyer, a consultant, or an internal team drawing on a standard template — and presented to the other side as a fait accompli. The question that is almost never asked is: what do you actually want to get out of governance?

The consequences are predictable. Strategic decisions are not taken because both parties are locked into the business case logic of the original agreement. Disputes escalated up the governance hierarchy encounter the same entrenched positions at every level; the anticipated objectivity of senior leadership fails to materialize. Governance becomes, in the words of one experienced practitioner, not proactive but reactive — a mechanism for managing crises rather than preventing them.

"Those who win in outsourcing are those who can preserve the relationship. Those who have a terrible contract but are really good at managing the relationship will out perform those with a perfect contract who are poor at maintaining it."

Governance as a relational investment

The practical alternative begins not with a schedule of meetings and reporting obligations, but with a conversation. Bringing together the people who will actually work under the governance structure — the sponsors, the delivery leads, the relationship managers on both sides — and asking genuinely: what do we need from this? How will we make decisions when we disagree? What norms of honesty, transparency, equity, and proactivity do we expect from each other?

That conversation will not produce perfect answers. But it will produce something a standard template never can: genuine mutual commitment to the principles by which the relationship will be managed.

It also raises a legitimate and under-discussed question about where governance principles should sit legally. Embedding them in the contract gives them binding force but risks making them rigid and likely to be ignored. A separate, signed statement of principles may carry different weight in tone and culture even if it has broadly similar legal effect. These are questions worth exploring explicitly, rather than resolving by default.

One practical dimension is increasingly compelling. We now operate in an environment where the frequency and velocity of change — geopolitical disruption, supply chain instability, artificial intelligence reshaping delivery models — means that contract change management is not an occasional event but a continuous process. Organizations that have not built clear, agreed governance for handling change are, in the experience of many practitioners, taking approximately twice as long to process contract amendments as their better-governed peers. The cost of that delay, measured in agility and organizational friction, is considerable.

Risk Transfer: The Illusion of Protection

The architecture of customer protection

Thirty years of outsourcing practice has produced contracts that are, by any measure, remarkably customer-protective. Every difficult experience, every dispute, and every unexpected loss has added its clause. Liability caps, indemnities, step-in rights, termination triggers, evergreen provisions, benchmarking, deliver first, settle later, extensive representations and warranties — the modern outsourcing agreement is a sophisticated instrument of risk transfer.

There is a legitimate reason for this. The moment an outsourcing contract is signed, the balance of power shifts materially in the supplier's favour. The customer has given up direct control of a function, transferred the people who understood it, and created dependencies that take years to unwind. Robust contractual protections exist because the power asymmetry is real.

The unintended consequences

But something else has also happened. Contracts have become so protective of customers that they have, perversely, begun to undermine the collaboration on which successful outsourcing depends.

When a customer knows that the contract gives it the right to demand remedy, to withhold payment, to invoke termination triggers — when the contractual armour is comprehensive — there is a strong institutional tendency to retreat behind it rather than engage. Collaboration that would have served both parties better than enforcement is foregone. Decisions that a customer ought to take — accepting that an agile software development programme requires the customer to make choices, own outcomes, and absorb some risk — are avoided because the contract allows the customer to point to the supplier instead.

"Have contracts become so protective of customers that customers are not incentivized to collaborate in a manner which is necessary — and if they don’t, is that really to their benefit or to their detriment?"

The supplier side, meanwhile, operates within the same dynamic. Unable to terminate for convenience when an agreement becomes financially unviable — for reasons that may have been entirely unforeseeable at the time of signing — a supplier facing losses has a rational economic incentive to deliver the minimum required to avoid material default. Economists term this shading behavior: the systematic reduction of effort, investment, and quality to the floor of contractual compliance. It is widely observed in practice. It produces exactly the outcomes that governance and service credits were supposed to prevent.

Risk transfer is not risk management

The conceptual error at the heart of this dynamic is the conflation of risk transfer with risk management. Transferring a risk to a counterparty does not make the risk disappear: it reallocates its consequences while simultaneously creating incentives for the party bearing the risk to minimize its exposure in ways that damage the overall relationship. Risk management, by contrast, involves understanding which party is best placed to influence a given risk, structuring the relationship so that both parties have aligned incentives to manage it, and maintaining the kind of collaborative engagement that allows emerging risks to be addressed before they become disputes.

None of the contractual mechanisms examined in this paper — service credits, governance schedules, termination regimes, liability caps — are inherently wrong. Each addresses a real concern. The problem arises when risk transfer becomes the only lens through which contracts are designed, and when the cumulative weight of protective provisions crowds out the relational and behavioral elements that actually determine whether outsourcing succeeds.

What responsible negotiation looks like

A more honest approach would begin by acknowledging the asymmetries and uncertainties that characterize long-term outsourcing:

• Requirements change. What a customer needs from a service today will not be what it needs in three years. Mechanisms for managing that change — openly, quickly, and fairly — matter more than the precision of the original specification.
• Economics change. The assumption, widely held until relatively recently, that technology would drive continuous year-on-year price reductions has proved fragile. Contracts that allowed no right of price increase, written in a world of low inflation, looked very different when inflation returned. Honest conversations about how costs are structured and how they might evolve are more valuable than either side pretending the future is knowable.
• Power is more balanced than it appears. Customers who feel disempowered once a contract is signed, often underestimate the continuing leverage they hold through the supplier's reputational interest in being seen as a high-performing, collaborative partner. That leverage can be used positively — through reference accounts, case studies, visible recognition— or negatively through contractual rights to disclose performance publicly. Both are legitimate tools in a balanced relationship.
• Termination rights should be mutual. Giving a supplier the right to terminate for convenience — with an appropriate notice period, a moratorium on early termination, and a pre-agreed compensation framework for transition costs — is not a concession to be resisted. It is a mechanism for ensuring that both parties remain genuinely willing participants in the relationship, rather than prisoners of it.

Conclusion: Negotiation as a Continuing Practice

The themes that run through each of the areas examined here — service credits, governance, risk transfer — converge on a single insight: outsourcing contracts tend to be designed for the moment of signing, when uncertainty is highest and adversarial instincts are most acute, rather than for the years of collaborative delivery that follow.

The result is a body of contractual practice that is, in many respects, highly skilled at the wrong thing. We have become expert at allocating risk on paper. We are considerably less expert at structuring relationships that manage risk in practice.

"Everything we have discussed today is about behaviors — and about incentivizing behaviors that support economic efficiency."

The opportunity is substantial. Contracts that are designed around the question of what behaviors we want to see —rather than what protections we want to enforce — would look meaningfully different from the templates that currently circulate. They would have service level regimes focused on learning and improvement rather than financial settlement. They would have governance structures designed by the people who will use them, organized around the decisions that actually need to be made. They would have risk allocation that reflects which party can best manage each risk, supported by the kind of transparency that only a genuinely trusting relationship can sustain.

None of this is straightforward. It requires customers to look honestly at their own capacity to be good partners, not just demanding ones. It requires suppliers to acknowledge that the instinct to shade behavior in an unprofitable contract is ultimately self-defeating. It requires lawyers and advisers to resist the temptation to add another protective clause and ask instead whether the clause drives the outcome their client actually needs.

And it requires all parties to accept that negotiation is not a moment in time. In any long-term service relationship, the terms on which the parties work together will need to evolve. Building the mechanisms — the governance, the trust, the mutual commitment to honest conversation — that enable that evolution is not a soft or secondary concern. It is, increasingly, the central challenge of outsourcing practice.