This is an excerpt of a chapter about outsourcing governance models. You might therefore find some references to “previous” and “next” sections.

Contents of a contract
Contracts contain a certain amount of flexibility. The main rationale behind contract flexibility is that certain external factors are not under control of the parties negotiating the contract.  Ulset (1994) defines three “levels” of contracts: market, hybrid and hierarchy. The different levels differ in the amount of flexibility allowed in the contract. Based upon various references (Harris, A. et. al, 1998; Ulset, S., 1996; Lee, M.K.O., 1996; Carmel, E. & Tjia, P., 2005) there seems to be a general understanding that IT outsourcing contracts should contain the following clauses :

Pricing
The three main options in pricing are: fixed price, flex price and cost-plus.

A fixed price construction is suitable for market transactions and the “buy” governance model. Fixed price contracts transfer most of the financial risks to the outsourcing provider and therefore limit overall project flexibility. Most likely the provider will resist mid project changes and will try to limit changes where possible.

A flex price structure is more suitable for projects with a lot of uncertainty or technical innovation.  Flexing a project’s price provides a lot of flexibility throughout the whole project but also transfers a lot of the financial risk back to the client.

A third pricing option is the “cost-plus” method, in which the client pays the actual costs made by the outsourcing provider plus a certain percentage of the costs as the outsourcers’ margin. The cost-plus method is a suitable model for long term contracts and relationships. Although a lot of the financial risk of a project is in the hands of the client, in long term projects the cost-plus method is often far less expensive than billing by the hour or setting a fixed price.

In order to bridge the gap between the pricing models one could include a price adjustment clause. in the contract. This clause describes what to do when the provider comes across unexpected difficulties or when the client changes project priorities or requirements.
With the current trend of agile development the pricing clause in the contract can be a real burden. Agile development makes a lot of sense to developers but can also put a strain on managers. Agile development embraces change and flexibility. Agile development by definition values customer collaboration over contracts and responding to change over following a plan, as can be read in the The agile manifesto.

In practice a lot of outsourcing providers use an agile development method internally but in agreements with the customer they pretend to work using a structured design method like waterfall. By pretending not to be agile they satisfy the customer with terminology and contracts known to managers and lawyers, avoiding discussions about agile development. This agile-covered-by-waterfall approach is definitely a suboptimal solution. The real benefits of the agile development are hidden from the customer while the risks of agile development are still there. The outsourced activities will be covered by a waterfall contract and therefore fines and lawsuits might control the financial damages in case the agile risks summon but in general it is better to prevent spending time on lawsuits and not tear a relationship apart with fines. One solution to the agile-covered-by-waterfall approach might be to partially flex the contract via a “target-cost” approach. Different contract approaches including target-cost will be discussed in the next section.

Incentives
Part of the “payment” of the outsourcing partner can consist of, for example, revenue and profit sharing, shared bonuses or a partial return of the cost savings that were enabled by the provider. Especially in the case of of “alliances” the description of incentives requires extra attention. In the next section on contract models and flexibility different incentives structures will be explained, among these the profit sharing contract.

Administration control
Administration control defines the amount of control the outsourcer has over the processes and employees of the provider and vice versa. Administration control correlates mainly to the financial risks a party commits to during the project. In a fixed price project the financial risks are at the side of the provider, leaving the provider in control of most if not all procedures. When using more flexible contracts administration control is shared between both parties. Two common things arranged in the administration control section are the rights to approve personnel and the right to approve subcontractors.

Contract duration
One way to achieve flexible contracts is to shorten the contract period. For many ICT technologies shortening the contract means that a contract is tied up to part of the software development life-cycle running between 2 to 5 years.

Early termination
Situations might occur where one of the parties involved in the relationship gets in a position  where prematurely ending the contract is considered a wise decision. Legal advisers recommend the use of a so called “mutual agreement” clause for these situations. It might be better to talk of these situations up front instead of at the height of a conflict. Early termination tied up with the renegotiation clause provides a way for the outsourcer to redefine, continue or terminate the project based on the status reports and intermediate results of the supplier.

Rights to dispute charges
An outsourcing client should negotiate the rights to dispute charges of the provider and withhold payment. This of course is not a favorable situation for the outsourcing provider. However, most of the times an agreement can be reached where the process of the disputes is formalized, possibly supported by securing a certain amount of the payments under escrow protection of a third party. The formalized procedure makes sure that the supplier doesn’t have to wait endlessly for its money  or that payments are held back over unfair reasons, while maintaining the possibility of the client to argue the charges.

Ownership of intellectual property rights
The laws protecting intellectual property rights (IPR) vary from country to country. The unavailability of unified IPR laws hardens the process of protecting your IPR when outsourcing. The specific possibilities of securing IPR strongly depend on the country of the outsourcing provider and outsourcer. When both companies are located within the EU IPR definitions get a little easier but international law remains a spaghetti or rules. It is advised to consult a legal counselor.

Information security and confidentiality
Since the outsourcing provider in most cases will have access to confidential and/or commercially sensitive information, like customer records, both partners should agree upon confidentiality and information security up front. The information security and confidentiality agreement should not only include the sharing and treatment of information but also the availability of IT security infrastructure elements like firewalls, user access policies and virus detection software.

Excuse doctrine, warranty and liability
With the outsourcing of R&D activities a lot of innovation and uncertainty is involved. To bridge the gap between the legal consequences of a mistake by the internal R&D department and a failure at the side of the service provider outsourcing contracts have an “excuse doctrine” or “liability clause”. The liability clause states that claims for refunding or remaking the whole project are only warranted in cases of severe malpractice. This being difficult to prove, cases of malpractice are almost never brought to court. One more reasons to think of early termination and renegotiation clauses.

Renegotiation
Renegotiation procedures allow parties to act quickly using readily available information without having to spend too much time on future problems. Some contracts contain fixed dates or events for renegotiation of (part of) the contract. Although neglecting renegotiation, avoiding the discussion, can save both parties a lot of time up front, renegotiations might end up being a time consuming and administratively costly in the long term. Breaking open a contract and bargain about the contract items is a resource intense activity.
It has often been said, “Write the contract, archive it, and when you need it you’re in big trouble.” The challenge of making a contract is in the interplay between trust, security and flexibility. According to Davis and Speckman (2004) “Contracts are used to codify the nature of the relationship and become useful in instances where partners have little past experience with one another. The contract reduces uncertainty by formally designating behavior and by adding predictability to the outcome of the exchange.” The contact provides both partners with a start, guidance through the relationship and a formal end, both the good and less pleasant ones.

References
Harris, A. & Giunipero, L.C. & Tomas G. et. al. (1998) “Impact of Organizational and Contract Flexibility on Outsourcing Contracts”. Industrial Marketing Management, 27, p. 373-384

Ulset, S. (1996) “R&D Outsourcing and Contractual Governance: An Empirical Study of Commercial R&D Projects”. Journal of Economic Behavior & Organisation, 30, p. 63-82

Rajneesh, N. & Hagedoorn, J. (1999) “Innovating through strategic alliances: moving towards international partnerships and contractual agreements”. Techonovation, 19, p. 283 - 294

Lee, M.K.O. (1996) “IT Outsourcing Contracts: Practical Issues for Management”. Industrial Management & Data Systems, 96(1), pp. 15-20(6)

Carmel, E. & Tjia, P. (2005) “Offshoring Information Technology: Sourcing and Outsourcing to a Global Workforce”. Cambridge University Press, United Kingdom