Historically, enterprise customers have been able to count on annual telecom cost reductions of 10-15%. Even with greater industry concentration, well done deals can still realize significant cost reductions. But in current economic conditions, where IT and telecom departments need to show some serious savings, 10% off a number that has been drifting steadily downward for over ten years simply may not yield the savings that some enterprise organizations must produce. As a result, many companies look to outsource management of telecom services and equipment by entering into a managed equipment services ("MES") agreement as a way to realize even greater cost savings by transferring to their suppliers some of the costs associated with acquiring equipment and managing equipment, networks and personnel.
Outsourcing through an MES agreement can, in fact, produce real savings. But outsourcing functions previously performed in-house can also lead to unexpected costs that swallow the anticipated cost savings. The objective of this article is to help enterprise customers avoid these unexpected costs. To that end, we offer suggestions regarding the specification of vendor responsibilities, the methods by which outsourced work will be performed, the mechanism through which changes to initial scope of work will be made, and the charges associated with the service.
Develop a Base Case: What are the Current Costs?
Many customers believe that they have a good sense of the current costs to acquire and manage their equipment. But when undertaking a competitive procurement for MES offerings, a "general sense of current costs" may not provide an adequate analytical basis to evaluate competing vendor offers relative to each other and, even more importantly, relative to the customers' current costs. Therefore, as a first step prior to soliciting vendor bids, customers should develop a base case of the current cost to self-provision the equipment and the service that they intend to outsource to a third party (or, at the very least, revisit and refine their "general sense" of such costs with some level of meaningful analysis). Without doing this work, it will be difficult--if not impossible--to evaluate whether the vendor bids submitted will actually save the customer any money.
Develop a Responsibility Matrix: Who is Doing What?
Too often customers do not adequately identify early in the procurement process the specific tasks they expect vendors to perform or those for which the customers intend to retain responsibility. As a result, vendors often structure their proposals and pricing based on their assumptions about the tasks they will perform for the base price. Not surprisingly, these vendor assumptions often vary significantly from customer expectations. If a customer does not catch the mismatch between vendor assumptions and customer expectations before execution of the contract, the customer will almost certainly pay more for the service than it had originally anticipated. Even if the customer recognizes the mismatch during the procurement process, the customer might thereby avoid later unpleasant surprises, but may have wasted valuable time negotiating through the confusion.
Savvy customers avoid these problems by developing a responsibility matrix that clearly identifies the tasks for which they expect the vendor to assume responsibility and those for which they intend to retain responsibility. If the responsibility matrix is distributed to vendors early in the procurement process, it can serve two valuable purposes that assist customers in exposing hidden or undefined costs: first, it will clearly establish the customer’s expectations about the vendor's obligations and thereby focus the vendors on submitting bids that can be measured against customer requirements, not standard vendor offerings; and, second, it can be included in the executed contract and/or be used to develop the comprehensive statement of work, described below, which can serve as a valuable reference point when determining whether something is "in-scope" (included in the cost) or "out of scope" (an additional expense).
A Good Statement of Work: How Will the Vendor Complete its Responsibilities?
Even if you have reached agreement about what responsibilities the vendor is going to assume, a common and effective way for a vendor to hide costs from a customer is to craft a vaguely worded statement of work (SOW) and change management process. Unless its responsibilities are described with specificity, a vendor will often reserve too much discretion to impose additional costs on its customer during the term of the agreement.
Following is a partial list of subject areas that should be addressed in detail in a managed telecom equipment/services procurement to avoid unpleasant surprises, either as part of the sourcing process used to determine which vendor is going to win your business or, at the very least, as part of the contract negotiation with the selected vendor prior to signing a deal:
* Site surveys and inventories: Will the vendor perform required site surveys and inventories as part of the basic or per device charge, or will they be charged on a time and materials or per site basis? During the term of the agreement, will the vendor impose additional charges for removal of in place equipment that is replaced or upgraded during the term of the agreement? Does the vendor assume responsibility for additional costs resulting from any errors it commits once it has completed site surveys in accordance with agreed upon criteria?
* Moves, Adds, Changes and Deletions (MACDs): Does the SOW clearly specify what tasks will be considered "hard" MACDs and which will be less expensive "soft" or "logical" MACDs? By not specifying how the vendor will complete certain tasks and the charges associated with them (and comparing those to the internal costs to perform the same work), customers can face unanticipated costs resulting from a greater volume of hard MACDs than originally anticipated.
* Preventative and Reactive Maintenance: Customers that purchase maintenance and monitoring services typically expect their vendors to perform a combination of preventative (maintaining the system while it is operating to avoid incidents) and reactive (fixing an incident when it occurs) maintenance. From both a technical and pricing point of view, it is important to specify exactly what tasks the vendor is expected to complete as part of its preventative maintenance obligations (e.g., maintain currency of manufacturer patches and service-packs, complete manufacturer recommended maintenance, implement software updates, etc.). Similarly, if the customer expects the vendor to fix something that breaks, it should identify all types of incidents that are the vendor’s responsibility, rather than rely upon standard vendor lists of such incidents. When an incident occurs, customers are focused on getting their equipment / service fixed; this is the worst possible time and the point of lowest leverage to negotiate the scope and price of a vendor’s service.
* "Maintenance Exclusions": These "additional" functions, which the vendor often agrees to perform on a time and materials basis, can quickly add costs to the customer’s bottom line. Make sure any maintenance exclusions are narrow and that the time and materials rates are priced consistently with the prices for other maintenance functions performed by the vendor as part of the base scope of work.
* Out-of band circuits: Is the cost of providing and managing out-of band analog circuits used for testing and maintenance included in the baseline charge?
While illustrative, the preceding list just scratches the surface of the many topics in an outsourcing deal that customers need to address with significant detail in their Statements of Work. The general point is simply that time spent fully developing the SOW will help the customer (1) better understand whether, and if so the extent to which, a vendor’s managed service proposal will produce cost savings and (2) avoid many unexpected charges once a deal is signed. A rush to “book the savings” by quickly picking a vendor and signing a deal without thinking through and documenting the full scope of work will inevitably lead to additional charges, which can eliminate the cost savings that drove the original decision to outsource.
Change Management Process and Contract Governance: How will you minimize the costs associated with changes to the scope of work?
Regardless of how thoroughly an SOW is negotiated during the procurement process, changes to the customer’s network infrastructure during the term of an outsourcing agreement beyond anticipated "refreshes" will inevitably occur. Although customers cannot reasonably expect the vendor to assume all of the financial risks resulting from customer-initiated changes, they should negotiate a reasonable allocation of the costs associated with operating a dynamic network environment. Often, vendors attempt to impose all additional costs on customers, nickel and diming them for run of the mill changes to their operating environments and creating disputes over whether changes required by the customer fall within the original SOW or base scope of work. If the changes are outside the strict language defining the base scope of work, customers can expect the vendor to impose additional charges unless their agreements specify otherwise.
To resolve these matters fairly, the outsourcing contract should contain a reasonable change management process agreed upon before the contract is finalized. First and foremost, the parties should agree upon a definition of what actually constitutes a "change." Completion of specific tasks or "unanticipated effort" that is inherently necessary for the vendor to complete the requirements of the agreed upon statement of work should not require payment of additional charges or constitute a change. For customer requests that really do constitute a change to the parties' original agreement, the parties should negotiate:
* a schedule of incremental additional charges that apply to changes that are likely to occur during the term (such as the addition of equipment or sites within a geographic region at which the customer already does business);
* a structure for negotiating a price for changes that are not anticipated, as well as a method for implementing such agreed upon changes. This can include the timeframes within which the vendor is required to provide a written proposal in response to customer change requests and a description of which representatives of the parties will negotiate scope and pricing for requested changes. It may also include a structure to address "expedited" changes that must be implemented quickly to satisfy a customer’s operational needs, often prior to the parties’ agreement on scope and, in some cases, the price.
* a description of any change management tool required by the customer to track agreed upon modifications to the base scope work so that fundamental changes to the underlying cost assumptions of the deal are not unexpected or inexplicable at the end of the customer’s fiscal year.
Negotiation of a good change management process can be a frustrating and arduous process for many customers, particularly those that are in a rush to complete their transactions, because the parties are necessarily talking about hypothetical changes for which neither party has a high degree of certainty. Avoiding the negotiation on this subject prior to signing an agreement, however, can be costly down the road. At some point during the term, customers will face the need for changes. In the absence of an agreed upon change management process, customers will have little leverage over their vendors and, in most cases, little time, given operational pressures, to negotiate the cost of such modifications.
As a final note, beware of one of the vendors' favorite last minute “solutions” to this problem--an offer to create a contract governance board or stewardship committee to manage the change process less formally through the parties' "relationship managers." While such structures can provide a useful forum for planning and tracking projects or ensuring that the customer gets desired face-time with appropriate levels of a vendor’s leadership team, when a scope change with a significant financial impact must be made quickly, stewardship committees or contract governance meetings provide little more than a placeholder to undertake the same time consuming negotiations that the parties avoided (when the customer had greater leverage) prior to executing the agreement.
Vendor Pricing: Watch Out for Regulatory Surcharges and COLAs
Although an explanation of best practices in negotiating and pricing managed deals is an article unto itself, there are two specific areas where customers should watch their vendors carefully: application of regulatory surcharges on parts of the service that are not regulated; and the use of automatic "cost of living adjustments" (COLAs) for vendor labor costs as a way to fatten margins on what they charge customers.
Regulatory Surcharges. In a typical transport deal, application of surcharges can increase the cost of the transport by over 15%. As a preliminary matter, customers should calculate these additional costs into their pricing models because the vendors' proposals seldom identify or include these charges. Second, there is no regulatory requirement that surcharges be applied to the managed services that the vendor provides; they should only be applied to the purchase of transport services. So, if a customer is buying transport as part of a managed services deal or if the vendor has quoted bundled pricing that includes both transport and managed services, application of regulatory surcharges to the management function will result in the customer overpaying for managed services.
Also, beware of vendors incorporating by reference their web-based service guides which may permit the application of additional surcharges or application of agreed upon surcharges to portions of the service you did not expect. Even if the guides did not contain such provisions when you signed the agreement, vendors always reserve the right to change and add provisions to them during the term of your agreement. In the absence of contradictory contractual language specifying the charges and the services to which they may be applied, customers could be put in situations in which they as a practical matter must pay the surcharges even if the surcharges were not specified when they signed the deal.
Cost of Living Adjustments (COLAs). Vendors often include, seemingly as a matter of right, COLAs for the labor resources they intend to deploy to provide your managed service. Too often, the negotiation of this issue begins (and ends) with the applicable percentage increase that will be allowed over the term of the agreement and the frequency with which the vendor will be permitted to apply the COLA to its labor charges.
Customers who are in control of their procurement should strongly question whether to agree to such COLAs at all. If you are outsourcing management of your infrastructure to eliminate responsibility for managing labor units and the risk of escalating labor costs, you should not allow the vendor to pass through those costs to you automatically. Moreover, customers should point out that inasmuch as underlying technology costs are declining, at a minimum a "net effect" should be calculated in determining permissible COLA adjustments. Put differently, vendors should not be allowed to pass through cost increases without also passing through cost decreases.
If you are not able to eliminate the inclusion of COLAs in your agreement, however, look carefully at how they are structured and applied. You may find the vendors have given themselves hidden opportunities to pad their margins at your expense. For example, if a portion of your labor pool has been off-shored to save money (such as a Help Desk function), the annual cost of living increases in many fast growing, low cost labor countries is significantly greater than cost of living adjustments in the U.S. Unless properly negotiated, you may find that over the term of the agreement, the labor costs increase substantially, at a faster rate than if the resources had been provided in the U.S.
Also, in every labor charge, the vendor has included some (in many cases, significant) margin. The COLA should only be applied to the vendor's actual costs in providing labor; otherwise you could be agreeing to pay a fat, uncontrolled up-tick in the vendor's margin for the managed services. Beware that this can be a very contentious issue, as vendors are reluctant to disclose their actual costs for labor resources. That said, a reasonable approximation should be made so that the COLA applies only to a portion of what the vendor has to actually pay for the labor resources, as opposed to what it charges you for them. And, of course, customers should never pay COLAs on any portion of vendor charges for non-labor related costs.
Conclusion
Outsourced managed network deals can provide effective solutions for many enterprise customers, including those seeking cost reductions in the management and operation of their networks. But unless the time and effort to procure such services includes adequate preparation, rigorous analysis of vendor proposals and careful and complete contractual documentation, savings may be illusory. Indeed, customers may end up inadvertently paying more than they would have had they retained management of their own resources.
Jim Blaszak and Andrew Brown are partners in Levine, Blaszak, Block & Boothby LLP ("LB3"), the telecommunications and IT law firm that specializes in the representation of corporate enterprise users. The lawyers at LB3 have successfully completed hundreds of transactions for enterprise users, including numerous agreements for managed equipment services. You can visit LB3's website at www.lb3law.com.
