Originally used within the construction industry 'output based' contracts are now winning favour in the IT industry.

This fact formed part of the findings of a 2007 survey by the IACCM (International Association for Contract and Commercial Management) whose respondents revealed that over half of them were already using this type of contract. Paul Carter Hemlin, director of commercial and contract management consultant Blake Newport, reveals why this approach to contracting can benefit almost any arrangement.

An 'output based' contract is an agreement between a customer and a supplier, which creates a relationship for the delivery of services or products. The driving force behind the contract is that it focuses on what the deliverables are in business terms rather than how they should be delivered.

By allowing the supplier to perform its obligations with the minimum of constraints, it creates the freedom for a supplier to leverage existing facilities, adapt to new technologies, products or materials giving cost and efficiency benefits to the supplier and enhancing services for the customer.

In order to maximise the effectiveness of the output based approach, both parties must seek to remove as many constraints from the contract as possible - for some IT companies this may require a significant shift of mindset.

An output based contract does not aim to remove all detailed specification, it simply looks to remove unnecessary constraints, positioning the supplier as the expert and allowing them to decide the best way to do things. For example a traditional IT service description may state;

‘The supplier shall provide 10 Unix based servers running Backup Manager 2000 to be located at the Manchester site and connected to the estate by a 10Mbps network link, maintained by no fewer than 2 technicians. The backups shall run every night between the hours of 6pm and 6am and copies shall be kept for 1 week.’

However under an output based contract this in terms of what the actual desired outcome will be:

‘The supplier shall provide that all of user data is to be recoverable to within 1 working day, with 99.9 per cent reliability.  Constraint: backups must not interrupt work during business hours.’

Although this example is fairly simplistic it helps to illustrate the flexibility the contract offers to IT suppliers in terms of offering them a choice of solutions and resourcing. For clients it can reduce risk, as by outlining the desired business terms they are less likely to specify the wrong technical details.

Benefits all round

The benefits that these contracts bring to both sides are significant and suppliers gain the opportunity to propose innovative solutions and the flexibility to adapt new technologies and existing services to reap economies of scale, which can create significant cost savings - these in turn can be passed onto the client.

The management of information also becomes increasingly easier for the providers, as extensive reporting of operational information gives way to succinct reporting at the business level - leading to clearer understanding from the customer.

As well as cost benefits, the maximisation of the supplier's knowledge and practices can give greater certainty and performance and lead to higher service levels. The client may also benefit from reduced risk as by stipulating the desired business outcome they do not take on the risk associated with technical specifications - this comes down to the provider.

In addition communication between clients and suppliers is found to be simplified as their respective roles are more clearly defined. This was highlighted in the findings of the IACCM survey as over half of all respondents felt that it not only improved communication but it also significantly improved performance.

It may seem that output based contracts are a win-win situation, so why aren't they standard practice? The main difficulty lies in the increased effort required to define and agree the terms, over 60 per cent of respondents in the IACCM survey felt that this was especially true because business requirements were notoriously hard to define. There is also a perception with the output based approach that 'If you do not specify the precise service you want, you will not get it'. 

What can be done?

In order to safe guard against this and to ensure that the business deliverables are met, output based contracts should be underpinned by carefully chosen performance indicators or service level agreements, with a focus on restricting service levels to the key business areas. 

Service levels have a very important role to play in supporting output based service descriptions in that they drive the quality of delivery. By specifying the 'what' and then setting a performance target for its delivery, the supplier is then responsible for designing 'how' this target can be met. This is fundamental to the output based approach.

The approach relies on clients trusting that the risk has passed to the provider and will fail if a client seeks to add extra assurances not relating directly to business goals, as the supplier will quickly lose cost savings and be forced to apply more constrained pricing.

In order for this practice to work effectively careful contract management is needed from the very start of the process. Ideally, the people negotiating and drafting the contract terms will be experienced in the output based approach, so that the constraint-light discipline can be achieved whilst maintaining sufficient detail to have a workable agreement.

This includes a strong commitment from the client to invest the time and human resources during the pre contract phase. However it is worth noting that a key benefit that arises from expending the effort to truly capture business requirements is a greater understanding of them.

In short the responsibilities fall upon both parties. Clients should be prepared to take the time to clearly define what their key business terms are and should also be prepared to undertake a more 'hands off' approach, which may mean require a culture shift in some organisations. However this should not mean that the client is deprived of key performance information or progress updates.

In order for providers to make sure that they are clear on the IT solution to be delivered they should ensure that every point at which client input is needed it is drafted into the contract. Output based contracts can be very rewarding for both parties allowing each organisation to focus on what they do best.

An open and trusting relationship is needed between client and supplier built upon a foundation of careful contract management, ensuring definitions of business and performance measurements are clearly defined and backed up with service level agreement.