Taking IT outsourcing to the next level

With businesses increasingly dependent on service providers to reduce costs, improve quality, and drive innovation, traditional contracts don’t work. In fact, they often undermine the partner-like relationships and trust needed to cope with external uncertainty. A better approach is to use what leading academics call a “formal relational contract.”

Why transactional contracts are a thing of the past

Over the years, outsourcing has become a popular way for companies to reduce costs, improve efficiency, and access specialized skills and technology. The conventional approach uses a transaction-based contract where the buyer pays the provider a negotiated price for set scope of work (e.g., price per billable hour of a software developer, price per licensed user for access to a SaaS product, price per call for desktop service support). 

The beauty of transactional contracts is their simplicity: use a competitive bid to negotiate the best price among all capable suppliers. But simplicity has trade-offs. 

Traditional contracting methods provide little room to accommodate changes in complex IT projects. While the fixed scope of work and clear deliverables and deadlines may seem straightforward, they can be limiting when technical challenges or changing business needs arise, unforeseen or otherwise. Even in the absence of a specific crisis, traditional contracts create room for three looming problems: hold-ups, incomplete contracts, and shading.

Hold-ups happen when one (or both) parties fear the other party will become opportunistic and use their power against the other. In essence, the weaker party feels trapped — especially if they feel they cannot easily get out of the relationship due to strict contract terms. Second, incomplete contracts amplify the problem in complex outsourcing relationships because complex contracts almost always contain gaps, omissions, and ambiguities. Third, shading manifests in the form of negative behaviors triggered in response to a party not meeting contractual expectations. For example, a supplier might make countermoves such as replacing the A-team on an account with the C-team to lower costs and increase profit. 

Trying to constrain a partnership on a complex IT project within rigid contractual terms will likely yield frustration on both sides. Relational contracts are more flexible and adaptable, enabling the parties to work together to address these changes.

Going relational

When two parties enter a complex IT outsourcing deal, they need to work collaboratively, communicate effectively, and build trust. This is where relational contracts come in. Unlike transactional contracts focusing on legal obligations and penalties, relational contracts emphasize collaboration, communication, and problem-solving by specifying mutual goals and establishing governance structures to keep the parties’ expectations and interests aligned over the long term.

Formally, a relational contract is defined as “A legally enforceable written contract establishing a commercial partnership within a flexible contractual framework based on social norms and jointly defined objectives, prioritizing a relationship with the continuous alignment of interests before the commercial transactions.”

Complex relationships in which it is impossible to predict every what-if scenario are tailor-made for relational contracts. Large IT outsourcing projects provide a strong example of this, due to the technical complexity of the work and the number of stakeholders involved. In addition, the outsourcing partner is often located in a different country with a different culture, which can lead to miscommunication, delays, and in the worst case, formal disputes and lawsuits.

Because they focus on flexibility, adaptability, and mutual understanding of expectations, relational contracts are well-suited for complex IT outsourcing deals, especially when the deliverable isn’t a “shipped” product but something much less tangible such as good desktop support or the value of using the service provider’s software to increase sales pipeline effectiveness. The buyer is not only buying material inputs that are essential to the creation process but the innovative capacity of team members.

Key elements of a relational contract

Relational contracts obligate the contracting parties to create a flexible framework to promote a fair and balanced exchange that accounts for the understanding that business is dynamic and things will change.

The figure below provides a comparison along five dimensions, showing the differences between a relational contract and a transactional contract along a continuum.

Building relational contracts that work

A relational contract specifies mutual goals and establishes governance structures to keep parties’ expectations and interests aligned over the long term. So, when business happens — there are guiding principles and processes to help the parties work through whatever the new economy can throw at them in a collaborative manner.

Researchers at the University of Tennessee developed a five-step “Getting to We” process for creating formal relational contracts. The underlying idea is to shift the focus away from negotiating “this deal” to determining how the parties can collaborate to create success in the relationship. The five steps are as follows:

Step 1: Laying the foundation: Establishing a partnership mentality is pivotal to sustainable cooperation. When both parties begin negotiations with the genuine partnership as a formal (written) feature of the contract, it creates room for trust, transparency, and high-level aspirations to flourish — rather than an inherently adversarial mindset. Laying this foundation focuses on outcomes, not transactions, in the earliest phase of the partnership.

Step 2: Co-creating a shared vision and objectives: Here, parties identify specific goals, concerns, and desired outcomes, complemented by clearly defined relationship-management processes. Both parties (not just the one with the upper hand) need space to explain their desired outcomes and goals and tactical and measurable objectives. This can be thought of as focusing on the what, not the how. Essentially, in step 1, negotiating parties agree to go on a journey together; in step 2, they draft a roadmap for where they both want to go.

Step 3: Adopt guiding principles for the partnership: Once parties have defined measurable outcomes, adopting guiding principles can help preemptively steer away from potential potholes. These principles are designed to avoid value-eroding friction in the partnership at all costs. No one wants to be treated unfairly — or leave themselves open to exploitation. Likewise, the more unknowns in the picture, the higher the risk. Another negotiation phase tries to head off tit-for-tat behavior and preemptively rewards reciprocity.

Step 4: Align expectations and interests: While guiding principles can define the direction of the journey, aligning expectations and interests demands more instruction. In this step, it’s time to hammer out the details, which requires full transparency and applies to all terms and conditions of the relational contract, such as responsibilities, pricing, metrics, etc. It also underlines a problem-solving mentality instead of a negotiation mentality.

Step 5: Stay aligned: Robust governance mechanisms help hold the contracting parties accountable for living to their intentions. If the shared vision and objectives are the beacons of the relationship, governance provides the structure and mechanisms for the parties to stop and redirect their efforts when detours occur. This involves both formal and informal governance mechanisms.

The bottom line

Getting contracts right can create millions — if not billions — of dollars of value. But getting them wrong can cost millions of dollars when the parties become misaligned. 

If you are frustrated with your IT outsourcing deal maybe it is time for an upgrade by putting past practices, beliefs, policies, and conventional transactional contract templates aside and embrace a more collaborative approach for contracting using formal relational contracting.