Service Level Regimes - Key Issues

I spent a good bit of time in the run up to Christmas 2023 in detailed negotiations regarding a particular service level agreement for one of the outsourcing projects I am advising on....so maybe now is a good time to revisit some of the key points for consideration in relation to such things!

• How will the SLA regime work?Before you leap into setting the service levels themselves, there are some fundamental questions you will need to address in terms of how the SLA regime is to work. For example:Will the Service Levels attract some kind of concrete sanction or consequence if they are not met, or are they for reporting and governance purposes only?Over what periods will they be measured? Monthly measurement is probably market standard, but there may be grounds for variation. The point to remember here is that the longer the period of measurement is, the more scope there will be for shorter term service deterioration without any associated SLA breachWill the service levels be based solely on objective data pertaining to the supplier's own performance, or might they also include either more subjective "balanced scorecard" type measures, and/or relate in whole or part to end to end measurements which also include elements of performance related to either the customer or its other suppliers?

Calculation of Service Credits

In most - albeit not all - cases (and especially in the outsourcing world), the consequence of missing a service level will be a financial one, applied initially as a reduction to the Charges otherwise payable by the supplier and usually referred to as a "service credit".

Again, a number of key questions arise:

How will the service credit model work?

There are at least three common models; the simplest one simply assigns an amount that will be incurred each time the relevant service level is missed, and has this hard wired into the contract at the outset. This certainly has the benefit of simplicity, but it also is inflexible and will not - for example - reflect any future changes in the amount of the charges arising either by virtue of more material volume fluctuations, or the addition or removal of service scope#.

The second model is often referred to as the "service credit point" model; this operates by assigning a value to an individual service credit "point" (usually as a percentage of the overall monthly charges); the service level agreement/schedule then sets out a mechanism for service credit points to be incurred each time a service level is missed, usually on an escalating basis so as to reflect the degree to which the supplier has missed the target. So for example if there was a service level which required a supplier to hit an availability target of 95%, it might then incur 1 service credit point per percentage point between 95% and 90%, 2 service credit points per percentage point between 90% and 85%, and 3 service credit points for each percentage point thereafter below 85%. This has the merit of reflecting the impact of worsening performance (and incentivising the supplier to stop things getting worse), but would again require renegotiation in the event that the customer wanted to revisit its priorities in terms of the perceived importance of different services.

The third model - and the one which perhaps is now seen most often in complex outsourcing engagements at least - is the pool allocation percentage model. This works by creating a "pool" to be allocated across all of the available service levels, which is itself set as a percentage of the At Risk Amount (see below). The size of this percentage will be subject to negotiation....suppliers will ideally want it to be restricted to 100% of the At Risk Amount, but customers will usually try to get it set at a higher percentage (200% or more); this works on the principle that if the pool were set at 100%, then the supplier would have to miss ALL of the service levels for the customer to ever be able to recover the full At Risk Amount; if instead there is a larger pool, then the customer will be able to create a greater degree of incentive/pain associated with more of the service levels (albeit with the key point being that under such a model, even though the supplier could notionally accrue a percentage from the pool which is then MORE than 100%, it can never actually be required to pay out more than the At Risk Amount in any given measurement period). The other key perceived benefit of the pool allocation model is that it will usually then allow for a reallocation of parts of the pool from one service level to another, so as to reflect changes in business priorities or focus on the part of the customer. Key for negotiation in this context will be:

• can such amendments be made by the customer as of right, or must they be agreed with the supplier?
• how often can they be made? eg so as to avoid the customer looking to "game" the system by changing every month, depending on where they think the supplier is most likely to miss its service level
• is there a limit on how MUCH of a change can be made at any one time? eg is there a maximum % from the pool that can be switched from one service level to another at any one time?
• Likewise is there a limit on the amount of the allocation that can be placed on any single service level? Suppliers will for example be wary of the risk of signing up to a regime which starts with a potentially challenging service level initially having an assignment of 15% of the At Risk Amount, only to then find that the Customer swiftly then reallocates the pool so as to have 100% of the At Risk Amount allocated to that individual service level!How much is placed at risk to failing to meet the Service Levels?This is usually referred to as the "At Risk Amount", and again will usually be expressed as a percentage of the charges payable over the relevant measurement period. Again, the setting of this cap will be a matter of much negotiation (!), with suppliers keen to set it as low as possible and customers trying to push it as high as possible (albeit that they should bear in mind that this may in turn have pricing impacts, depending on the supplier's assessment of the risk that this then creates to their profit margins!).Aside from the monetary sum of the At Risk Amount, some other key considerations to bear in mind will be:
• What aspects of the Charges does it attach to? Suppliers will for example be keen to ensure that it excludes taxes or pure pass through costs, and may also seek to restrict it to the elements of the Charges as relate to the ongoing services only (e.g and so as to exclude any element of the charges as relate to costs which have been amortised across the overall contract term, such as those associated with initial transition or implementation work which was not paid for at the time)
• Will the rate of accrual of service credits against the cap increase in the event of particularly serious or repeated service level failures, and if so, will the cap of the At Risk Amount still apply to any such uplifts?
• What is the relationship of the At Risk Amount to other potential claims which the customer might make in relation to service level breaches? Customers may well argue that there is NO link (on the basis that service credits are purely a mechanism for adjusting the Charges to reflect a lower-than-promised level of service delivery, and are not therefore compensatory in nature), but suppliers will often try to argue that they be treated as a sole and exclusive remedy for the related service level breach, or at least be offset against any future claims relating to the same underlying issue

Other Factors for Consideration

Even once all of the issues above have been addressed, there are other "shards of glass in the grass" to be considered and which may have unfortunate consequences for one or both parties if they are not addressed in the contract, including:

• How will volume fluctuations be addressed? If the supplier has set up the services to deal with an anticipated volume (eg numbers of calls to a service desk, numbers of transactions to be processed etc) and in fact the volumes turn out to be significantly higher, will it still be liable to any service credits accruing vis a vis the service levels it may then be - not unreasonably - unable to meet? Note that this risk may not be fully addressed even if the charges mechanism provides for the supplier to be paid more for such increased volumes. It may be possible to address such issues by way of a volume forecasting regime, although this in turn begs the question of what happens if the Customer estimates a high volume and this then does NOT arise in practice....will it then be liable to the Supplier for the estimated volumes as opposed to those which actually arose?
• What will happen if the Supplier is impacted by events beyond its control, whether that be force majeure type events or - more specifically - failures or delays on the part of the Customer itself? Many contracts have what is often referred to as a Relief Event or Excused Event mechanism which will allow the Supplier to get relief for impacts upon its service level performance in such situations....but often then CONTINGENT upon them following a prescriptive written notice process (which many suppliers are - in my experience - not very good at complying with in practice)
• If the Supplier OVER achieves, what happens? Some regimes will then provide for the Supplier to get a "service debit" or bonus (either in cash or by way of an offset against service credits as may otherwise have been incurred). Whilst one can see the potential logic for this, one should ask: (1) does the Customer actually gain any tangible benefit from over achievement? (2) How far back/forward should any accrued debits be capable of being applied? (3) Will such a regime end up being counter productive, e.g by encouraging the Supplier to "chase" such debits or bonuses vis a vis the applicable Service Levels, in circumstances where the Customer would actually want the focus to be on other Service Levels which are NOT then being met

All of these issues (and more!) will need careful consideration in the context of any significant service level regime, not only because of the importance of incentivising service delivery, but also because of the potential impact on the Supplier's margins (and possible risk premium then attached to its pricing) and also potential linkages to express SLA-related termination triggers....which are probably worth a separate posting in their own right!!

Kit Burden

Partner

DLA Piper - Technology and Sourcing Group