Legal Eye: How to save money with offshoring

Looking to save money from offshoring? Lawyer Scott Thiel offers some tips for what to put in your contract.

In the current economic climate, projects aimed at reducing operating costs are at the forefront of businesses' agendas. This emphasis on cost savings is driving a wave of interest in offshoring and what it can achieve across the businesses.

A business case supporting the initiation of an offshoring project will be underpinned by an expectation of cost savings. However, while this potential is undeniable, mere engagement with a third-party outsourcer is not in itself a guarantee that savings will be realised.

There are a number of contractual mechanisms which should be considered and adopted in order to maximise the potential for cost reduction and commercial success.

The foreign exchange factor
With the Bank of England's policy of sustained quantitative easing driving down the value of the pound, the impact of foreign exchange fluctuations must be considered. Any client that was exposed to the full risk of recent currency fluctuations might well have seen the entirety of their potential savings eroded in a matter of months.

In order to reduce this threat, contracts should include a foreign exchange risk sharing mechanism. This might include different exchange bands in which the parties share differing proportions of the risk or benefit that currency movements will bring.

It is also appropriate to consider the inclusion of certain exchange collars beyond which the economics no longer stack up for either party. In this case it may be appropriate to include explicit termination rights. It is important to carefully stress-test and tailor any such model against the project business case.

Amortisation of set-up costs
The creation of a long-term savings expectation is often offset for as much as the first twelve months as a result of upfront set-up and migration costs. Historically, the customer has been expected to cover these costs up front, which is at odds with the current rush to realise bottom-line savings.

Suppliers are also facing a squeeze and are keen to win business in an increasingly difficult market. As a result, they are becoming more nimble and increasingly prepared to consider alternative payment profiles. These might include a deferral or spreading of set-up costs in consideration for a long term contractual commitment from a client.

Indexation and the vanishing labour arbitrage
Clients are rightfully concerned about locking in rates for a long term transaction at a time of deflationary pricing. The issue is compounded in any offshoring activity due to the gap in the rate of inflation between the traditional and emerging markets.

Traditionally, fixed rates or use of a specified, published index have been relied on. However, the sharp contrast between the current retail and consumer price indices highlights the difficulty in selecting an appropriate index.

While the reaction of some has been to veto all services procurements over twelve months in duration, the cost and upheaval associated with an offshoring project is likely to be highly volatile with a policy of this nature.

Instead, it may be more appropriate to include more sophisticated and flexible indexation model. This could include reference to specialist indices (such as CEL for IT related goods and services). In order for a client to hedge its position, agreement might also be reached on using the lowest of a number of listed indices.

Benckmarking
Another key legal mechanism that ensures value is sustained throughout the life of a contract is benchmarking rights. These afford an opportunity for a client to periodically check if its costs are in line with current industry pricing.

While many contracts include benchmarking provisions, far less provide the client with the necessary contractual rights they need to implement the necessary changes which a benchmarking exercise might reveal. Constructive dialogue between the parties must always be at the forefront of any post benchmarking exercise.

Nevertheless, and in order to ensure that the client retains a degree of commercial leverage in such discussions, it is imperative that a client has certain contractual remedies if these discussions break down. Armed with an independent report which confirms it is paying too much, a client should retain a right to impose cost reductions and/or rights of exit from the deal.

Scott Thiel is intellectual property and technology partner at law firm DLA Piper Scotland.