Debunking the Top 5 SLA Myths

By Steve Martin

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It ranks as one of the most common and impactful outsourcing mistakes of the past decade -- too many service level agreements (SLAs), designed around the wrong business outcomes, and exceedingly focused on financial remuneration rather than operational remedies.

Whether due to a rush to get an RFP out the door and quickly ink a major deal or underestimating the effort required to design relevant service levels, companies often fail to appropriately link their SLAs to meaningful business results. Instead, they often blanket the outsourcing contract with too many SLAs, based on what “feels important.”

They also rationalize that setting service level targets beyond what is actually needed -- and often at unreasonable levels (e.g., 100 percent) -- will accelerate the realization of best-in-class performance, despite any inefficiencies and constraints with existing processes and technology.

In fact, this inevitably results in higher fees to ensure performance compliance and to cover the provider’s risk as well as a reasonable probability that, even when SLAs are met, the desired business outcomes are not accomplished. This is because the service levels are diluted with carve-outs based on the actual scope within the provider’s control.

While conventional wisdom suggests more is better -- e.g., 15 SLAs are better than 10, 20 percent provider fees at risk is better than 15 percent, 99.99 percent processing accuracy is better than 99 percent, etc. -- the problem with the “more is better” approach is that “more” results in higher costs, dilution of provider focus, and a misalignment between the provider’s incentives and the company’s desired business outcomes.

What follows are five myths about SLAs and why companies pursuing business process or IT outsourcing arrangements need to realize that more isn’t necessarily better. Better is better.

Myth No. 1: The more SLAs the better overall protection and performance realized - This is true in theory, but not in practice. Ideally, SLAs should be collectively exhaustive but mutually exclusive. Companies should ensure that key business imperatives are addressed by the SLAs so that the provider cannot fail to meet the customer’s expectations without failing to meet at least one of the SLAs.

Companies should also avoid multiple SLAs that measure different aspects of the same symptom, e.g., mean time to respond to service failures and mean time to resolve service failures. This helps reduce the number of SLAs, avoids a provider padding its price to protect against “double jeopardy” situations, and prevents misleading performance reporting.

Additionally, if providers are responsible for adhering to too many SLAs, the performance credits associated with a particular service failure may become inconsequential and therefore provide no performance incentive to the provider (i.e., experiencing a service failure may actually be more cost effective than providing an effective and appropriately resourced solution).

While the “right” number of SLAs generally depends on the scope of services being performed, as a guideline, companies should generally target 6 to 10 credit bearing SLAs for each major outsourced domain.

Myth No. 2: Increasing the provider’s fees at risk creates more incentive for them to perform - It would seem to reason that having a provider put 20 to 25 percent of their fees at risk for failure to meet SLAs would result in a sharper focus on meeting service levels than putting only 10 percent to 15 percent at risk. This is not the case. Service level credits do not provide equitable compensation for service failures and that shouldn't’t be their intent.

Performance credit amounts should be calibrated to cause some impact to provider margins, but targeting excessive credits will almost certainly result in the provider raising its prices to account for the increased resources required to “guarantee” performance targets are met and the increased financial risk of failure.

Customary financial consequences for failure to meet SLAs depend on the service, but most outsourcing transactions have 10 percent to 15 percent of total fees at risk, with “cap averaging” over all SLAs and for longer periods (i.e., yearly vs. monthly).

Myth No. 3: More stringent SLAs translate into higher provider performance and, thus, better results - Better availability, faster turnaround times, and 100 percent accuracy will only guarantee one result: higher costs.

Service levels should target the level of service that the company really needs and no more. While compelling providers to commit to service quality metrics in excess of what is actually required by the business might create the perception of better performance and higher value, it inevitably leads to higher costs, particularly for labor intensive processes and their associated metrics (e.g., requirement to complete all, as opposed to only the most critical/material GL account reconciliations within three days of the end of the month).

Many companies look to outsourcing as an opportunity to accelerate the achievement of best-in-class performance, but fail to recognize that the transition from current performance levels to benchmark levels often requires some level of process optimization. The existing organization and processes may not be mature enough to achieve such levels right out of the gate.

Companies should determine whether setting targets in excess of required performance creates any business benefit. If not, don’t require the provider to deliver, and moreover, price, to a gold-plated standard. If there is a meaningful benefit to more stringent performance targets, the contract may need to be constructed with provisions that allow the provider to achieve such performance over time, with locked in, planned performance target increases.

Myth No. 4: Hitting the provider with heavy financial penalties is the only real way to get their attention - Financial credits do provide an incentive for providers to meet performance targets, lest they suffer margin erosion or even the possibility of being financially upside-down on a deal. That said, as described above, providers have become quite sophisticated in their ability to manage the fees at risk vs. price dynamic, and while certainly not eager to provide credits, accept that some level of financial loss for failure to meet SLAs is acceptable or even likely.

There are several other methods, however, that are equally, if not more effective, in creating incentive for the providers to perform. One is requiring the provider’s executives to meet in person with the company’s executives when performance failure thresholds are hit -- and contractually commit to meeting each month until the service levels are consistently met.

Another approach is to require the provider to engage and pay for a third party to assess the causes of the failures and to develop a plan that the provider must follow to remediate the problems. Other non-credit bearing remedies/incentives include linking contract renewal and extension options to provider performance, requiring replacement of provider key personnel (at the provider’s cost), and stipulating that the provider perform root cause analysis and produce performance improvement plans to address deficient performance.

Myth No. 5: It is critical to hold providers accountable for the entire end to end process - Ideally, it would seem desirable to hold outsource providers accountable for meeting metrics for a performance goal related to an end to end business process cycle, e.g., days sales outstanding (DSO) within the order-to-cash cycle. However, more often than not, the provider does not have control over the entire business process.

In the case of DSO, the outsource provider may only have responsibility for portions of order-to-cash (e.g., cash applications, credit reviews), and not for example, order generation or invoicing. Excessively broad SLAs also lead to the provider building in broader carve-outs; often times neutralizing the applicability of the performance level altogether.

A good rule of thumb is to hold a provider accountable for the timeliness and accuracy of the dimensions of the process that are within its control. For example, in an accounts payable process, an outsource provider can be held accountable for the accurate data transcription from an invoice to the ERP system or the percentage of invoices entered and either successfully matched or properly routed to the client for resolution within a specified period of time.

While it’s perfectly reasonable to set aggressive performance goals and credit structures for your outsourcing provider, companies should resist the temptation to impose unnecessarily rigid SLAs that drive costs up and result in other unintended consequences without adding commensurate business value.

Companies should invest the time and resources necessary to ensure that the SLA framework and individual SLA metrics are designed to hold the provider accountable and motivate them to perform, rather than inspire them to figure out how to offset the credits through other creative means.

Steve Martin is a partner and David Borowski is a senior associate at Pace Harmon, a third-party outsourcing advisory services firm providing guidance on complex outsourcing and strategic sourcing transactions, process optimization, and supplier program management.