Service credits 101: the pros and cons of service credits for both suppliers and customers

In managed services contracts, service credits are a common feature designed to ensure accountability and quality. But what exactly are service credits, and how do they affect both suppliers and customers? Understanding their pros and cons can help both parties navigate their managed services contracts more effectively.

What are service credits?

Service credits are a form of compensation provided by a supplier to a customer when the agreed-upon service levels are not met. Typically, they come in the form of discounts on future services or additional free services. They serve as a remedy for service disruptions or failures, ensuring that customers receive value even when things go awry.

While service credits can be beneficial, they come with their own set of pros and cons, depending on which side of the agreement you’re on. Let’s dive into them!

Pros of service credits for customers

1. Accountability

Service credits hold suppliers accountable for their performance. If the service provided falls short of the agreed standards, customers receive compensation, which helps maintain fairness.

2. Financial relief

They offer financial relief by offsetting the costs associated with service interruptions. This can be particularly valuable during significant disruptions.

3. Encouragement of quality

Knowing that service credits are on the line can encourage suppliers to adhere more closely to service level agreements (SLAs), benefiting customers with improved service reliability.

4. Termination rights

Including a "three strikes rule" in the agreement allows customers to terminate the contract if issues are not resolved after multiple failures, providing a strong safeguard against ongoing poor service.

Cons of service credits for customers

1. Limited compensation

Service credits might not fully cover the extent of losses or damages caused by service failures, especially if the impact is substantial.

2. Complex claim process

Claiming service credits can involve complex procedures and documentation, which might be time-consuming and burdensome for customers.

3. Potential over-reliance

Relying too heavily on service credits might mask underlying issues in the service relationship, potentially delaying more fundamental improvements that need addressing.

Pros of service credits for suppliers

1. Customer trust

Offering service credits can build trust with customers, demonstrating a commitment to high-quality service and a willingness to take responsibility for service issues.

2. Market differentiation

Service credits can differentiate your services from competitors who do not offer such guarantees, potentially attracting more customers.

3. Strengthened relationships

Providing service credits can serve as a goodwill gesture that helps strengthen long-term relationships with customers, encouraging continued business and customer retention.

Cons of service credits for suppliers

1. Financial impact

Issuing service credits can have a significant financial impact, particularly if they are frequent or substantial, affecting the profitability of the business.

2. Increased expectations

Regularly offering service credits might set high expectations among customers, leading them to demand compensation for even minor service issues.

3. Reactive focus

Relying on service credits as a standard practice can shift the focus from proactive service improvements to reactive compensation, potentially overlooking deeper, systemic issues.

4. Three strikes rule risk

The inclusion of a "three strikes rule" can pose a significant risk. If the rule is part of the contract, repeated service failures could lead to termination, impacting the supplier's reputation and revenue. For this reason, it's important to carve out caveats to the "three strike rule", e.g. the three strike rule will not be applicable where the failure to meet the service levels is due to an external factor that is outside of the supplier's control.

A balanced approach

For both suppliers and customers, it’s crucial to find a balance. Customers should expect service credits when service levels are not met but should also be mindful of the limitations and processes involved. Suppliers, on the other hand, should consider offering service credits thoughtfully and explore other ways to demonstrate commitment and maintain service quality.

Alternative strategies for suppliers

For service providers, rather than offering service credits as a standard, consider other ways to assure customers of your commitment to quality:

1. Enhanced SLAs: Strengthen your service level agreements with clear, realistic targets and regular performance reviews to ensure that service levels are being met without needing to resort to credits. If you’re looking for a comprehensive standalone service level agreement, you can find our template here.

2. Proactive communication: Maintain open lines of communication with your customers. When issues arise, being transparent and proactive in addressing them can often prevent the need for service credits.

3. Flexible service models: Offer customised service models that cater to different customer needs, allowing for flexibility in how you handle service disruptions without relying on service credits

4. Mitigating risks: Service providers can offer a "three strikes rule" as a sign of confidence in their service, but it should be coupled with a robust internal process for rapid issue resolution. By focusing on proactive service management, providers can minimise the risk of triggering contract termination while maintaining customer satisfaction.

Key considerations when negotiating service credits

Negotiating service credits involves finding a balance that aligns with both suppliers' and customers' interests. Here are three key considerations to keep in mind for both suppliers and customers:

For suppliers:

1. Cap on service credits

To manage financial risk, suppliers should negotiate a cap on the total amount of service credits they may have to provide. This helps limit the potential financial impact of service failures. Caps are usually set between 5% and 20% of annual fees. Setting a reasonable cap ensures that the supplier remains financially protected while still providing meaningful compensation.

2. Clear definition of service levels

Clearly defining service levels and performance metrics in the agreement helps avoid ambiguity. This precision makes it easier to manage expectations and reduces the likelihood of disputes. Work with customers to establish specific, measurable service levels that are realistic and achievable. This also allows suppliers to manage their performance more effectively and reduces the risk of frequent credit claims. Our managed services contract includes fully customisable service level terms that can be tailored to suit the services and your business.

3. Monitoring and reporting obligations

Suppliers should agree to transparent monitoring and reporting processes to track performance against service levels. This reduces the risk of unjustified credit claims and provides clarity on service quality. Implement robust performance tracking systems and provide regular reports to customers. This transparency helps build trust and can mitigate disputes over service level compliance.

For customers:

1. Customer termination rights

Including a termination right in the agreement provides customers with a clear exit strategy if service levels are not met. This is especially important if the supplier fails to address performance issues after repeated failures. Negotiate a "three strikes rule" or similar provision that allows contract termination based on specific service level failures. This provides additional leverage and ensures that customers are not stuck with a subpar supplier.

2. Detailed tracking and reporting requirements

Customers often lack visibility into supplier performance. Imposing detailed tracking and reporting requirements ensures that performance metrics are monitored effectively and that service credits are justified. Require suppliers to implement comprehensive monitoring systems and provide detailed performance reports. This helps verify compliance with service levels and supports accurate claims for service credits.

3. Negotiating service level details

A sliding scale of service levels can incentivise better performance but can also lead to excessive complexity. Customers should negotiate a manageable number of service levels that are both realistic and effective. Work with the supplier to establish a clear set of service levels that reflect key performance areas without overwhelming the supplier with administrative tasks. Aim for a balance that promotes high performance while keeping the agreement practical.

Conclusion

Service credits are a valuable tool in the world of managed services contracts, but they are not a one-size-fits-all solution. For customers, they offer a form of compensation and accountability, especially when coupled with a "three strikes rule" that provides an exit strategy if service consistently falls short. For service providers, while service credits can build trust, they also carry financial and operational risks, including the potential for contract termination.

The key is balance. Customers should expect service credits when service levels are not met, ensuring they receive the value promised. On the other hand, service providers should carefully consider whether offering service credits as standard is the best approach or if there are alternative ways to maintain high service standards and customer satisfaction. By carefully weighing the pros and cons, and considering a "three strikes rule" when appropriate, both parties can ensure that their managed services contracts are fair and mutually beneficial.

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