With all the factors that contribute to a successful sourcing outcome, just how important is the choice of pricing model that you use? Well since the core tenet of offshore work is always cost savings, how you price the services you receive from your vendor has a huge impact on the profitability and ROI of your project.
As the recession recovery continues, providers are not offering price cuts anymore; instead they’re offering new pricing schemes. But as the models get more and more complicated, and the lines between fixed and variable costs blur, how can you as a buyer be confident that you’re getting the most bang for your buck?
We spoke with experts from KPMG and TPI, to bring you the new pricing trends in the ITO marketplace. Read on for more.
Fixed price vs time & materials
We know the basics of these two pricing methods. A fixed price or transaction-based pricing model means that you pay the vendor for a set amount of transactions and service volume, within a set period of time. By contrast, a time and materials (T&M) approach is where you pay for use of the vendor’s resources, including infrastructure and labor cost.
The fact is, many buyers don’t stop to weigh the benefits against the risks for these models, and end up with something unsuitable for their business. The benefit of a fixed price approach for example, is that the costs are known throughout the term. If you’re a CIO, you can plan your budget for the next few years. You may not like the price, but at least you know what it is. The risk is if your internal demand fluctuates; in other words, you need more service volume. When that happens, the vendor begins to see his profit margins erode, and may respond with low quality service delivery. On the other hand if volumes decrease, you’re now paying more than you should be for the reduced service volume.
Another thing to keep in mind is that “any unknown or variable factors in the transaction are going to get bundled into some sort of risk premium on the contract,” says Steven Hall, Partner and Managing Director, CIO Services at TPI. “Fixed price is like buying car insurance. If you don’t feel you can manage the risk of those unknown factors, pay the risk premium and have the provider manage it for you.”
The benefit of the time and materials model by contrast is that volumes can increase as much as necessary. “In an outsourced model, you need to really manage your internal demand. As the provider is holding the levers, he can adjust without a problem if your internal demand goes up,” says Mark Trepanier, Principal at Shared Services and Outsourcing Advisory Services, KPMG. “In fact he’s more than happy to, since he gets paid more.”
The risk with this approach is if you don’t fully understand where your costs come from. Especially with more complex IT sourcing, there are many more hidden costs that buyers don’t know about, leading to nasty surprises when the invoice comes in. Make sure to agree beforehand on what’s covered and what’s not – costs like travel, employee training, visas and phone charges are just a few examples. “If you know exactly what your costs are, go for T&M,” says Hall. “But I rarely recommend that a company use this model for anything like maintenance, or tech infrastructure-related functions. Most of the time, I suggest fixed price for large outsourcing deals of this nature.”
The other problem with the time and materials approach is that there’s no inherent motivation for more efficient service delivery. You, as the client, are responsible for directing the activities of the provider, and so there’s never really any investment in the process from the supply side. In fact, providers actually lose revenue if they reduce headcount, so why would they try to be more efficient?
New models: Doing more for less
The question for today’s buyers is, what pricing models incent vendors to innovate and be more efficient? “In terms of service offerings, providers are beginning to offer much more defined and integrated services that are configurable, but less customizable by the client, and based on a pure unit pricing model,” says Trepanier. “We’re seeing more of these approaches, and more second and third generation transactions, which reflect a maturing of the market.”
But the dominant pricing model at least in IT outsourcing continues to be a fixed price approach, which includes some flexibility. Essentially you pay a base charge for a set volume of services, which is then adjusted every so often by Additional Resource Charges (ARCs) or Reduced Resource Credits (RRCs), depending on how your internal demand fluctuates and how much of the vendor’s resources you use. This kind of pricing usually works well for buyers, since you now have the security of a fixed unit price, and your transaction volume can also fluctuate as necessary. According to Trepanier, “clients today are increasingly moving toward pricing models that more directly vary the cost in direct proportion to consumption, and away from fixed cost or ‘base charge’ type transactions.”
As the offshore market evolves to become more complex, so do the pricing models. The need for the buyer to motivate the provider to invest in the process has generated a new approach called output-based pricing, or pricing based on the outcome of the project. “So instead of the cost of delivery and the services that were inputted, it’s based on the profits of the output,” says Hall. “Usually the contract will contain some percentage of the profit from the product that will go to the provider. The idea is that this makes the provider innovate and be much more efficient.”
Another aspect that the industry is getting its head around is how to price for services delivered through the cloud. Post your comments below – share your experiences.