While outsourcing buyers and providers alike claim to want relationships based on strategic advantage, most continue to use pricing models based on labor arbitrage.
The most prevalent pricing model is based on the commonly accepted concept of a full-time equivalent (FTE), which is generally used to indicate how many full-time workers are needed to perform tasks.
The FTE model’s popularity is largely due to the fact it is the easiest to govern and typically yields immediate cost savings, says Sarthak Brahma, VP and head of Pricing Assurance for the Everest Group. The objectives of both buyers and providers are initially well aligned, with both looking to drive down costs. Over time, however, buyers seek to further lower their costs while providers seek to maintain and improve their margins.
This leads to what Everest Group calls a “point of dissonance” and can result in the parties considering alternate pricing models based on a buyer paying for individual transactions or rewarding providers for helping them achieve desired business outcomes, sometimes by sharing added revenues.
With the outcome-based model, at least in theory, buyers can enjoy additional cost savings and/or more strategic business benefits. Providers can benefit by further cementing their relationship with clients. The relationship tends to break down, however, if desired outcomes are not met.
“Then the entire premise takes a hit, and there is a blame game,” Brahma says.
Outcomes: Seeing Is Believing
An outcome-based pricing model is more akin to a managed services relationship, in which providers determine the people, processes and locations they will use to obtain designated outcomes while clients simply measure results, says Steven Kirz, a principal with Pace Harmon. Clients like these kinds of solutions because they can be 20 to 50 percent less expensive, he says, while providers like them because they can better leverage their back office operations and more effectively manage their margins.
Kirz says outcome-based models can become problematic, though, if clients feel they have trouble getting issues resolved due to a lack of transparency into a provider’s operations. An article about biopharmaceutical company AstroZeneca’s recent decision to end its outcome-based pricing arrangement with IBM quoted an AstroZeneca executive as saying the outcome-based criteria failed because the company believed it “had lost sight into how the work was delivered.”
And, Kirz adds, a lack of transparency can also make it more difficult for buyers to put out a bid to other suppliers at the end of a contract or even to renegotiate their contract with the existing supplier.
Kirz says outcome-based models tend to work best with suppliers that have already made significant investments in their people, processes and technology. “Where we’ve seen it work well is where suppliers have a lot of industry experience and feel comfortable with it,” he says.
Getting the Incentives Right
Outcome-based pricing will not work better than FTE or transaction-based pricing if the client does not understand the drivers and put the right incentives in place, Kirz says. He uses the example of a help desk to illustrate the importance of providing the right incentives. If a client agrees to pay for every call handled by the help desk, it may not get improved service.
“What is the help desk’s incentive not to have calls? They want people to keep calling,” he says. “This may lead to the help desk not solving issues on the first or even second call, so quality can actually decline.”
But if a client agrees to pay for an outcome of call reduction, providers might choose to offer self-service technology that allows users to re-set their own passwords and/or make other investments that should cut down on the number of calls while improving service.
Despite the potential pitfalls, outcome-based pricing can yield good results, says Ben Trowbridge, CEO of Alsbridge. And, he says, it’s a good idea to consider it as part of nearly every outsourcing discussion “just to challenge conventional thinking.”
Here are 10 tips from Brahma, Kirz and Trowbridge on making outcome-based outsourcing agreements work:
Make sure outsourcing is the right option. “If the outcomes are really critical, the buyer needs to be wary about whether they want to outsource those outcomes to any service provider,” says Brahma.
Establish realistic objectives. When buyers ask for the moon, sometimes suppliers promise to provide it in their eagerness to close a deal. Both sides are better served by establishing realistic objectives from the outset. Buyers should realize that general economic factors and other market conditions can impact a service provider’s ability to deliver the desired outcomes, Brahma says.
“Realize providers will want to make promises to win your business,” says Trowbridge. “Be careful to filter what they say and ask measured questions. You are trying to sign up a long-term partner, so you don’t want to agree to anything that isn’t fair.”
Utilize “pain sharing” as well as gain sharing. A good way to do this, says Brahma, is by writing contracts to reward providers if they come close to attaining a desired outcome. “If an agreement is that the provider will get 10 percent if they help the customer save $10 million in costs, it should not mean they get nothing at all if they deliver $9.8 million in cost savings,” he says.
“If an agreement is unfair in certain scenarios to a provider, then it is probably also not good for you as a client,” Trowbridge says.
Use an incremental approach. Instead of being highly aggressive at the outset, consider asking for your desired outcomes in stages. For example, ask a provider to deliver $2 million in savings the first year and $4 million the second year. This gives providers additional time to ramp up and reliably perform.
Use carrots as well as sticks. While penalty clauses are often a part of outcome-based agreements, Brahma says “a generous bonus for exceeding the goal is a good incentive.”
Create effective measurements. To do this, both sides must have a clear understanding of an organization’s current state and what that current state will look like if nothing is done, Kirz says.
Check in periodically. Schedule monthly or quarterly reviews with providers to see if they are on target to meet the objectives. These kinds of reviews can help both providers and customers by offering early visibility into potential problems, Trowbridge say
Get expert help with negotiation. Kirz says large suppliers employ estimating models to determine how many hours they believe will be required to deliver services included in a fixed-fee bid. Such estimates tend to be higher than if clients competitively bid out the requirements. “Clients need to have someone that can go toe to toe with a supplier and take apart the estimating model. This will generally reduce the cost of a fixed-fee bid,” he says.
Consider getting more suppliers into the mix. Kirz says his company’s clients sometimes want to contract with the same provider to develop and then maintain applications. A better approach, especially with outcome-based models, is to hire different providers for the tasks and to create a contract clause that says the company handling maintenance must sign off on the app in the final stages of development saying it meets specifications and that they agree to maintain it. “It gets you a second view of the warranty,” he says.
Realize not everything lends itself to an outcome-based approach. “You’re always going to have something new, something that you might be outsourcing for the first time. Your contract should include both FTE and managed services models, then you can work to move some of the FTE stuff to a managed services model,” says Kirz.