New Pricing Models for IT Outsourcing

Several new pricing models have evolved over the time since Enterprises that have gone the outsourcing way, now expect more value from their IT service providers and IT service vendors want potentially higher-margin of work.

In a typical and conventional IT outsourcing deal, a vendor provides a service —managing servers, developing applications, monitoring networks —and the customer pays for it, whether at a fixed price, on a time-and-materials basis or a cost-plus model.

Customers have grown to expect more value from their IT service providers and vendors have also become eager to win that higher value, potentially higher-margin work and as a reason several new pricing models have emerged.

Among the new pricing structures increasing in popularity are incentive-based contracts, shared risk-reward arrangements, gain-sharing agreements and demand-based pricing. “The better contracts aspire to satisfy the customer across prioritized business objectives.

But early adopters may find that while these new price models convey real benefits —from encouraging innovation to increased control over IT costs.

Few latest models that organizations may come across when negotiating their next outsourcing deal: what it is, whom it works for, benefits, and drawbacks have been listed below.

Gain-Sharing Pricing Model

What It Is: Pricing based on the value delivered by the vendor beyond it’s typical responsibilities but deriving from its expertise and contribution. For example, an automobile manufacturer may pay a service provider based on the number of cars it produces.

Best For: Customers seeking dramatic business improvements who want to create a true alliance with IT suppliers.

Pros: Theoretically, this model encourages collaboration and creative problem-solving as both parties work toward common business goals. It also affords the supplier greater freedom to determine how best to achieve the results.

Cons: Gain-sharing requires a high level of trust, an equitable distribution of risk and reward, and significant upfront investment. “In practice, very often neither the vendor nor customer is willing to fund the investment without a guarantee of a payback.” Gains can be hard to agree on and difficult to measure. Because results can be influenced by factors outside of their control, vendors charge a premium on these deals.

Incentive-Based Pricing Model

What It Is: Bonus payments are made to the vendor for achieving specific performance levels above the contract’s service level agreements. Often used in conjunction with a traditional pricing method, such as time-and-materials or fixed price, “the key is to ensure that the delivered outcome creates incremental business value for the customer.

Best For: Customers who are able to identify specific investments the vendor could make in order to deliver a higher level of performance.

Pros: Incentives can compensate for drawbacks in the primary pricing method and better align provider motivation and customer goals.

Cons: “This model often falls flat because companies end up rewarding their vendors for work they should arguably be doing anyway. “The ‘incentive’ should be that they get to keep providing the service.” Measuring bonus-worthy performance can be difficult and costly.

Consumption-Based Pricing Model

What It Is: Costs are allocated based on actual usage (e.g., gigabytes of disk space used or help desk calls answered).

Best For: Buyers concerned about service provider productivity and those with variable demand. The utility model is particularly well-suited to situations in which the fixed costs of the services are shared across many customers, like cloud computing engagements.

Pros: Pay-per-use pricing can deliver productivity gains from day one and makes component cost-analysis and adjustments easy. Capital expenses become operating expenses.

Cons: Utility pricing requires a fairly accurate estimate of the demand volume and a commitment for certain minimum transaction volume. Annual costs are less predictable.

Shared Risk-Reward Pricing Model

What It Is: Provider and customer jointly fund the development of new products, solutions, and services with the provider sharing in rewards for a defined period of time.

Best For: Customers with the level of governance necessary to partner with the provider on these projects. Most importantly, according to analysis by Gartner, the client must be willing to share in either the upside or downside potential.

Pros: This model encourages the provider to come up with ideas to improve the business and spreads the financial risk between both parties. It mitigates some of the risks of new technologies, processes, or models by assigning risk and responsibility to the vendor, according to Gartner.

Cons: Results can difficult to measure and rewards tricky to quantify. Clients must hand over much of the management to the provider.

About Author

Prabhakar Ranjan works with Systems Plus Pvt. Ltd.  He is part of the consulting team that delivers Vendor Management Office projects. He can be contacted at prabhakar.r@spluspl.com