Outsourcing Models

Let’s first understand what is outsourcing and then will move forward to different outsourcing and pricing models available.

What is Outsourcing?

A practice used by IT and manufacturing industry where they transfer some work to the third party vendors rather than completing it internally. The main reasons why companies opt for ‘Outsourcing’ is to save the production costs or when they don’t have the required skills internally to complete the work. It sometimes involves transfer of employees and assets from one organization to another and not always.

How Outsourcing works in IT industry?

In traditional IT outsourcing methods, a vendor used to provide the services like managing servers, monitoring networks, databases and developing applications and customer used to pay for the services used either at fixed price, as per use basis (cost and material basis) or cost plus basis.

Nowadays customers’ expectations has increased a lot, now they want more value from the IT Suppliers or vendors. Suppliers also expect to have more margin values from the services provided and it has given birth to various new pricing models for the services.

Outsourcing Models:

• Staff Augmentation: It is one of the simplest model used by companies where they expand their existing staff with the outsourced staff. It involves high involvement from client to supervise the augmented staff i.e. client is responsible for project management and technical leadership. The responsibility of the augmented staff is only to develop the quality software and perform the testing of the software if required. In this model there is very less innovation involved from the augmented staff as they have been given a set of clearly defined responsibilities and expectations by the client.

• Build-Operate-Transfer (BOT): It is also termed as ‘BOT’ model. In this model, a company lets an outsourcing vendor establish an offshore development center for them. This model is opted by the companies where they want to have optimized costs and access to a large pool of skilled professionals. Here the outsourced company keeps the core competencies with them only. The offshore partner have local knowledge and relationships, while client do not have to learn the local intricacies of doing business, hiring, or finding office space. They simply focus on their core business while the offshore partner takes care of development of the offshore center and transfers back the ownership to the client company when they are ready for it. 

It conserves client’s capital expenditure, reduces the operating risk and gives them the ability to launch a complete end-to-end solution in a short duration.

• Offshore Development Center (ODC): It is similar to BOT model with only one difference that in the end the ownership is transferred to client whereas in ODC it remains with the vendor. It helps outsourcer to accommodate a high variety of projects and activities such as new product development, legacy modernization and maintenance, testing services and other long-term activities whereas the ODC staff is managed by outsourcing vendor. Here the outsourcer has to take care of initial knowledge transfer between the company and the vendor. The outsourcer gets a consistent and dedicated resources for a specific duration (contract duration) and the infrastructure costs can be reduced by over 40%. 

• Project Based/ Tactical Outsourcing: Whenever a business need is identified, the outsourcer looks for the offshore resource vendors if they don’t have the bandwidth to develop it in-house. This model gives high level flexibility and focus but with a higher cost and knowledge transfer challenge. This model gives outsourcer the access to a pool of skilled professional which they need for a specified duration to match the requirements. It is very easy for the outsourcer to change the staff as per the needs. Outsourcer has the ability to terminate the contract at any point of time if they are not happy with the quality of services. The outsourcer need not have to bring the specific knowledge internally and get in to the cumbersome process of hiring as the outsourcing partner does the same for them. 

The main difference between offshore development center and project based outsourcing is that the resources are dedicated to the outsourcer 100% for the specified duration.

Outsourcing Pricing Models:

Selection of an outsourcing pricing model depends upon the organization’s budget and cash flow requirements. These days’ outsourcers have multiple options to pick from various models available

• Fixed Rate Pricing Model:  It is one of the most commonly used model in Industry. Both the parties agrees for a fixed price after discussing the scope and requirements of the project. This is helpful for the projects which has defined scope, objectives and a predefined set of requirements. The service provider and the outsourcer, both parties are aware of each other’s skills, capabilities and duties.

• Variable Rate Pricing Model: In this model, the outsourcer pays a fixed basic rate and have the flexibility to pay additional for additional services or can even pay less if the market price goes down. This method is best when you want to try out a new vendor, if you are satisfied with the quality of work you have to pay little additional for additional services.

• Time and Material Model: In this model, one has to pay as per usage i.e. pricing is based on time and material used to complete the project. It is mainly used for application development and maintenance projects which have long time duration. It is also known as Cost and material model. The outsourcing company may agree upon monthly/hourly rates depending upon the skills and experience of the resources engaged for the project or if any non-standard software or hardware is installed to meet their requirements. It is very beneficial for outsourcer as they can modify the specifications at any point of time based on the changed business needs and market requirements and can get the desired experience without any hassles of searching the required skills and hiring them.

• Cost plus Profit Pricing Model / Open Book Model: In this model, the outsourcer has to pay a fixed amount for the services used along with a pre-defined percentage or amount as agreed by both the parties. Here outsourcer knows exactly how much he is paying and for what he is paying i.e. its transparent model and hence also called as ‘Open book’. The only drawback of this model is its inflexibility to incorporate the business objective or technology changes.

• Incentive Based Model: This is a hybrid model which is used along with Fixed Price or Time and Material Model where the outsourcer decides to pay some bonus or incentive to the service provider at an agreed rate when they achieve some key metrics which adds value to business such as early completion, project completion at a lower cost than the estimated one and delivery exceeding service levels specified in contract. In some cases, outsourcer also adds a clause of penalty if delivery is delayed or metrics are not achieved and business faces loss because of that.

• Shared Risk/Reward Model: It is not very popular model and is used by the companies to fund new products and solutions with a deal to share the profit between the service provider and the outsourcer. Outsourcers has an advantage here that if the product or business ideas fails then the loss is divided among both the parties. Another advantage of this model is that Outsourcer can easily take the risk of launching new innovative ideas and solutions without much worrying about the loss and risk as it is shared by both the parties.

• Pay as you use/ per unit Model: This models offers the outsourcer to pay only for the services used i.e. a unit based rate is set and payment is made as per usage. This model is beneficial for the business which has variable demand based work and require random number of resources like maintenance services. At times, the services usage is at its peak and in off-screen it is hardly used service.

There is no single model which is the best one. The selection of outsourcing model depends upon the business requirements, business constraints and the budget. Both the parties should discuss together to find out which model will work best for them and which pricing model will serve their interests.

Aashima Chetal is a consultant in Systems Plus Pvt. Ltd. Within Systems Plus, She actively contributes to the areas of Technology and Information Security. She can be contacted at:aashima.chetal@spluspl.com