Supplier Margins in IT Outsourcing

In our prior blog, Outsourcing Pricing and Implied Productivity we discussed the value of having a reverse engineered pricing model to evaluate supplier pricing. The idea is that by creating transparency into supplier pricing based on the factors of production (i.e., hardware, software, facilities, labor and margin) a rational pricing discussion can take place between customer and supplier – particularly in a sole source/contract renegotiation situation. A key assumption in any pricing model is what reasonable gross margin to use for IT outsourcing services.

One challenge in talking about gross margins is that the definition of gross margin varies somewhat by industry and company. For purposes of our discussion, gross margin is revenue less the cost of delivering the revenue (i.e., cost of services sold). It excludes selling, general and administrative (SG&A) and research and development (R&D) costs. In the case of a services company, it’s generally the direct cost of delivering services to their customers.

Another challenge in looking at gross margin is that not all companies break out SG&A from Cost of Services Sold or they report business segments in such a way as to make it difficult to determine their gross margin on IT outsourcing services.

That said, in a review of the financial reports of five major IT outsourcing suppliers representing over $100 billion in FY 2010 reported revenue from IT services, the following observations can be made:

• Gross Margins ranged from 25% to 43%
• Average Gross Margin was 30%
• Average Gross Margins were essentially flat from FY 2009 to FY 2010

Some will find it surprising that a mature, competitive business can still generate gross margins that average 30%. Why is that?

First, remember gross margins exclude SG&A and R&D. There are some real costs that have to be funded out of gross margin. So even in a highly competitive market, there is a lot of work out there and most suppliers are not inclined to simply cut gross margin to win business. They would rather compete on service quality and gain growth though strategic relationship management.

Second, despite what you generally hear about the rate of inflation on offshore salaries, the major suppliers have been managing their overall cost structure (i.e., facilities, technology costs) very effectively. In addition, suppliers have used the constantly churning offshore labor pool to maintain higher margins on their less experienced staff to whom they give more work as the more experienced staff moves on within or outside of the supplier organization.

Third, we go back to productivity. Suppliers in the IT outsourcing space have realized significant increases in productivity. Some of the productivity gain is shared with clients through declining unit pricing over the term of the agreement – but certainly not all. And that is why looking at productivity at the beginning and throughout the life of the agreement is so important.

Finally, cost of living allowances or COLA. COLA provisions in IT Outsourcing contracts are designed to protect the supplier from inflation on their forward price commitments. Given the risk suppliers take in pricing an outsourcing contract over three to seven or even ten years, there is a rational case to be made for this provision. However, caution should be exercised during negotiations to ensure that these provisions don’t provide the suppliers with excessive guaranteed revenue growth while their productivity improvements are lowering their cost of delivery – a nice combination for the supplier.

What’s the right gross margin? That’s determined by the free market. But it should be noted that virtually every supplier publically states their desire to expand margins or touts margin expansion when they achieve it. Therefore, customers would do well to understand what the implied margin is in supplier pricing to determine if the price proposed by the supplier is rational compared to the overall industry.