Articles Posted in Cost Optimization

The pricing structure of outsourcing transactions often reflects a balancing of competing objectives. In the case of applications outsourcing services, most customers want the pricing structure to provide predictability and proper financial incentives for the supplier to continually increase productivity and efficiency in service delivery. At the same time, both the customer and supplier usually desire a pricing structure that is relatively simple and easy to administer.

While there are a variety of models used to price applications outsourcing services, the most prevalent model involves the following components:

1. a fixed monthly charge for applications support;

Getting to the right price. If not the primary objective, it’s certainly one of the more important goals of any customer who has ever outsourced a piece of their operation. While striving for the lowest price possible, in order for the transaction – and long term relationship – to be successful, it must be beneficial to both parties. If a customer negotiates a supplier below the point at which they can make money on the service, there will be problems with that relationship. It might take a little while for them to surface, but surface they will.

One of the longstanding precepts of pricing in the sourcing world is to maintain, as closely as possible, a linkage between the underlying cost of providing the service and the price being charged for that service. No customer should begrudge their supplier making a reasonable profit, for without a fair return on their work, it is unlikely the supplier will be there in the future to support the customer. Hence, if the costs of providing the service plus a fair margin are equal, in as many cases as possible, to the price being paid by the customer, then the chances for a long, happy and productive relationship between the customer and supplier are good.

This does not mean that one should strive for a “cost plus” arrangement. On the contrary, that pricing paradigm comes with its own set of challenges. What this does mean is the price should be closely linked to the underlying cost of providing the service. An O/S image support charge is directly attributable to the labor and maybe some productivity tools that are used in the delivery of that server’s support. Conversely, the charge for a gigabyte of data streamed to a tape has no linkage to the underlying cost of providing data backup services.

Horses for Sources recently published the output of a study which showed that buyers of outsourced services are saving money, but aren’t seeing a whole lot more.

The report stated that over 95% of current buyers of outsourced services view their outsourcing engagements as effective at reducing their operating costs. However, the report also showed that 30% of buyers consider their outsourcing initiatives as being ineffective in giving them access to new business process acumen, and 35% thought that their relationships with their service providers were ineffective in providing new and creative methods of achieving business value.

This begs the question: does the cost of implementing innovation and other value-add services from a supplier impact the cost savings associated with the outsourcing? Or can clients have both cost savings and innovation?

Typically, Suppliers ask for cost of living adjustments (COLAs) in IT outsourcing agreements to adjust prices periodically for inflation. We believe that the general assumption that a COLA is appropriate to “balance risk” in a three to five year IT deal should be challenged.

The Supplier community is highly sophisticated at managing a global workforce and associated delivery costs. They know their local labor markets (the source of most inflation) and, at least in the IT services domain, are adroit at managing labor cost and turnover. For example, for services delivered from India in particular, labor rate pricing has been flat over recent years in the face of sustained increases in labor costs. During this same time, Supplier margins have also been relatively constant. Why is that, and what are the implications for considering a COLA provision?

Suppliers have managed their non-labor costs extremely well though better expense management and economies of scale. In addition, by constantly moving into new labor markets, the large providers have been able to keep the cost of newer resources relatively flat. And they do all this while constantly cycling resources through their client accounts to replace the more experienced/expensive resources with less experienced/cheaper resources. Therefore, while the resource that was on the account last year may be more expensive this year, that resource has typically moved on and been replaced by a resource that cost the same as the prior one did last year – or even less if the resource is from a different geography.

In Outsourcing Pricing and Implied Productivity, we discussed the advantages of understanding the underlying staff productivity assumptions in a supplier’s solution and pricing.

What are the key IT infrastructure productivity measures that underpin a supplier’s price?

We’ve found that in medium to large, full service infrastructure outsourcing deals, a few pricing metrics typically drive 90% or more of the total supplier charges. And, within these pricing metrics, we found several key productivity ratios that (depending on scope) tend to drive the supplier pricing models:

Typically, the unit prices for outsourced IT infrastructure services include a base charge (or fixed price) and unit rates applied to defined units of consumption. The units could be physical devices, virtual instances, events (e.g., opening a help ticket) or any other measurable unit designed to account for changes in the consumption of IT services from the supplier. This unit rate pricing approach assumes there is a correlation between a change in volume and a change in the underlying level of work or value delivery by the supplier.

Suppliers can price their services over a volume range because they know the productivity that they expect to achieve at the start of the deal and their expected productivity improvements over the deal’s life. For example, they may assume immediately after transition that they will have a productivity level of 35 FTE per device, but over time they expect to be able to increase productivity to 50 FTE per device or more.

If the supplier can build its pricing models based on expected staff productivity, by reverse engineering the underlying cost of delivery, the implied productivity levels can be determined. There are several advantages to understanding the supplier’s implied productivity:

This question comes up whenever a client considers outsourcing IT. What they are really asking is: “Am I paying the right price for the entire life of the deal?”

At the beginning of a deal the outsourcing customer typically relies on competition to get the lowest price. On the other hand the supplier’s goal is to submit the highest price while winning the business. That’s how the free market is supposed to work. Not surprisingly, suppliers routinely acknowledge margin expansion as a strategic goal. With that in mind, is competition enough to ensure the customer is paying the right price? Does the competitive process really achieve the right price or just the highest price the supplier can quote while beating the competition?

We believe the best way to get to the right price is to link price with the underlying reasonable costs of production (allowing also for a reasonable profit margin) and then ensure it remains closely linked throughout the term of the deal.