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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.

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Providers are rushing head-first into the cloud revolution, marketing their latest cloud offerings and promoting the benefits of hosting data externally.

To The Cloud–Start-up–Windows 7 by windows-videos

But as customers analyze whether the cloud is the right fit for their technology and data, they need to carefully review whether the contract terms proposed by cloud providers truly work “in the cloud.” Customers may discover that cloud providers simply have taken their existing standard licensing agreements for software hosted at the customer site (or at least large parts of their existing agreements), slapped the word “cloud” on the document, and voilà! A new cloud contract!

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On Friday, April 22, Pillsbury hosted a meeting of the Washington, DC, chapter of the Cloud Security Alliance (CSA-DC). Dr. Ramaswamy Chandramouli, Group Chair of the NIST Cloud Computing Security Working Group addressed members of CSA-DC representing local businesses, government agencies and various consulting and law firms regarding the work NIST is doing to develop a security architecture for cloud services.

Dr. Chandramouli’s presentation focused, among other things, on the various ways the software development life cycle (SDLC) needs to be adapted to address the move to cloud based services, including ways to maximize the ability to move applications from one cloud provider to another. According to Dr. Chandramouli, when moving to the cloud, a number of aspects of the SDLC need to be re-evaluated, from access controls and use of things like OpenID to the use of third party-provided digital libraries and APIs. As Dr. Chandramouli and a number of other participants at the meeting noted, the move to the cloud also requires an examination of your disaster recovery/business continuity planning.

Naturally, the discussion turned to last week’s Amazon EC2 outage, opinions about its cause and a discussion of its effects.

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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:

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“Are you serious?” It’s a question we often feel like asking clients after they tell us they expect a service level of at least “four nines” from suppliers because that’s what they believe they are achieving. Yet many times, the client doesn’t have the historical performance information necessary to support their belief.

Let’s talk about nines. When someone says that they want “five nines” or “four nines” they typically mean they want availability or up-time of a system or application to be 99.999% or 99.99%, respectively. What does that equate to in downtime? Below is a chart that shows the allowable downtime under different levels of “nines” (assuming no scheduled downtime on a 30 day month):

Availability Level Downtime per Month
99.999% 26 seconds
99.99% 4 minutes, 19 seconds
99.9% 43 minutes, 12 seconds
99% 7 hours, 12 minutes

With certain exceptions (e.g., financial market systems, air traffic control systems, retail systems the day after Thanksgiving, etc.), it’s worth asking how many organizations would be seriously impacted if the unplanned downtime in month exceeded 4 minutes and 19 seconds for their critical systems. Clients all too often start at the four or five nines level and have to be convinced to consider a more rational (affordable) SLA.

There is a direct correlation between the supplier’s price and the SLAs required by the client, especially as it reaches the four and five nines level. Many suppliers will tie all sorts of provisions to providing four or five nine SLAs such that they effectively undermine the value of the SLA. Even so, suppliers will charge a premium for the risk associated with just the expectation that they achieve this level of perfection. Even a small move to 99.98% can help. While it doubles the amount of downtime, it’s still under 9 minutes a month.

Getting serious about SLAs also means getting the internal IT organization to address SLAs like you expect the supplier to. It’s interesting to see how many client organizations looking to outsource a critical IT function do not have their own effective “commercial grade” SLA measures, metrics and reporting. They’re absolutely sure they are delivering at a best-in-class level, but don’t have complete meaningful reporting to demonstrate it. How reliable is their level of confidence? Certainly not enough for the outsource suppliers: “show me the reports”.

Even if an IT function is currently insourced and there are no immediate plans to outsource it, CIOs should insist that a commercial grade SLA measurement and reporting structure is in place. If the function is ever targeted for outsourcing, this information is invaluable for preparing the RFP, obtaining an appropriate, properly priced solution and holding the supplier immediately accountable upon transition of services. If it’s never outsourced, the information will still be highly relevant to the proper management of the function. Peter Drucker said “What get’s measured, gets managed.” If the internal IT organization is not measuring performance consistent with industry best practices, there’s a good chance they’re not managing the function consistent with industry best practices.

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When clients raise the question of the security of an outsourced service, it’s frequently a proxy for the feeling that they can trust/have control over their own people, but don’t really trust the service provider’s personnel. This type of concern showed up in a recent survey of CFOs conducted on behalf of SunGard Availability Services, more than half (56%) of those polled said they are concerned about the idea of outsourcing the management of their IT infrastructure due to the perceived security risks. According to the survey, the responding executives’ fears are exacerbated by high profile media stories about third party IT outages or data losses – with 45% of the respondents confessing that such cases make them more inclined to keep their data in-house, despite the cost implications.

When these concerns come up in an outsourcing deal, it’s helpful to consider the current risk profile of the company and whether the company’s systems and data are actually more secure in their current environment with their current staff, or if it’s just the perception of loss of control that is making the executives feel that way.

There are, of course, risks associated with allowing your data and applications to sit somewhere else and be operated on by someone else, and some of these risks become more pronounced when you are operating in a cloud-based environment with little assurance about the physical location of your data. However, these risks can be managed both contractually and procedurally and have to be evaluated in the overall context of the business.

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When considering renewing and extending an outsourcing agreement, a different set of dynamics often comes into play when compared with the initial transaction. As organizations’ outsourced relationships change and mature over time, it’s a good idea to try and capture lessons learned by undertaking a post closing review in order to better understand what went well (and not so well) and to formulate those lessons learned for sharing within the client organization. So let’s explore a few of those lessons learned in the context of renewing or extending an outsourcing agreement:

• Plan and Prepare: Over the course of a long term agreement, things change, new needs emerge and certain areas almost always need correction or refinement. Identify all of these at the outset, solicit input from the stakeholders (sponsor, SMEs, procurement, legal) and prepare a plan.

• Understand the Risk (and have a Back-up Plan): There may be many sound reasons to remain with the current provider and forego a competitive procurement. But with no competition the leverage balance swings in favor of the provider. Be prepared with a plan B (and make sure you have enough time to pursue it if things don’t go well with the incumbent).

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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:

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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.

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I just got my new iPad and within a few hours, I was hooked on my new toy. After watching Letterman, I was thankful to learn I was in good company with my new addiction. When someone suggested I sync my tablet with my work email account, I wondered why would I want to pollute my fun. I finally relented, and once I began sending and receiving my business email, I realized entire nights and weekends passed without my needing to boot up my laptop. I could rely solely on my iPad for certain business purposes, and it appears I am not alone in this revelation. The ipad has become more than a toy for certain businesses and as Deloitte predicts more than 25 percent of all tablet computers will be bought by enterprises in 2011, and that number is likely to rise in 2012 and beyond. With those figures, could the iPad replace the business laptop?

As the Deloitte article points out, there are concerns around security, the cost of support, and price, but as iPad use continues to grow – and it will – support costs very well may go down. The average cost of laptop support for an enterprise is $20 to $25 per month. If we assume the cost to support an iPad is roughly similar to the cost to support a blackberry (i.e., $6 per month) that translates to significant savings to support an iPad over a laptop. For example, an enterprise with 30,000 end users would spend roughly $7.92M per year (assuming an average of $22 per month) in laptop support, but the same enterprise would spend only $2.16M in iPad support. This delta amounts to $5.76M savings per annum. With these savings, the cost to purchase the iPad devices (at approximately $600 each) would be entirely recouped in a little over 3 years. In this light, the iPad is most definitely more than a toy – instead, it could be employed as a potential cost saving strategy for certain enterprise users.

As it stands now, certain large international financial institutions are requiring their executives to travel with an iPad as the portability, battery life, and mobile internet connection make supporting such executive more efficient. Executives can easily receive, download, and project last minute updates to board presentations. Companies are also giving their mobile workforce CRM and other corporate systems designed for tablets. For example, some pharmaceutical companies are providing sales representatives with tablets.

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