Outsourcing Price – Don’t Lose the Cost Linkage

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.

Just a few weeks ago in Outsourcing Pricing Models: Recent Trends and Ever-Important Considerations we discussed an article from CIO Magazine that highlighted a trend in the industry to explore different pricing models. Customers are always looking for new ways to manage the cost of technology and commodity business functions and better align them with their lines of business. This is not a new concept and has been evolving for some time. In another example, about 18 months ago the Outsourcing Center assembled a panel of industry experts to discuss different approaches to pricing (see Outsourcing Experts Discuss New Flexible Pricing Models).

A desire for output based pricing is a common objective for customers seeking alternative pricing structures. An insurance company wants to pay by the number of claims processed; a payables department wants to pay by the number of checks written or invoices processed; etc. When trying to achieve these type of billing metrics, the buyer must not forget the still relevant principle discussed above (cost + margin = price). The challenge often encountered with these output-based pricing metrics is getting to an objective, measurable and agreed-upon cost basis for each of the output events. Sometimes there is a direct correlation between output and cost and in those cases, output based pricing is probably the right way to go. But sometimes the parties try to take the concept too far and bundle in costs that have nothing to do with changes in the volume of output. In those cases, there is often a hidden trap that catches either the client (through higher than necessary fees) or the supplier (through margin shrinkage or even loss).

The buyer of sourcing services should use caution when pursuing these types of pricing strategies in the absence of good historical metrics on the underlying cost structure. Suppliers try to give the customer what they want in as many cases as possible. If asked for an evolutionary pricing metric, most suppliers will try to accommodate the request. However, they will also ensure they are protected. When faced with a request to price for an unknown risk (e.g., if the underlying costs of a particular metric are not inherently clear), the supplier will mitigate that risk with either contingency funds, increased margin, or both. The customer may get the new billing metric they were after, but they may also end up overpaying for the service.

In summary, regardless of whether you are pursuing input-based, output-based or even a more revolutionary pricing metric, the underlying principle of cost + margin = price should be respected as a fundamental reality to supplier pricing. This should ensure you don’t overpay for the service and that your supplier earns a fair margin on their work. Both are necessary for a successful outsourcing relationship.