Applications Outsourcing Pricing – Part 1
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:
- a fixed monthly charge for applications support;
- a fixed monthly charge for a baseline number of applications enhancements hours (typically included as part of the fixed fee for applications support) with authorized incremental hours charged on a time and materials basis; and
- a framework for pricing significant development work on a project-by-project basis on a fixed fee, capped time and materials, or straight time and materials basis.
This is the first of three blog postings that describes the basic features of each of these pricing components, and discusses some of the key considerations in structuring and negotiating them. The discussion also highlights the complexities and financial incentives inherent in each component.
Applications Support – Fixed Fee Pricing
The fundamental commitment by the supplier is to support a defined set of applications for a fixed fee regardless of the actual level of effort required to perform the services. The fixed fee is established based on the supplier’s projection of the level and skill mix of personnel resources and associated costs required to support the in-scope applications. Except as noted below, if the resources or associated costs are higher or lower than expected, the supplier bears the additional cost or realizes additional profit.
Services Covered by the Fixed Fee. Under a fixed fee pricing model it is important to carefully define the scope of services included within the fixed fee and the circumstances under which the fee is adjusted. There are two key aspects to defining the services covered by the fixed fee: (i) the applications that the supplier agrees to support; and (ii) the functions that the supplier agrees to perform with respect to those applications.
In most cases, it is relatively easy to identify the existing portfolio of applications to be supported by the supplier. However, the portfolio is likely to change over time as applications are added, removed, enhanced and replaced. The contract should contemplate this possibility and provide a mechanism for adjusting the fixed price where appropriate to account for these changes.
The functions to be performed by the supplier may include production support, corrective and preventive maintenance, testing and installation of new releases, documentation, user support, and other activities. The description of in-scope functions should be robust and allow for their natural evolution over time.
Anticipated Productivity/Efficiency Gains. In most outsourcing transactions, suppliers anticipate (or should anticipate) increased productivity and efficiency of the applications support staff over time. The level of anticipated gains will, of course, depend on the efficiency of the in-house staff as well as the customer’s flexibility in allowing the supplier to utilize its own processes and methodologies in servicing the customer. If the in-house staff is believed to be inefficient, it is not uncommon to see projected gains in the range of 15 – 30% over the first two years, leveling off to 3 – 5% per year in later years of the contract.
The fixed fee should capture anticipated productivity and efficiency gains (i.e. the fixed fee and underlying resource baselines should decline over time assuming there are no material changes to the applications portfolio or scope of services). During the proposal evaluation and negotiation process, customers should require bidders to disclose projected staffing levels each contract year broken down by labor category and geography. This will enable the customer to understand and evaluate the staffing levels and projected efficiency gains and to ensure that they are reflected in the fixed fee.
Adjustments to Fixed Fee. As noted above, there should be mechanisms to adjust the fixed fee to account for material changes in the supported applications portfolio, such as a major addition, removal or replacement of an application or applications group. In general, “normal” ongoing enhancements should not trigger adjustments to the fixed price; otherwise, the fixed fee would lose predictability.
Adjustments to the fixed fee should be based on the increase or decrease in the number and type of skill sets of personnel resources required to support the affected applications. Before the contract is signed, the customer should negotiate personnel rates for a comprehensive set of labor categories that will be used as the basis for any such adjustments. The supplier should be required to keep accurate records throughout the term of the contract of the time devoted by its personnel in supporting each application so that the customer can assess the reasonableness of any proposed adjustments to the fixed fee.
Finally, customers should consider negotiating a sharing of the cost savings if the supplier is able to successfully provide the services with fewer resources than projected at the start of the contract due to better than anticipated (i.e. below resource baselines) productivity and efficiency gains. The supplier may argue that it should be entitled to the benefit of all such cost savings as long as it is able to meet the agreed service levels since it is taking all of the risk if more than the projected level of resources is required. Service level metrics, however, cannot fully capture all important aspects of the supplier’s performance and the customer should have the right to assess whether its performance requirements can be met with fewer resources.
As an incentive for the customer to agree to a proposed reduction in resources if the supplier can meet the customer’s performance requirements, the contract could provide for the parties to share in the cost savings. To implement this arrangement, the fixed fee would be reduced by a percentage (e.g., 50%) of the personnel charges of the resources removed from the account. This would allow both the supplier and customer to benefit from the supplier’s unanticipated productivity and efficiency gains.
Advantages and Disadvantages. The primary advantages of fixed fee pricing for applications support are that it provides a high level of predictability in the supplier’s charges (in the absence of major changes to the applications environment) and a strong financial incentive for the supplier to continually increase the productivity and efficiency of its applications staff. If the supplier is able to “overachieve” by providing the services with less than the baseline level of resources and there is a gain sharing mechanism, both parties will benefit from the cost savings.
The fixed fee, however, adds complexities that are not present in a level of effort pricing model (i.e. where the customer purchases a dedicated staff or number of FTEs on a time and materials basis to provide applications outsourcing services, including applications support). The parties must distinguish between maintenance/support activities that are covered by the fixed fee and activities that are priced separately (e.g., enhancements). In our experience, this can be source of friction between the parties. In addition, if the customer application environment is unstable or highly dynamic and there are a number of significant changes to the applications environment, it may be difficult for the customer to effectively monitor and manage the resulting changes to the baseline (and thus the fixed fee) and the predictability of the fixed fee may be eroded in these circumstances.
A fixed fee pricing structure for applications support does not by itself assure that the supplier will achieve specified levels of output. Therefore, it is important that the contract contain service levels that, at a minimum, commit the supplier to meet agreed time frames for responding to and resolving incidents and problems and managing backlog effectively.