As noted in our previous blog posting on the subject, the most prevalent model for pricing applications outsourcing services involves the following components:
(1) a fixed monthly charge for applications maintenance;
(2) a fixed monthly charge for a baseline number of application 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
(3) 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 second 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 first posting discussed pricing for applications support. This posting focuses on pricing applications enhancements.
Applications enhancements refer to the ongoing, steady state level of discretionary enhancements that are performed on the applications portfolio supported by the supplier. This is in contrast to major development projects that are generally priced on a case-by-case basis and will be the subject of Part 3 of this series of blog postings. The contract should provide the customer flexibility in classifying a particular enhancement as either a routine enhancement priced along the lines described below (which typically requires less than 80 – 160 productive hours of work to complete) or a major development project that is priced separately (and potentially competitively bid by the customer).
Staffing and associated pricing for applications enhancements are based on a projection of a baseline number of hours that is reasonably expected to be expended by supplier personnel each month in performing this work. The baseline hours are often included in the fixed fee for applications support, but may also be priced as a separate bundle of hours.
Under this pricing construct, the baseline represents a minimum number of hours that the customer commits to purchase each month. This means that the customer (i) pays for any unused hours, and (ii) incurs an incremental charge for any excess hours expended during the month on a time and materials basis. Therefore, it is important that the contract contain a number of protections for the customer, including the following:
Adjustments – The customer should have the right to adjust the baseline hours on short notice (e.g., 30 days) to reflect its changing requirements, subject to reasonable limitations on the extent and frequency of these adjustments. If the customer adjusts the baseline number of hours, there will be a corresponding adjustment to the committed monthly charge for applications enhancements based on the increased / reduced number of hours multiplied by the applicable hourly rate(s).
Excess Hours – The contract should require the supplier to obtain written authorization from the customer before expending any chargeable hours in excess of the baseline and permit the customer to prioritize work in order to minimize any incremental charges. Any unauthorized hours expended by supplier personnel should not be chargeable.
Workload Balancing – The supplier should be required to “load balance” work between applications maintenance, applications enhancements and other in-scope activities in order to maximize utilization of supplier personnel and minimize charges. For example, if the workload for enhancements during a particular month is expected to be less than the baseline number of hours, then supplier personnel should be required to use the extra hours in reducing the maintenance backlog or performing other applications related work requested by the customer. Similarly, if there is a spike in applications enhancements during a particular month, the supplier should be required to use reasonable efforts to utilize applications maintenance resources included in the monthly fixed fee for this work (consistent with meeting service level requirements) to minimize incremental charges for enhancements.
Rates and Charges
The pricing for applications enhancements is fundamentally a time and materials model. As a result, the contract needs to address the range of issues that are relevant to this type of pricing model, including the following:
Personnel Rates – The parties need to agree on the personnel rates that will apply to the performance of applications enhancements. It is a fairly common practice to establish a single blended rate (or small number of blended rates) that reflects the expected skill mix and geography of the supplier personnel performing this work. A blended rate has the advantage of being easier to administer than basing the charges on a granular rate card. However, it is still important to include the supplier’s rate card in the contract. Among other things, it will serve as the basis for making any adjustments to the blended rate(s) to account for material changes to the skill mix or location of the services (e.g., as a result of changes to the supported applications portfolio).
Inflation Adjustments – Most applications enhancement work is performed offshore by low cost offshore resources. While suppliers will point to steeply rising salaries in offshore locations and attempt to negotiate annual inflation adjustments based on offshore wage inflation indices, our database of outsourcing transactions does not show any appreciable difference in the rates for offshore resources from deals signed 5 years ago to deals signed today. Further, as reflected in their financial reporting, suppliers have been able to maintain their profit margins on this work without increasing hourly rates, mainly by offsetting wage increases with cost savings in other areas (e.g., through reductions in telecommunications costs). As a result, customers should expect to be able to lock-in personnel rates for 3 – 5 years without inflation adjustments. Any subsequent adjustments should be based on the U.S. Consumer Price Index (All Urban Consumers) and not on the faster rising and more volatile offshore indices tied on wage inflation.
Productive Hours – Only “productive hours” of work performed for the customer should be chargeable. We generally recommend including a definition of “productive hour” in the contract that specifically excludes items such as travel time to / from the work site, lunch breaks, vacation time, sick leave, administrative time (including billing), general skills training, and marketing / sales activities. These activities are overhead costs of the supplier that are factored into the supplier’s rates and should not constitute chargeable work.
Overtime – As a general rule, there should not be any uplift in the supplier’s rates for working more than a standard workday. It should be the supplier’s responsibility to manage its work force in a manner that minimizes any such costs to the supplier.
Daily Time Sheets – Supplier personnel should be required to complete daily time sheets describing the work performed each day. This information will be important both for invoice management and also baselining the productivity of the supplier staff as described below.
From a customer perspective, the most challenging issue in pricing applications enhancements is ensuring the productivity of the supplier’s staff (that is, the “Q” in the “P x Q” calculation of the supplier’s charges). Time and materials pricing does not provide an incentive for the supplier to strive for a high level of productivity and, therefore, needs to be coupled with other mechanisms to address this issue. While there is no silver bullet, consideration should be given to some combination of the following:
Skill Mix – Requiring a minimum skill mix of the supplier’s staff dedicated to performing applications enhancements with financial credits if it is not maintained. This requirement will discourage the supplier from using an excessively high level of entry level personnel who are inefficient and is particularly important if a blended rate is used to price applications enhancement work.
Attrition Rate – Establishing a meaningful attrition rate service level with financial credits if not met. There is a learning curve to be able to support an application efficiently which is lost where there is a high level of turnover of supplier personnel on the account. High turnover is a major problem on many customer accounts, particularly in offshore locations where most applications enhancement work is performed. This needs to be countered with strong financial incentives for the supplier to keep attrition to an acceptable level.
Estimation / Completion Service Levels – Establishing aggressive service levels for the estimation and completion time frames for applications enhancements with financial credits if not met. This will provide some incentive for the supplier to perform work efficiently in order to meet the performance requirements under the contract.
Baselining – Careful measurement and tracking of productive hours for completing applications enhancements. This information can be used to establish baselines for measuring productivity over time. That is, similar types of enhancements and the hours expended can be compared to establish a baseline of the expected number of hours required to complete various types of enhancements.
Demonstrated Productivity Gains – Requiring the supplier to reasonably demonstrate year-over-year productivity gains (or at least no degradation in productivity) based on the measurement and tracking of workload hours through the baselining process described above. If the supplier fails to achieve the productivity requirement, the customer would receive a significant financial credit against the supplier’s monthly invoices.