Articles Posted in Cost Optimization

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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.

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An effective pricing model is a foundational component for long-term success in an outsourcing relationship. Success or failure in a relationship can often be traced in part to the wisdom, or lack thereof, of the pricing model. A good pricing model will create predictability while serving to align interests, allocate risk, and manage expectations on both sides. A misguided one can foster mutual mistrust and lead to mismatched incentives, inefficiency, and unpredictable expenditures.

Given their importance to a successful outsourcing arrangement, it’s no surprise that industry pricing models continue to evolve. Stephanie Overby recently wrote on CIO.com about 4 new IT outsourcing pricing models; these include gain-sharing, incentive-based, consumption-based, and shared risk-reward pricing. While the nomenclature for pricing models may have taken a while to catch up, these “new models” have been in practice in some form for a number of years and may be more aptly construed as evolutions of existing models.

Here’s a quick run-through of a few of the traditional pricing models:

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There have been numerous articles written over the past couple of years linking productivity gains with the anemic jobs recovery. This spring USA Today ran a story that focused on the US being out of step with the rest of the industrialized nations by having a faster growing economy, but creating fewer jobs. A Forbes article similarly asks: “Are Technology and Productivity Gains Squashing the Jobs Recovery?” There is little argument that workers, in all corners of industry, are getting better. Always have, always will. There has been a particular bump in productivity since the recession late in the decade because businesses were forced to get by with less. Now that the economy has started to recover, many businesses have found this “leaner” way of doing things can be sustainable and leads to improved profits.

Focusing on the technology sector, and outsourcing specifically, these productivity gains can be magnified. In the sector defined by automation, advances in higher degrees of automation should come as no surprise. Last summer HP announced they would reduce their work force by 9,000 over the next three years, “due to productivity gains and automation.” And, this is after they wrung out the efficiencies realized from their merger with EDS.

When you couple automation advances with Moore’s law in the hardware arena, outsourcing suppliers have the opportunity to bring significant productivity gains to their operations, and ultimately their bottom line. And, well they should. If your supplier partner is not doing everything they can to improve their operations and service offerings, they will probably not be the supplier to support your organization in the future. So, you want your supplier to realize these improvements in capability and profitability, but you should also be sharing in those gains. Not just as the recipient of the new or better service next year or the year after, but you should also share in the monetary benefits of these productivity improvements.

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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?

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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.

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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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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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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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My Mother always told me that cheaper is not a statement about price but rather a comment about quality. In the outsourcing world, cheaper has always been measured as lower unit rates, whether for application developers (dollars per FTE) or computing power (dollars per box or CPU minute) or for a broad range of BPO services (price per employee per month (PEPM) or dollars per claim). There are many advantages to the fixed unit rate form of contracting that has developed in the outsourcing industry. It provides a pricing mechanism that is easy to understand and fairly (though not completely) flexible to adjust for changing volumes and business circumstances. It also puts an incentive on efficient supplier operations and provides a convenient metric for benchmarking against other suppliers or other alternatives.

However, at least in the IT arena, it does not provide much of an incentive for the efficient use of the resources being consumed. In most cases, the supplier asks the customer how many “widgets” it has, and develops both a unit price and a projected price over the contract term based on the number of customer-identified units. So long as suppliers were able to offer year-over-year reductions in unit prices and unit prices materially lower than a potential customer’s comparable unit costs, everyone was satisfied. Moves to offshore or remote support locations (so-called labor arbitrage) have been a key driver over the last ten years in producing constantly lower unit prices. Similarly, supplier investments in tools, enhanced training, common processes and other forms of forms of standardization have continued to drive supplier unit costs lower.

Within the last two years, we have observed a leveling off in the rate of supplier-offered unit rate reductions. It appears, at least for the near term, that the rate of productivity increases reflected in lower IT unit rates is not as great in years past. This is best seen in a number of very recent proposed IT outsourcing transactions where the supplier’s unit price is not much less (or not lower at all) than the internal customer’s cost to deliver a comparable service. But, even in these cases, customer IT management, as well as a customer’s business management, still view the total cost of providing IT services as much too high. How can this be? How is it that a customer’s unit cost to deliver a service is not much greater than the outsourcer’s price to provide the comparable service, but all users of the IT service still view the cost of the service as too high?