Outsource Pricing and Implied Productivity
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:
- Whether you are in a sole source or a competitive bid situation, you can assess whether the supplier’s price reflects a solution that is consistent with industry best practices. Often, we see productivity that seems calibrated to achieve a customer-defined savings goal, or to win the deal, rather than to achieve best practice. For example, if current industry best practice is 60 FTEs per device and the supplier’s implied productivity was half that, you now know that even if the overall price “looks good,” it does not reflect a market best practice price. The price is not as good as it should be.
- By knowing what the implied productivity is, it is possible to deconstruct the underlying cost of the solution including labor, hardware, software, facilities, etc. (depending on the scope of the solution). Once these components are understood, it is simple math to determine what margin the supplier has baked into the pricing. That knowledge allows you to determine if the supplier’s price reflects typical industry margins or whether you are on the leading edge of the supplier’s “margin expansion goals.”
- Looking at the implied productivity over the life of the deal allows you to evaluate the supplier’s expected productivity gains and ask if they make sense. Does the underlying pricing imply a 5% improvement in productivity per year or a 25% improvement? What productivity gains are realistic based on the scope, solution and customer’s environment?
- A pricing model empowers the customer to challenge the supplier’s pricing model. It also helps create pricing transparency and can be an excellent foundation for an open discussion about each party’s expectations, solution objectives and other assumptions. If the supplier thinks there is something wrong with the customer’s model, simply ask the supplier to point out what’s wrong. At some point, once the underlying factors of production are agreed to, then the productivity and the margin can be evaluated. They are either in alignment with industry standards or they’re not. Either way, the conversation is now based on transparent facts and agreed assumptions.
We have proved this time and again using our CostMarking tool. This tool replicates the supplier pricing models for infrastructure outsourcing solutions. Using CostMarking, we’ve not only been able to challenge supplier pricing in a sole source situations, but also where competition was expected to get the customer the best price. In many cases this has led to significant price reductions below the “competition-driven” rates; in some cases it has resulted in price increases to correct misunderstandings and crossed assumptions; in both cases we think the results have been good for the client.
Turns out, the market is not always as efficient as we’d all like to believe it is and understanding implied productivity as a key factor in supplier pricing can drive significant pricing improvement both initially and over the term of the agreement.