Outsourcing Pricing Models: Recent Trends and Ever-Important Considerations

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:

Fixed Price – In this model, the parties agree on a set of “base” services for which the customer pays a fixed amount, typically in monthly installments. The fee may be all-encompassing with respect to a particular function (e.g. application development), or it may correspond to a “baseline” figure for specific services (e.g. number of help-desk calls). The biggest challenge for this model is determining what is “in” and “out” of scope.

Rate-Based – In this model, the parties negotiate a per-unit rate for particular resources (e.g. maintenance hours). A rate-based contract usually includes a minimum usage requirement so that the vendor is guaranteed a certain level of income. Even with a minimum usage requirement, this model allows the customer to efficiently deal with fluctuating demand while still obtaining a volume discount.

Cost-Based – In this model, the customer pays the actual expenses incurred by the provider in supplying the services plus a negotiated profit percentage based on the total cost. The parties must agree beforehand which costs should or should not be passed on (e.g. expenses for maintenance are allowed, but expenses for training are not allowed). In addition, the customer will want to have some auditing rights to verify the accuracy of invoices.

These traditional models are often hybridized and now enhanced with new pricing mechanisms, such as those described by Ms. Overby. The driving force behind these evolutions is the desire of customers to maximize their leverage and assure that the vendor’s interests are aligned as much as possible with their own. Whether implemented as an independent model or more likely in conjunction with one of the traditional models described above, gain-sharing, incentive-based, and shared risk-reward pricing all serve to promote the customer’s interests by getting the vendor to play with more of its own skin in the game.

One pricing strategy does not fit all, as Ms. Overby points out, and innovations in pricing contribute to the increased complexity in outsourcing contracts and negotiations. Nevertheless, pricing mechanisms will continue evolving to the benefit of customers and vendors alike.

For a comical take on a different kind of pricing discussion see here.