Structuring Payments for Outsourcing Services

When customers decide to outsource part of their operations there are many factors to be considered and decisions to be made over the course of the initiative. Getting to the “right price” is obviously one of the key objectives in any outsourcing transaction. Nobody wants to pay too much for a particular service and, while it might seem nice at first blush, nobody really wants to pay substantially below market price for a service because of the problems that will ensue later in the relationship. However, once the right price has been determined, then a decision must be made as to how to structure the payment of this right price.

The Dead-Band Method: For some customers, especially those with little variance in their monthly usage, having a consistent invoice amount from month to month may be more important than perhaps squeezing that last dollar of cost savings out of the operations. For such customers, paying the same amount for volumes that are within some small percentage (up or down) of the original baseline volumes can be a preferred way to structure the payment.

With the Dead-Band Method, the amount the customer pays each month doesn’t change within a small percentage of volume changes (e.g., +/- 5%). In addition to the stability in amount paid, this method can also reduce the angst created by conflicts with the supplier over the accuracy of volume counts. Counting issues often arise in the early days of outsourcing relationships as volumes that have been loosely measured in the past suddenly take on far greater importance. If the invoice price doesn’t change until the dead-band is passed, then small changes in volumes can be validated and worked through without the pressure of an aging supplier invoice. Ideally, by the time the dead-band limit is reached, the counting issues have been worked out.

Within the Dead-Band Method, there are different ways to address changes in volumes. For example, with a baseline volume of 100 and a 5% dead band, the same price is charged for volumes between and including 95 and 105. When 94 or 106 is reached, the adjustment could be a credit or charge for 1 unit (i.e., the 5 units in the dead-band are not counted), or the adjustment could be a credit or charge for 6 units. Both methods are valid and really a function of client preference and negotiation.

Multi-Band Method: Beyond a single dead-band, pricing “bands” can be developed. This is a good method for clients who don’t want the variability and complexity of changing invoices once the single dead-band is breached. Under the Multi-Band Method, multiple pricing bands are predetermined and pricing is set for each band. This gives the customer the assurance of a somewhat predictable invoice month after month beyond the initial dead band.

One must exercise caution when constructing a Multi-Band Method pricing structure. If the bands are too wide, one of the parties could be at a disadvantage; which one will depend on whether the volumes are growing or shrinking. If the bands are too narrow, you will constantly be changing bands which might negate the value of choosing this method in the first place.

P*Q Method: A customer who does not have a strong desire for a stable monthly invoice, or a customer who might be in an environment of shrinking volumes may prefer the P*Q Method where actual volumes consumed each month are invoiced.

Under the Dead-Band Method, a customer who has shrinking volumes will have to wait until they are some percentage below the baselines before a reduction in their invoice will be made. Whereas in the PxQ Method, that same customer would receive savings from the reduced volumes each month as those volumes decrease. This can be particularly important if the customer, not the supplier, has more control over when and how far volumes will shrink. However, it’s important to consider the risk and impact of increases in volumes since, under the PxQ method, the customer pays for incremental growth in volume as soon as it occurs.

When considering what the right method is for your circumstances, it is important to recognize that not all services may lend themselves to the same approach. It is perfectly acceptable to employ more than one strategy across the many services you are outsourcing. In the case of billing methodologies, one size may not fit all.

For any method, it is critical that a clear definition of the metric being counted and the method of counting be determined, documented and agreed upon before the invoicing starts. You can have the perfect pricing and payment structure established, but if you’re counting the wrong thing or there is disagreement on what is counted or how it’s counted, you will waste a lot of time and potentially have a significant variance in your projected spend.

All of the approaches noted above are right for different customers and perhaps even for the same customer at different stages in their evolution or business cycles, or simply for different services within a single sourcing transaction. What is right for your organization will depend on many factors and should be discussed with your sourcing advisor during any outsourcing initiative you undertake.