4 new IT outsourcing models

In the traditional IT outsourcing deal, the vendor provides a service managing servers, developing applications, monitoring networks and the customer pays for it, whether at a fixed price, on a time-and-materials basis or a cost-plus model.

But as customers have grown to expect more value from their IT service providers and vendors have become eager to win that higher value, potentially higher-margin work, several new pricing models have emerged. “More creative fee structure attempt to better align the parties’ incentives,” says Shawn Helms, partner in the outsourcing practice of law firm K&L Gates.

Among the new pricing structures increasing in popularity are gain-sharing agreements, incentive-based contracts, shared risk-reward arrangements and demand-based pricing. “The better contracts aspire to satisfy the customer across prioritized business objectives that were either unable to be converted to traditional service level agreements or reduced to a performance specification,” says Steve Martin, partner with outsourcing consultancy Pace Harmon.

But early adopters may find that while these new-fangled price models convey real benefits from encouraging innovation to increased control over IT costs they’re not for everyone. We lay out the four of the latest models you may come across when negotiating your next outsourcing deal: what it is, whom it works for, benefits, drawbacks and caveats.

Gain-sharing pricing model

What it is: Pricing based on the value delivered by the vendor beyond it’s typical responsibilities but deriving from its expertise and contribution. For example, an automobile manufacturer may pay a service provider based on the number of cars it produces.

Best for: Customers seeking dramatic business improvements who want to create a true alliance with IT suppliers. Cost-focused buyers need not apply.

Pros: Theoretically, this model encourages collabouration and creative problem-solving as both parties work toward common business goals, says Ross Tisnovsky, senior vice president with outsourcing consultancy Everest Group. It also affords the supplier greater freedom to determine how best to achieve the results.
Cons: Gain-sharing requires a high level of trust, an equitable distribution of risk and reward, and significant upfront investment, says Martin of Pace Harmon. “In practice, very often neither the vendor nor customer is willing to fund the investment without a guarantee of a payback.” Gains can be hard to agree on and difficult to measure. Because results can be influenced by factors outside of their control, vendors charge a premium on these deals.

Watch out for: The second year blues. “If the provider has a windfall one year, then the customer is likely to demand a stricter formula or a new basis for the payment the following year. Conversely, if the supplier lost out due to poor overall performance by the customer organization, they will want to change the measurements,” says Tisnovsky. “This can lead to rebuilding the model every year.”

Incentive-based pricing model

What it is: Bonus payments are made to the vendor for achieving specific performance levels above the contract’s service level agreements. Often used in conjunction with a traditional pricing method, such as time-and-materials or fixed price, “the key is to ensure that the delivered outcome creates incremental business value for the customer,” Pace Harmon’s Martin says.

Best for: Customers who are able to identify specific investments the vendor could make in order to deliver a higher level of performance.

Pros: Incentives can compensate for drawbacks in the primary pricing method and better align provider motivation and customer goals, says Tisnovsky of Everest Group.

Cons: “This model often falls flat because companies end up rewarding their vendors for work they should arguably be doing anyway,” says Martin. “The ‘incentive’ should be that they get to keep providing the service.” Measuring bonus-worthy performance can be difficult and costly.

Watch out for: Vendors who tell you that it’s common practice to provide these bonuses if you require the provider to pay penalties for missed service levels. It’s not.

Consumption-based pricing model

What it is: Costs are allocated based on actual usage (e.g., gigabytes of disk space used or help desk calls answered).

Best for: Buyers concerned about service provider productivity and those with variable demand. The utility model is particularly well-suited to situations in which the fixed costs of the services are shared across many customers, says Helms of K&L Gates, like cloud computing engagements.

Pros: Pay-per-use pricing can deliver productivity gains from day one and makes component cost-analysis and adjustments easy. Capital expenses become operating expenses.

Cons: Utility pricing requires a fairly accurate estimate of the demand volume and a commitment for certain minimum transaction volume, warns Everest Group’s Tisnovsky. Annual costs are less predictable.

Watch out for: Internal reluctance to add needed services in order to keep monthly bills low. In addition, “this model only works from the service provider’s perspective if the services provided are directly related to the cost incurred as reflected in the price of the resource units,” says Helms. “The service provider bears the risk that an insufficient number of resource units will be used and the provider will not recover its fixed costs, but the customer bears the risk that it continues to pay an inflated price after the service provider has recovered all of its fixed costs.”

Shared risk-reward pricing model

What it is: Provider and customer jointly fund the development of new products, solutions, and services with the provider sharing in rewards for a defined period of time.

Best for: Customers with the level of governance necessary to partner with the provider on these projects. Most importantly, according to analysis by Gartner, the client must be willing to share in either the upside or downside potential.

Pros: This model encourages the provider to come up with ideas to improve the business and spreads the financial risk between both parties. It mitigates some of the risks of new technologies, processes, or models by assigning risk and responsibility to the vendor, according to Gartner.

Cons: Results can difficult to measure and rewards tricky to quantify, says Tisnovsky of the Everest Group. Clients must hand over much of the management to the provider.

Watch out for: Arguments over resources, overhead, investments and rate of return.

Stephanie Overby is regular contributor to CIO.com’s IT Outsourcing section.