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August 2017

Managing Demand Variation in Outsourcing Contracts | Sherpas in Blue Shirts

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Given how long the outsourcing model has had to mature, the lion’s share of “traditional” (read: not including digital labor) contracts today are realizing the expected benefits for both buyers and providers. But when unplanned levels of variation in the internal demand for outsourced services enter the picture, serious quality, satisfaction, and cost issues can quickly rear their ugly heads.

Effective demand management – whatever the reason for the unplanned level – entails meeting internal customers’ demand and service level expectations while maintaining adequate control over the total outsourced spend.

Everest Group recommends buyers embrace three methods for managing demand variation in outsourcing contracts.

Periodic adjustment of baseline or band pricing
Buyers typically opt for baseline or banded pricing to manage volume changes. While both mechanisms provide for some demand flexibility, they expose service provider risk and trigger a risk premium in service pricing. And although volume baseline/band definition is standard in new or renewed contracts, high variation or significant demand shifts can render them obsolete. A solution to these challenges is establishment of a periodic pricing adjustment in which the buyer and service provider agree to review volume in specified periods and set the baseline at the six-month rolling average.

Appropriate outsourcing agreement structuring and clear resource unit definitions
In order for an outsourcing agreement to be mutually beneficial, the buyer and service provider need to share responsibility for demand management. Devising an agreement structure and resource unit definitions that increase the service provider’s stake in managing demand is a way to accomplish this goal. For example:

Comprehensive benchmarking of both per-unit prices and pricing metrics
When demand variation is high, or when volumes consistently increase and decrease, benchmarking per-unit prices alone can result in sub-optimal financial performance for the buyer. Comprehensive benchmarking, including both the per-unit price and the relevant pricing metrics as below, is a valuable solution.

Baseline pricing metrics

  • Dead-band range and dead-band price
  • ARC and RRC ranges and rates

Banded pricing metrics

  • Band ranges
  • Unit changes in each band

By employing these mechanisms to manage demand variation, buyers and suppliers can avoid issues in their relationship, achieve the full potential of the contract, and experience a win-win situation.

To learn more, please read Everest Group’s viewpoint entitled, “Demand Variation in Output-Based Pricing Contracts.”