Output-based Pricing Gaining Ground in Application Services Outsourcing | Blog
Over the past several years, output-based pricing has increased in popularity in infrastructure services and transactional business process outsourcing deals. More recently, enterprises have warmed up to the idea of using this pricing model for application services.
This should come as no surprise, given the benefits. Here’s an example that paints a clear picture of the advantages of output-based pricing in application services.
One of our clients – a large retail firm – was using the managed capacity pricing model. While in isolation the pricing appeared attractive, the firm wasn’t able to differentiate the fee it was paying for critical versus non-critical applications. The fee it was paying was a black box with no foreseeable value. After a thorough analysis of its portfolio, we realized that there were instances of over-utilization, redundant budgeting, and unnecessary allocation of resources for certain applications.
After we armed the company with market best practices data on business criticality, support coverage, ticket volumes, ticket type, usage, change frequency, and underlying technology, it renegotiated its contract with its provider. The new contract is saving the retailer 15 percent compared to earlier spend. And the adoption of the output-based pricing model spurred conversations around portfolio transformation, particularly in the cloud.
Overall, output-based pricing brings a lot of transparency into the pricing equation, and makes underlying delivery nuances clear. Enterprises’ procurement teams also find this pricing model attractive, as they can expect greater delivery certainty, better transparency, and more flexibility from the suppliers, leading to higher value relationships.
Output-based pricing is good for providers too
Service providers also benefit from this pricing model, as it allows them to charge a higher price per service unit delivered. Because the focus in this pricing construct is on services offered, not on the underlying number of resources, providers can cross-utilize resources across projects or charge a premium fee resulting in improved project margins.
Key success factors
Output-based pricing works best in scenarios where transaction volumes are known, repetitive, and predictable. Enterprises with clearly defined parameters such as industrialized estimation models to measure resource productivity can derive optimum results from this model.
However, the model may pose limitations in situations wherein the organization’s processes are not standardized. Engagements involving activities with a higher degree of subjectivity should not go for this pricing construct. And because procurement and delivery teams need a certain level of maturity in order to leverage the model effectively, it shouldn’t be used when the enterprise is new to outsourcing.
In order to succeed with output-based pricing, the client and the provider must collaborate, and both parties must remove as many constraints as possible to allow the provider to go about the best ways to achieve optimal results.
The onus is on the enterprise to provide access to historical data, information around regulatory requirements, business fluctuations, and identify clear risk areas. The service provider is responsible for being transparent on its assumptions, inclusions, exclusions, and risk premium.
Careful contract management right from the pre-contract phase is a prerequisite to make this pricing model work. Unambiguous definitions of performance measurements will help deliver the most favorable outcomes. Finally, there must be an open and trusting relationship between the two parties. Relationships that are based on up-ending each other will likely result in failure.
To learn more, please replay our recent webinar called Output-Based Pricing in Application Services: Adoption in the As-a-Service Economy, or contact our pricing experts directly at [email protected] or [email protected].