Value Based Pricing for Outsourced IT Services: Are Customers Maximizing Gains By Mapping Pricing with Service Catalogue?

A Suggested Approach

The importance of picking the right outsourcing deal is critical in view of the long-term strategic implications it has on cost savings and performance quality. The choice is between pursuing a traditional, transaction based or outcome oriented pricing model. The deciding factors depend broadly on the level of flexibility and control an organization is willing to wield on the overall operations. This white paper focuses on discussing outcome based pricing models with the objective to highlight its aptness in meeting present-day outsourcing needs and its advantage over Fixed Price (FP) based pricing model. This paper covers the various options in outcome based pricing that customer could opt for. It also tells you how to overcome challenges in choosing the right pricing model that could be a win-win solution for customer and service provider.

Executive Summary

The outsourcing business environment over the past decade has evolved considerably.

While there have been far-reaching changes in technology, delivery and operations

areas, pricing models haven’t kept pace with changing times. As a result, clients fail to

maximize benefits of optimization gained in technology adoptions.

As pricing models are continually evolving, this is transforming the way outsourced

services are priced. As in other software projects, the ‘one-size-fits-all’ pricing model

does not apply to outsourced services. Given the vast scope of offerings like green field

development, support services, enhancements, quality assurance and testing, pricing is

based on scope of work and service requirements.

This white paper discusses the evolution of various pricing models with the objective to

share the knowledge gathered by Syntel with the reader about how best to respond to

outcome based pricing models. This paper also talks about pricing objectives, challenges

in choosing the right model and the process to identify applicability of a suitable result

based pricing model.

We hope this paper provides customer better insight into pricing strategies with service

provider.

Table of Contents

Executive Summary

Market Overview

Traditional Pricing models

Outcome (Unit of Work) Based Pricing Model

o Ticket Based Pricing

o Work Packet Based Pricing

o Test Unit Based Pricing

o Pay per Use

o Business Outcome Based Pricing

SaaS Pricing Model

Mapping Pricing Solution with Service Catalogue

o Understanding Pricing Objectives

o Defining Measurable Output

o Identifying Suitable Pricing Model

o Proposing New Pricing Solution

Pricing Maturity Models – Keeping Pace with Change

Suggestions to Overcome Challenges

Conclusion

Value Based Pricing – Syntel’s New-Age Solution

o How we help our clients

Market Overview

World economy has gone through a fundamental ‘economic reset’. Organizations across

the globe are constrained to cut cost of operations, while at the same time they place

strategic focus on IT transformation and business process transformation opportunities

to gain competitive advantage.

Today, IT optimization means more than typical cost cutting measures and

consolidation, to considering opportunities like reducing infrastructure outlay via cloud,

or moving to newer engagement models that ties business outcomes to IT spend. Along

with other optimizations, pricing models have also matured. In fact, IT firms that were

not particularly critical about gauging the specific value of pricing models have begun to

question the specific value of what they pay for.

While most buyers still negotiate for T&M (Time & Material) or FP (Fixed Price)

contracts, the more forward-thinking are moving towards business outcome-based

pricing models. Apparently, clients are seeing value in switching from a traditional IT

outsourcing model to an outcome-based model.

Last few years has seen a rapid increase in usage of outcome based pricing models

across different types of engagements. Some commonly used models are Pay per Use,

Ticket Based, and Business Outcome Based etc. In selecting the right pricing model,

companies must focus on service and support as the key differentiators, to ensure a

long-lasting, win-win service engagement.

We hope this paper provides a better insight into pricing strategies with service

provider.

Traditional Pricing Models

Traditional pricing models are effort based formats that offer flexibility of modifying

size and scope of service during the contract. The primary objectives of this model are

to deploy ready to use skilled resources and achieve optimized cost advantage.

Workload management function is handled by customer, and customers pay for what

they use. This model is preferred when scope of services are continually evolving in

nature. Service Provider is paid a predetermined rate based on the type of resource

deployed and their skill-levels applied.

A more evolved pricing model is where service provider is responsible for delivering

work based on predetermined milestones, while meeting expectations at a

predetermined price. Any deviation on meeting timelines and/or quality targets could

result in deferred payments or even attract financial penalties. Customers prefer this

pricing model for greater cost efficiency and to shift greater accountability to service

provider in terms on timelines and quality factor, besides sharing consequences of

underperformance.

One of the limitations of these pricing models is it does not provide flexibility to either

client or service provider to act in an economically efficient manner to manage cost.

There is very little traceability between price paid for the service and actual milestones

accomplished. This is especially significant in a weak economic scenario where both

client and service provider is looking at options to not only reduce costs but also

achieve greater flexibility in controlling spend.

Here are some limitations of traditional pricing model:

Drawback of Traditional Pricing Models Client unable to gain complete benefits of outsourcing May not be directly linked to customer’s business outcome Risk of Cost fluctuations due to changing requirements lies with

customer Strong possibility of under/excess staffing resources

Outcome (Unit of Work) Based Pricing Model

This refers to a pricing model where service provider is paid based on the business

outcome realized by customer. This could be based on number of units / transactions or

Units of Work (UoW) involved. The process for paying service provider varies, but

generally, payment is made at pre agreed frequency or when the result is accomplished,

In transaction pricing model, customer pays service provider based on number of

transactions processed. It is therefore important to determine scope of each transaction,

what are the inputs, outputs, measurement mechanism.

Determining the right outcome based model, therefore, is important in Unit of Work

based pricing. This structure is usually determined by identifying the unit that best

represents the underlying transaction and the costs related with processing that

transaction. The following are some variants of outcome based pricing model:

Ticket Based Pricing

This refers to a model where pricing is a direct function of ‘ticket’ as a unit of work. This

model is primarily recommended for application maintenance or support services

where service is calculated in terms of number of ‘tickets’ raised.

Work Packet Based Pricing

Work packet is a group of activities bunched together into small projects (preferably

repetitive). There are various categories of work packets defined for an engagement,

presumably from past pattern of usage. Any deliverable that can be mapped onto a pre-

defined delivery set can be priced under the ‘Work Packet’ based category. This is a

highly flexible UoW pricing model as it enables team to define their base unit for

defining the pricing strategy.

Test Unit Based Pricing

This refers to a model in which customer pays only on consumption basis. It also

enables use of risk based testing by prioritizing the regression suites to be executed

based on business risks and available budgets. These models can apply to exclusive

testing and quality assurance outsourcing contracts or testing services within overall

ADM outsourcing contracts. Depending on engagement maturity, Test Unit can also be a

test case which offers lot of business control.

Gain Share

Gain sharing is essentially an outcome based pricing model that relates to ‘pay for

performance’ kind. In this model, service provider gets additional revenue beyond base

price as bonus based on savings realized due to operational efficiency. While this model

emphasizes the benefits gained by customer, it nevertheless rewards service provider

for performance delivered. This model works in cases when a “partnership” approach is

needed to achieve a mutually-beneficial result, such as reducing purchase spend. In

gain-sharing model, both parties have incentives to work together creatively to achieve

common goal. It is critical to setup clear baselines, targets and mechanisms to measure

and report. Overall, this pricing model is supportive of a ‘partnership’ approach that

benefits both client and service provider.

Business Outcome Based Pricing

This model is leveraged by clients who want to reduce risk related to IT investments

and align outcomes with business results. In this model service provider shares a

percentage of revenue and picks up partial cost of creation or enhancement of a

product. This pricing model has multiple variants. Some of the variants are complete

pricing tied to business outcome, joint investment made by the customer and service

provider and revenue shared in pre decided ratio. In some cases the Service provider

may also get base (assured) price till a pre defined revenue cap, beyond which service

provider get % revenue share. The level of engagement in either model depends on

customer’s openness to adopt the pricing model.

Outcome based pricing is emerging as the preferred pricing model by businesses. Key

considerations for clients to achieve success in this pricing model include:

Get ‘buy-in’ support from major internal stakeholders

Decide on crucial business metrics, success criteria and measurement timeline

Assess service provider’s experience in handling large deals

Gain clarity and agreement on needed Investments, profit sharing terms and

conditions and timelines

Scope definition and roles and responsibilities

Ensure regular executive reviews to track progress

Following are some advantages and disadvantages of outcome based pricing models:

Advantages

Disadvantages

Linked to customer’s business outcome Smoothly aligns customer’s and service

provider’s interests to facilitate partnership, improvement and ongoing progress

Not easy to segregate service provider’s involvement and determine its impact on outcome

Service provider’s ability to achieve outcome may be inhibited by customer’s people resources, infrastructure, systems, etc.

SaaS Pricing Model

Software as a Service (SaaS) is a model of system deployment wherein an application is hosted as a service and provided to customers across the Internet. Traditionally, software companies used to purchase software products and incur heavy costs in deployment and employee training. SaaS is a new way of delivering software to companies, without having to make huge investments to meet their business needs. In this arrangement, software is hosted and maintained by service provider, whereas customer pays only for usage amount. SaaS model provides the flexibility to combine the cost of maintaining and upgrading the required hardware, software and other IT resources to support business needs. This pay-as-you-go subscription model enables companies to convert fixed to variable costs. There are different methods used for charging customers. Most commonly used pricing models are:

Subscription Based – These could be based on weekly, monthly or yearly subscription. In this pricing model, customer pays the stipulated fee, irrespective of time and level of service used. Customers engaging in this model seek price protection and benefit from higher usage. However, there may be minimum and maximum number of application user criteria.

User Based – In this arrangement customer gets charged based on number of users who will access the application.

Unit Fees Based - Customer pays for each unit that is used. For instance, user will be entitled to pay only for bandwidth used and no more.

Time logged Based – In this model instead of paying a monthly or weekly subscription fee, customer prefers to pay for duration application was used.

Transaction Based: In this method, customer pays for each business transaction executed by the application

Benefits of SaaS Pricing Models

Customer does not need to commit huge upfront Investment Committed quality of service Improved agility to respond to changing business dynamics

Mapping Pricing Solution with Service Catalogue

The importance of mapping the right pricing solution for outsourced services is critical

in view of long-term strategic implications it has on cost savings and performance

quality. The alternative can be between pursuing an existing model and going for an

evolved one.

The deciding aspects could hinge largely on the level of flexibility that an organization is

willing to assume and the degree of control that it wishes to exert on the overall

operations. However, it is difficult to point out one ‘most suitable’ pricing model that

exists in the business. Moreover, the requirements of client may differ over time.

The following are some major steps that need to be considered at this stage:

Understanding Pricing Objectives

First step is to understand client objectives for shifting to Evolved pricing model. At this

stage, it typically involves service provider understanding client’s business model,

business criticality, end customer sensitivities and pain points, etc. Data collection

around performance, current efforts spend is also given high importance at this stage.

Defining Measurable Output

Once service provider gains overall understanding of client’s business, next step is to

classify various activities into UoW vis-à-vis previous model. A detailed report is

submitted to client to highlight observations and associated activities that are classified

into UoW and should also have well defined inputs and measurable output. At this stage,

activities start taking shape of a measurable service. Moreover, service provider may

also spell out indicative performance metrics that can be leveraged to measure

performance. Outcome of this exercise should be to get broader agreement on

classification.

Identifying Suitable Pricing Model

Next step is to identify suitable pricing model that can be applied. Map various activities

to a specific pricing model; define needed inputs, outcomes, and dependencies for

completion of an activity. Mechanisms to measure, track, escalate and reporting are also

designed. RACI (Who’s Responsible, Accountable, Consulted and kept Informed)

Metrics are defined and clearly articulated along with roles and responsibilities of

participating teams to ensure client objectives are met. Next step involves identifying

right price for various activities, which involves historical data mining, considering all

possible levers/automation that can be applied, applying organization productivity and

coming with a price per UoW. This could be a single price across all multiple activities or

differential pricing based on nature of activities. Focus is to establish single price across

UoW.

Proposing New Pricing Solution

Final step is proposing the solution along with benefits to client on cost, improved

performance management system, ability to meet frequent changing needs, more agility

in operations etc. Once the agreement is reached, next stage is to start execution of the

engagement in changed pricing regime.

Pricing Maturity Models – Keeping Pace with Change Pricing Maturity models can be defined as having four maturity levels, as depicted in the

below.

Unmanaged At this stage organizations do not have a defined strategy for outsourcing. Each business

group usually has an independent plan and pricing mechanism. Key objective to be

achieved at this maturity level is to achieve cost arbitrage and ready to deploy resource

pool on need basis.

Standardized An enterprise implements a defined strategy for outsourcing with predetermined pricing structure. At this stage organization may engage in both T&M and fixed price model based on needs, risks envisages but every business group complies with pricing process laid out. This model facilitates improved cost management as price is linked to measured output.

Optimized At this stage of maturity, organizations have defined objective metrics to measure output delivered by service provider. Organizations may also evaluate joint investment with service provider based on risk assessment. Organizations are able to improve predictability by measuring outcomes and reducing total cost of ownership.

Value Driven Pricing At this stage of Maturity organizations pay price based on value delivered by the

investments or cost is linked to pay per use. There are mechanisms build to measure the

business value delivered before committing investments. The organization is also in

best position to manage cost by prioritizing initiatives thus reducing TCO.

Suggestions to Overcome Challenges

A study by IDC Research says IT budgets across enterprises are experiencing declining

growth rates each year and significant portions are being diverted to new compliance

and security mandates. While it is understood that services are critical, but for the first

time, enterprises are questioning if their investments are justified by the actual business

returns.

As enterprises play a more active role in determining that value, they will no doubt

arrive at a pricing model that offers significant value. Here are some considerations to

keep in mind while choosing the right pricing model:

o Choose an appropriate pricing model that aligns both parties’ interests including

customer and service provider

o Determine a mutually agreeable process to address requirements fluctuations

o Concur on defining and measuring SLAs during the early phases of the engagement and use this data for base modulating them for the remaining term of the contract

o Usage of Evolved Pricing Models to share business risks with the Service provider

Conclusion

Outsourcing has evolved from a tactical opportunity to a strategic necessity for

clients. Outcome based pricing models are altering how customers buy and pay for

their outsourced services.

Organizations today are more focused than ever to find ways to reduce cost of

operations minimize risk, raise quality and gain maximum price flexibility and

transparency. Newer pricing models are being explored to deliver higher business

value, and at the same time provide control on amount spent on operations and

transparency.

It is crucial to decide which pricing model should be applied in mapping outsourcing

deals. While customer will be more open to looking at multiple options in an effort

to justify IT spend, service provider will look for minimum operational and financial

risk, consistent revenue growth and profitability, long-lasting engagement term

possible and commercial feasibility.

However, an effective pricing model would be one that helps in aligning the interests

of customer and service provider. It should lead to reaching a price that is

competitive yet profitable, flexible, but not stifling.

Outcome based pricing works best with better appreciation of how it benefits both

parties. Some of the odds in arriving at a suitable pricing model can be resolved by

ensuring closer cooperation between customer and service provider. Other hurdles

would get eliminated significantly as stakeholders attain maturity and experience

from broader acceptance of this pricing model, thus resulting in cost reduction,

increased efficiencies and service level improvements.

Value Based Pricing – Syntel’s New-Age Solution As organizations look for innovative solutions to meet their current and future budgetary constraints, value based pricing integrated into a managed services model provides a compelling alternative to optimize outsourcing costs. Syntel pricing model Value 2 Price (V2P), a non-linear estimation and pricing system is designed to support this purpose. Its objective is to put customers in the driver’s seat with absolute control over the price they pay for the value of services needed. The Value 2 Price (V2P) framework, which is integrated with the Syntel’s AMO 2.0 Suite, provides a complete solution for Application Management in a Managed Services environment with a differentiated pricing model. The V2P framework’s “Service Design Value” allows IT services to adapt to evolving business needs through dynamic configurations based on anticipated changes in workload. In this pricing model, cost to customer moves from “fixed” to “variable” bucket, driven solely by the change in business priorities and what each service is designed to achieve. A comprehensive “Portfolio Maturity Assessment Model”, part of Syntel AMO 2.0 offerings establishes a roadmap for the engagement in terms of a “Point-of-Arrival” Service Platform.

How We Help Our Clients

Syntel helps its clients across the globe to choose and implement an appropriate service based pricing model that delivers optimal value and cost savings. It identifies parameters influencing delivery and how these parameters can vary based on services required. Hence, customer sees the benefit of this pricing model and is encouraged to shift towards variable costing for improved benefits.

Well-crafted “risk-reward” models that hinge on adherence to defined goals reduce risk for customer while signing up for penalties in case of non performance. V2P creates a

win-win situation for both the client (charged for the real value of the services delivered) and the service provider (pricing according to the type of services provided).

Further Reading

For additional details, please refer to the following resources:

PricewaterhouseCoopers “Software Pricing Trends – How Vendors can capitalize on

the Shift to New Revenue Models” article

PricewaterhouseCoopers and Indo American Chambers of Commerce, “Evolution of

BPO in India” article

http://www.inc.com/guides/price-your-services.html

http://www.itbusinessedge.com/slideshows/show.aspx?c=79766&slide=8

http://itonews.eu/it-outsourcing-will-grow-to-313-billion/

http://www.everestgrp.com/2011-11-everest-group-q3-report-global-outsourcing-

transaction-volume-declines-substantially-for-first-time-in-four-quarters-press-

release-8395.html

http://articles.economictimes.indiatimes.com/2011-11-

21/news/30424667_1_software-spending-research-peter-sondergaard-gartner

http://www.igate.com/ceoblog/managing-risks-in-an-outsourcing-contract/

http://www.itbusinessedge.com/cm/blogs/all/12-outsourcing-trends-out-with-

labor-arbitrage-in-with-added-value/?cs=40866

http://www.businessweek.com/magazine/content/06_05/b3969401.htm

TCS Whitepaper - Transaction Based Pricing in BPO: In Tune with Changing Times

(http://www.tcs.com/SiteCollectionDocuments/White%20Papers/Platform_BPO_W

hite_Paper_Transaction_Based_Pricing_in_BPO_05_2010_1.1.pdf)

iGATE whitepaper - Transaction-based Pricing Model for Outsourcing: Why and

When (http://www.inceptum.com.au/pdfs/TMO-Based-on-a-Survey.pdf)

http://emerge.nasscom.in/2010/06/outcome-based-pricing-model-the-litmus-test-

of-collaboration/