Incentive-based pricing models for your next IT outsourcing contract

Looking to add oomph to your standard IT outsourcing contract? Here are three incentive-based pricing models that might help.

IT outsourcing providers and their customers pay plenty of lip service to the win-win relationship. An outsourcing...

contract in which provider and customer each feel they've come out ahead remains a scarce commodity, however.

Steve MartinSteve Martin

That's because, for all the talk about mutual gain, structuring an IT outsourcing contract that drives benefits beyond the stated services is extremely difficult, according to Steve Martin, partner at Pace Harmon LLC, an outsourcing advisory services firm based in Tysons Corner, Va.

One way to structure an IT outsourcing contract that results in benefits to both vendor and customer is to use incentive-based pricing models. Traditional IT outsourcing contracts are typically based on a fixed price for a set scope of work, or a set price per number of units: Vendors are paid to provide a utility function (for example, managing servers, monitoring network devices, ensuring email is available). Incentive-based pricing, on the other hand, rewards vendors for adding benefit to the service: cutting costs, boosting revenue, improving efficiency, for example. But getting there isn't easy.

"These contracts are complicated, thorny and take a long time to negotiate. Despite not being new, incentive-based pricing lacks a clear and consistent definition," Martin said. "We see terms tending to favor one or the other party, but not both."

One big challenge in such arrangements is "attribution," or determining which part of a good result -- an increase in revenue, say -- can be tied directly to what the provider did. Another issue is sorting out a premium provider service from simply the price of winning the business. "CIOs have to be able to separate out what they expect their vendors to do in the normal course of business, versus the things the vendor should get rewarded for," Martin said.

Our argument is that vendors should not be rewarded for exceeding a target level if the target level is what the business needs.

Steve Martin,
partner, Pace Harmon LLC

Incentive-based IT pricing models require fortitude, analytical rigor, a trustworthy provider -- oh yes, and deep pockets. Martin said many IT outsourcing providers won't even consider such potentially nebulous incentive-based arrangements without the customer buying at least $10 million a year in services -- or at least a good prospect of winning that kind of business from the customer. "The Fortune 1000 are definitely going to be in that sweet spot," he said.

In this SearchCIO.com tip, Martin warns against a type of incentive-based pricing that benefits the vendor but not necessarily your business. He then outlines three variations (outcome-based pricing, revenue-based pricing and gain-sharing) on incentive-based pricing, including one model that could represent the CIO's best shot at capturing that elusive win-win.

Incentive-based pricing skewed in the provider's favor

IT outsourcing contracts typically spell out the service levels the vendor is expected to meet, and the penalties for not meeting those levels. Some providers will argue that if they incur penalties for falling below the contract's service levels, they should be rewarded with bonus payments when they exceed them. This pricing model is flawed, however, if companies end up paying vendors for a premium service that is not required by the business.

"Our argument is that vendors should not be rewarded for exceeding a target level if the target level is what the business needs," Martin said. "If the vendor resolves more help-desk tickets on the first call than the 80% target, they should earn more for that higher level only if it provides an incremental benefit to the business."

True incentive-based pricing contracts drive discernible and measurable benefits for the business.

IT outsourcing with outcome-based pricing

Outcome-based pricing is based on delivering a particular result or "outcome," rather than on headcount or the volume of services provided (for example, tickets handled; servers managed). Typical outcomes include things like reducing IT costs, increasing IT asset utilization or improving overall IT operations. Outcome-based pricing also can be tied to business results, such as improving product distribution or optimizing inventory, but these contracts are less common, Martin said.

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The challenge here is tracing cause and effect -- a tough, if not impossible feat, in Martin's experience. "Outcome-based pricing is a good concept only if the IT vendor can prove that its work has directly caused the desirable effect."

In cases where outcome-based pricing is applied successfully, IT vendors have complete control over the full IT infrastructure and application development and maintenance, so they can accurately show cause and effect between the IT services delivered and the business results.

An IT outsourcing contract with revenue-sharing

The revenue-sharing pricing model is essentially a subset of the outcome-based model. Here, the provider's fees are linked either directly or partially to an increase in the client's revenue that can be traced back to the provider's performance. Again, attribution can be a challenge. Especially difficult is sorting out the revenue generated by an IT function that is part of a business process.

"If the revenue goes up, can you separate that increase out to something the vendor did, versus something sales did or another improvement to a business process or the ad that ran on Super Bowl Sunday?" Martin said. "That can be tough."

In cases where revenue-sharing pricing is applied successfully, the IT service being provided is the primary enabler of the revenue increase. Developing an e-commerce portal is one example. Deploying an interactive voice response, or IVR, system integrated with an order entry system is another, Martin said.

Gain-sharing pricing for IT outsourcing

"We actually like this one," Martin said. In a gain-sharing pricing model, the provider offers to find new ways to reduce IT costs over and above the IT services commissioned in the contract -- and the client and vendor share in the savings.

For example, a provider might propose investing $200,000 to study whether it pays to move a platform to the cloud, or to quantify the cost and benefits of virtualizing IT workloads. Or the offer might be to identify IT assets that are underutilized or have no activity. The vendor makes the up-front investment knowing it can save the company X amount a year in recurring savings. "If the study results in $500,000 in annual recurring cost reduction, the vendor gets $250,000 and the company gets $250,000 of savings," Martin said.

The strength of this approach, Martin said, is that even without a contractual obligation, the provider still has an incentive to identify these kinds of cost-reduction measures because they ultimately benefit the provider in the form of improved margins. "The flip side, of course, is that the customer could have done that study or analysis themselves and kept all that money," he said. "But these are the kinds of mutual benefits that a good outsourcing contract should drive."

The challenge? It's difficult to hard-wire these benefits into a contract. "What you can do is stipulate that every year the vendor has to come in with two or three proposals that could lead to mutual benefits. That is how you get your vendor to think outside the box," Martin said.

This was last published in October 2012

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Have you used incentive-based pricing successfully?
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Clients who remain focused on a win-lose positional bargaining approach, will never reap the true benefits of any of these options
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Thats the future of Outsourcing.
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I'm a performance tuning consultant who would love to be paid by the amount of CPU and Elapsed time I remove from troublesome SQL and indexes. This requires a shop focused on solutions and not just monitoring, as if monitoring solved anything.
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I would say that as an outsourcing services provider it is more value generating both for the consumer and producer. Outsourcing transitions from being transactional to being more accountable for outcomes and cost efficiencies.
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I have been able to apply outcome based models few times. I agree, the main challenge is attribution, but when that is resolved this is the best way to engage with a vendor
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Yes, Cost plus contracts, many a times proved viable and effective. These contracts encourage creativity on both parties side to optimise cost savings.
Ch. Ramesh PMP, MBA
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Yes 3 successive outperforms gets you incentive bonus - calculated as average diff between contract and actual, likewise 3 consequtive failures yields penalties.
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Incentive based pricing should be on win-win strategy. We should treat the other party to the contract as our customer having given us opportunity to serve and survive. Hence it's the mutual trust and mission that should drive the contracts, not mere $calculations. The moment we achieve the same account with us going forward as well thats the real success manthra. And this manthra hones our strategies to win new accounts as well.
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