Pricing Models in IT Outsourcing
One of the primary goals of outsourcing has always been cost-effectiveness. This notion is reflected even in the pricing models of IT outsourcing. But as mentioned in our previous post about how outsourcing has transformed in this digital world and is increasingly becoming complex, a single pricing model is no longer realistic.
After taking account of various pricing models, I realized that Outsourcers today have many options where they can pick and choose between the pricing models which suit their organization’s specific budget and cash flow requirements.
Given a pricing model’s pivotal role in forming a successful outsourcing relationship by aligning to the interests and expectations of both the outsourcer and the service provider, let us take a look at the various pricing models new and evolved in the IT outsourcing industry.
- Fixed price
A fixed price model is the most common model used in the outsourcing industry, in which the price for the project is decided at the start. It is an ideal pricing model for projects which have clear scope, objectives and a stable set of requirements. Both parties, the outsourcer and the service provider are aware of each other’s duties, skills and capabilities. The service provider furnishes a detailed outline of the work to be executed with timeline based periodic deliverables in the product development lifecycle.
Nowadays, new hybrid models, suiting the current industry dynamics have emerged, like Fixed price with price adjustment.
In fixed price plus price adjustment, pricing is fixed with some width/leeway given for adjustments necessitated by movements in the macro/micro indicators in the industry which could have a direct implication on the pricing. These adjustments could be based on Forex fluctuations, cost of labor and material etc. These terms must be clearly defined and agreed upon by both the parties to avoid any kind of misunderstanding in the future.
- Time and materials
Time and material model as the name suggests, is based on the time and material used in completion of the project and happens to be another popular pricing model used in IT industry. It is typically used in application development and maintenance projects which have long time duration. This model is also known as Cost and material model and is ideal in the following scenarios:
- The project scope and specifications cannot be effectively estimated at that particular period of time
- For maintenance and support based projects
- In a dynamic domain where needs evolve at a rapid pace
The outsourcing company may agree upon either a monthly rate (on an hourly basis) for the resources engaged in the project. The rate can be based upon the skills and experience of the resources utilized and also includes any non-standard hardware or software required for the project.
This model gives greater flexibility to the outsourcer in terms of modifying project specs based upon changing business needs and scenarios. At the same time it also serves the interest of the service provider when there is no clear scope with regards to time and resource requirement for successful completion of the project.
- Cost plus model / Open book modelCost plus model also known as open book pricing, is where the service provider is paid for the actual expenses incurred for services plus an additional fixed fee or incentive (as decided by both parties) for the provider to turn profit.Here the service provider presents the outsourcer with a detailed cost structure highlighting the infrastructure and human resources required to complete the project. This cost can also include management and consultant fees to oversee the execution of the project. Based upon this, a margin above the fixed cost is agreed upon by both the parties.The advantage here is the outsourcer knows exactly what is he paying for with transparent cost structure, hence the name “Open book”.
- Incentive-Based This is a hybrid model often used in conjunction with the traditional models like Fixed price or Time and Material. In incentive based model, the outsourcer includes some bonus or incentive when the service provider achieves some key metrics which can add value to his business such as early completion, delivery exceeding service levels specified in the contract etc.
- Shared Risk/Shared Reward
This pricing model, though not yet popular but is gaining ground in the outsourcing ecosystem. Here the provider and the client jointly fund the development of new products, solutions with the profit shared between the provider and the outsourcer for a specified period of time.
According to Gartner, this model encourages the provider to come up with innovative ideas and solutions to improve business and also mitigates the risk associated with new technologies by spreading it over both parties.
- Pay as you use/Pay per unit This pricing model, the provider offers you a unit–based set rate and the outsourcer pays for the service as per his consumption.
This is best for businesses which have variable demand based work and require frequent scaling up or down of resources. For example, a client may outsource maintenance services to the provider, where the provider bills the client based on the number of units consumed to complete the project.
- Gain SharingThe gain sharing model is based on rewarding the service provider for delivering services above the contractually stipulated levels. This model, unlike the cost plus model, motivates the vendor to come up with innovative solutions and to reduce costs effectively.
For example, if the provider completes the project at a cost lower than the estimated one, or delivers the product in quick time, thus generating savings for the customer. The provider receives a portion of the savings in an agreed ratio.
There is no single right answer when comparing pricing models to find out the best one. Each outsourcing relationship is unique in terms of requirements, business constraints, etc. The parties must work together to determine which pricing model best serves both their interests.
There are more pricing models available now than a few years ago and with the rapidly evolving market dynamics they continue to evolve.