March 11, 2013, 10:34 AM — Historically, pricing models for IT outsourcing were relatively straightforward: input-based pricing for application maintenance and development services and output-based pricing for infrastructure services.
And while the cloud-based segment of the IT services market is becoming even more unit-based and commoditized, a growing portion of IT outsourcing deals are being inked with more complex hybrid pricing structures that combine input-, output-, and occasionally business outcome-based pricing mechanisms.
"Because clients typically have various requirements across and within services, hybrid pricing models are quite prevalent and are growing in usage," says Steven Kirz, a principal for outsourcing advisory firm Pace Harmon.
"This is driven by dissatisfaction with traditional models on the part of both the customers and the providers, including customer disappointment with traditional rate-per-hour models that deliver poor results, and the commoditization of technology resources that reduces provider margins," Kirz says.
Some IT outsourcing customers are using a hybrid pricing model to experiment with business outcome-based pricing. "It is rare to go all in with outcome based pricing across the full IT suite, so outcome-based pricing will be part of a mixed approach, targeted to where outcome-based pricing can be distinctly applied to advance client objectives," says Rich Kabrt, associate partner with outsourcing research and consultancy firm Everest Group.
Challenges of Hybrid Pricing
A mix of pricing mechanisms theoretically allows for greater flexibility to meet future needs. But "delivery models--and their supporting pricing--are changing fast. Making sure that the model memorialized in the contract is still relevant in the [later] years is hard."
For those that approach hybrid pricing with due diligence, however, the effort can pay off. "Assuming the incentives and contracts are done right, hybrid pricing can result in a more business-oriented focus, improved service delivery, reduced and predictable operating costs, mitigated delivery risk, reduced redundancy and ongoing innovation and transformation," says Kirz.
Here are five things to consider when implementing a hybrid pricing model for IT services.
1. The type of hybrid pricing model should be dictated by customer requirements and type of services."Customers that are buying application development and maintenance (ADM) services may be savvy enough to bid out a finite scope of services in a managed services model, but that is unlikely to satisfy all of their ADM needs during the life of their managed services agreement," says Kirz. In that case, the client might consider a contract that includes both managed services and full-time-equivalent hours-based pricing.
2. Know what you're incentivizing."Pricing drives behavior so whatever pricing models are employed be sure there are the appropriate performance metrics and governance checks and balances to avoid falling into perverse incentive actions," says Kabrt, "For example, providing incentive pricing to encourage moving IT help desk calls to Web-based self-service solutions is typically a good idea and a best practice. But taken to the extreme, [that] may hurt overall department productivity and potentially even reduce customer satisfaction to levels that cry out for another change in sourcing and undermine the overall deal."
3. Be clear during the contracting phase."The most important characteristic of good hybrid contracts is a clear understanding--by the customer--of its requirements at a detailed level," says Kirz. "If these can be articulated in a way that will allow the providers to accurately price them, then they can work together to achieve a mutually beneficial contract.
4. Anticipate management challenges."Particularly in evolving services areas, it may be hard to manage the more complex pricing structure from a governance perspective," says Arnold. The more complex the pricing model overall, the harder it will be for providers to invoice accurately and for buyers to validate those invoices. "While this administrative consideration may seem trivial, the implications of inaccuracies in the invoice can add up to substantial dollars over the life of a deal," Arnold says.
5. Approach gainsharing with care. Gainsharing can be added to any pricing deal to provide added motivation to innovate, drive costs down, or elevate services. But it's hard to get right. "Gainsharing is most effective when it is in line with 'pain-sharing'," says Kabrt. Both parties needs to invest in the program and there needs to be adequate governance and leadership support to make it work.
Gainsharing works best when tied to a specific application versus and entire portfolio of services. "A broad-based applications maintenance deal supporting an entire portfolio of apps is not likely to land in a gain-share model," says Arnold.
"A specific solution that is presented as a part of a business case to alter revenue or profitability, however, may well be," Arnold says. "Essentially, the provider would win the work to execute the transformative project in part because of a shared risk--and shared reward--for its success."
Read more about outsourcing in CIO's Outsourcing Drilldown.