May 09, 2014, 2:30 PM — Once upon a time, application development and maintenance (ADM) outsourcing was done via the staff augmentation or time and materials model. It was the proverbial lose-lose. Customers could end up paying more than they should and providers could wind up with slim margins.
Over the years, the preferred model for ADM outsourcing matured became the fixed-fee contract, whereby clients pay a set amount of money for specific amount of work. Clients liked fixed-fee deals because they feel they were more likely to get what they paid for and suppliers appreciated them because they could appropriately staff their deals and increase their margins a bit.
However, in recent years attention has shifted to the managed service model. Managed service pricing is seen as the "holy grail" of ADM pricing models, says Steven Kirz, principal with outsourcing consultancy Pace Harmon.
"Managed service deals focus on meeting the client's exact requirements regardless of how a supplier chooses to staff and service it," Harmon says. The client establishes the outcomes and service levels and the supplier delivers based on their own methodologies, processes, tools and locations. In theory, it's a win-win arrangement. The client gets requirements met more economically than with the other previous models. (Kirz says he's seen clients cut their costs in half over the course of a five-year management service deal.) The supplier gets increased flexibility and margin opportunity in exchange for taking on more risk.
But if it were easy, everyone would already be doing it. CIO.com talked to Kirz about the challenges of the managed service approach to ADM outsourcing and how to overcome them, why an effective outcome-based relationship requires more than new pricing, and what a successful managed service deal looks like.
CIO.com: How difficult is it to apply outcome-based pricing to ADM deals?
Steven Kirz: It doesn't have to be difficult if the client fully understands their requirements and how to effectively measure outcomes for both application development and maintenance. Truth be told, however, the art of translating requirements into a plan that can be aligned with realistic pricing requires expertise and deep marketplace knowledge.
For outcome-based pricing in application development deals, you're paying to create an application that performs to particular specifications. Whether you're paying a fixed-fee or viewing it as outcome-based, the end result is the same. In good ADM deals, the client only pays if the application is delivered and works based on requirements.
We've seen outcome-based pricing work well for application development deals. Outcome-based pricing can work well for application maintenance deals as well. For example, if a company needs to maintain a suite of ten applications but two aren't profitable, then a supplier may be contracted to retire the two underperforming applications and then receive part of the savings generated by the company not having to maintain them anymore.
CIO.com: How should a managed service model for ADM work?
Kirz:In a managed service model, a client looking to maintain a suite of applications needs to ensure that the supplier knows the good, the bad, and the ugly about the comprehensive application environment. Giving the supplier complete visibility into interfaces, incidents and outages, how data moves within the applications, and the infrastructure they sit on is required so they can gain a realistic understanding of the level of effort and expertise needed to maintain the apps.
The supplier applies this knowledge in determining ways to more efficiently manage the applications using their methodologies, tools, and locations worldwide. The client and supplier can then prepare a three- to five-year deal that includes SLAs to be met during the first year for a certain price, with pricing reducing in a graduated approach for each year thereafter to reflect the efficiencies generated by the supplier. We've seen many companies experience a 50% cost reduction over the course of five-year application maintenance deals.
Using a managed service model for application development requires a different approach as it is project-based rather than a consistent body of work. The same high level of visibility (as with application maintenance) should be given to suppliers regarding what needs to be developed and a fixed bid should be established with flexibility to build in ad-hoc projects. Milestones should be outlined and enforced for each development project. The biggest challenge for managed service models in application development deals is that business and IT stakeholders frequently have trouble agreeing on requirements as a first step.
CIO.com: What else has to change beyond the pricing model itself for this kind of approach to work?
Kirz:Pricing is the starting point for aligning objectives between clients and suppliers, but there is much more to establishing a successful ADM deal. When clients go out to bid for a project, full transparency must be given to suppliers regarding requirements, existing applications, and their issues. Clients must also be clear on contract terms, including key SLAs and personnel requirements, upfront. Additionally, there should be no commitments required aside from a specific managed service level of effort that aligns with an agreed-upon fixed monthly rate.
To build in flexibility for future projects, it's wise to ensure the contract is structured to include staff augmentation, time and materials, and managed service pricing models so both the client and suppliers understand all options. This includes gathering rate cards, resource certifications, and so forth.
Another key piece is that both application development and maintenance should be included in all contracts for statements of work in order to enable any supplier that bids on application maintenance to also bid on application development work at any time through a statement of work rather than entering into a major contract negotiation.
In this model, the client will ultimately choose one application maintenance supplier with the expectation of reducing costs by 50% over a five-year period. For application development, it is more beneficial to choose multiple suppliers to create a competitive environment for follow-on deals.
CIO.com: How receptive are vendors to the managed service approach for ADM?
Kirz:In our experience, suppliers have largely welcomed this approach as they can yield a much higher margin than with the commodity-based pricing of the time and materials or staff augmentation models. They also appreciate the increased visibility into the nuts and bolts of any given project, as well as contracts and requirements. Many suppliers realize this approach is more about building a long-term partnership than trying to reduce margin.
CIO.com: You note the importance of clients providing full transparency about all the issues associated with their application work to their vendors. Once customers have made their requirements clear, should they demand that their vendors provide visibility into their proposed pricing, plans, tools, and resources for meeting those demands?
Yes, this piece is central to the model's success. Clients must retain the ability to compare apples to apples across deals with multiple suppliers. While traditional negotiations involve redlining contracts, we've found that it consistently saves months of time and produces more predictable results when clients establish their needs and stick to them. If they give full visibility to suppliers regarding their exact needs, then it should just be a matter of what price the supplier will charge for those services. Once the price has been established, clients can then focus on how to differentiate among suppliers by comparing resource quality, methodologies and approaches, and transition plans.
CIO.com: What are the biggest benefits you've seen from the managed service approach to ADM?
Kirz:Well, one company's team that had been negotiating the same ADM deal for more than a year was able to close four ADM deals in four days each by using this model. But it's about more than the speed of closing the deal. Companies are more likely to secure the requirements outlined by business and IT stakeholders without having to compromise on key elements.
They can maintain a competitive supplier environment as well as land market-leading project pricing with a stable of development suppliers meeting identical contract terms. They get guaranteed application maintenance pricing for three to five years with the flexibility to shift work to qualified alternate ADM suppliers if performance doesn't hold up to standards.
They secure access to new thinking, resources, and tools among multiple suppliers that are aware of the competition and are trying to rise to the top. Finally, governance is easier with a standardized contract that multiple suppliers must adhere to. It levels the playing field.
Read more about outsourcing in CIO's Outsourcing Drilldown.