Outsourcing Pricing - Cost Plus vs. Unit Pricing vs. Fixed Fee. Performance Bonuses and Penalties.

Much time is spent by outsourcing clients and suppliers determining the optimal pricing structure for an outsourcing deal. Suppliers want to make a reasonable profit, and clients want to ensure they are getting value for what they spend. Some pricing structures are simple. If an easily counted and comparable “unit” exists for pricing – such as “cost per call” on a call center deal - then the pricing structure is fairly straightforward and easily determined - so long is the price is “reasonable”.

Unfortunately, simplicity is more often the exception than the rule. Finding clearly definable and manageable units that can be priced on a fee-for-service or a fixed-fee basis isn’t always possible, or becomes so complicated; counting becomes almost as big an effort as the services being provided. Even with the “simple” call center example, one must define what represents a “call”. Do you count the number of inbound calls to the ACD, or the number of tickets entered by the agent? Are there exclusions? – say for a system outage, where many people are calling in for the same issue?

Another seemingly simple arrangement is a cost-per-hour. Programming hours are a good example. The supplier provides a somewhat “fixed” number of staff (with varying skill sets) to a project. The personnel account for and document their time spent on the project. The hours spent times the headcount easily generates an invoice. But how does the client actually audit the time spent by a technician developing a new system?

Many deals that have no clear unit mechanism for compensating the outsourcing provider will turn to cost plus. Add up all the costs that the outsourcer is responsible for (salaries, supplies, travel, etc.), apply a pre-agreed formula for overhead, then add a contractually-determined profit margin, and this becomes the price for services. Most of the large mega-deals end up with this arrangement. Oh, the deal will “outline” a future "unit pricing" strategy - based on gathering tons of data, and implementing new, yet undiscovered measuring systems - but there are usually enough conditions in the contract to give both sides and easy out, and the contract ends up cost plus for the duration.

Each pricing formula has its strengths and weaknesses. Fixed-price and unit-price deals are sometimes difficult for the client to verify, but provide greater incentives for the supplier to generate efficiencies. Cost plus deals are relatively easy to verify, but lack incentives for the supplier to do anything other than maintain the status quo. So what’s the answer? Well, it would seem that the optimal pricing mechanism will accomplish the following:

• Compensates the supplier fairly, where compensation is not only based on the level of production, but its quality;
• Has built-in efficiency incentives, where the client will benefit from these efficiencies with lower costs;
• Clear, verifiable and auditable invoicing amounts.

None of the standard basic pricing mechanisms has clear-cut incentives for either quality or efficiency. Asking an outsourcing supplier to operate at a loss for “x” number of years until they gain promised efficiencies isn’t a likely outcome of contract negotiations (unless the client is a really crafty negotiator). Asking a client to pay a service premium well into the future for promised improvements in quality or efficiency over time, usually doesn’t work either.

Variable unit pricing seems to be something everyone likes. For the outsourcing provider, technology deflators ensure that processors and storage will get faster, smaller and cheaper over time, and that the use of the technology will always grow - hence they make more money (at least in theory). For the outsourcing client, the fees they pay via the unit price are directly tied to the amount of technology they use.

The selected pricing mechanism must balance all factors, and be something that both sides trust and can rely on. A mechanism that will allow the provider to make a reasonable profit, and one that will allow the client to feel they are getting reasonable value for their expenditure. Typically, this balance is created in the form of contract incentives for outstanding performance, or penalties for sub-par performance. These "incentives" or "penalties" can be easily implemented regardless of the underlying contractual compensation mechanism. But negotiating them can be a problem. No outsourcing firm wants to pay a penalty unless they've really messed up. Customers don't want to pay a bonus if the performance isn't viewed as exceptional.

It may be the terms we use - "penalty" and "bonus" that cause many of the problems. Many outsourcing firms won't even allow the term "penalty" to be used in the contract, since it may imply contractual default. Some outsourcing attorneys even say that courts view a penalty as a meaningless term. A bonus implies outstanding performance. The objective statistics may show that performance is exceptional, but in many cases, the subjective view of the client doesn't match these so-called "objective" statistics.

I've even heard of subjective performance measures being attempted - where the client and outsourcer periodically agree on the outsourcer's performance and pay (or deduct) bonus or penalties accordingly.

I'm afraid I don't have any perfects answers on how to effectively structure bonus and penalties, but I would like to hear your views. If you have any interesting, innovative pricing and/or performance-related compensation techniques (and whether they worked or didn't work), please comment.

B. Erenberger OMS