Cost reduction or control is often a primary reason that customers source complex services from a third-party supplier. A transaction employing a well-developed pricing structure can facilitate customer’s achievement of other core objectives and behaviors, such as transformation and standardization of processes. This article describes pricing best practices to assist customers in optimizing pricing and pricing structures to facilitate realizing its core goals.
Defining Requirements and Governance Are Key to Optimal Pricing
Achieving reasonable and competitive prices when the contract is first executed hinges on the customer completely and accurately defining its requirements, including terms, scope of services and service levels. Well-defined requirements enable the supplier to design (and quote a firm price for) a technical and service solution that meets the customer’s requirements. If the customer cannot articulate its requirements, the supplier will view gaps and ambiguities as risks and likely react by:
- Over-engineering its solution (driving prices up).
- Quoting a price that includes a risk premium (providing a cost cover if it must later enhance its solution).
- Conditioning its pricing on a narrow set of assumptions (so that it can increase prices if it must later enhance its solution).
- The customer’s clear statement of its technical and service requirements early in the sourcing process, supported by careful analysis and accurate current-state data, is a foundation for favorable pricing.
Sourcing transactions are frequently long-term relationships and may last up to 10 years (more typically, three to five years). Well-crafted pricing structures and the governance models work in harmony and anticipate that the customer’s requirements will change over time, ranging from mundane service adjustments to fundamental changes such as terminating or adding major categories of the services or mergers/divestitures. The governance model should include both: (1) constitutional principles that establish the parties’ contractual and economic approach to change; and (2) efficient procedures to handle the details of change, for instance, analysis and staging of technical changes. The constitutional principles should both prevent the customer’s financial benefits from eroding over time (stopping the supplier from charging above-market prices for new services is a good example), as well as protect the supplier’s legitimate interests, including preventing the supplier’s prudently incurred investments from being stranded solely due to a customer decision to modify its requirements.
Best Practices Pricing Principles
Pricing for global sourcing transactions should ideally:
- Be complete and predictable (as to all of the services that the customer is purchasing).
- Be simple (so the customer can understand the impact of its decisions and to avoid disputes).
- Be efficient (such that pricing of services corresponds to the supplier’s costs to perform them).
- Give rational incentives (for both parties to minimize costs charged to the customer).
Types of Pricing Structures
Commonly used pricing structures have two main characteristics: What the pricing “buys” and how the pricing itself is structured.
As to the what, the pricing will “buy” either: (1) a specified level of effort as an input to the services (with the customer paying for any additional resources); or (2) a particular outcome, with the supplier responsible for providing all resources necessary to achieve that outcome. The OUTCOME model is generally better for the customer—the customer obtains a complete and predicable result and price, and the supplier has a rational incentive to use its best talent (in order to minimize its expenses and maximize margin). However, the supplier can offer favorable outcome pricing only if the customer’s requirements are well-defined. In contrast, the input model provides the customer no predictability as to either cost or result and does not incentivize the supplier to assign its best talent—and can encourage underbidding, because the customer must pay for additional resources required to achieve its required result. “Time-and-materials,” “cost plus” and “open book” pricing are all variations of input pricing models; the latter two introduce risk and instability by encouraging disputes as to how “cost” should be calculated and should usually be avoided.
The outcome model also allows the parties to map the pricing structure against both the customer’s requirements and the supplier’s proposed solution. Not only does this ensure that the pricing for the services is complete and predictable; but it also tests the completeness of the customer’s requirements and should also reveal any double compensation (two or more unit prices compensating the supplier for its costs relating to a single activity or group of activities). In an outcome model, each resource category (RC), consisting of one or more resource units (RU) (a measurable component of the services, the volume of the customer’s consumption of which is then used to calculate the invoiced charges), stands as a proxy for the effort (and the underlying cost structure) that the supplier expends to produce that resource unit; the result is that the aggregate charges fully compensate the supplier for the services (as a whole). A supplier will sometimes attempt to limit a unit price to an exclusive list of activities that it intends to perform relating to the corresponding resource unit; usually, the customer should firmly reject this as a backhanded attempt to transform an output model into an input model.
As to the how, a pricing structure frequently contains a combination of fixed price (a specified amount for a specified scope of work) and variable price (a unit price for a specified segment of work on a volume basis) components. There are also many risk/reward or “skin in the game” gain-sharing structures that may be advantageous to both customer and supplier, depending upon the circumstances of the transaction. The nature of a supplier’s costs in providing a service often will provide insight on how best to structure the pricing.
The diagram to the right shows how a supplier’s costs can translate to a complete and predictable, simple and efficient pricing structure. Distinct categories of services are established as resource categories (green, orange and red). The cost of the supplier account team (green) translates to an RC for an overall fixed monthly base charge. Within each separate RC, the supplier’s fixed costs (e.g., facilities and sunk capital) relating to each category of services (orange/red) translate to RUs for the fixed monthly base charge for those categories of services. Similarly, the supplier’s variable costs for certain specific resource units (light orange/light red) each translate into a unit price (“UP”) for the corresponding resource unit consumed. The total monthly charge for each resource unit is calculated by multiplying UP by the volume (“V”) of the corresponding resource unit that customer uses during that month.
Click here to see the Supplier Cost Structure.
Note that the supplier’s cost structure is used to establish the optimal pricing structure. This may vary significantly from a customer’s cost structure in self-providing the services and is usually different from how a customer will “package” the services internally to its business units. Suppliers will usually resist quoting prices based on a customer’s former cost structure or internal charging requirements, viewing this as a risk-reducing efficiency, because the supplier will need to map (and cross-subsidize) its costs to the customer’s structures and add a premium to address the risk of the customer discontinuing certain services during the term. Sophisticated customers are increasingly viewing the integration of supplier services and other inputs into a customer “service catalog” as a function that is best implemented and managed internally.
Future inflation and exchange-rate fluctuations deserve special mention. The pricing structure should state prices for each contract year without any allowance for inflation. Only for those pricing components that are subject to inflation (typically labor), should a recognized index (e.g., consumer price index) apply (typically annually) to adjust inflation-sensitive portions of the prices up or down as that index moves. For exchange-rate fluctuations, suppliers will often agree to take the risk; however, suppliers are increasingly more reticent to undertake currency risk, either by viewing currency hedging as a component of the services which is specifically priced or by requiring the customer to hedge against this risk outside of the contract.
For transactions with a term exceeding three years, an increasing risk arises that a supplier’s costs for its factors of production will decrease (due to either declining market prices or by a quantum leap in technology), meaning that, over time, a customer may be paying higher prices than are then available in the market. A robust and enforceable benchmarking regime will help ensure that the customer realizes the financial benefits throughout the term.