4 New IT Outsourcing Pricing Models Gain Popularity

Enterprises that have gone the outsourcing route now expect more value from their IT service providers and IT service vendors want potentially higher-margin work. The combination has resulted in several new pricing models. CIO.com looks at four emerging options.

By Stephanie Overby
Fri, April 13, 2012

CIO — In the traditional IT outsourcing deal, the vendor provides a service —managing servers, developing applications, monitoring networks —and the customer pays for it, whether at a fixed price, on a time-and-materials basis or a cost-plus model.

But as customers have grown to expect more value from their IT service providers and vendors have become eager to win that higher value, potentially higher-margin work, several new pricing models have emerged. "More creative fee structure attempt to better align the parties' incentives," says Shawn Helms, partner in the outsourcing practice of law firm K&L Gates.

Among the new pricing structures increasing in popularity are gain-sharing agreements, incentive-based contracts, shared risk-reward arrangements and demand-based pricing. "The better contracts aspire to satisfy the customer across prioritized business objectives that were either unable to be converted to [traditional service level agreements or reduced to a performance specification," says Steve Martin, partner with outsourcing consultancy Pace Harmon.

But early adopters may find that while these new-fangled price models convey real benefits —from encouraging innovation to increased control over IT costs —they're not for everyone. We lay out the four of the latest models you may come across when negotiating your next outsourcing deal: what it is, whom it works for, benefits, drawbacks and caveats.

Gain-Sharing Pricing Model

What It Is: Pricing based on the value delivered by the vendor beyond it's typical responsibilities but deriving from its expertise and contribution. For example, an automobile manufacturer may pay a service provider based on the number of cars it produces.

Best For: Customers seeking dramatic business improvements who want to create a true alliance with IT suppliers. Cost-focused buyers need not apply.

Pros: Theoretically, this model encourages collaboration and creative problem-solving as both parties work toward common business goals, says Ross Tisnovsky, senior vice president with outsourcing consultancy Everest Group. It also affords the supplier greater freedom to determine how best to achieve the results.

Cons: Gain-sharing requires a high level of trust, an equitable distribution of risk and reward, and significant upfront investment, says Martin of Pace Harmon. "In practice, very often neither the vendor nor customer is willing to fund the investment without a guarantee of a payback." Gains can be hard to agree on and difficult to measure. Because results can be influenced by factors outside of their control, vendors charge a premium on these deals.

Watch Out For: The second year blues. "If the provider has a windfall one year, then the customer is likely to demand a stricter formula or a new basis for the payment the following year. Conversely, if the supplier lost out due to poor overall performance by the customer organization, they will want to change the measurements," says Tisnovsky. "This can lead to rebuilding the model every year."

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