Use the right pricing model for third-party services

Which pricing mechanism should your company choose when buying third-party services? What is the optimal contract length? And what is the best way to manage switching costs? These questions are even more important today than in the past because the services industry is switching to new pricing mechanisms for digital services. Understandably, these changes create consternation and confusion for buyers of services.  What comprises service prices? In this post, I’ll explain how pricing works and, hopefully, clear up confusion and help your company make optimal decision.   

What comprises a pricing mechanism?

The way your company buys third-party services is a function of two factors:

1. The service provider’s business model (the type and number of resources it provides)
2. The behaviors your company wants to influence in the company providing the services.

I’ll explain how the business models affect four types of pricing mechanisms and how buyers try to influence a provider’s behavior through those pricing mechanisms.

Labor arbitrage pricing mechanism

This is a consumption-based model. The services buyer/client consumes labor, or pricing by FTEs usage, which is based on hourly, daily, monthly usage and a commitment to those labor resources over one or more years as well as the quality of kind of skills you consume. The providers have rate schedules based on a skill set and the amount of time you use that resource. The model is a variable-based model, adjusted according to the number of FTEs or number of hours the buyer uses them.

Managed services pricing mechanism

The popularity of this pricing mechanism arose because buyers sought lower prices and ways to influence providers’ behavior. When a service provider offers a managed services business model, it utilizes a team of people who are responsible for the client’s portfolio of applications or functions. The buyer trades a variable-rate for a flat rate for this business model. The theory is that the lower price will encourage the service provider to grow its business by generating efficiencies (a win-win pricing mechanism).

These two pricing mechanisms largely framed the world we lived in prior to digital services.

How digital services change the pricing equation

Digital business models basically substitute technology (digital platforms) for labor. Therefore, the FTE consumption model, or the time-based labor model, is no longer the relevant way to buy a digital service. Technology and software platforms dominate the digital business model, and there are different versions.

• Component of a broader offering. Where the service provider’s offering is a component of a broader offering – for example, infrastructure or cloud – then the pricing is largely a time or a performance rate. If your company buys cloud services, your pricing depends on the number of servers and the amount of time you use those servers. You can buy that server usage on an hourly, monthly or yearly basis.
• Digital platform that includes an application. When we further collapse the IT stack and broaden the digital platform to include an application, it changes the pricing mechanism. Take Salesforce as an example. Customers don’t pay for the CPU cycles of Salesforce; instead, they pay for the number of people that use the platform, plus they often pay for additional functionality. The provider calibrates pricing according to how much functionality the customer uses and the number of the customer’s employees using the system. This is another usage-based or consumption-based pricing mechanism.

Output-based pricing mechanism

Digital platforms are ideal for output-based pricing mechanisms, especially in banking or insurance services with a volume of transactions. The price usually depends on the number of users on the system, number of transactions, the volume profit (output performed) or even the degree to which clients use the capabilities of the platform.

Results-oriented pricing mechanism

This is the most difficult of all pricing mechanisms, with risks for both the service provider and the buyer. In this alternative platform-plus-service structure, both entities share gainshare on the benefit or results achieved through the services. For instance, a service provider offering Robotic Process Automation (RPA) services may base its price on the number of FTEs eliminated by the automation. Another example is a provider offering procurement services and pricing according to the savings achieved by superior category management. Or a provider of audit services may price its work according to the revenue captured by the client when the provider’s platform plus service finds mistakes.  

How to drive the desired behavior in your provider’s services

An important component of choosing the right pricing mechanism for your company is to choose the mechanism with an incentive structure that augments the pricing by driving desired behavior in your service provider. But be careful: incentives can drive both positive and negative behaviors and unintended consequences.

For example, the theory behind the managed services model is that the lower pricing would drive the providers to increase efficiencies, thus leading to more business. But this pricing mechanism also drove negative behaviors and thus unintended consequences. It empowered service providers to game the system by excluding functions previously in scope (thus arriving at a lower price) but then charge those back as projects outside the scope.

Let’s consider the cloud’s consumption, output-based pricing mechanism. These models usually include riders that drive provider and customer behavior. If the provider prices according to the number of seats (or amount of usage), it creates an incentive for the customer to minimize the number of seats or hours of usage.

More importantly, this cloud pricing mechanism provides very little incentive for the service provider to drive innovation. Customers assume the service provider will continue to innovate its model to stay competitive. This works well while the market is new and growing and the service provider competes on functionality. But when the market matures, and the number of competitors drops, or when the “stickiness” is so great it prevents your company from switching to another provider, there is little incentive to drive innovation. Except for responding to regulatory changes, most vendors are slow to drive change.

Contract length and switching costs

The final element of pricing mechanisms is switching costs, or what is generally referred to as “stickiness.” There are two types of switching costs, both with advantages and disadvantages: (a) contractual stickiness and (b) transactional or structural stickiness.

Contractual stickiness

For many years, I’ve advised about the inappropriateness of a long-term contract for services. Effectively, a long-term contract takes advantage of the buyer. The tradeoff is to have a short enough period that allows the buyer to reset the bar for a new contract without having to issue a request for proposal (RFP) or constantly having to renegotiate.

A good services contract time frame is in the range of one to five years, depending on the switching costs and difficulty of renegotiation. A three-year contract is an effective length for resetting the bar. A contract of five years or longer becomes problematic. In the case of commodity-like services (such as cloud), monthly or yearly contracts are preferable, particularly if there are switching costs.

Transactional or structural switching costs

In the case of Software-as-a-Service (SAAS) products or APIs and integration, customers often become dependent on the functionality. They need to consider alternative vehicles to drive changes in the provider’s behavior. Most companies opt for penalties. There is certainly place for penalties in service levels, but an incentive structure often proves more powerful.

Deciding on your pricing mechanism

So, which is the best pricing mechanism today? There is no one right answer. In a changing world, most organizations will have a variety of service providers providing a variety of business models and pricing mechanisms. When choosing a pricing mechanism, be sure to include an incentive structure that augments the pricing by driving desired behavior in your service provider.