The globalization of information technology and related work like IT outsourcing has evolved to become mainstream in many organizations - large and small. Many organizations use it through - (1) partnerships, (2) joint ventures, (3) captive operations, etc., to obtain a sustainable competitive advantage. It - (1) decreases costs, (2) improves delivery, and (3) accesses a broader pool of skills, etc., and dedicated development team’s performance effectiveness. Managers are restructuring their organizations to stay competitive. Also, pricing plays a predominant role in outsourcing engagements.
Outsourcing Contract Models equate to cost models in generic outsourcing practice. The prominent ones are:
1. Staffing Model
It involves contracting resources by the outsourcing organization from the service provider. This model is useful when in-house teams lack the required skills for successful project completion. They outsource a specific number of resources from the outsourcing organization on lease or contract at an agreed-upon rate. The client-side holds the contracted resources. Therefore, this model assumes that the client will provide the necessary infrastructure for the resources to work on site.
The client can control the project and the contracted resources. It is agile as clients can progressively add or reduce resources and maintain absolute control on cost. Some of its strategic limitations include contract resources that belong to the service provider. The client can't build long-term competence and capabilities with external resources.
2. Fixed Price Model
It is also known as Lump Sum Model and is ideal for projects with a predefined scope, stable requirements, and established project management methodologies. It requires teams at both client and the service provider’s end to know the project requirements, establish a conducive working environment and be aware of the skills at hand. Service providers furnish a substantial amount of detail on executing the project before initiating the project.
In this model, the clients absolve the expectations and promised deliverables. Service providers bear the brunt in the case of managing project prices in a fixed price model. It requires checking the scope in advance, as any changes, later on, require additional cost. The service providers may set up payment terms with the client at periodic intervals. They get a fixed percentage of the total cost in such cases throughout the entire project life cycle.
The service providers must ensure that they cover their costs and enable risk management alongside. This model is most suitable for long-term projects and those having a high value to the outsourcing organization.
3. Fixed Price Contract With Economic Price Adjustment Model
It accommodates adjustments to the stated contract price according to any necessity/contingency triggered through macroeconomic indicators. Such price adjustments can be of three types:
- Based on established prices – It involves price divergence;
- Based on actual costs of labour or material – It involves price adjustments to the 'labour' or material cost during project execution;
- Based on cost indices of labour and material – It involves price adjustments to the 'labour' or material cost as identified in the contract;
This model is suitable if you are doubtful about market stability or poor labour conditions. Also, it is when you can define and cover all the contingencies mentioned in the contract.
4. Fixed Price Plus Incentive Model
The client of the outsourced services includes an incentive for achieving relevant metrics. Such metrics can be in the form of performance criteria, early completion, delivery that exceeds the specified scope. It is compulsory to articulate 'criteria' for both parties to agree to the terms and conditions. It contains elements like target cost, target profit, price ceiling, profit adjustment formula.
This model allows re-negotiating the final cost and makes adjustments to the profit upon delivery. If the resultant 'profit' is less than the expected target profit, the total project cost will exceed the 'expected' target cost. This model is suitable where service providers need to assume cost responsibility. Also, it requires negotiating the (1)target cost, (2) target profit, and (3) profit adjustment formula at the outset.
5. FPI Successive Target Model
This model is suitable when the realistic target costs and profits are not negotiable during project initiation.
An FPI ST Model with forwarding price re-determination consists of two components – An initial fixed price for the initial duration during the project start. This duration follows prospective price adjustments or re-determination at time intervals identified in the contract.
An FPI ST Model with backward price re-determination consists of two components – An initial fixed price for the initial duration during project start and backward price re-determination after determining the project.
6. Cost Reimbursement Model
It is also known as the cost-plus model, wherein the service providers get paid for the recurring expenses up to a limit and an additional balloon payment to allow for some profit. This model differs from the fixed price as the service providers get paid as much as the incurring expenses, not defined in the service contract. Here, they do not get paid any incentive, just the cost equivalent to the incurring cost; This model carries the highest amount of risk as the expenses are not customizable or predictable in the initial stages of project development.
This model is suitable in uncertainty regarding the project when a 'large' investment is to be made well before project completion, which involves high risk.
7. Cost Plus Fixed Price Model
It permits the service provider to charge back all the costs associated with project performance to the outsourcing organization and take an agreed-upon fixed fee upon project completion. The service providers make money through the fixed fee portion. This type of contract does not necessitate controlling costs. It contains three components:
The CPFF Completion Contract – In this model, the service provider requires delivering a certain amount of projects within a fixed budget. But, if not within time/budget, the client might mandate them to 'deliver' the entire project within the same budget, reducing the overall project profit.
The CPFF Term Contract – This type of term contract obligates the service provider to allocate a specific level of effort, defined in the service level agreement (SLA), for a period. They pay the fixed fee at the end of the contract term if the client approves their performance as satisfactory. If not, they can think about renewing the contract, subject to cost and fee revisions based on performance.
Cost Plus Incentive Contract – This type adds an incentive to encourage the service provider to submit on time. They clearly articulate all the measures to analyze performance. The 'incentive' is added as a percentage of the total project cost or by some metric that compares estimated project costs to actual project costs. It contains the highest risk because it cannot predict or the service provider cannot guarantee the final price. Also, there is absolutely no incentive for the service provider to optimize costs or operations.
8. Time And Materials Model
IT Application Development and Maintenance (ADM) projects use this pricing model. It is also known as the 'Cost and Materials Model'; Service providers bid for the project according to the client's project requirements, depth of scope, amount of work, and degree of coverage. Client's are required to clearly define the project scope to cover and correlate project requirements. It saves time and ensures considerable savings. This model also makes the client and the service providers agree upon an hourly, daily, weekly, or monthly rate for the project resources based on overall educational levels, skillset, and relevant project experience.
The TM model is essential for effective project execution. If the client organization puts strong project management in place, it becomes easy to track the project progress - schedule, scope, cost, quality and productivity. The client teams also need to manage all dependencies to avoid any lags or costly leads.
This model is preferable as it involves skilled people for the entire project duration. And this builds the competencies over time. On the other hand, it gives the requisite flexibility to the clients to progressively add or reduce headcount over time to adjust to the changing project demands.
9. Time And Materials Contract With A Cap
It is an extension of the time and materials model. It imposes an upper limit or cap on the costs to estimate the overall cost escalations in an outsourced project. It helps ensure that project lies within estimated budget expectations.
10. Consumption-Based Pricing Model
It is a dynamic model in which the costs are allocated based on actual resource usage. It is highly suitable for outsourcing organizations due to variable performance and variable demand. This model is 'suitable' where fixed cost is divisible amongst many customers. It delivers substantial productivity gains and makes cost structure analysis and adjustments relatively an easy task.
This model also converts capital expenses into operating expenses. It requires accurate demand prediction so that service providers could adequately provision their resources. The unit price of an individual transaction may be prohibitive for low transaction volumes. And it can be challenging to predict the annual growth rate due to changing demand patterns. Service providers require covering up their fixed costs. (forwarded to the client).
11. Profit-Sharing Model
It is an outcome-based pricing model. It involves incentivizing and rewarding the service providers for increasing the overall value delivered to the outsourcing organization.
This model is not suitable where cost savings are essential. Customers prefer this model if they require expertise from the service providers. Another way around, this model encourages service providers to engage in collaborative and creative problem-solving. It imparts flexibility to the service providers to achieve strategic business goals. Here, it does not reward the input; but the bottom line that the client expects, which differentiates this model from other incentive-based models.
12. Incentive-Based Pricing Model
This model facilitates bonus payments to the service providers (beyond service level agreements). It originates from TM or fixed price business model. Incentives drive value and intended behaviour from service providers. It, therefore, becomes a utility function.
13. Shared Risk-Reward Pricing Model
It is a flat-rate pricing model which facilitates extra payments for achieving specific goals. It is suitable if the service provider and client jointly fund a new product or service development. Both parties share rewards for an agreed period. Both parties agree to monitor and evaluate the project. In case of conflict, third-party involvement is applicable; This model is suitable for customers who seek some degree of governance to facilitate joint ventures or partnerships with service providers on strategic projects.
How to Choose A Suitable Outsourcing Model?
Effective pricing or business model composes a long-term success in an outsourcing relationship. A suitable pricing model creates governance mechanisms that align the interests of all intended parties in an outsourcing engagement. While a misinformed and misinterpreted contract breaches mutual trust, leading to mismatched incentives, inefficiency, and unpredicted expenditures. It prices the service correctly, and there is a fair margin for the supplier while incentivizing quality and delivery. Both are fundamental to the contract and pricing. Hire dedicated developers here!
