At first blush, it seems reasonable for organizations to contract with service providers for human resources based on their expertise and work performed over a set number of hours. After all, it's worked for time immemorial.
However, when faced with slow growth and new realities, what's a company to do? A growing number of forward-thinking enterprises are turning to flexible commercial models, tying supplier contracts to outputs such as cost per claim, cost per trade or completion times. These flexible models let transaction volume dictate the cost of service, while shifting the expense risks to the provider.
More specifically, outcomes-based commercial models for IT and business service delivery can deliver a wide range of benefits, including increased pricing certainty, lower cost of service, capital expenditures and performance-based incentives. It draws the commercial interests of customers and suppliers closer together and enables participating companies to reinvest the savings into core processes that either differentiate or reinforce their competitive advantage.
Our recent work for a global pharmaceuticals client is a good example of output-based pricing. In the past, we used a fixed team and preset amount of resources, no matter the volume of work. Now, the client pays for resources only on a per-clinical-trial transactional basis. By doing so, the client has effectively passed the risk and responsibility of optimizing operations to us. Thus, the client incurs increased costs only when its own business volumes grow. This arrangement is particularly attractive to industries like life sciences that incur high costs in developing new products.
It also benefits companies that are open to sourcing non-core technology functions like a large insurance client of ours. For example, we purchased the client's technology and real estate assets. We also hired a team of its employees to manage a significant portion of its business and then sell these processes back to the company as a service, on a per-transaction basis. This lowered the total cost of ownership, transferred employment risk to its partner (us) and secured stronger career prospects for employees. In addition, the client realized a financial return on assets no longer used, while incentivizing its partner (us again) to improve its processes on their behalf.
Sounds good, doesn't it? As with all things in life and business, there are some catches and considerations. Here are six in particular you'll want to understand before moving from a fixed time, people and materials model to an output-based pricing:
Have a deep understanding of the supplier.
In a traditional service provider agreement, good rapport, trust and a sound contract are all critical, particularly as the buyer gives up control in exchange for committed benefits. However, this relationship becomes crucial with output-based pricing models. The client needs to be confident that the vendor will continue to invest in and develop the platform to stay competitive. Otherwise, the buyer risks ending up with an outdated or ineffective platform, not to mention the high cost of transitioning the service back in-house.
Be patient while redefining relationships.
Like a marriage, it takes time to adjust to the new roles and greater intimacy of an output-based pricing relationship. Collaboration becomes more essential than ever, not only for business effectiveness, but also for agility and regulatory compliance. While acclimating to this new dynamic, buyers will do well to provide more feedback on performance, allowing providers to harmonize and better align their implementation with strategic goals.
Understand how each department is affected.
Obviously, different commercial terms require new forms of governance, better accountability and new communication streams. IT, procurement, finance and program management in particular will be significantly impacted by a move to business process as a service or BPaaS as it is known. For instance, CIOs need to be able to engage in fluid discussions with the CFO and COO about how these new approaches impact cash flow and financial reporting models.
Establish an oversight authority.
Defining transactions or units of work requires a high degree of collaboration between the organization and the provider. There's no room for ambiguity here; outputs need to be rigorously specified. Not only will you need to retain traditional service level agreements (SLA), you'll need operational level agreements (OLA) that go beyond just responsiveness and time limits. Even organizations with a long history of working with service providers will not have experience in specifying and valuing outputs in this much detail. Hence, businesses need to establish a governance team that assumes responsibility for these metrics, institutes a reward and penalty structure and periodically reviews and course corrects these measures.
Forecast transaction volumes
To stay within the parameters of the commercial model and give suppliers sufficient lead time to absorb variations, companies need to institute a way to accurately predict transaction volumes. For example, if the target is 100 transactions, the vendor will normally allow a latitude of between 90 and 110 and price between 80 and 120. If actual transactions surpass that range, the vendor will still do the work, but it will be more expensive on a per unit basis. To reduce costs, it's imperative to make transaction predictions months (not weeks) in advance and adjust as new information and data become available.
Be aware of risks.
Moving to a platform owned and developed by a third party will undoubtedly drive standardization. But it can also be painful to achieve. There is a risk — especially for smaller companies — that one or two dominant companies will influence the way in which the platform develops and where investments are made. To avoid this, output-based companies must ensure that each supplier is aligned with its business objectives and is investing in emerging and evolving trends and technologies to jointly develop the platform.
Output-based pricing models are breaking new ground with few precedents or industry benchmarks to follow. Compared with input-type data — the hourly salary of a claims administrator or Java programmer, for instance — it is much more difficult to obtain output-based data like the cost to process a claim. But their relative immaturity is not a good reason to wait before taking advantage of output-based pricing.
A conservative approach would be to run a flexible commercial model in parallel with a traditional input-based approach for a year while comparing results. This would reveal the benefits and risks of the output-based approach and how it best fits within your organization.
While it's tempting to fall back on familiar patterns of procurement and managing vital business processes, doing so is a recipe for stagnation. Only after embracing more flexible commercial models will organizations be equipped to contend with today's business challenges, while gathering the ability to contend with tomorrow's operational requirements. It's the best way we know to future-proof your supplier relationships.