For too long, buyers and sellers of IT services have engaged in traditional commercial deals that are safe but suboptimal — based on headcount and fixed costs rather than results. Although these models are easy to understand and implement, they have several shortcomings.
From the buyer's perspective, traditional service contracts require them to assume all the risk. Providers get paid to indirectly “show up” with a fixed service and availability, rather than having their work directly tied to performance and impact. And the absence of effective measurement mechanisms makes it difficult for buyers to compare the effectiveness of competing providers.
From the provider's perspective, traditional service contracts fail to provide the necessary ownership to proactively realize continuous improvement. They don't incentivize beyond manpower‑linked linear growth, which leads to declining profitability over time. And they make a provider reliant on labor arbitrage, rather than performance.
But there is another way. As businesses confront increased globalization, continued economic uncertainty and seek ways to productively unleash SMAC Stack™ technologies(social media, mobile, analytics, cloud), IT buyers are turning to output‑ and outcome‑based service contracts to better incentivize and empower IT services providers to deliver optimal results, while mitigating risk.
Defining Input, Output and Outcome: Three Important Sourcing Terms
At the outset, it is important to understand three terms related to sourcing that recur in most sourcing exercises: input, output and outcome (see Figure 1).
Outcomes are measurable impacts delivered by providers of IT services that can be assessed objectively by services buyers. This could include business outcomes, such as improvement in the enrollment rate of a healthcare plan or IT outcomes, such as reduced spending on quality assurance as a percentage of the IT budget.
Output represents activities that are undertaken to realize desired outcomes. This could also involve business outputs, such as healthcare policy quote generation or enrollment processing and IT outputs, such as test case creation and execution.
Inputs are the resources used to deliver the required output. Examples of inputs include available full‑time equivalents (FTEs), funds, time, equipment, etc. Ideally, all inputs needed by an IT organization should be traceable through the outputs they deliver and the outcomes that customers and businesses ultimately value.
Two Noteworthy Trends
After a recent three-month study of IT leaders across industries, we identified two prevailing trends of IT service contracts:
Managed services are gaining prominence
As old value propositions of labor arbitrage, scale benefits and access to skills are becoming less attractive to mindful buyers, more than 50% of the IT leaders we spoke to say they're planning to adopt managed IT services. Many already have. For example, after switching to unit‑based pricing, a respected global insurance company now only pays for the IT services it consumes. Additionally, it can accurately measure and encourage provider productivity. While this arrangement makes it harder for providers to predict revenue, cost and resource planning, it effectively pools risk, grants greater control of the outcome and increases the average profitability of both the buyer and seller. In response, many IT providers are meeting demand with similarly managed services offerings.
Non-headcount-based contracts are gaining traction
By one estimate, only 5% of business today is conducted through non‑headcount‑based contracts. But that figure will triple by 2017 as forward‑thinking companies decouple headcount and input‑based arrangements from their contracts. Given the changing tide, many analysts and industry experts are advising buyers to favor providers with end‑to‑end ownership of IT delivery, including processes, resources or platform services. What's more, adopters of non‑headcount‑based contracts are so encouraged by the early gains — one company we spoke with plans to convert 80% of its IT services deals to result‑based ones.
Moving forward, managed services with output‑ and outcome‑based commercial models will likely account for the majority of future IT sourcing deals.
Best-Fit Sourcing Scenarios
Admittedly, not all sourcing contracts are suitable for result‑based contracts.
But there are numerous scenarios where results-based contracts work well, provided they satisfy some of the following conditions
The proposed work is standardized and can be offered by the service provider in a repeatable manner on a sustained basis.
The scope of work can be decomposed into smaller units of consumption (e.g., tickets, applications, devices).
The proposed work is sufficiently large to allow economies of scale.
The buyer is willing to transfer some control to the service provider.
The service provider will have adequate rights to proactively optimize processes, technology and people.
The buyer is willing to pay a premium volume commitment for transferring risk to the service provider.
The service provider is willing to assume the added risk and pain‑share.
There is at least a year's worth of historical data to understand typical demand.
The events that trigger spikes in demand and seasonal peaks and valleys are understood.
The minimum volume required to break even is understood by the service provider.
Obviously, moving to result‑based IT services arrangements require special consideration, as the added complexities introduce greater room for error. But when executed properly, the gains are worth the added risk more often than not.