Pricing mechanisms for IT services contracts evolve as the business environment, nature of the services, and the underlying technologies change. Many times, the pricing for IT managed services arrangements follows the underlying cost driver. Consequently, technology infrastructure services are priced, either explicitly or implicitly, based on the utilization of capacity and the team necessary to support the environment. Customer care organizations are typically aligned to the quantity of contacts because of the correlation to the number of agents. Capacity-based services utilize unit rates that factor hardware, software, telecommunications and support. In a world of increasing technological complexity, can pricing models that align a service to the economics and objectives of customer’s business be accomplished in a mutually beneficial and risk balanced manner? The answer is yes, but it requires careful planning and long-term alignment to ensure the pricing mechanism begins and remains effective for both parties. This planning and alignment, while requiring more effort, however, does not have to be a barrier to agility.
There are many stories highlighting where two organizations entered into a services contract based on an alternative and innovative pricing mechanism and the outcome was quite different than expected. While it appears that one organization wins and one loses when this happens, in common practice both organizations suffer because the most healthy, responsive and beneficial relationships are based on mutual effectiveness. What are they key steps to moving away from consumption pricing and developing an effective alternative-pricing model?
- Vision – there is a clear vision for how the IT organization fits into the business strategy, including how IT is affected by changes to strategy and the effect of business initiatives such as new systems.
- Sourcing Approach – because of the disclosure and collaboration required in many instances to develop an effective, sustainable mechanism, alternative pricing models work best in a non-competitive sourcing and collaborative process.
- Data Analysis & Modeling – most models are linear and align pricing to consumption. With an alternative pricing model, there are multiple degrees of freedom, which can require greater modeling or statistical analysis of potential variance to ensure it works under multiple circumstances.
- Structure – the pricing structure should not only detail the mechanism, but the process by which variances to the assumptions are handled.
- Managed Evolution – businesses are dynamic and technology is ever changing so maintaining a mutually effective relationship based on trust is important to managing change. Win-lose situations reduce agility, responsiveness and innovation, while win-win relationships enhance those factors.
Case in point; a rapidly growing company made fixed investments in information technology, but they were not realizing expected productivity gains as the business grew. One of their objectives for engaging a service provider was to align their IT cost to revenue in a way that secured targeted efficiency levels over a reasonable span of business growth as their strategy was executed. The vision was clear. The sourcing method was collaborative and sole source; with a much more open book approach than the typical IT consumption-based managed services risk-shift approach. The more components in the pricing chain, the more potential variance that must be considered to ensure mutual success. Understanding key drivers of the business plan and its effect on IT operations was necessary to analyze the cost structure, model cost behavior, understand the correlation of cost to revenue and develop a pricing method. While there was greater complexity than a normal consumption-based structure, the vision, disclosure and collaborative discussion allowed for the process to be completed in a short time frame.
Did it work? The business continued to grow rapidly and IT as a percent of revenue decreased as expected. Both parties were succeeding and happy. They were working together on new initiatives. That is when a change to strategy, the nature of which was unforeseen at the time the structure was crafted, created a potential imbalance. One of the new forms of business growth, launched after the contract, had a significantly reduced IT need as compared to the base business, but carried greater core operating expense than the base business resulting in a potentially reduced incremental profitability for this growth. This became clear when the next revenue level was triggered and the contract cost increased bringing the situation into absolute clarity. This is where managed evolution and the trust and mutual effectiveness of the relationship were tested. Using the process established at contract inception and working towards the mutual benefit of both parties, the two organizations worked together to find a specific solution to this matter and made the pricing adjustments necessary. Had the potential for variance outside of the current state of the business not been considered and if a mutually effective relationship was not in place, the unforeseen consequences could have been costly. In this case, the structural modifications occurred in a few weeks and the relationship continues to prosper.
Moving away from consumption-based pricing models and adopting alternative pricing models are realizable and without an extended, costly process. The keys are a collaborative process, clarity into the business environment, and a mutually effective relationship that fosters trust.
About the Author
John Lyon is an IT services executive and consultant with more than 30 years of industry expertise spanning finance, operations and business development. With the ability to operate across strategic and tactical, conceptual and detailed matters, he has helped organizations to develop strategies and transformational programs, understand and shape key performance drivers and create sustainable business relationships. John currently serves as the chief financial officer for GuideIT.