A Practical Approach to Outsourcing Pricing

Pricing of outsourcing services must be a tricky formula. Most clients don't really know what they're paying end-to-end for the IT or business process function internally. So how can a service provider even begin to set a realistic price for its services? Is the mark-up on services so high that no matter what surprises are in store for the provider during actual delivery, the price tag will cover it? Hardly.

 

Sourcingmag.com has never seen stats spelling out how many outsourcing failures come about as a result of mispricing, but we'd guess it's a lot. Here's the story as we see it: The service provider needs to make a profit. So the work that hadn't been discovered earlier suddenly shows up under the category of uncontracted services, billed at rates the client finds hard to stomach. The client begins grousing, complaining that the service provider is always hitting it up with hidden charges. The grousing turns to vocal complaints. The complaints — and budget overruns — get executive attention. Suddenly, all hell breaks loose. The contract needs to be renegotiated. And once that happens, the whole deal is called into question.

Of course, the story could have a different plot. And it all hinges on what you tell the board when the topic of outsourcing expense comes up.

Phil Varney has spent nine years as a rainmaker and senior vice president of global solutions for BT Americas (yes, that British Telecommunications). In that time he's worked with a multitude of clients to deliver BT telecom and network services. About two years ago, he moved to the US to help build up BT's Americas business. Recent wins include Reuters, Bristol-Myers Squibb and Jacobs Engineering Group.

We asked Mr. Varney to explain how a service provider approaches pricing — especially since most bids are done early on, before deep due-diligence has taken place for a specific company's environment.

If the client doesn't even know what it is they are paying for services, how is it you can figure it out?

Phil Varney:

I have never yet worked with an organization that really does have a handle on its own cost. That is not a criticism of these organizations. That is just the real world we live in.

Most businesses have acquired business and all sorts of things happen. But the bottom line is that every single one of those businesses that I have dealt with wants to know what its costs are.

The challenge is if the business case that goes up to the board is based on incorrect or incomplete information, it sets an expectation at the board level. The expectation may be, "We spend $100 million dollars at the moment on this, and therefore, we are going to save $10 million, so our bill is going to be $90 million." And then through due-diligence, post-contract reconciliation — call it what you will — we discover the true spenders. They didn't capture that. So now you go back and say, "Actually, we spend $110 million." Alarm bells go [off] and it is like, "We can't have an over-spend of $20 million."

There is no over-spend and therefore, the only way that you can price this is to say, "Give us what you know. Let's work together. Let's establish what the assumptions are. If those assumptions prove to be correct, then this is the price. To the extent that those assumptions prove to be incorrect, the price will be adjusted this way."

So you have a formula that says, "We know what we know, and we know that that is not going to be complete." But both parties enter this with a view that we have to capture the true cost.

We might be able to leverage more discount, because the true cost is higher, therefore the economies of scale might be better, and that is great; but our commitment will be a minimum level.

Then to the extent that we discover more, you have to have flexibility in your business case to go back to the board and say, "Initially, this is what we believe we have got. These are the known caps. But there are some unknowns here. So what we want is authority to proceed with this contract on the basis of a minimum saving on that. Therefore, our price will be [x], but expect us to come back to you in three to six months' time with a revised view of what the real world looks like. But it will at least be 10% less than the real world is today." Most boards buy that.

What most boards don't buy is people coming up and saying, "We spent $100 million today, but yet, next year it should be $90 million." That is a recipe for disaster.

So, setting the price comes in several different ways. One, you have it at a commodity level, which is, "Design me a network and tell me what it costs." The second layer is, "Now design me a management infrastructure and tell me what that costs." "Now design me the future and tell me what that is going to cost to transform it from where we are now to the future."

The real world is very complex. Mostly, people have contracts in place. They have existing networks. And whilst the customer and we might muddle it — it goes down one second and comes light in a world different, you know? Day one, start, 100% switchover. It doesn't work like that. We know that there is a migration phase and a transformation phase before you get to steady state.

So part of the planning has to be that investment in time and resource to actually make that change. And the way that it goes is, the initial stage is that you capture all of the information on the contracts…

Where it gets smart is where we negotiate. We negotiate that contract on better terms or better still, we migrate that service onto our own platforms and therefore, at that stage, we can return that savings to the client. Then you are into steady state. Parallel with that, we set up all of the infrastructure to support the contract, to transfer the people over.

The greatest compliment we can ever be paid is [being asked], "When are you going to do this transfer?" And we say, "Actually, we have done it." And the operational units say, "Well, I have never noticed that." Great! Success!

So, that phase is very intense. It is working to do due-diligence, it is the innovations, migrations.

Then you get to the exciting phase, which is, "Now we understand the business. Now, we have got it. Now we have a handle. Now, let's take you by the hand and let's take you through the transformation — because you did this to change your business. Before you can change your business, we have got to understand it. And that is not verbally — that is intimately. We have to know who the suppliers are, who is performing, who is not performing, what the project plan is for transformation, how fast we can go, what the operational considerations are, what the geographical approaches are." Once you have all of that mapped together, you can go into that transformation phase and you can take them stage by stage and you have a project plan.

Then, at the end of that, you have all of the savings that you realized from there. Sometimes this is a tough message for a client that they actually want savings here, and we can financially engineer it so that they get savings earlier than they can actually be realized.

But most clients are mature enough to know that there is no such thing as a free lunch. So if there are usually costs there, you are going to pay for it at some stage. If we map this out for a client, they see a very clear journey.

Now, that's not always what they want to hear, because they want to do it faster. But what we say is, we can do it within limits faster, but you increase risks. So you have to balance faster migration, faster roll out to transformation with operational risks, because you are going to reduce your costs — maybe. You are going to be able to be better prepared with more bandwidth in different ways. But you have to balance that with how much resource you have to put in there to make that work. So, that's how we get to the end point.

Now coming back to your original question, which is, "How the hell do you price services?" what we probably say is that you continue to pay the same prices that you are paying right now. Into the second phase we may choose to say, "We will take a commercial decision that will effect from the date of novation. Your costs will be reduced by x and we will take the commercial risk on that and that is because we know some will drop by that, some will drop by that. The aggregate is that we are OK. And then, in terms of transformation, there will be technology savings, so it will drop further."

Therefore, we can price that journey for them with some degree of certainty, but as you know, it is not quite as simple as that, because you have, well, when do the people come in and how many? What do you pay them now? Are they fully allocated costs? Very often it is, these are the salaries, but that is not all of it. You have all the overhead and tensions and all of those good things, so that data capture initially is very important.

Generally we will lump all of those costs together into what we call an "enterprise charge," and we call it lots of other things as well, because the language is about culture with the business. So it is a management charge. Call it what you will, but that is an overall amount for the resource that we will apply to all of that transition of managing the service.

Then you can have a separate layer that would give a lot of people comfort, which is technology. They know what it costs to provide a circuit from x to y and they benchmark that and it's relatively easy.

What a lot of clients really would like is to unbundle as much as they can so they can get as much visibility as they can. And to a large degree we don't have a problem with that — providing it doesn't work against them by limiting our flexibility to provide them with creative ways of addressing those sorts of pricing issues. In essence, that is what we do. We give them the rate card for voice, we give them a circuit price for the data. And yet, it might be all aggregated up in ways that are unique to them in terms of the way it all happens. But what we try to do is give them a step-by-step budget that says, "If this situation is maintained throughout these steps, then that is what you pay."

We all know that businesses don't stay still, and they don't go as fast or they acquire a business or they dispose of a business, so their future is different. But at the beginning they have some degree of certainty on which they can make a business case that says, "This is where we think that we will go with BT. And this is where we think we would go with either an alternative or if we insourced, and continue to manage ourselves." Then the business could make a decision. So nothing in life is easy, is it?…

Sometimes we find [the RFP process] like being in a straightjacket.

Really? That comfortable?

When you respond to an RFP sometimes these days, the consultants have templates — methodologies — that work for them in evaluating whether or not the prices that they are getting from venders are compared on equivalent basis.

I can understand, you know. They have to have some consistency in the way that they measure to get that good advice.

But that is a problem, because like I said before, how could you put the value of a technical design when what you have been asked to do is to quote for a circuit between two points? Just the price of the commodity services. Then [the client] makes a very subjective decision based on the rest of the stuff.

When in actual fact, our passion is about, "Well is that secure? Is that going to meet your requirements for data storage? Are you going to be able to root the traffic at the right time of the day?" You can put those sort of things into words, but the focus tends to be — and this is why the straightjacket reference — the focus seems to be on these matrixes that are put together, which come up with a score at the end, which bears no relationship to the value that outsourcing creates for that organization.

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