The Elusive World of Transaction-Based Pricing

Today’s guest blog on the transaction-based pricing comes from Dinesh Goel, Project Director, TPI.

Incentive compatibility drives value maximization, and a transaction-pricing based outsourcing model better aligns the client and provider incentives. With symbiotic gains, the marketplace will see higher traction in such pricing arrangements, and the shift is only a question of time.

Effort-based pricing has been the popular sourcing choice thus far. In principle, the client pays the service provider on the basis of the full time equivalent (FTE) employee (time and material), location(offshore or onshore), skill and level.

It works, but creates conflict: The client wants to minimize FTEs supporting the process and desires a specific offshore-onshore mix of labor and capital, while the provider has an incentive to maximize FTEs and looks to standardize services.

But transaction-based pricing (or fixed fee projects) helps overcome such issues, as payments to the service provider are based on the number of transactions executed. Paying-as-you-go provides flexibility to scale engagement as needs vary, aligning client and provider incentives.

Over the past 12-18 months, there has been much talk about transaction-based pricing by both clients and producers, but little adoption.

So why has it been elusive so far especially in the world of offshore sourcing?

In my experience, the challenges to broader acceptance of such a pricing approach include:

• Platform-based solution – Creates inefficiencies if providers don’t offer solutions in a shared service manner across customers.

• Volume - Difficult to absorb significant volume fluctuations without minimum commitments from customers.

• Lead time - Clients demand fairly short lead time while expecting fluctuations with a wide band.

• Scalability and Flexibility- The scalability of solutions and flexibility of contracted terms and conditions are essential to success.

• Experience - Market maturity is key to such arrangements. In its absence, neither client nor service provider can truly assess the risk-reward equation.

TPI’s standard approach to pricing facilitates volume based fluctuation via resource unit rates, additional resource charges, and reduced resource credits. However, operation is limited by bands from the baseline volumes. In effect, we try to manage associated risks.

With a “shift to managed services” underway, alliances will form, services will be bundled, and transaction-based pricing will gain momentum in offshoring transactions. The marketplace will mature and inhibitors highlighted above will lose significance. Transaction-based pricing models will evolve into the next generation of outsourcing models and transcend to the next stage of outcome based pricing models where rewards to service providers are based on core business impact, revenues, and speed of product launches, etc).

In my view, adoption of such arrangements is not a question of “if” but a question of “when."

Comments

[Subir Dhar]

Hi,

We all are seeing a move from the FTE based pricing to a Fixed Fee Pricing/ Transaction Based Pricing.

The clients are asking for innovative pricing approaches (including Transaction Pricing), and the service providers are coming up with appropriate solutions - but adoption is still not very common.

Outcome Based Pricing looks attractive, but it is at times very difficult to link the success of the client firm to the performance of the service providers - especially in situations where multiple vendors contribute to the outcome.

I have been wondering whether the Service Providers rewards can be linked to the Stock Price of the client organization? The bigger vendors do get more "stock options" (thus more skin in the game). May be we can have a discussion on this sometime.

Regards

Subir Dhar
Bangalore

[Dinesh Goel]

Subir - Thanks for your comments and reading my blog entry. As you mentioned, it's certainly hard to link the Service Provider performance to the business outcomes of the client in many situations. I would think its even harder to link the Service Provider performance to the stock performance of the client and hence not a solution.

Of course, I am not suggesting that outcome based pricing will work in all situations of outsourcing but possible in cases where the Service Provider has greater control and end to end responsibility for some process or function which can directly impact some element of the business of the client. For instance, service provider responsible for the entire process of processing and paying vendor invoices for a client, can make the process efficient to the point that client can avail early payment discounts or stop incurring late payment penalties. Of course, this is assuming that working capital availability is not a constraint.

I don't believe stock option is the appropriate way of rewarding the service provider for their contribution to client's business. It has to be a monetary reward which has direct and obejctive (read "measurable")link to the performance of the Service Provider.

[Abhishek Bansal]

Well to add the discussion about linking rewards to service provider performance, some more apt metrics can be drawn.

One such would be Business benefits a project/program has delivered and which can be directly traced to some service/change delivered. Provided the client is willing to show transparency and such metrics are defined and baselined at the start of a program it could be a win-win for both parties.

[Nagaraj]

hi,

Could you please explain in detail about the advantages and disadvantages of FTE based pricing and Transaction Based pricing?