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".