Key Takeaways:
- Customers should shift to a pricing model when the work is more complex, variable in nature, and can create more value.
- A pricing model includes various pricing mechanisms to determine the optimum value exchange between a customer and a supplier.
- Most pricing models can be expressed in a simple spreadsheet; however, the model must also be included in the contract to be enforceable.
The big question customers face is, when should we shift from using a price mechanism to a pricing model? The more complex the services, the more likely the contract needs a pricing model, not just a price. Customers should shift to a pricing model when the work is more complex, variable in nature, and there is a higher likelihood of creating value by working more closely with suppliers (e.g., reducing costs, improving speed to market, or innovating).
Pricing mechanisms, such as a Fixed Fee, establish a pre-determined price. However, a Fixed Fee is not appropriate for all types of work. When customers or suppliers force a Fixed Fee pricing mechanism on to work streams that require something else, suppliers can be disincentivized to cut corners to make a profit, or push through change orders due to unexpected circumstances.
The last element that all performance-based contracts should have is the right pricing arrangement. A pricing model is not only more sophisticated than establishing a price, but it is also a flexible framework that can address different types of supplier work. And, the pricing model must be clearly communicated in the contract to be enforceable.
Pricing Models are Different from a Pricing Mechanism
A pricing model includes various pricing mechanisms to determine the optimum value exchange between a customer and a supplier. A good pricing model is often dynamic and enables the parties to adjust the underlying pricing assumptions as objectives, costs, and shifts in consumption changes the value being exchanged between the parties.
In some cases, a pricing model simply includes actual costs, volume targets, and incentives (link to the article on incentives), but it must match the supplier’s underpinning cost structure in order to be accurate and reflective of the value of the deal.
To achieve a model that matches the supplier’s actual cost structure, identify the types of costs incurred. Separating the costs, gives predictable rates to the buyer, helps with demand management, and reimburses the supplier based on their underpinning cost structure (plus profit margins).
For example, end user services (such as support for laptops, tablets, and the like) are often paid via a monthly service fee. The monthly service fee includes breaks, fixes, and helpdesk activities to keep them up and running with an additional add/move/change or disconnect fee for new devices. The monthly fee reflects the supplier’s costs of supporting the infrastructure. An event fee covers the incremental cost of provisioning and deploying new devices and software. These costs are different for different types of support and should not be bundled into one pricing mechanism.
Developing a Pricing Model
Here are four tips to develop a comprehensive pricing model.
1. Total Cost of Ownership Analysis
Perform a Total Cost of Ownership (TCO) analysis. A TCO (or similar analysis) is essential to determining all direct and indirect costs so that clear pricing decisions can occur. For example, the parties need clarity to make decisions on work scope and pricing based on intangibles such as market risks, corporate risks, social responsibility, responsiveness, innovation or flexibility. By combining the TCO analysis and decisions on work and intangibles, the parties have a clear picture of all types of costs for the work.
2. Pricing Mechanisms
Choosing the best pricing mechanisms requires an intimate understanding of the operational risk involved in the supplier performing the work. A Fixed Fee that covers all the end user services and event fees (noted above) does not address the operational risks associated with each type of service. Rather than shifting the risk to the supplier, the parties should conduct a joint risk awareness to identify operational risks, understand impacts to costs, and determine which party is best suited to manage and mitigate those risks.
3. Contract Duration
A longer-term contract duration is an essential element of developing a pricing model. Achieving step-level improvements in process efficiencies takes time and often a significant investment on the part of the supplier. Suppliers often lose money in the first six to 18 months of an outsourcing agreement as they make investments to transform the environment and recoup their losses toward the end of the deal. This means that where significant investments or innovation is required (e.g., ITO, BPO), contract lengths must be at least three to five years.
4. Incentives
The parties should also incorporate incentives that are mutually beneficial in order to offset the flaws of using pricing mechanisms. It is essential to design the right mix of incentives by aligning the parties’ interests and then rewarding proper supplier behaviors and performance results.
Learn More: Using Contractual Incentives in Performance-Based Contracts
Documenting Pricing Models
Here is one example of a pricing model: A client and its supplier had 1) a complex scope of work that was priced as a Fixed Fee; 2) work that was priced as a cost pass-through only (no mark up of any kind); 3) work that was on a time and materials basis; 4) a percentage calculation for the management fee; 5) an incentive fee for exceptional performance; and 6) a liquidated damages calculation for poor performance. This is one example of a pricing model.
Most pricing models can be expressed in a simple spreadsheet; however, the model described above required a macro-based spreadsheet. The parties’ finance departments helped develop this spreadsheet. To make managing the model easier, the parties used mathematical calculations, spreadsheets with examples, and tables in the contract itself.
Are you intrigued to learn more? Stay tuned. Each month right here, I will provide more information to help you draft, negotiate, and manage performance-based contracts. If you want the manual to learn at your own pace, purchase your copy of The Contract Professional’s Playbook: The Definitive Guide to Maximizing Value through Mastery of Performance- and Outcome-Based Contracting.
