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Outsourcing is, today more of a value adding exercise, though it saves costs too. And its role as a business-value-creator is endearing it to CEOs across the world who focus on long-term gains along with short term cost cutting. Along with changes in outsourcing objectives and practices, outsourcing pricing models also keep changing. Here is taking a close look at the ever-changing scenario of BPO pricing.
Most outsourcing rules and best practices of today may not directly fit into the new business requirements. Increasingly, experts see signs of some outsourcing deals going astray, citing the possible culprits as problems with a service providers' capabilities (or the lack of it), lack of governance models, offshoring challenges, cultural issues and so on. Yet, the real reason is perhaps this: Organizations are trying to achieve tomorrow's business goals with yesterday's principles.
The traditional cost centers such as HR, finance and accounting and some low-value, high-volume customer-facing functions have been the most frequently outsourced activities. In such services, reducing cost has been the objective, though the means of achieving that have evolved over time.
Initially, the business models were built on simple manpower replacement. This led to a pricing model that compared directly with what it replaced: The cost to the company per employee. In third-party outsourcing, this was translated into pricing per Full-Time-Equivalent (FTE).
A pattern was established where service providers delivered the promised cost savings. But this method of pricing for the input --- rather than output or quality --- did not spur service providers to gain efficiency.
That, in turn, led to the practice of paying the service provider for the smallest unit of work, usually per transaction. "Pricing models have evolved over the years from being labor arbitrage focused to efficiency focused," says Anurag Jain, Head, BPO Business, Perot Systems.
Transaction-based pricing
The model --- the much-touted transaction-based pricing model --- is the result (and iteratively, the cause) of a series of improvements such as process simplification, application of technology, standardization and finally a combination of all these leading to what is called platform BPO.
Transaction-based pricing offers significant advantages over the variations of Time and Material (T&M) based pricing where service providers charge for manpower employed per unit of time. In transaction-based pricing, since the service provider is paid for quantity of work, it breeds efficiency. It also helps the customer, as iGate's CEO Phaneesh Murthy points out, "to compare the service providers better."
"The math of transaction-based pricing is not merely about dividing an FTE cost by the production per year --- it is a whole different way of looking at managing delivery," says Perot Systems' Jain. "It is about accurate forecasting, staffing, shift management, productivity and production management," he adds. It requires a far more structured approach to managing the business.
Whether it is process consulting, applying the right application of technology, or improving productivity --- these steps offer enhancements in discrete processes. That helps a service provider trim its cost per transaction, and in turn to offer its customers a better per-transaction price.
In many noncore, support activities --- the cost centers --- being efficient is synonymous with being effective. Not surprisingly, this pricing is till in vogue and will remain so for these activities.
"In HR outsourcing, there is a tendency to follow transaction-based pricing," says Robert M. Finkel, New York-based Partner in the outsourcing practice at Milbank, Tweed, Hadley & McCloy.
Ultimately, transaction-based pricing (and the focus on per-transaction cost by the service providers) helps providers (and in turn their customers) achieve better process efficiency and nothing more.
Cost cutting alone is never enough
Core business processes, which directly map to business value creation are difficult to outsource for a variety of reasons, not the least of which is the one that they can't simply be executed in the same way at a lower labor cost. The value of these processes is aligned with business objectives, which in turn depends on organizational strategy and external market conditions. In short, these are not discrete, isolated processes that can be run exactly in the same manner irrespective of market realities, as is the case with most support functions.
This is where most of the disruption is happening.
To start with, the rules of outsourcing these activities have never been fully understood by C-level executives. In the absence of anything else, most executives tried to import the rules of non-core outsourcing and replicate them here. And quite often, these tactics worked. Measurable cost savings impressed stock market analysts.
Most processes that were offshored --- core or noncore, through outsourcing or captive model --- achieved huge cost savings. But that, as it is common knowledge now, was not the result of a managers' ability to transform processes, but because the wage gap between U.S. workers and other global service-delivery areas remains significant.
There was no innovation that was capable of achieving so much cost reduction (synonymous with value creation, then) in such a short time as offshoring did. With that one-time gain from offshoring now established, the real quest for innovation has just begun.
Pricing models
There is no dearth of discussion among various stakeholders about the future direction of BPO pricing --- business-risk sharing, gain sharing and so on.
But are these newer pricing models in use? These are scattered examples, with little indication that they have taken hold in the industry.
"There is a greater desire to try out innovative pricing models like gain sharing, though in reality there are very few contracts signed today with a gain-sharing arrangement," says Finkel of Milbank, who has worked with clients such as CBS, AT&T and MasterCard.
And customers of services are aware that the option exists. "Gain sharing is discussed in a majority of deals," adds Finkel. "The number of contracts with some gain-sharing provisions in the current deal is very, very few. Some contracts have provisions for a possible future gain sharing."
Simply speaking, managers know that the current pricing models are not adequate, but they think it is better to wait and watch and try something out some time down the line, as the "provisions for a possible future gain sharing" point toward.
"Risk/reward sharing models need a significant maturity and experience behind a given BPO process. It is still in a very nascent stage," says Avinash Vashistha, CEO, Tholons, a consulting and private equity firm in the outsourcing space.
The push for change needs to come from customers, not service providers. "Initially, customers need to be more willing to take risks," asserts Richard Garnick, President, North America and Global Business Lines, Keane, an outsourcing firm. Garnick believes the risk is worth the reward. "This can result in more asset-acquisition driven deals and outsourcing of higher-end processes," he says.
However, in the early stages of anything new, people usually take a once-bitten-twice-shy approach because every failure puts a question mark on the idea itself, and not on the execution.
"In a few cases, some innovative pricing models tried out by some of my clients with offshore deals with American vendors did not work out and the contracts had to be terminated," says Milbank's Finkel.
Successful outsourcing: the new approach
For a part of your core business processes to be successfully outsourced, a service provider must understand your business and respond quickly to market changes. The BPO business that has been built on process efficiency may not reflect the entire expectation from either the buyer or supplier's perspectives.
A re-alignment of BPO pricing models to business outcomes may lead to the enactment of a success-based pricing model. The service provider has to be given a share of the business rewards that it helps achieve. This shift may lead to a complete elimination of certain short-term cost reduction metrics or at least a dilution of them. And it may lead to a better integration of offshore captives with outsourcing service providers.
While there's no broad-scale shift to gain-sharing pricing models, what we know for certain is that the business rules have changed. The definition of value creation has changed. And to be in sync with the changing times, the outsourcing engagement deals need to change, too.
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