| by Shyamanuja Das |
Senior executives in corporations, contend that outsourcing is not strictly a cost-cutting exercise; it is a business-value creator. If they implement it properly, they can even point to stock price gains to prove their point. Sometime back, that would have settled the debate. For more than three decades, business-value creation has meant short-term stock price gains. For a CEO, that meant playing to the stock analysts’ gallery. And analysts love cost-cutting exercises. From GE’s Jack Welch to JP Morgan’s Jamie Dimon — CEOs focused on cutting fat have garnered much applause. For all practical purposes, value creation was cost reduction.
That is in all likelihood changing. The new thinking, exemplified most notably by Jeffrey Immelt, Jack Welch’s successor, is simply this: Don’t play to the stock market’s whims; focus long-term.
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.
When Efficiency was the Objective
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.
Customers are trying to achieve tomorrow’s business goals with yesterday’s principles.
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.
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.”
A Change of Approach
“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.
“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 [it].”
— Robert Finkel, Attorney, Milbank, Tweed, Hadley & Mcloy LLP
“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.
Efficiency is Not 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 noncore outsourcing and replicate them here. And quite often, these tactics worked. Stock market analysts were impressed by measurable cost savings.
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.
BPO PRICING MODELS
| Pricing model | What it means | Advantages | Limitations | Where the model is/can be used |
| Time and material | The customer pays the service provider for a number of FTEs engaged in providing the services per fixed time denomination (e.g per hour, per month). The price per FTE varies, and is based on the skill set of the employee and the complexity of the processes. The customer pays for the input that provides the services, and not for the output. | * Least risk for both the customer and the service provider | Is inefficient, as it provides no incentive for the service provider to enhance efficiency and productivity. | Virtually any process can be priced in this model. Customers and service providers prefer this model, when there is lack of information on both the sides and they want to minimize the risk till both the parties understand the dynamics completely. |
| Transaction-based pricing or the utility pricing | The customer pays the service provider for the number of transactions processed. How many employees are involved and how much time is taken to process the transactions are costs that the service provider manages. Also called utility pricing, pay-as-you-go, pay-per-use and pay-by-the-drink model. | * Since the service provider is paid for the output, he is incentivized to produce better outputs using the same quantity of input, leading to productivity enhancements | * Can be disastrous if the customer and the service provider have no idea of what the future may bring in. In fact, incorrect transaction-based pricing may lead to frustration by one or both parties in the future, leading to relationship turning sour | Any high-volume, repetitive process, with no direct impact on revenue is a good candidate for this model. Also, processes which have traditionally been inefficient are outsourced by customers to achieve efficiency. Examples include claims processing and cheque processing. |
| Performance based | The customer pays the service provider based on the performance levels such as number of leads generated by cold calling. It is often clubbed with a fixed base fee. | Incentivizes the service provider for better operational performance. | If not applied to right processes, it may backfire. For example, in a collections process, being able to speak to more debtors is not necessarily of business value to a credit card company as amount of debt recovered is. | Any process where operational performance needs to be improved is a candidate for performance-based pricing. Examples are lead generation, resolution of common customer problems in many inbound customer calls etc. Many processes with performance-based pricing can move to transaction-based pricing when the processes involved are standardized completely. |
| Result based | The customer pays the service provider based on the success rate in a task assigned such as amount of debt collected in a collections process or value of sales generated in a telemarketing process. It is often clubbed with a base fee that is fixed and/or a variable fee that is performance-based. The critical difference between performance and success based pricing is that in the first, the service provider is paid for quantity and efficiency of effort, whereas in the latter, the payment is made for the business results of that effort. | Directly maps to the customer’s business objectives. | In reality, very few processes that have direct impact on business are outsourced now. But as outsourcing becomes more mature, this will be the ultimate pricing model that customers will aim for. | Collections, telemarketing, procurement (where it could be linked to cost saved). |
| Cost-plus | The most primitive form of pricing, the service provider in this model is paid the cost incurred plus some margin. Usually prevalent in some older captive facilities and traditional claims and policy administration outsourcing by the insurance companies to some smaller third-party administrators. | Safest for absolute beginners. Some larger corporations too use this, especially in the captive scenario. | It goes against the basic philosophy of outsourcing, which is to be more efficient. | Some captives. |
| Hybrid | Most pricing is a combination of two or more of the above, and sometimes some amount of fixed fee. | N.A. | N.A. | N.A. |
Leading Edge
There is no dearth of discussion among various stakeholders about the future direction of BPO pricing — business-risk sharing, gain sharing and so on.
“Risk/reward sharing models need a significant maturity and experience behind a given BPO process. It is still in a very nascent stage.”
— Avinash Vashistha, CEO, Tholons
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.
Understanding the New Rules
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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