BPO Pricing: Are Companies Risk Averse?

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.

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. 

“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.

BPO Pricing Model

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 (eg 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.

* Easy to work out the
pricing as it is directly related to cost of manpower, which is often
replaced while outsourcing/offshoring.

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

* Lower per-transaction
cost may not always be the objective of outsourcing. For example, in a
typical collections process, how much debt (as a percentage) is collected
by the service provider is more important than the cost per call.  

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. 

* The comparison
between service providers is easier, as it measures the cost of each
transaction, which is what the customer is looking at managing 

* It often leads to
innovation and better use of technology by the service provider, which
sometimes results in drastic improvements in efficiency. In a highly
competitive market, part of the cost savings due to enhanced productivity
is passed on to the customer. 

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.

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 US 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.

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.

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.

Shyamanuja Das

vadmail@cybermedia.co.in

Republished with permission from Global Services

(www.globalservicesmedia.com)