New Outsourcing Pricing Models

In the traditional outsourcing agreement between a firm and vendor partner, the vendor is paid based on either a fix pricing model or a time and materials model.  In the fixed pricing contract, the firm pays the vendor a predefined amount for a defined service.  This amount is set regardless of the costs incurred by the vendor.  In this model, the vendor assumes some level of risk if unknown variables exist that may increase the costs associated with providing the service.  On the other hand, the time and materials removes some risk from the vendor by basing the contract on the amount of time required to fulfill the service request as well as the cost of the materials required for fulfillment.  Each of these models are quite common and each has benefits and challenges.

Overby wrote an article describing four new models for outsourcing contracts.  These are newer models emerging designed to create new opportunities for the firm to gain greater value from the vendor partner and allow the vendor to find ways to increase its profit margin.  These four new approaches seek to capitalize on the partnership between the firm and the vendor to extract value for each party.

Gain-Sharing - In this model the vendor partner is paid based on the performance of the firm.  The vendor is compensated more as the firm realizes greater performance.  For example, a college may engage a marketing consulting partner and this vendor is paid based on any increases to the number of students enrolled during the year.

Incentive-Based Pricing - Although this model is not new, it may be increasing in use as firms try to find more ways to increase value delivered from vendor partners.  In this model, the vendor earns additional incentive compensation as they reach service target goals.  For instance, a firm may outsource telephone support with incentive pricing for hold time.  If the vendor partner is able to bring the hold time below a threshold (like one minute) the partner receives compensation beyond the base fixed or time and materials budget.

Consumption-Based Pricing - This is the pay for what you use model and very similar to your electric bill.  Using this model, the firm pays the vendor partner based on the quantity of service units provided during a period of time.  For instance, a firm may outsource payroll processing and pay the vendor partner a fixed amount for each paycheck processed.

Shared Risk-Reward - This is a true partnership model where both the firm and the vendor develop a new product or service and each benefits from the new offering.  For instance, an automobile manufacturer could partner with a supplier to jointly develop a new technology for car batteries and each would share in the profit for sales of the battery or automobile.

I am currently consulting for a local Catholic diocese to negotiate a shared risk-reward outsourcing model with on of its vendors.  This new form of agreement has the potential to create fantastic value for both the diocese as well as the vendor.  This model requires some creative thinking, trust between the partners, a long-term strategy, and a willingness to try a new approach.

It is exciting to see these new outsourcing models.  These have a potential to foster great collaboration between these partners, increase the performance for each, and provide new innovations by building upon the strengths of each partner.