Offshore Pricing Models

Once the decision to engage an offshore vendor is made, the task of creating a pricing model begins. There are five general pricing models for offshore outsourcing contracts:

1. Fixed pricing
2. Transactional pricing
3. Activity-based pricing
4. Cost-plus pricing
5. Gainsharing (risk-reward)

Managers should examine the pros and cons of each pricing model to ensure the ultimate outsourcing contract meets your needs. Don't sign a contract that makes you uncomfortable, and don't hesitate to have a friendly discussion with your vendor if you feel the proposed billing terms don't satisfy your needs.

Each pricing model has its own set of advantages and disadvantages. Let's look at each in more detail.

Fixed Pricing
Some companies, especially in software development projects, provide a high proportion of their services on a fixed-price basis rather than on a time-and-material basis. Fixed-price contracts also comprise service level-driven fixed-price agreements ("fixed-price SLAs").

In certain fixed-price SLA contracts, revenues are conditional upon predetermined performance levels, which, if unsatisfactory, could result in lower revenue than anticipated. Any failure to accurately estimate the resources and time required for a project or any failure to complete contractual obligations within the specified time frame could adversely affect the profitability of the offshore vendor.

Pros

• Fixed-price models leave little room for misinterpretation.
• Pricing is easy to understand and easy to budget (especially when predictable volumes are involved).

Cons

• Offshore vendors may feel the need to overestimate their unit prices to minimize their risk and guarantee they'll cover their fixed costs.
• Fixed pricing can be advantageous for U.S companies but detrimental to the offshore vendors. Wages in India are increasing at a faster rate than in the United States, which could result in increased costs for software professionals, particularly project managers and other mid-level professionals.

Transactional Pricing
The most popular pricing structure in business process outsourcing is traditional unit pricing, also known as transactional pricing. With this form of pricing, client companies agree to pay offshore outsourcing vendors a flat fee per unit of work, whether that unit is defined as a customer complaint, mortgage loan application, or a claims case handled.

Pros

• Pricing structure is easy to design and implement.
• Clearly defined terms leave little room for misinterpretation.
• Pricing is easy to understand and easy to budget (especially when predictable volumes are involved).

Cons

• Offshore vendors may feel the need to overestimate their unit prices to minimize their risk and guarantee they'll cover their fixed costs.

Activity-Based Pricing
Clients agree to pay a flat fee to cover the offshore outsourcing vendor's fixed costs, including leases, computer equipment, telecommunications connectivity, and management. They also commit to a fee that covers variable costs such as hiring costs, transportation, and equipment maintenance. Activity-based costing (ABC) is popular with Offshore Development Center (ODC) or Build-Operate-Transfer models.

Pros

• ABC more accurately reflects services rendered and expenses incurred.
• Offshore vendors don't have to build fat into their unit prices to protect themselves from losses related to their fixed costs.
• ABC contracts allow companies to track logistics costs more accurately because they usually have more highly detailed invoices.

Cons

• ABC pricing structures are complex to develop.
• Activity-based pricing is difficult to structure for new relationships since there might be many unknowns.
• There are no inherent financial incentives for the offshore vendors to pursue continuous improvement without a well-defined gainsharing program included in the contract.

Cost-Plus Pricing
Also known as open-book, cost-plus pricing is most often used as an interim contractual measure. This structure consists of a fee for the cost of services plus a mutually agreed upon markup or profit margin.

Cost-plus pricing is especially effective if the nature of the contractual assignment is changing. Examples include companies starting new operations, launching a new marketing campaign, or undergoing some other transition that makes requirements volatile. Cost-Plus pricing is popular with Captive Centers or Build-Operate-Transfer models.

Pros

• Cost-plus pricing protects shippers from protective overestimating that may occur with transactional pricing.
• The offshore vendor is protected from losses due to unpredictable volumes/business levels.
• Service providers are guaranteed a profit and put in place procedures to keep that cost under control.
• Corporate customers have a highly accurate picture of costs.

Cons

• Since cost-plus is not a viable long-term pricing model, it could encourage an offshore vendor to generate costs because each cost carries a specified profit margin.
• Disagreements on what constitutes a cost can arise.
• Budgeting is more difficult for the shipper because the only constant is the markup.

Gainsharing
Regardless of the pricing structure, some form of incentive for continuous improvement is advisable.

Gainsharing works best with new relationships where the learning curve is highest. Gainsharing is built on a benchmarking foundation. Benchmarking identifies key performance indicators (KPIs) or areas where improvement is needed, and rewards those improvements or exceptional performance.

Each outsourcing contract is unique, and equitable pricing is only part of the contract. The resulting pricing structure may use one or more of these pricing models in combination with other performance incentives. Don't try to use the contract negotiation process merely as a chance to slash prices. All too often, companies that win these pricing victories end up losing some productivity and quality in the process.

Pros

• Offshore vendors work harder to create value when financial incentives are involved. If the client benefits, then they benefit.

Cons

• Companies have to develop metrics to carefully monitor value being created. This puts a lot of emphasis on value measurement.