As IT leaders focus on cutting costs, they continue to put pricing pressure on offshore outsourcers. Since suppliers who respond with repeated price cuts could be slitting their own throats, some are offering up new pricing models to soothe the savage customer.

Bangalore-based IT service provider MindTree is talking up its new "hybrid" pricing for offshore IT services.

There are two well-established methods for pricing an outsourcing deal: time-and-materials (where the client pays for work on a cost-plus-margin basis) and fixed price, though variations on the two themes continue to emerge. An outsourcing customer will opt for a time-and-materials deal when overall requirements aren't clear or they want the transparency of the cost-plus model. The drawback of such deals is that they require more hands-on management by the provider and costs can spiral out of control.

Other customers like fixed-price deals because the cost of the deal is, theoretically, capped, and deliverables can be directly linked to service level agreements and associated penalties. The downside is that requirements need to be well-defined upfront, and there is limited visibility into underlying costs.
The new MindTree model incorporates both time-and-materials and fixed-price methods in one contract. According to Dattaguru Hegde, general manager with the mid-tier offshore player, it combines the best of both worlds.

Say a customer wants to set up an offshore development center to create an e-commerce solution. The client is clear about the twenty features to be included in the first release, but beyond that, can only say that it wants multiple iterations to incorporate enhancements and fixes to the software throughout the year.
MindTree would draw up a deal with a fixed price for the first release and time-and-materials pricing for the remaining work. "Typically, when a fixed-price quote is given for a defined piece of work, the service provider plans the full-time employees for the project lifecycle, ramping up and down according to need," says Hegde. "In a hybrid model, the service provider plans fractional full-time employees for the fixed-price engagement to meet service level agreements, then the remaining [man-hours] for each role are made available to the client on a time-and-materials basis."

The model works best for customers who have some requirements in place for an offshore vendor, says Hegde. He adds that the hybrid model can save 15 to 25 percent more than pure time-and-materials or fixed-price contracts for similar work.

Next Page - Hybrid Pricing: Fad or Future?

Hybrid pricing is not yet prevalent in the outsourcing industry, says Adam Strichman, an independent outsourcing consultant who has studied IT service prices for more than a decade. "What is common, however, is that clients in this economy are pushing for price reductions and other mechanisms to ensure they are getting value."

A common gripe in outsourcing deals is that the pricing mechanisms built into fixed-price deals are opaque. IT leaders will notice an additional resource charge from their vendor even though no new people have been added to the project. "Certain price mechanisms charge more when there is no clear cost associated with it," says Strichman.

While MindTree's hybrid model seems to provide more visibility into costs, Strichman says it's more like window dressing. "Customers want to ensure they are getting what they pay for. If a hybrid pricing model makes them feel better, that is great," says Strichman. "But make no mistake, not a thing is different in operations. It is just different icing on the same cake. This was dreamt up by someone in accounting because a salesperson asked for a price model that was new and different."

Hegde, however, insists the hybrid model is innovative. "The underlying assumptions will not be the same, as the customer has a detailed view on the costs," he says. "Customers are expecting innovative pricing from service providers, especially in this economic environment. The customer will get maximum ROI in this model for every dollar spent with little more monitoring."

The hybrid model offers benefits for MindTree, including more guaranteed revenue than it would get from time-and-materials deals. But, Hegde says, there are drawbacks as well, including more management overhead, limited flexibility to rotate resources from client to client, and few opportunities to incorporate cost buffers into the deal.

Strichman says he's seen "cutting edge" pricing models come and go over the years. The changes that have stuck are the more incremental modifications to pricing models that have value for provider and customer, such as the unbundling of database administration costs from the cost of server services.

"These new models are often too confusing to last," says Strichman. "And the truth is, the vendor is doing nothing different, which quickly becomes apparent."