IT Strategy

IT Outsourcing Pricing Models: Fixed Price, Blended Rates or Salary Plus Fee?

In today’s business world many people still associate IT sourcing with cost efficiency and price arbitrage. Why not do more for less? However, given IT skills shortage still tops the technology agenda globally, IT outsourcing may be the only workable solution for companies to carry on keeping “head above water” and stay competitive in this tough business environment. As such, IT sourcing may do an about-face and entirely change its focus in the months to come from providing a sole cost reduction to being a strategic long-term corporate function.

Depending on your initial business goal and objective of sourcing IT solutions from external service providers, the right engagement model should be chosen from the very beginning to gain the maximum value from the relationship.

Nothing generates as much debate and apprehension between you and your prospective service provider as price negotiation does. You’ll agree with me if you have ever been involved with sourcing contract issues before. It’s never easy to determine a fair price for a particular scope of project. Now when more IT service buyers challenge their providers to offer flexible pricing to allow better internal budget planning and forecasting as well as easy exit clauses and zero or minimum commitments, providers have no other choice but to seek ways to preserve their margins. Thus, it’s very important to structure your sourcing contract around the chosen pricing model and create a win-win relationship for the involved parties.

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This article aims to compare and contrast the 3 pricing models used in IT sourcing contracts and conclude on which one is able to create a true win-win partnership and which may lead to win-lose engagements, with only one party getting real value and the other one cutting corners.

1. Fixed price (FP) model

When to use:

  • For long-term projects with a very clear scope, established PM methodologies and a stable set of requirements that isn’t likely to change throughout the project
  • For projects in a distributed environment when both the in-house and external teams have a good grasp of project details, have managed to establish a collaborative working environment, are well aware of each other’s skills and capabilities
  • When requirements are so clear that reaching milestones can be expected at agreed upon timelines

If you, as a customer, decide to change the scope when the project is being underway, the provider will have to reduce own margins or incur extra costs that will automatically turn such a business relationship into a risk management venture. Any provider will embed such risks into the project plan and budget, so you’re off to a bad start from the contract signature stage. Your whole relationship will focus on risk management rather than meeting your business goals, which will result in poor results at a much higher cost (when compared to other engagement models).

The other huge demerit of this model is that instead of encouraging effective working atmosphere between you and your service provider it leads to confrontations and situations when your and your provider’s project managers are at odds, each defending his territory – in case of scope change your provider’s PM is tasked to justify overheads by proving the scope wasn’t clear and your PM will have to fight for each extra penny incurred proving it was clear enough. So, change is evil in this pricing model. Time and energy you’ll waste on scope and contract formalization will create stressful situations rather than business value.

In situations when a target cost, profit and profit adjustment formula can be negotiated at the outset, it’s suitable to engage via Fixed Price with Incentive (FPI) model.

Within this model you, as an IT service buyer, will provide your vendor with an incentive or bonus for achieving important metrics and/or critical milestones. An FPI contract normally contains some of the following basic elements: 1) target cost; 2) target profit; 3) price ceiling, and 4) profit adjustment formula.

Under this contract the total project costs are re-negotiated with the use of the profit adjustment formula upon delivery and if the total project costs are less than the expected target costs, the overall profit is greater than the expected target profit. If the total project costs exceed the price ceiling, then your IT service provider will absorb the net difference as loss.

2. Time and material (T&M) model (blended rates)

When to use:

  • For long-term projects with dynamically changing requirements, unclear scope of work and varying workloads of development team

The model requires that your service provider bids for the project based on your requirements, project scope, workload and degree of coverage (scope vs time). Your in-house project management is responsible for defining the scope of tasks and overseeing the project. The clearer the definition of your project requirements, the less time will be wasted on re-work and the faster the project will be delivered to you. This will result in significant cost saving. On the other hand, if you, as a customer, fail to provide a clear definition of requirements, be ready to pay extra upon delivery. Hence, it’s pivotal that you continually verify and validate the project scope and control it in terms of consistency, clear communication with your provider’s team, escalation mechanisms, etc.

Unlike the FP model, in T&M you’re free to agree with your provider upon an hourly, daily, weekly or monthly rate for resources. This rate is based on each team member’s skillset and relevant project experience. Alternatively, you may agree on a single blend rate for all resources involved in the project.

To effectively manage the T&M project, you need to put in place strong project managers and PM methodologies to track the progress of schedule, scope, productivity and quality. Your PMs have to make sure the lag time is avoided and idle time is reduced not to pay extra upon the project delivery.

The biggest advantage of this model is that you’re able to lock external skilled resources for the entire project duration and scale up and down flexibly to adjust to macroeconomic factors or changing project demands. Also, management by metrics or by objectives during the different phases of mobile app development provides better insights into the ROI and cost structures.

In order to prevent uncontrolled cost escalations, you may impose an upper limit or cap on the costs. This model is called T&M with a cap. Such restrains always help ensure your project is within the budget.

 3. Dedicated Software Development Team (Salary + Management Fee)

When to use:

  • For long-term strategic IT / software development projects with unclear requirements, and frequent scope changes
  • For adding more manpower to own in-house IT/development team and operations by building an offsite team capacity that is 100% equal to your in-house team
  • For accessing expertise beyond your national borders and in-sourcing knowledge and digital know-how

In this model you basically retain project management control and only use your provider for recruiting, infrastructure and administrative support of your project team. The team fully reports to your company and adheres to your corporate culture and policies, development methodologies and practices, technical platform, workflow tools, and management style, i.e. considers themselves as part of your organization.

This model is perfectly suited for Software Development Team and PM, as it’s very flexible and allows scaling your capacity without sacrificing the project quality.

Are you looking to build your own highly efficient Software Development Team offshore?

In case you don’t have strong internal project management, you may engage with your provider via a Supervised Team model in which the provider will assign a dedicated PM to your project to track the progress and manage the team for you.

This model has the most flexible, transparent and clear pricing model ever – each month you receive a single bill from your provider comprised of each team member’s monthly gross salary and management fee that basically includes administrative and infrastructure expenses and overhead.

The project success rate within this model is very high due to the following factors:

  • You manage your team on a day-to-day basis via Scrum meetings, face-to-face communication and / or virtual PM tools and use the same productivity and quality metrics and incentives you normally use to appraise your internal staff
  • You have fully predictable costs and have a better opportunity to meet the budget and/or plan further actions
  • You have a loyal team of external developers committed to your project, fully aware of your business goals, sharing your company vision and really caring about your business success (unlike developers rotated from project to project and having very little understanding of the client’s objectives and business situation)

The conclusion is obvious - Dedicated Software Team model is the best value for those companies that are looking at IT sourcing as a long-term strategic function allowing for cost saving, effective budgeting of IT projects and strong skills exchange. For more information and practical tips on the effective setup of a Dedicated Agile team check out this blog post.

Vik is our Brand Journalist and Head of Online Marketing / PR with 11+ years of international experience in IT B2B. He's also a guest blog contributor to Business2community, SitePoint, Journal of mHealth, Wearable Valley and other IT portals.