New sourcing deals tie fees to deeds

While many virtual computing visions promise pay as you go utility-like pricing, some companies are already realizing metered rates in outsourcing deals that tie service fees to business performance.

Take Canada Life: The more insurance policies the company sells, the more money IBM Corp. gets for hosting its claims-processing application. Similarly, e-commerce service provider Digital River Inc.’s fees are based on the amount of baseball paraphernalia sold through the Major League Baseball Web sites it built and maintains.

There’s growing interest among companies to broker outsourcing agreements that are based on business metrics rather than technology metrics such as CPU cycles or storage consumption, observers say.

“There is no question that vendors are attempting to become more flexible in their pricing,” says Jasmine Noel, principal at research firm JNoel Associates. “Users are in the driver’s seat when it comes to contract structure.”

It’s not a new concept, but it’s gaining momentum, adds Andrew Efstathiou, program manager at The Yankee Group. Early examples of performance-based contracts are rare and typically reserved for a specific element of an outsourcing contract, Efstathiou says. For example, both parties might agree in advance that if a vendor is able to reduce the cost of service more than anticipated, the customer and vendor will receive a portion of the savings.

Applied more broadly, a business-performance-based contract could be good for users. “It has the potential to save customers money. Also, it has the opportunity to reduce business risk by converting fixed costs to variable costs,” Efstathiou says.

Companies also stand to gain greater insight into the profitability of business initiatives with performance-based contracts, Noel says. “Users can clearly and directly match the amount spent on IT with a revenue stream,” she says. “By doing that, they can immediately see if an e-business project is really profitable or not – and they can then make better decisions about managing their costs or offering a particular service.”

However, taking advantage of variable-pricing contracts might require a change in IT governance, because most companies budget for fixed IT costs. “Depending on who the vendor is talking to within an end-user organization, (their person) may not have the ability to accept a variable-priced contract,” Efstathiou says.

For example, an IT manager or CIO might be interested in variable pricing but can’t negotiate for it because it doesn’t match up with the budgeting process. In contrast, a CEO or line-of-business manager with revenue responsibility might have more leeway to negotiate variable pricing.

“When you’re dealing with profit and loss, if the revenue doesn’t show up, then you’re going to be losing money if you have fixed costs,” he says. “Being able to convert some of those fixed costs to variable costs helps you to maintain margins regardless of the volume that’s flowing through. For people who have profit-loss responsibility, this type of arrangement resonates very well.”

Ensuring vendor delivers

Canada Life outsources the care of its Genelco insurance claims and administration applications system to IBM in an arrangement whereby the Toronto insurer pays for IT services that are based on the number of insurance policies on the system.

The deal, inked in March, is not a “traditional outsourcing agreement where the vendor has a vested interest in having the customer consume more technology so that it can make more money,” says Doron Cohen, senior vice president and CIO at the insurance company.

A traditional technology-based contract would have put the onus on Canada Life to second guess whether the vendor was shortchanging it, Cohen says. For example, one executive at Canada Life wanted to require IBM to provide adequate application maintenance expertise and suggested a clause in the contract that said IBM had to commit six people who had experience with the Genelco package.

“I said no,” Cohen says. “The minute I contract for six people, it becomes my job to test them to see if they are qualified. That’s exactly what I don’t want to do.”

In its arrangement with Canada Life, IBM is on the hook to deliver results, Cohen says. IBM has an incentive to upgrade and enhance the services that the system provides to customers, because the more policies customers buy, the more money IBM makes, he says.

In addition, service-level agreements built into the contract call for IBM to adhere to a schedule of application upgrades and to implement code changes the insurer specifies within a predetermined time period. “I made it very clear to IBM and to everybody involved: you will make more money if, and only if, we sell more policies,” Cohen says.

Cohen says orchestrating the deal wasn’t easy – it took seven months and several lawyers to hammer it out. IBM felt the deal left too many things open-ended, and Canada Life staff felt they were giving up too much control, Cohen says. “Everybody was equally uncomfortable with it,” he says. “So I had to fight them all and bang heads.”

Sharing growth goals

Noah Garden, senior vice president of e-commerce at MLB Advanced Media, had an easier time ironing out a contract between Major League Baseball and e-commerce service provider Digital River – particularly because the vendor built its business around variable pricing.

“Our whole business is based on a revenue-share model,” says David Alampi, vice president of marketing at Digital River. “So our motivation is exactly aligned with our client’s motivation, which is to grow their business.”

Club owners voted in 2000 to centralize Major League Baseball’s Internet operations. Placed in charge, MLB Advanced Media farmed out portions to Digital River. MLB controls what merchandise is sold on the league’s site and the 30 individual teams’ sites, and how that merchandise – about 30,000 items – is priced and presented.

Since 2001, Digital River has handled the transaction side, including credit card authorization and fraud protection. Last year, Digital River added customer service and order fulfillment to its roster of duties.

Outsourcing appealed to MLB Advanced Media, because the business was a start-up and the schedule for launching 31 Websites was tight. “Essentially we didn’t really know what the size of business was,” Garden says. “And we were trying to launch 31 sites in four months.”

The revenue-sharing model was a deciding factor in going with Digital River, Garden says. “It’s been well documented the successes and failures of all those companies that provide these sorts of services,” he says. “We were not going to get into a relationship with a partner that didn’t have skin in the game.”

The arrangement motivates Digital River to keep improving its technology; the companies regularly brainstorm about new technologies that could drive sales, Garden says. “I don’t think that happens as much in a relationship where you just pay a vendor a flat amount and then they move onto the next client,” he says.

Variable pricing is not a fit for every outsourcing occasion. Companies with stable transaction levels might not have much to gain by switching to a usage-based or performance-based outsourcing model, he says.

In addition, there are technology hurdles to overcome. “It’s a big problem to do this if you can’t meter how much has been used, and if you can’t price per transaction,” Efstathiou says.

Still, vendors such as Accenture Ltd., Electronic Data Systems Corp., Hewlett-Packard Co. and IBM that are aggressively pursuing utility computing initiatives will drive adoption of IT services priced according to business metrics, observers say.

“An outsourcing vendor can only make money on these deals if it can allocate its internal resources in a flexible, adaptable way,” Noel says. “Utility computing efforts give the vendors the nuts and bolts with which to create these services.”

“The whole utility computing model plays to this,” Efstathiou agrees. “In the long run, a preponderance of pricing will be by business transaction.”