We’ve been covering IT and business services for over 20 years, and it’s still sold and bought the same way: enterprises pay for effort, and providers sell effort. However, the current “effort-based” model has become unsustainable in today’s climate for two reasons:
1. The economics of the current services model is failing
It is based on low-cost labor, and that labor is not so cheap anymore… or available. Service providers will walk away from this business as they simply can’t make the numbers work to deliver it effectively and profitably. It’s becoming a painful race to the bottom.
2. When the purposes of client and provider are not aligned, the relationship ultimately fails
When engagements are priced on the number of people, there is very little incentive to explore new methods of creating value, such as automation, AI, quality data etc. The service provider is incentivized to maintain/increase the staffing levels, not invest in programs to reduce manual dependencies. Enterprises need to pay for performance, not effort, if they ultimately want to benefit from sharing a common purpose with their provider. Net-net, enterprises and their service partners must be motivated to achieve the same goals if they want to enjoy a long-term, mutually beneficial relationship.
Why so many services engagements become bad business deals
So what incentive does the provider have to become more effort-efficient if they will be penalized financially? The short answer is that there is no incentive, which is why many services engagements move to different service providers when contracts end. In most cases, it’s preferable for the incumbent provider to lose the business rather than cannibalize its own revenues with that client.
The sad reality is that the enterprise client just lost a service partner which has years of experience running their institutional processes – which could probably have automated the crap out of them and delivered a game-changing scenario. But they just had no financial incentive to do so. So the cycle continues, and that same client has to go through the same dog-and-pony show with another provider for the next 5-10 years. They still have the same crappy operations that will remain crappy with another partner, which also has little incentive but to deliver the same crap to maintain the effort levels as bloated as possible, to keep the business as profitable for themselves.
The legacy services industry perpetuates mediocrity and is playing a zero-sum game
The even sadder reality is that the whole services industry has become a vehicle to run the same crappy processes for the same tired old clients – with as many staff as they can get away with – to eke as much profit as they can.
And the despairing, even sadder reality is that this industry has become a vehicle to move this litany of terrible antiquate processes – many of which originated after the second world war – into the cloud, where enterprises can spend a fortune operating with as much mediocrity as they did before.
The problems start when enterprise clients become increasingly uncompetitive because they drive Teslas with knackered old gas engines. Simply moving your mess for less to the next services provider willing to spin its 20% margin over the top is a zero-sum game. The clients will struggle to get the data they need to compete effectively with companies with much more digitally native front-to-back processes. And when the clients start to fail, so will their services partners feeding off the inefficiency.
So what needs to change to get the focus on value versus effort?
Clients and suppliers need to jump to a new S-curve of value creation where the client pays for the performance, not just the effort (See Exhibit below). Performance should be measured based on some attribute of business value, not just cost and efficiency. Business value can be defined in terms of working capital optimization, speed-to-market, improvement in business metrics (e.g., DSO or DPO), customer/employee satisfaction (e.g., NPS score), or procurement spend reduction.
Most services relationships get stuck at stage 1 and start witnessing diminishing returns because you just cannot keep squeezing the lemon for more juice. In a performance-driven relationship, the supplier and client share the risk and reward while providing services at the lowest cost possible starts to become a given.
Most sourcing advisory consultants describe a gain-sharing approach at this stage, but be careful as gain-sharing can drive opposite behavior than initially envisaged. A “pay-for-performance” pricing is often more practical. This is how it works:
- Identify the desired outcome for a potential relationship by milestone
- Supplier proposes fixed service fees to implement milestone
- X% of Supplier fixed fees “at risk” for non-performance
- Supplier earns a “performance bonus” (up to Y% of fixed fees) if it exceeds project Savings Target
This pay-for-performance pricing is simple, transparent, and mutually beneficial as the service provider is incentivized to create value, it is relatively straightforward to track and measure, and the buyer payouts cannot be so huge that they can cause budgetary issues.
A gain share model backed with an “innovation fund” is also a better idea than pure gain sharing. Here the supplier (and buyer) commits to a pool of money to drive innovation. A joint innovation council identifies potential projects and uses the innovation fund. The supplier recovers its investment using a gain-share approach with a potential upside if the project is a huge success and a downside if it fails.
Finding a common purpose in a relationship can convert it into a growth engine for both parties
The most mature relationships are not based on math on some complex savings calculations but on a shared drive or goal (see stage 3 above). This is where co-creation happens. When combined with the supplier’s experience and technology, the buyer’s data and real-life business context create a unique solution that can be taken to the market jointly, with both parties sharing the potential windfall. Suppliers struggle to develop innovative solutions in a vacuum, and co-creation allows buyers to drive the partnership toward revenue creation. Purpose-driven associations rely on each other’s strengths to build a strategic, mutually beneficial relationship. A recent example is where bp and Microsoft formed a strategic partnership to drive digital energy innovation and advance net zero goals. Microsoft would further bp’s digital transformation with Azure, while bp would supply Microsoft with renewable energy to help meet the company’s 2025 renewable energy goals.
Bottomline: There is no pricing nirvana in IT and business services. But pricing structures should evolve as the relationship matures from effort to performance to purpose
Each pricing structure – input or effort based (e.g., FTE-based), output-based (e.g., price per transaction processed), or outcome-based (e.g., gain sharing, pay-for-performance, innovation fund) has its pros and cons. It generally makes sense to start a new relationship with some effort-based pricing to establish the baselines and build trust, but then it is time to move on to pay for value.
Where we are seeing most progress towards performance-based relationships is when the CEO gets involved to learn the nuances and value of moving towards areas of common purpose that can also involve other entities in that industry ecosystem. The challenge for service providers is to have leaders capable of developing C-suite relationships and changing that age-old master-servant conversation to one of common purpose to create mutual value.