I often find that the most challenging part of finalizing an engagement with a customer is determining the best pricing model. This isn't because there is tension in negotiation or even on the cost of the engagement itself. It is largely due to shaping a pricing model that helps meet specific objectives without becoming a distraction well into the project. Part of it is expectation setting, another part is alignment with financial goals (for the customer and the service provider) and another part is the shaping of behavior since money often does influence how everyone behaves especially when it is written in a contract.
There are considerations to be made when working with a customer to construct an engagement supported by an optimum pricing model. Some of these considerations include:
In addition to defining these currencies, there are a number of pricing models to consider. Below I've described the most common pricing models that service providers and consultancies use. There are some great books written on how to price engagements, including The Price Advantage by Walter L. Baker, Michael V. Marn and Craig C. Zawada.
Time & Material (better known as T&M)
This model is perhaps the most common and is often the most problematic since it is entirely based on the cost of people with no responsibility on meeting specific value criteria or deliverables in the contract. Characteristics of this type of pricing model include:
Daily or hourly rate multiplied by the number of days or hours, sometimes referred to as "level of effort"
Customer is invoiced and pays strictly for actual services delivered
The rate is a factor of differing criteria that will likely include:
Competency and experience of the person and/or team
Geographic location that will impact the market value of the rates
Domain experience if industry expertise is needed
Discounting is typical based on:
Supply and demand
Competition and the desire to win the work
Duration of the project (the longer the engagement, the more competitive the price)
Low risk assumed by the service provider but also a lower level of control and influence over the outcome
High risk assumed by the customer since deviations or changes are usually dealt with by Change Requests that can be costly
Fixed Time & Material (sometimes called T&M Not to Exceed)
This can be confused with Fixed Price, which is different and discussed below. The idea behind a Fixed T&M model is to create a little more structure and security around the contract. Characteristics of this type of pricing model include:
An agreed price for the engagement in exchange for a defined scope of work
There is still negotiation on the rate per person or per team and the level of effort (number of days) BUT there is a fixed or capped amount that is discussed with the customer
Due to the exposure of the rates, adding anything to cover unexpected risk (contingency) is difficult. That said, I have found that discussing this with customers openly and honestly usually results in agreeing on some percentage of assumed risk added, e.g. 15% (although that number can be higher or lower and needs to be agreed and validated with the customer depending on the scope of work)
The payment is usually related to actual work effort vs. deliverables or milestones, e.g.
If it costs the service provider more time to complete the project and they exceed the "fixed" amount then they are responsible for the difference
If the service provider can deliver the project in less time and come in under the "fixed" amount initially agreed then the customer benefits from the difference in savings
High risk for the service provider since the engagement is still priced on T&M but is controlled by a fixed amount
Low risk for the customer - project amount is fixed (budgeted), early delivery is to their financial gain, late delivery is still to their financial gain although the impact on one or more of their value currencies could be negative
As it relates to service contracts, more and more companies are opting for Fixed Price and many more are now considering Outcome Based mentioned below since both of these represent mutual accountability and responsibility and reflect the intended partnership that was desired, to begin with. Characteristics of this type of pricing model include:
The engagement has a fixed price for the scope of work required and is NOT based on T&M discussion but rather perceived value - in other words, if the delivery of this new customer facing rating application will deliver an estimated £5M in new revenue then is spending £1.5M to build it sensible (I don't know since there are other variables but typically you need some level of an economic framework to assess the value of a fixed price engagement)
The service provider is responsible for determining the level of effort and the best team to deliver this work and then provide a fixed price to the customer that will often include some percentage of assumed risk (contingency). The assumed risk is predicated on certain factors:
The extent to which the scope of work is understood - doesn't necessarily have to be fully defined
The gap between the technical and business requirements vs. the service provider's ability to fully deliver it
External factors or resources that may be needed to make up skills, competencies or expertise
Price can still be negotiated
The contract defines not only the scope of work and the engagement methodology of the service provider but also clearly describes the assumptions from both parties, responsibilities for each and how issues will be resolved
While possible, penalties/late fees are not typical in a Fixed Price although some customers want to see them and this lends itself more to the Outcome Based model described below
The invoicing of a Fixed Price engagement is tied to an agreed payment schedule vs. billing for services rendered
The degree of risk for the service provider is high but their ability to shape and control the outcome along with the client is equally high therefore the exposure is limited assuming that the partnership intent exists
Customers can benefit greatly from this model if all parameters are well defined and communicated upfront
Outcome Based (often referred to as Risk/Reward)
Over the years I've seen several attempts at this type of contract. Most of them failed but not because the model doesn't work but rather the setting of expectations is not thorough enough and neither is the ongoing communication that is necessary to maintain complete transparency and trust. Unlike the other pricing models we've discussed, Outcome Based engagements require a bit more love and attention to make them really work.
They are often approached the wrong way by assuming that the key criteria is setting an SLA (service level agreement) and associated penalties. While these need to be represented, approaching this model with the intention of forming a benefit driven engagement proves to be far more valuable. Characteristics of this type of pricing model include:
The engagement is governed by rewards for performance and delivery of outcomes and the risk of losing or minimizing the total compensation if outcomes and deliverables are not realized
Similar to Fixed Price, the pricing model is a set amount and related to T&M but unlike a Fixed Price engagement that is simply a capped T&M contract, Outcome Based models are all about achieving deliverables and outcomes:
The scope of work is directly linked to specific deliverables/outcomes for the project that can be related to milestones (feature/function delivery), performance metrics (time to market/cycle time, cost/waste reduction, etc.) or some combination of both
Other outcomes can include a discounted rate from the service provider in exchange for revenue or productivity goals associated with the project
Establishing ceiling and floor scenarios so that there is understanding on how much reward a service provider can expect if they over-achieve and equally what is the worst-case scenario is something goes wrong.
You might find it hard to believe but it is this lack of expectation setting and math exercises upfront that often lead to broken contracts and relationships.
The degree of risk on the service provider's side in delivering the project needs to be balanced with the degree of potential upside, influence and control and the customer's objectives for the project.
Customer Value Analysis type work upfront significantly helps this discussion and can often help shape a mutually optimum agreement
The degree of risk for this type of pricing model is typically very high but again, the ability to shape and control the outcome is also high.
Do these types of contracts if you have an established relationship with a service provider that you know will put skin the game because your success is directly linked to theirs (not on just this project, which is obvious but in terms of overall long-term goals).
The best pricing model is different for each project and organization and is going to be driven by a company's maturity and experience in contract and vendor management along with their willingness to be creative and even re-shape existing policies. This largely depends on what they want to achieve with each project or program and what are the governing factors for the company itself. The explanation of these models will hopefully help some to re-think how they are doing it today and find ways to minimize their risk and exposure and more importantly build better relationships with their partners.