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Pricing is one of the most important elements of a shared service or outsourcing arrangement, dramatically influencing the relationship between a service provider and its customers. A great model aligns both “buyers” and “suppliers” to reach mutually-beneficial goals. Choosing the wrong one can create an adversarial relationship and drive inappropriate behaviours for both leaders and staff.
While third-party providers have developed comprehensive and advanced pricing models to support their business, most shared service centers struggle with sound strategies. Pricing principles for captive and third-party services are very similar, but internal organizations usually find it difficult to move from a “cost-allocation” mentality to a more appropriate “direct/usage charging” approach.
Making this transition builds the foundation for an effective service relationship, and the first step is to choose a pricing model which will incent both parties and appropriately balance their degree of risk.
In this article, we summarize key pricing principles, describe the most common pricing model options to consider for your unique situation, and outline a best-practice design methodology to follow.
Choosing the Right Pricing Model for a Shared Service
© 2010 StratForm
Key Pricing Principles and Elements for a Sustained Service Relationship
To ensure that a shared service pricing model will drive and maintain a balanced relationship for both the service provider and its customers, there are four key principles that must be adhered to:
1. Business View – Providing services “like a business”, with a focus on efficiency.
2. Transparency – Clearly linking price, scope of services and service levels being provided.
3. Incentives – Creating drivers for both parties to achieve mutually beneficial objectives.
4. Sustainability – Securing funding for the provider’s future development requirements.
In addition, there are two closely related elements that should also be implemented within a shared service relationship in order to control and manage the pricing model:
Service Levels – Meaningful, measurable levels of performance which the service provider will be held accountable to, through penalties or other means of enforcement; and
Adjustments – Agreed-in advance mechanisms to ensure that pricing for existing and new services are fair for both the shared service center and its customers.
It is important to remember that there is no such thing as the best pricing model; the “right” one is chosen and tailored to match the specific objectives of your business.
And you must take into account the relative maturity and experience of the service center and its customers. A model that worked well through a service center’s transition period will likely need to change to provide new incentives for the relationship’s next stage of evolution.
Common Pricing Model Options to Choose From
There are many pricing models available in the market. To make matters even more confusing, some of them are referred to using different terminologies or definitions.
To help simplify your choices, here is StratForm’s summary of the most common ones in use along with their relative strengths and weaknesses and applicability to different situations:
A very common model for both captive and 3rd-party service providers. Relatively simple, with certainty of pricing for the customer and “revenue” for the provider, it works well when volumes and outputs are relatively stable. However, is also inherently more difficult to change and lacks of incentive for performance improvement. Finally, providers may sacrifice service quality if their actual costs are too high.
Time & Material (Cost-Plus)
T&M models are most appropriate for specific programs of work such as the transition to a service center or addition of a new service. They tend not to work well for ongoing services, since there is no incentive for performance improvement and therefore customers will tend to micro-manage their provider. It is also, unfortunately, a frequently used model for shared services since it’s similar to the cost center charging approach often used by centralized operations before they transitioned to a shared structure.
Transaction or Output-Based
Favoured by 3rd-party providers, transaction models inherently incent customers to control their usage and providers to improve their efficiency. They are also transparent and easy to understand, and work when services are well-defined and have good baselines. However, elements need careful selection to motive the right behaviours, and prices are more difficult to benchmark and may be “padded” by providers to reduce their risk.
Benefit-Based or Gain-Sharing
These models work when a “partnership” approach is needed to achieve a mutually-beneficial result, such as reducing purchasing spend. Gain-sharing incents both parties to work together creatively and gives the provider ample flexibility in their delivery. However, this type of arrangement very clear baselines and target-setting, can be difficult to manage and may lead to debates about the level of contributions provided.
Effort or Headcount-Based
One of the easiest to design, implement, adjust and benchmark, effort-based models work well when outputs are difficult to quantify and volumes slow to change. On the downside, this model is not easily scalable and doesn’t incent the provider to improve efficiencies, so micro-management by the customer is a significant ongoing risk.
Other less-common models, worth evaluating in certain situations, include Revenue-Based, Demand-Based (i.e., pricing by capacity) and Incentive or KPI-Based models focused on service outcomes.
Designing a Service Pricing Methodology
A well-designed pricing methodology has three components: the Strategy, the Structure and the actual Pricing Levels. Each component should be designed in sequence to clearly link the strategic intent with the actual pricing elements and levels defined in further detail. When complete, the Strategy and Structure together are referred to as the “Pricing Model”.
Your Pricing Strategy summarizes the philosophy that will be used to determine actual prices for the services. Examples include $ per transaction, $ per headcount, gain sharing and many others. The pros and cons of each option should be evaluated relative to your particular situation, recognizing that hybrid approaches may also be appropriate..
Adjustment mechanisms to keep interests aligned should also be selected at this stage, because no pricing model is ever static – changes WILL occur, so anticipate and design-in the mechanisms to be used by both parties when required. Mechanism examples include volumetric changes, service level credits, inflation, benchmarking and joint forecasting,
The Pricing Structure then articulates the actual pricing elements, their scope and units of measure. They are usually defined at three levels: Business Drivers (such as number of employees), Process Outputs (number of transactions) or Activities/Inputs (cheques cleared or requisitions sent).
Business Drivers and Process Outputs are usually the safest since they closely align to business objectives. Activities or Inputs are more closely related to “how” the center performs its services, and using them increases the risk of the customer micro-managing the service provider.
Finally, Pricing Level represents the actual service price for each element. Prices are usually negotiated to meet customer objectives and still provide a sustainable source of “revenue” for the service center, and will vary according to the services levels required by each customer group.
In summary, by leveraging the key principles, rigorously following a structured design approach and objectively comparing the pros/cons of each option, you will improve the likelihood of selecting the right pricing model and also create a compelling story to explain “why” it is the best for your situation.
A final word of advice: seek objective advice and facilitation assistance throughout this process. It helps significantly for someone to keep both customer groups and service center management focused on the end-goal, adequately considering what is both ideal and pragmatic for their relative maturity, and building a compelling story to get all stakeholders aligned on the “right choice”.