There is an optimal price for any service, and it is different for every service provider and every customer. Sourcing and procurement managers often try to reduce prices as much as possible – sometimes to a point so low that they become disadvantageous to the business.
How can a price ever be too low?
It can’t – provided that we’re talking about a service that is utterly, in every way imaginable, a commodity. However, despite what we may like to think, and endeavour to create, such commodities do not exist. No matter how tight the agreement or how granular the SLAs, services that are in any way delivered by human beings cannot be a truly commoditised. From the engagement manager, to company leadership, to the very last person charged with providing your service – the human element has the potential to make or break an outsourcing engagement. As an IT programme manager, I had been on the receiving end of a “sourcing win” more than enough times to know that unhappy suppliers beget unhappy customers. Even enterprises with immense aggregate demand – and often a misguided sense of their influence on suppliers – can suffer what is sometimes referred to as the “winners curse”… a winning price and a losing service.
The labour market for IT service providers – particularly offshore – is very competitive. Churn (employee turnover) can be as high as 20 to 30% per year. Prices and demand continue to increase across the board, putting suppliers in situations where they need to make tough choices about where to invest time and effort, and above all, place their best people. Unless you’re a client with a great deal of perceived upside, those decisions will generally correspond with the business value you provide to the supplier.
What is the right price?
The best price you can possibly achieve in any outsourcing deal is what I call the “Omega Price”. This is the lowest (and ideally the last) price a supplier will give you where they are still 100% committed to sufficiently delivering on a deal. Most suppliers go into any negotiation with (at least) a few key price points in their mind:
- The List Price – in most cases, this is simply a ridiculously high price point whose purpose is to provide suppliers with the ability to subsequently woo you with “massive discounts”
- The Ideal Price – this is the highest price that suppliers think that they could realistically get if a client shows little or no negotiating resistance. However, because suppliers expect clients to push hard on pricing, this is often set well above the price needed to attain their target margins
- The Base Price – this is the lowest price that they would give a client given realistic expectations of the lifetime value of a client, and still be fully committed to taking all reasonable steps to fulfil a deal.
- The Loss Leader Price – this is the rock bottom price that they cannot go beyond – no matter what – and is generally justified by very risky assumptions about how much value a client may bring them over the lifetime of a deal.
Depending on your business, and ongoing perceived additional value to a supplier, your Omega Price will likely lie somewhere close to, but generally above, the “Base Price”. Benchmarking can help you get a reasonably good idea around what those price points should be, and while you should certainly not undersell the amount of future business you may provide a supplier, you should be realistic about how a supplier perceives you as a client.
But I have rigid SLAs & penalty clauses…
When your mission critical application is down and your customers are suffering… do you really care about penalty clauses and SLAs? Sure – you may get some compensation on the back end if you are willing to engage in the legal battle it will take to recover it but the damage to your business has already been done. Further, companies universally underestimate the cost of issues at the execution level. Because suppliers are almost entirely focused on meeting the SLAs put forth in a contract, they have relatively little concern about how they meet them. A global sourcing organisation can claim victory on a 20% reduction in, say, application development spend… but the IT organisation can be burdened with sharply increased management overhead, lower quality and employee dissatisfaction.
Indeed – complaints may well be escalated from the execution tiers to senior management… prompting a brief increase in resource allocation, soothing actions from sales leadership, but often little meaningful improvement. Possibly the most ignored reality of outsourcing failures is that they break down at the execution level well before business-level SLAs and objectives are missed.
Does the Omega price move?
Fortunately (and unfortunately) yes. As demand wanes relative to resource supply, there is an opportunity to either renegotiate pricing or to expand a supplier’s service offering without a proportionate increase in cost. In fact, suppliers will often welcome opportunities to reduce excess resource capacity for very favourable rates. If you grow in relative importance to a supplier’s other clients, another opportunity arises for you to find efficiencies. Conversely, as we have until very recently seen in many markets, suppliers’ Omega price can grow quite rapidly as demand increases relative to resource supply. The wider range of pricing given to clients by offshore providers also contributes to the pain of companies who negotiated strongly, but who’s pricing falls well beneath the Omega price.
A few ways to get YOUR Omega Price
- Benchmark. Even a cursory benchmarking exercise should give you a good idea around what comparable suppliers are charging for different types of services.
- Maintain strong relationships with your key suppliers. While suppliers generally strive to become a client’s supplier of choice, it’s a growing (and savvy) trend to endeavour to become a supplier’s client of choice.
- Multisource. Healthy competition is less a threat and more a reminder to your suppliers that they cannot take your business for granted. The more they feel that they have to work to remain your supplier, the lower your Omega Price becomes.
- Allude To Bigger Things… and Deliver. Reward your best suppliers additional business over time. Growth is the number one priority of most outsourcers, and the best way to maintain the lowest Omega Price with the best-performing suppliers is to continually increase their workload.
- Fluid Negotiation Styles. Negotiation styles that allow suppliers to quickly approach (and hopefully achieve) their Omega Price – such as a reverse auction – can be more effective than traditional negotiation techniques.
- Resist The Procurement Temptation To Save Money. As soon as you ‘coerce’ a supplier to reduce their price, they’ve already begun thinking of ways to recoup the lost margins. Reason number one: substitute less experienced and capable personnel to make up the shortfall. In small deals, you can (and should) interview and specifically designate key personnel, but in larger deals it isn’t feasible, and you are at the mercy of the outsourcer as to which resources work on your account.