Tuesday, November 29, 2011

Outcome based Contracts/pricing by Indian IT Outsourcing Vendors- Case Study reviewing Top 5 Indian IT Outsourcing Vendors


Indian IT outsourcing vendors have moved beyond the cost and process efficiency and moved towards Outcome-based models which is being paid on performance like improving total sales, working capital reduction, bottom-line improvement, etc, rather than one based on the number of people deployed. This model is best suited when the cost of change management is high or when there is an under-utilization of people. It is also best suited when the outcome is process-oriented and when the customer have accurate baselines, well-defined, measurable service levels and performance goals, and be willing to accept the provider’s solution to meet requirements. This model is more vendors driven and they try to complete the work as soon as possible, using the most efficient processes and reducing costs. The vendor is relying on client and client on vendor for outsourcing success and risk is transferred from client to vendor. Vendor should account for transference of risk and cover that by including a risk premium in the price. Indian Vendors have realized that the golden-age of T&M and throwing people at a problem has ended and they have already moved into fixed-cost deals and outcome-based contracts are the next step.

Outcome based contracts/pricing started to come into prominence in 2007 when the Global Financial crisis started unraveling and businesses were facing slowdown and IT budgets were tightened. Businesses started looking at IT Vendors for more value. In a survey conducted by InformationWeek in early 2008, 20% of 430 IT pros working with Indian outsourcers cited the "ability to tie project costs to business goals" as a key benefit that would prompt them to work with an outsourcer again. 31 % cite "understanding our business and industry" as an area that's improved significantly over the past year. Indian Vendors were focusing more to understand the clients business as whole and not restricting themselves only to the IT department. In 2008 Outcome based contracts or pricing was in a nascent stage where IT vendors just started to understand the significance of this model and how they are going to adapt this model. Businesses too due to the financial crisis and budgetary pressures started to work closely with vendors and provide them access to their business so that the vendors become a strategic partner who will help them in achieving the organizational goals.

Tata Consultancy Services Limited (TCS)
TCS has begun using a new success-based pricing in 2006 in some of its outsourcing contracts it signed with Pearl Insurance in UK, Tata Teleservices and Chilean TranSantiAgo in the last seven-eight months. Such success-fee based contracts accounted for about 4% of TCS’s revenues in 2007. In the Pearl contract, TCS has changed the entire business process and replaced the 13-odd IT systems floating in the company with a single system. In the TranSantiAgo case, which is a transportation contract, TCS’s job is not just to find a cheaper and better way of designing the new transportation system, but even generate demand for the new system. In 2008, TCS won a project from the Ministry of External Affairs to automate passports and is paid a combination of project fee and an outcome fee based on the number of applications it processes.

TCS has been very careful in adopting this model and structuring deals around measurable goals.  In 2009 this model accounted for about 1%  of the company’s total revenue and outcome-based projects are yet to become mainstream.Recently TCS' British BPO subsidiary, Diligenta, signed a deal to take over the IT and customer services functions of the UK’s Friends Life and it is based on outcome-based pricing and TCS will charge per policy to the client. With this deal TCS has shown that it is still looking out for outcome-based model.

Infosys Limited
Infosys took first steps into the managed services sector in 2008 through a business unit based on an “outcome-based” pricing model, moving away from charging per man hour toward what it calls a “software-assisted services” model. At Infosys, 50% to 60% of deals in the enterprise services group have some kind of outcome-based pricing. Infosys do not peg all the revenue to outcome based pricing as business outcome can be measured only after a period of time and there are other variables in the environment that can impact the outcome. So part of the fees (around 10-20%) is tied to the end result or outcome and the remaining gets billed through traditional models. Infosys signed a deal to support manufacturing, supply chain, finance, HR and other applications of AstraZeneca in 2008 and  services delivered through a global shared-services model that offers “fixed price for outcome-based deliverables, and flexible, unit pricing for managing changes in the base scope of the engagement.

Infosys in 2010 signed a deal to manage internal IT services for Microsoft worldwide through an outcome based pricing model, enabling Microsoft to associate and manage IT costs directly to business variables and demand. Recently Infosys launched TalentEdge, a comprehensive talent management platform that deepens employee engagement and the platform built on state-of-the-art technology and is delivered in the Cloud on an outcome-based pricing model. The sales team is constantly encouraged to pursue outcome based billing. Infosys management has given the mandate to push up the contribution of such outcome-based contracts from 3-4 % of revenues to 20 % in three years, translating into a $1 billion target.

Wipro Limited
Wipro had invested in outcome based models since 2008 and had been seeing increased customer interest as this result based model has inherent benefits like improvement in service levels and end-user experience. FlexDelivery is one such model for managing enterprise applications and Wipro had six clients using this model out which three were added in first quarter in 2008. IT also launched Cigma (Center for Integrated Global Management of Applications) for manufacturing clients with the unique capability of providing an outcome based model based on SLA’s (service level agreements) as well as BLA’s (business level agreements) to customers. Wipro aims to get 50 percent of its sales by 2012 from orders where it shares risk with clients seeking to cap their costs to boost its own profitability.

Wipro gets major portion of the contracts worth $500 million following its acquisition of Citigroup's captive IT arm in India 2008, based on outcome-based model. Friends Provident had signed a three-year contract for the provision of IT Application Development and Support services from Wipro Limited in 2009 and the contract enables Wipro to offer increased value in an outcome based engagement model through process excellence, higher offshore leverage, and greater accountability and ownership in delivering projects. Wipro signed a 10-year total outsourcing contract with TVS in 2010 which includes the comprehensive suite of IT infrastructure and applications across the enterprise and engagement would be governed by a unique mix of milestone-based, business outcome-based and operations-based Key Performance Indicators (KPIs). In June 2011 Wipro won an outcome-based deal from Chaucer Syndicates, a specialist insurer at Lloyd’s, to develop an end-to-end regulatory compliance solution that would generate better analytics and improved management reporting for the client.

Cognizant Technology Solutions Corp
Cognizant is also using an ‘outcome’ or ‘effect-based’ model to provide services by leveraging its global delivery network, talent pool and best practices. Outcome-based pricing is a very small piece of Cognizant portfolio and it expects that this model will evolve in future as the customers believe the vendors are capable of providing the relevant services and business value and manage the risk efficiently. Cognizant’s earliest projects based on outcome were with pharmaceutical company AstraZeneca and with Sanofi Pasteur, where there was an increase in effectiveness as measured by time. For 3M too, Cognizant used an outcome-based, managed service engagement model with productivity benefits over the long term.

HCL Technologies Limited
HCL Technologies missed the Y2K boat and therefore pioneered the use of ‘outcome-based’ pricing.HCL Technologies has a higher risk appetite and has a large proportion of its revenue coming from outcome-based pricing — a model where larger the profit for the customer, larger the revenue gain for the IT vendor. HCL earns 25% of its revenue from the Infrastructure service segment and the outcome-based model had helped them win big contracts. HCL has a revenue sharing arrangement with Cisco, CA and an output-based pricing arrangement to develop software for Boeing 787 Dreamliner. HCL has transformed its scope of public sector services and its open view toward outcome-based contracting is well-appreciated by governments in their bid to address greater efficiencies and as part of business and technology risks mitigation. HCL Technologies sees a trend in UK towards outcome-based contracts.

Outcome-based Contracts/pricing not yet picked up
Analysts estimate that while less than 5% of offshore contracts are currently outcome-based, this trend will pick up in 2011. NASSCOM estimates that 10% of total revenue is coming from outcome-based contracts/pricing for the Indian Outsourcing Industry. Nasscom believes that the industry is beginning to move beyond time-and-materials pricing. About 40% of the industry's total transaction value now comes from fixed-price deals (irrespective of the number of man hours spent). Despite the outcome-based model in prominence since last four years, the volume did not pick up in India. This model is best suited for existing clients and for new clients who have a clear understanding of the model and in this models both vendors and clients should ensure that the scope of the engagement and the outcomes are clearly defined.

The success of this model lies in the understanding of the customer’s business model, operations and industry nuances and how to manage risk involved at all stages. Risk is high for the vendors and they charge premium and since they cannot wait for payments till the business outcomes, only apportion of the revenues are being done on the outcome-based pricing. Business outcomes are time consuming. The clients and vendors should have a common basis for future value creation and vendors should be clear as to how much risk he can bear and how well he knows his own processes and business. Other external variables also have to be taken into account and for the model to succeed both the client and vendor should have a strong and open relationship between them so that they can achieve the planned common outcome. Customers prefer such billing models because they can keep their costs entirely variable and dependant on their own revenue growth.

Discussion Points:
  1. Why is Outcome-based Contracts/Pricing not picking up in Indian IT Outsourcing Industry?
  2. What percentage of revenues should come from the outcome-based model?
  3. How to manage the higher risk by the Vendors and are they equipped to manage such risks?
  4. Has Indian IT outsourcing Vendors matured enough to tackle the complexities involved in outcome-based model?
  5. What should be the strategy of clients/consumers in the outcome-based model?

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