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Outsource magazine: thought-leadership and outsourcing strategy | July 25, 2017

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The Mathematician and the Music Maker

The Mathematician and the Music Maker
William Hooper

There are many models by which a service may be priced and a deal constructed. Whatever the approach used, there are considerations that both of the parties should weigh before they agree. What is likely to be going on and how can you obtain the best outcome?

During the process of engagement between customer and supplier, there will be a process of exploration. Most effective outsource salespeople are very good at engaging senior customer staff and uncovering their objectives, constraints, wishes and influences. If the customer has a building surplus to requirement and its adoption would give the supplier a useful delivery centre, it is an easy decision to transfer it as part of the deal and price in its use.

There is nothing inherently wrong with playing around with pricing models and adjusting the variables. When done well, such adoption can significantly increase the value gained by both parties.

Striking a fair price

It is reasonable during negotiations to concentrate on the level at which the price is struck. This is as it should be. Whilst this level is not the principal focus here, there are some simple steps that can be taken to help you along the way.

The first is to define a pricing matrix within the invitation to tender, and to require completion of this for the bid to be acceptable. The basis of pricing should be delivery of the services required on the terms given. If a supplier should, having satisfied this, go on to supply a second, non-compliant bid that gives better value, all is good.  The reason for this insistence is that it gives comparability between the responses and at least at the time of the bid, transparency. A wise customer will ensure that the compliant and non-compliant financial models are comparable and that change from the base-case is advantageous.

Transparency and granularity are not likely to be seen as attractive to the supplier. This is because customers seek to understand where excess profit is hidden in their pricing, to negotiate this away. It also shows whether changes are being priced fairly. If you want to obtain this information, you as customer need to make it worthwhile for the supplier to disclose it.

Models

The variety of models possible is limited only by the imagination of the parties. Most wild fantasies do not survive scrutiny to make it into contract, although nightmares seem to occasionally.

Most models contain elements of some of the following:

  1. Time and materials for transition project effort; ongoing service is priced based on units x unit charge.
  2. Fixed price project amortised over the life of the service contract, recovered together with ongoing service as units x unit charge.
  3. Fixed periodic charge + volume-related variable element.
  4. Blended resource rates vs separate rates for skill, function and location..
  5. Output-based – milestones delivered (Applications Development and transition); servers supported price per unit (hosting).
  6. Risk/reward. Most commonly applied to project charges where an element (normally a small proportion) is placed at risk being charged as some outcome units x unit charge.
  7. Outcome-based. The charge is levelled on some measure of business outcome rather than input resources. E.g paying for training based on candidates passing an examination.
  8. Asset and liability transfer and recovery.

Prices can be fixed over time, inflated or deflated in line with some combination of performance and an index. An assumption of a stated range of volumes may apply, being subject to renegotiation should these conditions be breached.

None of these or other possible models is inherently good or bad. Some of them can suit your needs well, others less so.

The mathematics of pricing a service

A supplier will start by assessing their input costs. Their first objective is to ensure that in no foreseeable circumstance will the service go into loss. In this, they frequently fail. For a project, a bill of materials is prepared together with the project plan. In the early stages, guesses are used. These are later replaced by quotations from suppliers. The project plan will initially be prepared at high evel, the dependencies, resources and durations being progressively explored in greater detail.

The inputs have 101 factors driving their variation. The supplier is critically sensitive to input assumptions such as volumes, your delivery on time, third-party delivery and project dependencies. The wise write the big ones into the contract as obligations, many others will remain unstated and initially unknown. This risk has a price. Risk is frequently mis-priced.

Having established the base case, one hopes that there is a rigorous risk analysis and deal review. The finance department will analyse the cash flow, subject it to scenario analysis and may look at aspects such as taxation and currency. The suppliers, and bid teams within suppliers, vary in their attention to this. Wise senior staff know this and pay attention to the detail in bid review. On occasion some weird behaviours are seen in such reviews. The best account and bid managers know this and pay attention to their own stakeholders in negotiating the bid through internal consideration and accommodating their interests. If they should discover that the Mumbai delivery centre has a hole in its delivery schedule that this bid can fulfil, that may make a material difference to its business case if the timing can be tied down.

Considerations

Most of the considerations below will affect the risk, the pricing level that is acceptable, the pricing model and the terms of the agreement. When a risk becomes apparent during deal formation, the sensible approach is to consider whether it may be eliminated, mitigated, transferred or has to be accommodated. Avoidable residual risk is in nobody`s interest. Much of the art of deal-making is to determine appropriate and creative approaches to risk. Some negotiators really need to get out more. This provides the opportunity for deal-makers to add value:

  1. Assess and model risk. Working through categories such as business (merger/demerger), delivery, volume, currency, competitive can help ensure that due consideration is given.
  2. Transparency.
  3. Competitiveness.
  4. Trends in the business (growth, decline, considerations for divestiture).
  5. Incentives for desired behaviour by the supplier, core buyer and units of the buyer`s organisation.
  6. Early termination and extension.
  7. The costs of obligations (e.g. refreshment of assets).
  8. Flexibility and adaptability; exclusivity.
  9. Access to resources, commitment to use them.
  10. Break-points and levels of commitment.
  11. Simplicity, comprehensiveness and maintainability throughout the term of the agreement.
  12. The combination or separation of services.
  13. Continuity of service, knowledge of your operations.
  14. Retention of knowledge and skill, assets.
  15. The ability to govern, question, hold to account.
  16. Strategic considerations, innovation and new capabilities.

And doubtless others beside.

A well-framed procurement process will start with a top-down definition of what is desired, the ways in which that may be achieved and an assessment of their relative attractiveness. It will go on to engage the potential suppliers, seeing how each would address the issue and select the best. This has a degree of predictability and process. It also has scope for genius to shine through when done well. The great deal makers seem to find a way to break free of suffocating procedures, to the enormous benefit of their organisations. They are not rash in breaking important rules, they just use them well.

Playing a good tune well

The way in which a deal is framed, the price is set and the model formed is of enormous importance in winning over the parties, including your bosses who may not be in the negotiating room. The proposition is thoroughly analysed for risk and opportunity within a reliable process. Mathematics can get you a long way and is an indispensable foundation.

The second critical aspect is the artistry. The true artist knows that a foundation of hard work is essential, but not enough. Talent takes the maths and makes magic of it. Genius transforms the banal to the beautiful. There is no short-cut to this. Whilst the nature of such input is impossible to tie down, one of the activities that the successful seem to adopt is the deliberate adoption of a number of perspectives. Viewing the situation from each of these can provide insight that allows new possibilities to be discovered and magic injected.  Such perspectives may include:

  • Cost down vs Revenue addition
  • Benefits capture vs Risk reduction
  • Technology delivery vs Customer service

This approach is anything but the rigorous application of check-lists. The point is to break free of the checking mentality to see potential anew. Seek the unconventional and challenging. Asking the right questions can slow down the process for long enough for new approaches to be seen. If you are not looking, a competitor may be.

Just as the greatest poets transport the reader to delight, the deal-maker uses art to conjure unimagined value from the maths. That is a great deal.

We are the music-makers,
And we are the dreamers of dreams,
Wandering by lone sea-breakers,
And sitting by desolate streams,
World-losers and world forsakers,
On whom the pale moon gleams,
Yet we are the movers and shakers,
Of the world forever, it seems.

                           – Arthur O`Shaughnessey


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