Business Process Services. White Paper. Risk Mitigated Outcome Based Pricing: A Vehicle to Drive Transformation

Transcription

1 Busiess Process Services White Paper Risk Mitigated Outcome Based Pricig: A Vehicle to Drive Trasformatio

2 About the Authors Abhijit Pye Abhijit has over 19 years of experiece ad has worked with cliets across North America, Europe, the UK, ad Lati America. He holds a MBA from IIM Calcutta ad a BTech (Electrical) from Calcutta Uiversity. He also holds a certificate i Cyber Law from the Idia Law Istitute (ILI), New Delhi ad a Postgraduate Diploma i Busiess Law from the WBNUJS, Kolkata. Sourav Gaguly Sourav is a cosultat with eight years of experiece ad has worked with cliets across Lati America, North America, ad the UK. Sourav is a MBA from IIM Luckow ad also holds TCS domai certificatios o 'Health Isurace' ad 'Isurace Operatios'.

3 Abstract The cocept of outcome based pricig is ot ew. There are a umber of examples i various idustries where providers choose to charge their customers ot for products or services delivered, but based o how well they meet the expected outcomes. A example is Rolls- Royce's 'Power by the Hour', where a customer pays for the replacemet of egies accordig to the umber of hours the egies have bee i use before dow-time, rather tha payig [1] oly for the replacemets of parts, cosumables, ad related labor charges. This cocept ca also be applied equally effectively to BPS egagemets for busiess trasformatio. Such egagemets typically drive fudametal chages i a orgaizatio through the use of techology, resultig i toplie growth ad/or bottom lie improvemet. However, give the depth ad breadth of such egagemets, they are subject to risk. Correlatig the pricig of such a egagemet with the results of the program or solutio ca therefore greatly ease a cliet's cocers. This model of sharig gais is very attractive to the provider as well. Typically, eve at the ed of a large, complex trasformatioal program, a BPS provider stads to gai oly a fixed professioal fee, based o time ad material or resources utilized. A outcome based pricig model is thus a wi-wi for both parties. This paper discusses the busiess drivers for usig outcome based pricig i critical BPS egagemets. It draws up a model of pricig usig aspects of outcome based pricig ad 'optio' pricig to give providers a competitive edge. We have termed the ew pricig mechaism - Risk Mitigated Outcome Based Pricig. The paper discusses how the proposed model ca be used to price 'trasformatioal' cotracts, lists various scearios where it ca be leveraged, ad cocludes with a discussio of factors critical to the success of such a pricig egagemet. [1] Rolls-Royce plc, 'Rolls-Royce celebrates 50th aiversary of Power-by-the-Hour', October 2012, accessed May 2013,

4 Cotets Itroductio 5 Risk Mitigated Outcome Based Pricig Model i the Cotext of BPS 5 Pricig Trasformatioal Cotracts Usig Risk Mitigated Outcome Based Pricig 6 What to Watch Out for: Factors critical to the success of Risk Mitigated Outcome Based Pricig 8 Coclusio 9

5 Itroductio As IT ad BPS providers move up the value chai, busiesses are icreasigly cosiderig them as strategic parters i large trasformatio programs. Such programs aim to achieve the desired busiess outcomes of the customer orgaizatio with miimal risk ad cost implicatios. Orgaizatios are deeply impacted by the success or failure of their IT projects. For a trasformatioal IT program, the level of risk is proportioate to its expected impact. As the global ecoomy recovers, plas for reewed IT ivestmets are beig draw up by CIOs. At the same time, learig from past failures of large IT programs is likely to make them more cautious towards large ivestmets. While parterig with cliets o trasformatioal programs provides several advatages to service providers, it is importat for them to mitigate their share of risks ad costs. A outcome based pricig egagemet is more likely to ease a CIO's decisio to ivest, ad assure BPS providers that their efforts will be rewarded proportioately, resultig i a wi-wi for both. While egagig a service provider to deliver a trasformatio program, there are two optios for pricig the service: Traditioal Fixed Price (FP) or Time ad Material (T&M) billig that icludes a pre-defied margi over the actual cost icurred i deliverig the service. I this case, the cost is i proportio to the umber of provider persoel egaged i deliverig the service ad the duratio of the egagemet. Outcome based pricig usually ivolves billig that is similar to FP or T&M billig, with a added clause that the provider shares both the results ad the risks with the cliet. Sharig gais ca be through a predetermied bous or a direct share i the beefits of the project. I case the busiess outcomes are ot realized, the provider usually does ot pay a pealty. BPS providers ofte avoid such cotracts because of the greater risks ivolved, especially i large trasformatio programs. I additio to these models, we propose a way to create a third optio for billig, which mitigates the risk for service providers, provides them with a mechaism to acquire a share i the gais of a successful program, ad creates the possibility of geeratig reveues beyod traditioal cotract pricig. The cliet o the other had ca pass o some of the loss to the provider i the evet of a failure. This proposed pricig mechaism is based o cocepts used i fiacial optios pricig ad cotract law. We have termed this pricig mechaism 'Risk Mitigated Outcome Based Pricig'. Risk Mitigated Outcome Based Pricig Model i the Cotext of BPS Our model is similar to a 'call optio' for fiacial istrumets. A call optio gives the buyer the right (ot the obligatio) to buy a stock or ay other istrumet at a specific price withi or at a specific time. This specific price is called the 'optio exercise price' or 'strike price' (X). There is a cost (C) that a optio buyer (i this case the provider) has to pay to buy the optio. If the actual spot price of the istrumet durig the exercisig of the call optio is 'Sp', the the pay-off ca be expressed as show i Figure 1. The figure also shows how the attributes of the call optio ca be mapped to a risk mitigated outcome based pricig cotract. 5

6 Pay-Off- Call Optio Pay-Off = Max (Sp-X, 0) -C Risk Mitigated Outcome Based Pricig Call Optio Attribute Equivalet i Proposed Pricig Model -C X Spot price (Sp) Optio buyer Optio writer (seller) BPS Provider Customer for whom BPS provider is providig service Sceario Pay-off for optio buyer Remarks Sp > X Sp-X-C Buyer will ivoke the optio. Pay-off is positive after settig off the optio price C. Higher the Sp, higher the pay off. Sp = X -C Buyer caot ivoke the optio. Pay-off is zero ad buyer loses the price paid for the optio Sp < X -C Buyer will ot ivoke the optio. Pay-off is zero ad buyer loses the price paid for the optio. Strike price (X) Spot price (Sp) Cost of buyig the optio (C) Outcome of program - reveue icrease, cost reductio or icrease i profit estimated. E.g. customer reveue is estimated to icrease by 5% from curret level after completio of program at the ed of two years. It must relate to some absolute dollar figure Actual umber (reveue, cost or profit) o completio of trasformatio program Price that a provider is willig to pay for a share of the gai ad ot a share of the pai of customer. It eeds to be set-off from the provider fee to sweete the deal for the customer Pricig Trasformatioal Cotracts Usig Risk Mitigated Outcome Based Pricig To explai the pricig structure usig the proposed model, cosider two importat outcomes, 'program success' ad 'busiess success'. Program success is measured i terms of quality, timeliess, ad acceptace of service delivery by the cliet. Busiess success is measured i terms of reveue, cost, profit, ad productivity, as well as the favorable impact of the program. The pay-off is positive whe both program ad busiess success are achieved. Otherwise the service provider will have to absorb the cost of 'C'. This implies that the cost 'C' of this optio, to share i the beefits but ot the risks of the cliet, plays a key role i the pricig. Service providers ca gai a competitive advatage by sharig the cliet's risk as well, while usig risk mitigated outcome based pricig. Let's assume that: Figure : Pay-off i a call optio ad equivalet attributes of a risk mitigated outcome based pricig cotract A service provider is expectig a reveue of $ Z millio from this trasformatio program from a two years fixed price cotract. Uder ormal circumstaces the provider would bid for the cotract with Z. However, sice the cliet is lookig for outcome based pricig, the vedor will build i a additioal margi (say ) to mitigate the risk of failure. So the provider is likely to bid at $Z millio +. 6

7 The competitors of this service provider use the same operatig model ad equivalet cost structure, ad hece will submit competitive bids. I this situatio the provider ca use the proposed model to gai a pricig advatage, mitigate risk, ad esure profits from the success of the trasformatio program. Here are the guidelies to compute the pricig i a risk mitigated outcome based pricig model: Reduce the ormal price to [Z + - C]. This will esure that the price is more competitive. Secure a call optio cotract o busiess success locked at the strike price X. This is a better deal for the cliet sice the service provider is offerig a discout of C ad also, i a way, creatig cotiget iterest i the success of the program. Sice this is the equivalet of a call optio, the dowside for the service provider is restricted to oly a loss of C. These cosideratios ca create a wi-wi situatio for the provider ad the customer. It ow becomes critical to aswer the questio: 'How do we estimate C?' Estimatig 'C': Arrivig at the cost of buyig the optio [2] There are various prove fiacial models to evaluate a optio premium (such as the Black Scholes model ). However, these models are for fiacial market istrumets, where it is assumed that the price of heavily traded assets follows a geometric Browia motio with costat drift ad volatility. The busiess success parameters (except for the stock price of a listed compay) of a firm does ot satisfy these criteria. Therefore, we have modified this approach to calculate the optio price. The actual reveue icrease depeds o various critical success factors (CSF) such as the global ecoomic eviromet, idustry coditios, busiess dyamics, ad emergece of ew competitors. Iteral factors such as chages i the maagemet of a orgaizatio ca also affect the success of the trasformatio project. Ay estimatio of 'C' must take ito accout all such iformatio. Reveue ca be projected usig the statistical techique of 'Expected Value Pay' (EVP) assumig discrete probability distributio. This simply meas assigig a probability to aticipated outcomes. The pricig expert must have a soud uderstadig of the ecoomy, the idustry, ad the cliet's busiess, ad should be able to take a positio o each aticipated outcome. The ratioale for assigmet of probability for all levels of CSF should be documeted. Oce the EVP is estimated, the pricig expert has a reasoable estimate of 'C'. The expert's positio o the pricig ca be iterpreted as follows: Proposed C <= EVP calculated Coservative ad risk averse pricig: The pricig expert believes that the future is ucertai ad reasoable predictio is difficult Proposed C > EVP calculated Aggressive ad risky pricig: The pricig expert believes that the future ca be predicted with reasoable accuracy The price equatio of a trasformatio uder risk mitigated outcome based pricig ow is: Price = Z + - C [2] Developed by Fischer Black ad Myro Scholes i their paper- The Pricig of Optios ad Corporate Liabilities, first published i 1973 i the Joural of Political Ecoomy. 7

8 While, the fial reveue of the provider i risk mitigated outcome based pricig ca be modeled as: Reveue = Z + - C + R shared Where: Z = Regular price the provider would charge i a FP or T&M model = Premium charged by the provider for acceptig the risk of outcome based pricig C = Discout (equivalet to the cost of the call optio) give to the cliet for eterig ito a risk mitigated outcome based pricig cotract R shared = Part of the shared reveue of the cliet or bous from fial outcome (where R shared >= 0) What to watch for: Factors critical to the success of Risk Mitigated Outcome Based Pricig Profitable retur from risk mitigated outcome based pricig depeds primarily o the extet of busiess impact that the outcome produces. For istace, i the example discussed previously, the greater the icrease i cliet reveues, the larger the share of the provider. However, sice the fial outcome ofte depeds upo factors that caot be cotrolled by the service provider, there is sigificat risk ivolved. It is also ecessary to quatify the fial outcome i moetary terms that ca be ivoiced. To do this, the provider ad the cliet must agree upo metrics that ca be easily measured. It is therefore importat ad easier to defie the fial outcome i terms of busiess metrics such as operatig cost ad reveue to esure the successful applicatio of outcome based pricig (icludig the proposed risk mitigated model). Needless to say, such iitiatives always require a high level of trust i the cliet ad buy-i from seior leadership of the cliet orgaizatio. There are other factors that play a key role i the success of a risk mitigated outcome based pricig egagemet. The fial outcome of the egagemet may deped o exteral factors such as major market upheavals or exteuatig atural evets, which are beyod the cotrol of both parties. Such factors eed to be idetified ad addressed durig egotiatios uder a 'force majeure' clause. Other factors iclude: Goverig law of the cotract: For global orgaizatios that fuctio across multiple atioal jurisdictios, the impact o busiess metrics may have a global spread. I such situatios, it is critical to choose the correct goverig laws (or cotract laws), ad esure proper legal jurisdictio ad compliace. Legal teams of both parties should carefully review all such cotracts. Dispute resolutio: The cotract must also outlie dispute resolutio mechaisms, i additio to the recourse available uder the ormal court of law. This ca be a simple mechaism like settig up a joit committee of experts from both parties, or the iclusio of a formal clause for arbitratio. 8

9 Coclusio Orgaizatios today look for strategic parters i their trasformative jourey. BPS providers o the other had, are seekig opportuities to add greater value to their customers ad trasitio ito the role of 'true parters'. Risk mitigated outcome based pricig cotracts ca esure a true wi-wi situatio for cliets ad providers. O the oe had, customers get a upfrot discout ad are assured of the provider's best effort i executio. O the other, service providers realize greater reveue ad reduce the risk of pealty i parterig with cliets i large trasformatio programs. 'Risk mitigated' outcome based pricig ca help providers move beyod fixed price FP or T&M billig to a model where billig is proportioate to the effort ad complexity ivolved, as well as to the impact made o the customer's busiess. This model also miimizes the associated risks for both parties. Havig a clear uderstadig about where ad how the proposed pricig model ca be applied ca ot oly help service providers realize greater value from such cotracts, but also imbue cliets with a greater degree of certaity about meetig their busiess objectives. Eve though BPS providers are movig up the value chai, there are curretly oly a few istaces of outcome based pricig, as settig up this pricig model has its share of challeges. It requires the provider to predict future idustry ad busiess scearios, project reveues accurately, coduct careful egotiatios with the cliet, ad make itelliget calculatios. However, it also brigs immese advatages to both providers as well as their cliets. Risk mitigated outcome based pricig provides the opportuity for differetiatio that is ecessary for growth i a ear commoditized market. As cliets icreasigly cosider their BPS providers as strategic parters, services providers should actively look to usig outcome based pricig as a effective tool for co-creatio of value with the cliet while miimizig risk. 9

10 About TCS Busiess Process Services Uit Eterprises seek to drive busiess growth ad agility through iovatio i a icreasigly regulated, competitive, ad global market. TCS helps cliets achieve these goals by maagig ad executig their busiess operatios effectively ad efficietly. TCS Busiess Process Services (BPS) iclude core idustry-specific processes, aalytics ad isights, ad eterprise services such as fiace ad accoutig, HR, ad supply chai maagemet. TM TCS creates value through its FORE simplificatio ad trasformatio methodology, backed by its TM deep domai expertise, extesive techology experiece, ad TRAPEZE goverace eablers ad solutios. TCS complemets its experiece ad expertise with iovative delivery models such as usig robotic automatio ad by providig Busiess Processes as a Service (BPaaS). TCS BPS uit has bee positioed i the leaders' quadrat for various service lies by may leadig aalyst firms. With over four decades of global experiece ad a delivery footprit spaig six cotiets, TCS is oe of the largest BPS providers today. Cotact For more iformatio about TCS Busiess Process Services, cotact bps.coect@tcs.com Subscribe to TCS White Papers TCS.com RSS: Feedburer: About Tata Cosultacy Services (TCS) Tata Cosultacy Services is a IT services, cosultig ad busiess solutios orgaizatio that delivers real results to global busiess, esurig a level of certaity o other firm ca match. TCS offers a cosultig-led, itegrated portfolio of IT ad IT-eabled ifrastructure, egieerig ad TM assurace services. This is delivered through its uique Global Network Delivery Model, recogized as the bechmark of excellece i software developmet. A part of the Tata Group, Idia s largest idustrial coglomerate, TCS has a global footprit ad is listed o the Natioal Stock Exchage ad Bombay Stock Exchage i Idia. For more iformatio, visit us at IT Services Busiess Solutios Cosultig All cotet / iformatio preset here is the exclusive property of Tata Cosultacy Services Limited (TCS). The cotet / iformatio cotaied here is correct at the time of publishig. No material from here may be copied, modified, reproduced, republished, uploaded, trasmitted, posted or distributed i ay form without prior writte permissio from TCS. Uauthorized use of the cotet / iformatio appearig here may violate copyright, trademark ad other applicable laws, ad could result i crimial or civil pealties. Copyright 2014 Tata Cosultacy Services Limited TCS Desig Services I M I 10 I 14