Key Elements of a Pricing Model

Pricing IT services involves three dimensions:

• The pricing unit – what do you price by?
• Configuration of the price-demand function – how does the total price change with changes in demand or consumption?
• The third dimension involves answering the question: How often and when is the service provider paid?

Let’s take a closer look at each

The pricing measure – input, output, or outcome: Conventional pricing was based on a unit of input, such as a full time equivalent (FTE) or a managed server, or in some cases, on a unit of output, such as test script executed. In the outcome-based model, pricing usually depends on the extent to which a target value of a metric has been achieved. Contracts involving outcome-based pricing usually have only a fraction of the total fee computed in this manner, and pricing exclusively by outcome is rare. Sometimes output and outcome-based pricing are used interchangeably, partly because “output” is actually “successful output.”

Configuring the price-volume function – fixed, variable and “baseline with adjustments:” Fixed models, where the price remains constant regardless of the actual volume of work, tend to be appropriate when the work volume can be estimated with reasonable accuracy. Variable frameworks often involve the price moving linearly with the pricing unit. Time-and-material is a well-known variable model, where the project price depends on developer effort measured in FTE hours or months. Lastly, the “baseline with adjustments” model comprises estimating a volume and a fixed price for that volume, and creating rate cards for deviations from that estimated volume. This is commonly known as the “resource units with ARC/RRC” (additional resource credits and reduced resource credits) model.

The payment schedule: Payments can be periodic or milestone-based. Milestone payment is common in ERP and other packaged software implementation projects.

A fourth factor to consider is the use of pricing as a lever to shape service provider behavior. The fourth dimension affects every aspect of the other three.

Pricing as a lever for influencing service provider behavior: Pricing should also be viewed as another lever for nudging service provider behavior towards a desired direction (and often, away from a known problematic behavior). The behavior-modifying nature of pricing applies to all other pricing elements, such as the pricing unit of choice. Vendor behavior is influenced by the unit – whether, for example, it’s a full-time-person or a trouble ticket.   Whether the price-demand consumption function is variable or fixed determines whether the service provider builds in risk pricing, and whether the client’s governance team needs to manage demand better or improve negotiations to keep costs low. Therefore, every pricing element should be viewed through the lens of impact on vendor behavior and impact on governance.

Lastly, pricing is of course not the only lever for influencing behavior, and needs to be seen in the context of the entire relationship. The prospect of expanding the project and relationship is often the incentive that works best.