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Hybrid pricing changes the game for services . . .

For those of you who outsource services, such as Web site design, database design, call centers, etc., as well as those of you who sell services, such as Web site designers, designers, database builders, and so on, the current recession has forced both outsourcing companies and services companies to rethink how they structure their fees. And some are creating a hybrid between “fixed fee” and “per hour” fees, a “hybrid” fee system. About three weeks ago, I put up a pretty thorough and wonderful discussion of hybrid fees and the reasoning behind them. Well, now that we’re putting together a new book in the Shoestring Venture series called “The Pricing Bible,” I’d thought I’d revive that old article and give it more prominent play (since no-one really reads the roundups that I used to write). So when should you opt for a “cost-plus” fee and when does a fixed fee work best? When is a cross between the two the best option?

The standard answer (or, you might say, the “standard deviation” answer) is: risk. Which partner in the relationship is most responsible for the variability that drives up the cost of the relationship? In other words, every service will involve some variance (measured by a statistical function called standard deviation). Who’s the most responsible for that variance? That, it turns out, should govern which is the best pricing model for the relationship. It may not end up being the model chosen — the vendor or the purchaser may have more power in the sale and be able to offload all the risk to the other partner — but pricing relative to the source of risk is the best way to price services. More after the break.

Hybrid pricing was introduced to an American audience in a September 16 article in CIO magazine, “Offshore Outsourcing: Introducing a New, Hybrid Pricing Model.” Money quote:

As IT leaders focus on cutting costs, they continue to put pricing pressure on offshore outsourcers. . . . Bangalore-based IT service provider MindTree is talking up its new “hybrid” pricing for offshore IT services

Say a customer wants to set up an offshore development center to create an e-commerce solution. The client is clear about the twenty features to be included in the first release, but beyond that, can only say that it wants multiple iterations to incorporate enhancements and fixes to the software throughout the year.

MindTree would draw up a deal with a fixed price for the first release and time-and-materials pricing for the remaining work. “Typically, when a fixed-price quote is given for a defined piece of work, the service provider plans the full-time employees for the project lifecycle, ramping up and down according to need,” says Hegde. “In a hybrid model, the service provider plans fractional full-time employees for the fixed-price engagement to meet service level agreements, then the remaining [man-hours] for each role are made available to the client on a time-and-materials basis.”

Many of our readers are shoestring venture entrepreneurs that offer services and the rest will, at some point, be purchasers of such services, even if it’s something as modest as designing and coding a Web site.

I, for instance, started in business working for a marketing and advertising agency and I currently run a marketing services consultancy. So how do services vendors price their services?

There are two pricing models for services vendors: cost-plus (or “time and materials”) and fixed cost. As those who read this blog know, I am an dedicated evangelist for fixed cost models for one simple reason: transparency. Fixed-cost pricing forces both the vendor and the client to manage the relationship with enormous attention and precision. Clients have to get their act together and vendors have to communicate religiously with the client to track changes to the project. In addition, it puts all the risk on the vendor — which is good if you’re the outsourcer. As long as the client sits down and does all the necessary work planning out what needs to be done and manages the relationship with due diligence and effort, most if not all the risk should belong to the vendor.

Cost plus, on the other hand, encourages vendors to increase costs because, well, that increases the plus part. Say you have a contract that pretty much guarantees you a 20% margin. You need to buy a server for your client. If you buy a server for $2,000, your profit will be $400 (you’ll charge the client $2,400). If you buy a server for $10,000, your profit will be $2,000 (you’ll charge the client $12,000 for the server). That’s why Halliburton, which had a cost plus contract with the Bush Administration in the early years of the Iraq War, would buy gasoline at $200 a gallon. Sure, it’s outrageous, but there’s more profit in it, but with a 10% cost-plus contract, Halliburton made $20 for each gallon of gas it bought (as opposed to the $0.50 profit it would make if it purchased gasoline at the price it was selling within Iraq).

On the other hand, vendors shouldn’t have to shoulder any risk due to a client’s ignorance, lack of planning, or indecisiveness. “I want a database but I’m not sure what I want it to do.” With guidelines like this, the vendor will want a cost-plus deal.

In my former agency, we had one VP of Marketing who would make us do literally hundreds of covers for his catalog every year. We’d show him a dozen catalog cover comps and he’d say, “That’s not right. I’m not getting the right feeling.” “Well,” we’d reply, “give us some specifics.” “I can’t give you specifics. I’ll know the cover is right when I see it.” Since we were on a fixed price agreement with them and losing significant moolah on account of these hundreds of comps, the next year, we would estimate the comping cost at this considerably higher price, to reflect the fact that our client didn’t know what he wanted and required hundreds of cover comps. “Why is the comping part of the estimate so high?” “Because last year we had to do almost 300 cover comps for you — photography included.” “Oh, that won’t happen this year.” And he’d threaten, cajole, verbally bombard and bully the estimate down and . . . we’d do several hundred cover comps for him and lose money.

“I’ll know it’s right when I see it.” When a client says those words, the vendor is in trouble.

When done correctly, a pricing model apportions risk to the partner whose ineffiicencies are most responsible for overages and delays. Until hybrid pricing, this risk apportionment was an all-or-nothing affair. Fixed pricing is the best model when the client has their act together (in which case, vendor inefficiencies are the most likely source of overages and delays) and cost plus is the best model when the client does not have their act together (the “I don’t know what I want but I’ll know it when I see it” a**holes — in this case, client inefficiencies are most likely to produce overages and delays). But what happens when one part of the work bears risk because of client inefficiencies (such as photographing and comping out covers because the client has no idea what they want) and other parts of the work bear risk because of vendor inefficiencies (say, typesetting or print management). That’s the genius of a hybrid pricing model.

While CIO magazine largely thinks of hybrid outsourcing pricing as a gimmick, done properly, a hybrid pricing model accurately reflects the source of risk in any outsourcing relationship and directly assigns the potential cost of that risk to the responsible partner. It’s a brilliant idea. If you’re a designer, programmer, or any other service provider — or you’re looking to outsource some of these services — you should take it very seriously.

However, why would you, as a client, want a pricing model where you bear some risk for overages and delays? If you can outsource your work on a fixed price basis, why take responsibility for your inefficiencies? The answer is twofold. First, when asked to cost out a fixed price when you, the client, have not gotten your act together, vendors, if they’re smart, will inflate their costs dramatically. You now shoulder the risk of having the work done efficiently (in which case you overpay) and the vendor shoulders much less risk if the work is not done efficiently (since they’ve estimated the work at such a high price). Even if you get your act together eventually, a high-priced estimate means that you’re shouldering all the risk of the vendor’s inefficiencies.

Second, if the vendor does not provide a high estimate (thus assuming all the risk for your inefficiencies) and agrees to take the work, they may find themselves losing money because of you. As a result, they may show you to the door and throw your work out after you. Adding costly delays and expenses to your work. When the relationship between a client and vendor goes south, both parties end up losing significantly.

Here’s an example of a good hybrid model that I’ve used in the past. A client wants to build a customer database and link that to the Web site and several other databases. They don’t know what they want, they’re inexperienced with databases, and they have little idea of what sorts of uses they can put the information. This is where the database company comes in: they have expertise in customer databases, they’ve built them for other clients, and they’ve seen the uses those databases have been put to. So the database company can provide valuable services in drawing up the specs and requirements for the customer database, but because the client doesn’t know anything about databases and the spec and requirements process may be subject to client disagreements, vacillation, and education, a cost-plus model is best.

Once, however, the specs and requirements have been drawn up, the client can take those specs and requirements to any database vendor and ask for a fixed-cost estimate and choose the most reasonably priced estimate based on the vendor’s expertise and track record — thus offloading all the risk of building the database on to the vendor.

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