Changing the Paradigm: Accelerated Savings through ... · Savings through Innovative Pricing No...

Pillsbury Winthrop Shaw Pittman LLP

Changing the Paradigm: Accelerated Savings through Innovative Pricing

No Better Time for the Right Outsourcing Series

April 28, 2009

1 | No Better Time for the Right Outsourcing

About the Presenters About Pillsbury Global Sourcing

More than US$450 billion in completed transactions

Over 20 years’ experience in structuring and implementing complex delivery arrangements

Over 500 transactions across a premier customer base

The most experienced firm in the business – architecting the largest service delivery projects and strategic alliances

No Better Time

The only sourcing advisory firm offering integrated professional services (legal, sourcing, domain, financial & change management)

Guiding clients through the full sourcing lifecycle

Using straight-through processing for speed-to-value

Deploying a unique visual sourcing technique using ourpatented ValueChain method

John Nicholson is counsel in Pillsbury's Global Sourcing group. In addition to helping clients structure, negotiate and document complex sourcing transactions, he is also a lead member of the firm’s Privacy and Data Protection practice and a member of the Virtual Worlds and Video Games team.

Mike Beasley is a consulting manager in Pillsbury's Global Sourcing group. He has more than 30 years experience in the sourcing industry working from both the customer and supplier perspectives.


Why outsourcing makes sense Now

Reduced Execution risk

Favorable market engagement dynamics

Compelling Business cases

“Better resource management, more products at the same cost, efficient customer service at minimum dollar all continue to make outsourcing a viable and profitable option." New Trends to Watch in 2009: Raising Efficiency with Near-shoring , HRO Today February 2009

“In an effort to make its outsourcing and IT services more affordable in a down economy, Hewlett-Packard Co. is changing its services pricing to a model that's akin to ordering a customized laptop. ” - As Recession Hits IT, HP Tries Variable Pricing on Services, CIO, March 10, 2009.

“It is a good time to look at outsourcing as a means to cut costs, launch new business ventures, and improve efficiencies.” - Top Three Outsourcing Initiatives for 2009, CIO, January 27, 2009.

“The prospect of quick cost savings and improved results lead companies to take a closer look at external solutions.” - Savings Spur Interest in Learning Outsourcing, HRO Today, February 2009.

“Top Indian tech firms such as TCS, Infosys, Wipro, and HCL are signing new outsourcing contracts at 15-20% lower billing rates than last year, as customers including BT, Bank of America and Citibank renegotiate existing contracts and award new projects at much lower rates.” - IT majors sign new deals at a discount, The Economic Times (India), March 6, 2009.

The secret is out . . . . . . No Better Time


Objectives of the pricing process

GoalsDevelop a “fair” priceThat reflects the scope of the transaction andAligns the interests of the parties

Alternative pricing mechanismsMonolithic fixed priceFixed unit ratesCost plusTime and materialsGain-sharing

The help desk example – pricing by:People resourcesNumber of calls

With a capNumber of users


The elements of price

A supplier’s charge consists ofWhat it costs the supplier to provide the service, plusA reasonable profit – a function of risk assumed by the supplier

A supplier’s cost of service consists ofTransition costsDirect operating costs, typically

FacilitiesPeopleHardwareSoftwareThird-party contracts

Indirect costsAllocated overheadsGeneral and administrative expense (G & A)Others

A supplier’s cost depends on the technical / commercial solutionproposed by the supplier


Where do the savings come from in outsourcing?

Who knows!!!A too-common and terrible answerMeans the supplier is buying the business and will be under internal pressures to make up the difference

The usual suspectsMarket knowledgeEconomies of scaleProcesses and procedures – efficiencyLabor “arbitrage”

These do not provide an outsourcing customer with competitive advantage.

TransformationChanging the service paradigm (supply and/or demand)Altering the level of service (not everyone needs the gold standard)Eliminating or minimizing the service (NOT the same as de-scoping to get the price you want)


CostMarking – new look at ITO pricing

Based on the premise that we know or can model the cost of:EquipmentSoftwareMaintenanceFacilitiesEnergy Consumption (direct and indirect)Risk premiums (if any)OverheadMarginThe scope of work – directly from the ValueChain processesLabor (geographically adjusted)

And . . . .That any other unaccounted for moneys should belong to the BUYERIt puts the supplier in a difficult position to explain

By creating a normalized evaluation universe – ValueChain is the enabler


Revised approach

The important rowsThe battle is needlessly waged over the entire pricing modelOnly a few rows really count – classically

Always high Price times Quantity (P*Q) itemsAlmost always high Quantity itemsSometimes high Price items

Practically, in ITO deals that meansSevers (big, middle and small)Storage (JBOD, NAS and SAN)The rest generally is not material

Economic problems cannot be solved by chasing the high Quantity items…The large Price items are where the value is locked

A Quantity exampleTakes forever, requires resources that have other priorities, addresses onlypart of the price pie and not the biggest parts, frequently hard to test, andpotentially poses operational risk associated with migration activities

A Price exampleRequires the stroke of a pen, hired guns are available, no change, no ITresources needed, no operational risk, faster and cheaper (unlocks value)


Where the money goes

Situation:Equipment: Typical Windows 2003 Server

– 2 x 3Ghz Xeon – 8 GB Memory

Quantity: 1000 in Tier III Data CenterOther: Three year hardware warrantySupplier Charge: $1000/month

Shown:Best case: Supplier’s machine running supplier’s software in supplier’s data centerEstimate of supplier’s FTE cost at $100k per year means servers per FTE is 11.62Worst Case: Client’s machine in client’sdata center running client’s softwareServers per FTE is 8.33Productivity should be between 35 and 55 servers per FTE (see next page)An all-in monthly Client Cost should be $556 to $457For 1000 Machines => Savings of $500/month or $6M/year

$42

$8

$50

$100

$83

$717

SoftwareSoftware MaintenanceHardwareSpaceElectricityServices @ 11.62 Servers/FTE

If you accept the price, you have accepted the imputed productivity


What the data shows

Data points are for Windows or Linux on x86 @ $100k/FTE

p.a. loaded Assumes all

costs for servers and facilities are borne by the

client

186 167 152 139 129 120 112 105 99 93 88 84

209

834

556

417

334

278239

0

100

200

300

400

500

600

700

800

900

5 10 15 20 25 30 35 40 45 50 55 60 65 70 75 80 85 90 95 100Imputed Servers per FTE

Supp

liers

Quo

ted

Pric

e pe

r Ser

ver

Full-scope server productivity


Simple example

What’s this for – actual client data example


Recent client examples

Client ABC~ 1000 MIPs, 3000 servers, 25 AS/400s, 150 TB of storage

– estimated new deal at or lower than 50% of current pricingClient DEF

~ 3000 servers, 150 TB of storage– estimated new deal at slightly above 33% of current pricing

Client GHI~ 3000 MIPs, 1500 servers in a very complex environment, 125 TB of storage

– transaction completed at 75% of current pricingSupplier offered < 10% price reduction for renewalWhile transaction was completed with the incumbent, an equally well-pricedback-up deal was also secured

Client JKL~1700 TBs of storage

– we expect results at less then 50% of current– double the benchmarker’s swag

Lesson Learned: Think Radically – Not Incrementally


Price is a function of scope

Scope of an outsourcing relationship should include the broadest set of functions for which:

The customer is comfortable outsourcing; andThere is a valid business case

Bearing in mind that “business case” is frequently the fourth entry after lies, damn lies and statistics

Outsourced functions should give the supplier end-to-end responsibilities

Avoid retaining small pockets of isolated servicesBe aware of attempts to “protect” certain fiefdomsShould never include overall domain architecture, design or strategy

Start thinking of costs in terms of those that will be:OutsourcedRetainedTreated as pass-through


Organizing thoughts – factors of production

1. For each service being outsourced, identify the factors of production (resources) needed to deliver that function

2. In general, services consist of the following five factors of productionFacilitiesPeopleHardwareSoftwareThird-party contracts

Anything that is not a facility, person, hardware or software is a third-party contract

3. The objective is for the supplier to have access to the necessary factors of production for each outsourced service, either because

The customer “transferred” access to that resource, orThe supplier will provide that resource


Organizing thoughts – financial responsibility

4. Supplier should have financial responsibility for those assets that have the following characteristics

Infrastructure in naturePerformance depends on service levels, not type of assetCustomer cares less about the type of assetCosts are measurable by volume-based billing elements (e.g., ARCs/RRCs)

5. Customer should have financial responsibility for those assets that have the following characteristics

Functionality is important to customer and is driven by customer preferencesCosts are not easily measurable by ARCs/RRCsSubject to unknown and swift technological change

6. The same party should have financial responsibility for upgrading existing equipment and for replacing existing equipment

If these responsibilities are divided, supplier’s analysis of what to do in a particular situation might not be based on the relative economics of the two choices, but upon the separate question of who pays for it


Organizing thoughts – fundamentals

7. If financial responsibility is assigned to the supplier, it is necessary to ensure that the related costs are removed entirely from customer’s books

8. The foregoing guidelines may be roughly summarized in one helpful standard

Generally (not always), risk and control should go togetherThat is, the party having financial responsibility for an item also should be able to select the item (possibly subject to certain approval rights of the other party)


Outsourcing charging structures

Classic approachSetting a baseline with key volume indicators

ARCs (additional resource charges)RRCs (reduced resource credits)

Issues to be addressedGuaranteed revenue stream or minimum annual charge (MAC)Establishing the baselineProtected growth and dead-bandsNetting of key volume indicators and ARCs == RRCsSetting the incremental priceAddressing extraordinary growth or extraordinary volume reductions

Revised (better) approachFixed charge plus variable chargefor each unit used

Mathematically equivalent to classic approachBut, the issues are expressed in different, more meaningful terms

BenefitsBetter transparency into what drivesa supplier’s pricePrincipled discussion about level offixed and variable chargesLess likelihood of “subsidization”across towersMeaningful relationship between fixed charges and termination for convenience fee


Variability

Classic approachPricing based on inputsUnit prices based on factors of productionIT examples:

Expressed as computer resource unitsCPU minutes; MIPS; number of servers; gigabytes of storage; lines of print

Applications development & maintenanceFull-time equivalents (FTEs)

BenefitsUnderstandable to domain expertsEasy to implementCan be used to price new services

DisadvantagesDisincentive to be efficientOften requires benchmarkingCharge-back not in business units

Revised (better) approachPricing based on outputsUnit prices expressed as business transactions

Focus on the results produced

BPO examples:Health insurance claims processedInvoices issuedCost savings from procured items

Form of gain-sharing

BenefitsUnderstandable to end usersFacilitates charge-backCreates incentives to be efficient

DisadvantagesDifficult to formulateRequires supplier experience with businessNew services difficult to price


Best Practices – modern deal structure for ITO

Pillsbury best practice for structuring a new IT infrastructure outsourcing relationship

Especially useful in a multi-sourced environment

Separate out capital costs from operating and support charges

Consider having the customer buy all equipment and pay all capital costs

House the hardware with someone other than the outsource supplierConsider a co-location supplier

Evaluate the outsourcing price as the charge for ongoing operations and support, including (if appropriate) for service management and integration


Handling significant changes

The "New Service" concept

Different from, and in addition to

PricingAccording to volume chargesOr, if disproportionate, increase in resources or usageAs mutually agreedPursuant to default price listNet of cost savings


Cost of Living Adjustment (COLA)

Index characteristicsMagnitudeVolatility

US Bureau of Labor Statistics IndicesConsumer Price Index (CPI)Employment Cost Index (ECI)Producer Price Index (PPI)

Global indicesWas a major driver of cost increases

May, again, become a major driver of cost increases

COLA algorithmsDeferralProtectionSharingCaps


Termination fees

Termination fees are for terminations other than “for cause”For convenienceFor change of controlFor other reasons

What does the termination fee cover?Expectancy or lost profitsInvestment costs; so-called stranded costsAs a disincentive to terminate

What is a reasonable termination fee?Suggested “physical” interpretation: to eliminate the fixed fee componentComparison to transition fees, ongoing investment levelsComparison to net present value of remaining revenue stream


Developing the customer base case

Identify the starting point – a so-called “Year 0”Gather the data

Information about the factors of production (facilities, people, hardware, software and third-party contracts)

Resource volumes, andResource costs

Be comprehensive – include all domain costs including those that will be outsourced, retained and treated as a pass-throughValidate the information against the general ledger and other corporate records

Portray the dataDo not confuse operating costs with capital costsDevelop a simplified, consistent approach for grouping costs (row headings)Extend the cost from Year 0 for the proposed term of the agreement

Model flat scenarios versus growing/reducing scenarios

Give the underlying assumptions of the model to the supplierAs much a scope alignment issue as a pricing issue


Supplier pricing proposals

Provide forms that the bidders must use:ValueChain process creates these as an artifact of building the Scope ModelIdentify charges that are assumed, retained and pass-throughClear identification of all billing elementsResource volumes by domain or platform, by year and by billing elementAnnual service charge by domain or platform, by yearSpecify adjustments for increases/decreases in outputs by domain or platform, by year or by billing elementTermination charges by type of termination, by year (specify as of date)

In whole or in partInterpolation for mid-year terminations

Ask for prices that do not involve financial engineering and do not involve cross-subsidization among different domains


Supplier assumptions

Carefully review supplier statement of assumptions. They almost always:

Limit or change scopeImpose restraints or restrictionsContain extra cost itemsAre designed to limit supplier exposure or risk for what is not knownor what is not knowable

Ensure that assumptions are complete and specify the explicit consequence of the assumption not being true

I.e., The pricing assumes a minimum quantity of [x] units per year. If customer orders fewer than this amount, the per unit price will be increased to [y].

Need to eliminate changes based on post-contract due diligence


Evaluate against base case

Start with supplier’s annual charge

Add client retained and pass-through

Add “adjustments” - both positive and negative

Sum is price of outsourcing that should be comparedto in-house base cost model

Perform net present value (NPV) analysisSetting an appropriate discount rate

Share each supplier’s evaluation with that supplier

Objective is to reach a jointly agreed-to supplier price model


Other necessary evaluations

AdjustmentsPersonnel costs

Contract administration, etc.Retention bonus/severance costVariations in personnel taken

Timing of payments (beginning of month, end of month, after 30 days)

Taxes

Cost of living adjustments (COLA)

Contract risk issuesResponsibility for required consents

Scope mismatchBe wary of additional retained costs that are unknown or volatile

Service level mismatch

Sensitivity analysisChanged volumes

Changed economic assumptions (COLA)

Termination scenarios


Benchmarking

Two basic forms of benchmarkingAgainst the marketplace – developing a “commercially competitive” priceAgainst the supplier’s other contracts – a “most favored customer” clause

Benchmarking may be useful, but is not as valuable as assumedSignificant lag before declining prices are reflected in benchmarkers’ databasesHardly any good data for BPO

Absent “action-forcing” clauses, benchmarking is not likely to result in price changesBenchmarking rights often create leverage to renegotiate price

Pillsbury CostMarking provides data for that renegotiation without requiring the benchmarking exercise

Factors to consider in structuring a benchmark provisionWhat can be benchmarked and how oftenWho is an acceptable benchmarkerHow will the benchmark process be defined in the contract

Peer groupsNormalizationReport from the benchmarker

What is to be done with the benchmarkHow are benchmark disputes to be handled


No Better Time for challenging old assumptions

Most experience with outsourcing was developed during different timesCustomers had budget/staff for the projectCustomers could afford initial costsSuppliers were growing

Available staff was a constraintBusiness models reflected growth assumptions

When the environment changes, old rules of thumb need to be reexaminedNo one doubts that today is differentOutsourcing in hard times

All (remaining) client staff are fully employedClients face strong budget pressuresSuppliers are facing hard times, too

Deals are smallerGrowth rates are reduced (or worse)Existing customers want price reductionsBusiness models are being reexamined

Pillsbury offers new sourcing modelBetter, faster, cheaper


Assumptions re-examined

1. Assumption: Outsourcing transactions have high upfront costsHigh upfront costs are the norm (for some transactions)

Transition and transformation takes timeInternal costs of redundancies and other changeExternal advisors’ work is front-loaded

BUT - Some things can change, with prudence – successful suppliers have lots of cash and fewer investment prospects

Supplier often agree to recover transition fees over timeSupplier might agree to reimburse customer for transaction costs and recover costs in fees over timeSupplier might agree to pay/reimburse staff separation costsSupplier might agree to treat some transition work as sales cost


Assumptions re-examined (cont)

2. Assumption: Deals take 6-12 months (or longer) to get to contractOld ways of doing things

RFP, bidding, diligence, selection, contractWith loops in the process for clarification, correction, etc.

BUT - Pillsbury ValueChain approach is much quickerStraight through means touch things onceValueChain makes this go a lot faster

Combination of consultants and lawyers using the same tools and speaking the same language reduces inefficiencyStandard process/element definitions

Many suppliers have already seen and approved Pillsbury’s ITIL-based Process Definitions – eliminates negotiation about the words describing the scope and focuses attention on responsibility forelements of scope

Re-negotiations have an even faster time line



3. Assumption: Outsourcing deals lose money in the first yearTransaction and transition costs associated with lengthy negotiations may eat up first year’s savingsBUT - Transaction costs are lower if the time to agreement is shorter

Pillsbury calls this “Time to Value”Suppliers can agree to different payment schedules

4. Assumption: Competition (always) yields the best dealCompetition, especially in the current economy when there are fewer deals, can drive to better pricingBUT - Competition has costs

Both monetary and intrinsicSole-source speed Wringing out the last percent of savings

Pillsbury’s CostMarking provides a suitable proxy for competition, especially for contract renewals/renegotiationsRenegotiation can be done with market testing as a next step



6. Assumption: Each deal stands on its own for the supplierEach deal is compared to the suppliers’ internal standards profitability and cash flowBUT - Suppliers are facing extraordinary times, and re-working business modelsSome fixed costs become variable in hard timesStrong suppliers will use hard times to capture market share

If savings are coming from buying the business, look outSome suppliers are cash-rich, with fewer investment opportunities


Using pricing to structure manageable relationships

The likelihood that a supplier will undertake a particular action is independent of what the contract says

All parties (including both customer and supplier) always (and only) act in their best interest

Therefore, responsiveness is a function of:Aligning incentivesEstablishing a framework of principlesDeveloping a process to address change

These considerations produce manageable relationships and should guide the parties as they begin to craft the pricing structure

Pricing algorithms can achieve these results if they are:EfficientFlexibleEasy to administerDesigned to minimize the need to renegotiate


Conclusion

Pillsbury’s ValueChain method using CostMarking drives value to both customers and suppliers by:

Speeding up the deal process and decreasing time to value

Providing a uniform methodology for comparing the customer’s business case and supplier pricing proposals

Clearly allocating responsibilities so that both sides understand scope and associated pricing and

Enabling both supplier and customer to build a lasting relationship based on value

No Better Time than now for the right outsourcing


Upcoming Sessions

May 19 IT Outsourcing: Devising a Fast and Sustainable Diet

June 9 Renegotiations: Positioning for the Fast Path to Savings

June 30 Procurement & Real Estate Outsourcing: Short Term Strategy with Long Term Results

July 14 M&A – Business Continuity and Cost Effective Operations through Outsourcing

Pillsbury Winthrop Shaw Pittman LLP

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