GLOBAL GUIDE 2017

Analysis
OUTSOURCING

Pricing models in outsourcing agreements:

alternatives, adjustments and the need for
transparency
Ole Horsfeldt
Gorrissen Federspiel
global.practicallaw.com/w-010-9726

INTRODUCTION PHASE I: TRANSITION AND TRANSFORMATION

Most outsourcing strategies are carried out with the goal of reducing In most cases, a fixed pricing model is used during the transition and
costs and increasing the focus on the company's core business. In a transformation period. This is because the customer's requirements
world where reducing costs is king, transparency and insight into the are predictable, making it possible to qualify such needs and agree
customer's true price and cost savings can be crucial for outsourced on a fixed price.
businesses. However, complexity in outsourcing deals and the
customer's changing needs over time can often make transparency The benefits of a fixed-price model are that the customer can achieve a
and predictability difficult to fully achieve. high amount of predictability in relation to what his costs and savings will
be for the transition and transformation. During this period, payment is
This article describes the most common pricing models used during made in accordance with agreed milestones, and a considerable amount
the different phases of an outsourcing agreement. This article also of the total charges is often tied to the last milestone. This incentivises the
provides an explanation of: service provider to allocate sufficient resources to ensuring the agreed
deadlines are met, as the service provider will not receive payment until
• Alternative incentive-based pricing models.
then, especially with regard to the last milestone that marks the end of
• The importance of transparency in pricing models. the transition and transformation stage.
• The adjustment of prices during the term of the agreement
While providing the customer with a low financial risk, the service
through benchmarking and indexation.
provider takes on a considerable risk that the service provider's
estimated allocated resources will fulfil the customer's needs during
In an outsourcing agreement, the pricing models will vary depending
the term. Any cost overruns will have to be absorbed by the service
on the particular phase of the outsourcing. Generally, the different
provider and, as there is a high degree of uncertainty for service
phases can be classified as:
providers in fixed price model, service providers often add a risk buffer
• Phase I: transition and transformation. During the first phase of an to the estimate. In addition, if the fixed price turns out to be higher than
outsourcing agreement, known as “the transition and transformation the actual costs, the customer will miss out on such cost under-runs.
period”, the transition and transformation services are usually priced Consequently, although the fixed price model gives the customer a high
on the basis of either a fixed price or fixed price per system or per full degree of predictability, for the customer it is worth seeking a high level
time employee (in a business process outsourcing (BPO)). of transparency, so that it can see exactly what it is paying for when
the service provider is carrying out the transition and transformation.
• Phase II: takeover of management or performance of services.
When the service provider has taken over the management or
performance of the services, most services will be priced and PHASE II: MANAGEMENT OF ONGOING OPERATIONS
charged on a consumption-based price x quantity (P x Q) model,
Once the transition and transformation period is complete, the service
ensuring transparency and flexibility. If the customer's needs
provider will take over the management of the customer's operation of the
change, or changes to the existing services or new services are
transitioned services. Today, the most common (and most recommended)
necessary, the implementation of the charges will be priced on
charging model for the management of ongoing operations is a P x Q
either a time-and-material model or a fixed price, with the future
model based on consumption-based charges. This model is, among
running services after implementation priced on the basis of
other things, a reaction to customers' increasing need for scalability
consumption at the current price or at new prices per charging
and transparency. With the increased demand for cloud services,
unit (often called a “resource unit”).
consumption-based pricing has become ever more popular. Use of the
• Phase III: termination of services. When the agreement comes “black-box” pricing model, where customers would have a total fixed
to an end, either due to the expiry of the contract term or because price for all services or per service tower, is now outdated and rarely used.
the agreement was terminated, the service provider's re-transfer
services (at times called “termination assistance”) will be priced The customer's requirement for flexibility in accommodating business
based on a time-and-material model or a fixed price, depending changes (due to acquisitions, divestments or the general market
on whether the scope of services can be described concisely. climate) can be catered for by using a consumption-based pricing
model. With this model, charging is based on defined “resource units”.
Each of the above pricing models will be considered in turn below. However, unfortunately there are no common practices for defining
such resource units (and therefore, the same resource unit may contain
different service elements from agreement to agreement).

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Analysis

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The use of P x Q will require a substantial amount of effort in the short sets out the expected consumption and additional or less consumption,
term to establish the baselines, how these are to be calculated, and that will result in either extra charges or credit). It is common to fix
which resource units will be used. an ARC and RRC threshold where the unit charge for additional or
less consumed resource units within such band in a charging period
The price for a certain resource unit is just a pricing metric used for remains the same. If the consumption exceeds the agreed ARC or RRC
counting how many resource units should be charged. Occasionally, threshold, no unit price will have been fixed and will have to be agreed.
disputes can arise because the supplier contends that a unit price Therefore, the practical consequences will often be that the ARC rate
describes what will be delivered in the sense that any other service of the highest ARC band will be used, or if consumption is below the
will be separately payable. The drafting of pricing schedules should RRC band, the charges will often be invoiced as if the consumption
therefore make it clear that: was at the lower limit of the RRC band.
• Resources units are merely there for counting purposes.
Customers should be aware that the practical consequences of the
• The services as such are set out in a separate statement of work, RRC model is that effectively there will be a minimum commitment,
service catalogue, or other appropriate document. although this is not clearly expressed in the contract.

Consumption-based charges are generally invoiced on the basis of a A consumption-based pricing model can both be based on a simple P x Q
standard additional resource charge (ARC) and reduced resource credit model, but can also be extremely complex. The more complex the model
(RRC) methodology (that is, the parties establishing a baseline that gets, the less transparent the price and costs savings will often become.

Example of the ARC/RRC model with an ARC/RRC band. Consumption above the ceiling requires a change order and often the floor
(depending on agreed terms) will constitute an indirect minimum commitment.

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Consumption-based pricing models may also include an express Two other important principles that should be considered when drafting
minimum commitment by the customer. When such a commitment the outsourcing agreement are that:
is agreed, it will necessitate complex provisions in relation to:
• All resources necessary should be provided by the service
• What purchases of services and products will count against the provider.
commitment.
• No further investments by the customer should be needed.
• The consequences of not achieving the spend commitment.
The agreement should expressly state that the service provider will
New services outside scope of agreement be financially and operationally responsible for providing the assets
The terms of an outsourcing agreement often run over a period of years and resources (including upgrades and updates, improvements and
during which the customer's needs may change. In most outsourcing replacements, necessary to provide the services) unless otherwise
arrangements there will be a need to either: agreed. Furthermore, the service provider should also warrant that there
will be no need for further upgrades or investments by the customer
• Amend the existing services. other than those expressly agreed to enable the use of the services.
• Order new services which were not foreseen at the beginning of This warranty is to protect the customer against having to bear the
the contract and which were outside the original scope of the costs of unexpected future upgrades or investments that were not
agreement. calculated into the customer's business case.

Therefore, it is important to have agreed appropriate pricing principles In addition to the normal pricing schedules in an outsourcing agreement,
that establish some predictability and protection against a supplier's it is often beneficial to include a financial responsibility matrix that
monopoly-based pricing. sets out which party will have cost ownership in circumstances where
it is not necessarily about the cost of a service (for example, hardware
Ensuring pricing model is exhaustive costs, software costs, facility costs and so on). A detailed financial
responsibility matrix that identifies the costs owner combined with
When drafting the outsourcing agreement, the customer should ensure
a contractual protection against unexpected costs related to assets,
the price model is exhaustive: committing the service provider to the
resources and investments will increase transparency, provide
full envisaged scope without having to face additional charges.
the customer with a better handle on his/her true costs and avoid
In an outsourcing agreement, most service providers will calculate unexpected investment costs during the term of the agreement.
additional up-sale of further services at an extra 15% to 20% of the
Time-and-material model or fixed-price model?
contract's value. The issue for customers is that the price for such
additional services is agreed when the outsourcing agreement has Changes, new services and projects in outsourcing agreements are
already been signed and the service provider will in practice be the usually priced on either a time-and-material model or a fixed-price
sole service provider. Furthermore, customers experience that they model. However, during the term of the agreement, the parties will
are met with an argument that a specific service (which the customer often agree to a number of low risk and predictable standard changes,
expected to be a part of the agreement) is not part of the initial pricing which are relatively common. As the associated costs for standard
and will need to be paid for separately. changes are predictable, a standard fixed-price basis is usually agreed.
This methodology is used when the parties know there will be a need
To limit the risk of the customer being required to pay additional charges for a particular service but cannot easily predict the volumes required.
to those originally included in the customer's business case, most
outsourcing agreements contain protection for the customer against With a time and material model, the customer pays only for time and
the service provider charging for services that were not specifically set resources spent on the change, new service or project. The hourly prices
out in a service catalogue, but which are: for the resources are agreed during the negotiation of the agreement
and are set out in rate cards in the outsourcing agreement's pricing
• An inherent, interdependent, necessary or customary part of the schedules. This pricing model allows for great flexibility and scalability,
service delivery. as the customer will be able to decide where and how resources are
• Required for proper performance or provision of the services in to be allocated.
accordance with the agreement.
The parties may agree rates based on overall educational levels, skillset
This type of provision is called a “scope sweep clause”. and experience, or they can agree to a blended rate. If a blended rate is
chosen, it is important for the customer to be aware of how resources
There is also a trend for customers to add further protection by adding are allocated to the project, to ensure that the resources have the
a clear definition of a “new service” or “change” requiring a new necessary skillset to carry out the project successfully.
service that is not specifically described in the service catalogue of
the agreement to only be separately payable if both: The supplier's estimates under a time-and-material model are usually
non-binding (and so the customer must pay for any cost overruns unless
• It is materially different to the existing services. they are clearly unreasonable). Outsourcing agreements generally seek
• It requires significantly different levels of costs or effort. to address this by imposing a duty to report cost overrun, only allowing
payment if the overrun could not have reasonably been foreseen.
However, even if such protection clauses are agreed, a clear and precise Furthermore, the customer can also choose to stop the work instead
service description is key to avoiding disagreements over what is within of paying for the cost overrun.
and outside the agreed scope.

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A time-and-material model will often require significant transparency ALTERNATIVES: INCENTIVE-BASED AND RISK/
from the supplier. From a customer perspective, it can be difficult to REWARD MODELS
predict the total cost of the services based on time-and-material and
the customer will run the risk of being in the position of either having The pricing models referred to above are the most common models
to pay more than first anticipated or stopping the work altogether. in outsourcing agreements. However, for certain services in the
outsourcing agreement, other alternative price models may be
It is recommended that the agreement stipulates that the service provider considered.
in each case will be required to make two different price offers for the
change, new service or project based on the either a time and material Some outsourcing agreements also contain incentive-based pricing
estimate or a fixed price quote. It is then up to the customer to choose models that generally focus on the outcome of the services rather
which price offer to accept. This provides the customer with the opportunity than the input. These models include, for example:
to choose whether he/she prefers to take on the risk of cost overruns • Bonus model. This is where the service provider has the
instead of having to pay a premium for the supplier to take on such risk. possibility of earning a bonus for achieving some pre-agreed
performance criteria that is beyond the agreed service level
PHASE III: TERMINATION OF SERVICES agreements (early completion, obtaining better service
levels than agreed and so on). This model is usually used in
An outsourcing agreement will end due to either expiry of the agreed conjunction with the more traditional price models such as fixed
term or early termination, either for convenience or for cause. price, time and material and so on. In some situations, the bonus
incentive model can serve as an incentive for the service provider
If the agreement is terminated for convenience by the customer, the if the bonus can realistically be achieved and is of a substantial
customer will often be obligated to pay certain agreed fixed termination
nature. However, this model is only useful for the customer if
charges. The termination charges should reflect the service provider's
clear business benefits can be gained as a result of the service
undepreciated sunk costs (its investments) and costs for reallocation
of resources, but not compensation for loss of revenue. In a BPO and provider achieving the performance criteria, which is not always
application development and maintenance outsourcing agreement, the case.
the market practice is to have little or no compensation for loss of
• Risk/reward model. This is where the service provider is
future revenues. In infrastructure outsourcing, market practice usually
encouraged to develop new ideas to improve the customer's
dictates compensation of up to 5% of the remaining contract value (in
addition to compensation for agreed undepreciated asset investments). business by sharing the financial risk between the parties. The
Consequently, termination charges should also decrease as the service charges payable to the service provider will be dependent on a
provider's initial investments are depreciated and the potential revenue measurable increase in value or efficiency. The benefit of such
for the remaining term are less than at the beginning of the contract. a model is that both the customer and the service provider will
have a shared incentive, whereas with traditional pricing models
Regardless of how the outsourcing agreement comes to an end, the there will be opposing incentives for each party to reduce risk
service provider will be needed to carry out re-transfer of services. The and costs on each side. However, the disadvantages of this
re-transfer of services ensures that either: model is that it can be difficult to measure whether an increase
• The customer can take back the management of the operations in value or efficiency has happened and whether such increase is
of the services. due to the service provider's efforts or other circumstances.
• The customer can outsource the management to another service • Gain-sharing. This model is based on an incentive mechanism
provider. where the customer and the service provider share the savings
or revenue realised by a party. There are many different versions
As with changes during the term of the agreement, re-transfer of of the gain-sharing model. However, they will often stipulate
services is usually priced on either a time-and-material model or
that the service provider's fee is determined based on reached
a fixed-price model. Consequently, the same advantages and risks
as described above will apply when the services are re-transferred cost savings by the customer against a pre-defined baseline. The
(see above, Time-and-material model or fixed-price model?). It is also benefits of a gain-sharing model is that the service provider is
recommended that it be up to customer to choose between either a incentivised to focus on the customer's cost savings or revenue
price based on time and material or a fixed price. realisation, thereby aligning a common interest and reduce the
risk for customer that the payment of fees in an outsourcing
Although some re-transfer services are separately payable, most agreement are wasted. The disadvantage of gain-sharing can
outsourcing agreements contain provisions setting out that certain be that, in some cases, the service provider can achieve an
re-transfer services are an imbedded part of the ongoing charges for run unexpected and unpredictable bonus due to causes beyond his
services and are therefore not separately payable. This typically includes: control that affects the costs. Therefore, in order for gain-sharing
to succeed, a high level of governance and trust is needed.
• The service provider's continued performance of the services
during the re-transfer of services.
• The service provider's drafting and maintenance of a re-transfer THE IMPORTANCE OF TRANSPARENCY
management plan, describing how the service provider will When choosing a pricing model, it is important for the model to be clear
deliver the re-transfer services.
and transparent and to provide consideration of who is to bear the risk
• The service provider's assistance when transferring to a potential of unexpected extra costs. The higher the transparency in the pricing
replacement service provider. model, the easier it is for the customer to protect his business case.

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Pricing models can in many cases be overly complex and services can To provide some protection to customers against prices that are not
be bundled together in service towers in an arbitrary way, entailing a competitive, benchmarking is used to ensure that the supplier is
low level of cost transparency. One may take the approach that if the delivering to prices that correlate with market standards. In other types
customer receives cost savings, the customer should not be that interested of contracts, this is often solved by the fact that the customer can instead
in the costs of the services. However, cost transparency is of increasing decide to buy the same service or goods from another supplier at a
importance for customers who want to know what costs and cost drivers lie better price or quality. However, in long-term outsourcing agreements
behind the different services, in order to make a more informed decision on customers cannot terminate an outsourcing agreement without having to
how to structure an outsourcing arrangement (for example, a low financial pay a termination fee and it will often require a considerable amount of
risk may be important to the customer, but not if the risk management resources to transfer the services from one supplier to another. Changing
comes at a hefty premium). A low level of transparency can entail several supplier will effectively be so costly that for many customers it will not
issues and there are many reasons why customers should push for more be worth changing supplier even if the price for the services does not
transparency in the outsourcing arrangement, for example: follow market standard. Therefore, benchmarking is intended to protect
against the worst effects of the practical or financial lock-in.
• Demand management is not possible with a low level of
transparency, as the customer cannot correctly identify the
If the outsourcing agreement provides the customer with a right to
impact on prices if he/she changes his usage.
have benchmarking performed, the agreement will also often contain
• The less transparent the pricing is, the more difficult it is to perform provisions regulating how often benchmarking can take place during
benchmarking and establish a baseline for renegotiation of prices. the term of the agreement. As a general rule, in most contracts
benchmarking can be called upon once each year after a limited initial
• When prices are not related to actual costs, the service provider
grace period of up to 12 months.
will have the option of cross-subsidising the different services,
which entails less incentive for the service provider to be cost- The consequences of benchmarking are usually that either:
effective when providing the services.
• The prices are automatically adjusted to be in line with the
The old black-box price model (see above, Management of ongoing benchmarking results.
operations) has therefore been replaced with a trend towards increased • The parties must agree on a new price.
focus on transparency and prices based on real costs. Often the outsourcing
agreement will provide for separate prices relating to purchase of operating Only the former works well from a customer perspective and so-called
assets and prices for provisioning the services, enabling the customer to “auto-adjustment” has become international market practice. If automatic
decide on whether to purchase the assets himself or buy them directly adjustment is agreed, most outsourcing agreements will impose an
from the service provider. Also, to further increase transparency, service obligation to adjust on a unit price or service tower basis in accordance
elements are structured down into unit prices, and a logical connection with cheapest prices of the peer group. In addition, a deadband will often
between the price model and the service provider's real costs with regard apply (typically 3% to 5%), where no adjustments will take place if the peer
to fixed and variable charges should be established. An increased pricing group's prices is within the deadband. In some outsourcing agreements,
transparency that breaks down services in a service catalogue also enables a cap will be agreed whereby the service provider cannot be forced to
the ability to terminate certain services for convenience, or choose new automatically adjust prices exceeding the cap. If the parties must agree
services with a fixed price during the term, allowing for greater flexibility. on price adjustments, then often the outsourcing agreement will include
a termination right if no agreement can be reached. In most outsourcing
ADJUSTMENTS TO PRICING agreements, the benchmarking cannot lead to a price increase.

Benchmarking However, although most outsourcing agreements contain benchmarking

Outsourcing agreements are entered into as long-term agreements rights, benchmarking is rarely carried out. Often, benchmarking rights
over a number of years and often with fixed termination charges if the will instead be used as a negotiation tool and benchmarking provisions
customer wishes to terminate the agreement for convenience. One of (including automatic adjustments) will largely improve the customers'
the great challenges when entering into an outsourcing agreement is negotiation power when it comes to negotiating lower prices with the
ensuring that the contract will continue to provide value for money or service provider.
the agreed prices will remain competitive. If not, the customer risks its
operating cost structure not being as competitive as its competitors. Indexation
Similar to the customer's needs for benchmarking during a long-
Outsourcing contracts exist as a fixed frame while the technology and term outsourcing agreement (see above Benchmarking), the service
costs of technology underpinning them are changing fast. Mechanisms provider may also want mechanisms in the outsourcing agreement
to ensure that the customer, after a number of years, is not tied to an that provide for price adjustments that take inflation and cost of living
expensive product or service that is not in line with the current market into consideration. From a customer perspective, the use of indexation
standard are therefore required. This can partly be solved by including provisions can also be beneficial (if no such mechanism is in place,
pre-defined price reductions into the price schedule. However, it can be service providers are likely to factor this into their initial prices).
difficult to foresee how far costs are expected to fall over the term of the
agreement, especially in areas where new technology may emerge that If indexation provisions are agreed, a cap of how much the prices can
could not have been foreseen and which drastically reduces the cost of a change due to inflation and cost of living should be considered, in
service. For obvious reasons, service providers are conservative when it order to avoid unexpected big changes in pricing. However, not all
comes offering year-on-year price reductions and will only factor in fairly elements of service provider costs are affected by inflation or cost
well-known technology or resource-based future efficiencies and will of living increases. Therefore, it is often agreed that only a part of
not factor in the paradigm shifts that may or may not occur in the future. the costs are adjusted, namely the salary element of the total costs.

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CONCLUSION Practical Law Contributor Profiles

A deep understanding of the complexity and details of the pricing
model in the outsourcing agreement is a prerequisite to understanding:
• The total costs of the outsourcing arrangement. Ole Horsfeldt
• How flexible the agreement is in terms of services. Gorrissen Federspiel
T +45 24 28 68 40
• Whether the pricing model in reality results in a supplier lock-in. F +45 33 41 43 65
E [email protected]
A number of different pricing models are today used in outsourcing W www.gorrissenfederspiel.com
agreements that can both be based on input or outcome. In this article,
the most commonly useds and recommend price models during the
different phases of the outsourcing agreement have been described.
Professional qualifications. Masters of Law, 1987; Attorney, 1990;
In most outsourcing agreements, these different pricing models are
LLM, University of Michigan, 1997; ITIL Foundation, 2010
combined with contractual clauses that:
• Offer protection against unexpected extra costs. Areas of practice. Digital business.

• Provide an obligation on the supplier to be responsible for all Professional associations/memberships. Member of the Danish and
resources and investments that are not specifically agreed. New York Bar.
• In case of an incomplete service description, ensure that services
that are not be specifically set out in the agreement, but which
are an inherent and necessary part of service delivery, are within
the scope of the services.

Further to this, provisions on benchmarking rights ensure that the

outsourcing agreement continues to offer value for money during the
entire term of the agreement, by offering protection against enforceable
cost reductions in the market. This may be combined with clauses on
indexation that transfers some of the risk of inflation to the customer.

With all of the above taken into account, transparency in pricing

models is still an exceedingly important factor in achieving a successful
outsourcing, and is more and more becoming an increased focus for
customers that want to know the costs and cost drivers behind the
services in order to make more informed decision when structuring the
outsourcing arrangement. The choice of pricing models, contractual
protection clauses and benchmarking rights should be designed to
achieve such transparency and limit the risk of unexpected extra costs.

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