Element 6: Pricing Model and Incentives

Pricing is typically one of the top items on the table—and it can be the most complex issue—because getting pricing and the pricing model right speaks directly to the bottom line of an enterprise and its ultimate success.

Unfortunately, the approach of many procurement professionals remains stuck the Dark Ages: The focus centers on getting the lowest possible transaction price (price per hour, per widget, per call) rather than spending the time to create a pricing model that truly reflects the “real” nature of the business.

Vested’s Rule #4 directs a company to use a pricing model with incentives that optimize the business. When you successfully implement Element 6 you have created a paradigm shift—because the Vested approach ties the service provider’s profitability to meeting mutually agreed upon Desired Outcomes.

The Vested approach concentrates on establishing a collaborative, transparent and flexible pricing model—based on incentives—rather than on a price or cost schedule. Remember, the Vested methodology pays for outcomes, not transactions.

Inherent in this model is a reward for service providers to invest in processes, service, or associated product that will generate returns in excess of agreement requirements. Higher profits are not guaranteed—what business model can claim that?—but Element 6 provides service providers with the authority, autonomy and tools to make strategic investments in processes and product reliability that can generate a greater return on investment than a conventional cost-plus or fixed-price-per-transaction agreement might yield.

Incentives are a major part of this mix because service providers are taking on risk to generate larger returns on investment. An incentives package delivers the most commercially efficient method of maintaining equitable margins for all parties for the duration of the relationship.

The term model is used because a good pricing model enables the parties to manipulate the underlying pricing assumptions, allowing them to “model” the outputs relative to the input components. Common pricing model components include:

  • The total cost build-up and best value assessment
  • Underlying financial and operational assumptions
  • Risk factors and allocations
  • The desired compensation method (e.g., fixed price, cost plus, hybrid)
  • Margin-matching triggers and techniques
  • Contract duration
  • Incentives

When properly structured, a Vested pricing model should generate returns in excess of target margins for both parties when the parties achieve the Desired Outcomes.

In the Vested journey, the pricing model and incentives are where the rubber meets the road because the organizations must go beyond mere words about their partnership. They actually create a commercial pricing structure and associated budgets that equitably allocate risks and rewards with the purpose of realizing mutual gains for the duration of the agreement. In other words, the parties create a partnership.

There are 12 steps involved in developing a practical and coherent Vested pricing model:

  1. Form the team
  2. Establish guardrails
  3. Document input assumptions
  4. Identify total ownership costs and perform a best value assessment
  5. Perform risk assessment and allocate risks
  6. Agree on the compensation model
  7. Determine contract duration
  8. Complete the pricing model and establish prices
  9. Test the model and agree on the baseline
  10. Define margin matching triggers and techniques
  11. Agree on incentives
  12. Document deployment processes

Following the above steps will enable the parties to create a fair and balanced Vested pricing model designed to create value, not just exchange value for transaction. The process takes work and collaboration, as extensively described in chapter 6 of The Vested Outsourcing Manual, which is the book’s longest chapter on a single element. Another great resource to use when working on your pricing model is the Vested white paper, “Unpacking Pricing Models – Make ‘you get what you pay for’ Real for Business Relationships,” available as a free download on the Vested website.

And don’t forget that Vested’s free self-assessment is yet another useful online tool to benchmark how well you are applying Rule 4/Element 6.

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