CFO Bridge Insights January 2024

Charting the Course: Are you getting your pricing and engagement models right?

In our interactions, we observed that a knowledge-sharing mailer on usage of engagement or pricing model is the need of the hour for the mid and SME IT and professional service companies since many of these companies tend to go with the flow of what clients ask and submit proposals. They need to propose alternate or suitable engagement models to convince their clients / prospects. By not doing this, they can put their P&L at risk, so there is a need to understand this better.

Data of the engagement models of few large Indian IT companies which have disclosed the same.

Data as per the Annual report of FY23 of respective companies.

It is noticed in the above table that outside of LTTS, the Time and Material model contributes 34% to 48% of the revenue for these companies, which is less risky from and execution standpoint.

Looking forward to your valuable feedback, and we believe this would benefit all of you. We plan to bring more like this in the current year.

Various Pricing and Engagement Models currently prevalent

Typically, the above contract commercials are built as a combination of the above pricing and engagement models depending on the client and service provider’s requirements on the ground. A typical IT service model can take a staff augmentation route and / or managed services route coupled with various variants as add-ons tweaking the engagement model for the purpose and need. Some add-ons can be re-badging deals, upfront payment to the client, guaranteed productivity commitment, system integration deals, pass-through of transactions etc.

For example, in a Fixed-price managed service contract, the T&M rate card would be agreed for pricing any additional efforts or change requests for various roles. So on a future date, both parties have to concur on the additional efforts by role, and cost estimation for the extra work can be computed easily.

When should we have what kind of pricing and engagement model?

Generally, all projects start with a T&M arrangement since there will be no clarity on scope and both parties initially (testing waters). After reasonable progress over time, the scope and requirements would become clearer, and accordingly, the next level of variants would get initiated, which would be a win-win.

A slight variant of this is a monthly recurring billing (fixed monthly).

Periodic project milestone progress reviews are essential for the Buyer and the Service Provider. If any scope creep or support is needed, the right kind of escalations can happen on time.

Ensure periodic volume adjustments are made to avoid revenue or cost leakage.

Other Variants

• Incentive-based (Fixed fee + bonus outcomes)

o   In these models, there is an agreement on a base fixed fee, so the cost outflow is clear upfront, and the bonus is payable on outcomes. The outflow of bonuses is designed so that the achievement of outcomes will pay back more and cover the additional cost of the bonuses, too.

• Shared Risk / Reward (cost & benefits shared)

o   In these models, the upfront costs are shared between both parties, which works on the principle of “Pay as you reap the rewards.” If one works on improving the customer revenue, the upside benefits the buyer will reap will be much higher in lieu of a small committed spend until results are realized. Typically, in uncertain scenarios, these are adopted.

• Gain sharing / Profit sharing

o   In this model, the service provider is confident in an idea that will add business value. The buyer gives in-principle support to pursue the idea. The Gain-sharing principles are mutually agreed upon upfront and linked to profit generation. Here, the service provider shall invest and reap the benefit as the profits are generated over a period. This can be non-linear revenue at times in product development.

Other models

• SaaS: Upfront Fixed fee for install + Recurring subscription fee

o   This model is adopted when software product licenses or BOT sales are sold. The pricing structure will have scope study and installation costs, recurring license fees or one-time perpetual license sales, annual support and maintenance contracts, and increased volume-based licenses during the year or annual or periodic renewals. From the buyer’s point of view, this gives a stable operating cost and no upfront investment. From the Service Provider’s point of view, it has an upfront product investment but will be able to reap higher non-linear revenue.

• GTM (Go to market) / JV: Partnership to enter new markets

o   This model is an add-on to the various other models wherein two parties may have an arrangement constructed in a manner that can be a joint execution where one party who is well versed in a market due to their strength can provide the support and the other party will support their part on execution. There would be a mutual win-win model to provide the requisite services to the clients.

• BOT: Build Operate Transfer – Used for Global captives’ entry

o   Many Global captives use this model to ask the local Indian players to set up operations and build a scale so that they can get the transfer executed at a logical economic scale and size so that the Global captive center can become functional and managed by the parent company. Big IT companies do not undertake this model since, at the time of transfer in a BOT model, there would be a significant drop in revenue in a quarter, which investors may not like. Mid-sized IT companies or staff companies may see this as an opportunity.

Understanding the various pricing and engagement models in vogue will help the buyer and service provider choose the suitable engagement model.