Assessing the value in value-based pricing

Tuesday Jun 1st 1999 by Lisa Gandy Wargo
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Although it's tempting to build premiums and penalties into consultants' paychecks, value-based pricing isn't always the best solution. Look before you leap.


Spreading the wealth--and the risk--is a new concept emerging in corporate IT consulting. It's called value-based pricing, and it comes in many forms, from paying the consultant entirely according to revenue gained to building time-measured rewards and penalties into projects, including an enterprise resource planning (ERP) implementation.

Fundamentally, value-based pricing transfers some of the risk and potential reward to the consultant. Rather than valuing a systems implementation in the traditional time-and-materials manner, value-based pricing at least partially compensates consultants based on metrics, or achievement of specific goals at various points throughout a project. Metrics can vary from the timely installation of a specific SAP AG module to improving inventory turnover by a specified percentage. The consultant is then paid a reward for achievement of the goal.

AT A GLANCE: Commonwealth of Massachusetts Department of Social Services
The department: The DSS is a state agency charged with protecting children who have been abused or neglected in a family setting.

The problem: In order to apply for federal reimbursements, the DSS must gather detailed documentation on the type of services provided to each child.

The solution: A value-based systems implementation contract with Andersen Consulting.

The IT infrastructure: A LAN-based system.

Pricing based on value is, in part, a response to complaints about unsuccessful ERP implementations or companies not being able to calculate an ROI on their ERP system implementations. Value-based contracting forces a company to examine its business case for the systems integration project, i.e., that it's not just a "me too" project.

But value-based pricing is not yet widely used for systems integration projects. International Data Corp., of Framingham, Mass., estimates that in 1998 only 1.5% to 3% of systems integration projects were priced based on value. Most analysts, consultants, and clients expect that figure to increase, but no one predicts it will even reach 50% of systems integration projects because of all the time and effort it takes to find the right metrics, create an effective contract and then track performance. According to one expert, clients need to devote at least one person, full time, to keeping up with the contract.

Value-based pricing has been particularly successful in the government sector. "Basically, for managers in state governments, this has been an extremely powerful tool," says Ray Campbell, general counsel for the Commonwealth of Massachusetts' information technology division in Boston. "Value-based contracting lets us enter into almost joint-venture types of arrangements where there is a shared risk and reward model."

Where it works

Types of value-based pricing
Gain sharing. At least part of a consultant's pay is based on the gain or benefit to the client from the implementation of a system. Payment is based on specific metrics, which are usually tied to cost savings or revenue earnings. For example, a metric in a supply chain engagement might be improving inventory turnover by a given percentage.

Benefits-based. The client pays nothing until benefits accrue. The consultant absorbs all up-front costs.

Time/delivery or valuable milestone. Consultants are rewarded or penalized at certain stages during an engagement. The rewards are time- or delivery-based. A reward might be based on the implementation of a certain SAP module, for example, within a specific period of time.

The concept of value-based pricing is more popular in outsourcing engagements, because it's much easier to measure the success of a vendor taking over an entire department or function. Still, if you throw in outsourcing, only 20% of all systems integration, consulting, and outsourcing projects combined include some form of value-based pricing, according to the GartnerGroup, of Stamford, Conn.

The best types of systems integration projects for value-based pricing deals are those that are revenue-generating or cost-saving and apply to a particular department or function. Supply chain system implementations, for example, work well because specific measurements, can be used, such as improved inventory turnover or fewer orders lost.

"We have typically used these types of engagements in revenue management types of projects because there is a very easy way to define success--an established benchmark of revenue collections," says Massachusetts' Campbell. The Commonwealth has entered into a number of value-based contracts, including several with Andersen Consulting of Chicago and Public Consulting Group of Boston.

One of its agencies, The Department of Social Services (DSS) engaged Andersen Consulting from 1993 to 1997 to install a LAN-based computer system that would help the state agency track children's services eligible for federal reimbursement. In order to capture the federal reimbursement, department officials needed detailed documentation on the services provided--who received them, whether that child was eligible for Medicaid or other federal programs, and so on.

"Andersen Consulting put in a $6 million computer system at their own expense," says Campbell. "The agency paid no money." He adds, "That computer system, and a lot of work done to set up the data collection and entry processes, allowed the state to receive $120 million in additional federal reimbursement, and Andersen Consulting got a percentage. It was a very successful engagement for Andersen Consulting and the state." Neither Campbell, nor Edward Burke, an Andersen Consulting partner in Boston involved in the Commonwealth's project, would comment on what Andersen received for the project.

Burke says his firm has entered a number of value-based arrangements with government agencies where Andersen makes all the up-front investments. "If you don't at least achieve the baseline level, we don't expect to be paid at all," he says. That's the way it was with the Commonwealth project, notes Burke, who heads up Andersen's government strategy practice and is a member of a firm-wide steering committee that oversees value-based deals across industries. Then, "the more benefits we brought in, the higher the benefit percentage we were paid," he adds.



Edward Burke, an Andersen Consulting partner: "I have on occasion used a third party to help create a partnership agreement."

Indeed, a consultancy could earn 10% of the overall revenue captured on a project like the one Andersen did for the Massachusetts DSS. In a case like this, though, the overall benefit to the state and the taxpayers far outweighs the hefty fee.

Because you might end up paying as much as 10% of your total revenue earned to a systems integrator, Campbell recommends creating tiers in your payment structure. "The early dollars are easier to get," he says. "If you have a flat percentage arrangement, there's no incentive for the vendor to go after the [harder to attain dollars]."

Lessons learned about value-based pricing
Ray Campbell, general counsel for the Commonwealth of Massachusetts' information technology division, has the following advice for CIOs and other IT managers considering value-based contracting for systems integration:

Give careful consideration to how you structure the payments.

Be very careful in your selection of partners.

Be prepared to work closely with the vendor. "If you think the results will magically appear, you will be disappointed," Campbell says. You have to be in the mindset to "truly partner" with the vendor by committing human resources, he adds.

Massachusetts' information technology division has done a number of value-based integration projects with Chicago-based Andersen Consulting, Boston-based Public Consulting Group, and other consultancies. In one engagement with Andersen, the state received an additional $120 million in revenue it would not otherwise have earned.

For example, in a contract such as the one with the Massachusetts DSS, a consulting firm might be paid 1% for the first zero to $50 million in reimbursement received from the federal government, then a higher percentage for $51 million to $75 million, and a still higher percentage for $75 million on up. "That way the vendor gets past the easy revenue collection and starts working on difficult things," Campbell says.

Value-based contracts where the client makes no up-front investment and the vendor is paid on the overall results are more common in the public sector, according to consultants, analysts, and CIOs. Companies in the private sector, meanwhile, are able to invest money up front and are more likely to enter into deals that combine some traditional time-and-materials billing methods with value-based pricing.

Here's an example of a value-based formula used by New York City-based consultant Ernst & Young LLP in a supply chain contract. It involves three tiers of payment:

Keys to success

Users and vendors alike note the importance of the contract in value-based pricing deals. Lawyers are always involved, as are other advisers in many cases. "I have on occasion used a third party to help create the partnership agreement," says Andersen Consulting's Burke. "That helps make the contracts beneficial to both sides. It has to be an organization that understands the business situation and is able to act as a go-between, an honest broker between the parties."


One of the criteria for a successful contract is good metrics. The best engagements for value-based contracts tend to be those that are revenue-generating or cost-saving and apply to a particular department or function. "The more discreet the project, the more you can put a box around it and say this is what is affected by it, the easier it is to do value pricing," says Christian Munz, a Framingham, Mass.-based senior analyst for systems integration at International Data Corp. (IDC). For example, finding good metrics in the installation of a customer relationship management (CRM) system can be difficult, he says. "Unless the system itself is a new way to distribute products and services, it's hard to quantify the incremental revenues generated by the system," Munz says.

User buy-in and involvement throughout the project also are critical to success. "It's teamwork," says Ardie Bucher, an Indianapolis-based partner in the consulting practice of PricewaterhouseCoopers, in New York City, and leader of the firm's global facilitation and deployment group. "The client usually provides more people than we do. If they don't do their share and we help bring systems to bear, but they don't follow through, then we have lost."

Consultancies engaged in value-based pricing
Most IT consultancies are involved in some sort of value-based pricing. The following firms are working on value-based engagements with clients. Note that Big Five accounting firms are somewhat restricted by Securities and Exchange Commission regulations in the types of value-based contracts they can enter.
Andersen Consulting

Computer Sciences Corp.

EDS

Ernst & Young LLP

PricewaterhouseCoopers

Both Bucher and Garry Crowell, a Boston-based senior manager with Ernst & Young who focuses on pricing and negotiating contracts with clients, note Big Five accounting firms--as well as firms that audit public companies--are somewhat restricted by Securities and Exchange Commission (SEC) regulations in entering into value-based deals with audit clients. That does not mean, however, that these firms cannot put some sort of risk or reward incentive into consulting contracts with audit clients. "You want to make sure the fees being paid are on your competencies and efforts and performance--the service firm's performance as opposed to the business performance," says Crowell. Massachusetts' Campbell says to be very careful in the selection of your partners.

"Be clear that your project is well defined and scoped out with milestones that are deliverable," advises Bonnie Digrius, an independent analyst based in Basking Ridge, N.J. Secondly, she notes, "have very clear terms and conditions and commitments on both sides--not just what the consultant is going to do but what you are going to do." Lastly, at every milestone, it is important to determine whether you have accomplished your objective and be willing to tweak the contract if you need to.

Supply chain systems implementations are ideal for value-based contracting. The success of ERP implementations, however, where the new system impacts a number of departments, is difficult to measure. Here, experts say, the best type of arrangement other than the traditional time-and-materials contract is to base risk and reward on timeliness of delivery. For example, rewards could be linked to the completion of various modules of SAP.

Think before you act

It may sound like a good idea to negotiate your next systems integration project on the overall cost savings or revenue gained, but be prepared to spend a lot more time up-front and ultimately pay more for the installation than you would under a traditional time-and-materials contract. Sure, you'll have a successful project, but the time and effort expended to draft the contract, keep up with the reward metrics, and make sure your staff is heavily involved in the project may not make this type of deal worth your while.

Bucher points to a project where PricewaterhouseCoopers helped a client reduce its accounts receivable by $200 million. PricewaterhouseCoopers installed a system that helped achieve these results while the client worked on improving its processes. "Who was responsible for the $200 million decrease? How much comes from the process side, how much from technology? How do you measure that?" he asks.

Some who have tried value-based pricing are not sold on the concept. A CIO who has worked with systems integrators in value-based contracts says it's a "very difficult concept to make work." He notes, "I haven't seen a value-based pricing model that has the right incentives."

The CIO, who asked not to be identified, points to the estimation process as a major problem and notes that most consultants will not estimate their time, expenses, and other costs properly. "That is why integration people work their people so hard, they're trying to catch up," he says. "Do you want to be the one who is forcing them to cut corners because you are exacting a penalty? I would rather get the project done right than have people cut corners to save a few dollars."

The cio has worked in both the government and corporate America and says value-based pricing works better in the public sector, where the consultant absorbs all up-front costs and is paid solely on the benefit gained. //

Lisa Gandy Wargo is editor of Global IT Consulting Report, a monthly newsletter on news and trends in IT consulting--including IT strategy, systems integration, and outsourcing. Wargo, a non-practicing CPA, has been covering consulting for over a decade. GITC, based in Fitzwilliam, N.H. is published by Kennedy Information. Wargo can be contacted at lgandywargo@kennedyinfo.com.




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