Are your outsourcer's prices too low?

It's always a good idea to benchmark your outsourcer's prices periodically against the market. But what if you find that your IT service provider's rates are too low?

It could happen. And it's not usually a good thing. While every benchmarker, client and outsourcer has an opinion about acceptable variances in IT service rates, outsourcing prices that come in at more than 20 percent below the market rate are red flags.

Prices that are too low can lead outsourcing vendors to issue more change orders for work they claim is beyond the scope of the original contract. Bargain basement prices can also push vendors to replace skilled staff with lower-cost personnel and innovate less. And they can lead to poor service that may not be covered by the client's service level agreements (SLAs.)

"Many service level agreements are written to provide the customer with relatively little protection; the targets are easy for the vendor to meet, while the actual service fails to adequately address the business needs," says Bob Mathers, principal consultant with Compass Management Consulting in Toronto. "If the vendor is making a fair margin, client and vendor can work together to close this gap. If the vendor is bleeding, they are more apt to stick to the letter of the contract and provide nothing more, leaving internal IT groups to pick up the slack."

Services Likely Priced Too Low

Under-pricing can show up in almost any area of service--except storage, where costs fall so fast it's hard for outsourcing contracts to keep up. Areas of service that tend to experience flat or marginal price declines over time, such as service desk or desktop support, often end up priced too low down the line.

"Also, if the client environment changes over the life of the contract in a way that makes it more expensive to support--decentralization or greater complexity--and prices have not increased to reflect these changes, that may result in contract prices that are below market," adds Mathers.

There can be valid reasons for cut-rate pricing, but that's less likely in today's mature outsourcing market. "If a vendor organization can leverage particular capabilities to lower their costs, they have a competitive advantage that may allow them to lower their pricing while maintaining margins," says Mathers. "That said, there are few levers left for vendors to pull. If a benchmark shows pricing to be below market, and the benchmark properly accounted for all material drivers of price in the services, it is safe for the client to conclude that the vendor most likely has lower-than-market margins."

Bargain basement rates often are a result of errors on the part of the provider. Outsourcing prices are complex to set--even for the pros. "I once saw a mainframe deal where the applications were priced at 30 percent of market. I don't even think the vendor ever figured that out," says Adam Strichman, an independent outsourcing consultant in Mechanicsville, Va. "Application hours are a complicated calculation even for the best pricers and benchmarkers. Often, the accountants measuring the deal screw up the pricing."

Outsourcing customers may never notice that their prices are too low, either, particularly if their demand for IT services and, thus, their overall costs, are rising steadily.

"[Underpriced IT services] can hide quietly for years with no problems," says Strichman. "However, when they grow, it brings problems front and center, as the vendor tries to make it up elsewhere, which causes friction."

Address Price and Service with Your Vendor

Most clients that discover that an outsourcer is actually charging too little want to keep quiet, says Strichman, "but in many cases, it just makes matters worse."

No one wants to see their IT outsourcing prices go up, but smart customers opt for openness. "The first step is to acknowledge that this is a situation that needs be addressed," says Mathers.

Customer and provider should meet to discuss how to lower support costs (greater standardization, offshoring, more integrated processes) or expand the scope of services to allow the vendor to increase revenue and lower client costs. If there is no way for the vendor to make a reasonable profit on certain services, says Mathers, it may be time to shop for a new provider or bring them in-house.

In some cases, client and vendor will agree to rework prices "to better align not only with the vendor's costs, but with the way that the business consumes IT services," Mathers says. "This gives the business the levers it needs to affect its IT charges through better demand management, and ensures that the vendor's support costs are aligned with its revenues."