“Show me the incentives, and I’ll show you the outcome.” This famous saying of the inimitable Charlie Munger captures the software development industry’s shift toward pricing models that align vendor incentives with business value metrics.
The “growth at all costs” era is over, and businesses are contending with high interest rates, economic uncertainty, declining demand, and other macroeconomic headwinds. CIOs and CFOs are cutting spending to avoid high borrowing costs or outside funding at unfavorable valuations. Expenses, including for software development, are under increased scrutiny.
DataArt has responded to these pressures by working creatively with our clients to structure engagements around outcome-based pricing models. Alexei Miller, Managing Director at DataArt, describes our approach like this:
“For us, it’s simple: if you want to succeed in 2024 and beyond, you’ve got to deliver value the way clients need it in 2024, not as it was in 2014 or 2004. And today, it means taking responsibility for the outcome, taking charge of the process, being an equal partner who shares the risk and rewards.”
“We’ve been advancing our product design, program management, and labs capabilities for over 10 years – which are all essential components in this transition. DataArt is seen by clients as a product-focused partner with direct impact on revenue. No excuses, no hiding behind the contract.”
Let’s delve into how these different outcome-based pricing models compare to the traditional time and materials (T&M) model.
Under the T&M model, the client is charged for billable hours spent on the engagement. This model has many virtues, chief among them simplicity and flexibility. The scope of the engagement need not be fully determined at the outset, and changes in scope, timing, or labor costs can be easily accommodated along the way. The T&M model, however, is not tied to business outcomes.
Outcome-based pricing models, on the other hand, offer clients cost predictability and risk sharing with their software engineering partners. But they are also less flexible than the T&M model because the tie between the outcome and the price can be difficult to structure on the front end.
DataArt is proving that, with the right experience and expertise, outcome-based pricing models can be a win-win for software engineering partners and their clients.
Let’s look at some examples of outcome-based pricing models in more detail.
Fixed-Price Model
One of our long-time clients, an online travel agency, wanted us to build a Generative AI application for a fixed price. With adjustments from our legal, compliance, and project teams, we devised a mutually beneficial structure that provided for specific deliverables within a set timeframe. The structure was so successful that we executed more than a dozen similar contracts over 18 months for this client.
For clients with tight budgets or limited financial flexibility, the fixed-price model can be beneficial. The fixed-price model also requires a well-defined project scope before development begins. This clarity ensures that the client and the development team begin with a mutual understanding of the project’s requirements, reducing the likelihood of misunderstandings or scope creep.
The major challenge of the fixed-price model is its inflexibility. Any changes to the project scope after the contract is signed can lead to lengthy renegotiations and potential delays. This rigidity can stifle creativity and adaptability, especially in dynamic industries where requirements may evolve.
Deliverable-Based Pricing with Story Points
Another client, a multinational financial services company, also needed an alternative to the traditional T&M model, but it required more flexibility than a fixed-price model could accommodate. The DataArt and client teams devised a fixed-capacity model under which DataArt provides engineering capacity measured in increments of business value, with payment based on the number of completed “story points.” A price per story point was determined by equating a month’s cost of developers with the capacity to deliver a set number of story points within a specific timeframe.
This made financial planning more transparent and predictable. The client’s business stakeholders could more directly connect their business priorities to their outsourcing budgets by prioritizing their available engineering capacity, which was no longer expressed in abstract developer hours. This allowed them to easily reprioritize and pivot by reallocating the contract’s remaining story points. And, unlike a fixed-price contract with a predetermined scope, the team could start work without a full project description, providing flexibility for roadmap changes. If the team failed to meet a delivery commitment, we would earn less, but, if the team delivered as promised or exceeded expectations, there was potential for greater reward.
Shared Risk/Reward
In this model, the client and the service provider share the project’s financial risks and potential rewards. The service provider is financially incentivized to ensure the project is successful, as its compensation is tied to the project’s outcomes. The payment structure may include a lower base fee, with additional payments tied to delivering successful outcomes or achieving specific performance milestones. This model fosters a higher level of collaboration and alignment between the client and the service provider. However, defining and measuring success can be challenging, requiring clear and mutually agreed-upon metrics and milestones.
In this model, an organization outsources an entire function, service, or process to a service provider. Pricing can be based on fixed costs, variable costs, or a combination of the two, often through long-term contracts. The client transfers most of the operational risks to the service provider, who assumes and manages those risks.
The total outsourcing model allows the client to focus on its core business activities while the service provider handles the outsourced functions. Service levels and performance are often defined through Service Level Agreements (SLAs), with penalties or incentives based on performance.
Service providers often bring specialized expertise and efficiencies the client may lack, and fixed pricing arrangements can provide predictable costs. The challenge is that the client may have less direct control over the outsourced functions.
Progressive Pricing
In this model, payments are tied to specific project phases or milestones. Payments are made only when predetermined milestones or phases are completed, which reduces the client’s financial risk. The challenge is in the planning and precise definition of milestones, which can be complex and difficult to establish.
Revenue Share
Here, the service provider is compensated based on a percentage of the revenue generated by the project, product, or service. This model reduces the client’s initial financial burden, as the service provider is compensated based on performance. The service provider’s earnings scale with the success of the project, providing an incentive to continuously improve and optimize. Compared to upfront payment models, the downside for the service provider is having to wait longer to receive full compensation. Additionally, the client may end up paying more overtime than it would with other pricing models.
The models discussed above do not encompass all possibilities. Numerous additional variations and combinations can be devised to meet a client’s specific needs.
To assist in selecting a suitable pricing model, Gartner® has published the following:
Selecting a Pricing Model Based on Engagement Attributes
Identifying pricing models based on their attributes is crucial for making informed decisions that align with specific needs and goals of the project or engagement. Figure 1 below shows how favorable each pricing model is against the engagement attributes. SPVM leaders should take these attributes into account when evaluating pricing models.
- Flexibility: An engagement’s capacity to adjust, evolve and accommodate changes in goals, requirements or deliverables, based on evolving needs.
- Transparency:This means clearly and openly defining tasks, responsibilities and resource use of projects or services.
- Predictability:This refers to the ability to forecast and anticipate scope change, costs and revenue associated with a particular pricing model.
- Risks to buyer and provider:Different pricing models carry distinct types of risks, such as cost overruns, scope changes, profitability challenges, customer dissatisfaction and more. This can impact the financial and operational aspects of a business relationship.”
As featured in Gartner’s research, “Figure 1 shows the attributes of commonly used pricing models for IT outsourcing services.”
Conclusion
DataArt’s success with outcome-based pricing models shows how a willingness to think beyond the T&M model can produce a valuable win-win in the age of doing more with less. If you are interested in learning more about these and other potential pricing models and how they can benefit your business, please get in touch.
