Benchmark analyses of outsourcing contracts are a longstanding and commonly applied management tool to gauge the competitiveness of service delivery in the context of competitive market standards. 

Traditional benchmarks are often used to set a target price for service providers.  In justifying an aggressive number, clients will argue that top performance should be the goal and standard that service providers aim for.  Service providers, meanwhile, typically counter that top-performance targets defined by the benchmark are arbitrary, inaccurate, or based on cherry-picked numbers from myriad environments, not necessarily reflective of the unique, customized, and often constraining reality of the individual client.

In this context, the process often becomes contentious, and the benchmark’s role is limited to that of a club to wield during the negotiation process. The task of finding efficiencies and savings rests, moreover, largely with the service provider. As a result, the lower the price target, the lower the vendor’s profit margin.

These traditional rules of the game are fundamentally changing. Increasingly, benchmarks are being used to define and implement broader transformational change programs characterized by demand management, standard service delivery, and usage-based “pay by the drink” utility computing models.  In this context, benchmarking is the first step in a mutually agreed program of client/provider transformative change.

The Optimization Opportunity

While the utility concept of a model has been around for years, implementation capabilities have been lacking. Now, thanks to a combination of better measurement tools and more mature pricing mechanisms, businesses are increasingly looking to reap the benefits of usage-based standard service delivery.

Compass data shows that traditional improvement initiatives drive incremental efficiency gains within the existing operational environment, and typically produce annual savings of 10 percent to 20 percent.  A transformational approach to improvement, characterized by an optimized IT delivery model and utility computing, often produces overall cost savings of 40 percent or more.

In other words, rather than tightening the screws on the way things have always been done, IT leaders are establishing a new and significantly better way of doing things – a clean slate that fully leverages the benefits of standardization and utility computing.

The improvement reflects both increased delivery efficiency from the supply side, as well as improved commercial management from the demand side.

Growing interest in optimized service delivery is raising the bar for the comparative benchmark standard. The question is no longer, “How does performance compare to the what is of existing performance (either average or top quartile)?”, but rather, “How does performance compare to an optimal what could be state?”  In the could be state, client organizations effectively manage demand and service providers to drive efficiency and leverage economies of scale.  Here, the target is no longer the best that can be achieved in the existing environment; rather, it becomes the best that can be achieved in a transformed environment.

Squeezing Out Constraints

Following a benchmark analysis defining the “size of the prize” of standard service delivery, usage-based pricing models can be applied to gain transparency into the business drivers of IT spend as well as the cost implications of business decisions regarding how IT is used. 

A business can then apply this transparency to create “tensions” between the demand for and supply of IT services.  Ideally, the tensions produce incentives for the business to cost-efficiently manage consumption and for the service provider to cost-efficiently manage delivery.

Pricing tensions can also be applied to assess the operational constraints identified by the benchmark analysis and to determine whether their cost is justified in terms of value to the business.  These constraints typically come in two forms, either “contracted” – whereby the client dictates a particular custom requirement, or “non-contracted,” whereby lack of clarity surrounding processes, roles, and responsibilities drives duplication of effort and inefficiency.

Realistically, not all of these constraints and premiums can or should be eliminated.  But a benchmark analysis, coupled with tensioned pricing, identifies and quantifies the constraints, allowing the business to more effectively apply value-based decisions to its IT investment. 

Embracing the Concept

A focus on transformational optimization rather than incremental improvement redefines the roles and responsibilities of client and service provider.  Rather than place the onus solely on the service provider, the process is becoming collaborative; specifically, clients are assuming increasing responsibility for looking inward to identify the historical behaviors and operational constraints that lead to inefficiency and high costs. By allowing the service provider to leverage economies of scale and, potentially increase profit margins, this approach makes the aggressive cost reduction target more palatable to the outsourcer.

Indeed, many vendors are embracing the concept of usage-based pricing and standard service delivery, because it provides them with greater control to leverage economies of scale and their expertise at efficiently delivering IT services.  Coupled with the increased incentive to drive efficiency, this creates a significant opportunity to grow profit margins.

In addition, the savings generated through a utility exercise are likely to be re-invested by the client organization into new initiatives, which can be new opportunities for the service provider to generate revenue and strengthen the relationship.

That said, it’s certainly true that approaches to sourcing negotiations and contracts will have to adjust, as account managers are typically compensated by revenue or size of the deal. 

Moreover, while the concepts of utility computing and usage-based pricing mechanisms are gaining increasing credibility, much work remains to be done in terms of refining these mechanisms and establishing effective metrics to measure and manage IT delivery and consumption in a utility-based environment. That work is underway among service providers and advisors who have proactively recognized the opportunity, as well as by others who are being pushed by competitive pressure to meet the reality of changing business requirements.

Max Staines is President of North America for Compass Management Consulting