Market & Sourcing
Tier Pricing for Managed Services
by Dr. Jakob Rehäuser
One of the key success factors in outsourcing is an adequate pricing model. Especially in Managed Services, Tier Pricing is being used more and more frequently. What are the advantages?
Tier Pricing - also known as Tiered Pricing - refers to a quantity-based pricing model for IT outsourcing that is designed in layers or tiers over the years. This allows scale and learning effects (learning curve) to be worked into the pricing model, with low volumes having higher unit prices and higher volumes having lower unit prices. The idea behind Tier Pricing is that over the course of the contract, the IT service provider is compensated for the marginal costs per additional unit. First, however, the IT service provider has the opportunity to cover his fixed costs.
In my opinion, it is a fair and transparent pricing model for both customers and sourcing partners. Tier Pricing is ideal for Managed Services because the IT service provider is incentivized to reduce costs through continuous improvement over time. The service provider has to deliver services according to service levels - the skills behind are their responsibility, as is the number of experts deployed. The customer basically doesn't care as long as the service quality is right. This means that the customer does not have to pay for inefficiencies on the part of the IT provider. Two models are commonly used in Tier Pricing.
Two Models for Tier Pricing
The definition of how prices are determined is, therefore, essential in contract negotiations in order to avoid different interpretations afterwards.
Benefits of Tier Pricing for customers
Companies benefit from Tier Pricing because they do not pay too high unit cost at higher purchase volumes. Finally, falling prices are built in over the years. This is based on economies of scale as well as the learning curve that the IT service provider experiences. Initially, the IT service provider has deployed experts, but when the situation has settled down and the transition is finished, he can also use junior consultants. If rising or stable prices have been agreed in the contract, the customer must exert constant pressure to ensure that the IT service provider reduces its costs through innovation and automation. Tiered Pricing, on the other hand, automatically forces the IT service provider to do this.
Benefits of Tier Pricing for IT service providers
However, Tier Pricing significantly contributes to risk minimization for the IT service provider, as he can hedge and be reimbursed for his acquisition and overhead costs even if low quantities are purchased. Tier Pricing allows to mirror the cost structures of the IT service providers very well: First the fixed costs are remunerated, then the marginal costs. This means that no fixed costs are allocated for higher purchase volumes. In addition, fewer price negotiations are necessary, since prices are defined for a large or the entire quantity range - theoretically down to zero purchase volume.
Disadvantages of Tier Pricing
In relation to the benefits mentioned above, the disadvantages of Tier Pricing are limited. When demand decreases, the unit price increases over the entire quantity (blended unit rate), i. e., the average unit price. This can be a disadvantage if demand is influenced by several different IT organizational units (communities of interest) that consume services. The problem mainly occurs when the volume drops back below the threshold of the current tier, especially in Total Volume Tier Pricing. At the same point, there is an increased effort in budgeting when there are multiple communities of interest, since the presumed tier to be reached must also be planned.
Tier Pricing in practice
Five tiers (Tier 0 to Tier 4) have proven successful, with the baseline (i. e., the initial volume of a service) usually located in the middle in Tier 2. The lower Tiers 0 and 1 are primarily used to cover the IT service provider's fixed costs. Finally, the top tier should be set at marginal productivity, as no further economies of scale can be expected for all higher volumes. If these points are taken into account, the existing value creation stages and cost structures of the IT service provider can be incorporated into a target-oriented and cost-effective pricing model that also provides both parties with good flexibility and scalability.
As positive as the method of Tier Pricing sounds, some aspects have to be taken into account in order for this approach to achieve the expected effects. On the one hand, tiers must cover the ranges of demand, and on the other hand they must be oriented towards the cost drivers, for example in the case of stepped fixed costs or the transition from onsite and onshore to nearshore and offshore. However, it is becoming apparent that both IT service providers and customers sometimes have difficulties in building meaningful tiers due to a lack of experience and the fact that the actual cost drivers are often unknown. Both sides need to address the pricing of services in order to build meaningful tiers and build in mechanisms for longer duration. For this reason, tiers are defined on a customer- and service-specific basis, depending on the subject matter of the service.