White Paper




Transaction-based
Pricing Model
for Outsourcing:

Why and When


Kanth Miriyala, PhD
Vijay Gurbaxani, PhD
...
Transaction-based Pricing Model for Outsourcing: Why and When




                                               Executive...
Transaction-based Pricing Model for Outsourcing: Why and When




                                         Introduction
  ...
Transaction-based Pricing Model for Outsourcing: Why and When




                                                transact...
Transaction-based Pricing Model for Outsourcing: Why and When




                                         Prerequisites o...
Transaction-based Pricing Model for Outsourcing: Why and When




                                              Strategic ...
Transaction-based Pricing Model for Outsourcing: Why and When




                                             of FTEs sup...
Transaction-based Pricing Model for Outsourcing: Why and When




                                         A Three-step Pr...
Transaction-based Pricing Model for Outsourcing: Why and When




                       Illustration 1: FTE-based Vs.
   ...
Transaction-based Pricing Model for Outsourcing: Why and When




                                             month. We c...
Transaction-based Pricing Model for Outsourcing: Why and When




                                                        ...
Transaction-based Pricing Model for Outsourcing: Why and When




                                          Comparing FTE-...
Transaction-based Pricing Model for Outsourcing: Why and When




                                          Step 3: Since ...
Transaction-based Pricing Model for Outsourcing: Why and When




                       Illustration 2: Single Client Vs....
Transaction-based Pricing Model for Outsourcing: Why and When




                                         The client ther...
Transaction-based Pricing Model for Outsourcing: Why and When




                                         Transaction-bas...
Transaction-based Pricing Model for Outsourcing: Why and When


                                                          ...
Transaction-based Pricing Model for Outsourcing: Why and When




                                         Conclusions and...
Consulting
                                                                                                   Data Analyti...
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Transaction-based Pricing Model for Outsourcing: Why and When

  1. 1. White Paper Transaction-based Pricing Model for Outsourcing: Why and When Kanth Miriyala, PhD Vijay Gurbaxani, PhD April 2005
  2. 2. Transaction-based Pricing Model for Outsourcing: Why and When Executive Summary In this paper we hypothesize a characterization of a Transaction-Based Pricing Model for Outsourcing (TMO). Specifically, we will be covering the following: · Introduction to the Transaction-Based Pricing Model for Outsourcing and a discussion on the drivers and trends that make it possible and preferable to the mainstream alternatives. · Description of the features of TMO. · Strategic benefits of a TMO. · Provide a three-step process for determining a TMO, that includes: - Specifying it can be used; - Determining, in cases when it can be used, whether the TMO should or should not be used for outsourcing a particular process; and - If it can and should be used, providing a simple way to design it. · Explain, with the help of examples, how the TMO can be a more effective way of outsourcing a process under certain conditions, how it facilitates incentive compatibility between the client and the vendor and finally quantify the benefits. · Conclusions and recommendations. While the TMO has been in use for some time, there is a lack of clear understanding of what it is, when it can be used and whether it should be used in a particular situation. After reading this paper, the reader will understand and be able to communicate what a transaction-based pricing model for outsourcing is, its benefits over other outsourcing models, and how to design one effectively. Executive Summary Introduction Prerequisites of a TMO Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Page 1
  3. 3. Transaction-based Pricing Model for Outsourcing: Why and When Introduction Definition: “A Transaction is a sequence of steps that achieves a business purpose.” Examples of a transaction include: a claim, a loan, an accounts payable and so on. A transaction-based pricing model for outsourcing is one where payments to the vendor are based on the number of transactions executed. For example, the number of claims processed or the number of widgets sold through an outbound telemarketing campaign. This is known as a Transaction-Based Pricing Model for Outsourcing (TMO), since the client pays the vendor on a per transaction basis. Today, success is increasingly enjoyed by companies that partner in value networks A transaction-based integrated collaboratives of specialized companies providing complementary pricing model for intermediate goods and services - to deliver end products to customers. Value networks achieve superior performance by exploiting the economies of outsourcing (TMO) is specialization that accrue to focused partners, by sharing the benefits of lower costs one where payments to and by encouraging innovation. Developing, and partnering in these value networks brings new challenges. Building online partnerships requires customers and the vendor are computed suppliers to develop and implement shared technology standards, collaborative based on the number of business processes and share knowledge. Migrating to the value network model transactions executed. means digitizing much of what we do, but more importantly, requires understanding how to work within a collaborative network setting. Once a business process has been digitized, and carved out from its traditional business context, the process of outsourcing to a partner begins. Developing a chargeback model that encourages both parties to act in an economically efficient manner is a critical element in developing successful partner relationships. The goal is to implement an outsourcing model that is incentive compatible, a term that economists use to describe agreements that are value maximizing for both parties. While there are multiple models for pricing in outsourcing arrangements, these models can be broadly classified into two types: · Input-based schemes: where payments are committed upfront based on an estimated amount of work (such as labor input). For example, seat-based models in business process outsourcing (BPO) are typically specified as “300 seats or agents for processing claims at $30 per hour per agent.” This is known as the FTE-based model, since the client pays the vendor on the basis of the Full Time Equivalent (FTE) employees involved in managing and operating the process. The fee charged per FTE varies according to the kind of skill sets required and the complexity of the process. The higher these two are, the higher the fee charged. · Output-based schemes: Can be of the following types: 1. Pay-on-Performance: where the payments are based on the based on performance. For example, based on the number of leads generated by the vendor, from cold calls. Executive Summary 2. Pay-on-Results: where the payments are based on results achieved. For Introduction example, the number of policies successfully issued by the vendor, from the Prerequisites of a TMO leads that were generated, or the number of widgets sold through an Strategic Benefits outbound telemarketing campaign, all of which directly contribute to the top 3-step Process line of the client. Illustration 1 3. Pay-per-Use: where the payments are based on the basis of the number of Illustration 2 Conclusion & Recommendations Page 2
  4. 4. Transaction-based Pricing Model for Outsourcing: Why and When transactions being processed. These typically happen in processes that may not directly contribute to the revenues of the client, but involve processes that are a part of the client's business. For example, the number of claims processed by the vendor. There are also fixed-fee arrangements (e.g., $1 million to complete a specified IT application development project). We do not focus on the fixed-fee model as they are usually seen in settings that require custom work, are non-repetitive and typically require a long timeframe per transaction. We focus on the transaction-based pricing Developing an outsourcing model for outsourcing used in outsourcing processes where the client pays the vendor on a per transaction basis. model that encourages both parties to act in an While the TMO has been in use for some time, there is a lack of clear understanding of what it is, when it can be used and whether it should be used in a particular economically efficient manner, situation. And, when it is used, what is the best design for a TMO. In this paper, we will is a critical element in try and give a crisp and clear understanding of the same. developing successful partner relationships. This can be achieved by designing the model to have incentive compatibility between the client and the vendor. The TMO facilitates this over the FTE-based model, as explained later in this paper. Executive Summary Introduction Prerequisites of a TMO Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Page 3
  5. 5. Transaction-based Pricing Model for Outsourcing: Why and When Prerequisites of a Transaction-based Pricing Model for Outsourcing Features of a Good Transaction-based Pricing Model for Outsourcing (TMO) are: · Standardized process: The outsourced process is fairly standardized. For example, claims processing in insurance, mortgage loan origination in banking and accounts payable in finance and accounting. · Repeatable transactions: The standardized process is repeated often within a short time-frame (e.g., an hour or a day or a week). · Clearly defined beginning and end: The process can be clearly defined and The transaction-based pricing has a definitive beginning and end. model for outsourcing makes · Clearly defined inputs and outputs it easier to align the incentives · Vendor provided people, process and technology: A TMO makes most sense of the client and the vendor, when a vendor provides the people, the process and the technology out of the box. (This is in contrast to a BPO situation where the vendor adopts the process by virtue of its design. and usually the technology is from the client.) The model integrates the people, process and technology elements to deliver a business service in a transaction- based manner. · “Pay-By-The-Drink” model: A key characteristic of the TMO is that it resembles some ASPs or pay-per-use utility computing models. The client pays the vendor for transactions that it consumes. This does not need to be a “pure” transaction- based model. Variations of this could include: - The client commits to certain number of transactions per month for the vendor to justify an investment in infrastructure for delivering the business process - Or, the client might pay a certain “retainer” fee as a base in return for a set of transactions, and pay the balance on a per-transaction basis - There might be success fees or bonuses associated with certain types of transactions, for example if the total claim payments is below a threshold (benchmark) level or if the number of mortgages originated is above a benchmark level. · Alignment of Incentives: The transaction-based pricing model for outsourcing makes it easier to align the incentives of the client and the vendor, by virtue of its design. This has been explained in detail in the 'Strategic Benefits' section. Executive Summary Introduction Prerequisites of a TMO Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Page 4
  6. 6. Transaction-based Pricing Model for Outsourcing: Why and When Strategic Benefits of TMO There are many benefits offered by a TMO in addition to the usual benefits of outsourcing such as releasing management bandwidth to focus on processes that provide competitive advantage, better price, better location, access to best practices… The additional benefits of the TMO are: · Flexibility and variable cost structure. The client is able to buy capacity as and when needed without incurring high fixed costs. The vendor is able to spread its investment cost by scaling the delivery platform to multiple clients that need the same kind of service. For example, if the client is planning to introduce new products, there might be a need for greater capacity in the service line. Especially, if there is uncertainty about new product introduction or if the demand TMO helps in designing the for new products is unknown, clients would be unwilling to commit to resources but would want to retain the option of having flexibility to change capacity as outsourcing model in such a needed. way that the incentives can be · Incentive compatibility. The TMO helps in designing the outsourcing model in aligned between the vendor such a way that the incentives can be aligned between the vendor and the client. and the client. This leads to value maximizing for both parties by achieving better utilization of resources and economies of scale. In the FTE-based pricing model, there is a degree of conflict between the interests of the client and the vendor. Since the vendor is paid on a per FTE basis, the vendor has an incentive to increase the number of FTEs for a given amount of work. At the same time, the client wants to hold steady, or decrease, the number Staffing Level No Waste Lost Opportunities Wastage Pay only for what you use Operational Tasks Fixed Price Executive Summary Time Time Introduction Prerequisites of a TMO Strategic Benefits FTE-based Model Transaction-based Pricing Model for Outsourcing 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Increased Flexibility & Maximized Value Creation Page 5
  7. 7. Transaction-based Pricing Model for Outsourcing: Why and When of FTEs supporting the New Business process. However, in the TMO, the incentives of the client and the vendor can be aligned to insure that the outsourcing arrangement benefits both parties. For example, the incentives can be aligned on the basis of results achieved. The vendor in this case would try and generate better results, in order to maximize this bonus, translating into top line growth for the client. In addition, in the TMO, the vendor is motivated to increase efficiencies to reduce the cost per transaction. Some of these savings can be passed on to the client, benefiting both parties, and leading to new value resulting from the compatibility of incentives. For example, a client can contractually motivate vendor to generate additional savings by agreeing to share any such savings through productivity improvements with the vendor. Hence we see that it is easier to achieve incentive compatibility in the TMO, as compared to the FTE-based model, owing to a degree of conflict between the interests of the client and the vendor in the later model. ... in the TMO, the vendor is · Strategic alignment of IT and Operations. One of the common problems motivated to increase between business/operations and IT is a lack of strategic alignment. Once the efficiencies to reduce the cost Exec CIO and CEO align at business level, the alignment drives TMO, as they now want to measure things at business level. They want to buy business per transaction. relevant services (for example, number of loans processed). To implement the transactions, we could use a model known as the iTOPS Model*. This model is used to integrate the technology and operations, and in this case would help in implementation of TMO. · Lower costs per transaction, better economies of scale and improved efficiencies. If the vendor has scaled by adding multiple clients and therefore has a larger volume of transactions than any single client, technology, people and processing capacities are utilized to a greater extent decreasing dormant or wasted resources. This results in decreased per-transaction costs and better economies of scale. There is also compatibility of incentives: the client and vendor have the same interest increasing the number of transactions or successfully completing each transaction as quickly and as accurately as possible. As a result, the vendor becomes as cost efficient as possible and eventually cost pressures will iron out any inefficiency from each transaction. · A better basis for comparison among competitors. An hourly price is a misleading basis for comparing different vendors as it does not take into account efficiency, process maturity, skill-level and ability to deliver real business value to clients. On the other hand, something like “processing a claim” or “processing an invoice” or “processing a loan application” provides a sound basis for comparing different vendors, as is the case when a process is standardized and the inputs and outputs and quality of a transaction are clearly defined. This also leads to an increase in productivity and the ability to deploy technology more creatively, because there is motivation to do in case of the TMO. However, the FTE-based model fails here, as it does not offer any such motivation for this to happen. Executive Summary Introduction Prerequisites of a TMO Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations * iTOPS stands for a model which integrates technology and operations, used in iGATE. Page 6
  8. 8. Transaction-based Pricing Model for Outsourcing: Why and When A Three-step Process to Determine and Design a TMO The following is the process for determining if a TMO can be developed, should be developed and if so, how to design it: · Step One: A TMO can be developed if the transaction: Ø Is repetitive, Ø Is standardized, Ø Can have significant IT/automated component embedded, Ø Has a clearly defined beginning and end, Is the Ø Is easy to monitor/track/measure, and transaction Ø Is of a “short” duration (hours or days but not months or years). standardized · Step Two: A TMO should be developed if, in addition to “Step One”, there is: Ø Variability in demand that is “significant.” In other words, if the number of FTEs in a FTE-based model changes significantly and frequently, it Is it would not be a natural fit. clearly · Step Three: Once a process has “passed” through Steps One defined and Two, a TMO can be designed. The driving design principle is incentive compatibility to ensure that all parties are aligned. For the same problem context, for example claims processing, it is possible to define two different types of Is the pricing approaches for TMO, where one has the vendor and transaction the client on the same side of the table and the other where they are on opposite sides of the table. repetitive The following is a visual representation of the process: Does it have a clear beginning and end Is there significant demand Executive Summary variability Introduction Prerequisites of a TMO Strategic Benefits Does it allow 3-step Process compatibility Illustration 1 of incentives Illustration 2 Conclusion & Recommendations Page 7
  9. 9. Transaction-based Pricing Model for Outsourcing: Why and When Illustration 1: FTE-based Vs. Transaction-based Pricing Models New Business Processing in Insurance Industry To understand the benefits of a TMO over FTE-based pricing model, let us examine the case of a Life Insurance company that wants to outsource its Term and Whole Life New Business processing. We have taken up the new business process since it has the features for a process that is required for a good TMO. The actual new business process will have the following sub-processes - Receipt of Application/Proposals, Imaging System (Digital Room), Review of Application, Data Entry of Application, Generation of Requirements (Med/NM), Automated Underwriting, Manual Underwriting, Reinsurance, Communication/Follow-up, Policy Printing, Policy Issuance, and Medical Fees Payout. Sales and marketing (lead generation) precedes the new business process. In order to design a sensible TMO, which has incentive compatibility, we have combined the lead generation process into the new business process. Typically, transaction payments are made by each of these sub-processes. In terms of payment by the client, we will look at this whole process as one rather than separate sub-processes. This makes the example easier to understand, while keeping this paper instructive. Let's use the framework discussed earlier, to determine and design the TMO for the New Business process. Step 1: Determine if a TMO can be developed for the New Business process: Ø The New Business process satisfies all the criteria that are required for a process to be outsourced on the TMO. The process: - Is clearly defined. The new business transaction is considered complete when a policy is issued and is “In Force” - Is a repetitive and continuous process - Is a standardized process that involves lead generation, application processing, data entry, underwriting, case management and policy issuance - Has a significant IT/automated component embedded - Is easy to track/monitor (since the transaction is clearly defined) - Is of a short duration (1 FTE can process 250 of these transactions per month) Executive Summary Introduction Ø We can therefore safely conclude that the New Business process can be Prerequisites of a TMO outsourced on a transaction-based model. Strategic Benefits Step 2: To determine if the New Business process should be outsourced based on 3-step Process the TMO: Illustration 1 Ø In any insurance company, the number of policies written varies from month to Illustration 2 month. It is unlikely that the number of policies issued remains steady for each Conclusion & Recommendations Page 8
  10. 10. Transaction-based Pricing Model for Outsourcing: Why and When month. We can safely assume that there will be significant demand variability and therefore conclude that the New Business process should be outsourced on a TMO. To understand the significance of outsourcing the process based on a TMO, let us consider the example of the New Business process for the client's Term and Whole Life insurance segments. Let's assume that the insurance company client estimates, based on historical averages, approximately 10,000 new policies would be issued per month. Let's say that the client has two chargeback options for outsourcing this process: 1) An FTE-based pricing model, or 2) A Transaction-based pricing model for outsourcing (TMO). Option 1: FTE-based pricing model Assuming that one FTE (Full Time Equivalent) can process 250 of these transactions per month, 40 FTEs will be required to handle the anticipated volumes. If the client pays an offshore vendor $15 US per hour per FTE for New Business processing, based on an 8 -hour day, the vendor's monthly charge will be $96,000 for the contracted number of man hours, representing 6,400 total billable hours every month (assuming 160 billable hours per person per month). The client signs a contract to pay $96,000 per month regardless of the actual number of policies issued. Because of the low hourly rate, the client considers this cost attractive and rationalizes that even with lower policy volumes, the costs are reasonable. It is an accepted industry norm that the FTE model leads to a 5% decrease in the overall costs, y-o-y, due to process improvements and increase in efficiency of resources over time. However, we are not considering this in our example because it applies to TMO as well, and hence is not a differentiator between the two models. FTE-based Model Vs. Transaction-based Pricing Model for Outsourcing No. of new Costs as per Costs as per Month policies issued FTE-based pricing model TMO No. per month (in USD) (in USD) (1 new policy (40 FTEs) ($10.00 issued = 1 new per transaction) transaction) Intangible Costs Tangible Costs 1 7,000 Intangible Costs 96,000 70,000 2 10,000 96,000 100,000 3 13,000 Some wastage 96,000 130,000 Executive Summary Introduction 4 9,000 Delays + Loss of opportunity 96,000 90,000 Prerequisites of a TMO Strategic Benefits 5 12,000 Delays + Loss of opportunity 96,000 120,000 3-step Process Illustration 1 6 8,000 Delays + Deteriorated Service 96,000 80,000 Illustration 2 7 11,000 Intangible Costs 96,000 110,000 Conclusion & Recommendations Page 9
  11. 11. Transaction-based Pricing Model for Outsourcing: Why and When 140,000 FTE-based Pricing Model TMO 120,000 Tangible Costs to the Client (USD) 100,000 80,000 60,000 Clients realize several benefits 40,000 from a transaction-based model. Most of these benefits 20,000 are derived from access to flexible resource capacity. 1 2 3 4 5 6 7 Months Costs to the Client as per FE-based Pricing Model and TMO Option 2: Transaction-based model By outsourcing using the TMO, the client only pays the vendor for the number of policies issued. This is usually subject to a minimum threshold level we will use 7,000 policies as the minimum number of transactions per month for this example. The vendor charges $10.00 per transaction, with a minimum commitment of 7,000 transactions per month, or $70,000. If 10,000 policies are actually issued in a given month, the client will be billed $100,000, instead of 96,000 as in the preceding FTE- based example. The client actually pays a premium in the TMO model; as opposed to the FTE-based model because the Fixed costs of the client is converted to variable cost in the TMO model. Also, there is a Poisson arrival pattern (e.g., Monday morning shift needs 100 people and Tuesday afternoon needs 80) that forces a staffing change. Hence vendor incurs a greater cost. In the FTE-based model, excess demand is queued thereby precluding any possibility of professional service levels in that model. Executive Summary However in TMO, service level can be guaranteed even with demand variability and Introduction hence a premium is charged by the vendor. Nimbleness comes not because of FTE Prerequisites of a TMO or TMO model, but because in a TMO you own the technology and operations and Strategic Benefits therefore can have a pool of pre-trained people who are highly skilled. As the vendor 3-step Process is aware of the variability, these people will be deployed across multiple clients but Illustration 1 same technology. Hence the vendor is able to keep a pool as a shared resource Illustration 2 pool. Conclusion & Recommendations Page 10
  12. 12. Transaction-based Pricing Model for Outsourcing: Why and When Comparing FTE-based and TMO Costs In any insurance company, the number of policies issued varies from month to month. It is unlikely that there would be a steady issue of 10,000 policies each month. So, let us consider different months where the number of new policies fluctuates between 7,000 (minimum commitment by the client in the TMO) and 13,000. Note that the total number of policies issued in our example is 70,000 over 7 months, which is exactly equal to the forecasted average of 10,000 policies per month. The table illustrates these months, comparing the FTE-based pricing model versus TMO: As illustrated above, both the options yield similar results and similar costs when 10,000 policies are written each month (Month 2). The TMO model costs slightly more since the vendor charges a premium in this model because the vendor is bearing a greater share of demand-side variability and risk, as compared to the When there is demand FTE-based model. But it is highly unlikely that exactly 10,000 policies are written every month. variability in a process being Clients realize several benefits from a transaction-based model, as illustrated in the outsourced, the client can preceding table. Most of these benefits are derived from access to flexible resource save in terms of both tangible capacity, as is clear from the following: and intangible costs, by using a) Months 1, 4, and 6 - When the number of policies issued is lower than 10,000 per a TMO month, the transaction-based model saves the client between $26,000 and $6,000 per month when compared with the FTE-based pricing model. The TMO minimizes underproductive resources when compared with the FTE-based pricing model, where staffing levels are set to service the high end of the anticipated monthly transaction counts. b) Months 3, 5, and 7 - When the number of policies exceeds 10,000 per month; the FTE-based pricing model can result in diminished service levels. The 40 FTEs employed by the vendor are equipped to handle 10,000 policies per month. In Month 7, when the number of policies issued per month amounts to 11,000; there could be delays in the application, underwriting, case management and policy issuance processes. In Months 3 and 5, the number of policies is significantly beyond the capacity of 40 FTEs. Service levels, client and end consumer satisfaction would be negatively impacted. Daily carryover levels would rise, straining the organization further. Although the TMO appears more expensive when the number of policies issued each month exceeds 10,000, the inherent resiliency of the model eliminates the risk of losing business because of delays and service quality deterioration. The extra costs are also offset by revenue growth arising from the greater number of policies being issued. Let us assume that 50% of the policy applicants drop out from the “higher demand” portion in Months 3 and 5. For example in Month 5, the “increase in applicants” would be 12,000 minus 10,000 or about 2,000. Due to delays, 50% or about 1,000 of those applicants drop out. And let us say that the premium related profits are about $50 per new policy issued. So the lost opportunity in an FTE-based pricing model is $50,000 Executive Summary in Month 5. In comparison, the TMO eliminates this and yields additional revenue of $26,000, even after factoring in an additional cost of $24,000. Similarly, the additional Introduction revenue that would be generated in Month 3 would amount to $39,000, even after Prerequisites of a TMO factoring in an additional cost of $36,000. Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Page 11
  13. 13. Transaction-based Pricing Model for Outsourcing: Why and When Step 3: Since we now know that process should be outsourced on a TMO, let us determine how it should be designed. The design insures that there is compatibility of incentives between the client and the vendor. In the FTE-based pricing model, there is a degree of conflict between the interests of the client and the vendor. Since the vendor is paid on a per FTE basis, the vendor has an incentive to increase the number of FTEs for a given amount of work. At the same time, the client wants to hold steady, or decrease, the number of FTEs supporting the New Business process. However, in the TMO, the incentives of the client and the vendor can be aligned to insure that the outsourcing arrangement benefits both parties. For the New Business process example, the incentives might be aligned by giving an additional bonus to the vendor for premiums generated beyond a previously agreed threshold. The vendor in this case would try and generate as many leads as possible and convert Some of these savings can be them, in order to maximize this bonus, translating into top line growth. passed on to the client, In addition, in the TMO, the vendor is motivated to increase efficiencies to reduce the cost per transaction. Some of these savings can be passed on to the client, benefiting both parties, and benefiting both parties, and leading to new value resulting from the compatibility of leading to new value resulting incentives. For example, a client can contractually motivate vendor to generate from the compatibility of additional savings by agreeing to share any such savings through productivity improvements with the vendor. incentives. Although the incentives of the client and the vendor seem to be aligned at an efficiency level, some potential problems exist. In this case, the vendor is generating leads, and is also underwriting the policies. The vendor gets a bonus when a larger number of policies are issued in a given timeframe. It is possible, that in order to get the bonus by generating a large number of policies, a vendor may underwrite policies that have underlying risks that do not qualify completely to be underwritten as per the client's guidelines. This means that the vendor would issue policies that have a higher risk than admissible that may result in higher and more frequent claims being generated, and therefore losses for the client. Hence, it is of utmost importance to have adequate measures to monitor and regulate all these processes, to eliminate such occurrences. Claims Processing Ø Similar to the New Business process, the TMO can also be used to align the incentives of the vendor and the client for Claims Processing, and ensure that the outsourcing arrangement benefits both parties. The vendor does not initiate or generate claims. If the vendor is only paid per claim, there is a tendency for the vendor to be neutral as there is no motivation beyond processing each claim properly. However, if the per transaction payment is structured to bring in compatibility of incentives and alignment in interests, the vendor can be highly motivated to bring greater value to the client. In case of Claims Processing, the client's interest is not only to decrease the cost of Claims Processing, but also to minimize overall claim payouts while staying within the contract conditions. If the vendor is rewarded for not only correct processing of claims but for minimizing Executive Summary total claims payouts for a given number of claims, then the vendor and client Introduction interests are aligned. Prerequisites of a TMO Ø In addition, in the TMO, the vendor is motivated to increase efficiencies to reduce Strategic Benefits the cost per transaction. Some of these savings can be passed on to the client, 3-step Process benefiting both parties, and leading to new value resulting from the compatibility Illustration 1 of incentives. Illustration 2 Conclusion & Recommendations Page 12
  14. 14. Transaction-based Pricing Model for Outsourcing: Why and When Illustration 2: Single Client Vs. Multiple Clients, in FTE-based and Transaction-based Pricing Models Let us consider an example of how having multiple clients can help in the better utilization of resources and therefore reduced costs per transaction for the vendor as well as the client. Using this example we will demonstrate how using the TMO in a multiple client scenario results in savings for the vendor and the client owing to sharing of resources, in comparison to the FTE-based pricing model where this is not possible. To understand the benefits in the multi-client scenario, let us examine the case of an insurance company that wants to outsource its Property and Casualty Insurance New Business processing. The insurance company client estimates that, based on historical averages, there will be approximately 10,000 new policies issued per month. The client has the option of outsourcing this business on an FTE-based pricing model, as well as a TMO. Let us look at both the options: a) FTE-based pricing model: Assuming that one FTE (Full Time Equivalent) can process 200 of these transactions per month, 50 FTEs will be required to handle the anticipated volumes. If the client pays an offshore vendor $15 US per hour per FTE for New Business processing, based on an 8-hour day, the vendor's monthly charge will be $120,000, based on 8,000 total billable hours every month. The client signs a contract to pay $120,000 per month regardless of the actual number of policies issued. Because of the low hourly rate, the client considers this cost attractive and rationalizes that even with lower policy volumes, the costs are reasonable. b) Transaction-based pricing model for outsourcing: Applying the framework discussed earlier, we have determined that the New Business process can be outsourced using the TMO. By outsourcing on a transaction basis, the client only pays the vendor for the number of new policies issued. This is usually subject to a minimum benchmark level. For this example let's use 7,000 policies as the minimum number of transactions per month. The New Business transaction is considered complete when a policy is issued and is “In Force.” The vendor charges $12.5 per transaction, with a minimum commitment of 7,000 transactions per month, or $87,500. If 10,000 policies are actually issued in a given month, the client will be billed $125,000 just as in the preceding FTE-based example. Also, in any insurance company, the number of policies written varies from month to month. It is unlikely that there would be a steady issue of 10,000 policies each month. To set up the process for 50 employees, let us assume that the vendor spends the following in both the FTE-based and transaction-based models: Executive Summary Introduction a) Technology Costs - $2 million on technology set-up and maintenance costs Prerequisites of a TMO (which is flexible and scalable), and includes licensing fees, installation, Strategic Benefits maintenance and ongoing support 3-step Process b) Process Costs - $1 million on setting up the process which includes setting up the Illustration 1 process, documentation, monitoring, refinement of the process, and training the Illustration 2 employees Conclusion & Recommendations c) Infrastructure Costs - $0.5 million on the infrastructure costs including hardware, networks, storage, work-stations and peripherals Page 13
  15. 15. Transaction-based Pricing Model for Outsourcing: Why and When The client therefore spends a total of $3.5 million to set up the process for 50 FTEs. In addition, the client spends on the direct and indirect employee costs for the 50 employees involved in the process. Let us consider two different scenarios: Scenario 1: In this scenario, there is no major difference between the FTE-based and the transaction-based models. The vendor has only one client and has 50 employees working for this client, with a dedicated technology and process in either model. Scenario 2: Here, the vendor has four insurance clients, all of who are looking to outsource the New Business process for their P&C (Property & Casualty) businesses. In an FTE-based pricing model, the agreements between the client and the vendor prevent the use of common employees, technology platform and processes. This is generally done to protect the confidentiality of the data and to have tailor-made processes to suit a particular client's customers. But, the New Business process is a standardized and repetitive process, which can be performed using a standardized technology platform and process across clients, particularly since every jurisdiction proscribes standard policy forms and coverages. At IGATE, leveraging one technology platform and sharing process resources is called Business Service Provisioning (BSP) or the Pay-By-The-Drink model. In this model, the vendor provides technology, people, and process and bundles them together to deliver a business service that is charged per transaction. As with the earlier example, the number of policies issued by a carrier varies from month to month. It is unlikely that there would be a steady issue of 10,000 policies each month. So, let us consider different months where the number of new policies issued fluctuates between 7,000 (minimum commitment by the client in the transaction-based model) and 13,000 for the four clients. FTE-based pricing model: In the FTE-based model, the vendor will have 50 FTEs and a dedicated technology platform and process for each client. The agreements in the FTE-based models are such that there are dedicated people, technologies platforms and processes for each client, and do not allow any flexibility to share these. Without sharing of these resources, the vendor (or each of the clients) must invest in all these of these areas twice. To set up the process for (50 + 50 + 50 + 50) FTEs, the vendor spends the following: a) Technology Costs - $8 million on technology setting up and maintenance costs (which is flexible and expandable) b) Process Costs - $4 million on setting up the process c) Infrastructure Costs - $1.6 million on the infrastructure d) Employee Costs - the client has to bear the direct and indirect employee costs of Executive Summary 200 FTEs who are part of the two processes. Introduction The vendor spends a total of $6.8 million to set up the four processes with 50 FTEs Prerequisites of a TMO each, and bears the employee's costs for 100 FTEs. Strategic Benefits It is an accepted industry norm that the FTE model leads to a 5% decrease in the 3-step Process overall costs, y-o-y, due to process improvements and increase in efficiency of Illustration 1 resources over time. However, we are not considering this in our example because it Illustration 2 applies equally to TMO as well, and hence is not a differentiator between the two Conclusion & Recommendations models. Page 14
  16. 16. Transaction-based Pricing Model for Outsourcing: Why and When Transaction-based pricing model for outsourcing: In the TMO, there are various advantages that the vendor can leverage to reduce the average costs per transaction. Since the vendor already had flexibility and easy scalability in the existing technology, process, trained employees and infrastructure, he does not need to set up a new process altogether, like in case of an FTE-based pricing model. Sharing of these resources results in better/optimal utilization of the existing resources: a) Technology Costs - Since the technology platform can be shared between the two processes, the existing technology platform for the first client can accommodate the processes of the second client as well. We assume that the existing technology platform has the bandwidth to accommodate all the processes with some additions. Let's assume that the vendor spends about $4 million on the technology platform to handle the processes for the four clients. This results in a direct saving of $4 million when compared with the FTE-based model, savings that could be shared with the clients. b) Process Costs - Similarly, the incremental cost for setting up the process for all the clients will be significantly lower as compared to setting up a completely new process for each new client, since the same standardized process is followed for all the clients. Since the process has already been set up, documented, refined and the training modules exist, lets assume that the vendor only needs to spend approximately $0.4 million more than for each additional client. So, the total cost for the process for the two clients would be around $2.2 million. This results in a direct saving of $1.8 million when compared with the FTE-based model. c) Infrastructure Costs Once again, the vendor can leverage the existing infrastructure in terms of hardware, since the processes are standardized. The vendor may have to make some additional investments for each additional Demand Variability for the Two Clients Policies Policies Policies Policies Total Month Issued Issued Issued Issued Policies No. (Client 1) (Client 2) (Client 3) (Client 4) Issued 1 7,000 11,000 8,000 13,500 39,500 2 10,000 9,000 12,000 8,000 39,000 3 13,000 7,500 12,500 7,000 39,500 4 14,000 8,000 7,500 9,500 39,000 Executive Summary 5 9,000 10,000 7,000 13,500 39,500 Introduction 6 12,000 7,000 14,000 7,000 40,000 Prerequisites of a TMO Strategic Benefits 7 8,000 8,000 12,000 12,500 40,500 3-step Process Illustration 1 8 11,000 7,000 12,000 10,000 40,000 Illustration 2 9 13,000 13,000 7,000 7,500 40,500 Conclusion & Recommendations Page 15
  17. 17. Transaction-based Pricing Model for Outsourcing: Why and When 45,000 40,500 40,500 40,000 40,000 39,500 39,500 39,500 40,000 39,000 39,000 35,000 Total Policies Issued per Month Policies Issued for Client 4 30,000 Policies Issued for Client 3 Policies Issued for Client 2 Policies Issued for Client 1 25,000 Policies Issued 20,000 15,000 In a multi-client scenario, the vendor 10,000 can make use of the 5,000 transaction-based model to achieve 1 2 3 4 5 6 7 8 9 economies of scale, Months which will result in Policies Issued in a Multi-Client Scenario savings to the vendor. A part of this saving can process in terms of work stations and other office equipment, say, $0.1 million be passed onto the each. So the total costs of the infrastructure for the two processes will be around $0.8 million. client, thereby resulting This results in a direct saving of $0.8 million when compared with the FTE-based in direct benefits to both model. the parties involved. d) Employee Costs As shown in the table, the combined total number of policies issued for the two clients can fluctuate between 39,000 and 40,500*. In the TMO, since the client is charged on a per transaction basis, the vendor has incentives to increase the efficiency of each employee, as opposed to the FTE- based model, where the vendor does not have this incentive, since the client pays per employee. The vendor is in a better position to do this since the same process is being standardized and refined for both the clients. Moreover, we can assume that when the number of policies issued by one client goes up, with an increased demand for employees working on that process, employees from other similar processes where the demand is lower can be deployed. The result is a more optimal utilization of employees, and the employee costs are reduced when compared with an FTE-based pricing model. For all these reasons, the vendor will employ only 150 employees to work on the four processes, instead of the 200 in the FTE-based model, thus further reducing the employee costs in comparison. We conclude that in the TMO (specifically BSP in this case) the vendor spends $7 million to set up the process, in contrast to the $13.6 million in the FTE-based pricing model. This results in direct savings of $6.6 million for the vendor. The vendor is also Executive Summary able to reduce the employee costs by utilizing the services of only 150 employees, Introduction rather than 200 FTEs in the FTE-based model. Assuming that an employee costs the Prerequisites of a TMO vendor $8,000 every year, this would result in savings of $400,000 for the vendor, in Strategic Benefits Scenario 2. Most of these savings are shared with the client in the form of lower per 3-step Process transaction fees. Illustration 1 Illustration 2 * This is a contrived example where the individual figures have been assumed in such a way that it results in a Conclusion & Recommendations smoothened cumulative curve, in order to highlight the benefits of TMO. However, we believe that even in the real business scenario, having multiple clients do help the vendor in moving towards a smooth total/cumulative curve. Page 16
  18. 18. Transaction-based Pricing Model for Outsourcing: Why and When Conclusions and Recommendations Transaction-based pricing model for outsourcing can be a powerful mechanism that companies should seek in structuring outsourcing contracts in certain situations. Given the right transactional process and the appropriate design of the TMO, a client can derive significant benefits when there is demand variability. In particular, this approach can lead to the alignment of incentives of the client and the vendor so that both parties naturally act in the interests of the partnership. Strategic alignment between clients and vendors is critical when customer-facing processes are involved, and the chargeback scheme achieves this. In addition, the structure of TMO provides incentives for the vendor to invest in improving process performance over time, while the FTE-based approach does not. the structure of TMO provides This ensures long-term competitiveness over time as well as a focus on tangible and incentives for the vendor to intangible quality measures. Clients receive both good pricing and maintain or enhance other process metrics. invest in improving process We have provided a prescriptive framework that is simple yet powerful in determining performance over time, while whether a process context is right for employing a TMO and if so, how to design one the FTE-based approach does that would be effective. not. As business moves towards greater flexibility and agility, processes get standardized almost naturally. Companies will access such standardized business processes on demand and pay per transaction to ensure greater control over profitability and enhanced competitive positioning. Thus, given the right circumstances, transaction- based pricing model for outsourcing can be a strategic differentiator for companies to gain a competitive edge. Acknowledgement The authors wish to acknowledge the contributions of Sachin Xavier, Nina Babirad, Samir Agrawal and Tony DiRomualdo, IP Development & Key Initiatives Group, in the creation of this white paper. Executive Summary Introduction Prerequisites of a TMO Strategic Benefits 3-step Process Illustration 1 Illustration 2 Conclusion & Recommendations Page 17
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