Assessing the value in value-based pricing

Although it's tempting to build premiums and penalties into consultants' paychecks, value-based pricing isn't always the best solution. Look before you leap.
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Spreading the wealth--and the risk--is a new concept emerging in corporate IT consulting. It's called value-based pricing, and it comes in many forms, from paying the consultant entirely according to revenue gained to building time-measured rewards and penalties into projects, including an enterprise resource planning (ERP) implementation.

Fundamentally, value-based pricing transfers some of the risk and potential reward to the consultant. Rather than valuing a systems implementation in the traditional time-and-materials manner, value-based pricing at least partially compensates consultants based on metrics, or achievement of specific goals at various points throughout a project. Metrics can vary from the timely installation of a specific SAP AG module to improving inventory turnover by a specified percentage. The consultant is then paid a reward for achievement of the goal.

AT A GLANCE: Commonwealth of Massachusetts Department of Social Services
The department: The DSS is a state agency charged with protecting children who have been abused or neglected in a family setting.

The problem: In order to apply for federal reimbursements, the DSS must gather detailed documentation on the type of services provided to each child.

The solution: A value-based systems implementation contract with Andersen Consulting.

The IT infrastructure: A LAN-based system.

Pricing based on value is, in part, a response to complaints about unsuccessful ERP implementations or companies not being able to calculate an ROI on their ERP system implementations. Value-based contracting forces a company to examine its business case for the systems integration project, i.e., that it's not just a "me too" project.

But value-based pricing is not yet widely used for systems integration projects. International Data Corp., of Framingham, Mass., estimates that in 1998 only 1.5% to 3% of systems integration projects were priced based on value. Most analysts, consultants, and clients expect that figure to increase, but no one predicts it will even reach 50% of systems integration projects because of all the time and effort it takes to find the right metrics, create an effective contract and then track performance. According to one expert, clients need to devote at least one person, full time, to keeping up with the contract.

Value-based pricing has been particularly successful in the government sector. "Basically, for managers in state governments, this has been an extremely powerful tool," says Ray Campbell, general counsel for the Commonwealth of Massachusetts' information technology division in Boston. "Value-based contracting lets us enter into almost joint-venture types of arrangements where there is a shared risk and reward model."

Where it works

Types of value-based pricing
Gain sharing. At least part of a consultant's pay is based on the gain or benefit to the client from the implementation of a system. Payment is based on specific metrics, which are usually tied to cost savings or revenue earnings. For example, a metric in a supply chain engagement might be improving inventory turnover by a given percentage.

Benefits-based. The client pays nothing until benefits accrue. The consultant absorbs all up-front costs.

Time/delivery or valuable milestone. Consultants are rewarded or penalized at certain stages during an engagement. The rewards are time- or delivery-based. A reward might be based on the implementation of a certain SAP module, for example, within a specific period of time.

The concept of value-based pricing is more popular in outsourcing engagements, because it's much easier to measure the success of a vendor taking over an entire department or function. Still, if you throw in outsourcing, only 20% of all systems integration, consulting, and outsourcing projects combined include some form of value-based pricing, according to the GartnerGroup, of Stamford, Conn.

The best types of systems integration projects for value-based pricing deals are those that are revenue-generating or cost-saving and apply to a particular department or function. Supply chain system implementations, for example, work well because specific measurements, can be used, such as improved inventory turnover or fewer orders lost.

"We have typically used these types of engagements in revenue management types of projects because there is a very easy way to define success--an established benchmark of revenue collections," says Massachusetts' Campbell. The Commonwealth has entered into a number of value-based contracts, including several with Andersen Consulting of Chicago and Public Consulting Group of Boston.

One of its agencies, The Department of Social Services (DSS) engaged Andersen Consulting from 1993 to 1997 to install a LAN-based computer system that would help the state agency track children's services eligible for federal reimbursement. In order to capture the federal reimbursement, department officials needed detailed documentation on the services provided--who received them, whether that child was eligible for Medicaid or other federal programs, and so on.

"Andersen Consulting put in a $6 million computer system at their own expense," says Campbell. "The agency paid no money." He adds, "That computer system, and a lot of work done to set up the data collection and entry processes, allowed the state to receive $120 million in additional federal reimbursement, and Andersen Consulting got a percentage. It was a very successful engagement for Andersen Consulting and the state." Neither Campbell, nor Edward Burke, an Andersen Consulting partner in Boston involved in the Commonwealth's project, would comment on what Andersen received for the project.

Burke says his firm has entered a number of value-based arrangements with government agencies where Andersen makes all the up-front investments. "If you don't at least achieve the baseline level, we don't expect to be paid at all," he says. That's the way it was with the Commonwealth project, notes Burke, who heads up Andersen's government strategy practice and is a member of a firm-wide steering committee that oversees value-based deals across industries. Then, "the more benefits we brought in, the higher the benefit percentage we were paid," he adds.

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