One of the most difficult transitions that I participated in was a company that was trying to convert its traditional T&M (Time and Material) services offering to an outcome-based or fixed fee service. When they first started, the T&M contracts were simple to conceive of and gained them some favor with their clients. The clients had a rate sheet and could calculate what the people they were going to use would cost them. The clients liked this because the costing and pricing model being used was transparent, and they could easily consider and plan for projects using this type of model. The problem became that the client was accepting all the risk.
As the sophistication and complexity of what was being done increased, the client wanted less and less to take on the risk of paying Time and Materials. They did not know how long something was going to take to accomplish, so they were nervous about getting a group of people started on the project only to find out that they had not allocated enough time or enough resources. The clients began to push back on this type of contract, because they did not want to take on this risk. Other competitors were coming in and offering fixed pricing for specific outcomes, which effectively reduced client risk. The competitors were charging five to ten times the price for the same service, and the clients were accepting them due to one critical factor, risk transfer.
In the T&M model, the pricing was easy to figure out. Number of hours, number of people, and a specific hourly rate. Easy. The problem is that if there were overages, or a need for more effort, the client shouldered all of that risk. If people underperformed or did a bad job, the client shouldered that risk as well. They would have to repeat the effort to fix any issues that did not work the way they wanted them to. The initial allure of the exposed and straightforward cost model now had challenges. As a consequence, the clients started asking for “guarantees” or “not to exceed” values. This shifted risk to the contractor, and as a consequence, the contractor wanted to increase the price. This led me to a realization. You are not really pricing the cost of goods and services plus a margin. What you are really calculating is how much you are going to charge for taking the risk that the client does not want to take.
This means that margin, or at least good margin, is a calculation of how much risk you are transferring away from the client. That is ultimately where the value is derived. If you can figure out the risks that the client is facing, and they would like to avoid those risks, then you have figured out what you can charge for. The interesting part is figuring out how valuable that risk transfer is. In some cases, in the services business for example, I have found that to be significant.
This is not just a calculation of meeting the desired outcome or project completion. This could also relate to data quality, availability, feasibility of hitting targets for accuracy, pass through concerns with third parties, absorbing pricing volatility, and handling compliance and security concerns. All of these, and many more, are potential areas for risk transfer. Each can be more valuable than the last. As I learned with my experience in the professional services firm, the bottom rung of the risk price ladder is T&M, where the client takes all the risk. The next rung is fixed fees with some ability to issue change orders, and then the next rung after that is fixed fee with SLA penalties and credits. Then, of course, is the idea of outcome based, where the contractor only earns after the desired results are achieved. The hardest one, where the contractor accepts the most risk, is gainshare, the concept that the contractor gains as the client gains. This is the exciting one, where a great deal of wealth is generated, but the contractor is definitely taking on the most risk.
This concept of charging for risk is not new. Consulting firms have been working with this idea for decades. What is often not well designed is how to compute the premium cost that you will charge for taking the risk in a simple and defensible way. That seems to be the stumbling block when your client has a mutual conspiracy with you to get to a simple model based on cost that exposes the client to all the risk. Convincing them that this is not the best model is difficult, because not all people can see where the cost really lies, and that is with accepting and avoiding risk.
