57

Charging is frequently perceived by most lawyers

to be something of a black art, an area best left to

accountants and consultants. This article provides

a brief overview of some of the payment

mechanisms that may be appropriate in respect of

a large scale IT project. It also highlights some of

the key advantages and disadvantages of certain

ways of structuring payments.

In an IT contract of any size, the charging

schedule is likely to be both highly complex; and

possibly a hybrid, mixing and matching a number

of approaches to charging. This article considers

some of the charging mechanisms typically found

in a major IT contract. These include fixed

pricing, target pricing, cost plus, time and

materials and variations to all the above, including

open book accounting, benefit-sharing and use of

balanced scorecards.

A. Fixed pricing (plus indexation)

1. How it worksThe supplier agrees to provide certain services (eg

transition services or design and development of a

solution) for a fixed cost. Where these services are

provided on an ongoing basis, these fixed prices

may be subject to annual indexation to ensure that

the supplier is not exposed to the risk of inflation.

2. Advantages� Fixed pricing offers a guaranteed contract price

providing predictability to both parties;

� Fixed pricing means that it is simple to

calculate the total costs of ownership and easy

to administer; and

� Subject to the first bullet point below, fixed

pricing can be advantageous to a customer in

that the supplier takes the risk of estimating

the actual costs of delivering a service. In a

competitive procurement, the customer would

hope that the supplier’s estimate is too low,

rather than too high.

3. Disadvantages� Fixed pricing may be based upon a forecasted

level of usage throughout the contract term. If

the customer’s usage falls significantly below

that level, the customer may end up paying too

much for the service consumed. Likewise, there

is a risk for the supplier if usage goes

significantly above the forecasted figure; to

cover this risk, the supplier may seek to build

some contingency in its pricing.

� Fixed pricing can lead to the identification of a

number of services that are out of scope. The

customer therefore needs to be confident that

the specification it puts forward will meet all

its requirements. If the customer fails to do so,

subsequent changes may be priced at a

premium by the supplier.

� Indexing works best for services which are

easily commoditised. However, it is also

arguable that indexing works to stifle

innovation by locking the supplier into market

averages rather than rewarding the investment

that drives long term efficiency.

� If the supplier loses money, they may seek to

cut their losses (subject to payment of damages

and/or termination charges). A bargain

basement price may not therefore work to the

customer’s advantage.

B. Target pricing

1. How it worksThis form of pricing incorporates an element of

risk and reward. The target price for each year,

and for each element of the service subject to

target pricing, will be agreed by the customer with

the supplier. In the event that the supplier’s actual

costs of delivery (plus agreed margin) exceed the

target price, the supplier will be responsible for an

agreed percentage of all additional costs necessary

to properly provide services up to an agreed

threshold. The customer will pay the balance of

the excess costs up to the threshold. If costs

further exceed this threshold, they may be divided

according to an agreed but different percentage. If

the parties agree, there may be additional

threshold figures which envisage further and

different payment sharing percentages in respect of

higher levels of cost overrun.

If, on the other hand, the supplier’s actual costs for

Computer Law & Security Report Vol. 20 no. 1 2004 ISSN 0267 3649/04 © 2004 Elsevier Ltd. All rights reserved

IT procurement

An introduction to charging mechanisms in ITprocurementsJustin Harrington, Field Fisher Waterhouse

This article

considers some of

the charging

mechanisms

typically found in

a major IT

contract

58

delivery of the services plus agreed margin are less

than the target price, the customer will pay the

actual costs incurred by the supplier plus an agreed

percentage of the savings achieved by the supplier.

There may be a threshold below which all savings

go to the customer.

2. ExampleThe supplier’s agreed target price for each year of

the service will be set out in the charging schedule

of the agreement. It is agreed that if the supplier’s

actual costs exceed the target price, but are less than

120% of the target price, then the supplier and the

customer will each pay half of the overrun costs.

If the supplier’s actual costs are greater than

120% of the target price, then the parties may

agree that responsibility will be divided in the ratio

75:25, with the supplier paying the greater

proportion of the costs.

If the supplier’s actual costs are less than the

target price, then the saving may be split equally

between the supplier and the customer.

3. Advantages� The supplier has an incentive to keep its costs

low and to work to agreed budgeted targets;

� If the supplier agrees to meet all costs (without

limit) in excess of the target costs, then the

customer will benefit from predictable pricing.

But note linked disadvantages below; and

� Where a partnering approach is relevant, target

pricing arguably shows attributes of a genuine

risk/reward approach, thus driving the sort of

behaviour that is expected of a true partner.

4. Disadvantages� If the supplier over-achieves and the customer

pays the difference (or a percentage of the

difference) between actual and target costs, the

customer obtains no (or reduced) benefit when

compared to a time and materials approach;

� The supplier will typically seek to cap its

exposure to cost overruns. The amount of pain

suffered by the supplier may be small

compared to the total cost of the overrun. This

may also mean that the customer is left with

some uncertainty as to the amount payable;

costs may not be as predictable as this model

may suggest on first sight;

� Target pricing can be complex to administer; and

� Target pricing is dependent on the supplier

being comfortable delivering on this basis.

C. Cost plus

1. How it worksCost Plus typically incorporates some form of

open book accounting treatment. It relies upon the

supplier being entitled to make a set profit above

its fixed costs. The customer would pay for

equipment, staff, software and services at the

supplier’s actual cost plus an agreed margin. To

the extent that the supplier’s profit exceeds this

figure, the excess would be returned to the

customer.

2. Advantages � In common with all open book methodologies,

Cost Plus provides transparency as to costs

involved;

� Cost Plus provides some comfort that the

supplier is not making excessive profits at the

expense of the customer. This may be

particularly important when acting for the

public sector; and

� Cost Plus enables both parties to benefit from

marketplace trends; the supplier may have

negotiated discounts with certain hardware or

software producers which it will be able to

pass on to the customer.

3. Disadvantages� Cost Plus does not provide any predictability of

costs for the customer;

� With Cost Plus there is no incentive on the

supplier to reduce its fixed costs;

� The success of a pricing mechanism based upon

Cost Plus depends upon the supplier’s

willingness to provide transparency as to its cost

structure; many are coy about doing so; and

� Cost Plus may involve considerable complexity

in working out what base costs of the supplier

should be paid for by the customer. This is a

particular issue with regard to working out the

cost to be attributed to central and overhead

services. The concern may be that the supplier

will seek to increase its margin by

overestimating the cost of these services.

D. Time and materials

1. How it worksMost lawyers will be familiar with payments

based upon time and materials since it is the

usual basis upon which they charge. In a time

IT procurement

59

and materials contract, the customer would pay

for all services based upon the number of days or

hours worked by the supplier’s employees. Day

and hour rates will be set out in the contract. In

some cases, the day rates may be subject to a

maximum number of hours per day or week;

hours worked in excess of the maximum would

not be charged to the customer. There may also

be threshold figures which trigger reductions;

once invoices billed to the customer reach a

particular level the customer would be entitled to

a deduction of a set percentage from all future

bills.

In addition to time costs, any materials (hardware,

software costs and expenses) will be charged by

the supplier to the customer either at cost or cost

plus.

Time and materials will usually be linked to

broad audit rights and/or open book accounting.

2. Advantages� When linked with audit rights/open book

accounting, time and materials provides a

certain degree of transparency as to costs;

� Time and materials may be favoured by some

clients on the basis that it reflects the real cost

of providing the services; and

� Time and materials creates some flexibility

around volumes. If the customer wants more

or less of a service, the customer will know the

basis upon which it will be charged.

3. Disadvantages� Time and materials means that there is no

predictability as to costs for the customer;

� Charge out rates typically reflect the profit

margins for the supplier. Where this is

important to the customer, time and materials

means that there is no control over the profits

made by the supplier;

� Linked with the last point, customers may have

a potential concern as to ‘excessive profits’ to

be made by the supplier and value for money;

� Customers may also query whether the time

spent by the supplier was:

(a) required; and

(b) efficient; and

� A key concern in time and materials contracts is

that there is no risk to the supplier. All risk

remains with the customer unless time and

materials is linked to some form of target

pricing or capped fee.

E. Variations to the above

1. Project open book accounting Project open book accounting can be

interpreted in a number of ways:

� It may involve the supplier making available to

the customer for audit purposes all its financial

and other papers relating to the project or

services provided; or

� Alternatively, reflecting OGC guidance for PFI

contracts, it may require provision of a

certificate of costs (possibly provided by the

supplier’s auditor or, exceptionally, some other

third party) which details costs, profit and

expenses incurred in the provision of the

services.

(a) Advantages and disadvantagesOpen book accounting can lead to transparency as

to costings. The disadvantage is that some

suppliers are reluctant to provide full open book

and the supplier may argue that certain key pricing

information with its subcontractors is subject to

non disclosure agreements or equitable duties of

confidentiality. If there is a need to enforce, audits

are expensive to administer.

(b) Incorporating into the paymentmechanismOpen book accounting can be used with all of the

pricing methodologies referred to above.

2. Benefit-sharing or incentive pricingThis approach offers the supplier an interest in any

savings made by the introduction of services. It

differs from the normal punitive approach to

payment (the use of service levels and linked service

credits) by linking rewards to tangible business

benefits, such as lower operating costs. Where, for

example, the supplier introduces new technology and

that technology produces savings for the customer,

the savings are shared (meaning a reduction in

payments by the customer and extra payments to the

supplier) so that both parties benefit.

(a) Incorporating into the paymentmechanismBenefit-sharing works best where work is

commissioned on a project basis, for change

control and technology refresh provisions. The

downside is that the supplier is likely to ask for

some means of verifying the saving made to the

customer, whether by independent audit or

verification.

IT procurement

Open book

accounting can be

used with all of

the pricing

methodologies

60

3. Balanced scorecardThe balanced scorecard seeks to incorporate an

element of incentive into the payment mechanism.

The supplier typically agrees to put a percentage of

its charges on risk (usually between 3% and 20%)

and in return has certain aspects of its provision of

services scored by the customer. Typically these

would concentrate on the customer’s satisfaction

with certain “soft” aspects of the services, such as

user satisfaction, willingness to go above and

beyond the call of duty and the supplier’s attitude

towards partnering.

(a) Incorporating into the paymentmechanismAs noted above, since the scorecard would focus

on “soft” aspects of the services, the difficulty here

is that most suppliers will argue that the scorecard

should not relate to a substantial proportion of

the charges. The scorecard should be capable of

adaptation over the life of the project so that it

reflects the customer’s current concerns.

On the other hand, the key advantage of

scorecards is that it encourages a partnering

approach to working and the provision of a truly

integrated service. Depending upon the amount of

charges put at risk, the supplier’s profit may be

directly linked to quality of service. A key risk for

the customer is the preparation and administration

that scoring involves. Those who will score the

supplier will need to be properly prepared and able

to justify their scoring to the supplier; failure to do

so may result in the supplier successfully arguing

for a scoring increase.

F. Hybrid pricing and concludingthoughtsIn reality most complex IT agreements develop a

hybrid pricing model. This involves consideration

as to the nature of the particular services being

procured by the customer and selection of the

most appropriate payment method for each

element of the services.

By way of example, it may be appropriate for

the design element of new software to be provided

on a fixed cost basis. Certain other services may be

best costed on the basis of time and materials and

target pricing. This could be linked with open

book accounting, a balanced scorecard and

incentive pricing (eg for change control and

technology refresh). This approach involves taking

the best aspects of the pricing methodologies

noted above and tailoring them to the services

being procured.

Justin Harrington, Technology Law Group, Field

Fisher Waterhouse

jxh@fflaw.com

IT procurement