In sourcing negotiations, some service providers propose what they call a zero-charge transition in the hopes that it presents the buyer a favorable cash flow option and gives them a slight edge over the competition. The pricing structure waives fees up front that are typically required to finance a transition and recovers the expenses through higher base charges, project rates and termination fees.
Enterprise IT organizations should carefully evaluate zero-charge transitions in the context of the overall bid as this structure can result in a higher total contract cost. Additional factors companies should consider include lost leverage in the transition period, the challenge of completing critical milestones in a timely manner and pricing ambiguity that can complicate benchmarking.
Weigh the Effects of the Zero-charge Transition Pricing
Transition costs for application development and maintenance (ADM) services can be 25 to 35 percent of the first year’s base charges for services. There are numerous drivers for transition costs, including the company’s experience with sourcing transactions (whether it is a generation-one sourcer or a generation-two sourcer), the degree of complexity of the IT environment, the number of business units impacted, physical locations involved, and factors included in transition such as specific tooling.
It is unlikely that a provider is simply absorbing any transition costs. It’s more likely the costs are incorporated elsewhere.
Here are some considerations when a provider is willing to offer a zero-charge transition:
- Do you have complete transparency? Ask the provider to submit two pricing proposals – one with transition fees and one without. If the provider is unwilling to disclose the transition fees, conduct an analysis of the bid in total to tease out the transition fees inherent in the base charges, project and termination charges. Make educated estimates regarding costs, interest, inflation, etc., and then ask the provider to comment on whether the assumptions are reasonable.
- What are the base charges? Base charges are typically higher in a zero-charge transition proposal, but do the homework needed to determine if interest is a component of the differential. If it is, establish whether the implied interest rate is higher than the company’s cost of capital.
- Are the terms well defined? Transition costs implicit in termination fees can become a potential barrier for a buyer in exercising its option to terminate services for convenience. The zero-charge transition doesn’t just exclude the buyer’s leverage during transition, it shifts substantial leverage to the service provider if/when the buyer wants to terminate for convenience. To mitigate this risk, insist that all providers bid to a specific set of terms and fee types for termination for convenience. Typical termination for convenience fees include wind-down costs, unamortized costs and early termination fees. This proactively forces the issue and might have the effect of motivating the provider to bid transparently.
- How does this affect the books? Accounting principles may not permit deferring the recognition of expenses that are bundled with future service costs. IT should review the proposed pricing structure with the accounting team to determine the impact on the financial statements.
Maintain Leverage Over Critical Milestones
Smooth and timely transitions are key to a successful sourcing strategy. Traditionally, companies withhold payment if the provider doesn’t meet critical milestones. Zero-charge transitions eliminate that threat to the provider. Companies will have to employ alternative incentives to ensure the transition stays on schedule. Recommendations for alternative measures may include:
- Withhold payment for base charges until transition is fully completed and services have commenced. Also deny project work to the provider until transition is complete.
- If a critical milestone is missed, decrease termination for convenience fees by a predetermined amount (applicable if transition fees are intrinsic in termination for convenience fees). The amount could vary depending on the number of days by which the milestone is missed.
- Establish a fixed end date to the contract term in lieu of “a number of months post commencement date.” Each month the transition is delayed equates to a month of lost revenue for the provider.
- Require the provider to use your company as a reference once a year for the first three years of the contract.
Address Benchmarking Complexity in the Contract
Zero-charge transition results in ambiguous base charges that remain an issue past transition and for the life of the contract. It can be difficult to determine whether the provider’s bid includes annual price reductions in the base charges (as expected by the market) when those base charges have implicit transition fees. After “reverse engineering” the zero-charge transition proposal, a buyer will need to model annual reductions and negotiate to those terms. This can be increasingly difficult if transformation is also a factor in the solution and pricing.
Benchmarking base charges against the market can be complicated. Add enhanced language to the contract that allows for market price to be a “defined maximum percent lower.” Be sure to set up a price re-alignment trigger once you pass that allowance.
A zero-charge transition proposal is neither objectively “good” nor “bad.” It adds another dynamic to the negotiation process and necessitates some additional analysis, but it can be a useful tool that benefits both the provider and the client and allows for financial targets to be achieved in the initial year. IT sourcing is ever evolving, and zero-charge transitions could become the rule rather than the exception. ISG is the market leader in IT sourcing transactions and can support you in negotiating the intricacies of a zero-charge transition to attain your best deal.