Part II: Benchmarking sourcing contracts

Last week, I offered a short historical perspective on the use of benchmarking in sourcing projects. The net conclusion was that currently, neither clients nor service providers are fully satisfied with the effectiveness of benchmarking.

Such a situation suggests that either benchmarking is inappropriate, or that changes need to be made with respect to how it is positioned and used in order to increase satisfaction with its usage.

There are certainly those who argue that benchmarking can and should be abandoned. The reason often cited is shorter contract durations (no more than three years) which allow for direct market testing. Where shorter contract durations are appropriate, it is certainly sensible to leverage the resultant direct market testing. However, this is quite different from proposing the death of benchmarking.

In many situations, short-term contract are not appropriate so such direct market testing is not so relevant. In addition, many short contract durations are often short initially, with clients simply rolling over or extending the initial contract without direct market testing--thus, in practice, result in having a long term contract.

As such, given that benchmarking will continue to have a place, how should it be positioned to increase satisfaction with its usage, both for clients and service providers?

First, benchmarking should be positioned as one of many tools for maintaining price competitiveness and not be relied on as the sole, or even, primary means for setting appropriate pricing on an annual basis. This means that the normal pricing mechanisms such as year-on-year productivity adjustments, inflation adjustments and defined pricing for changes in required service volumes, should be used.

Second, benchmarking should be an infrequently used tool. As a guideline, for a contract that is valid for no more than three years, benchmarking is likely not appropriate. For longer term contracts, benchmarking could be reasonably limited to once every two years, where it cannot be used for a period at the start of the contract--usually, at least the first year.

Third, benchmarking should be positioned as a tool for validating pricing alignment to the market at a macro level (for example, 10 percent), and not at a micro level--consistent with its infrequent use, to ensure no significant misalignment with the marketplace. There are many who argue that sufficient data exists and that sufficient normalization techniques exist to identify minor differences in price (i.e. within a few percentage points). Even putting aside all those domains where it is clear that such data does not exist, there is still a challenge where it may exist. The narrower the data range, the lower the probability that any given data point is within that range and therefore, a greater reluctance to agree to pricing adjustments from outside to inside the range, thus creating fertile grounds for dispute.

There are other aspects of establishing a robust approach to benchmarking, such as how much pricing should move, whether such adjustments be automated, and what happens if the service provider does not move the price. These various components require a deeper analysis beyond that which is easily covered in this blog.

So, next time you're faced with a benchmarking situation, will this influence your thinking about effective solutions?