Service Contract Pricing

How to make after-sales services pay off

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2004-03-30 16:39

by Russell G. Bundschuh and Theodore M. Dezvane For many manufacturing companies, servicing products is an increasingly important part of the business. Manufacturers of everything from elevators and freezers to security systems and transportation equipment products built to last find that revenues from aftersales product installation, configuration, maintenance, and repairs are 30 percent or more of their total revenues, and the proportion is increasing. In some industries, the service market is four or five times larger than the market for products. Over the past few years, as sales growth for new products has slowed and product margins have fallen, services typically with higher margins and returns on invested capital have become an increasingly attractive way to provide a point of competitive differentiation. However, most companies have squandered this profit potential by using poorly designed and priced service plans. A building-equipment manufacturer, for example, discovered that 11 percent of its service contracts didn t cover its marginal servicing costs, let alone its fixed service costs. A transportation-equipment manufacturer found it had given customers discounts of up to 70 percent for the sole reason that sales representatives were claiming competitive pressures. Such instances appear to be the norm rather than the exception. No doubt, putting a price on services is more difficult than pricing products, because the benefits of services are less tangible and they often lack well-documented standard unitproduction costs as a benchmark. Service costs can vary significantly by the configuration, accessibility, and age of equipment; usage patterns; operating conditions; region; and even individual technicians. However, few companies factor this kind of data into their pricing. One heating, ventilation, and air-conditioning company took several weeks to gather enough data to learn that the cost of making a standard service repair varied by as much as 30 percent depending on the technician and on the configuration of the equipment. To complicate matters further, some companies have negotiated special service-contract terms with each customer and thus now have a bewildering number of exclusions, variations in coverage, and special conditions on their books. This variety makes it even more difficult to understand the true economics of services. The net result is that too many companies now price services on the basis of little more than intuition. Some raise prices to achieve a quick boost in earnings without understanding the competitive implications and then watch as profits fall. Others introduce new offerings but fail to tailor the service-delivery model, only to see costs escalate and margins shrink. Part of the problem is that a services business is too often regarded as the poor stepchild of the core product group, so service managers aren t given the resources to develop the right systems, tools, and incentives to maximize returns. However, a handful of companies are now capturing tremendous value from their services businesses by taking a more careful, fact-based approach to designing and pricing services and by making the task a priority of senior management. Customers are segmented according to their service needs rather than their size, industry, or type of equipment. These companies then develop the pricing, contracting, and monitoring capabilities to support the cost-effective delivery of the services. The results have been impressive: some companies have boosted their service operating

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How to make after-sales services pay off

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margins by three to nine percentage points, typically within a year. More important, they are also starting to see real productivity gains because their service contracts now provide them with incentives to improve quality and efficiency. For companies in maturing industries whose products are becoming commodities, raising revenues from aftersales servicing as well as developing a more distinctive offering, which might persuade customers to buy a company s products should be at the top of management s agenda.

Raising

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The starting point is to design the right services. At the moment, most companies provide too few or too many service offerings. One communications-equipment company used to offer a standard maintenance contract, at roughly the same price per unit, to all of its customers, from mom-and-pop grocery stores to large professional-services firms. Of course, most customers were unhappy with this average service package, and the company left a lot of revenue on the table as a result. It responded by offering some tailored services but then found that it had gone too far in the other direction by customizing each contract to the point where the services business was barely manageable. Customers were still dissatisfied, but now because of deteriorating service levels. While revenues increased, escalating costs had eaten into the company s service margins. Part of what drives this either-or approach is that many services businesses, unlike their product-marketing counterparts, have never segmented their customers by service requirements. Many companies believe that customers care only about price; others try to design a catchall package that meets six or seven needs. In reality, we have found, companies can fulfill most customer requirements by focusing their efforts on just two or three of the following: response times, parts coverage, after-hours availability, and add-on services. To judge the right mix, companies must invest in some basic market research. One equipment manufacturer that had never segmented its service customers sent a simple 25-question survey to 500 users of varying sizes and industries. The survey, supplemented by a series of targeted follow-up interviews, identified a few core needs that the company s existing service offering ignored. While all of the respondents said price was important, the research uncovered a subtler picture of the customers financial constraints and how they could be accommodated. For some customers, a predictable service bill was more important than the minimization of overall maintenance spending. Others were willing to spend more on maintenance in order to reduce the risk of a catastrophic loss. The survey found that response times usually stood at the top of the list of needs not related to price. Some customers are willing to pay extra for immediate service to fix mission-critical products, such as a busy hospital s magnetic-resonance-imaging machine or an ice cream maker s storage freezer. On the other hand, the managers of a commercial building with ten elevators might be willing to wait eight hours or longer to get one elevator fixed if the cost were lower, particularly at night or on weekends. While response times are often binary the equipment is critical or it isn t customers preferences for coverage and service levels vary considerably, according to factors such as risk tolerance and a willingness (and ability) to do the work inhouse. Most customers expect a threshold level of inspections and maintenance, but others are prepared to pay extra for more frequent or additional services, such as remote monitoring or the filing of permits. When customers are segmented according to what they need and not just industry or size they tend to fall into one of at least three common categories. The risk avoiders are looking for coverage to avoid big bills but care less about other elements, such as response times. The basic-needs customers want a standard level of service with basic inspections and periodic maintenance. And the hand-holders need high levels of service, often with quick and reliable response times, and are willing to pay for the privilege. Companies in each of these groups usually desire a common set of services that can be supplemented with a few standard options, such as guaranteed response times, the remote monitoring of equipment, or extended warranties (Exhibit 1). One heavy-equipment manufacturer developed platinum, gold, and bronze service levels for each of its segments and provided enough flexibility within every standard package to meet its customers needs without falling into the trap of totally customizing its services.

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How to make after-sales services pay off

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More than time and materials The second challenge is to understand the fundamental building blocks of services pricing time and materials, fixed-price jobs, and full-coverage service contracts and to determine how best to combine pricing structures into a targeted portfolio of service offerings that meet the customers needs but also improve short-term profitability. While most companies tend to favor a single approach to pricing services, those that offer more sophisticated combinations tend to enjoy higher margins, lower levels of risk, and improved productivity. Best-in-class service providers are also adept at finding ways of maximizing income from parts and assessorial fees. Customers that want maximum flexibility and a low financial commitment usually prefer time-and-materials billing: the company typically performs work as needed and charges an hourly rate for labor and a markup on parts and materials. While charges for time.andmaterials service are usually higher because service providers have no guarantee of consistent repeat business, local service competitors with lower overhead and labor costs usually exert some downward price pressure. With this type of package, service providers have little incentive to pursue productivity improvements that could lead to cost savings in the long run. Customers hoping to avoid cost overruns want to pay fixed prices for specific jobs ($300 to do annual maintenance on a forklift or $100 to change a door lock, for instance). Here, the risk of unanticipated service cost overruns shifts from the customer to the service provider, but so too does the opportunity to capture productivity improvements that reduce costs. However, while earnings can in some instances be increased through fixed-price service jobs, companies need to get their service delivery right or costs, far from being cut, could rise. Some leading service providers have turned the quoting and managing of fixed-price work into an art. By measuring their costs for parts and materials and typical times for servicing, they track the true cost of servicing their equipment and sometimes that of other manufacturers. With a sophisticated understanding of service economics, some companies now charge less for fixed-price jobs than for time-and-materials service and actually earn more from them. Customers that need greater predictability

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tend to demand full-coverage service contracts that work like extended warranties: they provide specific maintenance and repair services over a specified period, typically ranging from one to five years, for a specified price. For the service provider, this can be the most profitable pricing model, but it can also be the riskiest, especially if it involves servicing a competitor s products. Not knowing the repair history and unique service requirements of equipment can cause costs to spiral upward. The age and condition of equipment matter a lot. In one case, the cost of servicing a seven-year-old supermarket refrigeration system was 30 percent more than the cost of servicing a three-year-old system. Several of the company s sales reps didn t consider the importance of the equipment s age and priced both service contracts at the same level. Best-in-class companies mix and match all three pricing structures to meet the preferences of customers. Automobile maintenance might be a helpful metaphor: Some cost-conscious drivers want only an extended 100,000-mile warranty on the transmission (a partial-coverage service contract) and are happy to save money by doing most of the ongoing maintenance (5,000-mile oil changes, say) themselves. For more complicated jobs, such as replacing brakes, these customers will find a mechanic and pay for time and materials. Other drivers want as much service as possible and will pay for additional coverage from the dealer, typically in the form of an extended warranty. On top of this, they will pay the dealer fixed prices for services such as periodic oil changes or tire rotations. It is vital that companies using this type of price mixing work out the relative prices of their services to prevent customers from gaming the system and to improve the management of demand for their services. To prevent service-pricing arbitrage, the heavy-equipment manufacturer with platinum, gold, and bronze service levels ensured that its gold package with additional options never delivered more service for a lower price than the platinum deal. The company also sought to establish a base load of business by selling just enough multiyear service contracts to cover its fixed costs and then tried to win as many time-andmaterials jobs as possible to maximize revenues. The hidden side of contracts A good service contract brings together the service model and pricing structures in a way that enables a company to meet its service commitments and to make the greatest possible profit. Where multiyear service contracts and large fixed-price jobs are concerned, most companies focus all of their attention on the basic legal terms of the contract, at the expense of operational terms, conditions, and coverage exclusions that can make the difference between healthy profits and huge losses. It is surprising how often companies overlook even the most rudimentary operational terms and conditions for example, exclusions relating to vandalism, misuse, fire, floods, or customer fault. An air-conditioning company discovered that a surprising number of service calls came from customers that had inadvertently switched off the power to their equipment. It understandably wanted to charge for each call but found, after the fact, that its service contract had been structured in a way that prevented it from doing so. In addition, contracts should anticipate cases in which providing standard services might generate exceptional costs, as in the use of equipment at hazardous-waste sites. The companies that handle services most successfully have developed terms-andCompanies conditions packages that share risk with the customer: clauses cover co-payments to reduce nuisance calls, deductibles on major repairs, and limits on covered consumables, such as fluids and batteries. Finally, every contract, where possible, should include terms for automatic renewals, automatic annual price increases, and higher labor rates for overtime repairs. As well as anticipating operating risks, a wider range of terms and conditions promotes a more sophisticated approach to contract negotiations. Since almost every service customer requests some price concession, a limited number of standard options gives the sales force the flexibility to win business without running the risk of customizing every contract. Currently, most companies don t equip their negotiators with the insight or tools to understand what service trade-offs should be sought in exchange for price concessions. If a customer requests a 10 percent reduction in price, for instance, many companies accept or reject the request without modifying the contract. Instead, negotiators should look to compensate their companies for price reductions by winning changes to terms and conditions that, over the life of the contract, will more than offset the lost revenue; higher deductibles on equipment repairs or a premium for emergency repairs are two possibilities. Conditions and coverage exclusions are essential

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in supporting any such price negotiation. To design them successfully, the service provider needs a good handle on the customer s economic and risk profiles and on the economic value of certain contract terms. Sometimes, all that is needed is a relatively simple spreadsheet-based pricing engine that can give rough estimates of the impact of certain pricing decisions on revenues and service costs. Keeping an eye on performance The price-calculation engine is the first of several tools that companies need to manage their service contracts effectively. A second key tool one that tracks which bids are won, which are lost, and why leads to a better understanding of the service provider s competitive (or uncompetitive) position on prices and service delivery. A third tool tracks realized prices against actual costs to serve information that can provide useful feedback when it is time to renew a service contract. One industrialequipment company found enormous variations in the pricing of services for small accounts, while some other accounts were priced below the average total cost to serve (Exhibit 2). Careful monitoring of contracts can help identify emerging problems, segments that require higher levels of service, or regions with higher costs to serve. A manufacturer of transportation equipment, for example, noticed that the cost to serve customers in the northeastern United States was significantly higher than it was in other areas (in part owing to higher liability claims). Over time, this company therefore migrated to a regionally differentiated pricing scheme.

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Monitoring contracts can also be the launching point for tracking the effectiveness of service operations: changes to prices and service offerings must go hand in hand with an evaluation of their actual delivery. It is highly damaging to customer relations if, say, a high-end customer is guaranteed a two-hour response but the service provider can t deliver consistently because it lacks the ability to schedule field technicians in two-hour increments. It can be equally costly to discover that technicians are overdelivering by unintentionally providing platinum-level service to every customer, even those that have signed on only for the bare-bones service package. More careful analysis of metrics such as average service or transit times can indicate ways to improve the routing of technicians, reduce their downtime, and upgrade their skills to meet the customers needs profitably. In the short term, the best service-pricing companies have found that to deliver consistently they need to create a small team to gather reliable data on internal pricing actions, to track competitive shifts, and to facilitate regular cross-business reviews of pricing performance and strategy. Simple weekly or monthly pricing-performance reports and analyses, shared throughout the organization, can focus senior management s attention on service-pricing opportunities.

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A handful of companies have started to use service-performance monitoring to link compensation to price realization for service. This approach has given their sales forces incentives to limit the customization of service contracts and unnecessary discounting. For one food-equipment manufacturer, unapproved discounts brought its prices to levels averaging 16 percent below target in its installation business, thereby dragging down potential profits. Incentives that rewarded the sales force for negotiating profitable contracts, combined with a standardized price-quoting tool and a centralized bid-approval process, quickly improved the situation.

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