Service Contract Pricing

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How to make after-sales services pay off 2004-03-30

16:39

by Russell G. Bundschuh and Theodore M. Dezvane

For many manufacturing companies, servicing products is an increasingly important part ofthe business. Manufacturers of everything from elevators and freezers to security systemsand transportation equipment products built to last find that revenues from after-sales product installation, configuration, maintenance, and repairs are 30 percent or moreof their total revenues, and the proportion is increasing. In some industries, the servicemarket 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 productmargins have fallen, services typically with higher margins and returns on investedcapital have become an increasingly attractive way to provide a point of competitivedifferentiation. However, most companies have squandered this profit potential by usingpoorly designed and priced service plans.

A building-equipment manufacturer, for example, discovered that 11 percent of its servicecontracts didn t cover its marginal servicing costs, let alone its fixed service costs. Atransportation-equipment manufacturer found it had given customers discounts of up to 70percent 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 thebenefits of services are less tangible and they often lack well-documented standard unit-production costs as a benchmark. Service costs can vary significantly by the configuration,accessibility, and age of equipment; usage patterns; operating conditions; region; andeven individual technicians. However, few companies factor this kind of data into theirpricing. One heating, ventilation, and air-conditioning company took several weeks togather enough data to learn that the cost of making a standard service repair varied by asmuch as 30 percent depending on the technician and on the configuration of theequipment. To complicate matters further, some companies have negotiated specialservice-contract terms with each customer and thus now have a bewildering number ofexclusions, variations in coverage, and special conditions on their books. This varietymakes 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 morethan intuition. Some raise prices to achieve a quick boost in earnings without

understanding the competitive implications and then watch as profits fall. Others introducenew offerings but fail to tailor the service-delivery model, only to see costs escalate andmargins shrink. Part of the problem is that a services business is too often regarded as thepoor stepchild of the core product group, so service managers aren t given theresources to develop the right systems, tools, and incentives to maximize returns.

However, a handful of companies are now capturing tremendous value from their servicesbusinesses by taking a more careful, fact-based approach to designing and pricingservices and by making the task a priority of senior management. Customers aresegmented according to their service needs rather than their size, industry, or type ofequipment. These companies then develop the pricing, contracting, and monitoringcapabilities to support the cost-effective delivery of the services.

The results have been impressive: some companies have boosted their service operating

of 6How to make after-sales services pay off

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margins by three to nine percentage points, typically within a year. More important, theyare also starting to see real productivity gains because their service contracts now providethem with incentives to improve quality and efficiency.

For companies in maturing industrieswhose products are becomingcommodities, raising revenues from after-sales servicing as well as developing amore distinctive offering, which mightpersuade customers to buy a

company s products should be atthe top of management s agenda.

Sell the right services

The starting point is to design the right services. At the moment, most companies providetoo few or too many service offerings. One communications-equipment company used tooffer a standard maintenance contract, at roughly the same price per unit, to all of itscustomers, from mom-and-pop grocery stores to large professional-services firms. Ofcourse, most customers were unhappy with this average service package, and thecompany 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 inthe other direction by customizing each contract to the point where the services businesswas barely manageable. Customers were still dissatisfied, but now because ofdeteriorating service levels. While revenues increased, escalating costs had eaten into thecompany s service margins.

Part of what drives this either-or approach is that many services businesses, unlike theirproduct-marketing counterparts, have never segmented their customers by servicerequirements. Many companies believe that customers care only about price; others try todesign 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 orthree of the following: response times, parts coverage, after-hours availability, and add-onservices.

To judge the right mix, companies must invest in some basic market research. Oneequipment manufacturer that had never segmented its service customers sent a simple25-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 thatthe company s existing service offering ignored. While all of the respondents said pricewas important, the research uncovered a subtler picture of the customers financialconstraints 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 acatastrophic loss.

The survey found that response times usually stood at the top of the list of needs notrelated to price. Some customers are willing to pay extra for immediate service to fixmission-critical products, such as a busy hospital s magnetic-resonance-imagingmachine or an ice cream maker s storage freezer. On the other hand, the managers ofa commercial building with ten elevators might be willing to wait eight hours or longer toget 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 itisn 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 in-house. Most customers expect a threshold level of inspections and maintenance, butothers are prepared to pay extra for more frequent or additional services, such as remotemonitoring or the filing of permits.

When customers are segmented according to what they need and not just industry orsize they tend to fall into one of at least three common categories. The risk avoiders arelooking for coverage to avoid big bills but care less about other elements, such asresponse times. The basic-needs customers want a standard level of service with basicinspections 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 besupplemented with a few standard options, such as guaranteed response times, theremote monitoring of equipment, or extended warranties (Exhibit 1). One heavy-equipmentmanufacturer developed platinum, gold, and bronze service levels for each of its segmentsand provided enough flexibility within every standard package to meet its customers needs without falling into the trap of totally customizing its services.

Raising





More than time and materials

The second challenge is to understand the fundamental building blocks of servicespricing time and materials, fixed-price jobs, and full-coverage service contracts andto 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. Whilemost companies tend to favor a single approach to pricing services, those that offer moresophisticated combinations tend to enjoy higher margins, lower levels of risk, andimproved productivity. Best-in-class service providers are also adept at finding ways ofmaximizing income from parts and assessorial fees.

Customers that want maximum flexibility and a low financial commitment usually prefertime-and-materials billing: the company typically performs work as needed and charges anhourly rate for labor and a markup on parts and materials. While charges for time.and-materials service are usually higher because service providers have no guarantee ofconsistent repeat business, local service competitors with lower overhead and labor costsusually exert some downward price pressure. With this type of package, service providershave little incentive to pursue productivity improvements that could lead to cost savings inthe long run.

Customers hoping to avoid cost overruns want to pay fixed prices for specific jobs ($300 todo 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, couldrise.

Some leading service providers have turned the quoting and managing of fixed-price workinto 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 othermanufacturers. With a sophisticated understanding of service economics, somecompanies now charge less for fixed-price jobs than for time-and-materials service andactually earn more from them.

Customers that need greater predictability

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tend to demand full-coverage servicecontracts that work like extended warranties: they provide specific maintenance and repairservices over a specified period, typically ranging from one to five years, for a specifiedprice. For the service provider, this can be the most profitable pricing model, but it can alsobe the riskiest, especially if it involves servicing a competitor s products. Not knowingthe repair history and unique service requirements of equipment can cause costs to spiralupward. The age and condition of equipment matter a lot. In one case, the cost ofservicing a seven-year-old supermarket refrigeration system was 30 percent more than thecost of servicing a three-year-old system. Several of the company s sales reps didn tconsider the importance of the equipment s age and priced both service contracts atthe same level.

Best-in-class companies mix and match all three pricing structures to meet thepreferences of customers. Automobile maintenance might be a helpful metaphor: Somecost-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 theongoing 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 andmaterials. Other drivers want as much service as possible and will pay for additionalcoverage 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 tirerotations.

It is vital that companies using this type of price mixing work out the relative prices of theirservices to prevent customers from gaming the system and to improve the management ofdemand for their services. To prevent service-pricing arbitrage, the heavy-equipmentmanufacturer 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 platinumdeal. The company also sought to establish a base load of business by selling just enoughmultiyear service contracts to cover its fixed costs and then tried to win as many time-and-materials 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 waythat enables a company to meet its service commitments and to make the greatestpossible profit. Where multiyear service contracts and large fixed-price jobs areconcerned, most companies focus all of their attention on the basic legal terms of thecontract, at the expense of operational terms, conditions, and coverage exclusions thatcan make the difference between healthy profits and huge losses.

It is surprising how often companies overlook even the most rudimentary operational termsand conditions for example, exclusions relating to vandalism, misuse, fire, floods, orcustomer fault. An air-conditioning company discovered that a surprising number ofservice calls came from customers that had inadvertently switched off the power to theirequipment. It understandably wanted to charge for each call but found, after the fact, thatits service contract had been structured in a way that prevented it from doing so. Inaddition, contracts should anticipate cases in which providing standard services mightgenerate exceptional costs, as in the use of equipment at hazardous-waste sites.

The companies that handle services mostsuccessfully have developed terms-and-conditions packages that share risk withthe customer: clauses cover co-paymentsto reduce nuisance calls, deductibles onmajor repairs, and limits on coveredconsumables, such as fluids andbatteries. Finally, every contract, wherepossible, should include terms forautomatic renewals, automatic annual price increases, and higher labor rates for overtimerepairs.

As well as anticipating operating risks, a wider range of terms and conditions promotes amore sophisticated approach to contract negotiations. Since almost every servicecustomer requests some price concession, a limited number of standard options gives thesales force the flexibility to win business without running the risk of customizing everycontract. Currently, most companies don t equip their negotiators with the insight ortools to understand what service trade-offs should be sought in exchange for priceconcessions. If a customer requests a 10 percent reduction in price, for instance, manycompanies accept or reject the request without modifying the contract.

Instead, negotiators should look to compensate their companies for price reductions bywinning changes to terms and conditions that, over the life of the contract, will more thanoffset the lost revenue; higher deductibles on equipment repairs or a premium foremergency repairs are two possibilities. Conditions and coverage exclusions are essential

Companies





in supporting any such price negotiation. To design them successfully, the service providerneeds a good handle on the customer s economic and risk profiles and on theeconomic value of certain contract terms. Sometimes, all that is needed is a relativelysimple spreadsheet-based pricing engine that can give rough estimates of the impact ofcertain 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 scompetitive (or uncompetitive) position on prices and service delivery.

A third tool tracks realized prices against actual costs to serve information that canprovide useful feedback when it is time to renew a service contract. One industrial-equipment company found enormous variations in the pricing of services for smallaccounts, while some other accounts were priced below the average total cost to serve(Exhibit 2). Careful monitoring of contracts can help identify emerging problems, segmentsthat require higher levels of service, or regions with higher costs to serve. A manufacturerof transportation equipment, for example, noticed that the cost to serve customers in thenortheastern United States was significantly higher than it was in other areas (in partowing to higher liability claims). Over time, this company therefore migrated to a regionallydifferentiated pricing scheme.

Monitoring contracts can also be the launching point for tracking the effectiveness ofservice operations: changes to prices and service offerings must go hand in hand with anevaluation 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 tdeliver consistently because it lacks the ability to schedule field technicians in two-hourincrements. It can be equally costly to discover that technicians are overdelivering byunintentionally providing platinum-level service to every customer, even those that havesigned on only for the bare-bones service package. More careful analysis of metrics suchas 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 deliverconsistently they need to create a small team to gather reliable data on internal pricingactions, to track competitive shifts, and to facilitate regular cross-business reviews ofpricing performance and strategy. Simple weekly or monthly pricing-performance reportsand analyses, shared throughout the organization, can focus senior management sattention on service-pricing opportunities.

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A handful of companies have started to use service-performance monitoring to linkcompensation to price realization for service. This approach has given their sales forcesincentives to limit the customization of service contracts and unnecessary discounting. Forone food-equipment manufacturer, unapproved discounts brought its prices to levelsaveraging 16 percent below target in its installation business, thereby dragging downpotential profits. Incentives that rewarded the sales force for negotiating profitablecontracts, combined with a standardized price-quoting tool and a centralized bid-approvalprocess, quickly improved the situation.

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