Establishing the framework: Correctly pricing the services that you provide your clients is a key component to your company's viability.
Feb 1, 1998 12:00 PM, Alan Kruglak
In 1986, my former company was struggling through a cash flow crisis. That year, we departed from our typical response and hired a consultant. Our management team was seated around a table, waiting impatiently for his results.
"Unless you make a change," he said, "your company will continue to have cash-flow problems. To overcome your cash-flow problems and grow, you must raise your prices by 35%."
Silence ensued. We had no choice but to follow his advice. We raised our prices by 35%, and amazingly enough, the market accepted the increase with only a few peeps from a couple of accounts. In general, clients agreed to pay the premium to do business with us.
The consultant's report taught me one of the most important lessons of my business career: Even if you think you charge what the market will bear, in many instances, you set the price, not the market.
As entrepreneurs, we tend to place artificial limits on what we imagine the market will accept. This lesson was the major policy guiding the pricing of our service agreements and hourly T&M service.
Pricing service agreements Once you've made the decision to sell service agreements aggressively, the next step is to develop the right pricing strategy. One school of thought preaches that you should determine your costs and add 10% to 15% as profit. This strategy is used by many service businesses, especially electrical contractors. The problem is that few of us know the real costs of providing service. Calculating real costs is complicated because your largest cost in providing service is labor, and labor is only added when the demand requires it, following a step-cost model. For example, under the step-cost model, one labor unit may handle six service agreements. However, to handle the next account, you'll need to add another unit of labor. Even though the additional help will be able to service six more accounts, he is required only at the moment of hire because you've added a seventh account.
What price should you charge the seventh account? Your goal in establishing a price for your service agreements is to be consistent and reasonable. You want a universal pricing formula that can be applied across the board. That's why the cost-plus strategy is difficult to apply.
Another faction recommends keeping pace with and mirroring the pricing of your competition. Although it is a good first step, this approach has some problems. Is the competition truly charging what the market will bear, or is it self-imposing artificial limits as most of us do? Is the competition even offering the same high-level services you provide? Just because your competition offers a service agreement doesn't mean that it is the same as yours. Service is not a commodity, and there can be many levels of service.
A pricing plan Developing a pricing strategy for service agreements and T&M hourly service doesn't have to be a shot in the dark. Here is a simple procedure to develop a pricing strategy that can be adapted to your company:
Understand that you are providing an insurance policy. Before you establish a price for your service agreement, you must understand that your service agreement is a form of protection that reduces the client's exposure to risk. On one hand, a service agreement is a net that offers the security of knowing that problems will be resolved quickly. On the other, it's a fixed-price solution that fits nicely into the client's budget-another component of risk reduction.
Understand the client's predisposition. If you placed yourself inside your client's shoes, you would realize that most clients are predisposed to purchase a service agreement from the vendor that provided the original installation. From your client's perspective, using a different vendor to service their systems is too risky, jeopardizing their job security. Clients are consequently predisposed to purchase a service agreement from you, the installer. Therefore, competitive pressures, although important to recognize, often play a smaller role in price setting than you would expect.
Collect competitive information. Look for three companies you bang heads with regularly during project bids. Two of the competitors should be roughly the size of your company, and one should be a major player. To round out the group, look at one or two brand-name service companies outside your industry, such as Xerox and IBM. Competitive information on the three companies in your industry can be collected from a host of sources. Information on firms outside your industry can be obtained by calling and asking about service and pricing. Collect and encode your information in a table that includes a T&M hourly rate, availability, average response times, instant loaner equipment, quality of service and percentage pricing strategies. Maintaining this kind of data offers a competitive overview of services and prices from inside and outside your industry, which will not only help you determine price, but also identify the competition's weaknesses.
Set the price. It is sometimes difficult to determine whether the competition is charging what the market will bear. That was the case at my former company, so we took another scientific route to determine pricing for our service agreements. We benchmarked the pricing strategies from two high-level service providers, DEC and IBM. Their pricing strategy was simple: charge 15% of the installation price. If the original installation was priced at $20,000, the annual service agreement fee was $3,000.
We benchmarked our pricing strategy from DEC and IBM for a number of reasons. First, no comparable benchmarks existed in our industry. Our research indicated that few firms in the low-voltage systems integration industry offered a high-level service program similar to ours. These companies also had a long track record of success. Because fully estimating our costs was difficult, these companies' approaches provided the easiest way to establish a base price for service agreements.
Also, we were all service companies. The products from both industries are either required by law or are critical to daily business functions. Failure of these kinds of systems demands high-level service, including immediate response.
Finally, theirs is a preconditioned market. Computer and other technical companies have used 15% as a standard annual service fee for many years. As a result, our clients were preconditioned to accept 15% as a reasonable cost for an annual service agreement.
Add value to differentiate yourself from the competition. When a prospect asks whether you provide post-sales service and you say yes, you have just committed a cardinal sin. From a client's perspective, your answer means that all service, including that provided by your competition, is the same. As a result, it becomes a commodity, and the only way to compete with a commodity is on price.
One way to minimize price competition is to differentiate your service agreement from the rest by adding value. Anything that reduces a client's risk adds value. Ways to add value include guaranteeing instant loaners if equipment fails, showing your prospect reference letters from satisfied clients and providing remote software support.
Never undervalue your services. Many low-voltage systems integration companies believe that their clients base the purchase of a service agreement primarily on price. Although that may be true in some instances, the majority of commercial clients are much more concerned about performance.
We followed Glen's Rule on Pricing: If clients are going to complain, let them complain about your pricing, not about the quality of your service. If your service is terrible, its price is irrelevant.
The right price Following in the footsteps of IBM and DEC, we set our standard percentage factor at 15% of the installation price, excluding solid-state components such as conduit, cable and mortar and brickwork, which were unlikely to require maintenance. This percentage was adjusted depending upon the following factors:
* Project size. The larger the project, the greater the likelihood the percentage would decrease. Experience showed that as the size of a project increased, the percentage cost of properly servicing its system decreased.
* Client budget requirements. A good sales representative knows the client's budget. We gave the sales representatives some latitude to discount service agreements to meet a client's budget.
* Special contractual requirements. If the service agreement included contractual requirements, such as support for nonstandard equipment or stricter response times, we actually increased the percentage factor.
* Competitive environment. Occasionally, a highly competitive bid forced us to shave a couple points off the percentage factor.
After weighing all the factors, our pricing for service agreements typically ranged from 7% to 15% of the installed price of the system. We wandered outside the range only when there were special contractual requirements or with specialty equipment we typically did not service.
What is the right price to charge for your service agreement? Establish a standard price of 15% of the original installation price for all service agreements, but give your sales representatives limited discretion to discount from your price schedule. Require that all service agreements for large projects be reviewed, priced and approved by a team of decision-makers, such as the sales representative, the service manager and the vice president of sales. As you learn more about the financial and technical success of your service agreement program, adjust service rates for specific items that create service headaches.
Always go for the highest price you can. In most cases, if prospects really want you and your service agreement, they will come back and ask for a price break. Although you can find many ways to negotiate a reduction in your price, you will find few ways to raise it.
T&M service work I was recently invited to speak at a regional distributors meeting for Dukane. The night before the seminar, I had dinner with several distributors and asked what they charged for T&M service. They responded, and I followed with another question, which set everybody back a bit: Why do you charge that rate and not more?
Few of the distributors could provide a substantive answer. Some indicated that they had been charging the same rate for years. Some mentioned that their rates were comparable with those of the competition. Others simply didn't know why they charged a particular T&M rate.
Even if you stick with T&M service instead of providing service agreements, you need to consider establishing a price that reflects the value you provide as well as what the market will bear. To assist in this process, consider the following procedure:
Question your pricing policy. Never settle for the norm. Think what the impact would be on your profits if you could raise your T&M $5 an hour. It's an incremental addition that will probably go unnoticed by your clients but will help your bottom line.
Collect competitive information. Review the hourly rates charged by your competitors and the large outside companies and enter them into a table.
Establish an upper limit on your hourly rate. As a guideline, we used DEC's and IBM's hourly rate as our upper limit. Our rationale for using their rate was simple: They were the premium providers in the automation business, and clients had accepted their rate.
Gauge the value of your service. If you provide clients with superior service and clients seem content, your hourly price should be $10 to $30 higher than your nearest competitor. Remember, you must maintain focus on the goal of shifting clients from T&M work to service agreements. If you feel awkward about a major change, do it in $10-per-hour increments each year. That gives you time to gauge the response of your clients and make adjustments.
During the Dukane meeting, one distributor justified my pricing strategy to several other distributors. He mentioned that he raised his hourly price for T&M from $65 to $75 without hearing a single peep from a client. His comment got everybody at the table thinking about their rates, an important first step.
The development of a sound pricing strategy for your service agreements and T&M hourly service requires a combination of benchmarking and experimentation. Benchmarking from other high-level service providers and successful companies can offer insight into the correct course to take. But each of our markets is unique unto itself. That's why it is so important to experiment gradually and determine what price the market will bear.
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