How do you know if you are making money on your service contracts?
- To stay proactive and predictive on service contract levels, you need to know your selling price and how to manage your margin through cost. Coen Jeukens shares his practical three-step process for ServiceMax.
In my previous life I sold service contracts for a large OEM. Like many service executives, I was proud of profit margins in the range of 40-60%. But when I talked to my CFO, I discovered my numbers were not the same as what he saw in the bigger organizational picture. To gain better control over my true margin contribution and enable predictability, I had to make some adjustments. Let’s look what these were and how you can apply them to your business.
Move from reactive to proactive margin contribution
At the beginning of the fiscal year, it is easy to have high hopes of making your numbers. You may have a few high maintenance customers, but you also have a few cash cow service contracts. You assume they will balance out.
But as you approach the last quarter of the year, things look a little different. No matter how good your predictions and projections are, actual performance tends to differ from planned performance. This is hard to avoid when you depend on reactive and aggregate margin contribution. The way forward is, becoming proactive and predictive on an individual customer or contract level. To do this, you both have to understand how you can determine the selling price as well as manage your margin through cost. Here's my three-step process to get you there.
1. Determining the selling price
When I started selling service contracts, I had three contract pricing paradigms at my disposal:
- Selling price = Cost plus Margin (aka Cost-Plus)
If I had full visibility on cost and I had the upper hand in the commercials, then cost plus would work for me to come to a selling price. But in reality, my cost insights were more on guesstimate level. And my ‘upper hand’ was more perceived, resulting in margin erosion during the commercial negotiations with the buyer.
- Cost = Selling price minus Margin
Sometimes my selling price was defined by the market. Especially when I sold commodity services. With strict, CFO driven, target-margins my sphere of influence was relegated to managing cost, as framed by this second equation.
- Margin = Selling price minus Cost
More often I had to accept the third equation. Both selling price and cost were beyond my control. Margin was not a driver but a result. Margin was reactive. Of course, that was not satisfying. Certainly not for my CFO and shareholders.
2. Managing the margin through cost
Ultimately, in my commercial reality I had to understand the Influence of all three equations in determining the selling price of a service contract. The key to regaining control over my margin contribution was to create visibility and forward-looking capabilities on cost. Moreover, those insights needed to be actionable.
As a first step I structured my service contracts on entitlement level rather than on aggregate level. To determine the level of entitlements, I used a service menu card. For each ‘course’ on the menu card I would ask the customer what level of service he/she wanted to have. Then I would cost all those entitlements, giving me planned cost. When the contract went into service-delivery mode, I would keep a tally on the actual cost. If actual cost developed in a bandwidth of say 10% of planned cost, I knew I would deliver on the expected margin. Having insights on individual entitlement level gave me the handles to mitigate the outliers.
In a second step, I used a field service management tool to gain visibility into future service activities. This allowed me to create a cost outlook as well. Now I had all the info to make the right decision in real-time, protecting my margins. I could halt the accrual of cost before it was too late. I could present the buyer with the actuals and re-negotiate price adjustments and/ or upsells. I was a predictable ally to the CFO.
Beyond margin, better sales
Beyond the interests of my CFO, I want to highlight the role and importance of the Service-Sales persona. Setting the selling price for a service contract is a subtle process. Price pressure is prevalent in pretty much every sales cycle. The Service-Sales persona needs to balance revenue versus margin contribution.
When my cost insights were on guesstimate level, the cost-plus method did occasionally result in non-competitive price points. When my cost guesstimate was too low, my margin took a hit. When I started monitoring the actual margin, I could work out if I had priced my service contract at the right level. I say 'the right level' as high margins may be good for my bottom line, but from a customer perspective, high margins may not be sustainable. Margin insights were an absolute must-have for me when renewing or renegotiating service contracts.
By working through all the above, I had both a happy CFO and happy customers.
To learn more about the convergence of sales and service, check out Why are sales leaders taking over service?