Why is MSP profitability so elusive?

| By: Peter Kujawa

By most measures, 2022 was a banner year for the MSP industry, with 23% growth in total revenue and nearly 30% growth in managed services, according to the Service Leadership Index®. Compared to historical averages, these are great numbers – and with continued growth fed by ongoing digital transformation, these trends are likely to continue.

Growth is good, but profitability is even more important. If you’re not running your business profitably, you’ll struggle taking on more customers and effectively serve those who are also growing rapidly because you won’t be able to invest in your staff and tools. In fact, beneath the encouraging revenue numbers are some sobering ones on profitability in the industry. While best-in-class MSPs averaged 23% profit (based on Adjusted EBITDA), 31% of the market lost money in Q1 2023, and another 10-15% of the market barely made any money.

What accounts for the gap in profitability? There are indeed some discernable patterns among profitable and unprofitable MSPs, offering guidance in how to elevate your business to the ranks of the growing and profitable.

Factors affecting MSP profitability

MSPs seeking improved profitability have a few levers that they can pull:

Sales and pricing. Many MSPs make three key mistakes.  First, they neglect to define their target customer. They fall into the trap of grabbing as many customers as they can, with little thought on what serving those clients will actually entail. A customer base of widely varying sizes, with differentiated service and technology needs, will introduce more complexity – and therefore, more inefficiency.  Second, they sell too many managed service packages, often believing that customers who start on a less inclusive package will move to a more inclusive package later.  Third, they underprice their services, often basing their pricing on local competition (who may be amongst the 31% who lost money last quarter).

Services Cost of Goods Sold (COGS). For MSPs, Service COGS is the cost of tools plus the cost of payroll to run the tools and serve customers. Payroll consumes the largest portion of COGS at MSPs – typically 80%, plus or minus 5%. according to Service Leadership, Inc.

Efficiency of service payroll. In other words, how many techs, and at what pay level, are required to effectively deliver services and satisfy customers? Payroll is usually the highest cost in any business. For  MSPs, staffing is especially challenging because of the current talent shortage, which may make it seem like you have to pay top-dollar for IT techs (see what top MSPs do). Also, their wage inflation has usually exceeded other wage inflation, even during normal inflationary times.  Reaching optimal staffing levels without breaking the bank can seem next to impossible.  

What does inefficiency look like?

If left unchecked, service desk inefficiency will require a disproportionate amount of resources for MSP service delivery. Among the reasons are a significant mismatch between the skill level of techs and the types of tickets they work on, not enough use of automation, and poor documentation for customers.

Making things more challenging for bottom-performing MSPs, inefficient operations are often not even recognized as inefficient, because the MSPs don’t have processes in place to measure performance. This is an essential first step for keeping informed and having actionable information for improving efficiency.

Another source of inefficiency is the customer onboarding process. At our hypothetical inefficient MSP:

  • The onboarding period is one of confusion for many stakeholders as a new customer is handed off from sales to service.
  • Customer calls for service start too soon in the process, often before the MSP has completed transitioning the customer onto the MSP’s tech stack.
  • As a result the techs may be unprepared for the new customer’s needs, potentially increasing the need for escalations to higher level techs and a longer time to resolve. This is not only inefficient, it typically leads to a poor first impression with a new customer.

As these brief examples show, inefficiency breeds more inefficiency. And if MSPs don’t do the necessary groundwork and make plans to be efficient, then they are in effect planning to be inefficient.

Discover even more MSP efficiency best practices with our Efficiency Matters webinar series.

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