Excerpt from a Service Leadership newsletter, How to Successfully Raise Prices
The most stable customer-supplier relationships—those with the highest value to both parties—are the ones that create a win-win business outcome for both parties. Ideally, your solutions and services help your client and their clients be more financially successful.
Several cultural aspects of the IT services business conspire against win-win pricing—the technical people that deliver the service tend to be Good Samaritan personalities; the salespeople fear losing customers based on perceived cost; owners and executives of IT solution provider (TSP) companies can sometimes lack business acumen.
All three groups can lose business objectivity towards their customers due to long relationships and perceived loyalty. In the newsletter, you will find provides best practices for maintaining win-win pricing in a TSP business.
The iron triangle of the IT services business is the same in every IT company, everywhere in the world—rates, utilization, and wages. There are two ways to increase services margin:
Increasing the revenue by:
- Raising the amount charged per service
- Selling more services
Reduce the cost of the labor involved by:
- Automating
- Hiring lower-skilled (that is, lower-paid) people
- Using process and technology to drive efficiency that reduces the number of labor hours per deliverable
The Definition of Successfully Raising Prices
The definition of success in raising rates is to drive services revenue, including billable services and managed services. This can be done by attaining a multiple of service of two and a half times Taxable Wages [1] or better on labor-based services, or achieving four and a half times or better on your own cloud services and not lose any customers we didn’t want to lose. Attaining this multiple will deliver at or near best-in-class services gross margin percent of 50%.
Price increases apply to both existing and new customers. Your profit improvement will be sub-optimized if they are applied only to new or only to existing customers.
Eliminating the anxiety you and your staff—especially your sales staff—may feel during the price increase process is not part of the definition of success. This anxiety is natural but, as you will happily find, unmerited.
Why Raise Prices?
Interestingly, the most profitable TSPs are typically also the fastest-growing TSPs. This faster growth comes as a result of two factors:
- More gross margin dollars available to be spent on sales and marketing
- Service quality is high, so existing customers are happier and likelier to renew. More importantly, salespeople are more excited to sell services to new customers because they are confident the customer’s service experience will be good.
Attaining best-in-class, bottom-line profitability also helps ensure your company's stability, durability, and future competitiveness, providing better services to customers, partners, and employees. This is true during all economic cycles but is especially crucial during inflationary times.
How Much Should You Raise Prices?
How much you should raise prices is of course determined by how far below proper pricing you are.
The Service Leadership Index will tell you what Best-in-Class services gross margins are for your specific business model, but for this discussion, across all business models, in all markets, we can go with 50%.
That equates to revenue of about 2.5 times the Taxable Wages of the service team (including service management, pre-sales, service admin, post-sale account managers, etc.). If you have $1mm in service Taxable Wages in a given time period, you need $2.5mm in services revenue generated by that team, to be at about 50% gross margin.
It's important to note that this “multiple of wages” approach purposefully takes into account billable utilization without having to know what it is.
Meaning, it doesn't care if an engineer with a Taxable Wages of $100,000, attains $250,000 in revenue by billing 2,000 hours at $125/hour or by billing one hour at $250,000/hour!
As long as you get to 2.5 x Taxable Wages, you'll be at close to the targeted 50% gross margin. This calculation works whether your service team is five people, 50, 500 or 5,000 people. It works whether you are analyzing an individual engineer, a team, a location, a practice, your whole company, a proposal, or a contract.
The point is, no matter how you do it, if you want to attain top quartile bottom-line profitability, you need to get that $250,000 – or 2.5 x Taxable Wages – somehow.
What About Discounting?
Discounting occurs in a number of ways, and they can be perniciously hard to control, due to:
- The partial truth that it's better to close a deal at a lower price than to not close it all.
- The damage done by discounting not being correctly understood.
- Discounts being taken in ways that senior management doesn't see, or turns a blind eye to.
- Incentive plans which don't fence off unapproved discounts, so sellers get paid even when they break the implicit or explicit rules.
- Discounting can be incorrectly viewed as a necessary and low-cost way to get customers to commit to multi-year Managed Services agreements.
How do the Best-in-Class deal handle discounting?
First, they allow no or almost no discounts, and if they do, they do so by lower percentages. They have stricter controls, do not allow sellers to pit one approving manager against another, and set realistic floors on margin below which no commission gets paid.
Second, they start with higher quoted gross margin percentages.
Third, to the extent that they respond to RFPs and similar bid solicitation vehicles, they are good at “unhooking” them so they can quote differentiated solutions…and higher prices.
Fourth, those that are interested in multi-year contracts, start with the assumption that the longer term is the contract length and all pricing is based on it. When customers insist on shorter agreements, they may be willing to provide them but only after adding additional cost to offset the risk of the customer not staying with them as long. This approach is the opposite of discounting.
This is an excerpt from a newsletter published by Service Leadership titled, “How to Successfully Raise Prices.” This newsletter also focuses on improving service margins by raising rates (increasing revenue) and reducing actual cost per hour, but with your existing people. You will learn best practices for raising prices on managed services offerings, including annual increases in multi-year agreements and what to do with clients under contract. The methods apply to all TSPs, regardless of business model, geography, size, or customer segment.
[1] Taxable Wages: In the U.S., W2; in the U.K., P60; in Australia, Income Statement; in Canada, T4; in Germany, “Bruttoeinkommen.”
