Roadmap to Improving IT Services Profitability

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Pricing excellence can lift the profitability of services businesses by 300-500 basis points. Getting there requires a well-structured, multi-functional approach with strong executive sponsorship. The size of the prize though is well worth the pain.

CONTEXT

The Professional Services (PS) business at product-led enterprise technology vendors often fails to live up to its potential. Managed properly, PS can play a key role in enabling customer loyalty, deepening account relationships, and channeling insights from the frontline back into product development. At many vendors, though, the PS business falls short of delivering on these objectives and is plagued by low overall profitability.

This post lays out an approach to improving PS profitability which we have refined over the course of working closely with several Fortune 100 technology providers.

CHALLENGE

Managers in Professional Services businesses often focus on reported utilization, i.e., volume, as the primary driver of improving overall profitability, followed by a focus on structural labor cost (e.g., on-shore vs. off-shore mix). Compounding the profitability challenge, billable utilization is often affected by the need to remediate product quality issues in the field.

RESOLUTION

Pricing though can yield large potential for improving aggregate profitability but is often an undermanaged area, as it resides at the intersection of services product management (strategic pricing), the services field (tactical pricing) and services operations (enabling infrastructure).

In our experience, vendors fail to optimize value through PS pricing because of five pitfalls:

  • Value creation gap – Lack of clarity on what services and associated delivery modalities would best solve the customers business pain points
  • Value communication gap – Customers do not perceive (or value) the full benefits delivered by the service
  • Strategic pricing gap – The price structure, price levels or associated segmentation set by services product management leave money on the table
  • Tactical negotiation / transaction gap – Frontline discounts and other terms & conditions negotiated by sales do not optimize for customer profitability
  • Cost-to-serve gap – Value is lost through inefficiencies in front-office areas such as hiring, training, staffing, motivating, terminating employees or back-office processes such as accounting & finance

A road map on how to create value through pricing needs to address five distinct areas:

  • Cost floor vs. value ceiling
  • Selling process and incentives
  • Tools, systems and revenue recognition
  • Controlling and metrics
  • Channel and partner issues

Key analyses to triangulate pricing between a cost floor and a value ceiling include…

  • Your labor supply cost curve by practice, role, geography, delivery partner
  • Demand and competition
  • Margins and quantifying sources of value leakage

The selling process and associated incentives can have a large impact on value communication as well as value creation through strategic and tactical pricing. All too often, there is low hanging fruit such as…

  • Classifying all client-related travel time on T&M engagements as billable to the client
  • Standardizing the unit of time shown on quotes, sales orders, purchase orders and invoices to ‘hours’ vs. ‘days’, to avoid that, for instance, 3-hour efforts and 12-hour efforts get billed out as 0 days and 1 day, respectively
  • Streamlining quoting and billing of expenses by encouraging use of fixed expenses as opposed to ‘actuals’ or ‘actuals not to exceed’. This simplifies back-office processes but can also generate front-office profits through prudent expense management
  • Revising your volume discounting and approval matrix to make your frontline sales people more accountable for ‘as-sold’ margins (but not ‘as delivered’ margins)
  • Improving visibility into profitability of subcontracted work

Vendor-Specific Objective Evidence (VSOE) is often perceived as a ‘road block’ topic in the area of tools, systems and revenue recognition. More often than not, though, that perception is false:

  • To clarify, VSOE is not relevant in stand-alone consulting arrangements. VSOE is only relevant to consulting arrangements that are coupled with license transactions, so-called multiple element arrangements, where VSOE is used to determine revenue recognition. A multiple element arrangement requires allocation of the contract fee to its individual elements based on vendor-specific objective evidence (VSOE) of fair value regardless of the stated prices in the contract
  • VSOE is determined by the price historically charged when the same element is sold separately. If an element is not yet sold separately, the price established by management through comparison with several recent quarters of actual rates charged for similar stand-alone deals. Thus, VSOE of fair value is not based on list price, comparable industry pricing, estimates of fair value, pricing that produces an acceptable profit margin or prices stated in the contract
  • The challenge though is that VSOE only exists when a high percentage of the rates (for a specific type of service) fall within a narrow price range. If prices vary significantly, VSOE can not be established, which negatively affects revenue reported to the street
  • Thus, the challenge is that profit maximizing behavior requires tactical pricing flexibility, while the finance function would prefer to see uniformity in pricing
  • One way to mitigate this conflict is via a SKU structure with price zones coupled with improved discounting discipline. Details here will vary by company but the takeaway is that VSOE should not overly constrain a sound pricing strategy for the business

In the area of controlling and metrics, vendors have to decide what their approach is to SKU’ing service offerings. Objectives here include a short quote cycle (e.g., channel partners generally need offerings to be SKU’d vs. custom quoted), speed to market when a SKU is introduced (e.g., often a six month process), better reporting and visibility, as well as opportunities to bundle products and services (e.g., for promotions).

Once a company is ready for implementation of its new pricing strategy, alignment of responsibilities and a proper governance model are important. All too often, well-meaning HQ efforts in this area fall short in the field. Successful IT services organizations tend to split roles as follows:

  • Field = Execution. Communicates and delivers value to customers. Scopes and prices deals. Maintains discounting and margin discipline. Provides feedback on local needs
  • Services product management = Strategy. Defines offerings and their GTM in collaboration with the Field. Establishes pricing strategy. Articulates customer value. Tracks competitive landscape
  • Service Operations = Support. Aims to improve back-end infrastructure. Keeps up-to-date view of delivery cost. Facilitates deal review. Tracks aggregate progress towards margin targets

Pricing excellence can lift the profitability of services businesses by 300-500 basis points. Getting there requires a well-structured, multi-functional approach with strong executive sponsorship. The size of the prize though is well worth the pain.

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