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How to make after-sales services pay off

2004-03-30
16:39
US
UK
China
Europe
Asia-Pacific by Russell G. Bundschuh and Theodore M. Dezvane
MiddleEast&Africa
Americas For many manufacturing companies, servicing products is an increasingly important part of
the business. Manufacturers of everything from elevators and freezers to security systems
and transportation equipment products built to last find that revenues from after-
sales product installation, configuration, maintenance, and repairs are 30 percent or more
Global Equities
of their total revenues, and the proportion is increasing. In some industries, the service
Exchange Markets market is four or five times larger than the market for products.
Mutual Fund
Bond Over the past few years, as sales growth for new products has slowed and product
Asia Analysis margins have fallen, services typically with higher margins and returns on invested
capital have become an increasingly attractive way to provide a point of competitive
differentiation. However, most companies have squandered this profit potential by using
poorly designed and priced service plans.
Auto
IT
A building-equipment manufacturer, for example, discovered that 11 percent of its service
Finance
contracts didn t cover its marginal servicing costs, let alone its fixed service costs. A
Chemical&Energy transportation-equipment manufacturer found it had given customers discounts of up to 70
Consumables percent for the sole reason that sales representatives were claiming competitive
E&E pressures. Such instances appear to be the norm rather than the exception.
Entertainment
Medical&Healthcare No doubt, putting a price on services is more difficult than pricing products, because the
Retailing benefits of services are less tangible and they often lack well-documented standard unit-
production costs as a benchmark. Service costs can vary significantly by the configuration,
Telecoms
accessibility, and age of equipment; usage patterns; operating conditions; region; and
Others even individual technicians. However, few companies factor this kind of data into their
pricing. One heating, ventilation, and air-conditioning company took several weeks to
gather enough data to learn that the cost of making a standard service repair varied by as
CEO much as 30 percent depending on the technician and on the configuration of the
equipment. To complicate matters further, some companies have negotiated special
CFO
service-contract terms with each customer and thus now have a bewildering number of
CXOs exclusions, variations in coverage, and special conditions on their books. This variety
Strategy&Management makes it even more difficult to understand the true economics of services.
Biz Education
The net result is that too many companies now price services on the basis of little more
than intuition. Some raise prices to achieve a quick boost in earnings without
Biz Information understanding the competitive implications and then watch as profits fall. Others introduce
new offerings but fail to tailor the service-delivery model, only to see costs escalate and
China Markets
margins shrink. Part of the problem is that a services business is too often regarded as the
Made in China poor stepchild of the core product group, so service managers aren t given the
Law&Policy resources to develop the right systems, tools, and incentives to maximize returns.
Statistics
However, a handful of companies are now capturing tremendous value from their services
businesses by taking a more careful, fact-based approach to designing and pricing
Start-Up services and by making the task a priority of senior management. Customers are
Money&Finance
segmented according to their service needs rather than their size, industry, or type of
equipment. These companies then develop the pricing, contracting, and monitoring
Management capabilities to support the cost-effective delivery of the services.
Sales&Marketing
The results have been impressive: some companies have boosted their service operating

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How to make after-sales services pay off Page 2 of 6

margins by three to nine percentage points, typically within a year. More important, they
Earned Income Credit are also starting to see real productivity gains because their service contracts now provide
them with incentives to improve quality and efficiency.
Federal Budget
Federal Tax
For companies in maturing industries
Food Assistance
whose products are becoming Raising
Health policies commodities, raising revenues from after-
Immigrant Benefits sales servicing as well as developing a
Labor Market policies more distinctive offering, which might
Poverty/Income persuade customers to buy a
company s products should be at
State Fiscal policyies
the top of management s agenda.
Welfare Reform/TANF

Sell the right services

Analysis Report
The starting point is to design the right services. At the moment, most companies provide
Annual Report too few or too many service offerings. One communications-equipment company used to
Corporate Credit offer a standard maintenance contract, at roughly the same price per unit, to all of its
Industries Standard customers, from mom-and-pop grocery stores to large professional-services firms. Of
Country Briefing course, most customers were unhappy with this average service package, and the
company left a lot of revenue on the table as a result.

It responded by offering some tailored services but then found that it had gone too far in
the other direction by customizing each contract to the point where the services business
was barely manageable. Customers were still dissatisfied, but now because of
deteriorating service levels. While revenues increased, escalating costs had eaten into the
company s service margins.

Part of what drives this either-or approach is that many services businesses, unlike their
product-marketing counterparts, have never segmented their customers by service
requirements. Many companies believe that customers care only about price; others try to
design a catchall package that meets six or seven needs. In reality, we have found,
companies can fulfill most customer requirements by focusing their efforts on just two or
three of the following: response times, parts coverage, after-hours availability, and add-on
services.

To judge the right mix, companies must invest in some basic market research. One
equipment manufacturer that had never segmented its service customers sent a simple
25-question survey to 500 users of varying sizes and industries. The survey,
supplemented by a series of targeted follow-up interviews, identified a few core needs that
the company s existing service offering ignored. While all of the respondents said price
was important, the research uncovered a subtler picture of the customers financial
constraints and how they could be accommodated. For some customers, a predictable
service bill was more important than the minimization of overall maintenance spending.
Others were willing to spend more on maintenance in order to reduce the risk of a
catastrophic loss.

The survey found that response times usually stood at the top of the list of needs not
related to price. Some customers are willing to pay extra for immediate service to fix
mission-critical products, such as a busy hospital s magnetic-resonance-imaging
machine or an ice cream maker s storage freezer. On the other hand, the managers of
a commercial building with ten elevators might be willing to wait eight hours or longer to
get one elevator fixed if the cost were lower, particularly at night or on weekends.

While response times are often binary the equipment is critical or it

isn t customers preferences for coverage and service levels vary considerably,
according to factors such as risk tolerance and a willingness (and ability) to do the work in-
house. Most customers expect a threshold level of inspections and maintenance, but
others are prepared to pay extra for more frequent or additional services, such as remote
monitoring or the filing of permits.

When customers are segmented according to what they need and not just industry or
size they tend to fall into one of at least three common categories. The risk avoiders are
looking for coverage to avoid big bills but care less about other elements, such as
response times. The basic-needs customers want a standard level of service with basic
inspections and periodic maintenance. And the hand-holders need high levels of service,
often with quick and reliable response times, and are willing to pay for the privilege.

Companies in each of these groups usually desire a common set of services that can be
supplemented with a few standard options, such as guaranteed response times, the
remote monitoring of equipment, or extended warranties (Exhibit 1). One heavy-equipment
manufacturer developed platinum, gold, and bronze service levels for each of its segments
and provided enough flexibility within every standard package to meet its customers
needs without falling into the trap of totally customizing its services.

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Chart:

More than time and materials

The second challenge is to understand the fundamental building blocks of services

pricing time and materials, fixed-price jobs, and full-coverage service contracts and
to determine how best to combine pricing structures into a targeted portfolio of service
offerings that meet the customers needs but also improve short-term profitability. While
most companies tend to favor a single approach to pricing services, those that offer more
sophisticated combinations tend to enjoy higher margins, lower levels of risk, and
improved productivity. Best-in-class service providers are also adept at finding ways of
maximizing income from parts and assessorial fees.

Customers that want maximum flexibility and a low financial commitment usually prefer
time-and-materials billing: the company typically performs work as needed and charges an
hourly rate for labor and a markup on parts and materials. While charges for time.and-
materials service are usually higher because service providers have no guarantee of
consistent repeat business, local service competitors with lower overhead and labor costs
usually exert some downward price pressure. With this type of package, service providers
have little incentive to pursue productivity improvements that could lead to cost savings in
the long run.

Customers hoping to avoid cost overruns want to pay fixed prices for specific jobs ($300 to
do annual maintenance on a forklift or $100 to change a door lock, for instance). Here, the
risk of unanticipated service cost overruns shifts from the customer to the service provider,
but so too does the opportunity to capture productivity improvements that reduce costs.
However, while earnings can in some instances be increased through fixed-price service
jobs, companies need to get their service delivery right or costs, far from being cut, could
rise.

Some leading service providers have turned the quoting and managing of fixed-price work
into an art. By measuring their costs for parts and materials and typical times for servicing,
they track the true cost of servicing their equipment and sometimes that of other
manufacturers. With a sophisticated understanding of service economics, some
companies now charge less for fixed-price jobs than for time-and-materials service and
actually earn more from them.

Customers that need greater predictability

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tend to demand full-coverage service

contracts that work like extended warranties: they provide specific maintenance and repair
services over a specified period, typically ranging from one to five years, for a specified
price. For the service provider, this can be the most profitable pricing model, but it can also
be the riskiest, especially if it involves servicing a competitor s products. Not knowing
the repair history and unique service requirements of equipment can cause costs to spiral
upward. The age and condition of equipment matter a lot. In one case, the cost of
servicing a seven-year-old supermarket refrigeration system was 30 percent more than the
cost of servicing a three-year-old system. Several of the company s sales reps didn t
consider the importance of the equipment s age and priced both service contracts at
the same level.

Best-in-class companies mix and match all three pricing structures to meet the
preferences of customers. Automobile maintenance might be a helpful metaphor: Some
cost-conscious drivers want only an extended 100,000-mile warranty on the transmission
(a partial-coverage service contract) and are happy to save money by doing most of the
ongoing maintenance (5,000-mile oil changes, say) themselves. For more complicated
jobs, such as replacing brakes, these customers will find a mechanic and pay for time and
materials. Other drivers want as much service as possible and will pay for additional
coverage from the dealer, typically in the form of an extended warranty. On top of this,
they will pay the dealer fixed prices for services such as periodic oil changes or tire
rotations.

It is vital that companies using this type of price mixing work out the relative prices of their
services to prevent customers from gaming the system and to improve the management of
demand for their services. To prevent service-pricing arbitrage, the heavy-equipment
manufacturer with platinum, gold, and bronze service levels ensured that its gold package
with additional options never delivered more service for a lower price than the platinum
deal. The company also sought to establish a base load of business by selling just enough
multiyear service contracts to cover its fixed costs and then tried to win as many time-and-
materials jobs as possible to maximize revenues.

The hidden side of contracts

A good service contract brings together the service model and pricing structures in a way
that enables a company to meet its service commitments and to make the greatest
possible profit. Where multiyear service contracts and large fixed-price jobs are
concerned, most companies focus all of their attention on the basic legal terms of the
contract, at the expense of operational terms, conditions, and coverage exclusions that
can make the difference between healthy profits and huge losses.

It is surprising how often companies overlook even the most rudimentary operational terms
and conditions for example, exclusions relating to vandalism, misuse, fire, floods, or
customer fault. An air-conditioning company discovered that a surprising number of
service calls came from customers that had inadvertently switched off the power to their
equipment. It understandably wanted to charge for each call but found, after the fact, that
its service contract had been structured in a way that prevented it from doing so. In
addition, contracts should anticipate cases in which providing standard services might
generate exceptional costs, as in the use of equipment at hazardous-waste sites.

The companies that handle services most

successfully have developed terms-and- Companies
conditions packages that share risk with
the customer: clauses cover co-payments
to reduce nuisance calls, deductibles on
major repairs, and limits on covered
consumables, such as fluids and
batteries. Finally, every contract, where
possible, should include terms for
automatic renewals, automatic annual price increases, and higher labor rates for overtime
repairs.

As well as anticipating operating risks, a wider range of terms and conditions promotes a
more sophisticated approach to contract negotiations. Since almost every service
customer requests some price concession, a limited number of standard options gives the
sales force the flexibility to win business without running the risk of customizing every
contract. Currently, most companies don t equip their negotiators with the insight or
tools to understand what service trade-offs should be sought in exchange for price
concessions. If a customer requests a 10 percent reduction in price, for instance, many
companies accept or reject the request without modifying the contract.

Instead, negotiators should look to compensate their companies for price reductions by
winning changes to terms and conditions that, over the life of the contract, will more than
offset the lost revenue; higher deductibles on equipment repairs or a premium for
emergency repairs are two possibilities. Conditions and coverage exclusions are essential

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in supporting any such price negotiation. To design them successfully, the service provider
needs a good handle on the customer s economic and risk profiles and on the
economic value of certain contract terms. Sometimes, all that is needed is a relatively
simple spreadsheet-based pricing engine that can give rough estimates of the impact of
certain pricing decisions on revenues and service costs.

Keeping an eye on performance

The price-calculation engine is the first of several tools that companies need to manage
their service contracts effectively. A second key tool one that tracks which bids are won,
which are lost, and why leads to a better understanding of the service provider s
competitive (or uncompetitive) position on prices and service delivery.

A third tool tracks realized prices against actual costs to serve information that can
provide useful feedback when it is time to renew a service contract. One industrial-
equipment company found enormous variations in the pricing of services for small
accounts, while some other accounts were priced below the average total cost to serve
(Exhibit 2). Careful monitoring of contracts can help identify emerging problems, segments
that require higher levels of service, or regions with higher costs to serve. A manufacturer
of transportation equipment, for example, noticed that the cost to serve customers in the
northeastern United States was significantly higher than it was in other areas (in part
owing to higher liability claims). Over time, this company therefore migrated to a regionally
differentiated pricing scheme.

Chart:

Monitoring contracts can also be the launching point for tracking the effectiveness of
service operations: changes to prices and service offerings must go hand in hand with an
evaluation of their actual delivery. It is highly damaging to customer relations if, say, a
high-end customer is guaranteed a two-hour response but the service provider can t
deliver consistently because it lacks the ability to schedule field technicians in two-hour
increments. It can be equally costly to discover that technicians are overdelivering by
unintentionally providing platinum-level service to every customer, even those that have
signed on only for the bare-bones service package. More careful analysis of metrics such
as average service or transit times can indicate ways to improve the routing of technicians,
reduce their downtime, and upgrade their skills to meet the customers needs profitably.

In the short term, the best service-pricing companies have found that to deliver
consistently they need to create a small team to gather reliable data on internal pricing
actions, to track competitive shifts, and to facilitate regular cross-business reviews of
pricing performance and strategy. Simple weekly or monthly pricing-performance reports
and analyses, shared throughout the organization, can focus senior management s
attention on service-pricing opportunities.

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How to make after-sales services pay off Page 6 of 6

A handful of companies have started to use service-performance monitoring to link

compensation to price realization for service. This approach has given their sales forces
incentives to limit the customization of service contracts and unnecessary discounting. For
one food-equipment manufacturer, unapproved discounts brought its prices to levels
averaging 16 percent below target in its installation business, thereby dragging down
potential profits. Incentives that rewarded the sales force for negotiating profitable
contracts, combined with a standardized price-quoting tool and a centralized bid-approval
process, quickly improved the situation.

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