Prices, Margins and Discounts^©
by Al Hahn

In the past three years, my partner and I have trained close to two thousand people around the world in the specific techniques of selling service and support. In fact, I'm writing this column on my notebook computer, while my partner is working with a group of service managers, product sales people, and service sales specialists. We work in tandem, and he is on the platform at the moment. Later, we will model techniques together and put the students through role-playing exercises.

In preparation for this in-house class, we interviewed about 10 of these people to find out their problems in selling services. Price was their most common challenge. Many were focused on what they described as "The market" and competition. "Our company is just not in touch with the reality of how far street prices have fallen," they said. "We have to match our competitors discounts of 50-60 percent."

Discussions of their customers tended to revolve around what it takes to get their business. Little was said about customer needs in terms of business issues or service deliverables.

What's wrong with this picture? It's focused on competitors instead of customers. Our research of why thousands of customers bought service contracts revealed that these are not impulse purchases. Customers buy service because they believe they will need it.

You can use price to compete, but, do you really want to participate in an auction, where the service business goes to the lowest bidder? Yeah, but those are mean streets out there, you say. Only the tough, and the lowest priced can make it today.

Cruising the mall for service?

All right, let's try to put some reason into this chaos. Lets start with what the customer wants. As I mentioned above, customers buy service because they believe that they need it, or will need it. They don't cruise the mall, window shopping, and suddenly decide to drop into a store and buy a service or support agreement because it's in a really hot color or it's on sale. No, they buy service because they are convinced that they should.

In this context, price is only a comparative measure if the customer thinks they can buy the service cheaper a la carte, than in a contract. I have performed hundreds of analyses of annual service and support agreements compared to the cost of the same services at time-and-materials or per-call rates. Typically, the contract is 20-50 percent cheaper. This is a classic positioning of bundled services. It works the same way in a restaurant - buying the complete dinner is less than ordering a salad, main course, and dessert separately.

Where do you want to dine?

OK. Lets assume that the customer is hungry for a nice plate of your services. Will they shop around for the restaurant offering the biggest discount? Well, it depends.

First of all, if they're looking for a first-class dining experience, probably not. In fact, there are a few discriminating diners who are turned off by prices that are too low. They expect great service and also expect to pay for it. We'll call them the premium service buyer. Those who want to dine on caviar may surreptitiously check the price, but don't expect it to be cheap. From a service perspective, these buyers want seven day a week, 24 hour a day coverage, assigned engineers, and instantaneous response time.

Next, we'll consider the standard service buyer. You know, the typical customer that wants good food at reasonable prices. We're not talking fast food here. This is the Saturday night out with a date or spouse kind of thing. Can't be too cheap, but, hopefully, it's not the Ritz either. This customer wants a good package of services at a fair price. They don't expect the cheapest price, and certainly don't want bad service.

This service customer expects coverage during normal work hours, reasonable (four hour on site) response time, and competent engineers. They want a good package of services, at a fair price. Despite the posturing for negotiations that goes on, this is not an inherently price-sensitive customer. In fact, this buyer is also reluctant to consider low-priced alternatives.

Lastly, we consider the economy buyer. Depending upon circumstances, we can all find ourselves in this category from time-to-time. If you have four kids packed into the minivan, you're not looking for a divine dining experience. Pizza or tacos are fine, and are mighty popular with the children. They also don't require a bank loan to finance.

Some people always shop at this level. Others vary by situation. Taking the spouse out for an anniversary indicates an upscale target. Packing kids lowers the expectation.

The economy service buyer wants coverage to get things fixed when necessary and to avoid a catastrophic repair bill. They can wait a little to get a better price and they don't expect extra coverage or assigned engineers at their beck and call. Maybe they can bring their product to you for repair. If this is software support, they might send their questions in via e-mail, and wait a day r more for an answer. Price is important. Too high, and they don't dine out. If the price is right, they might dine out more often. This is a price-sensitive customer, to be sure, but still a good customer.

Speaking of price-sensitive, research shows that 10 percent of customers will make their purchase decisions primarily on price. They will select their restaurant - or their service provider - from among the low cost alternatives. If price is equal, or low enough to be an acceptable bargain, they will compare other features. This also means that 90 percent of buyers compare features and performance first, then consider the price. If everything else is equal, they might buy on price, but everything else is seldom equal.

Rampant price pressure

Research also indicates that customers are increasingly displaying price-sensitivity. Your own personal experience probably makes you question my statement that only 10 percent are price shoppers. Everyone seems to be beating you up for a better deal and competition is more vicious than ever. This guy is not in touch with reality, you may say. Well, there are a few fundamental issues driving this price pressure. The first is increased product quality.

Products have dramatically improved in quality in the past 5 to 10 years. In many sectors, the hardware requires no maintenance, rarely breaks, and is often serviced remotely. Customers are seldom inconvenienced, and rarely see a service person working to get their equipment back on line. The fact is that hardware service calls are trending down, causing customers to question the value of service contracts. This is manifested in falling renewal rates, and increased price pressure.

On the other hand, software support calls are trending up. Not because software quality has decreased. Quite the contrary, software quality and reliability is up. The call patterns have changed dramatically. In the not-too-distant past, most calls were for bugs. Today, bug fixing generates less than 10 percent of support calls - for some vendors, much less. Calls today are for advice.

In a Silicon Valley focus group of support center managers from companies such as ComputerLand, Hewlett Packard, Silicon Graphics and others, they told me that their biggest challenge was the customer asking "How do I get the product to do what I want it to do, the way I want it to do it?"

Other research, for a software company with millions of users, showed that customers call more frequently after they have tried support once or twice. Initially, they are shy, and reluctant to ask for help. Once they discover that they will not be made fools of for asking for advice, they tend to call more often. We teach them it is OK to call us.

If they are getting more software support, then why are they just as sensitive to price as hardware customers? It is because we as an industry, are inconsistent in the delivery of our support. While hardware service delivery has been delivering consistent response times for a long time, software support providers tend to advertise their response goals rather than the response that customers can count on. Although we may attain a decent average response time, this is no consolation to a customer waiting impatiently through a long call queue.

For may companies, this happens every time a new release is issued. Support may be great one day, and unacceptable the next. Customers are incensed when support is inconsistent, and this is manifested in complaints about the price they are paying as well as their unhappiness with the service. In fact, studies show that their satisfaction with the price they paid for their support contract will drop twice as much as their satisfaction with the quality of the support itself. Their reaction in the price dimension is leveraged because they feel ripped off.

One final reason for increased pressure on service and support providers is the dropping of product prices. Most high-tech segments are experiencing rock-bottom margins today. They have lowered product prices such that many are making no profits on product sales. In fact, services are generating over 60 percent of industry profits today. Many companies could not survive on products alone.

When company negotiators find that their vendors have discounted products to these fire sale levels, they look to services next. Many service providers used to escape this kind of scrutiny and negotiating pressure - not today. The pressure points are shifting increasingly to service providers and these corporate negotiators are much more adept than we have experienced in the past. Moreover, they expect that we can offer the kind of discounts that they have gotten on our products.

A tale of many margins

Generally speaking, product and service margins have been quite different. Before the bottom fell out, products frequently had 50-60 percent gross margins. Volume purchases could generate even greater returns. Thus were born aggressive product volume discounts of 30-40 percent or more.

Hardware services, on the other hand, typically generate about 35 percent gross margins. Therefore service discounts have always been less aggressive than product discounts. In fact, the aforementioned 50-60 percent discounts on services, even for large sales, make no economic sense. Given the industry's growing dependence on service for profits, steeply discounting service is a going-out-of-business strategy. It just does not make mathematical, financial, or business sense. Yet, we get persistent feedback that street prices (the price at which services are actually being sold) from some vendors, are discounted to these levels, particularly for desktop services. What in the world is really going on?

Some of these vendors have more at stake than PC maintenance. We know of service providers that target large, strategic accounts and buy their way in with lowball maintenance prices. Then they go after more profitable software support, asset management, and other professional services. Often, they raise their maintenance prices in subsequent years. This makes sense only when you can upsell your way into profitable business that more than offsets your losses.

Similarly, there are manufacturers that will do anything to keep major accounts that buy a lot of equipment. They will match a lowball service deal just to keep competition out. Their survival may depend upon retaining major accounts to insure that new products will be sold. We have heard of IBM and other major manufacturers responding in this way. It may make sense for them to lose a bit on services if the profits from new equipment sales are greater.

Low cost service providers

There can be another situation where these cut-rate prices make sense. That is a company that has designed its service to be low-cost. I don't mean lowering the cost of premium or standard services by finding ways to enhance productivity - everyone is doing that. t. I mean designing a service program that can be delivered at significantly lower cost.

A good way to understand this is to look at the airlines. Southwest Airlines has grown market share and profits by delivering a lower cost product. You don't get assigned seats and instead of a meal you might get a bag of peanuts. The service isn't comparable to larger airlines, but its not expected to be. Their customers know they are paying the lowest price and don't expect frills. Actually, the staff members are quite enthusiastic and the service they do provide is pretty good, as long as you know what to expect. The same is true for McDonalds. What they offer is consistent, low cost food and fast service. You don't go there expecting linen tablecloths and a string quartet.

So far, I haven't seen a true low-cost service provider positioning themselves in our industry. Yes, many third-party or independent service providers have lower cost structures than manufacturers. They typically position themselves as offering the same services as manufacturers at 10-20 percent less. McDonalds does not position itself as offering the same things as the Ritz, and there is a big difference in their respective pricing.

There is a definite opportunity here. One reason why we have not seen anyone claiming this niche is that few independents are large enough to have a service marketing staff to define the strategy and get the message out.

One thing that is important to understand is that a full-service provider cannot compete against a low-cost provider. They have defined their offerings differently. In essence they are delivering entirely different products to very different market segments. This is why United Airlines formed their Shuttle. They could not cut enough cost from their standard services to compete with Southwest. To get costs low enough, they would have ruined their profitable business with their business customers by degrading the service.

Competing on price

This leads me to suggest some things to avoid if you would like to preserve the value of your services and protect your revenues and margins. It is very important to know the point at which a deal becomes bad business for your company. If your competitors are really offering huge discounts for a particular deal, it may be time to bow out. It only makes sense to pursue this business if you meet one of the conditions we have already discussed - you either have other opportunities to leverage from this customer, or you have a true low-cost structure.

By the way, if you do provide low-cost services, it is better to position your list prices to reflect the difference, and let customers know what to expect in service deliverables. Setting your prices the same as a standard provider sends the wrong message. Customers will expect a higher level of service and may be disappointed later. Large discounts also send a message that you were overpriced and would have taken advantage of the customer if they hadn't negotiated. Next time, they expect an even better deal.

What is a reasonable discount? Probably 5-25 percent, assuming your margins are at the 35 percent level, which is typical. Larger discounts devalue the service product. They also tempt the salesperson to sell on price, instead of selling the value of the services you provide. Nordstrom's department stores are widely known for delivering better service than their competitors. They have sales, but you are unlikely to find anything at 50 percent off. A 20 percent discount is pretty good for them. They do have an outlet store, called the Nordstrom Rack, that sells their close-out merchandise at steep discounts. These outlets are not in elegant facilities, the clothes are not artfully displayed, and the service is minimal. By segmenting their merchandising this way, they avoid cheapening their normal stores and protect their high quality, excellent service reputation.

The bottom line

Price always communicates. Big discounts send messages that customers will interpret as indicators of high margins and/or desperate vendors. These are not good messages to send. It is far better to position your prices and services consistent with your delivery capabilities and offer modest discounts that reward long term contracts or service volume.
If you are a premium provider, don't let a low-cost competitor ruin your prices and margins. If a customer does contract with them, they will probably be back once they experience a lower level of service. If you are a low-cost provider, don't start high and discount down. Start lower to begin with, and position your services where they belong.