Opportunities for Action in Industrial Goods. The Price Is Right: Optimizing Industrial Companies Pricing of Services

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1 Opportunities for Action in Industrial Goods The Price Is Right: Optimizing Industrial Companies Pricing of Services

2 The Price Is Right: Optimizing Industrial Companies Pricing of Services Industrial companies are leaving millions of dollars on the table and missing a terrific opportunity to cement customer loyalty and encourage repeat purchases of their equipment by failing to think systematically and strategically about how they price their services. This issue becomes increasingly important as services become a core lever of profit growth for many manufacturers. Over the course of working on the issue of service pricing with leading companies in a wide range of industries, we have found that two sets of activities play critically important roles in successful pricing: understanding and exploiting your strategic pricing parameters, and leveraging your tactical pricing opportunities. Conducting these activities systematically can have a powerful impact on your company s pricing decisions. In the end, the rewards for getting the pricing of services right are higher profits, better customer service, and improved customer retention. Understanding and Exploiting Your Strategic Pricing Parameters The first step in service pricing is setting the fundamental strategic direction of your pricing activity by exploring the five key strategic pricing parameters: your company s objective in offering the service, your customers value proposition, your basis of competitive advantage, your competitive environment, and your full cost to serve. These five parameters define your strategic playing field.

3 Your Company s Objective in Offering the Service. Typically, industrial companies offer services for three primary reasons: to improve the performance of the company s core product and promote repeat purchases, to achieve standalone profits on the service itself, or to stimulate pull-through sales of equipment. These three objectives dictate different approaches to pricing. To enhance product performance and promote repeat purchases, companies frequently employ bundling, in which a certain level of service is included in the initial equipment sale. Conversely, pricing of services that aim to achieve standalone profits can be independent of new product sales. And companies seeking pull-through sales can offer attractive pricing of services on competitors installed equipment, with the intent of switching the customer over to their own equipment when the installed equipment requires replacement. For example, a major industrial-component manufacturer, recognizing the challenge of displacing incumbent competitors components, used very aggressive service pricing as an entry point to build relationships and ultimately displace its competitors equipment when it required replacement. Your Customers Value Proposition. Why do your customers buy services? Most often, their motivation is either to cut costs or to get better performance than they could if they provided the service in-house. Knowing which of these motivations is the primary value proposition for each of your customers is key to pricing your services most effectively. For customers seeking cost savings, your pricing flexibility will be constrained: your price must be lower than what it would cost the customer to conduct the service in-house. In contrast, for customers seeking better performance, you have an opportunity to set prices to reflect the true value you are providing each customer.

4 For example, a large HVAC-controls company had traditionally offered episodic services priced at cost plus. By developing a detailed and documented understanding of the value of preventive maintenance and of the optimal repair/replace cycles of its installed equipment, the company was able to transform its service business, creating fixed-term contracts. The company s customers benefited from superior performance (in terms of less downtime), while the company itself reaped new, long-term revenue streams. Your Basis of Competitive Advantage. Whether your competitive advantage in your service offering is based on scale and experience or on skill and capability will play a key role in how you price the service, particularly when the offering is a new one. For services in which scale is a significant source of advantage, such as the remote monitoring of building security and equipment functionality, prices should be set as low as possible initially in order to ramp up scale quickly. Conversely, for services in which competitive advantage is based on skill, such as IT integration and aircraft engine maintenance, pricing should reflect the degree of differentiation between your capabilities and those of your competitors. Your Competitive Environment. This one is fairly obvious: the degree of competition in your relevant market space is the key element in setting and negotiating the pricing of services. What are your customers alternatives, and what is the true competitive situation? Take the case of a distributor that was a rush-order specialist. For years the company had benchmarked its prices relative to the leading and low-price bulkorder specialists. This approach to pricing was particularly challenging because the company had a hard

5 time delivering rush services at bulk-order prices. Through detailed customer research, the company discovered that for the vast majority of its customers, it served as the only quick-turn specialist; in truth, these customers had few alternatives. Armed with this knowledge, the distributor was able to raise its prices significantly to reflect its higher-service-level niche position. It boosted its profits solidly while maintaining its customer base. Your Full Cost to Serve. Effective pricing requires a sound understanding of your company s true and full cost to serve, not only on average but also for specific offerings and kinds of customers. Full costs and cost drivers can be critically important in setting pricing floors and identifying more attractive customer segments to target. Consider the on-site maintenance of equipment. Two critical cost drivers for this kind of service are response time and local market density. Service level agreements (SLAs) that either call for faster-than-normal response times or address markets with lowerthan-normal local-market density can drive up costs significantly. For SLAs based on response time, it is critically important to consider not only average response-time requirements but also the actual frequency distribution of those responses. Without that specification, simultaneous or correlated service requests across customers (for example, service requests that cluster seasonally or on a given day of the week or month) can have a crippling effect on costs, so the company needs to factor that pattern into its cost structure up front. Similarly, low local-market density meaning that customers are widely separated geographically can significantly boost costs by increasing driving time

6 and reducing the number of accounts a service agent can handle. Companies that look only at average costs and densities may choose pricing that is highly profitable in one market and deeply unprofitable in another. Leveraging Your Tactical Pricing Opportunities After setting the strategic direction for your pricing based on a solid understanding of the five parameters outlined above, you should explore several key tactical pricing opportunities. These opportunities vary with the type of service you offer, how proprietary it is, the ticket size, the frequency of purchase, and the length of the customer relationship. The Type of Service. Services generally come in three types: required, unplanned service for which the need is immediate; required service for which the need is not immediate; and general discretionary service. Naturally, suppliers pricing power is highest when the need is most urgent and lowest when the service is discretionary. Companies generally capitalize on this pricing power by levying various surcharges for urgent or unplanned services. Classic examples are same-day surcharges and rush-order fees. The elevator maintenance industry, for instance, has recognized the incremental customer value created for unplanned emergency services and typically charges additional fees for immediate service. The Proprietary Nature of the Service. The degree of service differentiation, including the service provider s proprietary capabilities, is a critical dimension in optimizing the pricing of services. The more distinctive the service, the greater degree of pricing

7 power you have. Common applications of this principle include the use of certified service providers or parts, as well as warranty clauses that require authorized service. Auto and farm equipment OEMs deploy this strategy, specifying that their customers use factory parts and certifying certain dealers or service shops as authorized repair locations. The Ticket Size. The dollar amount of the actual service ticket can play a key role in setting and changing list prices. Companies and individuals alike share an interesting bias when it comes to prices, discounts, and ticket size. People tend to see discounts in relative or percentage terms. That is, a discount of $5 off a $10 item will motivate a buying decision, whereas a discount of $5 off a $1,000 item will have little or no impact. Conversely, when price increases are specified in percentage terms, people tend to be more sensitive to increases on large-ticket items than on smaller-ticket ones. For example, people will be more sensitive to a 20 percent increase on a $5,000 item (which comes to $1,000) than they are to a 20 percent increase on a $5 item (which comes to only $1). Understanding these common perceptual biases can suggest tactical pricing opportunities. The Frequency of Purchase. How frequently a service is purchased is an important factor to consider in setting the price of services. As frequency of purchase increases, purchasers become more astute and price sensitive than they are toward services that they purchase infrequently and particularly those that they buy erratically, such as unplanned disaster-recovery services. The Length of the Customer Relationship. Whether a relationship is new or well established can be an important factor in negotiating the pricing of ser-

8 vices. Early on in a relationship, the supplier can think about investing in that relationship, provided that there is reasonable stickiness to relationships within the industry or segment. Then, as the relationship matures, pricing can reflect the buyer s increasing confidence and comfort, and recognize the service provider s earlier investment. Initial or entry pricing used across industries reflects this principle. Next Steps To understand whether digging deeper into your current service pricing might create value for your company, consider the following questions: Is your current approach to pricing aligned with the overall objectives of your service organization? Do you fully understand your customers value proposition, and have you designed the pricing of your services to reflect that perspective? Do you have a clear understanding of your full cost to serve various customer segments and markets? Is your service organization competing on scale or on skill, and does your pricing structure reflect your actual basis of competition? Does your service pricing take into account differences in purchase characteristics, such as the urgency or frequency of purchases or the size of the ticket? Do you differentiate your pricing over the life cycle of each customer relationship?

9 If you can t answer yes to most of these questions, it may be time for you to revisit your service pricing. By taking a more strategic look at how you set your service prices, you not only can boost your profits but also can provide better services and cement customer loyalty. David Rickard David Rickard is a vice president and director in the Chicago office of The Boston Consulting Group. You may contact the author by at: rickard.david@bcg.com To receive future publications in electronic form about this topic or others, please visit our subscription Web site at The Boston Consulting Group, Inc All rights reserved.

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