The second component of managing your service gross margin is what sits inside your cost of goods sold. Your margin is simply the difference between revenue and all the various costs for that service revenue. That includes the cost of your team, their benefits, and the tools used to get the job done.
That last piece, the tools, is a bigger factor than most owners realize. Owners are generally very aware of wage pressure from their service techs. They also understand and manage benefit costs. But the cost of your client-facing software such as your RMM, security, O365 and other software licensing has been climbing in a way that is much harder to control.
Costs Move, Pricing Doesn’t
Here is the pattern. Managed service revenue is a flat fee with a variable component (per seat), renewed year after year, often with a three to five percent bump (sometimes negotiated into the contract). That bump might cover wage increases for your team just fine. It often does not compensate for the software increases vendors have been pushing through in recent years.
Software costs keep rising while your per seat revenue stays flat. And the reason nobody catches it in time is simple: the costs are charged monthly to the credit card and are individually small. Furthermore, the costs are difficult to calculate with staggered start dates and irregular increases. They are, after all, auto-renewed, and it is politically much easier to allow them to renew than to talk through alternatives with your team.
Why This Happens
Software spend has a way of becoming an oversight problem. It gets charged to a credit card, set to auto-renew, and forgotten. Individually, these increases are small enough that they fly under the radar. But stack five, ten, or twenty software subscriptions together, all creeping up independently, and those small increases compound faster than the rate you are increasing your clients’ pricing.
The Compounding Effect
One client with a ten percent software cost increase is not going to sink your gross margin. But that is not the environment we have been in for the last five or six years. Inflation has pushed vendors to raise prices aggressively just to stay profitable themselves, and when every vendor does that at the same time, the compounding effect becomes hard to ignore.
If your revenue is only increasing five percent a year and a meaningful portion of your software costs are compounding at fifteen to twenty percent, it will not take long before there is a meaningful compression in profitability: it will certainly not be the best in class if left unmanaged.
What Passing Costs Through Actually Looks Like
It starts with an honest conversation and a review. Every time a vendor raises their price, ask whether the tool is still delivering the value that you purchased it for. If it is essential and there is no easy alternative, then that cost increase needs to be accounted for in your pricing. The key is doing this review on a regular cadence, especially for the tools sitting quietly on a credit card nobody is paying attention to.
How to Fix It
A few concrete first steps:
- Pull your service cost of goods sold and export your software spend into a spreadsheet.
- Sort it by vendor and by tool, and look for duplicate functionality in the software.
- Track how much you are paying each vendor for this service starting at the current date. Add columns to update the change in pricing over time and calculate the actual rate of increase at regular intervals.
- Make sure every one of these costs is included in your service cost of goods sold so your gross margin number is accurate. Internal use only (expensed) software is usually minimal and most tools are used to serve clients and should be in COGS.
- Once you know which tools are essential, go back and determine what price increase is needed to keep your margins at best-in-class.
Closing
Sneaky software increases in your tech stack are a quieter reason for gross margin compression than pricing to the deal. While these costs often fly under the radar, and the increases are more subtle, this is a genuine reason your gross margin percentage is compressing, and it is one you can get ahead of with proper management.
Next in the series, we will look at another item compressing your gross margin: client grade.