Now that you have gone through the work of calculating an accurate service gross margin, structured your chart of accounts, and included a fully absorbed cost for your service delivery, the next question is simple; are you happy with you margins?
The industry’s best operators run a service gross margin over 50%. Most owners looking at this number for the first time are nowhere close. If that’s you, the next step is to diagnose why your margin falls short and figure out what to do about it.
There are many answers to that question and this blog starts a series of detailed posts about why your service gross margin is not with the industry’s best.
We start with pricing, because it is one of the most impactful reasons your margin is not where it should be.
Pricing to the Deal Instead of the Margin
As a business owner, you get excited by a new client. You also get a little terrified when a prospect tells you where a competitor’s bid landed. Managing by the emotion of the moment is exactly the moments where pricing goes wrong.
Instead of pricing to cover your cost and hit your margin, you get defensive. You shave the number down to beat the competition and make sure you do not lose the client on price. That single decision, repeated deal after deal, becomes a pattern. And that pattern quickly turns into a culture.
Sometimes this gets dressed up as value pricing. Often it is really just a slow cycle of pricing below your comfortable margin to close the deal. Once that becomes cultural, it feeds on itself. Good salesmanship starts to look like reducing the price to get the signature, but that decision is being made with no real idea of what the margin is on the work.
Your Sales Team is Building Proposals without the Finance Team
Pricing is a consequence. When it is wrong, it usually points back to a disconnect between sales and finance. Your sales team knows the market. They know what number they need to hit to win the deal, it is how they are incentivized. What they may not know is the company’s true cost of delivery.
When sales is incentivized on closing the deal and not on gross margin, you have built in a reverse incentive. Without a clear cost per hour and a structured pricing process, it is relatively easy for sales to hit their number by quietly shaving a few points off every deal. That is not a character problem. It is an access problem. Sales does not have visibility into HR records, overhead allocation, and management costs the way finance does. Pricing will not be right if you hand sales a target and tell them to get the deal regardless of what it costs to deliver.
Lower Margins Start to Compound
One underpriced deal will not sink you. But one becomes two, becomes five, becomes ten, once your team learns where a deal can get through. Renew those ten deals year after year and you have trained a piece of your client base to expect the wrong price. Try to correct it later and they will push back, because they were never priced correctly to begin with.
This is how a company can show strong revenue growth in the right direction and still have a service gross margin stuck in the 30s. It is not enough margin to command the premium you desire when you go to market to sell your company. And it can be a sign that you have trained the right clients to expect the wrong price.
Cost Plus Pricing Ensures You Like the Deal After You Win It
Cost plus pricing starts somewhere different. You calculate a fully loaded, fully absorbed cost of delivery, labor, tooling, and the administrative overhead that supports it. Then you build your target margin on top of that number. It is not based on what the competitor is charging.
This is hard and painful. Due to its cross-disciplinary nature, it mostly lives outside of sales. It pulls from HR, finance, and management in a way sales cannot do on their own.
Correct the Pricing by First Understanding Your Costs
Before you touch anything, take a moment. You have real clients paying you real money for your service right now. Be appreciative of that before you make changes. Past is prologue. However you got here, whether you built the company from scratch, bought it, or started with a pricing model that no longer fits, that history is real and it matters.
From there:
- Calculate your true absorbed cost, including labor, overhead, and management.
- Build a pricing floor that no deal is allowed to go below.
- Pull your closed deals and review them for margin, not just revenue.
- Get sales and finance talking regularly so pricing decisions are made with real numbers.
- Stop incentivizing on revenue alone.
Let’s Start a Journey to Better Service Gross Margins Together
This is the first post in a series on service gross margin. Getting an accurate number through solid accounting work is only step one. The harder part is managing the changes that get you to industry-best margins.
Every post in this series will come back to the same themes. Math is involved, and it touches your accounting. But the payoff is a company generating the best margin and profit it’s capable of, one improvement at a time.