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Value and Pricing Partners
At some point in the distant past, a manager inside a software company made an absolutely brilliant decision. The name of the individual is lost to history, but the brilliance cannot be denied. It was simple really, and necessary. When we install our software onto the company’s hardware, he reasoned, the software will work perfectly. From there, it’s all downhill. Over time, the company will change their requirements. They will upgrade their hardware and expect our software to continue working. They will want our software to talk to other software. They will change processes, and new best practices will emerge. The user base will evolve. Each of these changes will decrease the usefulness of our software to the customer.
Out of necessity, we need to continually upgrade and maintain our software so it continues to deliver the value promised, but how do we pay for it? He made the decision to charge customers 20% per year of the initial license price to cover these costs. In this moment, this manager gave birth to maintenance revenues. The rest is history. Maintenance is arguably the single most profitable revenue source inside software companies. With margins approaching 80%, it is a gold mine. And it is a mine that churns out those profitable revenues year in and year out. For at least three decades, maintenance revenues have been the mother’s milk of software companies, the gift that keeps on giving.
But Houston, we have a problem. A new cadre of competitors is emerging, offering software as a service. By hosting the software themselves, they can eliminate much of the complexity that justifies maintenance payments. Moreover, the CapEx software investment by corporate IT, requiring board approval, is becoming an OpEx decision made by a business unit head. Maintenance? What’s that? With remarkably low costs for trial and low risk in implementation, as of this writing, demand for SaaS solutions is growing exponentially.
The era of software maintenance may be coming to a close, and established players in the enterprise software industry have arguably the biggest pricing headache in the history of the world. This is the single biggest pricing problem any industry has faced since the early 2000s, when Business Week proclaimed “The China Price” as the three most terrifying words in business. Perhaps today, the terror is in “The SaaS Price.
But the demise of maintenance revenues is only the tip of the iceberg. What is the need for millions of highly skilled technology professional services people when implementation work decreases to a fraction of its former glory? The problem more broadly is essential services. The services that have contributed so much to the growth and profitability of software companies have largely been essential services. Put simply, they are essential because the software simply would not function if not for these services. Therein is the services pricing problem. Implementation and maintenance permit the product value to be realized, but offer little value in their own right. Their prices are a necessary evil customers are willing to pay to ensure the value of the software is delivered.
That’s why cost-based and market-based pricing models have worked for essential services. Historically, no matter which software supplier customers chose, implementation and maintenance services were a necessary part of the equation. In this world, how are proserve rates justified? Well, those are the rates everybody pays for these services. These are our costs or these are the market rates, so you should pay them. Similarly, why should companies pay 20% of the product price for maintenance? Answer: That is what all software companies charge. It’s not our fault. This is the market price, so you should pay it.
But the competitive game is changing. If customers can get the software value with little implementation and maintenance service investment, they will do so in a heartbeat. In this brave new world, essential services are no longer essential. Willingness to pay, therefore, disappears. That’s not to say that maintenance revenues will disappear overnight. Depending on your competitive situation, they could last a decade. But the end game is clear. So if software companies are going to maintain their services revenue streams, then they must transition to value-added services. These are services that have value in their own right, beyond the software value.
More broadly in technology markets, service revenue streams are facing new challenges and opportunities. Many companies are facing challenges with the “as a service” price. Look up “cloud computing” on Wikipedia, and you will find 14 XaaS models, from infrastructure as a service to backend as a service. What is the need for a field service force if hardware is delivered as a service?
Other forces are at play as well. For example, if your latest generations of technology are incorporating self-diagnostics, and diagnostics have been an important role of your service team’s value prop, then redefining the value prop and pricing accordingly are necessary to maintain service revenues and margins. If your services prices have been tied to your hardware prices, and hardware prices are falling, then service margins are in jeopardy. Service margins are often more sensitive to price changes than product margins.
Despite the challenges, whatever the technology and its benefits, smart people are needed to make it work. Hmmm…perhaps that sentence understates their contribution. Let’s try this: Smart people are needed to make these technologies, largely incomprehensible to most of us, work to solve our problems and enable our futures. Smart people are needed to make the technologies sing and dance. These are value-added services; services that have value in their own right. These are services that have unique value to groups of customers or even to a single customer. The one-size-fits-all service and pricing model of maintenance does not apply.
The role of services is changing. Historically, managing and solving systems issues were a critically important service role. Now consider salesforce.com. You can have a CRM for $5 per month per person. If I am a sales vice president interested in upgrading my CRM, the services I am interested in are those related to the productivity of my salespeople selling my products and services in my industry. If there are systems problems, I assume salesforce.com will handle them behind the scenes. I don’t have to worry about them and I certainly don’t expect to pay for them.
The shift from cost-based and market-based pricing to value-based pricing is also a shift from pricing tactically to pricing strategically. In Complexity Avalanche, the author refers to a question posed by the CIO of Computer Sciences Corporation: “I know how to improve operating efficiencies in services, but how do I make strategic investments there?” Strategic pricing provides an answer to this question. Strategy is fundamentally about resource allocation. The answer to the question, from a strategic pricing perspective, is to invest in services where value is high, providing high incentives for customers to buy, and permitting us to capture a fair share of that value for revenues and profits.
Post Date: February 26, 2014
Tim Matanovich is president of Value and Pricing Partners (VPP), a TSIA Consulting Alliance Partner and winner of the 2012 Recognized Innovator Award for Excellence in Consulting. VPP specializes in technology pricing where services are an important part of the value prop.
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