Managing Pricing of Bundled After-Market Agreements

Managed Print Services Connect (Jan 15 2010) Finance , Resellers

1. About “AS THE OWNER” Articles by Mike Dudek (www.astheowner.com)

    “AS THE OWNER” articles are written by Mike Dudek, founder and owner of Zygoquest and the Law Office of Mike Dudek.  The purpose of these articles is to draw an owner’s attention to critical business issues which impact financial results and value.  These articles will focus on frequently encountered issues with practical suggestions for improvement.  Owners and operating officers are expected to lead the overall business strategy.  In order to do so, leaders must also be knowledgeable about all vital business functions to be able anticipate opportunities.  In addition, management must be able to identify and correct issues and problems which have a material impact on financial results.

   Owners who are too detached from understanding day-to-day operations of their business leave their destiny in the hands of others who may not act like an owner.

    

   Bundled After-Market Agreements

   Many companies in different industries, including thousands of copier and printer dealers in the office products industry, sell after-market agreements to support equipment purchased by customers.  While some after-market agreements are for services only, many are comprised of a bundle of services and supplies.

   Companies that sell equipment along with related services and supplies generally realize substantially lower profit contributions from equipment sales.   After accounting for the equipment cost, the sales commission, and direct selling expenses, generally there has been little operating contribution to cover admin expenses and return a reasonable bottom-line profit.  This business model, resembling a razor and razorblades approach, has been to aggressively place equipment despite its relatively lower profitability in order to capitalize on historically reliable and healthy after-market margins.  If after-market margins profitability falters, the business model breaks down.

    

   Proper Pricing of After-Market Agreements is Crucial to Profitability and Value

   A dealer’s ongoing profitability, value and viability can be severely impaired long-term if the dealer misprices after-market.  While this article focuses more on the supply portion of bundled agreements, the same concepts apply to the service portion.  Dealers mispricing just the supply portion of an agreement, perhaps due to underestimating the cost of supplies to be consumed for a contracted volume of business or shipping excess supplies, can impair supply profitability and thus overall dealer profitability and value.  When mispricing occurs on a large scale, dealer profit can shrink dramatically to the point where a dealer’s viability is in jeopardy.  At a minimum, dealers with such problems have a substantially lower enterprise exit value than they would otherwise.

   Historically, after-market pricing was easier to measure and manage.  Costs and margins were much more predictable.  Many factors have evolved over the years to cause measurement and management problems in this area, including:

    

   ·         Bundled arrangements – most dealers now feature bundled agreements as their #1 offering;

   ·         Higher-end B&W and color products – carry very expensive supply cost investments;

   ·         New product introductions by manufacturers – with untested cost estimates and little to no service histories make pricing management very challenging;

   ·         Customer applications – which might consume extraordinary amounts of supplies, such as copying and printing of web-pages with high-density toner coverage, vary extensively; and,

   ·         Overall supply cost have increased - placing substantially more owner capital at risk.

    

   The evolution of such factors has created many dealer opportunities but these factors have also substantially increased risks which require proper planning and management oversight. 

   Years ago, most contracts were unbundled which created an effective self-controlling management process since customers generally only ordered and paid for supplies on an as-needed for consumption basis.  Even if customers over-ordered or over-consumed supplies, there was little to no concern because customers paid for supplies on a transaction basis.  Consequently, dealers did not have to devise sophisticated management systems to track and manage over-shipped or over-consumed or over-stocked supply inventories at customer locations.

   Since supply sale transactions were separate and distinct from service transactions, related mark-ups, pricing, discounts and profit margins were easier to measure and manage.  Dealers knew the cost of supplies and marked-up to achieve desired margins.  Dealers simply established standard supply price list and managed deviations for large customers with special pricing.  In summary, dealers more easily managed and realized healthy supply margins despite competitive pressures.

   Over time, dealers belatedly recognized that supply revenue was decreasing.  Dealers therefore introduced bundled agreements to lock-up customers from the competition and to capture supply revenue which was under assault by “toner-phoners”.  But jumping with two feet into selling bundled agreements often resulted in unintended consequences.  Bundled contracts had commitments based on estimates.  Big bucks were at risk and many dealers did not have adequate systems to measure and manage profitability.

   Risk increased as dealers moved up market.  Dealers in the old days were selling relatively lower-end equipment with lower supply costs to lower-end customers.  For example in the copier/printer industry, high-end B&W machines and color machines were not pervasive.  Supply costs per transaction, per machine and per customer were relatively lower.  Since less money was at risk and few transactions were bundled, many dealers did not modify their operating systems to track and measure costs and margins of bundled agreements.

   Over time, manufacturers and dealers moved up market to sell high-end B&W and color devices.  Supplies for these high-end and color machines are obviously much more expensive.  For example, even providing each customer with only a single replacement cartridge for each high-end B&W and color machine under contract could require an investment of many thousands of dollars.  Potential overstocking of supplies at customers merely compounds this investment.

   Another factor was that years ago, product introductions were far less frequent.  Manufacturers are now introducing products at a record pace.  The introduction of many high-end B&W and color machines carrying much costlier supplies along with the adoption of bundled contracts by almost all dealers have changed the landscape and formula for success.  More sophisticated management and management systems are required.

   As manufacturers rapidly introduced new products, some introductions may have been released with unreliable cost and consumption estimates, especially considerations the wide variation of customer applications.  Properly pricing bundled after-market agreements for new products without service histories is particularly challenging for both the manufacturer and the dealer.  Competition of course has often driven prices to painful levels; even below cost.  The absence of price escalation clauses in contracts can be especially haunting and damaging to a dealer’s on-going profitability.

   Dealers selling bundled agreements experience other problems which erode margins.  Customers were ordering excess supplies and dealers were shipping supplies according to a schedule whether the customer needed them or not.  Some dealers discovered extraordinary amounts of costly unused supplies at customer locations.  Self-controlling processes where customers paid for what they ordered were no longer in place.  Dealers instituted periodic collection programs for sales and service technicians to collect excess inventory.   Others began capitalizing inventory on balance sheets for supplies at customer locations.  While this captures the cost, it does not help cash flow unless the cost is then managed down.  In addition, although capitalizing such inventory can be an acceptable accounting practice, dealers must follow standard accounting conventions.

   With all of these changes over the years, unfortunately, after-market pricing is prone to mismanagement and problems are now prevalent in the industry.  Such problems create tension between dealers and manufacturers, dealers and customers, owners and management, and between sales, service and admin department employees.  This tension often translates to eroding bottom-line results.

   The age old tension among a dealer’s sales, service and accounting departments continues to exist.  Equipment sales reps want to win deals with competitively discounted pricing.  Aggressive sales reps of course want as much revenue ascribed to the equipment in order to realize the highest possible commission.  Astute service managers argue for a fair share of after-market revenue on service P&L’s, often irrespective of how sales commissions are computed.  Astute finance and accounting personnel argue to make after-market whole.

   One post-bundling phenomena in the office products industry which pertains to measuring functional profitability is particularly troubling.  Many years ago, a team of finance professionals at Alco Standard Corporation developed a functional P&L approach to benchmark and manage dealer profitability and productivity.  This approach has been adopted by countless dealers throughout the industry and remains the best way to both manage profitability and to identify material issues which warrant management attention.  The troubling development has been that many dealers, even many large and sophisticated dealers no longer even attempt to allocate revenue from bundled contracts even with the advent of pervasive bundling.  The effect is that the cost of supplies is not matched against supply revenue in order to properly compute both supply and service margins.  A combined after-market margin is substantially less insightful for managing the business.  The hodgepodge combination of bundled and unbundled aftermarket agreements without allocation of supply revenue has caused large portions of a dealer’s functional P&L to be unreliable and useless in managing critical aspects of the business.  This shortcoming should be corrected across the industry for what is not measured cannot be properly managed.  Many dealers may be in for a rude awakening when they better recognize that those once reliable and healthy supply profit margins may have dwindled to unacceptable levels.

    

   Owners Must First Identify Whether an After-Market Pricing Problem Exists

   Dealer owners have been striving to grow the top line while retaining historical profit margins despite increasing competition.  In order to maintain historical profit margins, owners and management teams must routinely capitalize on growth opportunities while examining the trends of the big chunks of revenue, cost and expense on their income statements.  Management gets paid to anticipate “What can go wrong”.  In the case of bundled aftermarket contracts, a huge portion of the business is at stake and many significant things can go wrong which have a dramatic effect on profitability.

   Each owner should determine whether an aftermarket pricing problem exists.  If there is a major problem, only the future profitability and value of your dealership is at stake.  Owners need to determine if any of your bundled contracts are mispriced.  Perhaps some adverse pricing commitments are long-term in nature without ability to escalate future prices.  Perhaps revenue with inferior pricing was prefunded in long-term leases carrying double-digit interest rates which mortgage the future.  Perhaps customers are consuming supplies substantially in excess of estimated supplies which were budgeted into bundled pricing by the manufacturer or dealer.  Perhaps excess supplies are being inadvertently shipped to and stocked at customer locations.

   Owners and management must make a thorough assessment of this most critical area.  If a problem exists, corrective action should be taken.  Not being able to identify whether a problem exists is a problem itself.

    

   Management Tools for Managing After-Market Pricing and Costs

   To operate effectively in the current environment, owners need to ensure that management systems are in place to measure and manage after-market pricing – both the supply and service portions separately. 

   For companies with many transactions, systems must be automated to measure costs by machine model and customer.  Models and customers that are consuming supplies in excess of budgeted amounts must be identified.  Once identified, management should revise pricing on future sales transactions and should closely manage price escalation on existing contracts.  Guidance from top management to support personnel must be provided because there will always be tension about how to handle price escalations on existing contracts as you run the risk of damaging customer relations and losing customers to the competition.

   Sales, service and admin management must work together especially on all substantial transactions to gain a good understanding of customer applications in order to properly price the bundle, especially when multiple high-end B&W and color machines are at stake.  Customers, such as print-for-pay customers who routinely copy and print high-density coverage on over-sized paper, need to be closely assessed both pre and post-sale.  You might find that such knowledgeable customers are effectively realizing two expensive clicks for the price of one inexpensive click charged by the dealer.  It is frustrating ironic when such customers run more clicks, the dealer is less profitable.

   There are various management tools and techniques which can be instituted on a dealer-by-dealer basis to improve after-market profitability.  Frankly, we continue to be amazed by the large majority of dealers, even the largest dealers who do not routinely generate management reports to assess contract pricing.  The population of customer contracts is the owner’s annuity and arguably the dealer’s most important asset.  The contract population warrants constant management attention and it is never too late to get started.  In this era of automated management systems and reporting capabilities, analysis of contract pricing, especially at a high level, should be routine.  Owners must challenge their management team if such analysis is not being performed.

   Please provide feedback to Mike Dudek and share your ideas or war stories.  Thanks.

    

   About Zygoquest Group and Mike Dudek (www.zygoquest.com)

   Zygoquest provides customized merger and acquisition services and advisory services to owners who are to buyers and sellers of companies.  Mike Dudek and Rich Wisniewski of Zygoquest are authors of over 400 M&A consummated transactions during their careers and experts at enhancing business value.  Zygoquest is the #1 M&A authority in the office products industry.  The Zygoquest website contains deals you will recognize.  You can reach Mike Dudek at (610) 873-6555 or mdudek@zygoquest.com.

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