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This article was written by Lisa Thompson and Jim Evans, Axiom Consulting Partners
We assumed the price spike was halted decades ago, alongside disco fashion and feathered hair. But 2021 has seen the US consumer price index climb to 7%. It’s an unpleasant reality that inflation is back and shows no signs of slowing down anytime soon.
Continued inflation poses particular risks for business-to-business (B2B) software developers. Why? Because executives in high-margin businesses like software are often not as sensitive to margin cuts as those in lower-margin industries. For example, a software company that sees its margins drop from 75% to 72% will not feel the same impact as a company that drops from 20% to 17%. This is especially true for the growing number of companies that sell both industrial products and software, and it makes understanding cost even more critical in today’s environment.
Many software companies operate in a way that hides creeping cost increases and squeezed margins, in part because they rarely track profit and loss (P&L) at the customer level. For example, consider how these companies typically approach:
- Services: Software vendors often offer non-contractual services and support in response to customer requests. But these services are not free; they may just appear as such because they are not actively tracked anywhere.
- Research and development (R&D): R&D costs are usually only assigned to the first version of the software. These costs show up in the company’s EBITDA, but not on a non-existent customer P&L. R&D costs for future releases could very well skyrocket, but out of sight.
- Accommodation: Moore’s Law states that computing power doubles every 18 to 24 months. But while hosting costs seem to drop to the unit level (from big vendors like AWS and Azure), the latest version of a software product often requires twice the computing power and storage than the previous version. In most cases, the software vendor foots the bill for these increased cloud hosting costs.
Inflation increases the need for software companies to understand their costs in order to make smart pricing decisions that will help protect their margins now and in the future. Although costs are only one element among others that influence pricing decisions, they are obviously a very important element. To uncover areas of opportunity, software developers should:
- Create a P&L at the customer level. The customer should be the first unit of measure. Software vendors often tally scores by measuring the different components of the delivery (software, services, maintenance, and support) separately. This can lead to a tug of war for margin as well as suboptimal decision making. For example, if the services team has a margin target, software licenses may be discounted, reducing long-term customer value. Or the services can charge the software team for the services consumed at an internal transfer price that includes the markup for the services team, hiding the true costs. In general, software vendors should:
- Take the time to determine the direct costs. Hosting, deployment, service, implementation and support costs are direct costs. But so do program and client management teams. Software vendors should take the time to document all costs and review those associated with software deployment, delivery, and performance.
- Stop calculating competitor P&Ls. The need to evaluate the performance and efficiency of services often leads to the practice of a separate calculation of the P&L. It may be acceptable to measure and track them to identify areas for improvement, but not for rewards.
- Score and manage like this all the time. The cost catalog provides the framework for measurement and improvement at all times, but it is essential to counter and respond to inflation. Separate P&Ls hide costs, focus team members’ attention on internal dynamics rather than the customer, and hurt overall profitability.
- Analyze all P&L line items and catalog costs that have increased over time, especially recently due to inflation. At a minimum, this will provide insight into the true cost of servicing customers, from licenses to services and support. When rising cost trends are seen, especially the more recent ones, there may be opportunities to raise prices.
- Quantify the value of differentiated software products and services. Not all of a company’s software products are differentiated, and even some may only be marginally so. Look for products and services that increase customer revenue or reduce cost and risk beyond what competitors’ offerings can do. Too often, software vendors fail to recognize or quantify how much their products benefit their customers through risk reduction. Rising costs, especially around differentiated products, provide a ripe opportunity for price increases.
- Establish policies for sales rep discounts. To facilitate complex, high-value transactions, many software companies employ a deal desk, a cross-functional team that helps prevent bottlenecks to close deals quickly. Although this seems like a positive practice, it is often achieved by lowering prices, sometimes unnecessarily. The deal desk should provide give-and-take trade-offs, so sellers can be responsive to discount requests while expecting something in return (e.g., longer contract terms, more favorable payment schedules, bill of materials expanded, a reduction in services or a reduction in training). Give-and-take trade-offs allow software vendors to meet customer needs while maintaining price integrity.
Even in the face of this unprecedented inflation, raising prices is easier said than done. Setting profitable prices in enterprise software requires understanding your economic value to customers, arming vendors with give-and-take trade-offs that recognize competitors’ strategies, strengths and weaknesses. But make no mistake, understanding how costs are changing and knowing if, where and how to increase them starts with knowing what your costs are.
Lisa Thompson and Jim Evans are partners at Axiom Council
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