Discounting Danger

IT providers face increasing pressure to produce profits. For some, their survival is at stake. Customers have many options and view some components of IT as commodities, making differentiation and winning customers difficult for the IT provider.

The main asset of IT providers (both service providers and VARs) is their customer bases. Customer acquisition is time consuming and can be costly. A limited marketing budget, limited time, and intense competition are challenges IT providers face when increasing customer bases. To gain a new customer, or keep an existing one, providers often resort to competing on price. In the short term, this is an easier and more tangible action to win the sale. By cutting price, they may land or keep that customer. But it can be a trap that leads to a false victory, where the customer is won but profit is lost.

From our experience working with over 1,000 executives of IT providers to SMBs, we have found that approximately 50% of these firms are technically insolvent, 40% are on the edge (two to three months of working capital reserves), and only 10% are healthy with significant reserves.

Marginal financial health across the channel combined with intense competition based on price make for a dangerous combination. We recently completed a survey to gain further insight into the state of the market around these issues. We offer the results here, and recommended actions to improve profitability.

Vendor Policies
As IT matures, individual technologies become commodities and are available to the customer from many sources. Many vendors can offer similar business benefits to the end user, although they may use different hardware and software. Differentiation on features and benefits can be difficult. This drives vendors who want to increase market share to turn to competing on price.

To gain market share, hit internal targets, and make the numbers for the quarter, vendors cut prices to boost volume. In order to keep some price control, rather than reduce list price, vendors initiate competing on price through complex discounting and rebate programs. Rebate programs allow for forms of tiered pricing — sales volume drives the magnitude of rebates. In practice, resellers that have the closest relationships with vendors have the highest awareness of rebate programs and are more likely to reap the benefits. Additionally, rebates are more opaque to the end customer than straight list price reductions, allowing more flexibility in a given transaction.

As many IT providers have experienced, rebate programs fall into two general categories: product-level and volume-level rebates. Product-level rebates refer to dollars given to resellers each time a specific product is sold. Volume level rebates are based on 'clip levels' of selling a specific volume (units or revenue) over a time period (usually quarters or annually).

Rebates have an influence over the behavior of resellers, who in turn offer deeper discounts to customers. In our opinion, rebate programs fall into the category of short-term gain at the possible cost of long term profits. As with many industries, lowering prices unilaterally can increase sales volume and market share in the short term. However, competitor reaction and price reductions quickly reduce or negate the benefit, particularly in mature industries such as IT. The long term consequence is shrinking margins for all, without significant shifts in market share.

Rebates reinforce a discounting mentality with the sales force. It is the easiest and most tangible approach making an individual deal more attractive to a customer. Customers learn to expect discounting, and often are keenly aware of the rebate discounts a reseller is getting, even if vendors take pains to obscure the program details from end customers. Rebates that began as a way for vendors to temporarily lower prices can transform into a permanent customer expectation of discounts.

End of the Quarter Scramble
"No revenue is better than bad revenue" - Anonymous
Many vendors, especially large vendors, are publicly traded and have the inherent pressure to produce quarter-to-quarter profits. Hitting quarterly targets is vital to share price, so vendors' business structures — sales, financials, targets, and programs — are tightly aligned with a quarterly cadence. All of this leads to the inevitable flurry of activity at the end of each quarter, where the pressure for vendors to hit certain volumes leads to further discounting and incentives to close ongoing deals before the end of the period.

This incentive structure is inherited by IT resellers. In general, the most significant incentives from vendors revolve around volume — specific sales targets that must be hit in order for cash back incentives to be paid. This passes on the pressure of the vendor's internal targets to resellers, and creates incentives to cut prices to close the deal in the present quarter.

Margin impact
Customers won through price cuts are likely to be those least likely to return a profit to the provider. They are likely the most sensitive to price, and also value the provider's unique talents and offerings the least. This is further support for the concept that winning business at any cost can hurt business more than help it. Yet in practice, many companies follow this path.

There is wide variation in the providers that serve the market, from single person shops to sophisticated large companies with national reach. Our experience looking at the financials of many such providers has given us perspective on the financial state of providers. Our archetypal provider, for sake of discussion:

• Has revenue of $5M (Companies we have worked with range from $0.5M to close to $100M)
• Sells hardware, software, and services (40% services, 60% HW/SW by revenue source)
• Has a gross margin of 15-18%.

In this scenario, consider the impact of discounting 5% in order to make a sale. Gross margins on such sales drop to 10 points. In this scenario, the sales volume required to produce the same total profit increases by up to 50%. More importantly, the customer has received a signal to expect discounting in the future. By winning the customer through low prices, a company now again has to add half as much sales to get the same gross profit. More transactions, in turn, require more infrastructure. Without sufficient infrastructure, more problems are created and thus more costs. All of this activity is predicated upon sufficient demand within the marketplace. Absent such demand, competition increases and creates pressure to cut prices further.

This takes place in the current context of resellers that are striving to evolve into a full services provider. This requires an investment and increasing capacity. Shrinking margins and increasing volume requirements absorb the fuel required for this evolution, and put the company at risk of failure.

Six Steps To Combat Eroding Margins
1. Analyze the lifetime value of each potential customer. Look at overall impact of making particular types of sales, and invest sales resources in only those that have the best chance of driving profit in the long term. In our experience, those customers most likely to be won over by price concessions rather than other factors tend to have the least long term value. The desire for rock bottom pricing doesn't go away (so follow-up contracts don't recoup upfront investment in winning this customer), and their focus on price is an indicator that they discount the unique value your firm can offer. It is your return on customer acquisition costs that matter, not the total number of customers. If the return for each customer is positive vs. the investment required to get them, your business will thrive.

2. Differentiate based on added value, not lower prices. Winning customer through deep discounts kills the customer's value to you forever. Your customers expect you to be able to articulate your unique value.

3. Sell solutions to specific business problems, not technology. Selling solutions to business problems makes it easier to price by the business value of the solution, rather than the cost of the technological components that are part of the solution.

4. Provide discounting guidelines. Discounting works in the long term only when discounts are tied to corresponding changes in value delivered or costs. If a customer pushed for a discount, consider changing the offering so that it costs less to deliver, by taking out something that a customer doesn't value. For example, delaying service delivery several weeks to better manage your capacity may lower your effective cost, justifying the discount.

5. Align sales incentives. In the end, a salesperson's performance will follow their incentive structure, so make sure their bonus structure reinforces the above strategy. Consider a rolling 90-day sales view, rather than quarter to quarter. By constantly looking at the last 90 days, you can see performance trends. The end of a quarter becomes less 'make or break' for your salespeople, and there are fewer transactions in the short term that can hurt the long term.

6. Invest in sales training. To deploy this approach, salespeople must be taught to articulate the value of your company's offering, and differentiate it from competition. The better the sales force can do this, the higher the win rate against competitors competing based on price. Most importantly, teach salespeople to respond to customer's requests for price reductions by rearticulating value.

All of this is easy to say, but can be hard to do. Behaviors are deeply entrenched, and in a competitive bid situation it is hard to get past the mentality of winning the business regardless of long term cost. The steps above reduce the discounting-first mentality, and can lead to a more profitable customer base.

The State of the Market
We completed a survey of IT providers to gain further insight into these areas and a snapshot of current conditions and practices. Participants were owners, CEOs, and/or CFOs of companies providing IT services, hardware, and/or software to the SMB market, across industries.

Highlights of Findings:

• Rebates: Regarding rebates, 74% of companies considered rebate dollars to be significant or vital to profitability. This dependence creates a situation where businesses should ask — what happens to my financials if rebates go away or are reduced industry wide? Also, are rebates clouding the financial picture in terms of what customers drive the most profit? Reports from Gartner and other firms illustrate the current weak state of many providers. In the context of borderline financials, the strong majority depending on rebates for their profitability is alarming.
• Sales Compensation: Close to 20% of companies reported that they offered incentives to their sales force based on revenue production, while 77% based bonuses on gross profit production. Incentives represented half or more of total salesperson compensation in 58% of companies.
• Growing annuity based services: While for the majority of companies, annuity type managed services made up less than 5% of services, over 90% of companies did sell this type of service. We expect this to continue to grow. This type of offering can help cushion against shrinking hardware/software margins.

About the companies interviewed/surveyed:

• Eighty-five percent of the companies surveyed sell hardware, software, and services. The remaining 15% were services only, or reseller only, companies.
• The overall IT revenue mix was 57% hardware, 13% software, and 30% services.
• Twenty-seven percent who resold represented more than 10 vendors. 85% represented more than one vendor.
• For those that provided financial data, 64% had revenues greater than $20 million.
• Thirty-five percent had a single office, 65% had multiple offices. Overall, the companies had customers across the United States.

 

Conclusion
Competing on price is increasing strain on the financial health of the channel. As an IT provider, you have limited influence on vendors, but can take steps within your company to avoid pitfalls of competing on price, and to grow profitably.

D. R. Widder has over 15 years of entrepreneurial experience in growth strategy and development in early stage high-tech companies. Recently, he was a consultant to IBM in the role of 'entrepreneur in residence' for a SMB IT services group developing new delivery models for IT. He has developed multiple technology patents and publications. He is currently a founder and partner in Milestone Strategies Group LLC, a growth strategy consulting and staffing firm. He can be reached at drw@milestonesg.com,and welcomes questions and comments on this article.

Warren Turner is the founder of Cardinal Points Group, LLC, where he co-authored and developed "Dancing with an Elephant," a financial management course for technology resellers and solutions providers. He has taught and shared his insights with thousands of technology resellers and solutions providers, both domestically and internationally. He can be reached at wturner@cardinalpointsgroup.com.