Services Pricing

Pricing in services: A look at spare parts (Part 4 of a Series)

In previous articles in this short series we discussed various pricing approaches, including cost /mark-up and competition / market based pricing, introduced value based pricing as a general concept and outlined a basic methodology for implementation.

We will now look at pricing specifically for services in (industrial settings), something which is easier said than done because services, having different characteristics and being more intangible, entail more dimensions than products. First we’ll look at aftersales services, typically services to support, maintain or sustain the functionality of a product after the sale –starting with spare parts which are usually included and in a subsequent article we’ll examine “solution services”, i.e. services provided as part of product-service systems / bundles or “solutions”. These are typically greenfield (new) purchases by a customer.

There are some important peculiarities about aftersales services (both activities and parts) which are important to keep in mind:

First, they can be segmented according to how captive the customer (or broader market) is to the service. It is, for example, often the case that in some types of equipment failure only the OEM has the necessary technical knowhow and parts to provide the repair. In fact usually the (proprietary) parts are the “limiting” factor, i.e. provide the basis for the captivity. In these cases the OEM has a monopoly position. In other cases this situation does not exist and aftersales services are exposed to varying degrees of competition.

Another way to segment aftersales services is on the basis of the nature of demand, which can be proactive or reactive. While proactive demand (e.g. for preventive maintenance) is discretionary, reactive demand (a repair) is forced. Therefore in the latter case the price elasticity of demand is essentially zero (in other words the customer’s “willingness” to pay is very high –almost irrespective of the price).

Another characteristic of demand for “forced” services is that it is intermittent, erratic, lumpy and difficult to predict at the individual customer level (though it is easier to predict at aggregate levels and therefore service providers can plan capacity, inventories and resource allocation).

Finally forced demand cannot be swayed by sales argument or marketing initiatives –after all it is not discretionary.

So while discretionary aftersales services are bought and sold under relatively normal market conditions (competition, sales and marketing engagement, price-responsive demand), this is not the case for forced, usually “captive”, services associated mainly with repairs after equipment failure. This is also the case with spare parts per se, as long as they are proprietary and the customer has no easy way of accessing them outside OEM channels.

The monopolistic conditions and the forced demand make this kind of services both important and special for OEMs: Prices are usually very high and they usually account for the bulk of profits. At the same time they are frequently also responsible for much ill will. It is therefore important to examine this issue further, focusing particularly on spare parts, as they constitute the limiting factor without which the monopoly position is not possible.

Prior to this however let’s look more broadly at spare parts pricing policies and practice:

Most OEMs have significant problems pricing parts for many reasons: First of all the sheer complexity and variety of equipment over many product versions and generations and the need to support legacy products over many years lead to very large numbers of parts, both in stock and made to order. Car and complex machine manufacturers often require hundreds of thousands square meters of warehouse space for tens, even hundreds of thousands of SKUs (stock keeping units – a medium sized machine builder typically carries 10-20,000 SKUs; large machinery or manufacturing companies can carry upwards of 500,000 SKUs). Even tracking the costs of these items (as raw material, production costs and supplier prices change for example) let alone pricing is a major logistical and administrative challenge –notwithstanding efforts at simplification through standardization and modularization. Of course the large majority of these parts are not proprietary, but are, nonetheless, necessary for the ability to service the product and to generate revenue streams. Second, the parts market (with exceptions) is relatively opaque regarding pricing –again mainly due to complexity, the multitude of vendors, brands and labels, differing cost structures, pricing, discount and warranty policies. Achieving a degree of transparency is a major exercise and costly. Third, OEMs tend to under-resource spare parts departments meaning that knowledgeable people are often lacking – identifying, sourcing, costing, pricing and quoting parts may require some extensive engineering skills. If, as often is the case, spare parts are not identified as an important department / profit center in their own right they usually also lack resources for marketing, sales or systematic pricing. They then limit themselves to the reactive role of tracking costs, applying mark-ups and taking orders.  One explanation may be that parts business is often looked upon primarily as a logistics business. Another one however, may be that parts departments are victims of their own success as they produce more profit than both the new and even the services business overall (estimates of the contribution of parts to after sales service profits range from 50% to 120% depending on industry) and therefore are not thought to need further resources. They are deemed to be good enough. However are they really? Given their role in driving service and overall company profitability one would have thought that it would be rational for companies to try to systematically maximize their contribution and provide the necessary resources. Good spare parts pricing and management can make a big difference as we know from many case studies of companies who have managed to significantly improve profitability (with limited or considerable investment depending on starting point). Furthermore spare parts service can be a major cause of customer satisfaction or dissatisfaction with potentially significant longer term effects for customer relationships and market success. So when spare parts are not systematically managed with sufficient resources and sophistication, it is usually a matter of lacking management focus, of underestimating what is possible while overestimating own capabilities.

In terms of best practice, a lot of effort has gone into designing and implementing software to assist in pricing spare parts –either custom-built, as part of standard ERP systems or as specialized solutions. Without doubt software systems are indispensable to handle the complexity, increase pricing consistency and track down, for example, the frequent cases of margin leakage (e.g. when prices have not changed though costs have increased) and reduce mistakes. They are also good at enabling implementation of parts pricing segmentation, incorporating some of the thinking that has evolved over the past 10-15 years: The basic idea here is that parts are segmented into groups depending on a number of criteria, such as competitive pressure (i.e. proprietary or not), complexity, position of the product in the lifecycle etc. Pricing decisions are then made for the group as a whole, for example standard or commodity parts are priced based on cost plus target mark-up, medium complexity parts relative to competitive offerings and proprietary parts at a relatively high price or mark-up, what many, including consultants, call (usually erroneously) value based pricing. Other factors can also be taken into account such as turnover /parts velocity (indicating sales frequency) or revenue predictions based on demand elasticity (presumably commodity parts do have a price elasticity and their demand patterns are more predictable). The bottom line is therefore that pricing of parts can be made more rational and consistent and profitability less arbitrary and more predictable –also in the sense that targets or budgets can be aimed for and met- and, of course, improved.

The sophistication of segmentation and rule making for pricing setting can be enhanced by forming combinations. For example parts can be grouped according to their relative position in a part velocity / proprietary position matrix. The relative position can be defined on the basis of some objective criteria. Managers could then increase prices for parts with low velocity and high proprietary positions (high carrying costs, erratic sales) while lowering (or not increasing) prices of parts with high velocity and low proprietary positions (commodities). Pricing consistency for items in between is also improved.

Still another way to price is to compare prices of product renewal (the cost to rebuild a product from spare parts) v. product replacement (the cost to replace a product with a new one). Rules of thumb indicate that customers’ tolerance in this case is at around 60-70% (renewal relative to replacement – nevertheless car manufacturers have probably never heard of these rules as empirical studies have shown that renewal to replacement costs for cars are often in excess of 300%) which serves as an overall price cap. This can be then combined with segmentation as described above with the additional implementation of a pricing logic for parts “families” based on some attributes or value drivers, which can be empirically defined through analysis (e.g. conjoint analysis), which researches customer preferences –for example the length of the diameter could be a value driver for bearings.

Tactically therefore much can be done to rationalize and improve management as well as pricing consistency and profitability of spare parts, albeit with some substantial initial investment and effort. Studies indicate that today not more than 25% to 30% of manufacturers and OEMs apply some form of sophisticated rational price setting or systematic pricing strategies, so there is ample room for improvement. It is also often the case that spare parts departments by default price parts in the same way that their sister product departments price products. Car manufacturers therefore have quite sophisticated parts pricing systems (given their B2C pricing expertise), whereas machinery manufacturers much less so, particularly those who produce non-standard products and rely significantly on cost plus approaches tempered with some competitive pricing insight. For spare parts, which often face a completely different market environment this is highly sub-optimal. Often however, price management awareness and know-how in these companies is insufficient and is therefore not invested in.

In any case, the issue remains that while there are good approaches for pricing consistency and pricing standard and commodity parts (cost plus, market/competitive pricing) the approaches are less good for determining price levels of proprietary parts. This is because competitive pricing for non-standard products is hard to determine and because a monopolistic position of the supplier relative to the customer exists, which in fact precludes conventional value based pricing by eliminating choice. The “value” of the part to the customer is not really possible to reasonably assess –theoretically it must be equal to the value of the product the customer has already purchased measured in terms of opportunity cost, much in the same way that the cost of downtime of a bottleneck piece of equipment is equal to the cost of downtime of the entire plant in Eli Goldratt’s Theory of Constraints.  The situation is also similar to the case of so called dependent goods, such as printers and toner cartridges or razors and razor blades. In these cases companies position the main product as a loss leader (razor) in order to profit through high prices for the dependent product (blade).

Pricing in monopolistic situations is more a matter for game theory than anything else and suppliers are well advised not to let it deteriorate to a zero sum game. How that is achieved will depend on objectives of the parties, their chosen behaviors and a number of other factors such as the relative market or relationship power of customer and supplier. A supplier may have a monopoly position for proprietary parts, the customer however may have substantially more general market power, as a machinery builder with $ 1 billion revenue selling to a process industry customer with $ 50 billion revenue might quickly find, particularly if that machine builder does not have a very broad market. Furthermore that machinery builder might want to sell more products and capture more of that customer’s spend. Increasing the price of proprietary spares to very high levels might not make good business sense. There are additional factors which can counterbalance a monopoly position, such as risk of reputation damage through too high prices which might be compounded if a supplier is failing to provide good customer service, e.g. reliable or rapid delivery. Furthermore monopolies are not permanent. Other suppliers, including customers themselves, might at some point enter the market for a particular part if potential margins are perceived to be sufficiently high. There is a completely different case to be made of course for OEMs with high market power relative to (individual) customers, depending on structure of the particular industry and the speed in turnover of product generations. For example, OEMs in B2C businesses (e.g. in tech or automobiles) increase prices of parts considerably over the (fairly short) product lifecycle to guide customers towards newer versions of products. This is something that cannot happen in industries where products, systems or plants have very long lives (e.g. machinery, industrial equipment and plant).

Concluding therefore it should be noted that value based pricing for proprietary parts has quite limited applicability when looking at parts alone. Parts are dependent goods and buying decisions are forced and made under monopolistic conditions. Therefore when looking at value it makes more sense to look at the value of the main product over the lifecycle, to define proprietary (particularly noble) parts as integral to that value and to determine a total cost of ownership encompassing both main product and parts in a value based manner with the value / price of individual parts defined a-priori relative to the value / price of the main product – which can then be adjusted as market conditions or (replacement) costs change over time.

In this context of value based pricing for parts it also makes sense try to boost subjective perception of value for customers by considering among other things the following:

  • Apply customer specific price differentiation:
    • Price parts for maximizing long-term over short term profitability. This means taking into account effects of parts (and associated service) prices on new product demand and share of overall customer spend and therefore on the customer relationship overall.
    • Segment customers not only parts based on strategic importance and other criteria, such as accessibility or probability of making sales, as well as potential profitability.
  • Surround (expensive) parts with high level of services, such as rapid response and delivery, high quality processes (zero errors), on-line sourcing and logistics tools etc (companies doing this usually find out that it is more efficient to apply the same processes to all parts and therefore end up improving customer service overall).
  • Search for ways to reduce cost to customers outside of the actual price of the part, for example by helping customers reduce obsolescence, parts carrying costs or by offering very high availability and short delivery times for parts, for example by creating pooled stocks.
  • Increase the sophistication of applying price caps and setting relationships between renewal and replacement values, while adjusting over the product life-cycle –particularly for so called “noble” parts, while determining the value of other parts relative to these. If actual parts costs get out of line with these values signal this to customers and offer them options, e.g. to stock early or provide engineering support for customers to consider replacements or, in fact, reduce the probability of failure through better maintenance practices.

 

In the next article we will look at value based pricing of “solution services”: complexity, risk, incentives

Previous articles in this series:

Pricing Services: Value Based Pricing (Part 3 of a Series)

Pricing Services: Understanding Pricing Approaches (Part 2 of a Series)

The issue of pricing in (mainly B2B) services – Introduction (Part 1 of a series)

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