Measuring and Optimizing Service Gross Margin
Table of Contents
The Importance of Service Gross Margin in an MSP Business
In any business, the primary need and often greatest challenge, is to generate Gross Margin dollars. From Gross Margin dollars, once you pay for Marketing, Sales, and General and Administrative costs (aka “Overhead”), what is left over is bottom line profit.
Because there is no guarantee that a business will be profitable, it is important the Gross Margin dollar production in a given month, quarter or year, be higher than the Overhead. If it’s not, then the company has run at a bottom-line loss. This means either that you go out of business, you sell the company as a distressed asset, or you learn to do some tough things (grow Revenue, but more likely first reduce cost) quickly.
In the Managed Service Provider (MSP) business, the most important Gross Margin is that coming from the Service side of the business. While the Product and Cloud Resale Gross Margin is important, it comprises only about one fourth of the Gross Margin dollars an MSP must generate.
In addition, the Service side of the business is riskier. Here’s why:
- To the extent you might fail to resell enough Product or Cloud, even though you fall short of your Revenue goal, at least you don’t have the cost (because you don’t order product you don’t sell).
- In the Service business, because you have Service people and therefore ongoing payroll, if you fail to sell enough Service, you not only fall short of your Revenue goal, but you also continue to carry the cost.
On the other hand, the reason we like Service is because – sold and delivered properly – it not only produces higher Gross Margin than does Product Resale, but it is also stickier. Meaning, it is generally easier for the customer to transition to a new Product provider than to transition to a new Service provider.
Thus, because Service Gross Margin should be the MSP’s largest source of Gross Margin, because Service is sticky, and because of its relative risk if not sold and delivered at sufficient Gross Margin, it is important be able to accurately measure, and then optimize Service Gross Margin.
The Most Common Mistake in Measuring Service Gross Margin
There’s a trick to most usefully measuring Gross Margin on the Service side of your business.
Measuring Product Resale Gross Margin is easier. You know what you paid the vendor or distributor for the product. You know what you sold it for. Subtract what you paid from what you sold it for, and the difference is Gross Margin.
On the Service side, it’s trickier. Say you sell an hour of Service for $150 (either for a given task or within a Managed Service agreement).
What is the cost?
Let’s say your Service employee who did the hour’s work, earns $50,000 a year. (Let’s leave out benefits, taxes and other cost “burdens” for now).
A standard work year contains 2,080 hours. So, one way to look at the cost of the hour you sold, is to divide the person’s annual pay by 2,080 hours: $50,000 / 2,080 = $24 per hour.
Since you sold the hour for $150, is your Gross Margin $150 - $24 = $126?
Calculated as a percentage, this would be $126 / $150 = 84% Gross Margin. If this is accurate, it’s great news because the benchmark for excellence is 50% Gross Margin.
This 84% Gross Margin would be great because average Overhead is 30%. Which means our bottom-line profit would be 84% - 30% = 54%! Given that the benchmark for bottom-line profit is 20%, this would be outstanding.
But is the 84% accurate? No.
Here’s why: If that’s the only hour of that person’s time you sell all year, your true cost for that hour isn’t $24, it’s $50,000. You can’t pay the person for just the hour they worked. You owe them the full $50,000 whether they bill 1 hour or 2,080 hours.
Which means that hour actually resulted in strongly negative Gross Margin: $150 - $50,000 = negative $49,850. The percentage calculation would be -$49,850 / $150 = -33,233%.
This is an extreme example. Let’s take a more common one, starting with the same $50,000 person and $150/hour bill rate.
Let’s say that, of the 2,080 hours in a standard work year, you are able to bill that person (either by the hour, by the project or within a Managed Services agreement) for 1,040 hours.
That person has generated $150 x 1,040 hours = $156,000 in Revenue.
But what is our cost basis? Our cost basis for each of those 1,040 hours is $50,000 / 1,040 = $48.
So our cost for those 1,040 hours we sold, is – you guessed it – $48 x 1,040 = $50,000.
Our Gross Margin is $156,000 - $50,000 = $106,000. Our Gross Margin percentage is $106,000 / $156,000 = 68% Gross Margin. This is lower than 84% but still excellent: 68% minus Overhead of 30% equals a bottom-line profit of 38%, still well above the Best-in-Class of 20% bottom-line profit.
It certainly seems easy to make great money in the IT Solution Provider business! You only need to sell half of that $50,000 person’s time, and at the relatively low rate of $150/hour, to make great money!
Then, why are only one-fourth of MSPs making 20% or more at the bottom line?
As you would guess, it’s not quite that simple.
First, there are additional costs to having that person:
- You must pay for their benefits, and for payroll tax. Let’s say that equates to an additional 20%. Now we’re up to $60,000.
- You must also train them from time to time and provide them with tools. Let’s say this adds another 10%. Now we’re up to $65,000 in cost.
- They also need a manager. Let’s say you have 5 of these Service people, and one Service manager whose compensation is $100,000 a year. You have to pay for their benefits and payroll taxes, so their total cost is $120,000.
- This management cost gets split between the five Service people. So the cost of each Service person goes up by $120,000 / 5 = $24,000. Which means my cost per Service person isn’t $50,000, it’s $65,000 + $24,000 = $89,000.
Recall that we have sold 1,040 hours of the Service person’s time, at $150/hour, for total Revenue of $156,000. We now know our cost for that person isn’t $50,000, it’s $89,000. What is our actual Gross Margin? It’s:
- $156,000 - $89,000 = $67,000.
- On a percentage basis, it’s $67,000 / $156,000 = 43%.
And if we subtract from this, our 30% to pay for Overhead, we have a bottom line of 13%. Not bad – it’s about average – but well below the top quartile benchmark of 20%.
If we factor in the cost of newly hired Service people who aren’t yet fully utilized, and the work we need to do twice (the second time for free) because we didn’t do it right the first time, and travel time we have a hard time billing for, Overhead expenses we didn’t anticipate, and so on, we can see why 13% bottom line is the mid-point: half of MSPs make less, and one quarter lose money at the bottom line.
Of course, there are known best practices for running the business at 20% or higher bottom line. The first is, knowing your instrumentation: knowing your financials, starting with Service Gross Margin.
A Foundational Best Practice: Usefully Measuring Service Gross Margin
A foundational best practice is to be able to measure Service Gross Margin usefully, so that you can see what is happening, take remedial action as needed, and see if your actions are having the desired effect.
Now that we understand the basics of measuring Service Gross Margin, let’s see how most top-performing MSPs set up their accounting system to do this for them.
A Common but Not Very Useful Accounting System Set-Up
Unfortunately, most accounting systems are not, by default, set up to measure Service businesses usefully. Here is how most accounting systems are set up by default:
| Line |
General Ledger Account |
Example |
% of Revenue |
Comments |
|
Revenue |
|
|
|
| 1 |
Product Resale Revenue |
100,000 |
|
| 2 |
Service Revenue |
100,000 |
|
| 3 |
Total Revenue (1+2) |
200,000 |
100 |
|
Cost of Goods Sold (COGS) |
|
|
|
| 4 |
Product Resale COGS |
75,000 |
37.5 |
|
Gross Margin |
|
|
|
| 5 |
Gross Margin (3-4) |
125,000 |
62.5 |
|
Overhead |
|
|
|
| 6 |
Payroll (Incl. Service) |
80,000 |
40 |
| 7 |
Other Expenses |
40,000 |
20 |
| 8 |
Total Overhead |
120,000 |
60 |
|
Net Income |
|
|
|
| 9 |
Net Income (5-8) |
5,000 |
2.5 |
The Revenue line and the Net Income line are useful. The other lines, while the math is correct, are not optimally useful to you in seeing what’s going on in the business.
Here’s why:
- The Cost of Goods Sold (COGS), only considers the cost of part of what I’m selling: the Products I am reselling. COGS is missing the cost of the other thing I’m selling, which is Service.
- This means that the Gross Margin isn’t accurate for Product Resale (because the Gross Margin line has Revenue from Service mixed in and therefore obscuring it). So I can’t tell if I’m making good Gross Margin or not, on my Product Resale.
- It means I don’t know my Service Gross Margin at all, which means we’re blind as to the Gross Margin performance of our most valuable and risky line of business: Service.
- In addition, because Service Payroll is improperly mixed in with the Payroll of the other (non-Service) people in the company – such as Salespeople and the Administrative team, we can’t see very clearly, the cost of those non-Service people. This means we can’t judge very effectively, whether we are spending too much, too little, or just the right amount, on those payroll areas.
The Accounting System Set-Up Most Often Used by Top-Performing MSPs
One way that MSPs improve their financial performance, is to adopt the accounting setup used by the top performing MSPS, which enables them to better see what is happening within the company. Here is how they most often set up their accounting system:
| Line |
General Ledger Account |
Example |
% of Revenue |
Comments |
|
Revenue |
|
|
|
| 1 |
Product Resale Revenue |
100,000 |
|
| 2 |
Service Revenue |
100,000 |
|
| 3 |
Total Revenue (1+2) |
200,000 |
100 |
|
Cost of Goods Sold (COGS) |
|
|
|
| 4 |
Product Resale COGS |
75,000 |
75.0 |
| 5 |
Service COGS (Incl Payroll) |
60,000 |
60.0 |
| 6 |
Total COGS (4+5) |
135,000 |
67.5 |
|
Gross Margin |
|
|
|
| 7 |
Product Gross Margin (1-4) |
25,000 |
25.0 |
| 8 |
Service Gross Margin (2-5) |
40,000 |
40.0 |
| 9 |
Total Gross Margin (7+8) |
65,000 |
32.5 |
|
Overhead |
|
|
|
| 10 |
Marketing Cost |
4,000 |
2.0 |
| 11 |
Sales Cost |
8,000 |
4.0 |
| 12 |
Subtotal Sales & Marketing (10+11) |
12,000 |
6.0 |
| 13 |
General & Admin Expenses |
48,000 |
24.0 |
| 14 |
Total Overhead (12+13) |
60,000 |
30.0 |
|
Net Income |
|
|
|
| 15 |
Net Income (9-14) |
5,000 |
2.5 |
You can see why the top performers most often set up their accounting systems this way. In this format, the Income Statement provides a more useful view into the performance of the different parts of the business:
- Line 7: Now that it’s not obscured by Service Revenue, I can see the Gross Margin performance of my Product Resale business. I know the best practices for improving it: negotiate a better deal, change vendors, or sell at a higher price.
- Line 8: Now that Service COGS is its own line and correctly includes Service payroll, I can see the true Gross Margin of my Services business. I can improve this by selling at a higher price, by utilizing fewer and/or lower cost people, and by selling more Service without increasing Service payroll (and other Service COGS) as quickly.
- Lines 10, 11 and 13: Now that my Overhead isn’t obscured by the mistaken inclusion of Service payroll, I can see clearly see what I am spending on Marketing, Sales and General and Administrative costs, which allows me to better manage their effectiveness.
It isn’t that the first setup is wrong – there is no standard guideline for setting up accounting systems – it’s just that it’s not very informative to the executive running an MSP.
A Quick Note About Owner Compensation
The top-performing MSPs – even small ones – make sure to include the owner’s compensation in either Service COGS, Sales cost or General and Administrative cost.
They do not put owner’s compensation below the Net Income line or pay it from the Balance Sheet.
Why? If I have a small MSP, and I’m putting 20% to the bottom line before I pay myself, doesn’t this look better than adding what I pay myself to COGS or Overhead, which would push my Net Income down, maybe even to zero?
The answer is, yes and no.
Yes, putting what you pay yourself, in COGS and/or Overhead, will drive down your bottom line.
But, no: because that is the actual profit. Meaning, you don’t work for free. And if you had to hire someone to do your job, then their cost would appear in COGS and/or Overhead. From the point of view of building a business that will scale and produce a profit, we are better off starting with the most accurate picture.
In a small MSP, the owner may spend their time equally, doing or running Sales, delivering or running Service, and running the back office of the business. In this case, the owner should divide what they pay themselves from the Income Statement (not the Balance Sheet) into thirds and put a third into each of the three parts of the Income Statement.
As the MSP grows, perhaps the owner stops managing the Service function and instead hires a Service manager to run it. In that case, the payroll of the Service manager goes into Service COGS, and the owner now divides their own pay into halves and puts half in G&A and half in Sales.
When the company grows to a suitable size, perhaps the owner hires a Sales manager. At the point the Sales manager’s payroll goes into Sales cost, and 100% of the owner’s pay goes into G&A.
At the point that the company grows to such a size that the owner can hire a General Manager (who payroll goes into G&A) and the owners only spends half their time running the company, then only half of the owner’s former pay would come from the Income Statement (and the other half would typically come from distributions of excess cash from the Balance Sheet.
Turning Useful Numbers into Action
From this one useful view of the Income Statement, how can we tell what action we need to take?
In our discussion above, we know that the benchmark for Service Gross Margin is 50%. With our accounting system now set up most usefully, we can see that our:
- Product Resale Gross Margin is 25% (which happens to be the benchmark),
- Service Gross Margin is 40%, which is below the 50% benchmark.
- Overhead is 30%, which is, as we mentioned, average,
- Our Net Income – our bottom line – is a mere 2.5% versus the average of 13%.
That 2.5% bottom line is dangerous. Even a small mistake in Revenue or cost could send us into loss-making territory, which means, to save the company, we might have to borrow money or start writing personal checks into the business.
Where do we go for improvement?
We may be able to raise our Product Resale prices a bit, or negotiate a little better deal, but this isn’t the first place to go for a stronger bottom line, because effort here won’t produce much benefit.
Overhead at 30% can be improved: Best-in-Class is about 28%. Getting to Best-in-Class would increase our bottom line from 2.5% to 4.0%, enough of a benefit that we should go to work on this.
However, those experienced in running successful business will observe: “You can’t save your way to profitability except in the short term.”
This means that getting to better profitability by cutting Overhead ultimately means starving the company of proper amount of Overhead needed to run the business. If Overhead in the example case was, say, 36% of Revenue, then cutting it down to average would bring up the bottom line by 6%. Likely that would be a good action to take. But in our example case, we are already at average, and while we probably should pursue saving 2% more to get to the benchmark, that alone isn’t going to get us to a safe, much less rewarding, bottom line.
The obvious place to go is our Service Gross Margin: It’s at 40% and the benchmark is 50%. Getting the Service business to 50% Gross Margin would add $10,000 to Gross Margin, which would bring our bottom line up to $15,000 or 7.5%. Not yet at average but taking a big step in the direction of safety.
How Can We Improve Service Gross Margin by 10%?
Since Gross Margin is the result of Revenue minus Cost, there are only two ways to improve Service Gross Margin:
- Reduce Service cost, and/or
- Increase Service Revenue by raising prices, and/or
- Increase Service Revenue by selling more.
Let’s look at these one at a time.
Reduce Service Cost
In our tiny $200,000 Revenue example MSP, we don’t have much room to reduce Service cost which, as we have seen, is largely comprised of Service payroll.
If we could – somewhat magically in this case – get to 50% Service Gross Margin by reducing Service COGS from $50,000 to $40,000, the $10,000 saved would indeed drop directly to the bottom line.
Here is what our Income Statement would look like if we could reduce Service COGS by 17% ($10,000) to get to the benchmark 50% Service Gross Margin:
| Line |
General Ledger Account |
Example |
% of Revenue |
Comments |
|
Revenue |
|
|
|
| 1 |
Product Resale Revenue |
100,000 |
|
| 2 |
Service Revenue |
100,000 |
|
| 3 |
Total Revenue (1+2) |
200,000 |
100 |
|
Cost of Goods Sold (COGS) |
|
|
|
| 4 |
Product Resale COGS |
75,000 |
75.0 |
| 5 |
Service COGS (Incl Payroll) |
50,000 |
50.0 |
| 6 |
Total COGS (4+5) |
125,000 |
62.5 |
|
Gross Margin |
|
|
|
| 7 |
Product Gross Margin (1-4) |
25,000 |
25.0 |
| 8 |
Service Gross Margin (2-5) |
50,000 |
50.0 |
| 9 |
Total Gross Margin (7+8) |
75,000 |
37.5 |
|
Overhead |
|
|
|
| 10 |
Marketing Cost |
4,000 |
2.0 |
| 11 |
Sales Cost |
8,000 |
4.0 |
| 12 |
Subtotal Sales & Marketing (10+11) |
12,000 |
6.0 |
| 13 |
General & Admin Expenses |
48,000 |
24.0 |
| 14 |
Total Overhead (12+13) |
60,000 |
30.0 |
|
Net Income |
|
|
|
| 15 |
Net Income (9-14) |
15,000 |
7.5 |
However, shaving 17% off of Service COGS is only survivable in extreme cases. A not uncommon example is when our largest customer makes up 17% of our Service Revenue (and 17% of our Service COGS), and they suddenly become no longer a customer. We terminate them, or they terminate us. Given the 17% reduction in Service Revenue- and therefore Gross Margin, we have to do something fast. We now have 17% of our Service team doing nothing, so we could at least in theory terminate those employees and thereby cut our Service COGS by 17%.
In practical terms this might not result in an increased Gross Margin percentage, but it will certainly result in 17% fewer Service Gross Margin dollars. This is best case: had we not terminated 17% of our Service payroll, the damage to our Service Gross Margin from the large customer departing, would have been even greater.
Of course, there are many instances when reducing Service headcount at least to some degree, is a practical way to improve Service Gross Margin dollars and percentage.
The Big Levers in Reducing Managed Services Payroll Cost
The most impactful and durable ways to reduce Service payroll cost to improve Service Gross Margin dollars and percentage are, starting with the most impactful first:
- Narrowly and uniformly standardize the technology stack across your customer base:
- Enables greater automation,
- Enables more of the workload to be handled by (lower cost) Level 1 versus (higher cost) Level 2 or Level 3 engineers,
- Reduces the number and duration of tickets per device or user.
- Make sure as close to 100% of customers as possible, buy your fullest package of Managed Services offerings (your “Gold” or “Complete” package):
- Again, drives uniformity which reduces Service labor cost,
- Maximizes Revenue per customer, as opposed to spreading the same Revenue across more customers,
- Enables a better customer experience and makes you more difficult to replace, both of which reduce costly churn.
These two powerful levers are most enabled by narrowing your marketing and sales to a tight range of customer sizes (by user count). This could be 25-100 users or it could be 2500 to 10,000 users; all customer sizes have potentially good Managed Services customers. The point isn’t which size, it’s that keeping to a narrow size range enables the standardization and “full meal” strategies described above.
It’s important to note that in any customer size range, in every market, about 25% of prospect decision makers value IT in their business enough to be willing (and able) to get into a win/win relationship with you.
That is, who will behave consistently with your efforts to accomplish #1 and #2, above.
Unlike the other 75% of decision-makers, this 25% has these four characteristics:
- Well-running IT is critical to their business,
- The CEO knows that IT is critical to their business,
- They want to delegate the running of IT to someone who is an accountable businessperson,
- They have the money and willingness to pay a win/win price.
These are the decision makers who will pay a high enough fee to give you a fair return on your efforts, risks and investment, and who will do the things you ask, such that their environment will remain most efficiently manageable by you. They will spend with you, about three times what one of the decision makers in the remaining 75% will spend. Not surprisingly, the top profitability (who are also typically the faster growing) pursue this 25% of decision makers and ignore the others.
It is also important to manage Service tool cost – which is part of Service COGS – effectively but once invested in a toolset, it is often too costly and risky to change simply for the sake of license cost.
More often, better use of the existing tool can produce Service cost efficiencies that more than match the license cost savings that might be had by switching. Driving efficiencies through better tool use should be a constant pursuit; the top performers only rarely change tools and when they do, it is only after careful evaluation and transition planning.
Obviously, in a larger MSP, there are more opportunities to drive labor efficiency, or to bring in lower cost skill sets. But in our example today of a $200,000 MSP, materially reducing Service cost is probably not possible.
Increasing Service Revenue by Raising Prices for New and Existing Customers
Raising prices is often fruitful for MSPs of all performance levels, but especially for low performers. The Service Leadership Index® indicates that – in the same market pursuing the same customers – the bottom quartile MSPs charge about half what the top quartile MSPs charge, for what initially looks to the customer to be the same set of services.
There are several reasons for this but in our discussion today what it means is, in every market around the world, there is meaningful room for low- and mid-performing MSPs (and often top-performing ones) to raise prices for new and existing customers.
Here is how our example Income Statement looks if we raise Service prices for our existing customers by 10% (not unusual in today’s inflationary cycle):
| Line |
General Ledger Account |
Example |
% of Revenue |
Comments |
|
Revenue |
|
|
|
| 1 |
Product Resale Revenue |
100,000 |
|
| 2 |
Service Revenue |
100,000 |
|
| 3 |
Total Revenue (1+2) |
210,000 |
100 |
|
Cost of Goods Sold (COGS) |
|
|
|
| 4 |
Product Resale COGS |
75,000 |
75.0 |
| 5 |
Service COGS (Incl Payroll) |
60,000 |
54.6 |
| 6 |
Total COGS (4+5) |
125,000 |
64.3 |
|
Gross Margin |
|
|
|
| 7 |
Product Gross Margin (1-4) |
25,000 |
25.0 |
| 8 |
Service Gross Margin (2-5) |
50,000 |
45.5 |
| 9 |
Total Gross Margin (7+8) |
75,000 |
35.7 |
|
Overhead |
|
|
|
| 10 |
Marketing Cost |
4,000 |
1.9 |
| 11 |
Sales Cost |
8,000 |
3.8 |
| 12 |
Subtotal Sales & Marketing (10+11) |
12,000 |
5.7 |
| 13 |
General & Admin Expenses |
48,000 |
22.9 |
| 14 |
Total Overhead (12+13) |
60,000 |
28.6 |
|
Net Income |
|
|
|
| 15 |
Net Income (9-14) |
15,000 |
7.1 |
We have neatly added $10,000 to our Revenue and – since we didn’t increase COGS or Overhead in doing so – $10,000 to the bottom line.
Increasing Service Gross Margin, and bottom-line profitability, by thoughtfully and meaningfully increasing prices, is something that probably 90% of IT Solution Providers including MSPs, can and should do soon, and annually thereafter.
Having raised prices many times in the four IT Solution Provider businesses we built and having helped hundreds of other IT Solution Providers around the world raise theirs, we can tell you the imagined negative fallout among customers and prospects materializes almost never.
Virtually every Sales team and most management teams are gut-level “sure” that, if we raise prices, many existing customers will leave, and materially fewer new customers will be won. In practice, these dire outcomes happen in perhaps 1% of cases.
Even with what seems like a stout increase in prices, you will lose only a handful of accounts, and the ones you lose are most often those you are happy to see leave. There are too many ways to increase price to cover here, but they all include courage. Move ahead; you’ll be fine.
Increasing Service Revenue by Selling to More Customers
The last way to increase the Service Revenue – again, without increasing Service payroll and other costs as quickly – is to sell to more customers.
Unlike raising prices, which generally incurs little or no increase in Service COGS, adding new customers materially increases Service COGS, typically in the form of Service payroll and tools. Of course, the goal is to run efficiently enough that your costs don’t increase as fast as your Revenue. This is what is known as “adding scale” or “leverage” in the business.
For this leverage equation to work best, the new customers need to meet the criteria in #1 and #2 above.
Many lower-performing MSPs struggle to find any new customers at all, much less those decision makers who match the profile of a) through d) above.
When starting out, that’s fine – we need new customers to pay bills and grow the team. Just keep in mind you want to charge about double what you are spending to serve them. That will put you at 50% Gross Margin. Assuming your Overhead costs are the average 30%, you will be putting 20% to the bottom line.
Again, there are too many ways to find and win new customers, to cover here. The point is to make clear that adding new customers – properly scoped and priced – can increase Service Gross Margin.
Bringing It All Together
Top-performing MSPs of all sizes and in all geographies, attain their results by finding and winning customers who meet criteria #1 and #2 above, and have characteristics a) through d) as shown above.
In improving the financial results from an existing set of customers, and in evaluating the likely contribution to your performance of a potential new customer, top performers use an often analysis method that focuses on the most important drivers of their growth, profitability, and customer experience.
The goals are to:
- Get to 50% Service Gross Margin,
- And to Best-in-Class Product Resale Gross Margin (of about 25%),
- To maximize Revenue per customer,
- To maximize the degree to which each customer resembles all other customers, in terms of their technology stack and what they buy from you.
Because this approach typically results in the best profitability, and the greatest span of control over the customer’s IT cost and experience, it most often results in the highest Service quality, greatest differentiation from competition and the best customers experience.
The matrix below illustrates this method:
In seeking new customers, the MSP is looking to find and win “A” customers and perhaps “B” customers, and not add any “C” and “D” customers.
Existing “C” and “D” customers are gradually sloughed off at the following pace: add a “A” customer, terminate a “D” customer. When all the “D” customers are gone, terminate a “C” customer with every “A” customer that you add. Care must be taken that terminated customers are not so large that their loss results in the need to materially cut your headcount. It may take winning two or three “A” customers to merit terminating a larger “D” customer.
Looking at the column labeled “Buying Our Fullest Range of Offerings”, remember that the higher performers set the goal of having 100% of customers buy 100% of their offerings, also known as “100% cross-sell”.
If the new customer is not sold 100% of your offerings from the start, the goal of the farmer and/or vCIO is to systematically add to what the customer is buying, until they do consume 100%. Then to keep them there as the MSP rolls out new offerings and replace aging segments of their standard technology stack.
Top performers also know that customers who don’t match criteria #1 and #2 above, and have characteristics a) through d) as shown above, most often do not consume 100% of their offerings, and will not in the future. Meaning, they will likely never become “A” customers on the matrix in this section. Hence they do not pursue finding or closing them.
A Few Important Notes Before You Proceed
Please note:
- A common mistake is to put into Service COGS (Line 5) only the portion of Service payroll that is productively utilized. Going to back to our example of the Service person who bills 1,040 hours out of 2,080 hours:
- The mistake some lower-performing MSPs make, is to include in Line 5, only half of the Service person’s payroll “because they only delivered Service for half their hours”. They also mistakenly put the other (unproductive) half of that person’s payroll into Overhead.
- This is incorrect because, as we have seen, whether that person is productive for one hour, 1,040 hours or 2,080 hours, you must pay them the full $50,000. That $50,000 is, in fact, your cost (COGS) to be in the Service business. Therefore, their full cost – productive or not, must be in Service COGS.
- Likewise, if you mistakenly put the unproductive half of their payroll into Overhead, you are again obscuring the true performance of your Overhead.
- The top performers also tend to further break down the Services Revenue, COGS and Gross Margin lines into the subsidiary Services: Managed Service, Project Service, etc., for even better visibility and control.
- This best-practice accounting set up is also used by the top performing IT Solution Providers in the Product-Centric (VAR), project-centric and other Solution Provider business models.
A Last Word to the Wise
Lastly, DO NOT change your accounting set up (known formally as your Chart of Accounts) based on this information. ONLY CHANGE your Chart of Accounts if and how your Certified Public Accountant (CPA) or Chartered Accountant instructs you to do so.
Why? Because – although most top-performing MSPs use a Chart of Accounts like this – neither they nor we can represent you if your taxation authorities decide they want to talk with you about what you’re reporting. Only your CPA or Chartered Accountant can represent you, and therefore you should ONLY set up your Chart of Accounts as they instruct.
