Act, Not Respond: Managing Inflationary Pressures in Business Software

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This article was contributed by Lisa Thompson and Jim Evans, Axiom Consulting Partners

We assumed skyrocketing prices were laid to rest alongside disco fashion and feathered hair decades ago. But in 2021, the US consumer price index rose to 7%. It is an unpleasant reality that inflation is back and showing no signs of slowing down in the near term.

Continued inflation poses particular risks for business-to-business (B2B) enterprise software developers. Why? Because leaders in high-margin companies, such as software, are often not as sensitive to margin reductions as those in lower-margin industries. For example, a software company that sees 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 of the increasing number of companies selling both industrial products and software and makes understanding costs even more important in today’s environment.

Many software companies operate in ways that obscure creeping cost increases and diminished 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 companies often give away non-contracted services and support in response to customer demand. But those services are not free; they may just appear that way because they are not actively tracked anywhere. Research and Development (R&D): R&D costs are usually allocated only to the first version of the software. These costs appear in the company’s EBITDA, but not in a non-existent customer P&L. The R&D costs of future versions could very well increase, but be hidden from view. Hosting: Under Moore’s Law, computing power doubles every 18 to 24 months. But while unit-level hosting costs seem to plummet (from major providers like AWS and Azure), the latest version of a software product often requires twice the compute and storage power of the previous version. In most cases, the software company foots the bill for these higher cloud hosting costs.

Inflation has made it increasingly important for software companies to understand their costs so that they can make sound pricing decisions that will help them protect their margins now and in the future. While cost is just one of many factors that come into play in pricing decisions, they are clearly a very important part. To discover opportunities, software developers must:

Create a P&L at customer level. The customer must be the first unit of measure. Software companies often keep score by measuring the different parts of delivery (software, services, maintenance and support) separately. This can lead to margin tug-of-war as well as sub-optimal decision-making. For example, if the service team has a margin target, software licenses can be discounted, decreasing customer value in the long run. Or services may charge the software team for services consumed at an internal transfer price that includes margin for the services team, obscuring the true cost. In general, software companies should: Take the time to determine direct costs. Hosting, implementation, service, implementation and support costs are direct costs. But so are program and customer management teams. Software companies must take the time to catalog and scrutinize all costs associated with software implementation, delivery, and performance. Stop calculating competing P&Ls. The need to assess service performance and efficiency often drives the practice of separate P&L calculations. It may be acceptable practice to measure and track them to identify areas for improvement, but not rewards. Always score and manage this way. The cost catalog provides the framework for measurement and improvement at all times, but it is essential to combat and respond to inflation. Separate profit and loss statements obscure costs, focus team members on internal dynamics rather than the customer, and hurt overall profitability. Analyze all P&L line items and catalog that have increased costs over time, especially recently due to inflation. Doing so will give you at least a snapshot of the true costs of serving customers, from licenses to services and support. Where trends around rising costs are found, especially recent ones, there may be opportunities to increase the price. Quantify the value of differentiated software products and services. Not all software products of a company are differentiated and even some are only marginally so. Look for products and services that increase revenue for customers or reduce costs 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, present a ripe opportunity for price increases. Set up policies for merchant discounts. To enable complex, high-value deals, many software companies use a deal desk, a multi-functional team that helps avoid bottlenecks to close deals quickly. While this may seem like a positive practice, it is often accomplished by lowering the price, sometimes unnecessarily. The deal desk should offer trade-offs between give and get so that sellers can respond to discount requests while expecting something in return (e.g., longer contract terms, more favorable payment schedules, expanded bill of materials, reduction in services, or reduction training). Give-get trade-offs enable software companies to meet customer needs while maintaining price integrity.

Even in the face of this unprecedented inflation, it is easier to talk about prices than it is to do. To determine profitable pricing in business software, you must understand your economic value to customers and arm sellers with trade-offs that recognize competitors’ strategies and strengths and weaknesses. But make no mistake, understanding how costs change and whether, where and how to increase them starts with knowing what your costs are.

Lisa Thompson and Jim Evans are partners at Axiom Consulting

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