Service Agreements Part 1

April 15, 2004

Service Agreement Pricing

By: Matt Michel


This is part of a continuing series of New Year’s Resolutions aimed at helping your company become “fiscally” fit. In this series, we will walk through the marketing mix of product, price, promotion, and placement. This Comanche Marketing tip focuses on Service Agreement pricing.

SERVICE AGREEMENT PRICING
The modern service agreement is a creation of the air conditioning industry, but has application to any service industry with variable demand. I want to spend a few minutes on the history of the service agreement because it has bears on the pricing philosophy.

CREATED FROM NEED
If necessity is the mother of invention, desperation is the mother of the service agreement. While I’m not sure if he was the first to design one, Ron Smith (ronlsmith@comcast.net) gets credit for bringing the service agreement to national prominence and he continues to be at the forefront of improving it. On the foundation of the service agreement Ron Smith built one of the largest and most successful residential replacement air conditioning companies in the nation. He started with one truck and grew Modern Air Conditioning to $15 million when he sold it. That’s not shabby by anyone’s standards, but Ron hit $15 million way back in mid-1980s. And he did it in Ft Myers, Florida.

What’s so unusual about that, you ask. Isn’t Florida air conditioning country? Sure. But that’s all it is, at least that far downstate. There’s not a heating season to speak of in Ft Myers. The state of Florida has always attracted “carpetbagger contractors” who come down from the north to take advantage of the robust cooling season, and then return home in the winter like some kind of migrant farm worker. If it sounds like I’m critical of the practice, I’m not. The state’s air conditioning industry needs help in the summer, but not the winter.

Ron Smith, however, wasn’t a migrant. His company needed to pay the bills year round in the Gulf side town of Ft Myers. All air conditioning companies have a problem with seasonality. Ron had it worse than most. But Ron is one of the creative marketing geniuses in the industry. He’s not one to let a little thing like, no need, want, or desire for his services stop him.

THE OBJECTIVES OF A SERVICE AGREEMENT PROGRAM
Ron created the service agreement. I don’t know whether Ron started with these objectives, but usually companies start service agreement programs for the following reasons …

1. Provide some off-season work to keep technicians busy when demand service dries up.
2. Help cover overhead.
3. Tie in the customer.

Of the three, the last is most important. As Ron says, “a service agreement is a replacement sale waiting to happen.” Sell a service agreement today and you can expect a replacement down the road. Furthermore, it’s a replacement that’s less likely to involve multiple bidders and competitive price pressure. It’s a replacement sale with a customer that believes in your company and has been a loyal customer. In other words, your close rate should be far higher.

A service agreement program is a customer retention program first, an employee retention program second, and a profit generator third. A service agreement does not need to make money to be successful, though it should make money. However, service agreements are profitable on a marginal cost/marginal revenue basis. You cannot burden them with your standard overhead and expect them to be affordable.

HOW SERVICE AGREEMENTS MAKE MONEY
Ron Smith found that one out of every eleven service agreements in any given year would result in a replacement sale. In other words, for every 1,100 agreements, he could plan on 100 replacements. He says the ratio varies in different parts of the country, but today Ron thinks he would achieve better than a 1:11 ratio in his old stomping grounds for the simple reason that people are more inclined to make replacements before equipment dies the good (or bad) death.

The close rate was also much higher with service agreement customers. Ron employed some top shelf sales professionals at Modern Air Conditioning (e.g., Tom McCart and Charlie Greer). His sales team’s close rate was 31% when the prospect did not own a service agreement. Among service agreement customers, the close rate jumped to 86%!

Want more? Attracting an equipment replacement prospect is expensive. By comparison, the costs of attracting an existing service agreement customer are inconsequential. If you do a good job performing the service each year, the customer will give you the first opportunity to buy.

Service agreement customers are also higher margin buyers. They are more likely to trust your company, more likely to buy top-of-the-line equipment from you, and less likely to price shop.

Your service agreement program should be profitable on a marginal cost/marginal revenue basis. However, the real profit is in customer retention and future sales.

HANDLING OVERHEAD
The only overhead you should apply to service agreements is marginal overhead that results from the program. When you first start a service agreement program, this is incidental. It might include the printing cost of the service agreement itself and a brochure. Later, when you add a service agreement coordinator, this individual’s salary and benefits should be charged to the service agreement program.

Once you start allocating overhead to service agreements separately, you must—I repeat, must departmentalize. The service agreement program needs a separate P&L. Frankly, you should already have separate P&Ls for your installation and service departments.

Why not burden service agreements with the same overhead that’s applied to service rates? Because service agreements are marginal business. Take them away and the overhead doesn’t change. Remember, overhead should be allocated against the expected number of standard service hours throughout the year.

CALCULATING COSTS
So how do you cost them? Take the fully burdened cost of the technician who will perform the tune-up, add vehicle cost, your material cost, your sales spiff, and other direct costs (e.g., post card reminders) to arrive at a base cost for performing the service. Your material cost won’t be much in most cases because you are not replacing parts, but merely inspecting, cleaning, adjusting, and tuning.

Of course, if you do have a service agreement coordinator, or dedicate part of one person to managing the service agreement program, you should spread the fully burdened cost for that person against the number of service agreements you expect to perform for the year.

Now add your pre-tax profit. It’s probably less than the going rate for a service agreement in your market. Does that mean you should lower prices? No.

PRICING IS AN ART
Service agreement pricing is an art, more than a science. You should price them high enough for the homeowner to perceive value, but not so high that they question whether they are worth it.

If all of that’s true, then why go through the exercise of pricing them up? To be sure. Calculate the price so that you’re sure you will make money on a marginal cost/marginal revenue basis. My guess is that you will generate a higher margin that you earn on service because service is saddled with overhead that does not apply to service agreements.

MULTIPLE SYSTEMS
Many homes have more than one piece of equipment. When there are multiple pieces of equipment, that should be covered under separate agreements, the homeowner should get a break. The break is the truck cost and the fully burdened labor for the average time between calls. If you have already figured these costs, simply discount the second agreement by that amount.

TUNE-UP PRICES
If you offer tune-ups separate from the service agreement, make sure that they cost more than the service agreement. You want to give people an incentive to buy the service agreement for the relationship opportunities they present.

Remember, the service agreement only “presents” relationship opportunities. You must follow up with these, your best customers, through the year to get the most from the program.

AUTOMATIC RENEWAL
Many companies with strong service agreement programs utilize an automatic renewal. Once a homeowner enrolls in the program, he remains in it until he says he wants out. This places the burden of ensuring the service is performed squarely on your shoulders. And it is a burden.

Every year, I have to pay my vehicle tax. If I don’t pay it by the due date, the cost of the vehicle goes up by a third. Thus, there’s every incentive to pay on time. Yet, I often forget. Though I see the sticker with the date every time I get behind the wheel, I don’t think about it.

Your service agreement customers are the same. You will need to mail to them and call them, sometimes successively, to get the service scheduled. It’s your responsibility to schedule it, just as much as it is the homeowner’s responsibility. You can’t renew if you don’t perform the service.


Source: Comanche Marketing. Reprinted by permission.
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Copyright © 2003 Matt Michel

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