The challenge of costing a service contract
As discussed in Article 1, on the surface costing a service contract may seem straight forward; however there are a number of factors to consider. Your Company needs to understand the importance of full-costing versus incremental costing of a new service contract. A full-costing is where every aspect, labour, operating expenses and capital expenditure is fully accounted for in the pricing of the contract. On the other hand incremental costing entails leveraging off existing costs and resources (especially labour) in order to efficiently service the new contract.
The problem with full-costing
Unless there are sufficient economies of scale with a new contract, your Company will never be able to fully cost a service contract, as your computed price based on a minimum return on sales and profit margin will be uncompetitive to the client. However an incremental costing of a contract also has its drawbacks. Your Company may enjoy existing scale with its labour, whereby large existing contracts help to subsidise the cost of labour for ancillary new contracts. This enables your Company to competitively price its services at a competitive rate to service new contracts.
The problem with an incremental costing of a service contract is the risk of losing scale; if your Company suddenly loses a large existing contract. Not only will the loss impact your Company’s income stream, it will materially affect your profit margin and render some of the existing contracts as unprofitable. Another way to view the alternatives is to see the full-costing as the extreme worst case scenario, the incremental costing as the extreme best case scenario, and forecasted business as usual as something in between.
How a financial model can solve the conundrum
It is not an exact science service contract pricing, hence it is fundamental to adopt a hybrid financial model. The hybrid financial model will present both the full and the incremental costing of a service contract. As the following screen shots exhibit, the contract model should incrementally apportion costs such as existing capital expenditure.
Your Company can then lever the contract price model to compute a respective return on sales/profit margin. One must remember it is paramount to adequately cost a contract, in order to protect your Company from potential contract losses (from other contracts), and guarantee you still enjoy a reasonable profit margin based on an agreed contract price.
Value-adding nature of a hybrid service contract pricing model
The hybrid will default to 50% full-costing/ 50% incremental-costing, which enables your Company to assess the impact on return on sales and margins, relative to a standard contract pricing as discussed in Article 1. Your Company can undertake sensitivity analysis to assess the financial impact if it were to lose a complementary and large contract, or the added margin benefit of acquiring additional contracts to leverage your existing operational base.
The benefit of the sensitivity analysis is the ability to guide management in the contract price negotiations. It will enable your Company to understand its ball-park price range to service the new contract, and still achieve an acceptable rate of return with sufficient breathing space even if you lose a major contract.