Renegotiating A Service Contract

by | May 11, 2020 | Customer Value Creation

Prepare to renegotiate service contracts
Renegotiating a service contract is not a topic I ever thought I would write about yet here we are thanks to COVID-19.

 

The definition of a contract

 

About 10 years after I received my undergraduate degree, I decided I needed to learn more about the business of business.  The first evening school course I took was on Contract Law.  The instructor was very precise in how he defined a contract and I still remember it today.
A contract is an agreement between two or more competent parties to do or not do a legal thing for consideration.

Summary of a B2B service contract

 

A service contract is an agreement between two or more businesses in which one party promises to perform a specific set of services, once or more times during the contract term, within a specific timeframe, for a fixed amount of money to be paid within a specific time.

 

An example of an extremely basic service contract

 

An OEM promises to send a qualified technician to a buyer’s facility twice a year, at a mutually agreed day and time, to perform a preventative maintenance process according to a company checklist which the buyer has seen, and make any repairs necessary to return the equipment to good operating condition, for a fixed total cost which will be due within 30 days of invoice after returning the signed contract and a valid purchase order.

 

Please keep this “contract” in mind because we will refer to it again.

 

Why businesses buy service contracts

In general, there are four reasons why people want to buy a service contract:

  1. Maximize uptime – PMs and quick parts and people
  2. Predictable expense – No added PO’s
  3. Peace of mind – One call and the OEM owns the problem
  4. No hassle – One PO a year and no further chasing for anything additional

Sometimes it is one of these four reasons and sometimes it is a combination.
Once a customer identifies the reason(s) to buy a contract, they look at the economics of the decision. They find out the cost of the contract that suits their needs and wants and then quantify the benefits.  If the benefits value exceeds their purchase price, and if they have the money in their budget, they happily sign the contract.

To read more about customer value creation read Creating Lasting Shareholder Value By Creating Customer Value</em

Reasons for a customer to want to renegotiate a service contract

 

There are two primary reasons why a customer decides to renegotiate or cancel a service contract
  1. The value is still positive, but the money is no longer available
  2. The math changes and the value of the benefits no longer exceed the purchase price
In the time of COVID-19, we are seeing a massive shift in company’s financial health.  In the U.S. in March 2020, 20 million people filled for unemployment insurance.  And as of early May 2020, the Federal government earmarked over $3 trillion for individual and business aid.

 

Most small businesses, except those considered “critical,” closed and many are unlikely to ever reopen.  This has caused businesses further up the supply chains to also feel the economic stress and start laying-off workers.  Even automobile and commercial aviation factories have shut their doors and 90% of all commercial airplanes are grounded.  In a climate like this, CFOs, CEOs, and Boards of Directors are quick to issue calls for spending reductions.  Common targets for savings include employee training, consultants, and service contracts! Note; having employees work from home is not a cost saving but a method to protect the employee’s health.

 

If a manager is fortunate enough not to be “voluntold” to reduce or drop service contract spending, they will still act responsibly and decide to try to minimize or eliminate their contract commitments. They first look at the configuration of their contracts and evaluate the importance of each element.  For example, they may realize that with their factory shut down or running on a reduced schedule, they have less equipment failures and so should pay less overall.  Or they may decide they can get along without a preventative maintenance inspection.

 

Some hospitals are not letting service engineers work on equipment but have shifted to having the OEM use augmented reality so one of their technical support people can remotely guide an inhouse maintenance tech to do the actual hands on repairs.  Of course, the hospital feels that they deserve a contract cost reduction.

 

Here are five examples of companies renegotiating contracts and consultants telling clients to cut back.

1.This is the opening paragraph from a Reuters article about Ryanair:

DUBLIN (Reuters) – Ryanair (RYA.I) aims to conclude talks with Boeing (BA.N) on a new plane order in the next two weeks, but possible price cuts or cancellations related to an existing 737 MAX order are also part of the discussions, its chief executive said on Friday.

2. These are from a McKinsey article recommending to IT executives how to cut expenses during the COVID-19 crisis:

Take advantage of the flexibility built into IT. As much as 30 percent of IT spend can be saved by taking measures that leverage the flexibility built into the cost base. These might include reducing demand volume and service levels, eliminating discretionary spend, delaying nonessential projects, or decommissioning applications with little usage.

Flexibility-driven reductions range from the obvious—project-portfolio pruning, contractor furloughs, stopping new hardware purchases, going to lower service levels—to the more sophisticated, such as decommissioning systems with low usage, limiting capacity of development environments, or reducing the availability of on-site support.

Some of these actions may not be possible immediately, such as negotiating new contracts or establishing new technology.  But during a crisis, there are often plenty of opportunities to adapt contracts and make slight shifts in technology that will unlock value within six months. Some vendor contracts, for example, include contingencies that allow reductions in services quickly, often within three to six months. “As-a-service” technologies, such as infrastructure as a service (IaaS) or platform as a service (PaaS), can be established and effective within three to six months in selective areas.</blockquote

3. OnStrategy, a consulting company, recently wrote:

It turns out, during an economic crisis like the one we’re currently swimming in, all the rules change.  Sure, contracts are binding in theory, but right now everyone wants to be around when all the dust settles- and if it means adjusting the terms of a contract in order to help your tight relationships in business, companies are willing to do it. The Harvard Business Review recently published How Struggling Businesses Can Renegotiate Rent with ideas from a Real Estate executive about how to renegotiate a real estate lease.

4. This article is about the results of major purchase contracts between General Motors and several major car rental businesses – Hertz and Avis Cancel Orders in Setback for Ailing Carmakers

Rental-car companies struggling to survive the coronavirus pandemic’s catastrophic blow to their business have been working with automakers to call off purchases, in some cases even redirecting vehicles in transit to their now largely neglected parking lots.

General Motors Co. is taking back cars it agreed to sell that were on their way to Hertz Global Holdings Inc., Avis Budget Group Inc. and closely held Enterprise Holdings Inc., a spokesman said. Hyundai Motor Co. also confirmed it has redirected some vehicles to its retailers that it was planning to produce for fleet customers.

5. In early May 2020, BAIN issued a report about how leading software firms prepared tactics that help customers stressed by COVID-19 but also protects finances. Here are the two key charts:
The first chart shows what customers who asked for relief generally received.

 

Talked about renegotiating service contracts

The second chart shows the types and frequency of payment relief received.

 

Results of renegotiating service contracts
As the financial pressure increases on business, there will be a strong push to renegotiate service contracts!
What a service executive should do

 

Let’s see what TSIA (Technology Services Industry Association) recently reported about what service executives should do:

  • With 9 out of 10 companies restricting or eliminating on-site dispatches, only 6% have reached out to their customers to discuss or renegotiate existing service level agreements.  Although another 41% are considering renegotiating service levels, this sharp drop off is a major gap for field service organizations.
  • Clearly operations are being impacted and hindering service organizations from meeting their commitments.  While shortfalls may be understandable, TSIA recommends proactive communications with your customers noting potential service disruptions and clear communication on how to escalate urgent needs. These are not normal times. Normal contracts and communications are insufficient.
  • 89% of member companies are considering changing product and offer portfolio pricing.
  • 57% of members have centrally authorized changes to offer list prices or discount policy.
  • Companies should establish a policy for granting customers in distress a grace period for renewing their subscription contracts
But we don’t need the TSIA to tell us that just like our customers are looking to reduce costs and conserve cash, our company is looking to sustain our current cash flows while protecting our long-term growth opportunities.  So, we are in the middle of a no-win contest, but I am positive that we will, and should, engage in some contract renegotiations.

 

Before we leave this section, it is worth pointing out that part of the reason your customers want to renegotiate their service contract is because your offer has not changed in many years.  Your customer’s needs and wants are continuously changing.  Also, your products are changing (for the better.)  Here is a graph produced by Warranty Week, the best source of real warranty data.  It appeared in their April 16, 2020 post Seventeenth Annual Product Warranty Report.  The data shows warranty accrual and claims rates for all public, US based, B2B industries from 2007 to 2019.
Warranty Claims
Note how the claims rate dropped from 2003 to 2013, increased as smartphones proliferated quickly, and then returned to a choppy but reasonably low level in 2015.  If the warranty rate is low, it is a strong indicator that reliability is high since many failure modes appear in the early use days. I discuss the suggested frequency of updating contract configuration in How Often Should Your Service Contracts Be Updated?

 

What our customers are being told about renegotiating a service contract

 

A recent OnStrategy blog post aimed at companies like our customers, Change Management Requires Cutting Costs by Renegotiating Contracts, included these six steps to renegotiation:

 

  • Bring raw material and market data or you won’t be able to back up what you say.
  • Reinforce that you are trying to build upon your long-term relationship and viability- not just cost-cutting.
  • Explain that your better financial health will likely translate into larger future orders.
  • Point out the difference between current prices (which have been gradually rising) and true market value (which has seen a quick decline).
  • Exchange a more favorable rate for a longer contract length.
  • Find out where you can save your supplier money.
Other articles on negotiations, including the previously mentioned HBR Real Estate article, all include the same point:
“The negotiations show focus on creating a win-win outcome and must be based on preserving the existing relationship.”
This means that neither side should come to the table clad in full body armor and carrying one or more AR-15s.

 

Preparing for renegotiating a service contract or cancellation meeting

 

You should have a list of the types of tradeoffs you can live with.  For example:
  • Change the contract so your company implements remote video technology to support the customer’s certified internal maintenance people and you dispatch your field engineers only after X hours of active support.  In exchange you will issue a credit that will be applied to an extension of the current contract for Y months or years.
  • Remove automatic software upgrades and charge for them individually but make your contract is contingent on the customer installing all upgrades within 2 months of release.
  • Include a supply of consumable items in the contract with the price adjusted to effectively discount the items if the contract stays in force.
Do you remember the basic contract I described in the top of this post?

 

An OEM promises to send a qualified technician to a buyers facility twice a year, at a mutually agreed day and time, to perform a preventative maintenance process according to a company checklist which the buyer has seen, and make any repairs necessary to return the equipment to good operating condition, for a fixed total cost which will be due within 30 days of invoice after returning the signed contract and a valid purchase order.
Here are some changes you can offer, in conjunction with a contract extension or something else, that is valuable to your company.

 

  • Change the PM from twice a year to annually
  • For remedial maintenance, do not send a tech but be available to support the customer’s certified in-house maintenance person
  • Remove the remedial piece of the contract and turn either parts or labor and travel into a billable service at list price
  • Make the payment term less than the current agreement
  • Wait for a purchase order before scheduling the billable service
Whatever you do offer, make sure that your customer understands that you are not trying to make a bigger profit from the new offer than from the original contract.  But, do not hesitate to remind the other party that your business must also remain financially sound. If your company is forced to make major support changes, then their company and your other customers could be left with equipment that experiences unreasonable.
As the current advertisements say, “we are all in this together.”

 

Additional resources:

 

 

About Middlesex Consulting

Middlesex Consulting is an experienced team of professionals with the primary goal of helping capital equipment companies create more value for their clients and stakeholders. Middlesex Consulting continues to provide superior solutions to meet the needs of their clients by focusing on our strengths in Services, Manufacturing,  Customer Experience, and Engineering.  If you want to learn more about how we can help your organization create more value for your customers please contact usor check out some of our free articles and white papers here. 

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