What are the Effects of Sales Giving Away Service?
Impact of ASC 606 Accounting Standard
The practice of sales people giving away or discounting service to close a product sale is pretty common and has been going on for decades. Companies have tolerated this behavior in order to achieve quarterly/annual product revenue targets. Unfortunately, the effects of sales giving away service produce a number of negative consequences that will ultimately affect the long-term profitability of the company.
1. Service provides an annuity revenue stream that cannot be recouped if given away or discounted during the initial sale.
2. Margins for service are typically more than double product margins.
3. Customers don’t perceive any value for a service when it is free, which sets a false precedent for future service sales.
4. There is always a cost associated with service delivery that cannot be recovered if provided for free.
One of the most disruptive trends, particularly in the technology industry, is the shift from products to services due to commoditization. This refers to a phenomena in which products become relatively indistinguishable from competing products in terms of features and quality, consequently forcing prices lower and thereby eroding profit margins. The best defense against commoditization is to develop a value proposition that incorporates service as a crucial component of the total solution (product + service) that will enable your company to differentiate its brand.
The old behavior of sales giving away service will not be tolerated by the new accounting standard ASC 606. The full name of the rule is Accounting Standards Codification 606, revenue from contracts with customers. The guidelines are about the results of your end-to-end processes starting with contracts, through pricing, quotes, orders and ending with revenue recognition.
In the USA, this rule was issued by the Financial Accounting Standards Board (FASB). This organization maintains the gold standard for accounting, Generally Accepted Accounting Principles (GAAP). Private companies are not required to use GAAP standards, but generally, many do adhere to it as a best practices and also to encourage external investment.
ASC 606 outlines 5 steps:
1. Identify the contract with a customer
2. Identify the performance obligations in the contract
3. Determine the transaction price
4. Allocate the transaction price to the performance obligation in the contract
5. Recognize revenue when the entity satisfies a performance obligation
6. Under the new ASC 606 rule, as an example, if a salesperson wants to bundle in free support, extended warranties, or other services to close a deal, this will slow down or prevent revenue recognition, thereby hurting the company’s top line.
Sales, Finance, Legal and Service need to work together to be compliant with ASC 606. Aligning sales incentives and compensation plans with the new revenue recognition policies are necessary. As a best practice, sales compensation plans should now be based on margin rather than revenue, with added incentives for subscription services or other programs that bring revenue in faster.