Different from the break-fix service business in which customers are paying you to keep the systems running per their original specifications, the upgrades business is one in which they pay you to make their systems do more than they were originally capable of doing. While customers hate paying for break-fix services, they will jump at any opportunity to extend the capability of the systems they have already purchased.
Upgrades extend the life of your customer’s capital investment and create tremendous value for them. This, in turn, creates one of the best profit opportunities for capital equipment manufacturers. This business has all the hallmarks of a perfect business including
- A compelling value proposition,
- No direct competition, and
- High profit margins.
Your customers are highly motivated to extend capital life. For many types of capital equipment, the acquisition cost is the single biggest driver for the total cost of ownership. Therefore, your customers want to avoid purchasing new equipment for as long as possible. Anytime they can extend their existing installed base of equipment to the next generation technology or improve its productivity is an opportunity to avoid another round of acquisition cost. Sometimes customers even demand to see upgrade roadmaps before they will make their initial system purchase. It’s that important to them to ensure long capital life.
As the original equipment manufacturer, you are usually the only one who can provide these upgrades. Upgrading the productivity or process capability of complex equipment requires complete knowledge of the system’s hardware, controls, and software. That creates a significant barrier to entry for a third party. Without direct competition to drive pricing down to minimum acceptable margins, you’re able to achieve pricing anchored to an upgrade’s full market value.
How to Price Upgrades
Your customer’s upgrade buying decision is simple. If the upgrade results in more profit than available alternatives for his company, then he will buy it. Profit can be thought of as the financial gains produced by the upgrade minus the cost of acquiring those gains as shown in the figure below.
Model for upgrade value to a customer
The two ways that capital equipment installed-base upgrades can produce financial gains are
- Increase equipment output and
- Lower operating costs.
Increased equipment output provides your customer with some combination of avoiding new equipment purchases and increased revenue. This increased output can take many forms including
- Higher throughput,
- Higher uptime,
- Higher yield,
- Ability to perform a new process, or
- Compliance with a new regulation.
Lowering operating costs increases your customer’s profit margin. Lower costs can also come in many forms including
- Higher energy efficiency,
- Lower operator costs,
- Reduced consumables consumption, and
- Lower maintenance costs.
The cost to acquire those gains includes the price for the upgrade plus any implementation costs. Your upgrades pricing goal is to find the highest price at which the upgrade value is still so compelling that the customer will buy it.
The equipment suppliers’ cost to produce the upgrade is not a factor in determining the upgrade’s price. This concept works in both directions. A high cost to produce an upgrade does not give you a license to sell at a high price. Nor does a low cost to produce mean you must keep prices low. Price is determined by the upgrade value to the customer as compared to available alternatives. Your costs have nothing to do with it.
Let’s walk through three scenarios to demonstrate how to use this value-based pricing model for your upgrades business. In the first scenario, our favorite product manager, Max tackles the value versus cost-plus basis for pricing upgrades. In the second, upgrades are used to provide compelling value and protect new system pricing. And finally, in the third, Max uses the extraordinary value that can be created with upgrades to recover from a disastrous product launch.
Value, Not Cost Determines Upgrade Pricing
EquipCo’s product manager extraordinaire, Max just learned that a system-throughput-improvement upgrade was about to be launched through the service organization. Max met with the service manager in charge of the launch, who told him
- 500 fielded systems were eligible for the upgrade,
- The original systems could process 100 units per hour and were sold for $4M each on average,
- The upgrade improves system throughput by 25 percent, and
- The upgrade cost of goods sold is $25K.
“Wow sounds like a gold mine. How much are we selling the upgrade for?” Max asked.
The service manager replied, “To hit my budget this year, I need to get a 50 percent gross margin. So, the price is $50K.”
That wasn’t the gold-mine Max had in mind. His mental image looked more like the one shown below.
How to think about upgrade value
“Hmmm,” Max said, “from what you’ve told me, I’d bet each upgrade is worth about $1M to our customers.”
To which the service manager snapped, “Don’t go messing with my pricing. I know what I’m doing. Remember, this thing only costs $25K. I’m happy with a $50K price and so is my boss.”
Max thought, “If my hunch is right, we were about to leave a ton of money on the table.” So, Max went back to his office and sent an e-mail to the company’s head of sales, describing the upgrade and asking how much he thought EquipCo could get for it.
The head of sales wrote back, “Most of the factories housing the upgradeable systems are filled. They are four-wall constrained. Expanding by adding new systems is not an option. The way I see it, every four upgrades is like getting a new $4M system without having to expand the facility. I suggest that we list at $700K. That’s a compelling value for our customers, and I imagine an incredible profit opportunity for us.”
Protect New System Sales and Pricing with Upgrades
One of EquipCo’s customers has an installed base of 20 Generation I, 100-unit-per-hour systems. EquipCo has since introduced Generation II of that same machine. This new machine can process 125 units per hour. This customer’s business is expanding, and he now needs an additional 2,000 units per hour of production capacity. Do the math and that comes to a need for 16 Generation II machines.
EquipCo wants to keep this customer and establish a $4.8M selling price for its Generation II machines. But a competitor has emerged that is willing to sell 16 125-unit-per-hour systems for $4.5M each. The competition’s total proposal for 16 systems is $72M.
Max inserts himself into the sales-strategy discussion. “You can defend our installed base and shut this competitor out by linking system upgrades to the new systems’ sale. Look at this.” He says as he distributes the handout shown in the table below.
|Price Each ($M)||Total Price ($M)||Equivalent #Systems|
|11 New Gen II Systems||4.8||52.8||11|
|20 Gen I 25-UPH upgrades||0.7||14.0||5|
|Total EquipCo Proposal||66.8||16|
EquipCo’s proposal delivers the needed 16 systems worth of additional capacity for $66.8M. That’s $5.2M lower than the competitor. The customer gets the same capacity, lower acquisition costs, lower facilities cost, commonality, and none of the hassles of changing suppliers.
Rescuing a Failed Product launch with Upgrades
EquipCo’s newly designed deposition system was ready to start shipping just as the market was taking off. Customers couldn’t get enough of them. In just eighteen months, they sold eighty units at over $4M a pop. That was nearly three times more systems than anyone had forecast. They felt like geniuses.
Then as the market mania calmed down, those eighty customers started to plug in their new machines and qualify them for production. That’s when it started to get ugly. Once in the customer’s environment, these machines were simply incapable of meeting their yield specifications. They weren’t even close. Virtually none of EquipCo’s customers were able to put their machines into production.
Customers were screaming. Some were so upset that they would not even let EquipCo’s service engineers on site. Others got fired for selecting EquipCo’s deposition system and failing to get their production lines up and running. For EquipCo, orders dried up like a Savannah watering hole in the summer. The once frenzied business came to a screeching halt. EquipCo was burning cash fast. If they didn’t solve this problem quickly, their days were numbered.
Back at headquarters, EquipCo’s engineers figured out what went wrong. There was a fundamental flaw in the system’s source material distribution module. This flaw was missed during in-house testing because they didn’t use the exact source materials used by their customers. The good news was that they had a fix. The bad news was that the fix required replacing the entire module to the tune of $100,000 per machine. It was going to take $8M to make their customers whole. $8M that they didn’t have.
So, the management team called an emergency meeting to figure out how to dig out of this hole. The meeting started with Bill, Vice President of Engineering, explaining in detail what went wrong, and his team’s solution to fix it. When he got to the solution part, Bill let it slip that the fix will also boost the system’s throughput by 25%.
“Wait! Do you mean the new source material distribution module will not only fix the installed base problem, but it will also improve the system throughput to 25% better than the original specification?” Max, EquipCo’s product manager, asked.
“That’s right,” Bill confirmed.
“I have an idea,” Max said as he walked up to the whiteboard. “If I understand our situation correctly, we promised our customers a certain level of value. Then we under-delivered by a wide margin. Now we have a fix for the problem that will result in 25% more value than our original promise.”
“That’s right,” was the chorus from the around the table.
“What if we could get the fix in our customers’ hands and get paid for the portion of the value that’s beyond what we promised?” Max asked.
“How would we do that?” again the chorus.
At the whiteboard, Max draws Figure XX. “Our customers paid around $4M for each machine. The fix that Bill’s proposing increases throughput by 25%. If we had these new modules in the original machine, the machines would have been worth $5M instead of $4M. What if we proposed to our customers that we will not only fix their machine, we’ll make it run 25% faster than we originally promised and charge a mere fraction of this added value?”
Upgrade value analysis
“Sounds good when you say it fast,” Bill snarked. “But there’s no way our customers will go for it.”
Ken, the head of sales, stands up, “I think they might. They are in a tough spot too. They have factories full of equipment that doesn’t work. They don’t have the capital or time to scrap it all and start over. They can dig their heels in, but eventually, the rational ones will act in their best interest.”
“Exactly what I was thinking” Max chimed in, “Our customers need us to do this. I propose that we each price upgrade at $175,000. Our customers will be getting $1M in value above their original purchase at an incredible discount. While they won’t be thrilled about cutting us another purchase order, they will be getting an amazing deal. They can get on with running their factories, and we can start rebuilding credibility with our customers. Our message to our customers would go something like this,
‘You will be getting a completely new source distribution module that will both fix the yield issues you’ve been experiencing and make your equipment run 25% faster than its original specification. These original machines specifications sold for $4M. The 25% productivity improvement makes them worth $5M each.
We understand the disruption we have caused your business, but we cannot afford to upgrade your machines for free. It will bankrupt us. If that happens, we won’t be able to help you recover your investment. The price for this upgrade is $175,000. That represents less than 20% of the $1M in value that you will derive from it.’”
Don’t Let Upgrades Be an Afterthought
Creating a successful upgrades business requires some forethought. Products must be planned and developed with the upgrades business in mind. Equipment companies with a successful upgrades business typically have the following attributes:
- Products are derived from a common, multi-generation platform.
- Installed-base-upgrade and new-product roadmaps are integrated.
- Both systems and upgrade products are managed by professional product managers.
A robust platform strategy is an essential ingredient for capital equipment, upgrade-business success. A common platform that survives multiple generations of new products facilitates backward compatibility. This means that capabilities developed with new products can easily be packaged into upgrades for the installed base. The longer the platform survives, the larger the upgrades revenue stream. That alone, however, doesn’t ensure success.
The organization must have the discipline to make sure that each new product development program considers making some or all the new performance capabilities available as upgrades. Designing new capability into a new product is almost always easier if it is not constrained with backward compatibility. The easy way out is to remove the constraint. However, this forfeits the upgrades revenue stream. You need to make a robust trade-off decision between reducing design constraints and maximizing the upgrades business opportunity. Force a return-on-investment review for any potential upgrade that includes
- Incremental effort and risk of including backward compatibility as a requirement,
- The value that the installed-base upgrade would have to your customer and target pricing,
- The cost of goods sold for the upgrade,
- Total available market for the upgrade and expected revenue capture, and
- Total potential profit.
Next, you need to think about where in the organization to manage the upgrades business. Sometimes the upgrades business will get assigned to the service organization. In capital equipment companies, service groups are fantastic at executing the customer service function. They excel at managing large organizations, moving spare parts, installing systems, rapid response, and controlling complex cost centers. The capabilities needed to develop your aftermarket business are different. Upgrades-product management is not any different from systems-product management. Both require the skills to evaluate opportunities, create and capture value, and generate demand.
These attributes are likely to be found in your product management team. Manage your upgrades business from there. You’ll be more likely to hire a product management professional with the right skills. He or she will also be under the tutelage of your other product managers. Plus, it’s critical that new systems and upgrades roadmaps are integrated. You have a much better chance of pulling that off when both are managed by the same organization.