Seeking a Cure for Shrinking Margins?

Shrinking MarginsNo matter where in the worldwide Microsoft ecosystem I go, I find that Partner businesses are experiencing at least some measure of financial pressure. Having benchmarked now nearly 100 such businesses (VAR’s, ISV’s, SI’s, MSP’s) over the last 7 years or so, I have also noticed a fairly steady decline in overall profitability.

For the most part, this is caused by shrinking margins.

What I’ve also noted is that although different Partner businesses will have different revenue stream compositions, not all margin is created equal. In fact, there is a “hierarchy” to margin potential, depending on the revenue stream one is talking about. This is represented in the following graphic.

Margin Heirarchy 4Starting at the bottom of the margin ladder, hardware at best delivers 20% gross margins. In many cases, it can be half that. 3rd Party Software tops out at around 35%, and that almost always requires the sale of business applications software such as ERP. Other software carries generally lower margins. Project Services comes next, in some cases driving 45% gross margins, although this requires careful management attention to achieve. In essence, you are selling labor and there are inherent limits to how much margin you can drive. Managed Services can deliver as much as 55% in gross margins, because it is a form of “insurance” that customers buy, should they need it. They tend to overestimate the support they will require, and under-consume. So you earn a higher margin than is possible for project services. And finally, Intellectual Property can deliver as much as 75% gross margins, because it is a product that is “manufactured” once and sold multiple times.

It is also important to note that the only revenue stream that is not under pressure these days is Intellectual Property. This is largely a supply-and-demand phenomenon. Intellectual Property has high perceived value to the customer, so it can be premium-priced. There are also fewer entities producing it, so there is little competition to drive prices down. Consequently, margins remain high.

So the cure for shrinking margins, quite simply, is to shift your revenue composition in favor of higher margin activities such as Managed Services and Intellectual Property. Not only do they drive higher gross margins, but they are things a Partner can control.

Tap into the clear demand for Cloud solutions, and you will have a double-win – your margins will increase, as well as your company’s valuation.