What You, The Customer, Needs to Know About IT Project Pricing

tldr: your supplier is guessing.

OK, so there’s more to it than that, but not much more – pricing IT projects is essentially a form of applied guessing. Like a lot of things in the IT industry, without a professionalising body like the RICS, IT companies each have to work out from first principles how to price such that profit it made and this leads to a) commonality in approach, and b) sometimes sketchy results.

I like writing articles like this because, as a customer of IT services, you are much more advantaged to understand what’s behind the curtain. So let’s take a peak…

Like all businesses, IT companies are seeking to make a profit from the work that they do. This – naturally – means that they would like to buy something for X, apply some value (Y), and sell it for X+Y. The IT industry creates rather ineffable value that is able to make material impact to the customers bottom line, so in certain areas, the IT company is able to make good profits, both in terms of margin and in terms of actual cash.

If you break down the margins in the three aspects of any IT spend, we find that hardware has virtually zero margin, software has some reasonable margin, and services has astonishing margin. The margins on hardware is so bad that effectively anyone selling you hardware is more or less just doing it for convenience. IT companies love to sell “solutions”, and if you need hardware it is safer to sell hardware and make zero profit on it than it is to have you have a relationship with another provider who might gazump you, or otherwise interfere with the more profitable parts of the relationship.

Software margins can be good, but even a 15% margin on a Microsoft 365 Professional license will net the seller a £1.40 profit. (This is why it is more interesting to sell to you if you have 1,000 employees, as opposed to 10.) If the software you’re buying is not a commodity product (i.e. relatively cheap, lots of vendors to choose from), you’re being asked to pay 20%-25% margin.

Services is where the real bank is made – but hold that thought because there are two types of costs: direct and indirect.

Direct costs are just the salary package, somewhere to work, whatever IT bits and pieces they need, and then other bits and pieces like training. The biggest cost is salary, which is simply just divided by their “capacity” in a given period, most typically a month. If we have someone on £80k a year, add 13.8% for employers NI, then round up to £100k a year for the other stuff they need.

When selling services, a limiting factor is that the supplier is selling “time for money”. That £100k person is costing you £274 per day. Even keeping someone busy you are unlikely to sell more than 17 days of their time per month over the year. Your adjusted capacity cost is therefore closer to £500 per day. When estimating, this is the value that we use – and we do this just to keep the same “units” on both sides of any planning equations. This tells us we need to sell them for more than £500 per day – we’ll call this “cost per saleable day”.

And clearly the IT companies do – whenever you’ve seen a proposal, day rates are typically much closer to £1k per day. This strongly implies that there is a typical industry markup of 100% on IT services. It’s a valid implication – no one is paying technical specialists in PAYE employment more than £80k-£100k per annum.

The problem that IT suppliers have is that of the indirect costs. Some of these costs are more easily dealt with than others, e.g. spend related to regulation, compliance, governance, etc. It’s easy to budget year-on-year for things like accountancy fees, legal fees, getting compliant with whatever ISO standard/standards you need, etc, and as such its easy to add a fixed number to that £500 day cost per saleable day. Let’s add £100 to that figure before, so now we have £600 cost per saleable day.

A whopping problem with costs is that of marketing. Cost of acquisition of a new customer is both eyewatering and substantially more variable than the indirect costs enumerated above. Coming back to the idea of selling either commodity services or specialist services, commodity services have a much larger audience, but much higher competition. Higher competition demands higher sophistication in marketing, i.e. more spend. Specialist services have tiny audiences, but less competition – it’s not uncommon for a sales team to be able to identify every single person in their total addressable market. Smaller audiences demands higher sophistication in sales, i.e. more spend.

If you’re about to sign a sales contract worth £100k, them spending £10k to get you to this point is common.

However, where this gets wonky is that the spend is less certain. You can almost guarantee that being quoted £x getting your accounts audited and posted will result in that same spend of £x. You can’t do this with marketing – it is a highly variable indirect cost. For ease though, let’s add another £100 to the cost per saleable day value, giving us £700. The fact the cost is both high and uncertain means that the industry will tend to much prefer a long relationship with a customer, because of the benefit of amortising the cost of acquisition over multiple projects over multiple years.

Now when the supplier is estimating, the job is to preserve the £300 profit between the £1k sale per day and the £700 cost per saleable day. The difficult bit is that the secret of the IT industry is that we only know for certain how much something will cost when we have built it. Accurate estimating ahead of time is to all intents and purposes, not possible. The absolute best we can do is plus or minus 10%, and we nearly always underestimate.

That’s workable in a £700 cost per saleable day, because applying that 10% means that the cost falls in a range of £630 per day to £770 per day. Against a sale of £1k, that yields a comfy worst-case margin of 20%.

(The reality is though that I’ve used very round numbers here. If we have a cost of £770 against a sale of £1,200, the shareholders are laughing all the way to the Ferrari dealership.)

This is the ideal case, and at this point I hope this has been helpful as it should give you a quick breakdown of just how your IT project is being estimated.

There is the issue of the worst case though. If the estimate is wrong, because that cost per saleable day is so expensive in real terms, pain can get inflicted on the supplier very quickly. A 30% miss seems them making a small loss – a 50% miss is disaster for the supplier. As such, it’s so absolutely critical that you as a customer “hold their feet to the fire” to make sure the estimate is correct before you commit.

By Matthew Reynolds