Office 365 and Gross Profit Shrinkage – How To Tackle It (part 1)

It’s clear to anyone offering cloud services that gross profit margins have shifted. MSPs with offerings like Office 365 have seen their margins steadily shrink, but don’t necessarily understand why. This brings with it a number of challenges for MSPs, in particular the drag it’s creating on overall gross profit margin.

We’ve talked in a previous blog about the magical 42% target and what we need to do to get it.  A critical element of this is having a clear picture of how the gross profit target is being reached, along with the gross profit targets for each of your revenue streams.

Traditionally we’ve always been able to look at our P&L with two buckets of revenue – product and service – and each of these two buckets has their own gross profit target. Those targets reliably sat at around 20 percent gross profit for products and 50 to 60 percent gross profit on services for many years.

However, cloud services like Office 365 presents challenges when it comes to aligning this revenue with the regular MSP revenue streams of services and product because of the much lower margins associated with Office 365 and its bed fellows. It means that our ability to impact those margins in ways we’ve been used to is limited. In addition, putting these cloud services in one of our traditional revenue streams of product or service places an artificial drag on their associated gross profit margins. This leads to some MSPs putting Office 365 and similar services in their product revenue stream, while others align such offerings with their services revenue stream. Meanwhile, many are just putting it wherever it makes sense in that month or on that day.

We understand why this is happening, but suggest that it’s time to get some clarity on the matter and accept that this is a challenge that needs a definitive solution.

Why? If we’re lucky, we might get seven to 15 percent on our resold cloud services like Office 365. This is obviously significantly lower than our traditional margins, and presents us with a conundrum – where do I put this revenue on my P&L? Product or service?

The answer is neither.

The only way to avoid that artificial drag on your product or services revenue stream is to create a third stream of revenue purely for your resold cloud services. Once the stream has been created, accept that the gross profit target in this revenue stream is going to be lower than both the service and product gross profit targets. This will give you a much healthier picture of where your margins are at, as well as managing your expectations and providing a clear vision of which areas need your attention.

The resold cloud services category needs to be built into your general ledger, and your PSAs need to map the three buckets in your P&L. This will change the trajectory of your financials and protect existing revenue streams from the drag of low-margin cloud services.

The resold cloud services revenue stream will make it easy to see where your slowest growth is, and once you’ve separated out the three streams, you will be able to answer the question of how to increase your revenue and make up for the low margins your resold cloud services have traditionally brought.

Be sure to check out the second blog in this series, Office 365 and gross profit shrinkage – how to tackle it (part 2) coming out soon.