Servitization is the process of adding services in order to add value to a tangible product.

Are You Winning or Losing the Race Towards Servitization and Outcome-Based Models?

Oct. 15, 2018
Products are becoming commoditized and service is a sound way to establish a position in a market and sell at a premium.

The servitization megatrend is upon us. Product-driven companies are adding services revenue streams and business models, usually to augment but sometimes to replace product-based business. This creates an outcome-based model that appeals to customers and is usually more profitable for the service organization.

Servitization is the process of adding services in order to add value to a tangible product. In some cases, a product may be delivered entirely through an advanced services outcome-based model. This may start with something such as warranty repair and progress to complete servitization, where a piece of industrial machinery is provided free to the customer, who pays per unit the equipment produces.

There is ample evidence that manufacturers feel the pressure to servitize, and are making preparations:
-  According to Digitalist magazine, servitization and the development of new business models are among the top five major trends affecting the industrial manufacturing space between now and 2022.
-  Something as traditional as an aftersale warranty can, according to Wipro, increase margin, revenue and differentiate a product offering in the market.
-  Technology is important to realizing this new source of revenue. According to an IDC white paper, “Navigating the Changing Landscape of Aftermarket and Engineering”, the industrial equipment sector, affected by this trend, plans to invest in analytics for predictive maintenance,, process optimization and spare parts inventory, among other organizational and technology priorities.

Why servitization?
What is driving this trend towards servitization? When a major change or megatrend happens, there is usually not just a single reason. Multiple forces push a culture, society or economy inexorably in a single direction.

Aftermarket services also may make the customer more dependent, as they push off important value-added services like maintenance, operation and asset lifecycle management onto the supplier. This may insulate the vendor from competitors. It also enables a vendor to access deep insights on how their customer is using their products, which can in turn drive a consultative selling process.

Consumer culture also plays a role, as transportation and entertainment media become increasingly servitized. We have become accustomed to buying not a tangible object, but the defined outcome that object would have delivered to us. But enabling technologies are also making servitization more feasible. The internet of things (IoT) is enabling companies to sensor products they sell and use the resulting data stream to automate everything from re-order to dispatch of a service technician.

But in industrialized societies, products are becoming commoditized and service is a strategically sound way to position a company and sell at a premium. This "commoditization" and other factors result in limited opportunity for many product-centric companies to grow in terms of product revenue and profits—due to factors like downward price pressure, volatile demand and increasing prices for inputs and raw materials. In other markets like machine tools, lumpy year-over-year business may see the stable, recurring revenue of services attractive.

A recent report from McKinsey suggests that while margin on new product sales is typically 10%, aftermarket service margin averages 25%.

But, realizing that revenue poses some significant management and enterprise software problems. Executives will need to live increasingly in the mental future—planning around not only the product lifecycle but the service cost and revenue cycle. When the service agreement is sold, a company will be committing to deliver against a contract that they could make or lose money on for years.

“To gain clarity and remain competitive, they must undertake a more detailed examination of aftermarket lifetime value—the total revenue they receive from servicing their installed base,” the report states. “This measure, which is typically calculated for each product line, provides a more comprehensive view of aftermarket value than commonly used metrics, such as service revenue captured per customer.”

Now, a 2018 IFS study of 200 North American manufacturing and industrial executives delivers insights into the extent of servitization, its impact on profitability and the extent of the adoption of service lifecycle and field service management technologies.

Current progress towards advanced services
Among the respondents of the IFS study, the majority had some type of aftermarket revenue stream, even if that revenue stemmed strictly from aftermarket parts sales. The smallest segment was those who had servitized completely—essentially doing away with product revenue and charging for a product by duty cycle, usage or some other metric.
•  38% of respondents sold only products, with no aftermarket or other service revenues.
•  19% sold products and some aftermarket service parts.
•  15% sold products and aftermarket field service through break-fix repair.
•  16% sold planned maintenance contracts with service level agreements (SLAs).
•  Only 4% of respondents reported full servitization—selling advanced services rather than a discrete item through power-by-the-hour, fee-for-usage or revenue sharing agreements. Companies operating in this fully-servitized business model include:
-  22% of medical device manufacturers
-  5% of metal fabrication businesses
-  5% of companies in the oil and gas industry

The study identifies a number of patterns in how far companies have progressed towards servitization and the challenges they surmount along the way, including:
1.  Greater service maturity equates to greater profitability of the service organization
Across both manufacturing and pure services businesses, companies that are further along in their servitization maturity journey also report greater profitability. Manufacturers selling aftermarket parts were only slightly more likely to report being profitable (47%) on service than those who do break-fix repair (just under 43%.)  This suggests that the transition from selling parts to reactive field service may be challenging. Among manufacturers involved in planned maintenance or service contracts, 62% reported profitable service operations.

According to IFS senior product evangelist, North America, Tom DeVroy, the move to selling a service contract is a key inflection point. A company is, at that point, in a better position to engineer profit into the agreement and offset this with the value of more reliable operations for the customer.

“Planned revenue streams in service are a key profitability driver,” DeVroy said. “Product can be priced with a margin baked in. You can monitor the profitability of a contract in a proactive way. Reactive service is primarily a matter of time and materials, with a much tighter margin. From contract-driven service, full servitization is just the next step in a planned revenue stream that includes product output or performance and where proactive service becomes a critical success factor. This is not to suggest that a service parts business can’t drive significant revenue, it just is usually much more competitive.”

2.  The more sophisticated a service operation, the greater will be the technology challenges
Companies involved only in selling aftermarket service parts experience fewer technological barriers to delivering service because their need is limited to the supply chain and securing and fulfilling orders. But by the time an organization is involved in break-fix repair, just under 40% reported problems due to inefficient back-office processes for warranty management.

As sophistication progresses and respondents get involved with annual maintenance contracts, 39% report challenges with efficient utilization of the field technician workforce. Efficient utilization of the technician workforce is still a challenge even for the most sophisticated, digitized companies. 60% of organizations that offered products through a fully-servitized model reported this as an issue.

On a related note, 40% of these advanced service organizations say they struggle with efficient technician routing and high fuel costs. Furthermore, among this advanced group, it is remarkable that 60% also struggle with work that is completed but not invoiced in a timely fashion, if at all. This may be because of ineffective methods to determine what is and is not covered by more complex and customer-specific contracts.

“As noted, selling aftermarket service parts is not a difficult service revenue business,” DeVroy said. “The parts are already defined in the manufacturing supply chain, so this becomes a distribution and fulfillment challenge but little else. Most of the infrastructure already exists to support this business, aside from perhaps an e-commerce web site. In service delivery, all the complexity of sales, delivery, and workforce management are part of the equation. It is a whole new set of challenges, but with great challenge can come great reward.”

3.  Companies are investing in servitization
Companies who are more advanced in their journey towards servitization seem to be budgeting for more increases in funding for even more digital transformation than their peers. But companies in the lower maturity process are still planning to increase their budgets and have funded projects that could prepare them to offer more proactive services offerings.
•  27% of respondents who offer only aftermarket service parts are expecting digital transformation budgets to increase by more than 10%, trailing the more progressive, outcomes-based services organizations by less than 3%.
•  40% of companies doing field service for break-fix repair have budgeted for mobility-related projects.
•  Across all servitization maturity categories, analytics was the most popular area for planned expenditures. Companies involved in annual maintenance contracting lead the charge with 47% planning analytics projects—a key factor to intelligently pricing and executing on contracts over the product and service lifecycles.

Investments necessary to realize the potential of servitization include, in large part, enterprise software capable of extending the existing product business model into a profitable service model.

According to IFS global industry director for Service Management, Mark Brewer, this enterprise software must deal not just with the scheduling and provision of service, but also with the integration of service delivery with supporting functionality like contract management, formal service level agreements (SLAs) and inventory management.

“True digital transformation also requires the elimination of data- and functional silos, so business processes can be integrated from end to end across the service lifecycle,” Brewer said. “There needs to be a clear view of what the contract means from an entitlement standpoint, including SLAs, customer-specific billing that comes out of your contracts’ module, inventory carrying costs, resource load, which comes out of technician scheduling, and revenue that comes out of invoicing. Only when all of these disciplines are integrated can you get to the point where one plus one equals three. But that is precisely the result you can achieve when you have a holistic system and all of the components from mobility to logistics to scheduling are talking to each other.”

What’s next for servitization?
Product-centric companies are in fact moving to augment or even replace their business models with servitized pay-for-performance offerings. This disruptive change in business models will certainly continue to progress. The study shows not only that some companies are more advanced on this journey than others, but also that those who win this race towards servitization can expect to be more profitable than their competitors. So, we can expect to see more product-centric companies add service offerings, and those with service offerings enhance their systems and processes to make greater progress towards a fully-servitized model.
Charles Rathmann is senior marketing snalyst, North America, IFS.  Contact him at LinkedIn

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