In 2014 McKinsey & Co., a management consultancy, conducted on behalf of VDMA (German mechanical engineering and manufacturing association) an extensive survey and analysis (in German) of the sector to assess success factors and future potential. The sector includes machine, engine and machine tool builders of all types, process, system as well as component suppliers (excludes automotive and electrical engineering). It generates over € 200 billion in revenues, had an average profitability (EBIT) of 6% in 2012 and employs approx. 1 million people –the third largest machinery sector in the world after the US and China. The sector is further characterized by strong export orientation (10% of companies are global players, another 60% are exporters), high innovation (97% either develop original product innovations or are early followers) and a large variety of companies in terms of size, ownership and management structure.
The study identified a number of success factors for growth and profit, ranging from company size and degree of international orientation to operational excellence, stringent focus on core business or capacity for innovation. Furthermore, two of the success factors were related to services, though rather ambiguous in their effect. One was service itself, whether after sales or in other form. The other was the ability to provide customized solutions. According to the survey these were the least mastered factors, however they were expected to gain significantly in importance over the coming years. In other words success in services –whether with focus on the product installed base or on servitization of offerings into product / service bundles (solutions in one, though not only, sense) – will be a major determinant of overall success of the sector in the medium and longer term.
We will analyze the findings of this study in three posts. In the first we’ll look at after sales service. In the second at solutions business and in the third we’ll draw some overall conclusions (still to come).
According to the study after sales service accounted for (only) 15% of revenues on average, with a significant difference between supplier types: 16% for solution and system suppliers and 12% for product and component suppliers. While large companies (over € 1 bill t/o) generated some 25% of revenue from services, smaller companies generated only fairly insignificant fractions of revenue.
What however was both interesting and perhaps surprising was that there was no difference in profitability between companies with high or low service to total revenue ratios, whether the comparison was between solution and component suppliers or large and small companies. However companies with low levels of product profitability (e.g. due to declining markets) tended to do better in services and vice versa, implying that services is usually a defensive strategy.
While, as we will see below, about two thirds of companies see service as gaining in importance in the future and fully 88% see it as playing an important role in customer procurement decisions, it is only in a minority of cases that service attracts significant management attention: 37% of companies see service as a competitive tool or differentiator, while 50% either don’t have separate management accounts for services or manage it as a cost center. Consequently the vast majority of offerings (and the bulk of revenues) involve “traditional” services -spare parts, repairs, installation and customer training. Only a few companies offer “advanced” services such as process optimization or outsourcing, insight or advisory services and virtually none offer services unrelated to the existing installed base, such as outcome based performance contracts or “power by the hour“ equivalents, i.e. a transformation of products into product/service bundles which would require a servitized business model. From the low relative numbers it would also be fairly apparent that only a few companies have ventured into services to generate significant additional revenue streams from exploiting the totality of installed base (i.e. including competitors’ installed base) with the possible exception of companies in sunset industries (e.g. textile or paper machines), where services also help improve profitability. In contrast in strongly growing markets (e.g. robotics and industrial automation) services tend to reduce profitability as they are not monetized, but given away for free to support product sales (and accounted for mostly as cost of sales).
Overall companies gave a number of reasons as hindering service development:
- Many customers are not prepared to pay for services, either because they don’t perceive sufficient value or because they expect service to be part of the product cost (as reflected in the price)
- Companies lack infrastructure and qualifications to develop and offer services, particularly in international markets. Developing and sustaining service delivery chains requires significant investment, which is difficult for smaller companies to afford
- In many emerging markets installed base is relatively new and therefore service demand is low. In addition customers seem to have an aversion to remote monitoring and intervention
- Third party service providers, particularly for spare parts, make service business difficult
- Some customers for various reasons, including confidentiality or competitive reasons, prefer to internalize all or most services and not buy from external suppliers.
To understand this (for service enthusiasts rather disappointing) picture better, some further analysis is required: The large majority of German mechanical manufacturers are small (narrow) niche players and component exporters with large market shares in their particular niche. Traditionally they have relied on high quality and strong technological innovation (implying high prices) to sustain advantage in the face of rising labor costs and increasing competition. Practically it is more difficult and there is less opportunity to servitize a component business (beyond traditional services such as repairs and parts supply, though new technologies may be changing this) and the investments required for international service delivery, development of offerings or enhancement of qualifications are hard for smaller players to afford and undertake. Therefore the lumping together of all types of suppliers and the drawing of conclusions from such aggregated results can be misleading and is a weakness of the study. In addition in markets closer to home, efforts by smaller players to expand services may be stymied by powerful third party service incumbents, of which Germany has a good number. Finally there may be cultural reasons for some German reluctance to venture forcefully into services, as traditionally the (advanced) product was seen as the pinnacle of capability and the main raison d’etre of a manufacturing company, rather than the more mundane hunt for profit (e.g. by exploiting the installed base), more prevalent in other cultures. Of course it is not clear that these attitudes are sustainable in the face of both intensifying competition and rapidly evolving technology which is enabling servitization of offerings in previously unimagined ways. But the fact that few, if any, companies in this sector include servitized offerings in their portfolio, as opposed to, for example, the automobile sector which deals primarily with international consumers, does point to at least some form of cultural barrier.
Nevertheless, 67% of German machinery manufacturers expect the importance of after sales service to increase in the coming years. As a consequence 70% want to expand their service networks, 69% to enhance the qualifications of their service employees and 68% to expand their service offerings. For most the way to do this profitably is not yet clear, however a number of ideas and ways forward were put forward by McKinsey and seem to be crystalizing into more concrete strategies:
- Adaptation of offerings to specific customer needs
- Stronger focus on helping customers to extract more value out of assets, including through utilization of IIoT and analytics based technologies
- Value based selling
- Improvement of service processes and delivery systems
- Organizational repositioning of service as a separate organization with own channels to market
- Partnerships to access international markets
- Improved spare parts management and pricing
- Addressing the spare parts “grey market” problem
Services to generate revenue streams from the installed base (i.e. after sales service) is a straightforward business. It requires additional capabilities, specialized processes and offerings adapted to market needs and some organizational adjustments, however it requires no major change in business models. The installed base of German mechanical manufacturers should, under conservative assumptions, exceed € 2-2.5 trillion in replacement value terms. This should represent a market potential of € 60-90 billion annually in standard after sales services (excl. advanced services) of which, according to the survey, only 50% or so is captured, probably significantly less, as new build installation is accounted for as part of after sales services. Advanced services might represent a potential of another 10-20% (€ 5-18 billion). That companies are not capturing this additional value is due on the one hand to lack of management attention or even ignorance of the potential, but also to objective difficulties in investing in services on the other, incl. building service networks, finding the right people in sufficient numbers, reconfiguring the organization and designing processes or investing in technology. Probably the single most important factor is lack of deeper understanding of customer demand levels and market dynamics by top managements. Unrealistic or misplaced expectations of customer demand has sometimes led to failed service investments and development of offerings that were not accepted by customers; this makes managers risk averse. However to make general conclusions about lack of customer demand or customer willingness to pay can be equally misleading –as this can only be based on existing offerings, which might not conform to customer requirements. A customer in a far-away, low cost emerging market may not see sufficient value in long reaction times, high travel costs and high fees to diagnose and troubleshoot a fault. The conclusion however should not be that there is lack of willingness to pay, rather that the service offering does not generate sufficient value to justify its price tag and that another solution needs to be found.
The lack of sufficient focus on the installed base not only undercuts revenue potential, but can be seen as a strategic management error giving rise to a competitive threat as the internet of things, analytics and applications start to drive asset performance improvement. Manufacturers which do not have access to data generated by their own installed base will have a significant disadvantage, as they will not be able to utilize insights to design new or improve existing products, design new services and run the risk of losing proximity to customers. Too limited after sales service is therefore a luxury nobody can afford anymore and this is something the study failed to emphasize sufficiently. Small manufacturers, including component (lower tier) manufacturers who are the backbone of the German machinery industry are in a particular danger zone and run the highest risk. How they should strategize to address the issue, turn threat into opportunity and maybe leapfrog the conventional service strategies (as described above) is, however, another story.