Within the general servitization buzz the talk is a lot about transitions to outcome or performance based services (including on this blog, see for example our take in this briefing: Outcome / Performance Based Services and Contracting: A Briefing for Managers), where a supplier contracts with a customer for outcomes -not activities- and gets paid accordingly. OEMs often bundle products and services into solutions (product-service systems) to produce the outcome, Rolls Royce’s “power-by-the-hour” being the prime example. However pure play service providers can and do also sell “outcomes”, as when an energy services company contracts to provide ambient climate, defined by temperature and moisture while reducing energy consumption -rather than heat and cooling by the kWh, or when a maintenance provider makes an agreement on the basis of Overall Equipment Effectiveness (OEE) and a budget constraint for a plant -rather than selling “spares and repairs” or a preventive maintenance program. The change from an “activity provider” to an “outcomes provider” transforms the supplier’s risk profile (the supplier assumes outcome risk rather than just operational and technical risk), requires a better understanding of the customer’s business, changes in processes and integration with the customer’s own. For customers, outcomes must represent value that is often subjective, but, at the same time, must be quantified. By necessity therefore the supplier’s compensation for the outcome must be somehow value based, i.e. in the sense that the outcome represents value as perceived by the customer, whereas the activity is perceived as cost. Accordingly it makes sense to define outcome based services which are compensated on the basis of the value created as “value based services” and to distinguish them from the conventional model of “fee for service”. Fee for service models can be very lucrative for suppliers, at least in the short term, but create conflicting interests, warp incentives and increase costs. This is, for example, the case in after sales services, where suppliers, particularly OEMs, can and do profit significantly from equipment failure. Outside industrial environments, healthcare comes to mind, where fee for service (however tough treatment and drugs prices are negotiated by insurance companies) has led to a cost explosion as health care providers’ income and profits increase the more treatments they prescribe. The cost increase is facilitated also by the fact that in both after sales services and healthcare there exists a so called “asymmetry of information”, i.e. a situation where the provider knows more about what is really required than the customer, as anybody who has received a quote from a car dealer or been prescribed a battery of tests by his doctor can attest. This is also the case in industrial B2B services, where customers often do not have sufficient technical know-how to argue with OEMs on the merits of interventions.
In previous articles (see below) we have discussed pricing methods, ranging from “cost plus” to “market based”, to “value based pricing” and we are building up to discuss value based pricing in services. However prior to doing this, it is important to look at value based services strategically, that is ask whether they make business sense? First of all, it should be pointed out, they do not necessarily increase and, in fact, often decrease –sometimes permanently-, the profitability of the service or solution activity. In many cases the transition to an “outcomes provider” requires a permanent increase in overhead to understand and manage risk, change and sustain robustness of processes and manage a different value chain*. Profit increases only when the business can be sufficiently scaled and the market expanded so that the additional revenues can compensate for the increased, mainly fixed, costs. Nevertheless the transition can make sense and companies do try to make these transitions, usually for strategic / competitive reasons –to counteract, for example, an attack by low cost competitors or to avoid commoditization of their product offerings over time. However there is another reason why companies decide to make these transitions, which is actually very problematic: The impression that they will quickly increase profits combined with lack of understanding of what such a transition entails. This notion of increased profitability is frequently false and once realized leads to disappointment and strategic reversals, usually with high long term costs, including damage to reputation and organizational capacity.
Managers need to understand that a transition to “outcomes or value based services” is, in fact, a long term fundamental strategic choice that is made for market and competitive reasons, requires significant investment and a different way of working (organization, processes, culture, remuneration etc) –often in ways that may surprise, in short a paradigm shift, which can create conditions for long term strategic advantage and business sustainability and that may or may not increase profits depending on how the industry evolves.
It is not a decision that usually improves short term profitability while the rest remains “business as usual”. Plans that are made on this assumption will often fail, as many companies have discovered to their detriment, though often they blame their strategy, offerings or execution rather than their wrong assumptions**. In this sense such transitions should involve a tough judgement call by managements backed by intuition and deep data about how their industry will move forward. It may confer a competitive advantage (e.g. first mover advantage) if there is a general and timely market shift towards outcome / value based models due to competitive pressures at industry levels and/or the market is sufficiently large for the new business model to scale.
In industrial markets this is happening in infrastructure, aerospace and other forms of transportation (e.g. trains, shipping), defense, and is starting to be observed in other areas such as oil and gas, power generation, utilities and large industrial plant. Without doubt the Industrial Internet of Things (IIoT) will accelerate developments, as connectivity and data analytics help reduce risks and cost of service delivery. We will look at this in more detail in other articles. However one area where there are major efforts underway to change the paradigm from “fee for service” to value based services is in healthcare, simply due to the unsustainability of rapid cost inflation and its impact on patients and insurers (customers) of the current system***.
In a powerful recent article in Harvard Business Review, Turning Value-Based Health Care into a Real Business Model, Laura S. Kaiser, COO of Intermountain Healthcare, a large not-for-profit health system, encompassing hospitals, physician practices and insurance, based in Utah and Thomas H. Lee from Press Ganey Associates, a consultancy from Massachusetts, argue very persuasively that a transition to value based services is a strategic choice which can negatively impact short term profitability –but provide long term competitive advantage. Similarities to industrial environments are close and thought provoking.
Two striking examples are the following cases of organizations who made strategic choices, fully aware of the implications (see original article for others). The strategic logic deserves particular attention as does the objective:
At Mayo Clinic (note: possibly the top US hospital), surgeons who perform lumpectomies or partial mastectomies for breast cancer work during the operation with the Frozen Section Pathology Lab to determine whether all the cancer has been removed. Such microscopic analysis of frozen-tissue samples can take 24 hours or more at some hospitals, but Mayo achieves it in, say, 20 minutes while the surgery is in process. Yes, 20 minutes is valuable extra time in an operating room while the surgeon and staff wait for pathology findings. But Mayo doesn’t do it just to get results to a patient 23 hours sooner. The main benefit is the on-the-spot chance to extend the surgical excision, if needed, to remove all evidence of cancer. That approach eliminates the need for repeat lumpectomy in about 96% of patients. In a study of five years of lumpectomy data, the 30-day reoperation rate was 3.6% at Mayo in Rochester, Minnesota, compared with 13.2% nationally. The result: Mayo’s costs for surgery are higher in the short term, and it earns less revenue from follow-up operations. But it reduces overall medical costs, and the patient gets peace of mind more quickly.
Intermountain Healthcare initiated a care-process model for febrile infants in 2008, including guidelines for the use of physical exams, lab tests, antibiotics, and discharge criteria. As a consequence, more infants with urinary tract infections or viral illnesses were identified and appropriately treated, and fewer infants at low risk for serious bacterial infections received antibiotics unnecessarily. Infant outcomes improved, hospital stays shortened with no increase in readmissions, and overall costs declined. Intermountain made a major investment even though one of the results was lower patient revenue.
What drove these, and other pioneering organizations, to shift to a value based model eventhough short term profitability was negatively impacted? The authors see four compelling reasons for making the strategic choice and they amount to creating conditions for competitive advantage (though the fact that both Mayo Clinic and Intermountain are not-for-profit organizations may have played a role):
- Sustainability: Compete for and attract more customers with lower prices and higher-quality care and services. As value-based payments gradually replace the fee-for-service model, providers that have not adapted will be left behind (This is decisive competitive reasoning).
- Gather experience in managing risk: Pioneering providers gain expertise in managing outcomes and delivered service bundles -in this case providing care for a population with specific outcome targets (what in industrial services we would call Service Level Agreements)-, while assuming outcome and budget risk. This requires that providers “up their game” – by recognizing and managing the full continuum of care, focusing on both prevention and intervention, and using evidence-based care practices to ensure appropriate utilization. In the industrial services case, for example in after sales services, this would require providers understanding the full spectrum of customer requirements and operational needs, as well as equipment behavior in the field and using the entire asset, process and change management toolbox to ensure successful outcomes (win/win) for both sides). Organizations that start sooner will be better positioned for success.
- Relationship building: Learning to collaborate with stakeholder groups takes time. Health systems are seeking closer alignment with physicians and other staff (whether or not they employ them) who can help to achieve higher value in an evolving marketplace (this is about “value networks” and how to enlist and integrate customers (including their employees), sub-suppliers, specialists and other know-how and auxilliary providers into the service value network).
- Last, but perhaps most important, what the authors call “Lack of alternatives”: A business that delivers health care that patients don’t need is pursuing a poor strategy. Providing relatively affordable, high-quality care is much less likely to fail as a strategy, not just with respect to the bottom line but also in terms of how an organization fulfills its mission. Persisting with an outdated model ultimately may lead to unacceptably high financial and public-relations costs, as payers shift their business to higher-value competitors whose approaches to care are perceived as more responsible and sustainable.
The last reason can be applied directly to any industry. Furthermore the authors argue these reasons are compelling enough for providers to act immediately and transition to value based models. For the healthcare industry they are probably right, at least for the US and other western markets, as the transition seems unavoidable, also due to government intervention. For other industries a more differentiated approach is required: In our article Outcome / Performance Based Services and Contracting: A Briefing for Managers we had argued that the issue of timing in a business model transition to value based services is very important, as scale is a paramount factor for success:
In order to be successful a company must change its business model and operating system and therefore must undertake substantial initial investment and, probably, accept permanently higher overhead. To be justified the model needs to scale. Customers however require choice -an adequate number of suppliers providing services under the new model- before they change what and how they buy. A “chicken-and-egg” problem ensues. So in industries without “facilitators” (organizations with oversized influence, including governments), suppliers need to proceed carefully so that on the one hand they don’t overextend and on the other they don’t fall behind when their industry does transition. To achieve this they must prioritize systematically and target their efforts initially at those markets, industries and customers that offer the best chance for quickly reaching critical mass. But a correct strategy is a necessary but not sufficient condition for success…”
Even if a company has recognized the difficulties and investments required for a transition and can set priorities, when and how to execute and how to manage both timing and execution risk remains a major management challenge. Not least a company risks making large investments, increasing overhead while cannibalizing existing revenue -hardly an initiative that goes down well with top leadership or shareholders. Nevertheless, it may strategically be the right thing to do. More on this in future articles.
* For a deeper explanation see Outcome / Performance Based Services and Contracting: A Briefing for Managers
** Many studies have shown reversals in profitability of companies as degree of servitization towards value added services increases, however the reasons are not always clear. Two of the main reasons are increases in required overhead and investment in knowhow and loss of prior revenue producing services, which are now delivered as part of an outcomes based package. True providers can partake in the upside, however the degree to which that is possible might not, probably will not, compensate sufficiently.
*** One should bear in mind that healthcare has the peculiarity that the direct customer, the patient, usually does not pay directly for services he receives –the insurer does-, but indirectly through ever increasing premiums – and there is no difference in reality (outside of redistribution effects) whether this premium is paid to a private insurer or a government mandated, compulsory scheme . Therefore very often the patient is not fully aware of the cost of the treatment service that he receives or buys, which is rather different from industrial contexts where the customer bears the direct cost, is aware of it and tries actively to reduce it. The cost escalation in healthcare has therefore been greater, nevertheless this is counterbalanced by stronger competitive pressures in industry, which force suppliers to act.
***Many studies have shown reversals in profitability of companies as degree of servitization towards value added services increases, however the reasons are not always clear.
Pricing in Services articles: