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The services operations of industrial OEMs (Origi-nal Equipment Manufacturers) have developed favorably during the last 10 years, but the appar-ent success has been driven mainly by growth in installed base. Looking forward, companies will need to make a leap to create monetary value from the intangible part of their offerings. Such a leap requires decisions on the highest level, where
the insight about value drivers in services gener-ally is low. To make a lasting performance leap, industrial OEMs will therefore need to increase transparency about service contribution and po-tential, become truly value-focused in their busi-ness model, allow for investments adequate for a services business, and create financial equality for services.Ö
Whitepaper OEM Services
Authored by Jonas Strömgård and Bo Johannisson
www.differ.se
A leap across the abyssThe new imperative for industrial OEM services
2 | A leap across the abyss www.differ.se
Today, any industrial corporation seeking investor confidence will emphasize its focus on the aftermarket. A review of official investor communication over the last 10 years shows that attention and space devoted to aftermar-ket and services (or similar activities) for Nordic OEMs has more than doubled over the period. Looking at the financials, aftermarket revenues have grown at an average CAGR of close to 5% since before the financial crisis, thereby significantly increasing their share of total OEM revenues, see Figure 1 below. Margins have remained healthy and less volatile than for new product sales. Also companies selling components and consumables, whose ser-vice activities often are embedded and not an explicit business, have grown their service activities considerably over the period.
But what are the dynamics behind the ap-parent success and what learnings should we keep in mind going forward? Building on a similar study conducted ten years ago, our current study looks behind the financials to get a long-term perspective of the Nordic industri-als’ efforts within aftermarket and services.
Satisfactory results, but no real transformation
In 2004, the focus on aftermarket and ser-vices had just begun. Following the then
recent transformation of the IT and Telecom industries, many industrial companies were about to set up separate profit and loss units for the services operations. We could see a “one-size fits all” approach, where aftermar-ket and services’ share of total business was the dominant measure of success. Ambitions were high and many new services were on the drawing board, but services development investments and top management involve-ment were still lacking.
Now, ten years later, we find that growth has been mainly driven by growth in the installed base of the OEM’s own equipment or vehicles. The exceptional growth in the first half of the period came to a halt with the financial crisis. Since then, the decline in Capex spending in Europe and North America has been partly offset by growth in emerging markets, espe-cially in the BRIC countries (Brazil, Russia, India, China), where a large share of capital sales adds new units to the installed base.
In addition, companies have captured some of the “low-hanging fruits” following from the previous lack of proactivity and profession-alism. Pricing of parts and consumables has been improved and maintenance contracts are now proactively sold to customers. These and other measures have increased the over-all market share on the installed base to some extent.
OEM Services
Aftermarket and services’ share of total sales has increased since 2007
Figure 1: Development of aftermarket business as a share of total sales for selected Nordic OEMs
|
0
5
10
15
20
25
30
35
40
45
50
55
2013 2012 2011 2010 2009 2008 2007
Metso
Volvo Alfa Laval2
Ericsson Wärtsilä
ABB
Cargotec SCANIA
Total average3
Atlas Copco Kone
ASSA ABLOY1
%!
Av!31%"
Av!35%"
%
1.Business area Entrance Systems; 2.Share based on order intake; 3.Total average also include Sandvik Mining (45% 2007, 53% 2013) and SKF Service Technologies & Industrial Solutions (2,8% 2007, 4,0% 2013)
Ö
OEM Services
www.differ.se The new imperative for industrial OEM services | 3
In contrast, the development of value-added services, beyond standard maintenance contracts, shows surprisingly little progress. 10 years ago, brave ambitions were expressed in areas like process consulting, customer training, remote monitoring, multi-vendor main-tenance, services outsourcing and perfor-mance-based contracts. Our study shows that very few have managed to create any substantial business within these areas over the period, see Figure 2.
Trapped in the services catch
Looking forward, OEMs will face increased market pressure in the spares and consuma-bles market, caused by:
• Slowdownininstalledbasegrowth,asthe BRIC countries gradually mature• Increaseinaveragelifetimeofparts, reducing demand• Increasedglobalpricetransparency, putting pressure on the high OEM parts margins• Loweredentrybarriersforme-too,“pirate”, parts suppliers, as new technologies such as 3D printing trigger competition also for custom/ drawn parts with low volumes. The OEMs’ response to this needs to some-
how include services. Some firms have cho-sen to work exclusively with external service channels, but there is a clear trend towards building in-house service capabilities. It has proven difficult to control the service quality of external partners, and OEMs are afraid to lose access to end-user insights and relationships. Most study respondents have also come to the conclusion that further growth in the parts business will need tighter bundling with ser-vices. However, our study shows very modest growth in service contract coverage, and even slower growth in other service areas. Based on these findings, we conclude that OEMs’ have difficulties to add value in servic-es to balance out their cost disadvantage. The average hourly cost of OEM service is of-ten 2-3 times higher than competition, whether that is a local service provider or the custom-er’s own in-house service staff.
What we find is that the services part of the OEM’s offering is often not competitive in itself, but is made possible only through bun-dling with high-margin spares, or sometimes through regulatory entry barriers for non-OEM service providers. This fact is not evident in the
Figure 2: Illustrative breakdown of Aftermarket and Services development 2004-2014
Aftermarket and service business
2004
Installed base
growth
”Low-hanging fruits” like
pricing and proactive
service contract
sales
New value-added service
2014
” What we find is that the services part of the OEM’s offering is of-ten not competitive in itself, but is made possible only through bundling with high-margin spares.
Ö
figures, as the “intangible” part of the aftermar-ket business is rarely reported separately. As one study respondent put it; “our high parts margins cloud poor service performance”. In our view, the root cause of this problem lies in the overall setup of an industrial OEM. Al-though most companies casually use market-ing taglines like “product, service and solution provider”, they are still employing business and operative models geared only towards prod-uct sales. This is illustrated in Figure 3 below.
Our analysis shows that for most OEMs, there is a negative development of the contract margin by the increase of services (intangibles such as labor and software) and 3rd-party products in their customer offer. This relation-ship is valid for both capital and aftermar-ket businesses. For instance, large capital projects, which normally include 3rd party products and services such as installation, in-tegration, start-up, training and commissioning, will be less profitable than sales of the same volume without the services. In the aftermarket, a pure spare parts contract will have higher margins than a maintenance contract includ-ing parts for the same volume.
This means companies will only have the incentive to perform services, or integrate foreign products, if this can boost or protect their own product business, and they will not perform more services than necessary. Services costs and profitability will not be measured properly and service staff will be
seen as overhead rather than contribution units. As a consequence, the services busi-ness will not get sufficient investments and will not attract the best people. Service contracts will not add enough customer value and will continue to be a hard sell. Value-added services will not take off, since these offerings usually include little or no own products, etc. It becomes a vicious circle that we call the “services catch”.
Since many OEMs are dependent on after-market and services for continued growth, we believe this catch is the main challenge facing industrial companies in the coming years. Although definitely no quick fixes, there are still ways to overcome the obstacles.
A leap across the abyss requires alignment with the investors’ perspective
To address the challenge, OEMs will need to change the slope of the line in Figure 3, i.e. they need to learn how to make money on intangibles. Please note that this proposition is valid for all companies, regardless of business model. We are not suggesting that all industri-als should charge explicitly for intangibles. We are merely saying that the contribution of labor and software should not dilute profitability. Large corporations like Ericsson and SKF have shown that industrial OEMs can build a sub-stantial and profitable services business that is not dependent on bundling with high-margin spares.
However, our experience as advisors in this field over the last 15 years leads us to the con-clusion that there is no gradual “step-by-step” development path to services competitive-ness for industrial companies. Making the nec-essary changes in business and operative models is a structural transformation that will affect many parts of the organization, a leap that needs to replace rather than complement current practices. Such a move always means
Figure 3: The services catch – negative margin contribution from services
and 3rd party products
Operating Margin
Expected operating margin in a product-centric business
Share of service and 3rd party product included in contract
0% 100%
” There is no gradual “step-by-step” development path to ser-vices competitiveness for indu-strial firms. Making the necessary changes in business and opera-tive models is a major transfor-mation, a “leap across the abyss” into services.
Contract Margin
4 | A leap across the abyss www.differ.se
OEM Services
Ö
taking short-term risks for longer-term benefits, especially when the current product-centric practices seem to be working fairly well.Many managers working directly with services in OEMs share this insight and conclusion al-ready. However, a leap of this magnitude re-quires decisions on the highest corporate level, where insights about the dynamics of servic-es value creation generally are rather shallow. Here is a gap to fill.
To better understand this gap, we interviewed board members and institutional investors fo-cused on the Nordic manufacturing sector for this study. Since the results of OEM’s aftermar-ket efforts so far have been rather satisfactory, investors have had no urgent need to chal-lenge the progress. However, concerns are raised by investors about the lack of clarity and transparency in the services business. These investors are used to scrutinize the product strategies of industrial OEMs. Bold growth targets must be backed up by visible investments in R&D and production capacity, both of which can be found in traditional finan-cial statements. A pure spares & consumables business is relatively easy to incorporate into the valuation models, but investors are less familiar with the dynamics of a services busi-ness, and what indicators to look at to critically evaluate companies’ future ambitions and growth approach in services.
Making the leap – transparency, value-orientation, adequate investments and financial equality
Based on the findings from our study, along with the additional investor perspective, we can devise an agenda prescription for Nordic OEMs. Four areas of change have been identified, each contributing to the overall transformation. They can be viewed as differ-ent enabling tools, each challenging current practices to some extent and all necessary to carry the organization over the abyss and make the leap.
1. Specify the abyss - increase service business clarity and transparency
The first step is to bridge the transparency gap in the contribution and potential of services, with a focus on intangibles. First of all, market sizing and share estimations for services are often very vague, especially when compared to the main product markets. Investors are rarely impressed by statements like “our customers spend 10 BUSD on mainte-nance annually” when everyone knows that only a small part of this market is realistically addressable to the OEM. Market analysis should be performed with the same rigor as for the main product market.
Figure 4: Four enablers of change to make the leap
Specify the abyss Increase service business
clarity and transparence
Make the leapEnsure truly value-oriented
business models
A steady flightAllow for adeguate
investments for services
Soft landingCreate financial equality
for services
OEM Services
www.differ.se The new imperative for industrial OEM services | 5
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Secondly, many services generate limited sales or are implicit, i.e. not charged to the customer but used in pre-sales, as brand builders or enablers of other business. The contribution of these services needs to be visualized and controlled, e.g. through com-parison of the overall development of ac-counts with and without certain services. Such KPIs are vital to justify investments in services development, but very few firms use them today.
Thirdly, the true costs and profitability of ser-vices must be properly measured. Unlike prod-uct costs, which are mainly tangible and hard, services costs are soft around the edges. Service offerings are not clearly defined in the systems and service labor, especially white-collar staff, is often seen as cost of sales. Costs of software used in provision of services are seldom fully accounted for.
Improving clarity in this way will enable more accurate target setting and internal control, as well as improved communication with boards and investors around services.
2. Make the leap - ensure truly value-orient-ed business models
Most OEMs have some kind of program for val-ue selling, which clearly is a step in the right direction. Understand-ing the provided value gives many advantages. A focus on value argumentation in the sales phase will, in the end, improve the business outcome for both the customer and the OEM, as it puts pres-sure on the service organization to perform to the quality standards required for a premium-priced services business.
However, our experience shows that a gen-eral value orientation alone is not enough to impact the slope of the “services catch” line. To succeed on a broad scale in value argumentation for services, companies need to somehow align the pricing model. In the traditional pricing model, OEMs make more
money when their products break than when they work, and they discount a large share of the customer-perceived value (the intangible part) to enable high margins on physical prod-ucts that sometimes have very low perceived value. This sends the wrong signals to the customer and creates distorted incentives for the own organization. Of course, not all ser-vices can be value-priced, but most services can introduce some sort of value-oriented price element. In risk-averse industrial companies, linking parts of the price to a customer outcome will face large internal resistance. Systems and processes are poorly configured for this type of business and product managers will insist on knowing their margin at the time of the sale. Making this move will therefore require strong leadership from the highest level and willing-ness to take short-term risks for long-term benefits. In other words – it takes a leap.
3. Make a steady flight - allow for adequate investments to increase value and compet-itiveness of services
To enable the necessary investments for services competitiveness, there is a need to understand the dynamics of ser-vices performance. To some extent, investments in services development can be tangible, such as engineering of new software or erection of new workshop facili-ties. However, the most important investments in services do not show up as assets in the balance sheet, since services are depend-ent on people and their capabilities. Service employees are potential profit units and must be treated accordingly. The services “factory” must often be built (hired and properly trained) before it can generate revenues. New service offerings must be developed, packaged and deployed globally. Structural intellectual capi-tal must be developed to enable scalability of knowledge services, etc.
In industrial OEMs, these types of investments often show up as operational expenses and
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6 | A leap across the abyss www.differ.se
OEM Services
are not built into investment cases that can be made visible to boards and investors. The necessary change of practices will challenge traditional investment calculation principles and the prevailing view on SG&A costs, and will thereby fulfill our qualifications for a leap.
4. Monitor the landing - create financial equality for services
The final and most dif-ficult part of the leap towards service com-petitiveness concerns the firm’s basic earning mechanism, i.e. what KPIs are used by management to ensure overall profitability. The negative slope of the line would not exist if product and service were treated equally from a controlling per-spective. However, as stated above, products are hard while services are soft. Products are easy to define, aggregate and control. Global targets for product margins can be easily de-rived from the overall ROCE (Return on Capi-tal Employed) targets set by the board. The supporting controlling mechanisms have been refined over decades in industrial firms. None of this tends to be true for services.
This means that even when intangible offer-ings are defined, packaged and recorded correctly in the systems, they still tend to be discounted or given away in sales, to se-cure product volumes and margins. Account managers may argue that overall customer margins are satisfactory. However, the deci-sion to discount services, either explicitly to the customer or internally through allocation of overall contract revenues, reinforces the view that services are less important than products.
The first step to create financial equality is that all services provided to customers should be recorded and charged at internal “trans-fer price” to the accounts. This price should include a small margin to create pressure on account managers, just as the transfer price from production units do for physical products.
Secondly, overall account margins should be the dominant KPI to track and control.
Discounts should be related to the overall contract volume and distributed proportionally between products and services.
Thirdly, financial targets should be revised to reflect the uniqueness of services. Intangible offerings usually do not tie up nearly as much capital as physical products. A pure labor-based business will make handsome returns also at operative margins well below 10%. Furthermore, services are hard to scale rap-idly, and must often be deployed and refined gradually in the market to succeed. Payback requirements shorter than 12 months, which is not uncommon in industrial firms today, effec-tively kills most initiatives in services.
Just like no physical tool alone will carry you safely over the abyss, our four leap enablers should not be seen as a menu to pick from. They need to be interlinked in a coherent program of initiatives to reach a sufficient combined effect.
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Services are crucial to continued growth of Nordic industrial OEMs, but current approaches are stalling. Awareness and action must move from the service department to the highest level. Our four leap enablers can help companies out of the “Services Catch” and unlock the true shareholder value potential of industrial services.
OEM Services
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Jonas Strömgård Director, Differ Head of Industrial Practice
Mobile: +46 (0)736 88 96 31
Bo JohannissonIndependent strategic advisor
Mobile: +46 (0)706 89 23 [email protected]
Whitepaper OEM Services
Differ is a consulting firm focused on demand side strategy. Our service offering covers the entire revenue generating process. Differ’s 20 year history includes management consultancy Xlent Strategy and brand consultancy Differ. We are part of Xlent Consulting Group. Please find more information at www.differ.se
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