THEMES – SERVITISATION
Manufacturers are embracing servitisation as a means of generating revenue based on the reliability and durability of their equipment, writes Charles Orton-Jones
The European Commission has a bit of a problem. When regulating imports and exports it needs to decide whether the transaction involves goods or services. Yet today it is hard to discern whether certain trades are one or the other. Manufactured goods are supplied as a service, complete with care packages, upgrades and other necessities. Lucian Cernat, the chief trade economist at the Commission, notes in a paper on the subject, “A growing share of manufacturing goods can no longer be simply referred to as ‘goods’ but should be regarded as a complex bundle of products and services interactions”. It’s a business model known as ‘servitisation’.
Rolls-Royce pioneered the concept. It used to sell aircraft engines as individual products, paid for in a one-off transaction. Then in 1997 Rolls-Royce switched to a long-term care package concept. The service agreement covers all and any work. If there are any repairs to be done Rolls-Royce engineers conduct the work at no extra cost. The engine can be completely replaced, if needed, with no surcharge. Users pay for what they use, and no more.
Rolls-Royce expanded TotalCare as the strengths became apparent. Under the ‘servitised’ contract incentives are converted from low-reliability to high-reliability. Rolls-Royce used to get paid when engines broke down and they could fix them. Now they are rewarded for durability. The cash-flow for both parties is smoothed. There’s no huge capex outlay for buyers. And Rolls-Royce enjoys recurring revenues year after year, in a predictable pattern.
By 2014 a total of 90 per cent of the Rolls-Royce Trent engine fleet was under TotalCare. In a customer satisfaction survey three-quarters cited increased availability of engines, 83 per cent highlighted predictable costs, and 72 per cent called the deal “value for money”. The ongoing communication engendered by a service package changes the nature of the vendor-buyer dynamic. Rolls-Royce found 87 per cent of TotalCare customers felt the service model had improved their relationship.
The model has coincided with a period of extraordinary performance at the engine maker. During Sir John Rose’s tenure as CEO from 1996 to 2011 total shareholder returns totalled 373 per cent – and that included the bleak post-9/11 airline market, and 83 per cent under his successor. The share price suffered in 2016 but rallied at the end of the year.
COUNTLESS COPYCAT SERVICE MODELS
The success of Rolls-Royce triggered countless copycat service models. Caterpillar has charged for tonnes of earth moved. GE charges for pounds of thrust by its jet engines. Reg Kenney, president of engineering and manufacturing at DHL, works with many Fortune 100 companies on their supply chain, and he believes the trend is justified by the outcomes for both parties. “At DHL, we’ve noticed a clear trend emerging in the industry towards more service-oriented business models.” says Kenney.
“This is being driven by three things. First, the fact that manufacturers must meet new and changing customer demands. Their customers want more value-added services and now expect continuous care beyond the point of sale. Let’s take the example of a jet engine purchase. The purchaser is increasingly likely to insist that the manufacturer includes maintenance, repair and even upgrades in the deal.
“Second, there is the ever-present need for manufacturers to control costs. But they’re operating these days in a challenging and uncertain economic landscape with fluctuating commodity prices and increasingly saturated markets. Given this environment, many manufacturers find that developing a new service offering is less risky and less asset-intensive than developing a new product.
“Third, manufacturers are now able to access more data in the supply chain. With this information, they can move from a ‘to-stock’ business model to a ‘to-order’ business model. Manufacturers can reduce their inventory because they can predict when a product or part will be needed and they can manufacture any required items on demand. This capability is enhanced by using intelligent parts – in effect these are items that anticipate and communicate their own status and maintenance needs.”
This analysis is supported by manufacturers. JCB enthusiastically offers service, repair and maintenance deals on plant kit. It calls the model the “the ultimate risk-free method” of acquiring, running and maintaining vehicles. Costs are capped. It’s tax efficient. Working capital is preserved.
Martin Leeming is the chief executive of TrakRap, a packaging machine maker based in Lancashire. He reports the service model has changed the way customers use his products, and how they regard his company. “In the traditional model, a customer buys a piece of packaging equipment and they’re stuck with it,” says Leeming. “Even worse, they will usually use it for a long time after it’s fully depreciated, because the equipment is not high on the list for capital expenditure or because the perception is that it’s cheaper to maintain it. Either way, the pace of technological change means that, in the bigger picture, they miss out on vital advances in productivity, energy saving, reliability and cost improvements.”
By shifting customers to a rental model, backed by aftercare, the entire approach changes. Customers want to upgrade as soon as possible. “We are aligned to our customer’s objectives: if it breaks down, it costs us money to fix it, so we are incentivised to make the product super-reliable. When a customer increases the speed of their production lines, we upgrade our equipment to suit. Over the last four years, one of our partners has increased production from 16 to 28 packs per minute. We have worked with them to constantly upgrade our equipment without the need for any capital expenditure. By offering our customers this pay per wrap structure, our relationship moves more to one of partners rather than client and supplier.”
MAKING THE SERVICE MODEL WORK
Naturally, the contract is the key to making the model work. Leeming is happy to explain how he’s shaped his contract offering. At the start comes a cost for packaging film consumption a year. This is then divided into fixed monthly payments over a fixed term, usually five years, but with a ‘walk away’ clause after two and a half years. Siemens Financial Services takes care of the leasing arrangements. Lemming says, “The customer gets improved margins and reduced energy costs with no capex, and no requirement to maintain the asset, so a better return on net assets.”
The technical challenges of the servitised model are considerable. For a contract to work smoothly it is essential that the vendor know how their equipment is being used. Typically,
sensors report usage data back to the vendor over the internet. Data analytics is used to identify behavioural patterns.
This has led to companies like GE re-imagining themselves as digital-first enterprises. As CEO Jeff Immelt said in 2014, “All companies need to become Internet and software companies. The industrial world is changing dramatically, and those companies that make the best use of data will be the most successful.”
Each year Cranfield University hosts a course on implementing servitisation technologies. Professor Ian Jennions, who runs the course called Asset Management: coupling business and technology, says the model comes alive when all aspects of the chain of action are mastered. “The chain is sense, acquire, analyse, and react. You start with sense, using sensors to gather data. Don’t use too many, as ou get an awful lot of data. Then you acquire it, usually locally. Often you find you are in the wrong place. You could be on a wind turbine in the middle of the North Sea, or in an aircraft at 35,000 feet. You need this data on the ground, because by and large you want to look at it on a fleet basis. So you transfer the data. You then analyse it. And then, by exception, the stuff that isn’t conforming to what you expect, you then flag to operational control centre. We concentrate on the whole chain. There is no point putting a sensor on something if you don’t know what you are going to do with the data, or what action to take if something is going wrong.” Companies come to Cranfield to improve their use of machine sensors, and usually, says Prof Jennions, their failings are due to a neglect of one aspect of the chain.
When the process is done smoothly the potential to optimise a servitised offering is immense. Manufacturers can monitor the use of their equipment, and liaise with the user to repair, upgrade, and modify hardware before the client even realises there is a problem.
“Those that aren’t offering a servitised model will probably go bust,” says Prof Jennions. “The MD of Man Trucks was convinced by the service model, and took Man from six per cent to 12 per cent of the UK truck market by offering a service rather than a product.”
Yet, he notes, not all companies are on board. “It reminds me of Kodak and the digital camera. They just don’t want to change. The blockers we’ve seen are incredible. It can be something like an accounts department that can’t cope with a different billing system, to someone who says, ‘Oh, it’ll never catch on’.”
For those that do grasp the potential, there are umpteen ways to capitalise. Jennions points out, “One of the clever things is that you can change your model very quickly. You can change the service, despite offering the same product.” The plurality of service packages offered by companies like JCB and GE testifies to this.
In the future we’ll see a growth of new and disruptive service models. NetJets changed the private jet market by offering travel by fractional ownership. It made the idea of owning a jet outright seem obsolete. Now Surf Air is bringing a similar model to the consumer market. It offers all-youcan-fly travel for a fixed fee. Launched in California in 2013 as the first private members’ airline, Surf Air has 3,000 members with 90 flights daily to 13 destinations. In 2017 it launches in Europe, offering London, Zurich, Geneva, Dublin, Paris and Cannes for £1,950 a month. The planes are Learjets and Embraer Phenom 300 turbo-props. The engines are usually supplied on a servitised lease.
Innovations like this further blur the lines between services and manufacturing. It poses a problem for regulators. Lucian Cernat at the European Commission proposed an entirely new category of trade goods for servitisation. Since the World Trade Organisation GATS calls cross-border services Mode 1, tourism Mode 2, overseas branches Mode 3, and temporary expat workers Mode 4, Cernat suggests Mode 5: which he defines as services exports of “domestic intermediate services inputs that are incorporated in one country’s merchandise exports traditional sense but as complex bundles or hybrids of goods and services interaction”.
The Brexit negotiations will cover arrangements for Goods and Services separately. The treatment of servitised trade, booming across Europe, will give negotiators another issue to worry about.
SERVITISATION: THE UK STRATEGY
Rolls-Royce and the High Value Manufacturing Catapult launched the National Strategy in Throughlife Engineering Services in July 2016 in London. The Through-Life Engineering Strategy’s goal, says partner Cranfield University, is to achieve a 20 per cent reduction in cost, with a 20 per cent improvement in asset availability, across more than £20 billion of UK economic output: a 20:20 vision, heralding “a significant transformation of national productivity and global competitiveness”. Around 16.8% or £275.2bn of the UK economy is attributable to sectors that could be influenced by engineering services. Of this at least 1.9% or £31.6bn is potentially associated with the creation or application of throughlife engineering services. (Source: A National Strategy for Engineering Services, 2016, Cranfield University). “Within ten years many more companies will sell service capability across multiple platforms creating applications for economic growth at firm and national level,”says Prof Raj Roy, director of manufacturing, Cranfield University.
Seven critical success factors in the shift to services
- Assess your market and internal readiness: making the shift to services means all parties involved must be ready to change and understand the value of doing so
- Create the right strategic and cultural context: a service business is different to a product business and needs a completely new mindset to be instilled throughout the whole service ecosystem
- Build the structures and governance for services: firms need to make a clear commitment to services by creating properly empowered teams and the appropriate organisational structures
- Get the resources ready for innovation and delivery: short- and long-term budgets need to acknowledge that services are very resource-intensive, and change over time
- Proactively manage engagement and trust: services are co-created with customers who are active participants in the service journey
- Develop and embed service processes: firms delivering services must experiment and adapt and they need processes that enable them to do that
- Optimise services and communicate best practice: services rely on continuous innovation and so require a ‘best-practice’ mindset
Source: University of Cambridge, Cambridge Service Alliance