The servitization of manufacturing: Further evidence 1

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1 The servitization of manufacturing: Further evidence 1 Andy Neely University of Cambridge Ornella Benedettini University of Cambridge Ivanka Visnjic University of Cambridge/ESADE Business School Abstract: There is clear evidence that manufacturing firms are servitizing either adding services to or integrating services in their core products (Davies et al 2006; Neely, 2009; Vandermerwe and Rada, 1988). This paper provides an update to an earlier study (Neely, 2009) covering the global trends in the servitization of manufacturing. Using longitudinal data collected at three separate time periods , 2009 and the paper explores the changing nature of servitization in manufacturing industries. In particular the paper looks at the issue of whether the growth of servitization in China, witnessed between 2007 and 2009, has continued. Keywords: Complex services, servitization/servicisation, product-service systems Introduction: There is clear evidence for the servitization of manufacturing (Vandermerwe and Rada, 1988). This is especially the case where manufacturers are offering complex engineered products. As figure 1 shows the shift to services can be encapsulated by five underlying trends: (i) the shift from a world of products to a world including solutions, (ii) outputs to outcomes, (iii) transactions to relationships, (iv) suppliers to network partners, and (v) elements to ecosystems. The intention here is not to suggest that solutions will replace products, or that relationships will replace transactions, but instead to highlight the fact that solutions are supplementing products, relationships are supplementing transactions, etc. As manufacturers servitize they are expected to provide solutions that support or complement their products. Providers of complex engineered equipment are often encouraged to offer outcome or availability based contracts, where the provider guarantees the uptime and availability of product. These outcome-based contracts are often long-term. 1 We would like to acknowledge the support of the Cambridge Service Alliance and our founding partners - BAE Systems and IBM - for this work.

2 Hence providers are not engaged merely in transactions, but instead long-term relationships. Frequently multiple providers co-operate to support complex services. Indeed these partnership networks often coalesce around specific contracts. Organisations can find that they are collaborating on one project, yet competing on the next. The networked nature of the collaborations makes it important to consider the industrial eco-system when analyzing complex services. Issues of regulation and legislation clearly influence the way that partners work together and their respective roles and responsibilities. Figure 1: Describing the shift to services The question this paper seeks to address is how far do these trends influence manufacturing? Is the extent of servitization consistent across the globe? Is the extent of servitization consistent across industrial sectors? And how have these trends changed since 2007? The paper is deliberately descriptive in nature. Its seeks to shed light on the phenomenon of servitization by presenting empirical data drawn from a public database, the OSIRIS database. The remainder of this paper consists of four sections. The next section reviews the background literature, highlighting work that this research builds on. Following this in section three the research methodology is presented. Section four contains the results, while section five discusses these, identifying their implications for theory and practice. What do we know about servitization? In a manufacturing context the term servitization is usually traced back to the work of Vandermerwe and Rada (1988). Their paper is upbeat about the potential for services, arguing that services are sweeping the industrial landscape. Servitization is happening in almost all industries on a global scale. Swept up by the forces of deregulation, technology, globalization and fierce competitive pressure, both service companies and manufacturers are moving more dramatically into services (Vandermerwe and Rada, 1988, pp. 315). Some twenty years later Schmenner (2009) adopted a more skeptical stance, arguing that the servitization of manufacturing was not particularly new. Indeed Schmenner suggested that ever since the 1850s manufacturers have been seeking to expand into services to reduce their reliance on distributors and increase the strength of their customer relationships.

3 Operations history has much to teach us. It is the thesis of this paper that servitization has antecedents that stretch back 150 years. Supply chains, as we now know them, have always been a mix of manufacturing and service steps, but, before about 1850, these steps were accomplished by different and distinct economic actors. The innovations in the supply chains of companies in the latter half of the nineteenth century lead us straight to the servitization innovations of today; it was then in history where service begins to be bundled with goods and controlled by the same company (Schmenner, 2009, pp. 431). Interestingly the evidence base used in both of these papers is relatively sparse. The case studies used to illustrate the points made, while informative, do not really give a sense of the scale or range of servitization within manufacturing. This is a criticism that could be leveled at much of the literature on servitization, which appears to draw largely on case studies. It was for this reason that one of the authors started in 2007 to collect large scale data set on the servitization of manufacturing (Neely, 2009). Using publically available data drawn from the OSIRIS database we began to create a dataset covering over 10,000 manufacturing firms from around the world. The 2007 dataset revealed some interesting facts. First, the scale of servitization in manufacturing runs at about 30%. That is 30% of firms with manufacturing SIC codes also offer services. Second, the range of services offered by manufacturing firms is varied. The original analysis identified 12 different types of service, including: consulting services; design and development services; financial services; installation and implementation services; leasing services; maintenance and support services; outsourcing and operating services; procurement services; property and real estate; retail and distribution services; systems and solutions; and transportation and trucking services. Third, the original dataset suggested some significant differences in the extent of servitization in different countries. For example, 58% of US manufacturers had servitized in This compares with less than 1% of Chinese manufacturers. The aim of this paper is to update these findings. Drawing on two further rounds of data collection, one in 2009 and a second in 2011, this paper seeks to present the current state of play in the servitization of manufacturing. Research Methodology As previously mentioned the primary data used in this paper are drawn from the OSIRIS database. The OSIRIS database consists of financial data on 50,000 firms listed on different stock markets around the world. In January 2007 the first data set was downloaded. A second dataset was downloaded in January 2009 and a third dataset in January For the purpose of this study the only firms considered are manufacturing firms, employing over 100 people. Manufacturing firms are defined as those with standard industry codes in the range Table 1 summarises the datasets for 2007, 2009 and It is worth noting that firms with no business description and those that have declared bankruptcy are excluded from the sample. The business description is used to classify whether or not the firms offer services, so where no business description exists the data cannot be used. The data were coded using an automated coding process, developed using a grounded approach as described in Neely (2009). In essence the business description for each firm was interrogated in a search for keywords and phrases that could be used to ascertain whether or not the firm involved offered services.

4 An example will illustrate the point. The business description for Siemens, for example, mentions that the firm is predominantly involved in electronics and electrical engineering, but that it is provides a wide variety of consulting, maintenance and other services. Hence Siemens would be classified as a servitized firm. PetroChina, on the other hand, is described as a firm that is principally engaged in a broad range of petroleum and natural gas-related activities. As there is no mention of services in PetroChina s business description the firm is classified as a pure manufacturing firm. Clearly this coding process is a conservative one. The coding process assumes by default firms with manufacturing SIC codes are pure manufacturing firms unless there is clear evidence in their business descriptions to the contrary dataset 2009 dataset 2011 dataset Source of data OSIRIS database OSIRIS database OSIRIS database Nos. companies 44,000 publicly listed firms 55,000 publicly listed firms 46,000 publicly listed firms Nos. manufacturing firms 22,952 firms 27,670 firms 24,010 firms (US SIC codes 10-39) Nos. manufacturing firms 12,521 firms 13,259 firms 14,974 firms with over 100 employees Nos. firms with no business 1,478 firms 706 firms 1,077 firms description Nos. firms declaring 216 firms 222 firms 122 firms bankruptcy Useable sample 10,827 firms 12,331 firms 13,775 firms Table 1: The datasets used in the study Servitization Trends: Descriptive Statistics The first question to ask of the data is what is the trend in terms of servitization. In the 2007 sample, 29.52% of manufacturing firms were classified as servitized. By 2011 this figure had hardly changed, with 30.10% of manufacturing firms being classified as servitized. Even at a headline level this finding is interesting. There is a great deal of discussion about the servitization of manufacturing. Policy makers argue that servitization offers a route to competitiveness for manufacturing firms in developed economies. Academics write extensively about the shift to services (the current authors included). Yet the data suggests that we have not seen a significant shift to services in the last six years. To explore this observation the authors also examined in detail the share of revenues generated by specific firms from services versus products. Figure 1 illustrates the trends observed in a sample of firms drawn from lists of the world s largest firms. Data were drawn from firms annual reports. It is notable that while organisations such as Rolls-Royce are frequently lauded as good examples of servitization, the proportion of revenues that Rolls-Royce generates from services appears to have declined slightly in the period , from 53% to 49%. While for other firms the proportion of revenues generated from services have remained relatively stable. Clearly there are challenges with these data as the sample is constrained to firms that report service revenues separately in their accounts and accounting standards mean that sometimes the classification of revenue as product or

5 service revenue can be blurred, but the data raise an interesting question about how significant, or perhaps how straightforward, the shift to services is for some firms. In manufacturing firms particularly, there is also the question of how far firms can make a shift to services, especially if the services they offer are linked to their products. In some cases the sale of products has to precede the sale of associated services, for without the product sale there is no call for the service. Figure 1: Service versus product revenues Returning to the OSIRIS dataset, the next question we asked was how does the extent of servitization vary by country. Figure 2 summarises the 2007 and 2011 data. There are several notable factors in Figure 2. First, in 2011 as in 2007, the United States was the country with the highest level of servitization, although there appears to be a slight decrease in servitization levels in the United States (a fall from 57.68% in 2007 to 55.14% in 2011). Second, for many countries there has not been a significant shift in servitization levels between 2007 and Third, the biggest and most notable shift is that in China. In 2007 less than 1% of Chinese manufacturing firms had servitized. By % of Chinese manufacturing firms claimed to offer services. This dramatic growth in servitization in China is an interesting phenomenon, which appears partly to have been sparked by Government intervention. It is clear that Chinese manufacturers intend to move up the value chain, just as manufacturers in developed economies. Hence the race to innovate and offer higher value products and services will remain just that a race.

6 Figure 2: Servitization by country The third question asked of the data was what type of services are offered and has the profile of services changed significantly in the last six years. Figure 3 presents data on this issue. As Figure 3 shows, it is still the case that systems and solutions are the most common form of services offered, now followed by design and development, maintenance and support, retail and distribution. The order of frequency for these four sets of services has changed, but they remain by far the most common services offered. Figure 3: The profile of services offered The Servitization Paradox There is an ongoing debate in the literature on servitization about the financial consequences of the decision to servitize. Some authors present compelling evidence of the benefits of servitization, often basing their analyses on in-depth investigations in particular firms (Visnjic and Van Looy, 2009). Others argue that until firms achieve specific levels of service revenue they will fail to recoup superior financial

7 returns (Fang et al, 2008). Yet others highlight the challenges of servitization, arguing that the cultural and organizational shifts required mean that often firms fail to captialise fully on the opportunities services afford (Gebauer et al, 2005). To explore the question of the servitization paradox we undertook two sets of preliminary analysis on all of those firms with 2-digit SIC code 36, electronic and other electrical equipment and components. We chose SIC code 36 because this was the most common category of servitized firms and by choosing a single SIC code we could control for industry sector. Two outcome variables were used in the analyses firm profitability and market capitalization (enterprise value). Figures 4 and 5 present the raw data, while Tables 3 and 4 present the associated regression analyses. In the regression analyses we control for prior financial performance (last year s financial performance), as well as firm size (measured in terms of number of employees). Both of these control variables are associated with current financial performance and/or enterprise value, but whether or not the firm had servitized has no statistically significant relationship to either current profitability (Table 3) or current enterprise value (Table 4). Indeed, as can be seen from the raw data in Figures 4 and 5, some firms that have decided to servitize achieve superior financial results, while others achieve superior financial results remaining as a pure manufacturing firm. Figure 4: Firm size, firm profitability and servitization for SIC 36

8 Figure 5: Firm size, enterprise value and servitization for SIC 36 Table 3: Regression of firm profitability on prior performance, firm size and servitization Table 4: Regression of enterprise value on prior performance, firm size and servitization Servitization: The story so far Clearly there is more analysis to be performed on the data reported in this paper, but some interesting issues and questions emerge from the analysis to date. First it is clear that there have been widespread efforts to servitize. The data suggest that around 30% of manufacturers with over 100 employees offer services globally. They also suggest that servitization is much more prevalent in some countries although the gap between countries is closing. In % of US manufacturers offered services, while less than 1% of Chinese manufacturers offered services. By 2011 the US figure had fallen slightly to 55% - while the Chinese figure had grown to just under 20%. This rapid shift highlights that manufacturers in China will not remain as the world s workhorse, concentrating on the low value added manufacturing activities. Second, this paper presents further data that highlights the servitization paradox. We have examples of servitized firms that are extremely successful both in terms of profitability and market valuation and we have examples of firms that have

9 servitized that are unsuccessful. Across the sample as a whole we find no evidence that firms in the electronic and other electrical equipment and components industry (SIC code 36) experience better or worse financial performance by servitizing. Given that some firms do well having servitized, while others do badly, our data suggest the question of execution of building the right organisational capabilities and culture is essential to successful delivery of a servitization strategy. Perhaps the most surprising finding from the 2011 data (and the associated analysis) is the relative stability of service revenues for many firms. While there are clear signs of within country differences, at the aggregate level we still find that around 30% of manufacturers have servitized and with individual firms service revenues are relatively stable. The fact that the proportion of revenues that manufacturers receive from services has not shifted significantly in the last few years is interesting, both from a practical and theoretical perspective. From a practical perspective one has to ask what is holding back firms from their avowed intents of increasing their service revenues. Especially in recent years, with the financial crisis, one might have expected service revenues to increase as customers sought to increase the life of existing products rather than buying new capital equipment. From a theoretical perspective it seems we still need to understand much better the transformation to services, especially in terms of the business models that best enable manufacturers to create and capture value through the provision of services. References: Fang, E.; Palmatier, R. and Steenkamp, J. (2008) Effect of service transition strategies on firm value, Journal of Marketing, 72, pp Gebauer, H., Fleisch, E. and Friedli, T. (2005) Overcoming the service paradox in manufacturing companies, European Management Journal 23(1): Neely, A.D. (2009) Exploring the Financial Consequences of the Servitization of Manufacturing, Operations Management Research, 2, 1, pp Schmenner, R.W. (2009) Manufacturing, service, and their integration: some history and theory, International Journal of Operations & Production Management, 29, 5, pp Vandermerwe, S. and Rada, J. (1988) Servitization of Business: Adding Value by Adding Services, European Management Journal, 6, pp Visnjic, I. and Van Looy, B. (2009) Manufacturing Firms Diversifying into Services: A Conceptual and Empirical Assessment, proceedings of the 20 th POMS conference, Orlando, Florida.

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