Author: Kalle Aerikkala
A study of seven leading industrial manufacturers based in Europe shows a clear correlation between overall organizational profitability and the share of total business delivered as aftermarket services. Moreover, a healthy aftermarket service business offers commercial stability in periods of high market volatility. This has played out in the current COVID-19 pandemic environment with companies who maintain the highest share of aftermarket service business able to retain high profitability. Companies need to continuously invest in the aftermarket service business to ensure a more stable and recurring stream of profit., as the author explains, as he provides pricing insights that can be applied across multiple industries. Kalle Aerikkala, Senior Consultant at Vendavo, has worked in the pricing and product management profession for the last 12 years. He can be reached at kaerikkala@vendavo.com.
The Journal of Professional Pricing, September 2021
A study of seven leading industrial manufacturers based in Europe shows a clear correlation between overall organizational profitability and the share of total business delivered as aftermarket services. The study analyzed average EBIT% over the last 2 full reported years for companies that separately report their share of aftermarket service sales. The results clearly demonstrate that investing in an aftermarket service business is a winning and profitable strategy.
EBIT% VS SHARE OF AFTER SALES BUSINESS
Moreover, a healthy aftermarket service business offers commercial stability in periods of high market volatility. This has played out in the current COVID-19 pandemic environment with companies who maintain the highest share of aftermarket service business able to retain high profitability (see chart). The impact on those companies is consistently lower when compared to their industry peers with smaller aftermarket business. As the frequency of major disruptions continues to increase – from trade disputes, impact of climate and political instability – so the need to find drivers of business and profit stability becomes increasingly important.
Companies need to continuously invest in the aftermarket service business to ensure a more stable and recurring stream of profit. Dedicated investment in the aftermarket service business is needed to give it a chance to grow, rather than considering it an afterthought. Start with a maturity assessment covering the various areas of the aftermarket service business. Maturity should be evaluated from both aftermarket service business categories – such as service contracts and on-demand spare part support, as well as from functional perspective – covering logistics and commercial excellence.
CHANGE IN EBIT% 2020 H1 VS 2019
Historical Journey of Aftermarket Service Business Within a Manufacturing Company
Historically, the aftermarket service business in industrial companies has followed a development path that starts with “service as a necessity” (i.e., to support warranties or repairs), but not considered as a revenue and profit generating business worthy of focus. In this stage of maturity, the critical next step is the development of organizational capabilities: building the right teams to create a platform upon which the aftermarket service business can grow. This is the beginning of the shift in the organization’s mindset to perceiving aftermarket services as a key value driver delivering benefits for the whole company.
The next step is to promote the aftermarket service business into a stand alone entity with a Head of Department and links to the main business through technology. At this point, the investment is focused on functional aspects of the aftermarket service business: commercial excellence logistics, technical support and development of new business models.
Once the aftermarket service business reaches maturity, the next step is actually incorporating it back into the rest of the business. Aftermarket services are seen as an integral part of the overall offering and a way to differentiate in the market. Investment is now focused on creating leading capabilities in the most important functions. However, any competitive advantage gained can be short lived without continued development.
Innovation around new business models delivering enhanced customer value will be key to maintaining a competitive advantage.
The development of a service centric business is the final step in the process and will completely transform the structure of the organization. Service takes the lead and is supported by the technology that itself used to be the main business. In recent years, a trend has grown of new market entrants leapfrogging directly to a service-led thinking. This is done through business models that no longer use the classic sales / aftersales split, but instead have adopted subscription-based business models from the outset. This jump has been made possible by advancements in both technology and finance.
How the Aftermarket Journey is Changing
Leapfrogging the aftermarket service business maturity ladder has become easier through developments in technology. These open new possibilities to establish aftermarket service business models as the core strategy of any company. One key technological enhancement comes from the Internet of Things (IoT) that that enables remote equipment condition monitoring and, in time, remote break-fix support agreements with the accompanying subscription-based business models. In reality, we are a long way from completely automating all maintenance tasks, but a significant proportion of onsite visits by an equipment specialist will be replaced in the near future by remote support. This in turn will create both significant pressure, but also the opportunity for business model innovation around technical support and aftermarket services. This is especially true for those companies proactively investing in new technology and ways of working. The changing perception of ownership is also a driver for this change. Companies are tending towards ever more “asset-light” models in an effort to optimize their cost position and margins.
The evolution towards subscription-based business models in industry brings challenges with it. One major consideration is the impact to the balance sheet. Selling capital heavy equipment as a service requires specific risk management practices and investments in product development. For example, manufacturers will need to ensure that products become modular and transferable from one customer operation to another in case the service agreement ends before the useful lifetime of the equipment itself. Transferring ownership from the “user” of the equipment to the supplier also has an impact on the user’s business. When outsourcing major parts of the operation and maintenance activities, expertise and knowledge will be transferred to the equipment providers, away from the operational organization. This shift will enable the equipment provider to work towards gaining more of the total value created. This redistribution will not happen without specific investment in commercial excellence capabilities within the aftermarket service business. Success will be determined by the ability to set and capture the right value for the services delivered.
All these changes create vast opportunities for organizations to adopt new ways of service centric working without needing to follow the traditional maturity step process. However, without dedicated investment into developing the aftermarket service organization whether as a completely new company or as a part of the corporate entity, long term success will not be easily achieved.
Some things need to remain consistent.
Even though many elements in the aftermarket service business are going through dramatic changes, there are areas that need to remain stable. It is appropriate to understand the cornerstones for continuity and link current business models to the new ones. Examples include:
- The need for value creation for multiple user groups of industrial equipment
- Diverse commercial strategies within industrial equipment users requiring a differentiated service portfolio
- Equipment will still need maintenance delivered through an onsite presence
1. The need for value creation for multiple user groups of industrial equipment
To successfully serve industrial customers, regardless of the business model, the solution must provide value to the various user groups; operators demand ever easier adoption and self-maintaining equipment. The production output from the equipment should be easily scalable to allow volumes to be ramped up or down according to business cycle. The fundamental elements of value creation will remain regardless of whether the equipment is sold or is part of subscription offering.
In considering the introduction of new business models, it is critical to align this with your customer’s own strategy. Two elements have an effect here: willingness to pay and willingness to outsource. Willingness to outsource is the customer organization’s ability and strategy when it comes to operational capabilities. Willingness to pay measures the customer’s propensity to pay out a fair share for the value created.
2. Diverse commercial strategies within industrial equipment users requiring a differentiated service portfolio
There will always be customers who want to maintain ownership for at least some part of the operations and maintenance, as they see those as core competencies contributing to their overall competitive advantage. In addition, a company may follow a strategy to only pay for minimal external services while focusing on lowering the direct cost of operations to a minimum. These different scenarios demonstrate the need for a fully differentiated service portfolio.
3. Equipment will still need maintenance delivered through an onsite presence
Regardless of concept or ownership model, the physical tasks to operate and maintain the equipment remain. This again requires constant investment in teams who can either perform the maintenance within the organization or provide support for other organizations to carry it out.
Business Model Innovation
There is a growing need to develop new ways of working and looking at the aftermarket service business. This requires innovation.
What defines a business model?
Clay Christensen suggested that a business model should consist of four elements: a customer value proposition, a profit formula, key resources, and key processes. Let’s take this definition to examine the aftermarket service business.
When advancing through the maturity stages of the aftermarket service business, it is important to periodically consider what parts of the business model need to be adapted in order to create long-term, sustainable competitive advantage. An important aspect in considering what needs to adapted is in fact to look at what elements need to be removed. Over time, a business model can become too cumbersome and complex because, as new layers are added with each adaptation, nothing is removed. This tendency of preferring additions to removals stems from a general business tendency to (over) value existing concepts due to the significant investment made. Adopting a sunk cost mentality will lead to faster trimming of unwanted complexity.
This can also be the reason why new entrants are faster to the goal than incumbents. Not because of superior development, but simply because they do not have to fight with letting go and coping with institutional debt. If tweaks are not sufficient, then a complete redesign of the whole business model may be necessary.
CLAYTON MAGLEBY CHRISTENSEN
Clay Christensen was an academic and entrepreneur who worked successfully in both worlds. He published his most influential work as professor in Harvard Business School, including ”The Innovator’s Dilemma” which introduced the concept of disruptive innovation that has shaped business in significant way.
Customer Value Innovation
The Customer Value Proposition is at the heart of every business model. The key question is what customer problems am I solving? For traditional aftermarket services the answer to this question has been clear: services are offered to keep or restore equipment to an operational state. The overall customer value proposition is, however, more complex. In aftermarket services it also includes the availability of the physical good or service as both are needed at short notice by customers. The level and availability of expertise and the way customer relationships are handled are both important factors in the value proposition. These elements need to be evaluated against the competitor’s position to determine not just the completeness of the value proposition to customers, but also the level of value differentiation compared to other players in the market. If the customer base is diverse, it may require multiple value propositions, separated by channel, brand or some other distinct concept. When updating the customer value proposition, it is prudent to examine the effects of change on the profit formula, processes and resources. Changes in the value proposition commonly cause changes in these elements as well.
Investment in organizational capabilities is needed to ensure continuous renewal and innovation of the business model. Increased capabilities are prerequisite for advancing through the levels in aftermarket services maturity.
Value Proposition in Service Level Agreements and Subscription Services
In considering the different service level agreements or subscription services, the customer value proposition needs to be viewed through different lenses. This will depend on whether the offer is the primary business model or if it is being considered as an alternative model sitting alongside traditional aftermarket services. Where the organization has leapfrogged to the last 2 levels of the aftermarket service maturity model and selected to only offer services through agreements or subscription model, then the customer value proposition needs to be defined purely based on the outcome of how the equipment is used. The value outcome pricing model may also take external factors into consideration: e.g., the consumption rate of inputs or the quality of output. If service models are offered in parallel to the traditional approach, the value proposition should be tailored to those segments that have been identified as the best targets for subscription service level agreements. Remember: not all of your customers want to leap to the same model at once. This will enable a more precise definition of the value proposition but will also challenge the organization to look at other elements of the business model and check for relevance.
Profit Formula
The business model profit formula includes1:
- REVENUE MODEL – PRICE X VOLUME
- COST STRUCTURE – VARIABLE AND FIXED COSTS
Out of all the factors, price is by far the most influential. Set too high, volumes will not materialize. Set too low, assuming a consistent cost structure, then profit will not be achieved. There are numerous techniques available to aid in the process of setting the right price. The most important consideration is simply the alignment to customer perceived value. In practice, this means that price setting needs to carefully consider both the value delivered and the competitive alternatives. Customer value is not uniform across all customers, and neither is the competitive landscape.
This requires a systematic approach and platform to match the differentiated value a customer perceives with the recommended price. Modern technology is important in supporting these methodologies, especially given the high volume of products to price, and in driving a long-term sustainable advantage. However, technology alone is not enough. Focus on organizational maturity and development is needed to ensure that these improvements are cascaded throughout the organization. Marketing operations need to make sure that the price is strongly tied to the customer value proposition. Lastly, the price must be consumed and understood by sales teams who need to justify the position in front of a customer. Innovation in pricing models can open completely new business opportunities that were not viable with old pricing models.
1Clay Christensen also introduces other factors, but we focus on the core elements
PLANNING FOR VOLUME AND COSTS
Linking price to differentiated value is a fundamental process that needs to work. It also creates a starting point to define the cost structure needed to successfully execute the business model. Supply chain and logistics optimization is a key role to manage the cost structure. Typical aftermarket service organizations recognize a need to develop and invest in these capabilities in the second level of maturity. Development done here will carry forward into the future as the foundation for future service level agreements and subscription business.
FROM OPERATIONAL EXCELLENCE TO COMMERCIAL EXCELLENCE
Focusing on all elements of the profit formula requires a shift from function-based operational excellence to cross-functional commercial excellence. Commercial excellence maturity can be seen to develop along the same lines as the overall aftermarket maturity, but it can and should be measured in a more detailed way based on several dimensions. These dimensions include: customer, product, pricing, sales and analytics.
KEY RESOURCES
Key resources are defined in the literature as the most important resources, whether organizational, buildings, technology or other that ensures that the customer value proposition gets delivered. In aftermarket services, ,key resources in the traditional sense would be the assets securing support availability such as stocks and pools of highly skilled support personnel. Focus needs to shift from not only the availability of highly skilled technical
resources to also a platform for operation support and the development of partners to scale the business. Aftermarket service teams can learn from consumer service concepts where modern technology is used to coordinate, manage demand, and allocate capacity in an optimal way. The equipment itself will become a key resource in outcome based commercial models, and this will in turn highlight the need to consider the maintainability and total cost of operations even further. The same shift also makes equipment’s design and delivery teams key resources is aftermarket services, making this an important consideration in organizational development initiatives.
KEY PROCESSES
Breaking down organizational silos as a common way of working will be the winning concept for the future. Businesses need to focus on delivering value to the customer and setting the right metrics. They will need to focus on process development to:
- Improve remote support capabilities
- This shift can be seen initially as a process change. Thereafter, innovation in the business model will create sustainable profitability.
- Improve purchasing and logistics
- In many organizations where aftermarket services are separate business, these functions are organized independently from the equipment business. These should be combined to leverage overall economies of scale and share expertise.
- Pricing
- In lower levels of maturity, pricing processes of aftermarket services and capital sales of equipment are separate. When taking on subscription-based revenue models, this in no longer possible.
- Sales and pricing activities can act as change agents for the all processes in the aftermarket services and therefore merit special focus and investment.
Driving process change within aftermarket services can be challenging in the lower levels of aftermarket service maturity as it is difficult to get the appropriate levels of management attention. Focus on developing key processes will become a source of sustainable competitive advantage and should be managed in a long-term roadmap and plan.
In Conclusion
- Market research of leading industrial equipment manufacturing companies reveals that investment and focus on aftermarket services will boost company profitability and create a platform to navigate disruptive market situations
- Investment in the aftermarket needs to focus on both organizational and technological aspects
- Investment should aim to drive innovation in business models as a way of achieving competitive differentiation
- Business model development needs to consider both areas that need to be removed from the companies offering, as well as developing new concepts
- When refining the business model, start with the customer value proposition, then think about price and define the cost structure, resources and processes to support them