SERVITIZATION AS A STRATEGY FOR SURVIVAL: AN INVESTIGATION OF THE PROCESS IN DANISH MANUFACTURING FIRMS

SERVITIZATION IN DANISH MANUFACTURING FIRMS: A STRATEGY FOR SURVIVAL? Dmitrij Slepniov* Brian Vejrum Waehrens John Johansen Center for Industrial Production Aalborg University Fibigerstraede 16 9220 Aalborg Denmark * Corresponding Author, E-mail: ds@production.aau.dk Abstract This paper focuses on servitization, i.e. re-focusing of firms from running fabrication and assembly processes to developing integrated product solutions with a large service component. The phenomenon has been recognised in the literature (e.g. Neely, 2008; Baines et al., 2009; Schmenner, 2009) and by many traditional manufacturers is perceived as a strategy for survival. On the basis of multiple cases of Danish companies, this paper discusses the main reasons and strategic implications of servitization. Furthermore, it outlines the strategies of how traditional manufacturers can recoup the desired level of return from the developments associated with servitization. Key words: Servitization, Global operations networks, Manufacturing firms, Case studies Introduction Manufacturing companies from the traditional industrial ‘triad’ of North America, Western Europe and Japan are increasingly participating in highly elaborate cross-border and interorganisational arrangements. In other words, they organise their operations in global operations networks replacing traditional vertically-integrated value chain. This shift represents one of the most identifiable trends in the manufacturing industry (Shi & Gregory, 2005; Hayes et al., 2005). There is evidence to suggest that with this trend, production activities are transferred to low-cost locations and manufacturing capabilities are gradually degrading in focal companies from developed economies (Kotabe et al., 2008; Slepniov et al., 2010). As a result of that, these companies are forced to search for new activities and ways to re-assert themselves. To replace the degrading production competencies many manufacturing companies in the developed economies choose to re-focus their attention from running fabrication and assembly processes to developing integrated product solutions with a large service component. The extent of the phenomenon varies; while some traditional manufacturers still cling to production, others redefine their business in such a way that the physical products simply become the vehicle for the revenues generating service provision. In academic literature, this trend blurring the boundaries between traditional manufacturing and service is broadly defined as servitization (Vandermerwe & Rada, 1988; Neely, 2008; Baines et al., 2009; Schmenner, 2009). 1 It goes without saying, the idea of combining product and service is not new. According to Davies et al. (2006), the introduction of ‘systems selling’ strategies can be traced back to the 1960s. What makes the current wave of servitization rather unique is its magnitude and that in the current climate of intensifying global competition it is perceived by many traditional manufacturers as a strategy for survival. For example, Peter Loscher, CEO of Siemens, argues that ‘Europe’s future edge will depend on industrial companies pushing into services’ (Financial Times, 2010). Accepting this premise means that in today’s business environment, traditional manufacturers in addition to being producers have to become innovators, supply chain managers and service providers or, in other words, they have to become global servimanufacturers. Although management literature is almost unanimous in recognising the importance of servitization for product manufacturers (e.g. Oliva&Kallenberg, 2003; Neely, 2008; Baines et al., 2009), it offers little or no answers as to what are the drivers and strategic implications of servitization at the firm level? Therefore, this paper aims to explore these drivers and implications and derive propositions relating servitization and the longer term business sustainability of the firm. The paper is based on multiple cases of Danish manufacturing companies. It may be argued that reasons for servitization as well as it s implications at the firm level may depend on the respective company’s product, manufacturing strategy, industry, to mention just a few factors. Therefore in order to get a more consolidated view of servitization practices used by manufacturing companies in developed economies, for this study we choose five cases representing four different industries. The cases are investigated from the perspective of focal companies in Denmark. All five face a dilemma of how to find a strategically viable balance between in-house production and in-house service activities. The paper has three parts. The following section introduces the theoretical background of the study. We then proceed with the methods and the case studies used in the paper. The third section presents the analysis and discussion before we conclude with major findings and limitations of the study. Theoretical background In defining servitization, we adopt the definition by Baines et al. (2009) taking the view on servitization as ‘the innovation of an organisations capabilities and processes to shift from selling products to selling integrated products and services that deliver value in use’. This definition shares basic principles with the work on product-service systems (PSS) (e.g. Pawar et al., 2008) and is broadly in agreement with how the term was first used by Vandermerwe & Rada (1988). Drawing on a broad array of examples, Pawar et al. (2009) find that actual manufacturing operations now account for a smaller share of profits in many traditional manufacturing firms. The provision of services is increasingly taking over fabrication processes. In discussing origins and rationale for servitization, the literature commonly puts forward three sets of factors: financial/economic (services provide new stable source of revenues), competitive advantage (services are more difficult to imitate, thus providing a strategic source of competitive advantage), and marketing/demand (customers are demanding more services) (e.g. Oliva & Kallenberg, 2003; Gebauer & Friedli, 2005; Baines et al., 2009; Schmenner, 2009). However, the phenomenon of servitization has recently got a new impetus. Currently, many manufacturing companies from developed economies are actively pursuing the transition from offering products to offering combined product-service offering not necessarily driven only 2 by one of the factors mentioned above. Rather they actively pursue transition from products to services in the attempt to develop new higher-value activities that would substitute their manufacturing operations, which are increasingly being offshored or outsourced. To the best of our knowledge, this ‘supply’ driven servitization is largely overlooked in the existing literature and thus constitutes the main focus point of the current paper. In the face of increased competition, manufacturers from developed economies are turning their attention to high-value added activities (Davis, 2004; Mudambi, 2008). Discussing the global disaggregation of the value chain, Mudambi (2008) positions the three functional areas, i.e. R&D (input), manufacturing (processing), and marketing (output), along the curved value chain as illustrated in Figure 1. The curved shape of the chain is determined by differences in the value-added potential of various functional areas. According to Mudambi (2008), processing is the least value added, while the input and output ends of the chain are intensive in their application of knowledge and creativity and thus offer a higher potential of value added. Increasing fragmentation in the value chain allows the focal company to amplify its focus on activities associated with the highest value added, while outsourcing or offshoring the processing part. Figure 1 – Globalisation and disaggregation of the value chain In the context of global manufacturing, a very broad spectrum of dynamic and quite distinct offshoring and outsourcing strategies can be divided into two broad categories: 1) captive offshoring and 2) offshore outsourcing (e.g., McIvor, 2005; Aron & Singh, 2005; Hayes et al., 2005; Mudambi, 2008). The category of captive offshoring refers to the process of relocating a company’s activities overseas without giving up ownership and direct control. In other words, captive offshoring occurs on an in-house or ‘intra-firm’ basis. Offshore outsourcing, on the other hand, can be viewed as a complete or partial discontinuation of in-house domestic or in-house international activities and, thus, refers to externally supplied or ‘outsourced’ activities. However, regardless of which of the two basic offshoring strategies is chosen, the implications for the focal lead firm are likely to be similar and include focal companies move downstream in the supply chain (Slepniov et al., 2010). The implications of this transition are illustrated in Figure 2. 3 Figure 2 – Transition from traditional manufacturer to servi-manufacturer This transition should not be seen as a linear straightforward process. Davis (2004) argues that it is important not to confuse this move downstream with simply moving into services. Rather the transition involves developing and provision of innovative combinations of products and services based on combined manufacturing, sourcing and service capabilities that allow global servi-manufacturers to occupy a new base centred on ‘systems integration’. As Figure 2 illustrates, the transition from traditional manufacturer to servi-manufacturer leads to changing relationships and occurrence of new actors. Due to the use of internal and external sources of supply by servi-manufacturer, the transactions which previously involved two parties, i.e. customer and manufacturer, now also involve sourcing partners. According to Baines et al. (2009), one of key features of servitization is a strong customer centricity; therefore the role and involvement of customer is also changing and the links with them intensify. The transition process presented in Figure 2 is an abstraction based on the literature study and observations from practice. However, it is important to stress that it by no means represents the full complexity and practical challenges of managing servitization. The existing literature on the subject comes short in developing a more refined understanding of position servimanufacturers find themselves in and what enables them to remain competitive in their new role. Relative importance of services Relative importance of tangible goods Tangible good as ’add-on’ Service as ’add-on’ Another important aspect of servitization is its degree. The literature measures it along the socalled ‘product-service continuum’ (Oliva & Kallenberg, 2003). The continuum is illustrated in Figure 3. Figure 3 - The product-service continuum Baines et al. (2009) envision the continuum to be a dynamic area, ‘with companies redefining their position over time and moving towards increasing service dominance’. However, how far should companies go and why remains unanswered. Drawing on multiple cases of Danish international companies, in the rest of the paper we address the questions outlined in the previous sections. 4 Methodology and case studies The empirical part of the study is based on five case studies of Danish industrial companies from four industries including maritime, telecommunication, textile and furniture. They are currently engaged in a number of initiatives, which stretch their operations on a global scale. To remain competitive, the companies are also forced to reconsider their product offerings, which increasingly are based on the integration of products and services. The multiple-case study strategy, one of several strategies of qualitative enquiry, has been chosen for this investigation for several reasons. First, case studies can describe, enlighten and explain real-life phenomena that are too complex for other approaches requiring tightly structured designs or pre-specified data sets (Voss, 2009; Yin, 2009). Second, the case study strategy is well equipped instrumentally for furthering understanding of particular issues or concepts which have not been deeply investigated so far (Eisenhardt 1989; Yin, 2009). Third, the choice of the case study strategy is based on the fit between case research and operations management (OM) (Voss, 2009), which is acknowledged but underexplored in the literature. Last but not least, multiple cases were used in order to avoid vulnerability of single-case designs to misjudging the representativeness of a single event. In addition to enhancing external validity, the analytic benefits of having multiple cases are significant (Voss, 2009). Despite having many advantages, case study research also has several pitfalls and poses significant challenges (e.g. Meredith, 1998). First, there is the problem of the observer’s perceptual and cognitive limitation. Second, a high probability of overlooking some key events also constitutes a threat to the quality of case studies research. Third, case studies are exposed to the challenge of generalizability. Fourth, the accuracy of some inferences can be undermined by the reliance on intuition and subjective interpretation of an investigator. To address these challenges and formulate a research design of high validity and reliability, we followed practical guidelines and steps discussed in qualitative methodology literature (e.g. Yin, 2009; Voss, 2009). The current research relied on extensive use of triangulation and research protocol. Multiple sources of evidence (semi-structured interviews, documents and on-site observations) as well as triangulation of multiple data-points within each source of evidence (e.g. multiple respondents at the top and middle management levels) were used. These data combined with secondary material (annual reports, media material, presentation material to customers and stakeholders) were used to build the cases database presented below in Table 1. All the cases were followed intensely by the authors in December 2009 – May 2010. Some events relevant to the study also were captured in retrospect. The number of cases deemed sufficient for the study was decided through a discretionary judgmental process. According to Yin (2009), because sampling logic is irrelevant to the multiple-case study design, the typical criteria regarding sample size do not apply either. Instead, this matter was approached as a reflection of the number of case replications that satisfy the desired level of theoretical saturation of the study. Achieving a higher degree of certainty about the propositions of the study also played a role in deciding the number of cases. The cases overview is provided in Table 1. 5 Table 1 – Overview of case companies used in the study Company Boilers Engines Satellite Proftex Chairs -Industry Maritime Maritime Telecom. Textile Furniture Core product Marine boilers Development and licensing of diesel engines production Equipment for mobile communication Furniture fabrics and related textile products Designer furniture Ownership Private Equity Fund Group Owned Public company Public company Holding owned Established 1987 1980 1981 1850 (1986) 1872 Employees 2763 8000 700 117 279 Turnover (EUR m) 450 2500 167 37 88 Oper. profit (EUR m) 64 387 26 3 14 75% of operations offshored to key markets 95% of operations at external licensees abroad Risks, Threats and Challenges related to operations set-up ƒ Risks of highly vertically integrated firm ƒ ‘Too many eggs in the Chinese basket' ƒ IPR protection in the licensing model ƒ Knowledge sharing with licensees Main role of lead site R&D, sourcing, operations network coordination Service element in product offering Product related services, collaborative development and after sales support Operations set-up attributes 60% of operations outsourced domestically and overseas ƒ Brand vulnerability in the outsourced network ƒ Avoiding overstandardization of products and processes ƒ Search of new strategic partners 100% offshore outsourcing Minority stake in offshore production sites 65% of operations outsourced overseas ƒ Maintaining knowledge about production ƒ Management of multiple dynamic relationships ƒ Org. identity split between service and manufacturing ƒ Brand vulnerability ƒ High fragmentation ƒ High requirements for commun., coordination, information flows R&D, licensees R&D and operations support, operations network coordination network coordination Operations network coordination, R&D and innovation Operations network coordination, design and distribution development Collaborative development projects and service network Collaborative development, matchmaking services for main customers After sale support, collaborative development and innovation After sales support and product related services Discussion and implications There are several servitization-related drivers we can distill from the cases presented above. First of all, as the price competition increased companies faced the challenge of how to reorient domestic in-house resource and competencies base to higher value adding activities. Some re-orientation happened as a result of offshoring and offshore outsourcing of manufacturing operations activities. The resources that could be utilized for high-value activities were freed up. Referring to the smiley of the value chain introduced in Figure 1, these higher value activities are likely to be found in the input and output parts of the chain, where service element of the business is also more likely to occur. Therefore, the manufacturing offshoring and outsourcing trend encapsulates one important servitization driver we observed in all the cases. Its origins are illustrated in Figure 4, where thickness of the line and dark areas represent focus areas of focal organisations in the cases and how they change over time. 6 Figure 4 – Offshoring and offshore outsourcing trend in the cases Although there is also some evidence to suggest that the offshoring and outsourcing trend affected higher value added activities, the propensity to offshore these activities remained lower than the propensity to offshore manufacturing activities. One significant challenge faced by the case companies was related to the manufacturing operations, which remained at the home base. These activities left in-house domestically were commonly related to the core business processes; nevertheless, they over time were increasingly marginalized and, therefore, received less management attention, fewer investment and less development effort. This marginalization was partly driven by the loss of operations-based significance within the internal manufacturing network, and partly by the loss of significance vis-a-vis emerging strategic agendas within the company. In this situation, the companies found themselves in a position where they became more oriented towards context knowledge (facilitating processes, identifying and managing sourcing partners) and less oriented towards production content knowledge (knowledge about what actually goes on in production). The above was particularly prominent in organizations where the fitness of the operations function has traditionally been placed in the hands of corporate functions (e.g. the Satellite case) or where top management represents a non-technical perspective on the business (e.g. the Chairs case), both of which had little regard for the strategic impact of manufacturing operations. The cross-case analysis also showed that servi-manufacturers can have very different approaches to developing and managing service component of their business. All case companies find themselves on a journey from the pure manufacturing oriented company to the company: 1) with services to support the product (service as a cost centre); 2) with services to extend the product (service as a strategic focus area), and 3) with the full service operations where service outweighs the product and the product role is reduced to its order qualifying properties (Figure 5). Producer Producer supported by service Service as a strategic focus area Service orientation Figure 5 – Servi-manufacturers profile continuum Although the case companies can be positioned at different points along this continuum, there is strong support to suggest that all of the cases have gravitated towards the service orientation. The finding supports Olivia & Kallenberg (2003) findings that moving along the product–process continuum is a dynamic process, ‘with companies redefining their position over time and moving towards increasing service dominance’. Our study also shows that the 7 companies, which have retained a strong manufacturing base in-house, or which seek competitive advantages through operations and, thus, maintain strong operations capabilities, generally found it more difficult to integrate products and services beyond seeing services as an extension to the product. The role of management profile and mindset also was found as a strong factor determining the position of the company as well as the development trajectory. Management resources are scarce in most organizations and the engagement with a running operations system consumes attention and focuses it to the efficiency of the existing apparatus. On this basis, we find strong support for the argument that the effective management of servi-manufacturers, demands attention to the interlinked issues of mindset and organisational identity (Pratt & Foreman, 2000; Voss et al., 2006; van Rekom et al., 2008). The profiles of global servi-manufacturing cases seemed to include multiple organisational identities, which were associated with both the mindset of a traditional manufacturer as well as the mindset of a service organisation. But while the service mindset was continuously strengthened at the home base, the manufacturing mindset along with manufacturing capabilities was pushed offshore, generating a number of conceptual as well as operational conflicts between these different foci. For companies, which had retracted themselves from upholding a strong manufacturing capability in-house (e.g. the Proftex and Engines cases), the service provision and ‘systems selling’ strategy became a natural choice. In other words, servitization for them emerged as the new strategic agenda and with this the management attention more naturally drifted towards seeing the product as one of many components in the total offering. Providing additional services to accompany the sale of products was increasingly central to the strategies of the companies, and this was reflected in a growth of services importance and the general trend away from a ‘pure product’ orientation towards an integrated offering. According to Schmenner (2009), the bundling of manufactured goods to downstreamavailable services is led by companies with relatively new products, but with no great manufacturing capabilities,. Servitization provides them with an opportunity to develop unique offerings without committing to an extensive in-house operations base; while companies with significant manufacturing capabilities are quite slow and defensive and struggle to achieve a complete integration of manufacturing and service. Our studies show that this compensation strategy is also at work within companies with a strong manufacturing base, which due to competitive pressures have relocated manufacturing activities to offshore destinations. This happens as managerial resources and attention are freed-up and can be reasserted into new activities. Here it is obvious that companies turn to marketing the capability that their products bring. So, for example, the engine manufacturer markets a stable and reliable supply of power to denote its ability to sell propulsion capability rather than an engine itself. However, this transformation requires a capability set not that distant from the historical manufacturing capabilities. Slack et al. (2004) argue that “the ability to do this requires the co-ordination of manufacturing systems, maintenance systems, spare parts supply systems, logistics systems, and so on. These individual operations processes need to be integrated in the same way as the physical systems that make up its products have been integrated. Again, the underlying technical knowledge on which products themselves have been developed over the years has become significantly relevant in the development of the operations processes that enable them to be delivered into the market. But, this depends on the application of these ideas into a practical business context”. Now the companies were just left with the challenge of sourcing these capabilities and knowledge from a network of globally dispersed activities, some of which remains in-house while others have been externalized. This adds another relational layer to traditional supply chain thinking, which has evolved around the flow of goods and services. 8 In spite of clear strategic intents supporting this transition, the approach to this transition tends to be incremental and companies are to a large extent building the operational bridge as they walk on it. While a whole series of incremental decisions, taken individually, may make economic sense, they may collectively also represent the surrender of the company’s capability to compete in new markets as they largely compete based on historical operations based capabilities. This can, for example, be observed in the case companies through their capability to contract and mange relationships with suppliers to meet order qualifying standards, but also in their capability to meet specific order winning market demands. In spite of the emerging service orientations it remains a fact that all case companies relied on the companies’ capability to supply world class product solutions as a condition for the service provision itself as well as a source of strategic legitimacy in the market. The position of the company on the continuum in Figure 4 can also be linked with the nature of services being offered. In the cases where services just support the product, we could see trends to offer products accompanied with a one-off service (e.g. design and configuring products to customer demands), while in the cases seeing services as a strategic focus area or having a strong service orientation service ‘through-life’ was offered (e.g. in some contracts in maritime boilers and engines). To illustrate, in the Boilers case the company developed a strong service orientation in the boiler segment. Being able to service their customers in any major harbour around the world is an order winner for Boilers, which has been difficult to match by competitors: ‘We have concentrated a lot of our resources on developing our after-sales business – we are very pleased with this today, since we all know that the demand for new boilers will decrease and the demand for after-sale service will go up. We have a strong position on the after-sale business’. In the pursuit for growth, Boilers has increasingly focused its resources to the after-sale service division. This is not only due to the market conditions, where very few orders are received from shipping operators, but also to inflict more direct control over the endcustomers. As a manager at Boilers noted: ‘We base our delivery of new boilers on a good service package. We can do this on a large proportion of our deliveries, but there are parts of the service, e.g. exchange of a boiler tube, that are not unique enough for us to withhold a strong position. Or at least historically it has not been that way. We need to earn money on both things and look at them independently. But of course we try to sell a service contract with each of our deliveries, and with that a sparepart package and things like that’. For Sattelite services was also a predominant factor on the demand side of the company’s business: ‘If the sufficient service is not provided, sales tumble. This element is build into the product and the way they are produced. The service department monitors and supports all service partners to ensure quality of services to customers’. This example also demonstrates that in addition to the perspective on servitization as ‘new manufacturing’, the cases also tended to use services for differentiation purposes in competitive marketplaces and as a potential lead to additional demand for products. The Engines case operated primarily in two interrelated business areas: 1) sale of licenses, and 2) services, including sales of repair parts and technical services. The firm has turned its focus from production of engines to servicing the customers: 9 ‘Due to shifting conditions in the ship market, we are producing fewer engines, and therefore expect that the service part will become more influential and that this business will count for 50% of total income’. One of the reasons for Engine’s high market share was its large service network. The competitors had difficulties in offering the ship owners the same global service agreement. The company had around 70 engineers travelling the world and following up on new constructions, a capacity which competitors could not match. Furthermore, they provided the engineers in Denmark and the licensees with feedback on the issues at hand, thereby enabling optimization of the product. This case illustrates the importance of new emerging relationships in the service-based environment, where in addition to traditional manufacturer and customer the system also included licensees. Conclusions The purpose of this paper has been to provide empirical insights into the trend of servitization and to discuss the drivers and strategic implications of servitization at the firm level. Based on multiple cases of Danish international companies exposed to servitization, the paper addresses the issue related to conceptual move from product-driven operations to service-driven operation, which has so far received limited attention in the operations management literature. We specifically focus on the ‘supply’ driven servitization, the type of servitization that is largely overlooked in the existing literature. This type of servitization is concerned with traditional manufacturing companies from developed economies actively pursuing transition from products to services in the attempt to develop new higher-value activities that would substitute their manufacturing operations, which are increasingly being offshored or outsourced. The paper provides conceptual and practical insights into how servitization is used by manufacturing firms and what are the main drivers and impediments of this practice. It also demonstrates how managerial attention to servitization can help to resolve some of the pressing challenges and dilemmas of contemporary manufacturing firms; namely how focus on the integrated product-service solutions helps the global servi-manufacturers to remain in tune with fabrication processes even though these processes may be outside the boundaries of the company. The study also shows that the profile of a global servi-manufacturing firm is associated with multiple organisational identities. They include both the mindset of a traditional manufacturer as well as the mindset of a service organisation. Such complexity and dynamism of the organisational identity of global servi-manufacturers have to be recognised and effectively managed if the potential synergies of this type of firms are to be realised. The study covers the broad contours of the role of servitization as well as its strategic implicatons. While the results are highly suggestive, the significant limitations of the analysis should be noted. First, there are several methodological imperfections in this study. It is exposed to the usual limitations associated with the use of one method, rather than a multimethod approach. Second obvious limitation of the study is in geographic delineations made in it. Because Denmark was chosen as the main empirical base of the investigation, not all results may be transferable to other countries. Despite some generalisable parallels may exist, the best way to find out which findings are country specific is to replicate the study elsewhere. The same limitation applies to the industrial base of this study. Although the cases were drawn from several industries (i.e. maritime, textile, telecommunication, furniture) future research should include studies from other industrial sectors. 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