IFS: outcome-based models drive manufacturing profitability
Condition, or usage-based approaches to service and maintenance within the manufacturing industry are already widely adopted. Companies utilise predictive techniques to understand when equipment is likely to fail and perform pre-emptive maintenance as part of their service contracts. This model is a profitable one for manufacturers. A McKinsey analysis across 30 industries demonstrated that the EBITDA (earnings before interest, taxes, depreciation, and amortisation) margin for aftermarket services was 25%, in comparison to just 10% for new equipment.
Fixing assets before they go wrong and keeping parts moving as they were designed to, prevents financial losses and maximises operational performance. However, large enterprises are increasingly evolving from this traditional cost-based model to a value-based one focused on outcomes. They are no longer simply thinking about maintenance or even service for its own sake, and instead are considering harmonising their service offering to satisfy customer needs in terms of achieving specific outcomes.
In this new model, what’s delivered must meet the precise value that the customer is looking for – and the evidence shows that this practice is very rewarding, as illustrated by research undertaken for IFS by Noventum. Entitled The Service Business Growth Model for B2B Manufacturers, the research benchmarked the financial performance of 120 B2B industrial manufacturing companies with considerable service revenues. What it found was that proactive services, which included outcome-based services, generated the highest gross margin, resulted in double digit-productivity improvements and correlated with increased recurring revenue for the manufacturers surveyed.
Driving up profitability and margins in manufacturing
The research shows that these proactive customer-based services are really the next logical progression of servitisation and service revenues. The researchers found that when manufacturers grow their service business and continue to develop their service business capabilities, the proactive customer business-related services become the majority (53%) of their total service revenue.
The study also found that best-in-class manufacturers providing proactive outcome-based services can achieve compound annual growth of 11%, a significant 3% higher than service providers offering just reactive and preventive service. This growth also translates to more profits, with gross margins of almost 60% reported by the best-in-class providers of proactive services.
When looking at the predictability of financial results, the study really highlights the benefits of outcome-based approaches. It shows 65% recurring revenues from service contracts reported by best-in-class proactive services providers. This is a major improvement on the 13% and 15% recurring service revenue reported by reactive and preventive service-providing manufacturers. These stark differences further underline how recurring revenues increase as companies offer more proactive services that result in higher contract penetration rates.
Challenges of change in the manufacturing sector
With so many benefits clearly on the table, many manufacturers are keen to move to outcome-based business models, even though it represents a significant change for them. An educated estimate is that around 15% of businesses are experimenting with this approach today, with approximately 30% of businesses expected to be operating at this level within the next five years.
Yet moving even further into that true value-based digital business evolution is one that a business should take in incremental steps. On the ground this is often difficult for businesses because they discover they lack the specialised skillsets or experience in-house to fully capitalise on being a digital organisation. It’s almost certain too that, even if it is already a servitised enterprise, the company will have to develop new ways to sell its service.
A technology shift whose time is coming
Given all these factors that interfere with an evolving business, how can manufacturers best navigate such challenges? The most fundamental shift is to move away from a focus on conventional service contracts and attach rates, and instead think about outcomes. At each stage of their journey, businesses will need to bring in the right types of technology but also the right people with the requisite skills to allow them to move to the next level as and when required.
To take advantage of the full array of bottom-line benefits, manufacturers will also need to become more intrapreneurial and start looking at their service business through the lens of customer outcomes. In that sense, it goes far beyond the simple incremental change that a move from condition-based maintenance to predictive maintenance entails.
To transform to an outcomes-based service model, manufacturers need to define the service business vision and strategy for the future. This involves building a solid business case and ensuring stakeholders are aligned and signed up to the vision of the organisation, a vision which should attempt to standardise services to utilise economies of scale. Building on this, businesses must use their customer insights to develop compelling value propositions to drive sales strategies.
This level of focus builds new relationships with customers and represents the next chapter of servitisation. It will in turn support the delivery of incremental revenues and build enhanced loyalty between a business and its customers that will only deepen over time.
Byline written by Marne Martin, President, IFS Service Management Business Unit (SMBU)