SERVICE TECHNOLOGIES are not just revolutionizing internal organizational configurations. They are restructuring whole industries'—and nations'—entire competitive postures. Service technologies now provide sufficient scale economies, flexibility, efficiency, and specialization potentials that outside vendors can supply many important corporate functions at greatly enhanced value and lower cost. Thus many of these functions should often be outsourced. Strategically approached, this does not "hollow out" the corporation. Instead, it decreases internal bureaucracies, flattens the organization, gives it a heightened strategic focus, and improves its competitive responsiveness. Taking advantage of this opportunity requires a whole new approach to strategy.
Services Dominate the Value Chain
The process begins by redefining what the company really does. Most companies primarily produce a chain of services and integrate these into a form most useful to certain customers. So dominant is this consideration that one questions whether many companies—like those in pharmaceuticals, computers, clothing, oil and gas, foods, office or automation equipment—should really be classified as "manufacturers" anymore. The vast majority of their systems costs, value-added, profits, and competitive advantage grows out of service activities.
- For example, the strategies of virtually all pharmaceutical companies are critically dependent on service functions. This is especially true of the top performers like $5-billion Merck and ¥1.7-billion Glaxo, and less true for lower profit generic drug producers. The direct manufacturing cost of most patented ethical drugs is trivial relative to their sale price. Value is added primarily by service activities— discovery of a drug through R&D, a carefully constructed patent and legal defense, rapid and thorough clinical clearance through regulatory bodies, or a strong preemptive distribution system. Recognizing this, in recent years Merck's strategy has focused on one portion of the value chain, a powerful research-based patent position. Glaxo has successfully targeted rapid clinical clearance as its key activity. Both strategies rest primarily on adding value through service activities. Merck and Glaxo outperform the industry in gross margins (71.5 percent and 79.6 percent versus an industry composite of 66.9 percent), in operating income margins (27.1 percent and 38.2 percent versus 21.2 percent), and in profits as a percentage of shareholders' equity (48 percent and 35 percent versus an industry average of 2 3 percent).
As manufacturing becomes more universally automated, the major value added to a product increasingly moves away from the point where raw materials are converted into useful form (i.e., steel into an auto "body in white" or grain into edible cereals) and toward the styling features, perceived quality, subjective taste, and marketing presentation that service activities provide at all levels of the value chain. At each stage, technology has increased the relative power of services to the point where they dominate virtually all companies' value chains (see Figure 1).
The "Intellectual Holding Company"
The fact is that many large companies, like Apple Computer and IBM, initially succeeded by recognizing and leveraging this concept—becoming essentially "intellectual holding companies" purposely manufacturing or producing as little product internally as possible. For example, until the early 1960s IBM was known as an "assembler," outsourcing up to 80 percent of its manufacturing costs. And Apple succeeded by masterminding the highly sophisticated interconnection of architectural, design, software, and hardware supply relationships that became its explosively successful Apple II system. This strategy may have been essential for Apple in its early years when it lacked both the time and capital to build factories or hire a salesforce. But even today—with three to four times the sales per employee and a third to a quarter the fixed investment per sales dollar of its competitors—Apple is structured less like a traditional "manufacturing" company and more like a $4-billion "service" company that happens to have three manufacturing facilities (see Table 1). In a more mature industry, Chrysler and Honda have recently achieved lower unit costs than Ford and GM in U.S. competition by outsourcing more of their manufacturing dollar. The whole auto industry is moving more toward this concept as it increasingly uses modular assembly of outsourced subsystems.
Elsewhere in the manufacturing realm, major successes have repeatedly come from taking specific sets of service skills and building them into dominating product-market positions. Procter and Gamble (P&G) created a $15-billion corporation largely based on two central sets of service skills: its R&D capabilities in eight core technologies, and its superb marketing-distribution skills. Today its extremely broad product line flows naturally from the interaction of these two service activities. Figure 2 shows how skills associated with bar soap could lead P&G naturally to flaked soaps, Tide detergent, and many of its later products. P&G's research depth in surfactant chemistry provided the central linkage among products apparently as diverse as soap and acne or bone disease control drugs, while its marketing and distribution strength allowed P&G to move powerfully, but incrementally, from market to market.
Service Technologies Smash Overheads through Outsourcing
Because of the scale economies they permit, new service technologies also make it possible to achieve major economies of scale by purchasing not just manufactured parts, but also crucial services, externally—and also to manage such outsourcing effectively on a global basis. This focus on services is especially critical when one realizes that 65–75 percent of most manufacturing companies' costs are in overhead categories, and that most overheads are merely services the company began buying internally. Restructuring and attacking service over-heads should be a high priority for any company seeking to increase productivity.
In another article, we noted how well-integrated service linkages to suppliers (upstream) and to institutional buyers, wholesalers, and retailers (down-stream) offer high strategic leverage for manufacturers.1 Less recognized is the fact that other outside service groups can often provide greater economies of scale, flexibility, and levels of expertise for specialized overhead services than virtually any company can achieve internally, To thoroughly develop these potentials one should consider each overhead category—whether in the value chain or in a staff function —as a service that the company could either "make" internally or "buy" externally. This perspective will, at a minimum, introduce a new objectivity into overhead evaluations and create some strong competitive pressures for internal productivity. In many cases, companies find that specialized outside service sources can be much more cost effective than their internal groups. And they start outsourcing to lower costs or to improve value-added. For example:
- ADP Services has developed a flexible payroll handling system that is so low cost that it now processes payrolls for more than 10 percent of the potential client base in its geographical areas. From this vantage point, it has expanded into routine bank accounting and tax filings for its customers and their employees. It has made further logical extensions into ERISA reporting, personnel records and analysis functions, and even personalized communication functions—printing slogans, messages, or logos on checks or notes included with payroll checks. Outsourcing these activities has given ADFs customers expertise they could not afford in-house, a check on their own costs for these functions, and access to substantial economies of scale and lowered overhead costs.
- Similarly, the $3-billion ServiceMaster Company (described in Part I) can take over many of its customers' equipment and facilities maintenance functions, simultaneously improving the quality and lowering the costs of these activities through system economies and specialized management skills. So effective are its systems that ServiceMaster can not only lower absolute maintenance costs, it can often joint-invest in new equipment with its customers, sharing productivity gains to the benefit of both parties.
This does not imply that all overhead costs are "bad" and should be eliminated. Many of the most essential activities of modern companies are in what used to be considered overheads. The objective is not simplistically to lower such costs, but rather to produce or buy needed service activities most effectively. Whenever a company produces a service internally that others buy or produce more efficiently or effectively externally, it sacrifices competitive advantage. Conversely, the key to strategic success for many firms has been their coalitions with the world's best service providers—their ex ternal product designers, advertising agencies, distribution channels, financial houses, and so on. How can companies best exploit such opportunities?
Learning to Love the "Hollow Corporation"
Considering the enterprise as an intellectual holding company (à la Apple Computer) restructures the entire way one attacks strategy. One needs to ask, activity by activity, "Are we really competitive with the world's best here? If not, can intelligent outsourcing improve our long-term position?" Competitive analyses of service activities should not consider just the company's own industry, but should benchmark each service against "best in class" performance among all potential service providers and industries that might cross-compete within the analyzed category—both in the United States and abroad. This can completely change the focus of competitive analyses, creating a much more external, market-value orientation for the process.
As companies begin to outsource nonstrategic activities—particularly overheads—they often discover important secondary benefits. Managements concentrate more on their businesses' core strategic activities. Other internal costs and time delays frequently drop as long-standing bureaucracies disappear and political pressures decrease for annual increments to each department's budget. Managements begin to consider more carefully which departments really are critical to success, which activities can be cut to minimal levels and purchased as commodities, which must be maintained internally for strategic reasons, and which must be managed as the company's true source of competitive advantage. All this leads to a more compact organization, with fewer hierarchical levels. It also leads to a much sharper focus on recruiting, developing, and motivating the people who create most value in those areas where the company has special competencies.
Perhaps most important, management in the new environment shifts away from functional skills and the capacity to manage bureaucracies and toward more coordinative, strategic, and conceptual skills— and the capacity to manage contract relationships. These are quite different from the skills that have dominated most companies—including startup and emerging companies—in the past. One venture capitalist summarized the issue clearly:
I keep trying to convince my partners and our client companies that we don't want to invest in hard assets. They are too short lived and risky. We certainly don't want to invest in bureaucracies. We want to invest in people who have a clear viable concept, who can manage outside contracts with the best sources in the world, and who can concentrate their internal energies on that small core of activities that creates the real uniqueness and value-added for the company. That's where the action is today, but it's a tough sell against traditional thinking.
Dominating Those Services Crucial to Strategy
Many have expressed concerns about the hollowing out and loss of strategic capability outsourcing could cause.2 However, if the process is approached properly, careful outsourcing should increase both productivity and strategic focus. By limiting or getting rid of those activities (both production and service) where it can develop no strategic advantage—and where it is generally much weaker than the best outside sources—a company can increase the value it delivers to both customers and share-holders.
But a company must maintain command of those activities crucial to its strategic position. If it does not, it has essentially redefined the business it is in. For all other activities, if the company cannot see its way to strategic superiority, or if the activity is not essential to areas where it can attain such superiority, the company should consider outsourcing and actively managing any resulting relationships. But it is essential that the company plan and manage its outsourcing coalitions so that it does not become overly dependent on—and hence dominated by—its partner. In some cases this means consciously developing and maintaining alternate competitive sources or even strategically controlling critical stages in an overall process that might other-wise be totally outsourced.
In other cases, by creating a "strategic partnership" the company can even outsource a critical activity that another noncompeting company can perform more effectively—provided it can still control the crucial relationships with its customers. For example:
- Seagate Technology, the world's leading manufacturer of hard disk drives for personal computers, concluded that one of the best ways to stay ahead of its Japanese rivals was to guarantee delivery dates and to pay for the cost of delivering products to customers. At the same time it decided to switch its manufacturing to Singapore. To handle its in-bound logistics, Seagate contracted for space on Flying Tigers four times a week from Singapore. For outbound logistics from its one U.S. distribution center in California, Seagate partnered with Skyway Freight Systems as the sole vendor serving the entire United States with Seagate's new "guaranteed four-day delivery-freight paid program." Neither Flying Tigers nor Skyway, of course, had any interest or capability in disk drives per se. This strategy was crucial for Seagate, even though their payments to Skyway amounted to less than one percent of each disk drive's total cost. Yet the service was so good that in six months—in which thousands of shipments were handled —the program only experienced three customer service "incidents" all of which stemmed from a misunderstanding of what "four business days" really meant.3
Carefully developing the company's strategic focus around selected service activities—and partnering or outsourcing those where the company cannot excel —not only creates a stronger strategic focus, it can also prevent a takeover by those who might identify missed potentials as opportunities to substantially lower costs or raise post-takeover yields.
Highest Activity Share, Not Market Share, for Profits
Once a company develops great depth in certain selected service activities as its strategic focus, many individual products can spring off these "core" activities to give the firm a consistent corporate strategy for decades. Unfortunately, the true nature of these core capabilities is usually obscured by the tendency of organizations to think of their strengths in product—not activity or service—terms and by each functional group's need to see itself as the source of strategic strength. The key point is that a few selected activities should drive strategy. Knowledge bases, skill sets, and service activities are the things that generally can create continuing added value and competitive advantage.
Too much strategic attention has been paid to having a high share of the market. High share can be bought by inappropriate pricing or other short-term strategies. High market share and high profitability together come from having the highest relevant activity share in the marketplace—in other words, having the most effective presence in a service activity the market desires and thus gaining the experience curve and other benefits accruing to that high activity share. In service-dominated marketplaces—and most are—competitive analyses must focus on the relative potency of the activities or service power that undergird product positions. Too few strategists and companies realize this.
To be most effective, this service-activity dominance needs truly global development. As noted, the major value-added in most products today comes not from direct production or conversion processes, but from the technological improvements, styling, quality, marketing, timing, and financing contributions of service activities. Since these are knowledge-based intangibles that can be shipped cost-free anywhere, producers who expand their scope worldwide to tap the best knowledge and service sources available anywhere can obtain significant competitive advantage. Their capacity to command and coordinate service activities, supplier networks, and contract relations across broad geographical ranges has become perhaps the most important strategic weapon and scale economy for many of today's most competitive enterprises.
Avoiding Vertical Integration
Since most firms cannot afford to own or internally dominate all needed service activities, they tend to form coalitions, linking their own and their partners' capabilities through information, communication, and contract arrangements—rather than through ownership (i.e., vertical or horizontal integration). Because of their high value-added potentials, service companies and service activities within companies are central to many of these coalitions. An entirely new form of enterprise seems to be emerging, with a carefully conceived and limited set of "core strategic activities" (usually services) at its center, that allows a company to command and coordinate a constantly changing network of the world's best production and service suppliers on a global basis. This is a logical and most powerful extension of the Kieretsu concept (linked networks of banks, producers, suppliers, and support-distribution companies) that has long been at the heart of Japan's trading success.
- For a Xerox or an IBM to try to produce all elements of their value chains internally would be a strategic disaster. As large and capable as these companies are, neither one can conceivably create and control the full range of design, hardware, software, communications, and networking capabilities they need to deliver their core "document handling" (Xerox) and "information management" (IBM) capabilities—as complete systems—most effectively to their customers. Hence, each has moved away from early attempts to vertically integrate through acquisitions—and toward wide-ranging, constantly changing coalitions with outside service and support groups. Now they compete both with a service core themselves and as giant international coalition networks against other competitive coalitions (like AT&Ts or NEC's). Internally, both IBM and Xerox generate about one-third of their revenues from direct sales of software and services—and at least as much more of the value added to their products from embodied systems, software, design, and marketing services. Still, IBM has joint ventures or partial ownership in Network Equipment Technologies, Rolm, MCI Communications, Sears/MCI, Open Software Foundation, PCO Fiber Optics, Intel, Nippon Tel&Tel, Ericcson, Bell Adantic, Credit Agricole, Banque Paribas, and other worldwide partners. It needs them to compete against other firms' similar arrangements with outside groups.
Given today's rapid technological advances, many enterprises find they can lower their risks and lever-age their assets substantially by avoiding investments in vertical integration and managing "intellectual systems" instead of workers and machines. There are several reasons for this. First, well-managed out-sourcing can put the world's very best talent at the disposal of the enterprise. Second, it decreases the firm's risk; if one unit in the system underperforms, the firm can quickly substitute competitors' components or services. Third, if new technologies suddenly appear, it is easier to switch sources. Fourth, if there is a cyclical or temporary drop in demand, the coordinating firm is not stuck with all the idle capacity and inventory swings of the entire production chain. Fifth, the system enjoys all of the motivation, flexibility, and lowered bureaucracy and overhead costs of a much more decentralized activity. With their high value and easy portability, the service inputs to these systems, especially, can be sourced anywhere in the world. The core strategy of a coordinating or systems company then becomes: "Do only those things in-house that contribute to your competitive advantage, and try to source the rest from the world's best suppliers."
Manufacturing Industries Become "Service Networks"
Many industries are becoming loosely structured networks of service enterprises that join together temporarily for one purpose—yet are each other's suppliers, competitors, or customers elsewhere. Biotechnology provides an interesting example of this phenomenon.
- Highly specialized companies are developing at each level of biotechnology. Many research groups or companies only identify and patent active biological entities (or proteins) at the laboratory level. Others only develop and license cell lines, which reproduce these entities. Still others create pilot-scale processes that can use the cell lines to produce proteins in sufficient quantities for clinical tests and commercialization. Other enterprises run clinical trials, and still others have the large-scale marketing expertise and distribution channels to reach wide markets.
Because of the relatively small scales, high risks, and expensive expertise needed at each level, it is often difficult for a single company to support the full chain of activities in-house. As a result, the industry is becoming structured as a number of multiple-level consortia; each enterprise has its own network of contract and information relationships involving a variety of research, clinical, production, and marketing groups around the world. Although biotechnology is commonly thought of as a manufacturing industry, all these are essentially service units, providing specialized activities for one another.
The semiconductor and electronics industries are moving toward a similar structure. Independent design, foundry, packaging, assembly, industrial distribution, kitting, configuration, systems analysis, networking, and value-added distributor groups do more than $15 billion worth of customized development, generating almost $140,000 of revenue per employee.4 Even large OEMs are finding that these groups' specialization, fast turnarounds, advanced designs, and independent perspectives can lower costs, decrease investments, and increase value at all levels.
Strategically Redefining the "Focused Company"
Given the vast changes being wrought by new technologies, and the resulting potential for worldwide strategic outsourcing, the whole notion of what constitutes an "industry" or a "focused company" needs to be reexamined. True focus in strategy means the capacity to bring more power to bear on a selected sector than anyone else can. While this once meant owning the largest production facilities, research laboratories, or distribution channels supporting a single product line, this is no longer desirable or sufficient for most companies. Today, physical positions like a raw material source, a plant facility, or a product line rarely constitute a maintainable competitive advantage. They can be too easily bypassed, back-engineered, cloned, or slightly surpassed. A truly maintainable advantage usually derives from developing skill sets, experience factors, know-how, market understanding, databases, or distribution capabilities that others cannot reproduce and that lead to demonstrable value for the customer.
Two considerations are important. First, virtually all these sources of competitive advantage derive from service activities. Second, to the extent that these can be marshalled and integrated internally, they can successfully support extraordinarily wide product lines (a la P&G, 3M, IBM, Honda, Siemens, Mitsubishi, or Matsushita). For example:
- Honda's current multiple product strategy developed naturally out of its dominant skills in three key areas: the design of small, efficient engines, the management of the technologies and logistics for small-scale assembly with extensive outsourcing of fabricated parts, and the creative management of offbeat distribution channels.5 Any product line using these became a natural extension for Honda, leading to today's ads that say you can fit "Six Hondas in a Two Car Garage." The "six" doesn't refer to cars, but to a snow blower, a lawn mower, outdoor power tools, and so on. Similarly, 3M built on its research skills in three critical related technologies (abrasives, adhesives, and coating-bonding), a highly entrepreneurial development function, and broad-based distribution skills to create its diverse product line. Despite the seeming maturity of its basic technologies, as long as 3M stayed with these core skill areas it grew at a 10 percent annual rate and earned high margins. Although the firm stumbled when it tried to move into core activities beyond its origins, it quickly recovered when it refocused in the late 1980s.
Properly developed, a broad product or service line does not necessarily signify loss of focus if a firm can deploy especially potent service skills against selected marketplaces in a coordinated fashion. (In fact, a broad line may represent the lever-aging of a less obvious strategic focus.) The key question is whether a company dominates a set of service skills that has importance to its customers—in other words, can bring more power to bear on this activity than anyone in the world. If so, the company can be a strategic success, provided it focuses its attention on that activity, obtains at least strategic parity through outsourcing elsewhere, and then blocks others from entering its markets by leveraging its skills across as broad a product line or customer base as it can dominate. Competitors must be defined as those with substitutable skill bases, not those with similar product lines. As the industrial examples above show, product lines can be remarkably broad when the service skill base is deep enough to be dominating. Further examples include:
- Super Valu, whose extensive development of inventory control and product-handling (service) technologies has allowed it to manage thousands of lines, is viewed as a "channel commander" controlling distribution and product functions upstream, downstream, and geographically. Its success has eliminated many specialized and regional wholesalers that once dominated the industry, helping the $9.4-billion firm to redefine the grocery-whole-saling function in the United States and to consolidate grocery wholesaling from 1,400 to 300 participants in the last ten years. Its combined purchasing skills and in-depth electronic systems enable Super Valu to manage its suppliers more effectively and to provide the widest possible range of packaged foods at lowest prices to its retailers. Super Valu's extensive host-support services for its customers' EPOS systems permit independent, smaller supermarkets to manage their operations with large-chain efficiencies through instant access to price files, shelf tag printing, and detailed reports about their products' turnover, gross profits, category profits, and so on. They could not otherwise afford such systems. Super Valu's systems even handle the complex functions of field produce buying, fresh meat delivery and marking, and in-store shelf price verification. Through its Plan Mark and Studio 7 programs, Super Valu can also perform architectural design and manage construction projects on request. So effective are Super Valu's systems that it has destroyed many of the industry's distinctions between manufacturers, wholesalers, transporters, and retailers. Its real competition is not other wholesalers, but those few companies (at any level of distribution) that could develop similar systems skills and a correspondingly wide product line.
Super Valu itself is a clear case of, first, a dominating service activity focus, and second, the extraordinary breadth of line it can support. And Super Valu's retail customers provide excellent examples of the dramatic redeployment that makes eminent strategic sense for a wide range of industries. These firms strategically outsource those activities that technology and specialization allow others to do with greater skill or at lower cost, and then concentrate on things their own enterprises can do with unique skill — providing friendly local service, in this case.
Most companies create a major portion of their incremental value and gain their real competitive advantage from a relatively few—generally service—activities. Much of the remaining enterprise exists primarily to permit these activities to take place. Yet managements typically spend an inordinate amount of their time, energy, and company resources dealing with these latter support functions—all of which decrease their attention to the company's truly crucial areas of strategic focus. Virtually all managers can benefit from a more carefully structured approach to managing their service activities strategically. Doing so involves defining each activity in the value-creation system as a service; carefully analyzing each such service activity to determine whether the company can become the best in the world at it; and eliminating, outsourcing, or joint venturing the activity to achieve "best in world" status when this is impossible internally. Perhaps most important, managers must recognize the cold reality that not achieving a strong enough competitive performance in each critical service activity will relegate the company to an inevitable loss of strategic advantage, provide lower profitability, and create a higher risk of takeover by those who do see the missed potentials.