How to Sell Services More Profitably

Product companies often try to differentiate themselves by offering ancillary services. Many struggle to make money at it.

by Werner Reinartz and Wolfgang Ulaga

Manufacturers frequently believe that adding value in the form of services will provide a competitive advantage after their products start to become commodities. When the strategy works, the payoffs are impressive, and a company may even discover that its new service business makes more money than its products. But for every success story, at least five cautionary tales remind us that manufacturing companies will most likely struggle to turn a profit from their service businesses.

Sidebar IconWhy Services?

Even the best stumble. Consider one large technology firm we studied—a world leader in medical equipment, IT, automotive equipment, and transportation systems. Back in 2003 the company’s €5 billion IT business unit realized that the limited product-related services it offered, such as installation and training, generated twice the 3% to 4% net margins it earned on its increasingly commoditized product offerings. The unit decided, therefore, to invest heavily in developing its service capabilities for large clients. Managers estimated that such customized services would soon generate margins of 15%.

The estimate proved very wide of the mark, and the unit recorded a negative net profit margin of more than 10% in 2005. The venture was a serious loss-maker, costing the group around €260 million in 2005 alone. The losses stemmed from several distinct causes: First, the company found that the back-office production of complex services was much more difficult than expected. Each client’s requirements were highly customized, which meant that little learning and knowledge could be leveraged across cases. Second, the salespeople were used to selling products with basic service contracts attached, and their traditional contacts at target firms were too low in the hierarchy to make decisions about multimillion-euro solutions contracts. Third, much of the knowledge around the service production had to be sourced externally—which proved time- and resource-intensive. The board member responsible for services was frank about the mistakes: “We wanted too much too soon, and we simply weren’t ready for it.”

Over the past three years we have investigated how manufacturers in business markets can develop profitable services. We conducted in-depth studies of 20 industrial companies operating in a broad variety of product markets, including adhesives, automotive coatings and glass, bearings, cables and cabling systems, energy generation and distribution, onboard electronics for civilian and military aircraft, printing presses, and specialty chemicals. Every firm was among the top three in its industry, and the managers we interviewed were all key decision makers, frequently executive board members. Throughout the process we interviewed multiple people in different business units and country organizations. We went on to have discussions with more than 500 B2B managers in a series of executive workshops; these complemented the insights from our interviews.

As our research process unfolded, we uncovered a wide variation in revenues and profits from service offerings. One group of companies derived up to half of their sales from services, and margins up to eight times those on product sales. A second group reported a very different experience: Although those companies had made significant investments in the development of services, customers proved unwilling to pay, revenues were low, and the companies barely broke even. Comparing the two groups, we were able to identify clear differences in the ways they had developed their service businesses.

Like the technology company in our example (which has since turned itself around in this respect), companies unsuccessful at developing service businesses have tried to transform themselves too quickly. Successful firms begin slowly, identifying and charging for simple services they already perform and using those to build enthusiasm for adding more-complex ones. They then standardize their delivery processes to be as efficient as their manufacturing ones. As their services become more complex, they ensure that their sales force capabilities keep pace. Finally, management switches its focus from the company’s processes and structures to the nature of customers’ problems, the opportunities that customers’ processes afford for inserting new services, and the new capabilities needed to deliver those services. (See the exhibit “The Path to Profits in Industrial Services.”) Let’s take a closer look at those four steps.

Sidebar IconThe Path to Profits in Industrial Services

1: Recognize That You Are Already a Service Company

Many product companies are in the business of delivering services; they just haven’t realized it yet. These companies are missing out on the revenues they could generate simply by charging for what they already do. The first step in expanding a service capability is to make both the company’s managers and its customers aware of the value provided by existing services.

Take the pharmaceuticals giant Merck. In one of the company’s product categories, its French subsidiary had a long-standing tradition of including delivery in its product price for customers. Because specialty chemicals are high in value but low in volume, Merck had never questioned its responsibility to assume transportation and insurance costs, which represent a tiny fraction of the amount invoiced. And because no shipping costs were itemized, customers were unaware of the value Merck provided. A few years ago the company put this tradition to a test: Managers randomly selected 100 customers and changed the terms of delivery from “shipping and insurance paid” to “ex works,” though the bottom line barely changed. Ninety percent of those customers readily paid the additional charges, seemingly without noticing. Of the 10% that recognized the change, only half insisted on returning to the prior terms of payment. Merck re-established the original terms for those customers—but it had succeeded in managing the transition from “free to fee” for the other 95%. Once the new billing terms had been rolled out to the entire customer base in France, Merck’s profitability in this product category improved significantly, even though the cost to customers was minor.

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