This is a three-part blog series from enterprise software thought leader Dr. Timothy Chou. Look for parts two and three in upcoming editions of the AEM Industry Advisor.
If you’re the CEO or board member of a company that manufactures any sort of industrial machine, you’ve probably heard about IoT, edge, AI, 5G and cloud computing.
But why should you care? Why should your company care?
While finding ways to use technology to save money is always good, the bigger driver is using software to increase revenue. I’ll make the case that, as a manufacturer, you can double your revenues and quadruple your margins by building and selling digital service products. Furthermore, you’ll create a barrier that your competition will find difficult to cross.
Learn more about the impact of disruptive trends and technologies by signing up for an AEM Thinking Forward event in a city near you.
Next-generation machines are increasingly powered by software. Porsche’s latest Panamera has 100 million lines of code (a measure of the amount of software) up from only 2 million in the previous generation. Tesla owners have come to expect new features delivered through software updates to their vehicles. A software-defined automobile is the first car that will end its life with more features than it began. But it’s not only cars, healthcare machines are also becoming more software-defined. A drug-infusion pump may have more than 200,000 lines of code, and an MRI scanner has more than 7 million. A modern boom lift — commonly used on construction sites — has 40 sensors and 3 million lines of code, and a farm’s combine harvester has over 5 million. Of course, we can debate if this is a good measure of software, but I think you get the point: Machines are increasingly defined by software.
So, if machines are becoming more software-defined, then the business models that applied to the world of software may also apply to the world of machines. In the rest of this article we’ll cover three business models...
Early on in the software industry, we created products and sold them on a CD. If you wanted the next product, you’d have to buy the next CD. As software products became more complex over time, companies like Oracle and SAP moved to a business model where you bought the product (e.g., ERP or database) together with a service contract. That service contract was priced at roughly 2% of the purchase price of the product per month. Over time, this became the largest and most profitable component of many enterprise software product companies. In the year before Oracle bought Sun Microsystems (when they were still a pure software business), they had revenues of approximately $15 billion, only $3 billion of which was product revenue, the other $12 billion (over 80%) was high-margin, recurring-service revenue.
But what is service? Is service answering the phone nicely from Bangalore? Is it flipping burgers at McDonald's? The simple answer is “No.” Service is the delivery of information that is personal and relevant to you. That could be the hotel concierge telling you where to get the best Szechwan Chinese food in walking distance, or your doctor telling you that, based on your genome and lifestyle, you should be on Lipitor. Service is personal and relevant information.
I’ve heard many executives of companies who make machines say, “Our customers won’t pay for service.” Well, of course, if you think service is break-fix, then the customer clearly thinks you should build a reliable product. Remember Oracle’s service revenue? In 2004, the Oracle Support organization studied the 100 million requests for services from Oracle support, and over 99.9% of those requests were answered with known information. Aggregating information for thousands of different uses of the software, even in a disconnected state, represented huge value over the knowledge of a single person in a single location. Service is not break-fix. Service is personal and relevant information about how to maintain or optimize the availability, performance or security of the product. All delivered in time and on time.
The next major step in software business models was to connect to the computers that ran the software. This enabled even more personal and more relevant information on how to maintain or optimize the performance, availability and security of the software product. These digital services are designed to assist IT workers in maintaining or optimizing the product (e.g., database, middleware, financial application). For example, knowing the current patch level of the software enables the service to recommend only those relevant security patches be applied. Traditional software companies charge between 2-3% of the product price per month for a connected digital service. The advantage of this model is the ability to target the installed base of enterprises, which have purchased the product in the traditional Model 1.
Now let’s move to the world of machines. If a company knows both the model number and current configuration of the machine, as well as the time-series data coming from hundreds of sensors, then the digital service can be even more personal and relevant. In addition, it allows the company to provide precision assistants for workers who maintain or optimize the performance, availability and security of the healthcare, agriculture, construction, transportation or water purification machine.
Furthermore, assume you build this digital service product and price it at just 1% of the purchase price of the product per month. If your company sells a machine for $200,000, and you had an installed base of 4,000 connected machines, you could generate $100 million of high-margin, annual recurring revenue. And since digital service margins can be much bigger than product margins, companies who have moved to just 50/50 models (50% service and 50% product) have seen their margins quadruple.
While this business model has been aggressively deployed in high-tech applications, we are still in the early days with machine manufacturers. However, there are some early leaders. Companies like GE and a major elevator supplier derive 50% of their revenue from service. Voltas, a large HVAC manufacturer, is an 80/20 company — meaning it derives 20% of its revenue from services. In the healthcare space, Abbott has introduced a digital service product called AlinIQ, while Ortho Clinical is selling Ortho Care as an annual subscription service. While some of this is lower-margin, human-powered, disconnected services, the value of a recurring revenue stream is not lost on the early leaders.
Once you can tell the worker how to maintain or optimize the security, availability or performance of the product, the next step is to simply take over that responsibility as the builder of the product. Over the last 15 years, we’ve seen the rise of Software-as-a-Service companies (SaaS) like Salesforce.com, Workday and Blackbaud, which all deliver their products as a service. In the past seven years, this has also happened with server hardware and storage products, as companies like Amazon, Microsoft and Google provide compute and storage products as a service.
All of these new product-as-a-service companies have also changed the pricing to a per-transaction, per-seat, per-instance, per-month or per-year model. We’re likely to see the same with agricultural, construction, transportation and healthcare machines. Again, there are some early examples: Kaeser Compressors is delivering air-as-service, while AGCO is selling sugar cane harvesters by the bushel harvested. In the consumer world, we’re all familiar with are Uber and Lyft, which provide transportation machines as a service — priced per ride. Of course, the most expensive operating cost of the ride is the human labor, so like those of us in high-tech software and hardware products, they are looking at replacing the human labor with automation.
So why should you care about IoT, edge, 5G, AI and cloud computing? Not because they are cool technologies, but because they will enable you to double your topline revenues, quadruple your margins with high-quality recurring revenue and — perhaps most importantly — allow you to build a widening gap with your competition.
Dr. Timothy Chou is a leader in the third generation of enterprise software, a computer science lecturer at Stanford University, the former President of Oracle on Demand, a technology consultant and an investor in emerging technology.
A digital service product has the potential to double the revenues and quadruple the margins of any company that makes construction or agricultural machines. If you assume a digital service product is priced at 1% of the purchase price of machine per month, if your company sells a machine for $200,000 and you had an installed base of 4,000 connected machines, you could generate $100 million of high-margin, recurring revenue annually.
So, with that fact in mind, how would you build a digital service product?
The first step is to have your newly appointed product manager define the digital service product. Let’s start with what it's not. Digital service is not break-fix support. Digital service is not based on human labor. Instead digital service is information that is personal and relevant information. But what kind of information? Digital service is personal and relevant information about how to maintain or optimize the availability, performance and security of the machine. Whether you make machines or you use machines, you've dealt with the frustrations associated with disconnected service based on human labor.
“What’s the serial number of the machine?”
“What rev level are you on?”
“Can you tell me whether the light is green or red?”
“Let me find a time for Mary to call you back.”
“We’ll be there from 1–5.”
Learn more about the impact of disruptive trends and technologies by signing up for an AEM Thinking Forward event in a city near you.
Let's take a step back for a moment. What, exactly, is a digital service product?
A good example of a consumer digital service product is Google Search. It’s an application focused on the worker, not the developer, with a millennial UI and uses many heterogeneous data sources. Open the hood and you’ll see a ton of software and hardware technology inside.
Once your digital service product R&D team has established the definition and requirements of a digital service product, the next step is to inventory the data you already have. As the product provider, you already have access to information in your document management, CRM, service management, parts inventory and call center applications.
The third step is to connect the machines and in particular develop a way to connect any of your legacy machines. Monetizing your installed base is the fastest way to double your revenues and quadruple your margins. When you connect the machines, make sure you have a way to segregate the data and put that control in your customer’s hands. There are four types of data:
1. Static machine data -- This is data about the machine, which never changes, or changes infrequently. A prime example would be the serial number.
2. Environmental machine data -- Machines exist in the physical world, so location, humidity, temperature and altitude all fall into this group.
3. Dynamic machine data -- Machines have a large number of sensors, which can provide data frequently. Wind turbines have over 500 sensors. Vibration sensors can sample at 10,000 cycles per second.
4. Nomic (I made the name up) data -- A gene-sequencing machine produces genomic data. Agronomic data includes the nitrogen level at a particular location in the farm. I’ve used the term nomic data to refer to this type of data across any kind of machine.
Just as you do on your phone, you choose which applications are allowed to see your location or access your photos. You should build a similar model for the owners of your machines.
Now that we have established the data infrastructure, the next step is to identify the workers. We’ve said a digital service product delivers information, which is personal and relevant. This of course could vary from person to person. Using cars as an example, personal and relevant information is different depending on whether I’m the driver of the Mercedes or a member of the design team. In general, workers could include the operator of the machine, the customer’s service people, the OEMs, the process expert (assuming the machine is part of a production process) and even the R&D team that designed the machine.
Finally it’s time to invest and build the digital service product. You’re in luck. In the past 10 years there have been major innovations in cloud computing, AI, 5G and the edge. Today you can get 1,000 servers for 48 hours for $1,000 And the costs are only going down. Meanwhile, on the software side, there are more and more choices both as open source and as cloud services. Check out my article to learn about 16 classes of software that will be part of your digital service product.
While one day I hope there will be packaged applications -- as we’ve seen in back office ERP -- today your best alternative is to create a team mixed between internal and external people. While some of you may be able to afford a totally in-house team, the practical solution in a fast-changing world is to partner with one or more external suppliers.
While the task of building a successful digital product is far from easy, there's a pot of gold at the end of the rainbow for those who do.
There are no shortage of research development teams (R&D) that built great -- yet ultimately unsuccessful -- products. And while any manufacturer -- no matter the industry -- is capable of doubling its revenues and quadrupling its margins by building digital service products, it's a task that's more easily said than done.
Why? Because the digital service product still has to be sold. And successfully doing so requires not only investment of time, effort and resources. It also requires a concerted effort to focus on five key components:
Let’s start with pricing the product. While it can generate significant amount of debate within an organization, I propose you start with something simple. Price the digital service product as a monthly percentage of the purchase price of the machine. In the world of software, this often ranges from 2-6% of the purchase price of the product. Consider starting with 0.5-1% per month. So if your microplate reader is priced at $75,000, you should price the digital service product at $375-$750 per month. Of course, you’ll have a volume discount matrix, which will offer customers who spend more money a bigger discount.
Next, you’ll need to define the marketing message. Since your No. 1 competition is the status quo, you should start with “selling the not.” Plenty of people both internal and external to your company think service is break-fix. A few months ago, I had breakfast with the CEO of a company that builds machines for the semiconductor industry. I asked him how many machines he had in the field. He responded by saying around 10,000 to 20,0000. The precision of his answer caught my attention immediately. I went on to ask him how much service revenue he generates, to which he responded with the universal sign of a goose egg.
I then asked “Why zero?” He replied “No one wants to pay for service.” Of course the reason no one pays for service is he defined it as break-fix support. Anyone who has just bought a $250,000 machine would assume it would work, so why pay anything more?
Well, service is not break-fix. Service is information, personal and relevant; information on how to maintain or optimize the performance, availability, security and changes of a machine.
Then there's the importance of top-level marketing stories. In the modern era, it's critical for you to find a way to tell your story as a story. Every night when you watch your favorite television show, you’ll see some essential aspects of storytelling. Stories have characters. Stories are set in a particular place and time. And all stories fall into three categories: man vs. man; man vs. nature; man vs. himself. Now check out your marketing collateral. How many stories do you see?
Once you’ve clearly articulated your digital service product story, your next major step should be to hire and organize your sales team. Make sure it's a dedicated team. Selling service is not the same as selling new product features. Think of it this way… You may have noticed the Mercedes sales person and the Mercedes service manager isn't the same person. Your digital service salespeople will be more farmer than hunter, since the goal is to monetize your installed base. Given these are all customers you should know, this is not the same as trying to prospect for new names.
No sales team works without a compensation package. Given you’re moving from selling one time to selling a recurring service, you’ll need to establish a compensation plan which both incentivizes the initial sale of the service, but also more importantly the renewal of this valuable recurring revenue stream. In software companies, it’s not uncommon to have customer success managers whose sole focus is continually satisfying the customer.
Next you’ll need to have business operations create new contracts and ordering documents. You could borrow some of the terms and conditions from the software-as-a-service industry, but my most important recommendation is you avoid the creation of service level agreements with associated point-by-point penalties depending on how you did or did not perform the service. Instead, create a digital service product guarantee, which is all encompassing. In this guarantee, you should stipulate that, no matter the reason, the customer is entitled to a rebate of 20% in the month the claim is made. This will simplify revenue recognition, which will make your CFO happy, reduce legal expenses and expedite the contract signing (which should, in turn, make your sales teams happy).
Finally, building and selling a new product line will not happen without investment. You’ll be challenged to re-allocate resources from your traditional business. If you’re looking for a tool to help think about how to fund this transformation check out Geoffrey Moore’s last book, Zone to Win. He talks about putting your annual budget into four major categories:
The performance zone is money you spend to deliver material bookings, revenues, and contribution margins in this fiscal year. The productivity zone is money you spend to increase the efficiency and effectiveness of your R&D or sales organization. The money spent to deploy a new CRM application would fall into this category. Again, the time horizon is the current fiscal year. Most companies will have 100% of their budgets allocated to these two categories, which brings us to the last two categories. The incubation zone allocates funds to developing new business models or new products. The time horizon for these investments is 36-72 months. If you have not started a digital service product, then you’d allocate financial resources from the incubation bucket. Finally, the transformation zone is where you put the wood behind the arrow and fund not only the development of the digital service product, but all of the sales and marketing that’s required for it to be successful. Moore says pick only one project from the incubation zone. The CEO must sponsor it. Furthermore you’d expect to deliver 10% of the current company revenue in a 36-month horizon. Given the market opportunity is at least two times your current product revenues, this is certainly possible for any digital service product.
While not easy, the next major step for any company that makes combine harvesters, front loaders, industrial printers, water purification equipment, agitators or ultrasound machines is to build and sell digital service products. Digital service products deliver information on how to maintain or optimize the performance, availability and security of the machine. These are the fundamental components of the last major step, which is to deliver the product-as-a-service.
We’re already seeing the digital service product revolution occurring in certain industries. When will it start in yours?