The classic example is the Rolls-Royce aero engines business, which went from selling large jet engines to renting airlines the capabilities of the engines on a by-the-hour basis. You can unbolt an engine and swap it for one from another manufacturer with some difficulty; it's much harder to unpick the financial, legal, service, maintenance and support issues surrounding a deal to rent engine power by the hour.

It's understandable that Western companies are trying to develop services on top of their manufacturing base. South Korea has compressed the equivalent of 200 years of Western industrial development into 40 frenetic years. China has made a triumphant return to the world economic stage with its low-cost manufacturing strategy, but is already looking to move away from reliance on such a low-margin, capital-intensive business. India is developing itself as an intellectual powerhouse, starting out by taking on 'grunt work' from the West but steadily moving itself up the value chain. That's the threat - on the opportunity side of the balance sheet, businesses have also recognised that services offer a new way to add value, as well as vital customers.

What's concerning as the West tries to maintain its standard of living through high-value services is that there seems to be little understanding of how to innovate in the service sector. Many service organisations innovate, but the intellectual underpinnings for most innovation practice are still derived from the manufacturing sector, where value is measured by the output of tangible goods, rather than by softer factors such as customer satisfaction, repeat business, and recommendations.

Service innovation demands a different approach. The research literature usually talks about services having a special set of characteristics. These include the intangible nature of service outputs, as noted above; the close interaction between production and consumption; the key role people play in delivering services; the importance of a company's organisation to its success in providing services; and the weakness of intellectual property protection in the sector.

This landscape throws up fundamental questions for companies trying to move from manufacturing to services. Who does the service innovation? Should these businesses create a department with 'Service Innovation' on a plaque on the door, much as they have with the R&D function, or do they boldly insist that everybody in the company make service innovation part of their day-to-day jobs? What sorts of people and skills does a company need to be a successful service innovator? Does a company need to re-engineer its financial base to match new revenue models? It's a whole new set of problems, and the responses are still being worked out.

The policy dimension

Policymakers have begun to grasp the idea that simply creating more science does not automatically lead to the emergence of more innovative companies, and are now acting to promote the application of new science as well as its creation. But even as these issues are being addressed, the increasing economic importance of services is adding further complexity to innovation policy. The OECD has recognised the issue in its Science, Technology and Industry Scoreboard, pointing out that “in terms of non-technological innovation (organisation, marketing), service industries are as strong as manufacturing industries, but they account for much less technological innovation. For service firms, non-technological innovation is a strong driver of performance.”

The UK's National Endowment for Science, Technology and the Arts (NESTA), has made similar points about the under-reporting of certain types of innovation in its report on hidden innovation. It says that science-based innovation only happens in 6% of the UK's economy, and that a gap has opened up between innovation support policies and the types of innovation that matter most to the UK economy, with its emphasis on services and the public sector.

NESTA's analysis found at least four types of hidden innovation. The first is innovation that doesn't get included in standard measurement exercises, such as that which goes into developing new oil-exploration technologies. The second form of hidden innovation is in organisational structures and business models, such as the introduction of telecommuting for contact-centre workers.

The third form stems from combining existing technologies and processes in new ways, for example linking back-office systems and the Internet to create online banking systems. The fourth is local, small-scale innovation that doesn't get noticed, such as new approaches to classroom teaching or team working.

The point is that such innovations are often enabled or blocked by policy issues such as taxation, skills and regulatory frameworks, and by wider political conditions. Better recognition of these forms of innovation could lead to policies that support the types of innovation, especially in the service sector, that don't rely on simply doing more science.

Organising for service innovation

Professor Bruce Tether, research director of Design-London, a collaboration between Imperial College, the Royal College of Art and the Tanaka Business School to develop new ways to innovate, has been studying service innovation.

He says service innovation tends to flow from ad-hoc teams, drawn from operational groups, which form for a project and are then dissolved.

“That's not to say it can't have a more R&D-like role,” he said. “We're seeing a convergence of manufacturing companies moving away from an R&D-centred approach, and service companies moving towards that model.”

Tether has analysed some large surveys carried out in the 1990s, such as 1997's European Community Innovation Survey, to better understand how service innovation happens.

“We're finding three modes of innovation,” he said. “The first is the R&D mode using internal R&D, often in collaboration with universities or other research institutes and oriented towards product development. These are usually high-technology firms in high-technology industries.

“The second form of innovation is in process technologies, adapting or acquiring advanced equipment and using it to improve efficiency and effectiveness. This is usually done in lower-technology industries.

“The third mode of innovation is the organisational/co-operative mode, which is focused on organisational changes and which highlights the skills of the workforce. It often also involves co-operation between the organisation and its supply chain for mutual benefit. This is a very soft and difficult-to-measure form of innovation. It is much more about disseminating innovation within the organisation, giving people more power to innovate, as well as having more innovation within the value chain.”

Tether gives the example of Siemens, which has been trying to change its medical-imaging business into one that sells usable time on it scanners, rather than capital equipment.

“This means the company begins to think less about adding new features to the products [in order to sell the next generation] and more about making them inherently more reliable, so they cost less to run,” he said. “This starts to change the mindset of the product development teams and provides incentives to look at how the scanners are used.

The result is that a shift to a more service-oriented business starts to have an impact on design issues, boosting the uptake of usability studies and people-centred design. In turn this demands that product development people spend more time talking with customers, and even, as companies such as Intel and design consultancy Ideo have started doing, employing anthropologists and ethnographers to observe their behaviour.

Challenges

This approach brings challenges of its own. An iPod may be recognised internationally as a desirable consumer product, giving Apple useful economies of scale in its manufacture. But its supporting iTunes music download service has to be adapted to local regulatory requirements and musical tastes, complicating the global introduction of the iPod. As markets fragment, service operations will need to adapt their offerings quickly to each niche. This requirement for localisation may, however, turn out to be a blessing - of which, more later.

There are other issues with service innovation, especially around its reliance on people to deliver the differentiating value. For example, how do you map human needs to a formal service specification? How do you continuously drive down costs, as manufacturing organisations have done for years, without destroying the personal and emotional relationships inherent in a successful service offering? How do you know which parts of a service you can automate, which must be handled by human interaction, and how the two approaches work together? How do you respond to the vast breadth of possible human reactions to a service issue?

The need to localise services highlights another key issue: complexity. Successful service innovators need to be able to cope with evolving customer needs, and the requirement to include functions in a product to support potential service offerings (think of the 'reserved' buttons on a remote control or the unused ports on a broadband modem). So the components of a service (the product, the service proposition, the financing etc) need to be packaged as modules that can be rapidly assembled to deliver a targeted service. The corollary of such an approach is, unfortunately, increased uncertainty and cost, decreased reliability, more complex interactions and a greater likelihood of unintended consequences.

In turn, this can demand new business models, as the value chain fragments and service providers have to act as both service integrators and as 'governors' of an overall service delivery system, which may be made up of contributions from multiple sources. It's a new problem set that can appear to be worlds away from the 'simple' business of inventing new products and selling them to customers.

Case study

BAE Systems, the global defence contractor, is already some distance down the road from manufacturing to services. Following pressure from the UK government, a major customer, at the beginning of the millennium, BAE has been converting its offerings to a service basis. The work started in the company's air sector, where contracts were renegotiated from payments for inputs such as spare parts, to payments for outputs such as the availability of its systems.

The approach was successful and led to a € 1.4 billion contract for supporting and maintaining the Royal Air Force's fleet of Tornado fighters. The National Audit Office, a UK body that looks at how effectively the government spends its money, says that similar contracts have saved the Ministry of Defence € 1.8 billion so far, a saving it also expresses as halving the per hour costs of flying Tornadoes.

New contracts are being developed that move from paying for the availability of the aircraft to paying for its capabilities as well. BAE has therefore been put in charge of a continuous technology upgrade programme for the fighters, on a two-year cycle, compared with the previous approach of doing one high-cost, high-risk technology update every 10 or 12 years. This cuts costs and risks and enables technology to adapt much more quickly to evolving threats.

'Pay for capability' is also changing the way BAE thinks about its business. It used to be in the company's interests to sell as much equipment as possible. Now, the fewer pieces of kit that end up in service, and the greater their capabilities and reliability, the better it is for business.

Part of making this work means getting closer to the customer, understanding their cultural outlook and behaviours. Working with customers has various potential benefits. The customers have the operational data, while BAE has the design data, and to date the two haven't been effectively shared. With the new Tornado contract, that data will be more freely sharable, enabling BAE to understand how to build more reliable, serviceable systems. BAE has also moved some staff from its Wharton, Lancashire, manufacturing site down to RAF Marham, the main operating base for the Tornado, where it manages a combination of 250 BAE Systems employees and subcontractors, and 250 RAF people, as one unit.

Being a defence contractor, BAE is keen on systems and models, and it has developed an 'integrated support business model', based on systems engineering practices, to help it innovate in services.

According to Greg Bolan, head of capability development for BAE Systems Business Improvement, UK/rest of world, the model acts almost as a warehouse for developing and running new services. All the parts of a service delivery operation are described in the model, so people remember to consider all the factors involved as they develop ideas. The model also provides a single point from which all BAE's learning about each aspect of delivering a service can be accessed, including all the initial design and development activities.

“It's the place where we capture and share learning as individual service elements are developed,” he said.

Bolan says that the shift to offering services has made the organisation into its own customer for efficiency upgrades. It has also driven the company to strengthen its modelling capability: “We can model new [equipment] designs and we are now starting to model operations, especially partnering operations. We may be the first to have established partnering solutions and applied business-process management techniques across a joint industry/military collaboration.”

BAE is now developing modelling capabilities that enable it to work out the best way to run support operations. Dynamic solutions modelling at the enterprise level, for example, lets the company test how a solution should be offered, work out the most appropriate levels of manpower, and consider whether repairs should be done on military bases by military people, or back at the factory by industrial partners. The company is also using its systems engineering capabilities, developed creating hardware and software, to do systems integration at the enterprise level, for example looking at issues like the supply chain or approaches to maintenance.

“We tend to run models of operations to work out how to refine them for more efficiency and effectiveness,” Bolan said. “We use those models to underpin our business decisions, which means we have to build confidence in the model's output by ensuring that the input data is good.”

The development of the integrated support business model hasn't prompted BAE to create a 'systems innovation lab' with a plaque on the door, rather the opposite.

“We haven't got an independent body that provides R&D for business-process innovation,” said Bolan. “What we have got is the capability of avoiding someone reinventing the wheel, by being able to take a good new capability and repurpose it to other uses.

“The model allows different parts of the business to tap into a generic corporate model which illustrates the key processes to design and deliver solutions.

BAE is now investing in new capabilities to flesh out various aspects of its support model. It has spent money developing demand-forecasting systems to create a more reliable supply chain, embedding the resultant capabilities in the support model. The maintenance capability is also being enhanced to apply new regulatory requirements, with the resultant processes being optimised as part of the support model.

“Our innovation is in two key areas: the ability to integrate and optimise processes across the military and industrial sides of the partnership; and the innovative application of a generic model that enables projects to feed off all the learning developed elsewhere in the business,” said Bolan. The upshot? “We can now achieve in a few months what originally took six or seven years.”

Tools and insight

The huge importance of building an intellectual framework around service provision has not gone unnoticed in academia or industry. In May 2004, IBM and others suggested the formation of a new academic discipline that was first described as services science and has since become known as Services Sciences, Management and Engineering (SSME).

According to Dr Liba Svobodova, program manager for technical strategy and planning at IBM Research in Zurich and IBM's European lead on SSME issues, SSME is focused on getting academia, industry and government to support the right programs, so that people have the right skills for a service economy. It's also about developing research programmes to push the state-of-the-art.

IBM is also working on applying its research to service innovation.

“Service innovation is happening across industry and we're trying to bring rigour to it by applying engineering disciplines to service design, development, management and life-cycle issues,” said Svobodova. “We're also looking at how to encompass the more complex problems of service networks, such as how they are modelled. Mostly we're trying to take new technologies from research in, for example, optimisation, and use them to establish a scientific framework to make service design and operation more efficient. We're also trying to find ways to analyse whether service ideas make business sense.

“An important part of this is the people, who act as the most unpredictable element,” she added. “We have 550 people in research focusing on bringing innovation to our service businesses, as well as 180,000 people in the business who are innovating on services as part of their daily work.

“What we do in IBM Research is closely coupled to the services business, through a strong partnership with the business units,” she added. “This is critical. You need to understand the business issues and the customer problems to be effective in services.”

Svobodova says it is still difficult to work out where new technology, methods and algorithms can make a difference to service innovation. But IBM is trying various approaches, such as business-oriented design, in which it looks at the whole process from the definition to the realisation of a service on a platform. It is also developing optimisation models and technologies to underpin the services.

“We do it once with one customer, drawing out the general principles and then developing an asset that can be used in many later engagements,” said Svobodova. For example, IBM is working on data-driven models and new analysis techniques to understand risk. It is involved in a project where 36 international banks are pooling their data on operational risk, and IBM is researching new correlations between the inputs and the operational risk.

“If we can make that work, banks would be able to reduce the money they have to set aside to cover their risks, because their risk is better defined,” she said. “So it's a solution delivered as a service, with a spin-off asset and perhaps the potential to develop the risk analysis techniques into a service.”

IBM has also been applying itself to the issue of running IT environments for customers, where efficiency and customer interaction are very important because customers expect better service from IBM than they were receiving from their internal organisations. So there's lots of pressure and lots of requirements for a standardisation of the process of delivery, as well as for its efficient management.

“It is difficult because you have to have people involved, and people aren't considered part of the process yet,” said Svobodova. “So we have to really understand how people work and adapt an optimised process to that, so people feel integrated but not stressed. We have started an analysis of how we can better adapt for people-to-people interactions and how we can better handle the alternation between people-to-people interactions and automated interactions, for example in customer service.”

Getting academic

The SSME initiative is an attempt to codify the learning and tools that companies such as IBM are developing so that industry will be better able to compete in the global service economy, and governments will be better placed to help them do so.

“SSME is a call to action to develop more sophisticated understandings of service innovation,” said Svobodova. “How do you ensure that services stay in one geography? We have to compete on value, not cost. Hong Kong is already saying that its economy is 85% services. And China is very interested to move to higher value services. It doesn't want to remain a low-cost manufacturer, so it is investing in education to build up the skills of its people to deliver services.”

According to Svobodova, service innovation already has a very high priority at the European Union level, both within the Seventh Framework Programme and within Commission policy development. There are also moves afoot to create a virtual centre of expertise on service innovation in Europe, to match the US's Service Research and Innovation Institute, which was launched in March 2007.

But she points out that it may take some time for the discipline to develop.

“It's not easy to pinpoint what service innovation is but we all feel is very important,” she said. “I'm looking from the more scientific point of view. IBM helped create computer science in the 1960s but it took 20 to 25 years to get to find the point it is today - and computer sciences is really 20 to 25 separate fields.”

Getting sticky

Service innovation may, as yet, be largely uncharted territory. But at least that territory may be defensible against the relentless march of added value to the East.

Tether makes the case: “Companies often try to launch services when they are in crisis or can see a crisis coming. I went to a conference in Taiwan a few years ago about service innovation, where the Taiwanese were clearly worried about China taking away their cost advantages. They wanted to know how they could move from providing goods to providing services for the ageing populations they saw developing around the world. They'd seen the clouds on the horizon and were acting.”

He says the same is true of the UK's design consultancies, who are worried about their work being outsourced to China, where employing a good design graduate costs one fifth of what it does in the UK. But Tether argues that Western economies have a strong advantage in knowing about their local markets and how goods and services are used in them.

“This kind of tacit knowledge is much harder to export around the world,” said Tether. “It's what they call sticky knowledge.

“Ultimately a product is an expression of knowledge in a tangible good,” he added. “If you have close knowledge of how things are used, that knowledge is more sticky.”

He compares this kind of knowledge with that involved in competing in a highly regulated and structured industry such as air travel, where everyone has access to the same equipment and services and acts under the same constraints. It was this standardisation which enabled Sir Stelios Haji-Ioannou to create easyJet, his low-cost airline, by taking the business model pioneered by SouthWest Airlines, adapting it very slightly and applying it to another geography.

Tether also points out that in a world with much more global competition, some organisations will be able to secure differentiated advantage simply by being near their customers: “The ultimate scarce commodity is time, and having people close by saves that scarce commodity.”

The financial issues

Shifting to a service-based model is likely to demand some changes in the financial underpinnings of a company, to account for the move from upfront payments to fees paid over time. Companies also need to consider the impact of working to different measures of success, for example payment for continuing performance rather than for meeting milestones. There's also some evidence that making the transformation to a services-led organisation can be hazardous to a business's health.

Professor Andy Neely, director of research at Cranfield School of Management, has been researching the relative fortunes of manufacturing and hybrid organisations using the OSIRIS database, which contains information on 44,000 publicly listed companies from around the world. His research looked at 10,827 companies that were defined as manufacturing organisations by their standard industrial classification codes, and which had more than 100 employees. Of these companies, 29.52% offering a combination of manufacturing and service, while 1.78% of them appeared to be pure service firms.

He found that, on average, firms that offer a combination of manufacturing and services generate higher revenues but lower profits as a percentage of revenues than pure manufacturing firms. He also found that hybrid companies are more likely to declare bankruptcy than pure manufacturing operations.

“The finding [about profit margins] is true at the aggregate level for all manufacturing firms, though there should be sectoral and country differences,” said Neely. “The important point to make is that there are two sides to this coin: a smaller percentage of a bigger pie may be better for the organisation.”

Neely thinks that lower margins may be attributable to the fact that companies starting to offer services have to invest in people and infrastructure assets up-front, and then get paid back over the life of the service contract. Once the service business grows into the asset base provided, and the service revenues start flowing, profitability may return.

The bankruptcy issue may stem from the same source. According to Neely, about two thirds of the companies surveyed were pure manufacturing firms, and about one third were combined manufacturing and services organisations. Yet of the 216 firms that declared bankruptcy during the survey period, over half were combined manufacturing and service firms.

“If you think of traditional manufacturing firm making the move into services, it increases the complexity of the organisation, and you have to invest in the asset base,” said Neely. “This can potentially create a more risky business.”

Neely also argues that companies making the transition need to manage public perceptions of what they are doing closely. He draws a parallel with the introduction of lean manufacturing techniques, which reduced the amount of work in progress held in factories. This was correctly reported in financial statements as a reduction of a company's asset base, which was easy for casual readers to misinterpret as having a negative impact on the company.

“Manufacturing firms thinking about adding services have to manage that transition,” he said.

Neely's analysis also shows that it is only in the top 10% of the companies surveyed that the majority of firms offer a combination of manufacturing and services. So the question is whether this means that adding services to a manufacturing company is only a strategy for the largest players. If it is, what are the implications for the smaller companies that work with them in a value chain?

Making a shift to a service-based, or a hybrid manufacturing and services organisation is clearly a major challenge, which may offer some companies the ability to create more strongly differentiated value than they could as a pure manufacturing operation. But much of the logic of service innovation has yet to be worked out, leaving companies to feel their way with a combination of gut instinct and common sense. And making the transition has its own perils, as well as offering no guarantee of success.

As Neely succinctly put it: “The data doesn't say manufacturing firms shouldn't go into services. Nor does it say if they do they'll be more successful or stable.”