Part 1
Collaboration and new ecosystems made possible by technology are in vogue today, but they usually involve either some form of tighter integration along a value chain (supplier to customer), better project oriented cooperation within companies or the coalescing of industry participants around a central platform provider to access that provider’s market and customer base. However, another possibility might be for smaller organizations coming together to strengthen their competitive position collectively. An interesting segment of such SMEs may be independent technical/industrial B2B service providers (ISPs).
As noted elsewhere in this blog*, for both competitive and market reasons, there is a strong trend among manufacturers and OEMs to servitize. The strategy has both offensive and defensive elements: Servitization enables new technology driven offerings and closer relationships with customers. OEMs that don’t provide such offerings risk commoditization, if they get cut-off from data required to deliver improved outcomes to customers on an on-going basis. But in the process of OEM servitization relationships between them and companies they cooperate with for purposes of servicing the installed base (e.g. authorized service providers of various types) is bound to change: ISPs may get dislodged; Their activity mix may change (lower value), their pricing power reduced or, in some cases, as the service capabilities of OEMs are extended through technology, they might find their business volumes declining. In such an environment ISPs must either find new sources of revenue or find new ways to compete. Cooperating may be one such way.
In a defining article (The Nature of the Firm) in 1937, Nobel Laureate Ronald Coase ascribed the existence of firms to the costs of transactions in the market place, which, in total, can often exceed the value of a good or service. Examples of such costs include search and information costs, obtaining and policing intellectual property and trade secrets or costs of procurement. A firm’s primary function is to internalize these activities and therefore reduce the associated transaction costs. Furthermore, many costs are fixed so it makes sense for companies to grow to be better able to spread these fixed costs over a larger number of products and customers and keep prices low. Coase did not think that it made sense for firms to grow indefinitely however, as at some point the cost of complexity associated with size would overcome the advantage of size (what Coase called “decreasing returns to the entrepreneur function” or the propensity of managers to make mistakes in resource allocation, something closely related to company size). A short article by the Economist provides a good explanation of the need to balance “economies of scale” with the “diseconomies of complexity”.
Over the past 80 years however, technology has helped make increasing complexity ever more manageable and therefore companies have grown to sizes that are far larger than Coase could probably have imagined. In addition, technology has fueled businesses and markets where “network effects” are pronounced and “winner takes all” conditions prevail – providing ever more incentives for size, internalization of value chains and market domination. For example, platform companies (Google, Facebook, Amazon) may be upended through technological innovation or if they run out of market (unlikely). But they don’t seem to be constrained by complexity economics.
The question here however, is can smaller companies in today’s environment come together to become more competitive in their markets in a form of horizontal collaboration to, in some way, punch above their individual weight? In other words, can collaboration lead to a situation, where smaller companies reap the benefits of being one “firm” in the sense of Coase (internalizing more activities and reducing transaction costs) and size (reduce unit fixed costs) without becoming too complex and compete against larger companies as equals -without, it might also be added, sacrificing their independence (as in a merger)? And can that collaborative group be more than purely the sum of its parts, i.e. can it create additional value?
The idea is not new. For example, one form of “natural” collaboration -industrial clusters- has existed for centuries. The physical proximity of firms in the same industry, along the value chain, increases the competitiveness of all. Key drivers are access to deep pools of skills and expertise as well as to information channels which make understanding of developments in markets, as well as innovation far easier. Critical mass in customers and product sold or installed create a reinforcing feedback loop. Clusters abound in almost all industries, historically from the flower growers in the Netherlands, to the watchmakers of Switzerland, to the mechanical engineering and automotive clusters in southern Germany. Modern high profile clusters include the City of London, Silicon Valley and Hollywood.
In an influential article (Clusters and the New Economics of Competition) in 1998, Michael Porter, a Harvard economist famous for the “Five Forces” competition model, suggested that clusters are key sources of value creation and competitive advantage in all economies. He defined clusters as geographic concentrations of interconnected companies and institutions in a particular field. They encompass an array of linked industries and other entities important to competition.
According to Porter, clusters represent a kind of “spatial organization form” in between arm’s-length markets on the one hand and hierarchies, or vertical integration, on the other, so a cluster is an alternative way of organizing the value chain.
“Compared with market transactions among dispersed and random buyers and sellers, the proximity of companies and institutions in one location—and the repeated exchanges among them—fosters better coordination and trust. Thus clusters mitigate the problems inherent in arm’s-length relationships without imposing the inflexibilities of vertical integration or the management challenges of creating and maintaining formal linkages such as networks, alliances, and partnerships. A cluster of independent and informally linked companies and institutions represents a robust organizational form that offers advantages in efficiency, effectiveness, and flexibility. A cluster allows each member to benefit as if it had greater scale or as if it had joined with others without sacrificing its flexibility.”
Porter placed significant emphasis on the fact that clusters are geography based, the physical proximity creating multiple advantages, so for example:
Better access to employees and suppliers: Not only do clusters provide deep skills pools and reduce search and transaction costs. But because a cluster signals opportunity and reduces the risk of relocation for employees, it can also be easier to attract talented people from other locations, often a decisive advantage. Sourcing locally instead of from distant suppliers lowers transaction costs. Not only does it streamline the supply chain by minimizing the need for inventory or eliminating importing costs and delays, but, importantly, because local reputation is important, it lowers the risk that suppliers will overprice or renege on commitments. Even when some inputs are best sourced from a distance, clusters offer advantages: Suppliers trying to penetrate a large, concentrated market will price more aggressively, knowing that as they do so they can realize efficiencies in marketing and in service.
Linkages among cluster members results in a whole greater than the sum of its parts: In a typical tourism cluster for example, the quality of a visitor’s experience depends not only on the appeal of the primary attraction but also on the quality and efficiency of complementary businesses such as hotels, restaurants, shopping outlets, and transportation facilities. Because members of the cluster are mutually dependent, good performance by one can boost the success of the others.
Local rivalry is highly motivating: Peer pressure amplifies competitive pressure within a cluster, even among noncompeting or indirectly competing organizations. Pride and the desire to look good in the local community spur companies to attempt to outdo one another.
Companies inside clusters usually have a better window on the market than isolated competitors: They can identify customer needs and trends with a speed difficult to match by companies located elsewhere. The ongoing relationships with other entities within the cluster also help companies learn early about evolving technology, resource availability or service and marketing concepts. Such learning is facilitated by the ease of making site visits and frequent face-to-face contact. Furthermore, clusters not only make opportunities for innovation more visible. They also provide the capacity and the flexibility to act fast. A company within a cluster can often source what it needs to implement innovations more rapidly. Local suppliers and partners can and do get closely involved in the innovation process, thus ensuring a better match with customers’ requirements.
Porter wrote the article because he was wondering why in an era where companies can quickly source capital, goods, information, and technology from around the world, location still matters so much. In theory, more open global markets and faster transportation and communication should diminish the role of location in competition. But if location matters less, why, then, is it true that the world’s best mutual-fund companies are located in Boston, a large chunk of the world’s pharmaceuticals industry is located in a corridor spanning southwestern Germany and German-speaking Switzerland, high-performance auto companies are based in southeastern Germany and the heart of the world’s leather fashion industry is located in northern Italy?
Nevertheless, much has happened in the intervening 18 years since Porter published his article. The advantages of clusters undoubtedly still apply. But is “location” only a physical or can it now also be deemed a virtual concept? Might technology have advanced so far so as to enable virtual clusters to emerge?
Consider a platform like Upwork, a virtual location mainly for IT professionals to sell their services. Essentially it provides a marketplace where potential clients can post projects or jobs that potential suppliers can bid on. In reality however, it is much more than that. It also provides access to information: Both clients and vendors can scan the site to see what is happening: Who has won what project; How suppliers and clients are rated; What clients are demanding (applications, technologies); What technologies are offered; What prices are charged; What is the approximate productivity (hours per job); and so forth. While the platform does not provide the explicit means, there is nothing to stop suppliers from getting to know each other, assess each other’s reputation, experience, skills and cost levels and, eventually, collaborate. Of course it is not the same (yet) as being in the same location, but it is an improving approximation. Numerous social and task oriented tools are today available to enable cooperation across distances between cooperating vendors and between vendors and customers. Cloud technology is making a mockery of distance. Not only that, but is even providing an advantage to geographically dispersed teams that can work cooperatively on a project on “follow-the-sun” principles: When one goes to bed, the other starts working.
Part 2
Based on the reasoning described in Part 1 of this article, we can conclude that for collaboration to make business and economic sense, in particular for smaller and medium sized companies such as most of those operating independently in technical / industrial (after sales) service markets, it must help make those companies more competitive, in terms of both cost reduction and value creation capability. In addition, it should help them expand the market opportunity.
Before looking into the specifics of how this can be done, let’s briefly examine the structure and dynamics of the market in which independent service providers (ISPs) operate -in broad terms: servicing/maintaining, sustaining and sometimes operating the installed base.
The overall market is big: The installed base (however measured), is usually a few orders of magnitude larger than annual new product sales. Assuming anywhere between 3-8% service/maintenance expenditure p.a. relative to the notional market value of an industrial asset, means therefore that the “after” market is significantly larger than the market for new sales or installations. A major share of the market (approx. 70+%) is controlled by OEM’s (or service units of OEMs) and diverse large engineering/construction contractors and “hard” facilities management providers, which, for different reasons, have moved into the space.
ISPs become more evident, as services become more equipment centered -they are essentially niche players in a broader market, basing their competitive position primarily on cooperation with OEMs, which provide access to product and product knowhow, spare parts and technical information as well as customer proximity. As OEMs increase servitization (broaden, deepen offerings and intensify efforts to internalize service revenue), this relationship will be stressed, while competition from the other big players will also strengthen -as their profitability is linked to scale. ISPs must therefore think of and strategize a competitive response.
At this point we should also consider why equipment focused service providers are relatively small (as a rule, though with exceptions):
- The market has low barriers to entry: It requires little investment in product development, distribution, working capital or capital equipment. Hence it tends to be competitively more intense. For each OEM offering a product, there are bound to be numerous companies servicing it.
- The market has been fairly local in nature (though this is changing). This was derived from the need to be close to customers, understand them well and provide fast and credible response.
- The nature of the business has been craft-like with high labor intensity. It has therefore been characterized by high variable (and relatively low fixed) costs. In other words, revenues drive costs, as labor needs to be added to execute additional work. Such businesses do not scale easily, nor is the pressure to scale as strong. In contrast, businesses which are driven by high fixed cost investment must scale quickly in order to amortize the investment by spreading it among many customers or orders. Such investments may be in processes, fixed assets or working capital.
Note: Technology based servitization efforts by OEMs, which are substituting capital (automation, IoT – fixed cost) for labor (variable cost), are changing the nature of the business making it easier to scale while progressively dislodging craft-like operations.
Given therefore the structure and dynamics of the market and the changing nature of an ISP’s business, how would collaboration help these companies negate the disadvantages of size and make them more competitive or open up new market opportunities?
Collaboration can expand the business scope of individual collaboration partners, provide better market coverage, improved client access or stronger bargaining power. However, its strongest competitive impacts are i) through sharing and ii) through collaborative value creation.
Regardless of the controversy surrounding the term, sharing economy applications can today be experienced in many market spaces. Uber and Airbnb are prime examples. The key economic impact of sharing arrangements is the increase in utilization of assets (vehicles in the case of Uber, housing facilities in the case of Airbnb) and the corresponding decline in “deadweight costs”, or costs associated with underutilization. It is easy to expand the understanding of these “assets” to include labor and technical pools, equipment and facilities, as well as intangibles such as systems and processes, accumulated knowhow and data.
At the same time cluster theory (see Part 1) explains how collaboration enhances value creation: through peer pressure which enhances momentum and intensity of effort; by increasing diversity in the way business is approached and conducted, which allows rapid dissemination of best practices; and through the transfer of experience which allows reduction of risk. This can lead to improved offerings, better productivity and a higher innovation rate.
So let’s examine in slightly more detail the benefits of a hypothetical collaborative scenario for ISPs:
Scope
Partners can expand their scope by adding businesses/activities based on a partner’s -not their own- competence, market access and references.
Market Coverage
Obviously the partnership as a whole has broader coverage than the individual partner, which is important in itself. But there are also more subtle advantages, e.g.:
- The partnership can play a role in projects or activities with customers who operate in different markets, but want to reduce numbers of suppliers -as the partnership can be considered as one supplier.
- A partnership can have an advantage over an individual partner in accessing new markets, i.e. where no individual partner is active, either by sharing market entry costs or by making the partnership more attractive to potential customers in that market (experience from more markets, industries and knowhow) as well as implying greater solidity and dependability.
Client access
Collectively a partnership should be able to exploit individual partner customer access to improve overall access. In addition, it may be able to improve access to larger projects (scope or scale) by providing combined competences and a (virtual) combined balance sheet in the sense of consortium arrangements.
Bargaining power
A partnership not only has increased bargaining power with suppliers, customers and partners (e.g. OEMs), which is highly important for profitability. It also shapes supplier pricing strategies and intentions creating an enhanced effect. Furthermore, its positions carry more weight with partners (e.g. OEMs) and its influence is greater.
Sharing
A significant number of overhead functions can be brought to partnership level and shared reducing unit overhead costs for partners, including sales and marketing, particularly as active online content-based marketing becomes more important in B2B contexts. In addition, utilization of resources of various types, including people, inventories, tools and equipment can be increased while the balancing of supply and demand for resources can be improved (opportunity cost of overutilization reduced).
Value creation
A partnership allows pooling of investment in innovation and competence building, which helps make both the individual partners (and the partnership as a whole) more competitive through improved offerings, enhanced productivity (processes) and reduced risk. In the case of ISPs, this is particularly important if/when there is a shift in the service mix which requires higher fixed cost investments to obtain recurring revenues (IoT, data, outcome based services) -in essence moving from a craft-like to a more industrialized form of operations.
So given the potential benefits of collaborative partnerships, why is it that they are not happening on a continuous basis? In the past partnerships (in the sense of this article) have been difficult because of distance and the prohibitive associated cost of communication without which the building of necessary trust and sufficiently deep understanding of each other’s strengths and weaknesses to envisage, coordinate and act on opportunities is impossible. However, the fundamental reason is that up to the present technology shift and the induced changes in markets and business approaches, partnerships of this type did not have sufficiently compelling strategic justifications. The combination of improved tools, decline in collaboration and coordination costs and the need to improve chances of success in a disruptive competitive environment will probably make all forms of cooperation far more ubiquitous in the future.
Finally, implementing a successful collaborative partnership is not an easy task and requires some significant effort. The understanding and appreciation of potential benefits, but also the cost associated with achieving them need to be shared by participants. Some critical success factors are as follows:
- Start with a small number of peers who have in common both the willingness to participate as well as the rationale for the need and justification, in particular a common view about how markets and competition will evolve. The number must be small enough to allow fairly rapid progress (without too many obstructions by widely diverging ideas), but also big enough that it can make a real difference in the ability to compete.
- The partner companies should be of varying sizes and competences but no participant should be so big, as to be able to dominate proceedings and exercise power over the rest.
- Create initial hypotheses on how the partnership could enhance competitiveness and support business objectives of the individual partners and set out a vision for the partnership as a whole.
- Establish a joint team to validate hypotheses and set protocols for sharing of sensitive information.
- Try out and select technology tools to enhance the collaboration process and increase the frequency, breadth and depth of interactions between team members.
- Create an integrated collaboration platform to support strategic initiatives and actions.
- Define strategic initiatives and prepare and endorse business cases around them.
- Develop and agree governance, operating and value sharing models.
- Identify key dependencies and risks and plans/actions to mitigate risks.
- Regularly monitor and review progress and adjust plans as required.
- Attract and integrate further partners as required.
Titos Anastassacos is Managing Partner at Si2 Partners, a consultancy helping clients leverage services to win in industrial markets