8 steps to a "servitized" supply chain

Companies are facing an array of challenges these days: higher costs, shrinking margins, increased customer expectations for customization, and rapid commoditization of products. To deal with these challenges, more companies are moving beyond focusing purely on creating a product and instead are providing bundled product-service packages, a strategy referred to as "servitization."

Servitization provides a differentiated source of value to customers, and thus increases the probability of more profitable relationships between them and the manufacturers with which they do business. As the trend toward servitization grows, it is important for supply chain management professionals to understand how to successfully design and manage a servitization offering.

Article Figures

[Figure 1] The 8 steps for creating a servitized supply chainEnlarge this image

[Figure 2]Focused service opportunityEnlarge this image

The "servitized" supply chain that supports such an offering is different than a product-focused supply chain. For one thing, it has to be more responsive and agile. For another, it must be able to offer varying degrees of service outcomes to a differentiated customer base. To successfully deliver superior quality and service to customers, the servitized supply chain should be organized around clearly defined, customer-driven, focused outcomes. This enables synchronization between the product-service packages that are most valued by customers and the supply chain designs that are best suited to provide them.

To help supply chain managers successfully adopt a servitization strategy, we have designed the eight-step plan outlined in Figure 1. Following these steps will guide you in creating product-service bundles that will increase customer loyalty—and your company's profitability.

The eight steps
First and foremost, as is true with many strategic supply chain initiatives, it is important to create a collaborative team that will carry out the project. Ideally, representatives from marketing, supply chain, and finance should design the model and guide the implementation.

Before beginning the servitization process, your company should already have segmented its customer base. There are many ways to do this. One often-cited method is outlined in the 2006 paper "Customer segmentation and strategy development based on customer lifetime value: a case study."¹ In that paper, Su-Yeon Kim and three co-authors proposed that customer segmentation should be based on three dimensions: past profitability, the estimated potential value from additional sales possibilities, and customer retention (retention = 1 - the churn rate, where churn rate is defined as the percentage of regular customers that abandon a product-service relationship).

A key success factor in segmenting the customer base and, in turn, creating a servitization model, is having up-to-date knowledge about customers that is based on accurate data. This knowledge enables the necessary cost-to-serve analysis and the ability to evaluate trade-offs. Up-to-date knowledge of the customer base also ensures that an organization consistently meets specific customers' needs. This information, matched with the appropriate supply chain design, will provide the basic elements required for a servitization model.

Step 1: Determine value drivers and service level for each customer segment.
Once the segmentation of the customer base has been completed, the process begins with determining the value drivers for each customer segment. Value drivers are attributes that increase the value of a product or service by improving the perception of the item and providing a competitive advantage. Value drivers can come in many forms, such as cutting-edge technology, brand recognition, or customer satisfaction.

How can you identify value drivers? For each customer segment, determine what those customers value when shopping for and/or using your product or service, and list the attributes that motivate both the initial purchase and long-term loyalty. Determine what your customers care about and what their biggest challenges are. Think about how you can help them achieve their goals and address their challenges. Without considering price, understand why some would buy the product or service and some would not. These considerations will translate into value drivers for each segment.

Value drivers will differ for every company and its customers, but these examples from the computer and technology company Dell give the general idea:²

• Provide a meaningful connection with customers based on shared interest
• Provide customers the ability to express themselves
• Provide recognition for contributions the customer makes
• Support customers in getting advice, validation, or assurance regarding their decision making
• Help solve the customer's problem

It is critical that before proceeding to the next steps, you decide the level of service you wish to provide to an individual customer or customer segment for each of the value drivers. That is because the distinction between "low-service customers" and "high-service customers" will drive decisions later in this process, when you develop a cost-to-serve model. A low-service customer typically requires simple, product-based transactional services, doesn't use the product very much, and would not pay a premium for the product or service to be readily available. A high-service customer typically requires ready availability of the product or service, makes optimal usage of it, and wants comprehensive related services.

Step 2: Identify the supply chain design required to service your customers.
Once you have identified your customer value drivers, the next step is to ensure that your supply chain is properly structured to support those drivers and deliver customer value.

When designing a supply chain, it can be helpful to consider the six basic supply chain outcomes that Melnyk et al. described in their paper "Outcome-Driven Supply Chains": cost reduction, responsiveness, security, sustainability, resilience, and innovation.³ Designing around these outcomes will help you create a supply chain that is designed to focus on a specific customer segment's value drivers and service levels.

For example, if a customer segment values low prices, then the supply chain should be designed around the outcome of cost reduction. Simply adding a new objective to an existing supply chain will not be successful. Thus, a supply chain that is designed for innovation will rarely be adequate to deliver a low-cost product with spare-parts service. This is due to the nature of the supply chain elements that aid in achieving a low-cost outcome. Often, the elements that enable cost savings coincide with a lean operating environment (limited changeovers, highly standardized product offering, high capacity utilization). Conversely, an innovative product offering typically requires a supply chain that can handle a wider variety of material processing and lower capacity utilization, to allow small-batch and prototype products to be scheduled into the manufacturing operation.

It is important to note that the six outcomes are not all mutually exclusive. Successful supply chains typically incorporate a combination of them. In fact, focusing on only one of the six can leave your supply chain unable to sustain an advantage over competitors. A lean supply chain that focuses solely on cost reduction, for example, may not be very responsive or resilient when it comes to services; it may lack the people and resources needed to respond to unexpected changes in demand and supply driven by new trends, new products, or economic setbacks.

A supply chain that provides a relevant mix of two or more of the six outcomes, by contrast, can capture an advantage over its competitors. Think of this approach as designing a supply chain with a major and a minor focus. In the example above, the major focus would be cost reduction. To gain a competitive advantage and offer customers a unique value proposition, the secondary focus could be responsiveness and resilience. By designing a hybrid that focuses on both the major and minor outcomes, and then manipulating resources across them, you can succeed not only in gaining competitive advantage but also in providing customers value-added products and services that competitors may overlook.

Step 3: Determine which supply chain network changes are required to drive the desired outcome(s).
Once the desired outcome has been chosen, the next step is to determine what key characteristics and/or design traits are required in the organization's new, servitized supply chain offering, and what changes you must make to achieve them. In "Outcome-Driven Supply Chains," Melnyk et al. discussed key traits for each of the six outcomes. (It is important to realize that these design traits do not need to be inherent in each link of the supply chain, and that each link should be focused on the right processes.)

For example, if your decision leads you to a cost-driven supply chain, your organization would work to standardize products and processes where possible, with an emphasis on reducing waste and variance. Another cost-driven design trait is a modular supply chain design in which there is close interaction with the immediate customers and first-tier suppliers to drive cost reductions, leaving the suppliers at lower levels to manage their own supply chains.

If you have chosen responsiveness as an outcome, you will need to establish transparent information linkages between critical customers and suppliers that will allow you to monitor demand and supply as well as improve forecasting. These information linkages should be designed into information systems that will coordinate the flow of data. In addition, the supply chain function may utilize prequalified suppliers, emphasize small-lot production, and utilize delayed product specification in order to improve responsiveness to changing supply and demand trends. (An example of the last would be Dell's postponed final product specification, which quickly provides customer-specific designs according to demand.)

A security-driven supply chain design trait might be a redundancy in resources or a limitation in the number of touch points in order to protect the supply chain from external threats. A sustainable supply chain design will be similar in some respects to the security-driven approach but will also be designed to reduce the impact on resources. A resilient supply chain will be designed to ensure extra resources and the ability to deal with contingency scenarios. Finally, an innovation-driven supply chain will develop new product-service packages through intellectual-property protection and collaborative, early-stage design work with suppliers.

After identifying the traits that the desired supply chain outcomes require, it will then be necessary to design an implementation plan to put them into practice. Depending on the complexity of the supply chain, this could become a major change management undertaking.

Step 4: Evaluate what information is required, from both a systems and reporting standpoint, to ensure service offerings are profitable.
To make appropriate decisions around service offerings, collaborative supply chain teams need data that can help them answer key questions: What to offer? How to offer it? To whom should it be offered? The information required includes total cost, customer segmentation, sales volume across channels, service contracts, service coverage, installation base, and warranties. This information and data will come from multiple sources across the organization.

In addition to data collection and analysis, reporting is also necessary to ensure profitable decision making around servitization. Important shared metrics include gross margins, lead time, and sales conversion rates. Gross margins provide insight into supply chain costs and efficiency. This information helps marketing organizations understand what strategies to use for servitization cross-selling or upselling as well as for positioning to gain greater profitability from an offering package. Lead-time information helps the sales and supply chain teams understand whether they are offering customers appropriate delivery frequencies and product specifications. Sales conversion rates help the marketing team understand whether the servitization offerings are accomplishing the desired level of effectiveness within the targeted customer segments.

Achieving this level of data synchronization can require integrating applications across customer relationship management (CRM), enterprise resource planning (ERP), and supply chain management (SCM) modules. This is no small task. To determine whether you have the data necessary for making appropriate decisions about service offerings, start at the beginning of the product-service chain and outline the data requirements for each process step. Then evaluate whether this information can easily be collected from your various systems, and what format the data output must be in for the purposes on your ongoing servitization analysis.

Step 5: Determine cost to serve based on service offerings and supply chain design requirements.
Once data has been collected, a cost-to-serve (CTS) analysis is required to ensure that service outcomes will be profitable. Without adequate CTS insight, an organization could incorrectly assign costs to products and services, which would mask true customer profitability. Additionally, CTS data can aid in identifying new servitization opportunities for profitable growth.

To understand the true cost of serving a customer (servitization cost), you will need to conduct a detailed analysis of all activities required for a particular customer's servitized offering. At the highest level, these activity categories should include sales and marketing, order administration, and logistics and distribution. To calculate cost to serve, begin by determining the total activity cost per unit of product sold to a customer or channel. The total activity cost is the sum of the individual activity costs per unit (the estimated time it takes to complete a required activity) multiplied by the loaded cost per employee minute to perform the activity.

Next, use a simple Pareto Analysis to identify your key customers—the 20 percent of customers that generate 80 percent of your revenues. For the top customers, take their total activity cost and multiply it by the sales and service volume (total units of demand) over a given period of time; three to six months usually is appropriate. This will identify the total cost to serve your customer—in other words, the servitization cost. Over this time period, be sure to net or adjust for any seasonal variation. This will allow for an accurate comparison of costs to net sales for key customers.

Using a CTS model can help companies run profitability scenarios and decide whether to offer a specific mix of servitization offerings. For example, if an organization decides to offer its customers product-innovation oversight, engineering, and design services, what is the impact on the company's profit and loss statement? How will the costs of new activities influence its ability to maintain or exceed targeted profitability? This same sensitivity analysis should be run across all proposed services to determine the optimal offering mix for each key customer.

Step 6: Identify the trade-offs between cost and revenue for providing different combinations of service.
While the CTS model helps to determine profitability if revenue is held constant, companies also need to consider the upside revenue potential for servitization. To identify the trade-offs of providing the servitized offering packages, conduct an analysis to estimate the opportunity costs. (Opportunity cost is the benefit or value of an activity that must be forgone in order to achieve another alternative.)

At this point, you should have an understanding of your customer segmentation, desired service outcomes, and supply chain design requirements. The process for estimating the potential revenue opportunity is as follows:

1. Identify all of the individual opportunities to bring in revenue associated with a specific service offering, such as cost per claim, out-of-warranty service, and efficiency gains from improved field service, among others.
2. Estimate the potential range of financial benefit for each opportunity.
3. Determine which opportunities could contribute the most significant gains. In Figure 2, for example, the biggest opportunity drivers are increased productivity from field service, out-of-warranty service, and upgrade/upsell. If you selected these three drivers as a service focus, the potential increase in revenue would be US $110,000 ($50,000 + $30,000 + $30,000).
4. Use this estimated opportunity potential together with the CTS analysis to determine profitability for specific initiatives. For example, if the original service model generated $500,000 in revenue on expenses of $100,000, and a new service initiative is estimated to generate $110,000 in additional revenue on $30,000 of additional expenses (determined from servitization cost drivers), then this opportunity would generate a corresponding increase in profit from $400,000 to $480,000.

Lastly, take the service focus areas that have been identified as offering the greatest revenue opportunities and conduct a pricing analysis with the customer to determine what price the customer would pay for those services. This will ensure proper margin preservation for the new servitized offerings.

Step 7: Verify customer-segmentation analysis based on profitability projections for specific offerings.
Now that a full analysis has been performed, it is important to revisit your original customer segmentation analysis to determine whether you should make any changes to a customer's designated segment.

Suppose you are using the segmentation analysis described by Kim et al. in the 2006 paper discussed earlier, which incorporates past profitability, potential value estimate from additional sales possibilities, and customer retention. Servitized offerings could impact potential value and retention factors enough to move a customer out of one segment and into a higher or lower stratification. If this is the case, then the original segmentation analysis may need to be updated.

Step 8: Present service offerings to customers and perform ongoing monitoring.
Ongoing monitoring is essential in order to maintain a closed-loop feedback cycle among your servitized supply chain outcomes, supply chain design, and marketing strategy. Data from the customer must be collected and reported back through the supply chain and marketing groups to verify whether product and service offerings are profitable, and whether the supply chain for manufacturing and delivering the offerings is best configured to cost-effectively meet the customer's requirements.

As mentioned previously, at a minimum we suggest collecting gross margins, lead times, and sales conversion rates. However, depending on the level and sophistication of data collection and reporting capabilities, companies may need a broader set of data, including servitization price and cost per offering, order processing time, pick and pack time, ship time, percent of customer interactions that result in a sale, and percent of cross-sell/upsell offers that result in a sale. These additional metrics will help the servitization team determine why top-level metrics, gross margins, lead time, and sales conversion rates moved up or down.

Powerful benefits
The eight-step process outlined above can help you determine the optimal setup of a servitized supply chain within your organization. Servitization can not only drive organic growth through increased revenues and profits but can also provide tangential benefits, including smoothing of sales flow, differentiation from competitors, and increased customer satisfaction.

The supply chain function historically has been a key contributor to increased profitability through cost savings and cost cutting. However, leading organizations now are tapping collaborative teams across the supply chain, marketing, and sales functions to drive profitability from both additional revenue opportunities and cost savings. The most powerful benefits of this business model arise from integrated teams that can provide closed-loop feedback from the customer all the way back to suppliers, ensuring that the correct marketing strategies and supply chain designs are in place to achieve the desired servitization outcome.

Notes:
1. Su-Yeon Kim, Taesoo Jung, Eui-Ho Suh, and Hyun-Seok Hwang, "Customer segmentation and strategy development based on customer lifetime value: a case study," Expert Systems with Applications, Vol. 31 No. 1, pp. (July 2006): 101-107.
2. Steven Groves, "What the 5 Customer Value Drivers and Top 5 Metrics are for the Dell SMB Social Presence," July 2010 (accessed April 30, 2012).
3. Steven A. Melnyk, Edward W. Davis, Robert E. Spekman, and Joseph Sandor, "Outcome-Driven Supply Chains," MIT Sloan Management Review, Vol. 51 No. 2 (Winter 2010).