Innovation has always been a challenging and risky business. These days, it is getting harder and harder for many companies to compete, escaping the forces of commoditization, as manufacturing spreads around the world to lower-cost regions. With the increasing flow of knowledge and information, largely spurred by the proliferation of the Internet and enabled by technology, product life span is shortening.
As new products come to market with increasing frequency and take valuable market share, more and more companies are finding it increasingly challenging to keep up and compete. Product life span is further shortened by customers’ increasing demands for products and services customized or tailored to fulfill their needs better. The combination of these undeniable forces creates a commodity trap, an often perilous phenomenon that pulls at even the most innovative and successful companies.
Many companies and industries are beginning or trying to make a shift as our advanced economies increasingly are oriented around services. Products are becoming a smaller and smaller share of the economic pie, yet we know much less about how to innovate in services than how to develop new products and technologies.
Innovating in services is the escape route from the commodity trap and a solution for growth, giving firms a significant competitive advantage. As they innovate into the future, companies must think beyond their products and move outside their own four walls to innovate. Do not think that service businesses are not immune from stagnation. Like commodity businesses, they too have to raise their game, but they do so in different ways, often by working effectively with products to create platforms. This requires a different mind-set and a different stance toward business, customers, business models, and the ability and willingness to open up the innovation process.
Let’s take a look at how GE Aviation transformed their business model in a way that converted their business from one that makes products to one that delivers services.
Case Study: GE Aviation
GE is a world leader in manufacturing aircraft engines. Such engines are not cheap: each costs $20 or 30 million or more. However, the market for new engines is competitive (Rolls Royce and Pratt and Whitney are strong competitors), and aircraft manufacturers are highly concentrated (Boeing and Airbus are the dominant customers). So it is hard for GE to make much money selling its engines. Instead, it looks to maintenance, spare parts, and financing as ways to make money from its engines once they are sold. This heavy industry manufacturer therefore makes most of its money from services, not the product. The product increasingly is just its way of acquiring customers to receive these services. As aircraft engine sales have leveled or fallen off, services have become an increasingly important part of GE Aviation’s 2008 sales (25 percent of revenues) and profits (50 percent of profits).
GE has transformed its business model for its aircraft engines. In the past, each engine sale involved tens of millions of dollars, with a long sales cycle, lots of negotiations, and high-stakes bargaining. Yet most of the profit for GE from the engine comes not from its initial purchase, but rather from the services provided over the estimated thirty-year useful life of the engine.
This insight about the long tail of after-sale use prompted a shift in GE’s business model for its engines. GE’s new model is ‘‘Power by the Hour,’’ selling its engines much as a utility company might sell power to a residence or commercial enterprise. GE will sell its engines for some thousands of dollars per operating hour, and the customer pays only when the plane is flying. Again, a large fixed cost for the customer is transformed into a variable cost instead.
This new model has an important second effect: better-aligned incentives. Both GE and its customers want to minimize the amount of downtime for unscheduled maintenance. Customers make no money from planes that are grounded for repairs, and under this new business model, GE doesn’t make any money either. In fact, GE maintains a group of specialists who will fly anywhere in the world within twenty four hours to repair a GE engine while it is still mounted on the wing of the plane (versus taking the engine off for repairs, which requires a tricky and time-consuming reinstallation process). They want to get that plane back in the air as quickly as possible, the same goal that GE’s customers have.
These aligned incentives also stimulate GE to learn more about how to reduce unscheduled maintenance of its engines. Lessons that GE learns from servicing one engine are quickly shared with other GE technicians and engineers in order to prevent grounding another aircraft with that same engine for unscheduled maintenance, or to reduce the time needed for such maintenance to a minimum if the issue cannot wait until the next scheduled engine servicing. Across its fleet of engines, GE can develop sophisticated algorithms for predicting likely sources of future engine failure and the optimal time to service the engine to prevent such failures. The more data and experience GE accumulates, the better these algorithms become, and the more effective GE will become in delivering these services. Only a company with lots of data to work with can hope to do this well. This is a less appreciated knowledge-based economy of scale for GE.
GE also benefits from a third effect, one that reduces competition in the aftermarket for its spare parts and repair services. Most of the profit in an aircraft engine is derived from its thirty-year service life, but GE does not have this market to itself. A cottage industry of other companies that remanufacture GE parts and provide repair services has arisen around GE’s engines. Many of the people who provide these services used to work as service technicians for GE, so they have been expertly trained on GE’s engines.
The Power by the Hour business model is an important answer to this challenge. Third-party service companies cannot take on the responsibility to keep the planes flying the way GE can. Changing the pricing model for GE engines to this utility business model drives the repair business for GE’s engines right back to GE itself. Of course, the customer could instead choose to buy the engine upfront for tens of millions of dollars and then find a third-party service organization that can maintain and repair the engine for less than GE would charge, but such an investment would pay back only in the very long term. And GE’s fleet of technicians available around the clock on demand, along with the rapid knowledge transfer that arises from servicing the fleet of GE engines in service around the world, provides important knowledge advantages that third parties cannot obtain. In the long run, GE is likely to be able to reduce unscheduled maintenance of its engines to levels far below what third party servicers could provide. Many GE customers therefore have opted for the variable-cost option of Power by the Hour instead.
As services have grown in importance to its business, GE has become more focused on organizing to exploit them. In 2005, GE created its OnPoint brand for all of its aviation services offerings. This allows the company to work with its customers across the range of services available and provide one-stop-shopping. GE thus realizes economies of scope through this process.
More and more companies are discovering that by focusing on service offerings, they can get a better sense of the utility customers want from a product. This is a key point for two reasons: First, it helps companies provide real value to customers – which may prevent them from switching to lower-cost competitors – and second, the knowledge gained about a customer’s challenges will provide insight that an organization’s competitors may not even know. It is time to transcend the limits of product-focused innovation and move to a way of thinking that can lead to increased margins for companies and add more jobs to our economy.
1. ‘‘GE’s Focus on Services Faces Test,’’ Wall Street Journal, Mar, 3, 2009, p. B1
2. See C. Anderson, The Long Tail (New York: Hyperion, 2006). Anderson points out that the long tail phenomenon is not limited to the Internet; it can apply to other businesses where the Internet is at most a minor part of the value chain.
3. This business model is not unique to GE, just as Xerox’s managed print services model is not exclusive to Xerox. An interesting account of Rolls Royce’s experience with a similar model can be found in ‘‘Britain’s Lonely Flier,’’ Economist, Jan. 10, 2009, pp. 60–62. However, both GE and Xerox have executed this model well to date.
Dr. Henry Chesbrough is a professor and the Executive Director, Center for Open Innovation at the Haas School of Business. Adapted with the permission of the publisher from Open Services Innovation: Rethinking Your Business to Grow and Compete in a New Era, Introduction and Chapter Six, by Henry Chesbrough. Copyright (c) 2011 by Jossey-Bass, A Wiley Imprint. All rights reserved.