Small businesses in the U.S. that produce any kind of manufactured goods or technology products are at a significant disadvantage these days. The Internet has made it far too easy for competitors in such places as China, Bangladesh, and India to copy their ideas; relatively cheap labor allows them to produce at much lower cost. As a result, many American businesses find themselves in a state of profitless growth or headed toward insolvency. That's the unsettling wake-up call in "open innovation" father Henry Chesbrough's new book, Open Services Innovation: Rethinking Your Business to Grow and Compete in a New Era.
Chesbrough, who is a friend and colleague at University of California, Berkeley, offers what might seem like an obvious premise: to compete, businesses need constantly to be innovating. But they are often mired in a commodity trap—the number of units sold of their products or similar products is increasing, but profits are declining. He suggests that struggling product businesses do something radical to escape their downward spiral: transform themselves into service businesses. His book revolves around making the transition by combining ideas from outside the company with those from within to advance a company's technology and business model.
To build his case, Chesbrough argues that product businesses tend to think of customers as consumers. They research what a group of customers wants and is willing to pay for. They develop specifications for a product that meets the needs of the majority; then they manufacture it and market it. Their customers make purchase decisions based on the product's features and function. The customer is involved in the beginning of the product-development process and at the end. Customers don't help shape or define the product once its development is under way.
The big problem, he explains, is product businesses fall prey to global competition because a product is tangible: Anyone can see it, measure it, reverse-engineer it, and then copy it.
The Intangible, Not the Tangible
Services businesses, on the other hand, focus on providing experiences rather than physical items. They focus on selling the value of a product rather than just a physical item. Their goal is to delight customers with individual experiences. They do this by inviting customers to participate in the product's creation. They give the customers design choices or tools with which they can themselves modify the products. They build and improve their products and services based on what they learn. Services businesses often build platforms on which they combine products and services. And they allow others to build on top of these.
Here are two particularly salient examples from Chesbrough's book that show how this transformation from product to service can happen.
Computer & Structures Inc. (CSI), founded in 1975, makes software to test the mechanical stresses of major structures, such as bridges, towers, and office buildings. CSI's founders learned early that architects needed new tools to test their designs for structural integrity before the designs were built. They realized that, instead of doing a product for one architectural firm, it made more sense to offer CSI's software to all architects. This meant that CSI had to train customers to use its software. It soon learned that engineers were more effective sellers and trainers than traditional marketing and sales staffers were. So it got into the software services business.
CSI began to give away copies of its software to public agencies that had responsibility for reviewing and approving designs, so buildings could be reviewed with the same tools used to design them. It now works closely with public agencies and allows its data to be used by other programs that review other aspects of building design.
CSI's transformation paid off. The company has 100 people on its payroll, and its software is in its 14th iteration. Virtually all the tallest buildings in the world have been tested with its software. It has become something of a de facto standard for building design and review around the world.
Smoothing the Revenue Stream
Also located in Berkeley but serving a completely different market is The Olympic Circle Sailing Club. Started in 1979 with one boat and a shed as a sailing school, the business quickly found that its revenue rose and fell seasonally because sailing lessons were most popular in the summer and dropped off in the rainy winter. The club learned to focus less on sailing lessons and more on offering memberships that would be recurring sources of revenue. Once it shifted its focus to the recurring revenue, the task was to provide new sailing experiences to its members so they would keep their memberships active for a longer period, even during the rainy months. One crucial investment was to build a database of all members and allow each to query the database for sailing partners for the next outing.
Now Circle Sailing gets most of its revenue from its members, not from the newbies taking sailing classes. And the members get a better experience and use the club's boats more often. The club even learned another trick: Instead of owning the boats itself, it acts as rental agent for boat owners—who get free upkeep and slip. This saves the business from having to buy the more than 45 boats it currently offers for use. In this way, it provides a service to the boat owners as well as to club members.
Gaining Customer Satisfaction
There are many benefits to being a service business. The revenue flow, for example, moves from lumpy, occasional transactions to smoothly recurring. Customer relationships no longer end with the sale of a product but continue indefinitely through installation, operation, maintenance, and even replacement or upgrade. Instead of tracking the gross margin on each product sold, businesses start to track the lifetime value of each customer they have, as well as how much it costs to attract their next customer and how frequently they lose a customer.
They also discover a new lever to improve profitability: customer satisfaction. Satisfied customers stick around longer, spend more, are less likely to switch to competitors, and have a higher lifetime value for the business. Once management grasps this, it also learns to prioritize the people who work directly with customers.
These are steps any small business can take. Knowing customers better, satisfying them more, and keeping them longer are sustainable ways to increase profits in the long term. And they're much harder for someone in China to copy.