Think differently when developing a service-based business

Many commentators have described Enoch Godongwana’s latest budget as a safe budget.

While the Finance Minister did what he could with the limited resources at his disposal, we are still waiting for a concrete plan to address the economic crisis we currently face and the fact that the South African economy is heavily dependent on the mining industry to achieve economic growth.

With South Africa increasingly taking its place in the global tech economy, there should be a focus on moving from a manufacturing-based economy to a service-based economy. As an article on the Harvard Business Review (HBR) website points out, a different mindset is needed when making this shift.

Strategic thinking

The HBR article points out that top managers should ask themselves six questions about strategic management. The questions are fairly common, but the answers for service businesses are often unique.

• Do we fully understand the specific type of service business we are in? Although service-oriented businesses are different from product-oriented businesses, the nature of the difference depends a great deal on the specific type of service business. I will present a classification scheme to help distinguish between service businesses along some important strategic dimensions.

• How can we defend our business from competitors? Every business must consider how it can build and protect a strong competitive position. To do this, the economics of the business must be carefully analysed. Service businesses often require different competitive strategies from those of product-oriented companies. If an enduring institution is to be created, some attention must be given to the management of economies of scale, proprietary technology, and reputation of the company.

• How can we obtain more cost-efficient operations? Manufacturing companies can improve operating leverage by, for example, purchasing faster and more reliable machinery. But most service businesses are not able to follow this approach. Other methods must be explored.

• What is the rationale for our pricing strategy? The pricing of services is a nebulous area. Cost-based pricing is often difficult to determine, and there are few formulas for effective value-based pricing. It is important to look at pricing strategy and think about the economic and psychological effects of a change in that strategy.

• What process are we using to develop and test new services? Every company depends on the ability to renew its franchise in the marketplace. The service-oriented company must pay particular attention to this area because of the difficulty of developing protectable competitive positions. The process of new service development and testing must recognise the abstract, perishable nature of services.

• What acquisitions, if any, would make sense for our company? Once the nature of the current business is understood, the acquisition question can be faced. The acquisition game in the service sector can be dangerous. More than one company has acquired a service business using only criteria that would be used in the acquisition of a product-oriented company. As several of these companies have learned, this type of analysis, although necessary, is insufficient.

Building Barriers

The HBR article points out that, in product-oriented companies, capital is the most commonly used barrier to the entry of competition. As a product-oriented company grows, it can take advantage of economies of scale in producing the product, invest in technology that will become proprietary, and offer a differentiated product through product development and marketing. These efforts pay off largely because they are centred on a uniform product that has concrete dimensions and is sold as a package. They are made possible by the fact that the production, distribution, and sale of the product can be uncoupled, often being accomplished by different companies.

Service businesses rarely have this luxury. The service, because it is an abstract, perishable quantity, must be produced and delivered by a single company, often by a single unit of equipment or people. The result is a decentralisation of the service production process to the local level and a reduction in the opportunity for developing economies of scale. As a result, location decisions are often very important and multiple locations can serve as a barrier to entry. One example is the car rental business, where a large number of airport locations is very important. Think about the fact of why the majority of law firms in Gauteng are based in Sandton which is the commercial hub of the country.

Service Differentiation

The HBR article points out that product differentiation, or service differentiation, is another barrier to entry. In product-oriented companies, the product is developed and marketed in such a way that it attains a brand name identification in the marketplace. In the more successful efforts, the product’s brand becomes an almost generic name for the class of products—Bic, Coke, and Xerox, for example. Very few services have developed a brand name identification. Instead, a service business develops a reputation for the type and quality of service it produces. The more abstract and complex the service is, the greater the need and potential for developing a reputation that will serve as a barrier to entry.

Consulting firms illustrate how a reputation can be a barrier to entry. There are many management problems that anyone consulting firm could solve effectively. However, the large ones have unique reputations and thus each tends to be called in on different kinds of problems. Such reputations provide some barrier to the entrance of other consulting firms.

The article adds that, historically, the executive recruiting business, or “headhunting” as it is often called, has had a terrible reputation as a business. There are virtually no capital barriers to entry. All that is needed is a desk and a telephone. Recruiters work on a fee-plus expenses basis, with the fee to the employer based on a percentage of the first year’s total compensation to the person recruited. As a result, the business is highly fragmented and somewhat specialised by industry.

Building barriers to entry in service businesses is generally more difficult, or at least must be done in less traditional ways, than in product-oriented businesses. Managers must think less about brand identification and more about the reputation of the company. They must look for areas in which the advantages of economies of scale are available. Finally, they must seek ways to develop and protect proprietary technology.

Cutting Costs

The HBR article points out that a common misconception about service businesses is that it is almost impossible to obtain operating leverage and thus to improve profit margins. Operating leverage exists in a business when, through a change in operations, the relative cost per unit of the product or service decreases.

Substitution of capital for labour is the classic method of obtaining operating leverage in both products- and service-oriented businesses. Capital is used to purchase machinery that can produce a product or service at a faster rate and with more consistent quality. Many service businesses have followed this path of development. Twenty years ago, virtually all car washes used unskilled labour; today, most are automated.

When the tasks cannot be automated because human judgment must be exercised, cheap labour can often be substituted for expensive labour as a means of obtaining operating leverage. This is often the case in people-based service businesses, and law firms are expert in the practice. A large percentage of the tasks are routine and require little legal expertise. For example, routine and time-consuming research and the preparation of briefs can, in many cases, be done by recent graduates of law school or by paralegal assistants, whose time is less expensive, while partners in the firm work on client relationships, develop legal strategies, and so on.

The HBR article points out that other service businesses use the same basic technique in different ways. Consulting firms use teams of consultants who perform different tasks, depending on their skills. Many insurance companies break the sales task into its component parts of initial contact, presentation, and closing the deal, and have different people perform each function. In each case, the service is further broken down, and the aspects that can be performed by less expensive labour are identified. The expensive labour is then free to do those crucial tasks that bring profits to the company.

Changing course

One of the most challenging manoeuvres in sailing is changing course in response to changing conditions such as winds and currents. However, it is vital to the success of a journey.

South Africa is not alone in its shift towards a service-based economy. This global trend was started by tech pioneers (such as Bill Gates) and has gained momentum as the prevailing landscape changed with the growth of the Fourth Industrial Revolution.

Apply this rationale: companies look for a service where the best skills are accessible at a reasonable price. The growth of technology has seen the realisation of Marshall McLuhan’s 1960 concept of the Global Village. South Africans are highly skilled and are competitive when it comes to pricing. Further, South African entrepreneurs increasingly have access to a global customer base. This provides a perfect opportunity for the Government to diversify our economy and address the growing number of companies that find themselves financially distressed.