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Chapter 1

Services Restructure the Economy

This book is about managing intellect and the services, servicebased strategies, and service technologies that are revolutionizing competition in all industries, including manufacturing, today. Intellect is the core resource in producing and delivering services. Since World War II provision of services has become by far the largest component of the U.S. economy (see Figure 1-1) and dominates manufacturing in virtually all "industrialized" nations. In the United States, the service industries -- as broadly defined -- now account for 74 percent (or $3,345 billion) of the Gross National Product and 77 percent (or 92.6 million) of all jobs. Through 1990, the services sector continued to grow during recessions and booms alike, although there were some signs that its rate of growth might be slowing and that it too might become vulnerable to downturns. Reflecting its increasing dominance in the economy, during the 1991-92 recession services employment dropped for the first prolonged period since the early 1950s.

In contrast, total employment in manufacturing had declined erratically but in a continuous downward secular trend over the past fifteen years. While this represented some serious deficiencies in selected industries and a personal tragedy for many workers, the shift was not as radical as often portrayed (see Figure 1-1). The United States has long been the world's strongest manufacturing country, but it has never had a dominantly manufacturing economy. Figure 1-1 shows that services employment has always exceeded that of manufacturing in the United States.

Manufacturing employment remained relatively steady as a percentage of the total for a long period of time; what declined continuously was agricultural employment. Nevertheless, in recent years, some traditional and highly visible U.S. industries -- such as basic steel, automaking, and electronic appliances -- have experienced pronounced losses in both output volume and employment. And many others operating from a U.S. base have lost export sales since the mid-1980s.

In the meantime, service industries have grown steadily in scale, technological sophistication, and capital intensity. Why have services become so important today? Steady productivity increases in agriculture and manufacturing -- largely technology induced -- have meant that it took ever fewer hours of work to produce or buy a pound of food, an automobile, a piece of furniture, or a home appliance. While productivity improved, demand for goods was somewhat capped; people could consume only so many units of food, automobiles, sofas, houses, or washing machines. Meanwhile new technologies lowered services' relative costs and increased their variety and value. The relative utility of nonproduct purchases therefore went up for each individual. And in recent years, as people became more affluent, they began to seek increased satisfaction and improved life quality through more services.

The basic cause of this massive economic transformation is the emergence of intellect and technology -- particularly in services -- as highly leverageable assets. Leveraged intellect and its prime facilitator, service technology, are reshaping not only the service industries but also U.S. manufacturing, the country's overall economic and growth patterns, national and regional job structures, and the position of the United States in world politics and international competition. They are forcing totally new concepts of strategy and organization on both the services sector and the product industries -- nationally and globally. The manufacturing-services interface is now the key to most manufacturing strategies (Chapter 6). And the competitiveness of both nations and companies will increasingly depend upon carefully exploiting the new strategic potentials of better-managed intellect and service technologies. Based upon multiple years of research, this book will suggest how best to analyze and implement these new knowledge and service based strategies and the new organizations that support them.

BASIC RELATIONSHIPS: SERVICES, INTELLECT, AND ECONOMICS

What do services and managing intellect have to do with a sound economy? Economic texts barely mention either. Many executives and policymakers dismiss services as predominantly "taking in laundry" or "making hamburgers" for others. Such simplifications belie the complexity, scale, employment, and profit potentials of services in the 1990s. While there is not a complete consensus on definitions, most authorities consider that the services sector includes all economic activities whose output (1) is not a product or construction, (2) is generally consumed at the time it is produced, and (3) provides added value in forms (such as convenience, amusement, timeliness, comfort, or health) that are essentially intangible concerns of its purchaser. The Economist has more simply defined services as "anything sold in trade that could not be dropped on your foot." "Service technologies" are technologies developed by or primarily for use in the services sector. They include not just information technologies but transportation, communications, materials handling, storage, health care, and other technologies predominantly used by service enterprises.

The "service industries" include transportation, communications, financial services, wholesale and retail trade, most utilities, professional services (like law, consulting, and accounting), entertainment, health care and delivery systems, and so on in the private sector -- and government-social services in the public sector. "Service activities" include personnel, accounting, finance, maintenance, legal, research, design, warehousing, marketing, sales, market research, distribution, repair, and engineering activities, which may be performed as functions inside an integrated -- manufacturing or service -- firm or by a separate firm (like a market research or accounting firm). The common element among all these activities and industries is the predominance of managing intellect -- rather than managing physical things -- in creating their value-added. The key to productivity and wealth generation in over three-fourths of all economic activity is managing intellectual activities and the interface to their service outputs. As we shall show, this is just as true in manufacturing as in the service industries. Indeed, the lines between these two are rapidly being obliterated.

FOUR MYTHS ABOUT SERVICES

To develop a proper perspective about these changes, we first need to expunge some of the more misleading myths, held over from the past, about services.

The "Lower Value" Misconception -- perhaps first stated by Adam Smith -- regards services as somehow less important on a "human needs scale" than products. Since services are essentially marginal (so the argument goes), they cannot add the same economic value or generate the growth potentials manufactures can. Karl Marx made this a central part of his dogma. As a result, all his adherents so underinvested in services that their countries today tragically cannot store, transport, distribute, finance, communicate about, or repair the products they could otherwise produce in abundance. So prevalent are these misconceptions that many economists -- particularly in developing countries -- refer to services as "the tertiary sector."

In very elemental societies it is perhaps true that the first production to meet basic needs for food, shelter, or clothing do take precedence over all other demands. However, as soon as there is even a local self-sufficiency or surplus in a single product, the extra production has little value without further distribution, financing, or storage -- all "service" activities. In most emerging societies services like health care, education, trading, entertainment, religion, banking, law, and the arts quickly become more highly valued (high-priced or capable of generating great wealth) than basic production. And the positive wage differentials their practitioners receive tend to be even more marked as societies grow more affluent.

Far from being inferior economic outputs, services are directly interchangeable with manufactures in a wide variety of situations. Few customers care whether a refrigerator manufacturer implements a particular feature through a hardware circuit or by internal software. New CAD/CAM software can substitute for added production or design equipment, and improving transportation or materials handling services can lower a manufacturer's costs as effectively as cutting direct labor or materials inputs. These "services" improve productivity or add value just like any new investment in physical handling machinery or product features.

Even more fundamentally, products are only physical embodiments for the services they deliver. A diskette only delivers a software program or data set. An automobile delivers flexible transportation or a personal image -- both services. Electrical appliances deliver entertainment, dishwashing, clothes cleaning and drying, convenient cooking or storage -- all services. In fact, most products merely provide a more convenient or less costly form in which to purchase services. Although it is a surprise to some people, on a national basis value-added in services is much greater than that in manufacturing (see Table 1-1). In fact, value-added in the services sector accounts for approximately 74 percent of all value-added in the economy, while the total goods sector (including all manufacturing, construction, mining, agriculture, forestry, and fishery outputs) accounts for only 25 percent.

Although the total value-added per employee in private services nationally is slightly lower (at $38,069 per person) than that in manufacturing (at $40,622), in the strategic business units of the larger companies sampled by PIMS data, value-added per service employee is quite comparable to that in manufacturing (see Figure 1-2.) This suggests (1) that important economies of scale and scope may be available through technology investments in larger private service enterprises, and (2) that it is the government sector's $30,132 of value-added per person that poses the major problem.

The "Low Capital Intensity" Perception asserts that service industries are much less capital-intensive and technologically based than manufacturing. While this may be so for small-scale retailing and domestic services, many service industries today are extremely capital- and technology-intensive. The prime examples have been communications, transportation, pipelines, and electric utilities. But the banking, entertainment, health care, financial services, auto rental, package delivery, wholesaling, and retailing industries also increasingly qualify.

Stephen Roach, Chief Economist of Morgan Stanley, has calculated that total capital investment -- and in particular hightechnology investment -- per "information worker" (mostly employed in service industries) has been rising rapidly since the mid-1960s and now exceeds that for workers in basic industrial activities. Similarly, Kutscher and Mark's data show that nearly half of the thirty most capital-intensive industries (of 145 studied) were services. And certain service industries -- notably railroads, pipelines, broadcasting, communications, public utilities, and sea and air transport -- were among the most capital-intensive of all industries. Surprisingly, few service industries were found in the three lowest capital-intensity deciles. PIMS data, collected on a different basis, show aggregate capital intensity in larger service entities to be comparable to -- although slightly less than -- that in manufacturing. Fortune 500 data, which often contain large service units like GM's $115 billion (asset) GMAC within an "industrial" company, do not break investments out to the SBU level as PIMS data do. Fortune's more aggregated figures show large industrial companies to be more capital-intensive than their predominantly services counterparts. But total capital investment in the service industries has been growing much more rapidly than that in manufacturing. Even excluding the heavy investments of the transportation and public utilities sectors (usually considered services), aggregate annual investment in services now surpasses that of manufacturing (see Figure 1-3).

The "Small Scale" Misconception considers the services sector too small in scale and too diffuse to either buy major technological systems or to do research on its own. Although complete Herfindahl indices of concentration are not available, PIMS and Fortune 500 data suggest that concentration and scale among larger service units are comparable to that in larger manufacturing units (see Figure 1-4). In fact, as we shall demonstrate shortly, many companies in the services sector are much larger than their manufacturing suppliers.

Large banks, airlines, utilities, financial service institutions, communications companies, and hospital, hotel, or retail chains now not only have the scale to be lead purchasers of technology, they also contribute extensively to its initial design, early financing, reduction to practice, and wide diffusion. In addition, such companies acting in intermediary roles (like distributors) often force new technologies out into smaller service and manufacturing companies (through their just-in-time systems), further assisting diffusion. Many large service institutions now also support extensive R&D activities, creating or guiding major new technological developments themselves. AT&T-Bell Labs, Federal Express, COMSAT, Arthur Andersen, Citicorp, Arthur D. Little, Microsoft, EPRI, and Rand Corporation are just a few among many such organizations.

The "Services Can't Produce Wealth" Viewpoint holds that services are not capable of producing the ever higher levels of real income and personal wealth that have been the hallmarks of the "industrial" era. This argument assumes, in part, that services inherently cannot achieve the productivity increases available through automation in manufacturing. If not, services cannot possibly provide the inflation-free income growth rates manufacturing can. While many past measures of productivity in services have tended to support this view at the macro economic level, there is increasing evidence that the measures themselves may have serious flaws. Productivity in services is notoriously difficult to measure because of problems in numerically defining output units and quality levels. For example, how does one evaluate medical procedures that may use greater resources but may substantially decrease patients' pain or morbidity levels? Of what validity are the standard economic productivity measures that ignore the output value of many public services (like sewage treatment plants or air depollution) and assume that the output value of critical services (like fire departments, police forces, some aspects of banking, and many welfare services) is equal only to their cost inputs? One should be very careful in interpreting aggregate productivity data about services and should look behind the numbers to the measurement methodologies used. Chapter 11 will deal with this issue in much more detail.

Productivity measures are more valid in competitive arenas, where customers can make direct purchase tradeoffs between one class of service and other services or manufactures. Here the sales value of the service can provide a better surrogate for measuring output. In some of the more measurable service segments, Bureau of Labor Statistics (BLS) historical data -- and some new measures -- suggest that individual service industries can sustain productivity growth rates as high as those in major manufacturing sectors for substantial periods (see Table 1-2). As managers become more sensitive to the value-added potentials of service activities and focus on the 60-75 percent of their (nonmaterials) costs that typically lie in internal services, further growth in productivity can be expected. Since in the future most of a company's or nation's competitiveness and productivity increases must come from better performance of service and intellectual functions, a central focus in this book is on managing such activities for greater productivity, output quality, and value-added.

SERVICES OFFER PERPETUAL GROWTH OPPORTUNITIES

The growth of the services sector should not be viewed with alarm, despite the comments of some spokespeople to the contrary. Fortunately for the economy, until the 1991-92 recession demand growth in the services sector caused services employment gains to far outstrip employment declines in the goods-producing sectors (see Figure 1-5). And despite the problems of certain industries, the total output of U.S. manufacturers is growing in both quantity and quality. As we shall show, service technologies have actually supported manufacturing productivity in the United States and -- in many sectors -- have begun to cause the "remanufacturing" of the U.S. economy. Lower transportation, communications, retail and wholesale distribution, and financial service costs in the United States have presented unrecognized cost advantages to U.S. producers. As virtually all services have grown on the basis of their improved technologies over the past several decades, they have enhanced both the standard of living of individuals and the manufacturing outreach of U.S. companies. For example:

* Jet aircraft have made long-haul passenger and freight handling much more efficient and convenient. New containerization, loading, refrigeration, and handling techniques for dangerous and volatile materials -- by making it possible to transport virtually all goods safely and effectively -- have vastly extended international trade. Electronics, information, and communications technologies have stimulated innovations in virtually all service areas, most notably in retailing, wholesale trade, engineering and design, financial services, communications, and the professional services that support manufacturing and service industries alike. In addition, new technologies have revolutionized other fields affecting U.S. quality of life, like entertainment, personal security, or medical care. The high-technology fax, cellular phone, movie, theme park, videotape, and emerging virtual image and multimedia industries of today were unimaginable a few years ago. New noninvasive imaging devices, drugs, diagnostics, genetic engineering, and life-support and surgical systems have revolutionized medical research and practice. And so on.

Note that it is not just information technologies, but service technologies developed across a wide spectrum, that have changed the entire structure of U.S. and world competition. Not only have service technologies revolutionized the U.S. economy, they have had the same impact in all other major industrialized countries (see Table 1-3). All these countries now increasingly compete as service economies. And service industries are becoming the bellwethers of all countries' future international competitiveness and standards of living.

The services-produced trends in value-added in the U.S. economy since World War II (see Figure 1-6) can, with nurturing, continue to provide opportunities for unending economic growth -- with fewer of the undesired environmental effects of a heavily production-oriented society. Since the value of all services (as well as service-based or high-style products) exists solely in the mind -- i.e., a jewel, an opera, a Ferrari, a sightseeing tour, or a stylish coat may have little functional value relative to its high price -- the growth of a service-based economy is limited only by the capacity of the human mind to conceive of activities as having higher utility. Surely a safer, healthier, better educated, or more stable society can easily be considered "wealthier" than one with more physical goods. And this wealth can be passed on to future generations. Services like better education, art, music, literature, information repositories, banking, trade, transportation, scientific or design know-how, public health, and legal systems are true national assets -- intellectual assets with greater value than physical assets -- for posterity. In fact, such "intellectual assets" have generally been the measures of a nation's wealth throughout history (as in Florence, Athens, or Alexandria) and have proved to be the basis (as in Hong Kong, Japan, Singapore, France, or Germany) of rapid recovery from disasters.

One must hasten to add this does not suggest that the United States could or should exist without its advanced manufacturing capabilities. Instead, in a healthy economy, the two go together. Well-developed service industries upgrade and add significant value to the manufacturing sector, making it more effective domestically and more competitive internationally. And they support a strong military capability, as the advanced transportation, communications, and logistics support systems of the Gulf War proved. Strategic opportunities and economic growth are maximized when services and manufacturing are developed in tandem.

SERVICES RESTRUCTURE THE ECONOMY

As services have expanded, they have restructured virtually all individual industries, the basic relationship among industries, and the total economy. First of all, the scale and power of service companies have increased markedly relative to manufacturing companies. As their economic power has grown, service companies have redefined their roles versus those of manufacturing. Table 1-4 demonstrates the relative scale of manufacturers in several consumer product industries versus that of their retailing, wholesaling, or product using partners. For example, Toys "R" Us, with its $5.5 billion sales, enjoys three times the revenues of the world's largest toy suppliers. With its greater information about the marketplace and capacity to control the positioning, display, retail advertising, and pricing of toys, Toys "R" Us can in many cases dictate what toys make it to the marketplace, how well they sell, and even how they should be designed, packaged, transported, or presented. Within the industry Toys "R" Us packaging and marking procedures set the standard for all producing companies.

* Because it has specialized, Toys "R" Us can sell products virtually year round, while its competitors can afford to carry significant inventories only during the short pre-Christmas season, when over 60 percent of all toys are sold at retail. Consequently, Toys "R" Us, with its high volumes and sophisticated electronic inventory and point of sale systems, has a powerful mechanism for pretesting what toys are likely to sell -- and in what form -- when the big Christmas sale season comes. In addition, with its sophisticated models of toy sales, toy production, and changing tastes, it can invest in its inventories with considerably less risk than other companies. Finally, it can force many of these risks back onto its suppliers -- especially those for inventories -- by insisting on very efficient "just in time" deliveries. Such practices further decrease markdown losses, which are as much as 25 percent of the industry's cost for other retailers, while increasing Toys' own returns on capital invested relative to its competitors.

* Similarly, $7.8 billion McKesson Corporation's wholesale drug divisions can strongly influence the sale and distribution patterns in its field. By providing its retail dealers with analytical services that spring off its ECONOMOST inventory control system, McKesson can create a mutually beneficial relationship with retailers, making it very difficult for them to shift suppliers. As a result of McKesson's and other drug wholesalers' use of similar technological power, wholesaling's share of the pharmaceuticals market grew from 47 percent in the mid-1960s to 77 percent in the late 1980s, and is expected to become 85 to 90 percent by the end of the 1990s.

POWER SHIFTS TOWARD SERVICES

Manufacturers have had to adjust their strategies to the reality of this kind of economic power. As Table 1-4 further shows, textile companies like West Point-Pepperell, Inc., Burlington Industries, or Springs Industries, Inc., have become quite small relative to their retail customers -- i.e., less than one-tenth the sales of Wal-Mart at $32.6 billion or Sears at $32.0 billion. Increasingly, these customers actually co-design the products they want, dictate precise inventory and shipment standards, and dominate manufacturers' relationships with the ultimate marketplace. This is particularly true when such retail giants source from overseas, where suppliers have relatively little direct power in the U.S. marketplace and are highly dependent upon orders from U.S. soft goods retailers for their very existence.

McDonald's fast food chain provides a dramatic example of the impact such scalar shifts can have.

* McDonald's feeds 22 million people a day -- approximately one-third the population of Britain. Each day it uses 2 million pounds of potatoes and dictates the fortunes of many farmers in that segment of agriculture. It purchases an astonishing 3,400 tons of sesame seeds a year. Its volume potentials are so great that when it sought to "lighten its menu" by introducing a shrimp line, it found that not enough shrimp could be caught in the world to supply its needs. When it tried to introduce a raspberry sorbet, it discovered that there were not enough raspberries being grown. And when it decided to go to a more healthful, low-fat milk shake, it destroyed the already weak price of butterfat in the marketplace. Now, because of this and similar trends elsewhere, a whole series of entrepreneurs are busily working on ways to use butterfat chemicals in new and interesting products.

With their combination of size, electronics, and market power, major retail chains -- like Toys "R" Us -- can provide both maximum flexibility or differentiation and lowest cost at the marketplace level, calling into serious question theories about "generic strategies," which hypothesize that low cost, flexibility, and differentiation are inherently incompatible. Because retailers have much more access to and information about the marketplace than any individual producer, they can also -- with their electronics communications systems -- sense and respond to detailed changes in the marketplace much more rapidly. To put it differently -- and more positively from the manufacturer's viewpoint -- the producing system is so closely related to customer needs at the retail level that the ultimate customer now dictates desired responses throughout the entire system in extraordinarily short time cycles. Virtually all apparel merchandising has become a "fashion" industry forced to react to the current whims of the consumer marketplace within days. Most noticeably, low-cost discount, "off price," and high-volume chains are beginning to sell essentially fashion -- rather than staple -- goods as a result of the new flexible, worldwide marketplace that retail information, electronic communications, fast transport, and materials handling technologies have made possible.

Even extremely large manufacturing companies like GM Truck, GE Transportation, Fruehauf Trailer, Lockheed, and McDonnell Douglas Corporation's aircraft divisions have become smaller relative to their customers in the services sector (see Table 1-5). And in information services, only IBM, with its $69 billion (1990) sales, is larger than the biggest information service users in the financial service industries. Increasingly these large service users are forcing even the manufacturing giants to respond to their needs in real time. Time-based strategies have become a necessity in the new service economy but are only one element in the service-based strategies now needed for success.

CUSTOMERS DETERMINE STRATEGY, DESTROY INDUSTRY BOUNDARIES

These powerful service companies, directly connected to their product producing sources, have placed ultimate consumers ever more in command of the world's production system and able to dictate responses to their individual and collective desires. Being able to sense, produce for, and service these trends is the sine qua non for success in the new service society. Service technologies have created both the need and capacity for such responses. They have also radically changed the sources and options one can call forth in responding.

Most importantly perhaps, the widespread penetration of service technologies has virtually destroyed the boundaries of all industries. The example of the financial service industry is often cited. But airlines no longer compete just against airlines. They also compete against travel agents, tour groups, retailers (for products sold from in-flight catalogues), financial service companies (credit cards), ground transportation providers (rental cars or buses), communications companies (network and database services), and so on. Similarly, accounting companies no longer compete just with accounting companies, or computer companies just with computer hardware companies. Instead, the software and computer service divisions of accounting companies compete with the software and service divisions of computer companies, as well as those of user companies. Their executive recruitment activities compete with headhunters and personnel organizations, their consulting groups compete with independent consulting firms as well as staff arms of manufacturers, and their merger and acquisition groups compete with specialists in investment banking. And so on.

As a result, managers can no longer define their corporation as being in a single "industry." Technology demands that they reconceptualize the "industries with which they compete" to include all functional and potential cross-competitors for the services and products they create. Later chapters will show how this changes the very basics of one's approach to strategic analysis, strategy formulation, organizational structure, and control systems. Those companies that do not respond could join the long list of enterprises and industry segments that service technologies have already made obsolete. Fortunately, experience has led to some very concrete and productive ways to analyze technological advance, to think about strategy in this milieu, and to organize for maximum service and responsiveness in today's more service-oriented marketplace. The remaining chapters will define in detail how to develop such service-based strategies and manage the knowledge-based intellectual resources at their core.

TECHNOLOGY'S DISTINCTIVE IMPACT PATTERNS

New technologies tend to invade and diffuse through the service industries -- and the service arms of manufacturers -- in more or less predictable ways. As they do, they usually initiate vast economic restructurings and important new strategic opportunities. These forces cause industries to pulse from concentration to decentralization, from economies of scale to economies of scope, from simpler product lines to greater complexities, and often from regulation to deregulation to reregulation. Fortunately, this sequence of impacts is both distinctive and relatively repetitive in pattern -- and hence manageable once recognized. Each stage creates a new group of strategic options, possible organizational responses, competitive threats, and industrywide structural impacts.

New Economies of Scale generally appear