Chesbrough on Service Innovation

By: Karin Wall

Henry Chesbrough has earned a worldwide reputation for his pioneering work on open innovation, influencing a generation of executives by identifying and describing the practice of innovating in collaborative groups outside the enterprise. We caught up with Henry to talk about his upcoming appearance at the European Innovation Conference and his new book.

You will be the key-speaker at the European Innovation Conference in Denmark, hosted by the Innovation Roundtable and REGX. What will your presentation focus on and why is that topic important?

— I have a new book coming out, Open Services Innovation, which looks at innovation trends in the service side of advanced economies, including Denmark.  We know a lot about how to innovate new products, new processes, and new technologies, but know far less about how to innovate in services.  Yet this is the majority of economic activity for most OECD countries.

— What gives this topic special importance is the rise of China and other emerging economies, who are now innovating as well as manufacturing the innovations of others.  There is a risk of a commodity trap, where firms that focus exclusively on developing better products and technologies run the real risk of failing to differentiate their offerings sufficiently, and instead become commoditized by innovative entrants from the emerging parts of the world.

“….firms that focus exclusively on developing better products and technologies run the real risk of failing to differentiate their offerings sufficiently, and instead become commoditized by innovative entrants from the emerging parts of the world”

What would you say is the main message of Open Services Innovation?

— I would say that there are three core messages to the book.  The first is that innovating services is not the same thing as innovating new products.  Services are intangible, so customers play an even more central role in service innovation, due to the need to engage closely with the customer to access tacit knowledge about real needs that customers will really pay for.  The second is that innovating services, like innovating products, needs to be done more openly.  Companies cannot provide by themselves all the things that customers need, yet customers want a complete solution to their needs.  So connecting to others and collaborating with them is vital in services innovation, as it is becoming in product innovation.  Third is that doing this well changes your business model to one that becomes a platform for others to connect to and build upon.  So you must learn how to construct, manage and innovate platforms well in order to sustain services innovation over time.

One of the things that you write about in the new book is the importance of thinking about your business as a service business – regardless if you offer a product or a service. Why is that so important and how can this way of thinking help you develop your organization and being more innovative?

— Michael Porter has been a powerful influence on business strategy.  One of his core ideas is the Value Chain, the set of activities that transform inputs into outputs, from the raw material through to the final consumer.  In Porter’s conception, the product is the star.  Companies need to compete on cost, compete on differentiation, or compete in a niche.  This gets back to the commodity trap I described before.  Thanks to the spread of ERP, supply chain management, Six Sigma, rapid prototyping, etc., it is getting very hard to sustain differentiation in products over time.   Porter’s Value Chain, while very helpful when it came out in 1985, is now a roadmap to a dead end.

— Service is actually included in Porter’s Value Chain, but it is the final ingredient before one ships to the customer (who isn’t part of the value chain, but is instead the passive recipient of the output of the chain).

— Thinking of your business as a service changes this focus entirely.  The customer is central throughout the process of innovation.  You don’t get all the customer’s needs identified at the outset, and them freeze them there for the rest of the process.  Instead, with a service you create offers to invite customers into the process, and work iteratively and collaboratively to arrive at innovative outcomes.

“You don’t get all the customer’s needs identified at the outset, and them freeze them there for the rest of the process.  Instead…. you create offers to invite customers into the process, and work iteratively and collaboratively to arrive at innovative outcomes.

—A great example of this is in mobile phones.  Consider Motorola’s Razr, which was  introduced in the fall of 2004.  At the time, it was the slimmest cell phone available, and its cool, slim design made it a hot product.  More than 50 million units were sold.   Three years later, however, the follow-on products failed to attract much interest.  Today, Motorola is has fallen from #1 to #7 in mobile handsets.  It would seem that Motorola was punished severely by the market because  it didn’t come up with another innovative product to follow up on the success of its Razr.

— But was that the real reason for Motorola’s failure?  No.  Motorola’s real failure was in its product-focused conception of innovation.  Motorola thought about innovation in terms of coming up with another breakthrough product.  What it didn’t think hard enough about was its customers’ experience with its products, and what additional services it could wrap around its devices to deliver a superior customer experience.

— Nokia, which has taken over from Motorola as the leading cell phone manufacturer in the world, faces a similar challenge today.  It is no longer enough to come up with ever better cellphone products.  While Nokia leads the world in the number of cell phones it produces, it faces mounting pressures from new entrants like Apple, Google, Microsoft, Palm (now part of HP), and the ecosystem of companies supporting each of them.  Nokia must focus its innovation efforts on the applications and services that will enrich its customers’ experience with its phones, or risk being supplanted as Motorola has been.  This will require radical changes in Nokia’s approach to innovation.

— To see this, consider one of Nokia’s challengers, the Apple iPhone.  Introduced in 2007, it too captured the public’s imagination.  To be sure, the iPhone was a neat device.  It had a sleek design, an elegant user interface, and a novel touch screen.  However, the iPhone became much more than a device like the Razr; in conjunction with iTunes and the AppsStore, it evolved into a system that attracted many third party applications and services to provide users with a wide range of experiences with a single device.   Unlike the Razr, the iPhone shows no sign of being overtaken by competitors any time soon.  And other recent entrants like Google and Palm are also making significant efforts to recruit third party application and services developers to support their respective efforts.

— So companies making cool products must think beyond the product, in order to turn it into a sustainable, profitable business.

Would you say that open innovation in the service business is different from open innovation in traditional product making industry? Are there, for instance, different barriers to open innovation in services – or a different potential?

— Yes, I do see important differences in open innovation between products and services.  One key distinction is that most services firms don’t have a formal R&D process.  Another difference is that the business models are different.  A product firm gets its revenues in lumps from its customers, whenever they buy the product.  Then there is little or no revenue from that customer unless and until the customer buys a new product.  So companies focus heavily on gross margin, trying to get a lot of profit from that product sale.  Services actually are cost centers, and companies do their best to minimize these costs, and they are often quite separate from the innovation engine of the company.  Their sales force is similarly compensated on moving products.

— A services firm thinks differently.  Revenues typically flow continuously, never as big as the initial product sale, but continually being renewed.  Services are actually profit centers, and solve real customer problems that keep those revenue streams flowing.  They are often close to the innovation engine of the firm, because the things that customers ask for become possible enhancements or even new service offerings.  Sales people are compensated on customer satisfaction or account profitability, and products and services are subordinated to these.

 

As I understand it your original concept of open innovation was “born” from R&D and the benefits of using more brains that those of your cadre of internal experts. Many service companies don’t have R&D departments – does this have any impact on how the concept of open innovation can work in service industries such as airlines, hotels, health care providers for example?

“Services are actually profit centers, and solve real customer problems that keep those revenue streams flowing.  They are often close to the innovation engine of the firm….”

— The premise of your question is right:  I did develop my thinking on Open Innovation by studying R&D departments.  And most service firms don’t have such functions formally organized.  This was how I came to care about services, in fact.  A few years ago, I sat in Paul Horn’s office at IBM.  Paul was the Senior Vice President of Research, in charge of IBM’s 3,000 researchers, scientists and engineers.  We had a wonderful conversation about innovation, and the many successes IBM had obtained from its research activities.  At the end of our time, I asked him a final question:  what is your biggest problem today?

— His biggest problem was that his research activities were geared to support a company that made computer products:  systems, servers, mainframes, and software.  But most of IBM’s revenues were coming from services, not from its products.  “I can’t sustain a significant research activity at IBM if our research is not relevant to more than half of the company’s revenues going forward”, he stated.  His answer intrigued and stimulated me to start working on an academic area that has become known as “Service Science”.  One way to think about Open Services Innovation is as an effort to translate what many academics have found about service innovation into practical insights for business managers in both product and service companies.

— In the book, I apply these insights to lots of service firms (and some product firms as well), including banking, airlines, online books, restaurants, paint distributors, and aircraft engine servicing, to name just a few.  I have also taken care to provide examples from all over the world, not just the US.

Since services are about interactions, they are typically consumed at the same time they are produced. This might have implications for scalability since services often can’t be codified the same way as products. How does open service innovation deal with codification and scaling of services? In addition to this there is the question of national/local cultures. How can you distribute a service globally, when some evidence seems to show that services have to be localized to be relevant and effective…?

— This is a great question!  There is a deep tension between scalability, which makes services innovation efficient, and customization, which makes services innovation attractive to customers.  Part of the art of services innovation is coming up with ways to manage this tension.

— I talk about this in some depth throughout the book.  Economically, we want to achieve economies of scale (more efficiency as volume increases) while also providing economies of scope (one-stop shopping to our customers).  Each type of economy can create value, but the real secret sauce is somehow doing both at the same time.  This is where openness really pays off:  it can enable firms to achieve both types of economy.

— A great example of this is Amazon, the online retailer. Amazon used to sell only books.  Today, it sells a wide variety of merchandise.  But how does it manage the vastly increased complexity of knowing what products to offer, how best to merchandize them, how much to stock, etc.?  It does so through opening up itself.  The same APIs and tools it uses to create its web pages for its books are made available to third party merchants to create Amazon pages for their merchandize.  It creates a consistent user experience for Amazon customers, who cannot tell the difference between an Amazon web page that sells goods stocked by Amazon, and a web page that sells goods stocked by third party merchants.  The pages all look the same!  So the customer gets a great experience, the third party merchant gets the chance to offer their wares on one of the most highly trafficked websites in the world, and Amazon shares the profits, while shifting the merchandizing risks to the third party.

— Amazon also illustrates the economy of scale.  It has one of the largest server farms in the world to process all of the transactions its website generates.  Many of the assets Amazon needs to access, store, retrieve, and utilize the requisite information needed to serve its customers require fixed investments, in the form of computers, servers, routers, switches, and software.   These fixed costs of acquisition can be lowered if they are spread over more volume.  So Amazon also offers third parties the ability to access this infrastructure, via Amazon Web Services.  This service rents out a portion of the infrastructure to other customers.  These rentals help to spread all those fixed costs Amazon incurs over more volume, reducing the cost per transaction to Amazon.

— There is an even deeper level in which economies of scale contribute to services innovation.  It comes from sharing gains from increased knowledge accumulated through more transactions or uses across those transactions or uses.  Instead of spreading fixed costs of a physical asset across more volume, this deeper level develops greater knowledge over more volume.  When you buy a book on Amazon, Amazon also tells you what other books other people have purchased with the book that you are buying.  Amazon knows this, and knows it better than anyone else, because it handles more online book purchase transactions than any other book reseller.  And your purchase adds just a little bit more information to Amazon’s ever-increasing database of transactions.  So Amazon increases its knowledge edge over its competitors, even as you increase your knowledge of possible other books to buy.   This is truly a sustainable competitive advantage.

By Karin Wall, Chief Editor

Thanks to Paul Hobcraft of Agility Innovation Specialists, contributing & review editor with InnovationManagement.se & Christian Bason of MindLab for their contributions to the questions for Professor Chesbrough.