Pure Drinks Company Case Solution Financial Management

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Many managers of service businesses are aware that the strategic management (by which I mean the total process of selecting and implementing a corporate strategy) of service businesses is different from that of manufacturing businesses. This article discusses how pure service businesses are different from product-oriented businesses and why they require different strategic thinking. A pure service business is one in which the service is the primary entity that is sold.

That distinction is important because everyone in every type of business sells some element of service. In pure service businesses any transfer of a physical or concrete product is incidental to the service—for example, the written report of a management consultant. Examples of pure service businesses include airlines, banks, computer service bureaus, law firms, plumbing repair companies, motion picture theaters, and management consulting firms.

Top managers should ask themselves six questions about strategic management. The questions are fairly common, but the answers for service businesses are often unique. Each question will be raised here and discussed in depth later.

1. 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.

2. 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 analyzed. 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.

3. 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.

4. 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.

5. What process are we using to develop and test new services? Every company depends on an 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 recognize the abstract, perishable nature of services.

6. 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.

Describing Services

In product-oriented businesses, the physical reality of the product provides a simple but powerful base on which to build a business description. The question is far more difficult for service-oriented businesses to answer because services are more abstract than products. For example, it may be difficult to describe management consulting as a business to someone who has never experienced the consulting relationship. What does a consultant do?

One way to deal with the difficulty of describing services has been to talk about them as if they were products. G. Lynn Shostack, a vice president in charge of business planning and analysis at Citibank, has noted:

"Banks often devote significant resources to an activity they call 'new product development.' The phrase is so alluring that groups are regularly set up to create these 'new products.' The realization seldom seems to occur to such banks that they are not in the product development business at all. In fact, many banks do not seem to have arrived at the insight that things are not the basis for their industry. Even marketers in such banks apparently do not understand that they are engaged in perhaps the most difficult and dimly understood realm of business endeavor—the development and marketing of financial services." ¹

The predominant mental image about "the way things work" in business is a product-based image. This image leads to a product-oriented language, and the language in turn constrains communication in such a way that one cannot develop really innovative approaches to managing the service business.

Because they are often lumped together, service businesses can be misunderstood. As we shall see later, they differ greatly, and an understanding of their differences can help the thoughtful manager to understand the nature of the strategic opportunities in each.

The traditional image of the service business is that the service is "invariably and undeviatingly personal, as something performed by individuals for other individuals."² This perspective is erroneous. Automatic car washes, automated banking services, and computer time-sharing are just three of the many examples of service businesses in which the service is provided by automated equipment. The strategic requirements for these businesses are obviously quite different from those in which individuals perform services for other individuals.

The Exhibit shows one way to separate service businesses into general types, with different strategic management requirements. At the pinnacle of the pyramid is the service that is provided by the business. To place a specific business on the spectrum in the exhibit, it is necessary to answer two questions: (1) How is the service rendered? (2) What type of equipment or people render the service?

Exhibit A Spectrum of Types of Service Businesses

Placement of a specific service business along the spectrum may be difficult, but two general observations may ease the difficulty: (1) as service businesses evolve, they often move along the spectrum from people-based to equipment-based or vice versa, and (2) many companies are in more than one type of service business. Virtually all banks, for example, operate multiple-service businesses. Some of these are equipment-based, as in the transfer and storage of funds. Others are people-based, as in the financing of a home, car, or business, because they require judgment about the financial management of funds.

Building Barriers

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 centered 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 decentralization 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.

Economies of Scale

Managers of service businesses should not conclude that they have no opportunities for scale economies and the resulting capital barriers to entry. On the contrary, there are many examples of scale economies, especially in equipment-based service businesses. The introduction of wide-bodied jets by the airlines enabled them to fly twice as many passengers with the same number of high-salaried pilots and flight engineers. Although not on the same scale, other reductions in maintenance and ground handling personnel were possible.³

A second example of economies of scale is the multiple-unit motion picture theater that can be found in most suburban locations in the United States. These facilities may have four or five theaters, some of which may be fairly small. The refreshment stand and the ticket selling booths are centralized, thus requiring both less floor space and fewer people to operate them. In some cases, there is a single projection room for more than one theater, and the equipment is almost completely automated. Central heating and air conditioning are provided for the entire building. Obviously, the cost to operate this type of facility is much lower than the cost for an equal number of separate theaters.

Advertising clout is the third example of an economy of scale that service businesses can use as a barrier to entry. Once it achieves a size that makes regional and/or national advertising economically feasible, a service business can use advertising as a competitive weapon to build and maintain market share. O.J. Simpson's advertisements for Hertz are an obvious example, but other companies such as Orkin, John Hancock, and FinanceAmerica also use advertising effectively. Smaller companies simply do not have the capital required to mount a competitive advertising campaign.

With the probable exception of advertising clout, the economies of scale that may provide a barrier to entry exist primarily in equipment-based, and not in people-based, service businesses. Where economies of scale cannot be developed easily, two other barriers to entry can be used: proprietary technology, and/or service differentiation.

Proprietary Technology

In equipment-based service businesses, proprietary technology is perhaps most commonly used as a barrier to entry. In the computer services industry the set of "canned" programs that a time-sharing company offers is crucial to the sales effort for the company's services. So-called raw computer time is a commodity product supplied by many vendors. The purchaser of time-sharing services is interested in knowing what other services the company has which are technologically advanced over the competition. The software provided by the time-sharing company must be technologically advanced in both what it will do and how efficient it is.

Less commonly, proprietary technologies have been developed by people-based service businesses, particularly those that provide professional services. The Boston Consulting Group has developed several proprietary technologies around its experience curve concept, including market segmentation and strategic portfolio analyses.

Service Differentiation

Product differentiation, or as I have called it, 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 market place. 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 any one 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.

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 specialized 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

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

When the tasks cannot be automated because human judgment must be exercised, cheap labor can often be substituted for expensive labor 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.

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 labor are identified. The expensive labor is then free to do those crucial tasks that bring profits to the company.

Value Engineering

The process of value engineering has become popular in many manufacturing companies in the last decade to determine what changes in design and/or manufacturing process can be made to reduce the cost of manufacturing a product without reducing its utility.

A similar process can be used for services. Once again, the service provided must be broken into its component parts. This time, however, the purpose is not to determine how the service is rendered, but rather what service is provided. The goals are to determine what parts of the service are essential, what parts can be eliminated, and what minor additions could greatly enhance the service.

Although they have not called it value engineering, a number of service businesses have used the technique. Perhaps the best current example is provided by Holiday Inns. This company has promoted the service as one that has no surprises. The quality of service has been set at a level that does not provide the extras that one would find at an expensive hotel. The service is guaranteed to be of consistent quality throughout the country. The company believes that consistent quality with no surprises is more important to its customers than swimming pools and other added services; therefore, the emphasis is on maintaining the quality of the primary service.

A second example is provided by first-class service on the airlines. The quality difference between first-class and coach service was significant ten years ago. Today, although the incremental fare is in excess of 50% for first class, the traveler receives a slightly larger seat, two free drinks, and marginally better food. Yet first-class seats still sell. First-class customers are apparently buying status, not personal service.

Value engineering is somewhat more difficult for a service than for a product, since the physical nature of a product allows a checking of its continued appearance and function. For a service, it is often difficult to know which attribute is most important to the customer's purchase decision.

In sum, it is probably more difficult to obtain operating leverage in service businesses, particularly those that are people-based. The opportunities for finding operating leverage are there, but they require different ways of thinking about operations.

Competing on Price

Virtually all product-oriented companies have ways of determining their product's cost per unit at various volumes. Part of their strategic game is to become the low-cost producer and use this position as a competitive weapon.⁴ Other pricing strategies are of course available, such as the premium-price strategy for a premium-quality product.

In service-oriented businesses it is often difficult to determine what a unit of a given service is, much less its cost. In general, it is easier to determine costs in equipment-based service businesses than in people-based businesses. To be converted to an equipment-based service in the first place, the service usually has some routine character that can be analyzed. People-based service businesses, however, are much more complex. Until the theorists and practitioners who work with human resource accounting can refine the art sufficiently, it will be difficult to determine the cost of people-based services accurately on anything but an aggregate basis.

The pricing of services is thus often based on value rather than on cost. Value is generally determined by the customer and to some extent by competition. Customers tend to get a general feel for what they will have to pay for a particular service, but the source of this feeling is often unclear, because comparison shopping is often difficult. Customers will pay whatever they think the service is worth; thus pricing in many service businesses is based on whatever the market will bear.

An interesting game is played in the pricing arena. I have never heard a businessman brag that he had just hired the least expensive consultant available. People-based service businesses that rely on professionals to provide the service can, by pricing the service too low, create an image that is counter to that necessary for a professional operation that expects to remain competitive. Any good consultant knows that it is easier to sell a recommendation for which the customer has paid a significant amount than when the fee was quite low.

Prices can be set too low in equipment-based service businesses as well. At virtually every airport, one can find a fixed based operator (FBO) who performs one or several functions necessary to the operation of general aviation aircraft. One FBO at a busy municipal airport tried to increase the usage on the aircraft that he rented to local pilots by reducing prices by 5% to 7% throughout his fleet. The result was a decrease in volume. Somehow a rumor had started that the FBO had been able to reduce prices because he had cut back on the maintenance on the airplanes.

Probably less is known about the use of price as a strategic weapon in service businesses than about any of the other strategic variables. One fact, however, is clear. The general manager of a service business must use marketing methods that will enhance the perceived value of the service.

Developing New Services

Virtually all product-oriented companies have some form of research and development effort that is responsible for designing and testing new products and/or modifications to current products. The R&D task in service-oriented companies is different because it is complicated by the lack of a physical product. A service, especially in people-based businesses, can be a little bit different each time it is rendered.

The entire process of creating such services deals with concepts rather than physical objects. The testing process varies depending on whether the service is equipment-based or people-based, but in either case it is difficult to do test marketing or other types of market research on the new service. Customers must be enticed into experiencing the service, and this often requires major marketing efforts. Thus the cost of introducing a successful new service may be quite high because it is difficult to predict what service concepts will be understandable and attractive to the customer.

An example of a new-service development that most observers agree has stalled—at least for the next several years—is that of electronic funds transfer. Why has it faltered? The reasons are obviously complex and include political, legal, and economic factors. Perhaps most important, however, is consumer resistance rooted in fears about computer errors, invasion of privacy, and changes in lifestyles. It should be made clear that the failure is not one of technology. The technology is available to create the so-called cashless society, but consumers do not want the service.

The example illustrates a major difference between R&D in product-oriented and in service-oriented companies. A product can be shown to a customer who can make some crucial decisions about whether he or she is interested in trying the product. But how do you test-market the concept of a cashless society?

The difficulty of test marketing can, however, be turned into an advantage. Service concepts, especially in people-based service businesses, are malleable and can be changed even after they have been introduced in the marketplace, and the cost of such a change is often quite low.

Any business must develop new services if it is to survive. This task is quite different from new-product development. It is highly abstract, and the services that are developed require difficult and expensive testing in the marketplace. Thus there is little real innovation and a great deal of imitation of services. For example, airlines and banks are well known for their imitative practices.

Growing Through Acquisition

What is bought when a service business is acquired? There are several answers to this question, depending on the type of service business that is under consideration.

Many managers, particularly those with product-oriented experience, feel most comfortable when acquiring an equipment-based service business. Then the acquisition includes physical assets that can be quite valuable if bought for less than comparable new assets, if there is a limited supply of the assets, or if the business is in strategic locations (for example, a car rental business, or a string of self-service laundries). Unless one of these conditions exists, it is often less expensive to buy new assets than to buy those of an existing service business.

In people-based service businesses, the acquisition is more risky because people and their skills are the major purchase item. Regardless of the employment contracts and benefits that may be offered, there is always the risk that people will leave and take their skills with them. When physical assets are purchased, they are owned when the papers are signed. Decisions about their use and disposition can be made by the acquiring company. The same is not true of people; they may decide to depart at any time after the purchase is completed.

This lesson was learned by a well-known consulting firm. The firm had been quite successful in the northeastern United States. Being an astute observer of current trends, its president noted that business activity was increasing rapidly in the southern half of the country. Rather than spend several years and a significant amount of money developing a field office, he decided to acquire a small consulting firm in Dallas that had an excellent client list. The acquisition was made, and the president and two vice presidents of the smaller firm were given employment contracts. Unfortunately, four of the better young consultants regarded the president of the new parent firm as a "Yankee carpetbagger." They left, formed their own firm, and within 18 months had acquired 40% of their former employer's clients as their own.

Whenever acquisition of a people-based service business is being contemplated, it is important to ask: "What is the business worth without the key people?" There are some instances where the "franchise" in a market is worth the price of the business. In other instances, the services provided have some proprietary characteristic that is valuable even without the people in the company. Often, however, the answer to the question is that all one is buying are people. When this is the case, it is usually less expensive simply to hire away the best of these people.

Growth through acquisition in service businesses is a risky proposition, but the risk varies. It is generally riskier as one moves down the spectrum toward people-based businesses, and within people-based businesses the risk increases when the service is provided by professionals or highly skilled persons. Any company that wants to acquire service businesses must make sure that it can attract and keep skilled service-oriented managers to run them.

Concluding Comment

Because manufacturing has been the dominant economic force of the last century, most managers have been educated through experience and/or formal education to think about strategic management in product-oriented terms. Unfortunately, a large part of this experience is irrelevant to the management of many service businesses. The general manager of a service business must develop a healthy skepticism about his and others' approaches to strategy.

One of the best ways to change managers' thinking patterns and thus to avoid the trap of force-fitting product-oriented management techniques into a service-oriented business is to change the language system in the company. If managers talk about services instead of products, they also think about services and those characteristics that make services unique.

1. G. Lynn Shostack, "Banks Sell Services—Not Things," The Banker's Magazine, Winter, 1977, p. 40.

2. Theodore Levitt, "Production-Line Approach to Service," HBR September–October, 1972, p. 43.

3. See W. Earl Sasser, "Matching Supply and Demand in Service Industries," HBR November–December, 1976, p. 133.

4. See Patrick Conley, "Experience Curves as a Planning Tool" in Corporate Strategy and Product Innovation, ed. Robert R. Rothberg (New York: Free Press, 1976), p. 307.

A version of this article appeared in the July 1978 issue of Harvard Business Review.

Pure Drinks Company Case Solution Financial Management

Source: https://hbr.org/1978/07/strategy-is-different-in-service-businesses

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