Research

Service as innovation: China's coming service revolution

Soon, innovation in China will take the form of a move from a primarily manufacturing economy to a more service-oriented one, according to experts gathered at the Fourth Annual Executive Forum in Shanghai. The forum is part of graduation exercises for the W. P. Carey MBA Shanghai, an executive MBA program delivered by the W. P. Carey School of Business and the Shanghai National Accounting Institute.

2007-06-20

On a recent Business Week list of the top 25 innovators in the world, more than 40 percent of the companies listed were service firms — not just high-tech firms where innovation is expected. Indeed innovation, often associated with traditional, "hard product" industries, can be applied to the softer stuff of service. Innovation, in fact, is imperative to success.

"The critical component to being competitive in global markets over the next 20 years is the ability to be innovative," said Michael Hitt, a management professor at Texas A&M University who cited the Business Week ranking during a panel discussion entitled "Innovation in Services: An Industry Perspective" at the Fourth Annual Executive Forum in Shanghai.

The forum is part of graduation exercises for the W. P. Carey MBA Shanghai, an executive MBA program delivered by the W. P. Carey School of Business and the Shanghai National Accounting Institute. According to the gathered experts, part of China's coming innovation will involve a move from a primarily manufacturing economy to a more service-oriented one. The central government in China issued an innovation initiative more than a year ago, citing the need for creative thinking in everything from steel processing to specialty retail boutiques.

From products to services

Robert E. Mittelstaedt, dean of the W. P. Carey School, traced a brief historical survey of economics in the west, from agriculture to manufacturing and then service. The service industry, now 70-80 percent of the west's economy, developed over just 25 years, he said. China's own transition from manufacturing to service may well be even faster.

"Like everything else in China, I'm sure it will proceed very rapidly," Mittelstaedt says. "Manufacturing cost advantages are not sustained very long" and China will need to look for "ways to create value beyond manufacturing." Philip Francis, chairman and chief executive officer of U.S.-based retailer PetSmart, knows first-hand about the opportunities for innovations in service.

His Cinderella story might serve as an inspiration for China. In 1987, PetSmart was founded to be a "category killer" in the realm of pet supplies; Francis says their goal was to be the "Toys R Us of pets." Like all category killers, PetSmart relied on a large variety and low prices to move products, and for a while, it worked.

When the company issued its IPO in 1993, it was featured on the cover of Forbes and Fortune magazines and was considered a company to watch. Six years later, "the business model had worn out," Francis explains. Still a category killer, PetSmart wasn't having the impact it used to. By the time Francis became full-time CEO in 1998, PetSmart was in need of a complete turn-around.

PetSmart was transformed from a low-cost retailer to a specialty store, "one that leaves behind customers interested in price only and goes after more affluent and aspirational customers," Francis explains. PetSmart made stores lighter, brighter, cleaner, and more inviting. But most importantly, they added services to what had been a product-driven business model.

PetSmart began to offer dog grooming, obedience training, day camps, and upscale boarding in high-end "pet hotels." Photography and veterinary services followed soon after. "There is a retail principle in the United States: only the person with the lowest costs can thrive on a strictly low-price message," Francis explained. And in the United States, he said, that is usually Walmart.

PetSmart is priced 3-5 percent above Walmart, but a greater than 3-5 percent difference in shopping experience allows the company to maintain its edge. From a single store in 1997, PetSmart has grown to about 930 stores today, and has increased its market capitalization from $300 million during its lowest slump to $4.5 billion this year. Service accounts for an average of 10 percent of sales today, and more than 30 percent in some full-service locations. What do Chinese businesses stand to learn from Francis' turn-around story? As incomes rise, something more than just price matters.

"As affluence increases, from what I've observed, customers value time more heavily. People who used to say, 'I want to do it for myself, at a low cost,' now say, 'you do it for me and I'll pay a little bit more.' As you look ahead at the rising affluence in China, you see that time is becoming more important to people." For companies whose customers are harried, adding services to a product-driven business model can ensure a level of customer loyalty that low prices alone can't shake.

A culture of innovation

PetSmart's metamorphosis form category killer to service champ would only have been possible as part of a broader culture of innovation, where business leaders are encouraged to seek out new ideas and apply them. Perhaps one of the high-technology sector's most significant contributions is the ideal of a culture of innovation, which attracts intelligent people to a work environment that stimulates the imagination.

Kui Chen, general manager of Microsoft's Eastern Pacific and China regions, spoke about the software giant's in-house tools for service innovation. "Is IT a service industry?" Chen began. The conclusion: IT is both a service industry and an innovation industry — one with the capacity to "change our work style and our lifestyle."

IT is itself perhaps the biggest innovation of our time, while simultaneously functioning as a service tool. Innovation, Chen says, begins with a dream. Thirty years ago, Microsoft founder Bill Gates had a dream: he wanted to bring PCs into the homes of thousands of ordinary families at a time when most computer experts estimated the worldwide demand for computers to be fewer than a dozen large scale machines used primarily for research.

Today, that idea seems laughable. Gates challenged his earliest employees to innovate, and provided them with the environment to do so. The first Microsoft campus in Seattle allotted an independent 12 square meters of working area to every employee and granted them total authority on how to arrange and decorate that space — even if, as in the case of one boisterous employee, that meant raising a crocodile in the office.

The idea was to encourage an innovative mindset. Decades later, Shanghai has the only full campus outside of the U.S., and Microsoft hopes to recruit a large number of top Chinese professionals to fill it, all while fostering a Seattle-style innovation culture. Meanwhile, Chinese Microsoft offices host their own monthly Innovation Days where employees build platforms to exchange new ideas or participate in global conversations with Gates himself.

An innovative culture is even more fundamental to the work of Dr. Edward Tse, vice president and managing partner for China of Booz Allen Hamilton, one of the world's top three management consulting organizations. "We're not selling any hardware or software, we only 'sell' people," he said. Founded in 1914, Booz Allen Hamilton has made an international business out of studying innovation. Of more than 100 international offices, four are in China.

"The nature of our firm is [that we are] a knowledge-based organization. We sell our knowledge and ideas," Tse said. "To differentiate ourselves in the marketplace, we consistently, continuously need to develop ideas that work in the marketplace, that turn innovative ideas into real business models."

For almost 15 years, Booz Allen Hamilton has been developing innovation in the Chinese market, first assisting multinationals in setting up in China, and now increasingly turning to local Chinese companies. The consulting firm is responsible for some of the "stickiest" ideas in business, but no matter how wide-ranging their ideas may become, the starting point is always the client.

Tse explains that as a service business that sells innovation, Booz Allen must constantly gather information from both clients and the marketplace. That information is shared within the firm through an intranet that allows employees to "share ideas without boundaries."

A culture of innovation means that Booz Allen employees aren't afraid to share ideas, ask questions, or take risks. "There is a trial and error process as part of innovation. There is no process which can give us a 100 percent success, but there is a process which will enable us to use trial and error that is always market-based."

Risk and reward

Even the strongest companies heading down a road from a product to a services focus will need to be prepared for some trial and error. PetSmart manages risk with staged roll-outs. "We'll try just about anything," Francis laughs, but initial concepts are only launched in 10-15 stores on average, and for only six months.

Successful concepts may go on to phase two, where they will be tested another six months in 50-60 stores while issues of operations and scalability are fine-tuned. At last, a full roll-out will bring services like pet photography or doggy day camp to all 930 outlets. This measured approach allows PetSmart to embrace innovation enthusiastically while remaining cautious.

However, Francis warns, the service industry carries other forms of risk as well. "The quality of execution is more important than initial risk . . . the penalty for failure in a service is bigger than for products," he said: customers are less forgiving of faults in service than in manufacturing.

"It is possible for a retail store to disappoint a customer if they are out of stock on a product, or if the check-out line is too long, but in service, the loyalties are different," Francis said. "In service, customer loyalty is not necessarily to the brand name or the location, the loyalty is to the service provider." Well-trained staff and staff retention are key; if a service provider leaves for another groomer or obedience school a few miles away, it is likely his customers will follow him.

Businesses with innovative services are challenged not just by their customers but by their competitors. "All innovation has something to do with competition," Chen says. And innovation has become more difficult as it becomes a household word. Chen refers to other technology companies as "friendly competitors."

She is grateful to them for forcing innovation; for example, the way Google and other companies' web-based services have caused Microsoft to rethink their own software delivery models and launch services like Windows Live. Other risks, Tse adds, may be specific to China.

"A deep understanding of local tradition is needed to translate" management concepts and make them relevant in a local context. While Chinese service providers are striving to align themselves with global practices, "there is still a lot of special context for China," particularly regarding management styles. "The concept must be locally applicable as well as successful with global development for marketplace success," he concludes.

However, the pay-off for assuming the risks of a service model is great. Services can increase margins, and adding service products leverages readymade infrastructure with a high degree of capital efficiency. More than that, though, Chinese companies that introduce service innovations anticipate the needs of the country's growing middle class.

Bottom Line:

• China must begin the process of moving from a primarily manufacturing economy to one in which the service industry plays a large role. As China's economy grows, middle class consumers will demand increasing services to save time.
• Adding services to a product-driven business model can increase revenue and build customer loyalty, while making retail businesses more resistant to price undercutting from larger retailers.
• The service industry demands innovation in the coming decades; this innovation will come from companies that foster creativity and communication.
• Service innovation has many inherent risks from both customers and competitors, but wise management of these risks can lead to increased profits and a stronger long-term position.

Marketing Management Economics Faculty