10 Mar 2016

Servinomics and the competitiveness of EU manufacturing firms

European manufacturers are competing in global and increasingly tough markets. The pressure for lowering costs has changed the geography of manufacturing, moving a high share of production overseas where labour costs are lower. In 2014, in the European Union (EU), the manufacturing industry had declined to around 15% of the total GDP, a share that the European Commission (EC) seek to increase above 20% by 2020.

The renaissance of European manufacturers is linked to the benefits they can derive from the use of services and the adoption of digital business models. Some iconic examples are Rolls-Royce Aerospace with the implementation Power-by-the-hour, Xerox with document management, and Alstom with Train-life services. These firms compete in different industries with specific lifecycles and supply chain structures, having in common an increased preference for use over ownership of equipment, vehicles, machinery, or any other asset. 

The increasing adoption of services by manufacturing firms and the necessity to create and sustain well-qualified jobs have thus picked the attention of European policy-makers upon servinomics, i.e. the economic impact of service implementation in manufacturing firms, and the potential benefits coming from it. 

The evidence on the relationship between service implementation and firm performance is nevertheless mixed. Empirical evidence tends to agree that the relation between service implementation and firm performance is not linear. The impact of service implementation on manufacturing firms’ performance also varies with time, i.e. firm performance and size increase significantly in the first year after implementation of services, while staying fairly constant after the second year.  

European manufacturing firms which tend to be reluctant to implement service business models, as their returns are difficult to predict. In this scenario Europe might be experiencing a misalignment of economic incentives between manufacturers and the rest of society. Whilst society wants to establish a knowledge economy, manufacturers are finding it difficult to obtain private profits. There is a role for policy-makers to realign incentives by implementing reforms in the service sector. Europe has two main challenges. 

Firm size. A primary concern for European manufacturers is the uncertainty entrenched in the implementation of new services given that the average size of firms is particularly small: according to the Eurostat’s structural business statistics, in 2015, 92.7% of EU-28’s non-financial firms are micro enterprises employing fewer than 10 employees, while roughly 20% of the manufacturing workers are employed in firms with less than 250 persons. Small manufacturers cannot easily internalize the uncertainty and investments related to service implementation. Their competitiveness is thus reduced unless there is a rich ecosystem of service firms with capacity to offer those services as external providers. 

Leadership in the digital economy. Another important aspect in the debate on servinomics is the impact of digitalization on European wealth and competitiveness. The difference between EU and US ecosystems is reflected in the fact that number of digital services producers was created in the US rather than in the EU. With the exception of firms like Skype or Spotify, companies like Google, Facebook, Twitter, Linkedin, Dropbox, Amazon, etc... were all born in the US. Reducing the digital gap with the US will be crucial to increase the competitiveness of European manufactures in the upcoming years. 

In sum two broad policy recommendations can be identified to overcome those challenges. 

Agglomeration effects. European manufacturers acknowledge the importance of service implementation. They also pointed out though that whether services will play a bigger role in the European manufacturing sector will also depend on the ability of policymakers to push for a change in the European management culture. The adoption of services is likely to be facilitated by an environment in which innovation and internationalization policies are better coordinated. Since European manufacturing firms, especially SMEs, are often present in international markets and networks with a mix of relatively simple international and innovation activities, e.g. via the outsourcing of (knowledge) service activities. A better coordination would allow firms to enjoy the benefits of service implementation without having to fully internalize the costs associated to it. This seems to be particularly the case when Knowledge Intensive Business Services (KIBS) companies, i.e. firms which are both sources and carriers of knowledge, provide high value-adding services to other organizations lacking internal capabilities. This process of firm collaboration ultimately impacts job creation in the area where they gather. Finally, the implementation of soft policies could also help, e.g. through the explicit inclusion of KIBS in industrial clusters, even if the nature of the businesses seems to be unrelated. 

Building a digital ecosystem. The leadership of US firms in digital services have been traditionally based on building a critical mass and establishing firm networks. This leadership was sustained on network mechanisms for gaining early feedback on designs. Feedback from the network of clients and customers allowed making early adjustments that increased efficiency and reliability. Firms networks are collaborative models of innovation that, even when is difficult to measure (i.e. software developed for internal use vs. software for retail sale), have a positive effect on economic performance. These collaborative networks have an essential role on the creation and evolution of a digital ecosystem. Territorial models based on firms networks (i.e. Silicon Valley) have outperformed the high investments of European and Japanese manufacturers. Additionally, the access of capital is another essential element of a digital ecosystem. European and Japanese firms have been losing global share in major consumer products, in part explained by institutional practices that “inhibit the development of a market for venture capital backed startup products and services”. Then, a long list of technological start-ups has moved to the US for achieving commercial success. This is the example of Ludei, a firm that develops apps and games for smartphones that decided to move from Bilbao (Spain) to Silicon Valley. European policy makers need to retain those companies and, if possible, attract leaders in the industry to localize partly or fully in Europe. In doing that, they will grow a critical mass that will attract technological developers, entrepreneurs and financial backers all over the world, and therefore building a virtuous circle and an enhancement of the global competitiveness of digital start-ups.

* This post is a an old version of the post “Servicein European manufacturing: servinomics explained” published in Bruegel blog on March 1st 2016. I co-authored this post with Tommaso Aquilante and Oscar Bustinza.

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