IoT, edge, AI, 5G, cloud computing, blah, blah, blah..

Timothy Chou
Jul 28 · 6 min read

How do we double our revenues and quadruple our margins using software?

Based on an executive workshop held in Minneapolis, MN in 2019

If you’re the CEO or board member of a company that manufactures any healthcare, construction, agriculture, power generation, pharmaceutical or industrial machine you’ve probably heard about IoT, edge, AI, 5G and cloud computing. But why should you care? Why should your company care?

While finding ways to use technology to save money is always good, the bigger driver is using software to increase revenue. I’ll make the case as the manufacturer of construction, packaging, oil, gas, healthcare or transportation machines, you can double your revenues and quadruple your margins by building and selling digital service products. Furthermore, you’ll create a barrier that your competition will find difficult to cross.

Software Defined Machine

Next-generation machines are increasingly powered by software. Porsche’s latest Panamera has 100 million lines of code (a measure of the amount of software) up from only two million lines in the previous generation. Tesla owners have come to expect new features delivered through software updates to their vehicles. A software-defined automobile is the first car that will end its life with more features than it began. But it’s not only cars, healthcare machines are also becoming more software defined. A drug-infusion pump may have more than 200,000 lines of code, and an MRI scanner more than 7,000,000. A modern boom lift — commonly used on construction sites — has 40 sensors and three million lines of code, and a farm’s combine harvester has over five million. Of course, we can debate if this is a good measure of software, but I think you get the point: machines are increasingly software defined.

So, if machines are becoming more software defined, then the business models that applied to the world of software may also apply to the world of machines. In the rest of this article we’ll cover three business models.

Business Model 1: Product and Disconnected Digital Services

Early on in the software industry we created products and sold them on a CD; if you wanted the next product, you’d have to buy the next CD. As software products became more complex, companies like Oracle and SAP moved to a business model where you bought the product (e.g., ERP or database) together with a service contract. That service contract was priced at roughly 2% of the purchase price of the product per month. Over time, this became the largest and most profitable component of many enterprise software product companies. In the year before Oracle bought Sun Microsystems (when they were still a pure software business), they had revenues of approximately $15B, only $3B of which was product revenue, the other $12B (over 80%) was high-margin, recurring-service revenue.

But what is service? Is service answering the phone nicely from Bangalore? Is it flipping burgers at McDonald’s? The simple answer is no. Service is the delivery of information that is personal and relevant to you. That could be the hotel concierge telling you where to get the best Szechwan Chinese food in walking distance, or your doctor telling you that, based on your genome and lifestyle, you should be on Lipitor. Service is personal and relevant information.

I’ve heard many executives of companies who make machines say, “Our customers won’t pay for service.” Well, of course, if you think service is break-fix, then the customer clearly thinks you should build a reliable product. Remember Oracle’s service revenue? In 2004, the Oracle Support organization studied the 100 million requests for services from Oracle support and over 99.9% of those requests were answered with known information. Aggregating information for thousands of different uses of the software, even in a disconnected state, represented huge value over the knowledge of a single person in a single location. Service is not break-fix. Service is personal and relevant information about how to maintain or optimize the availability, performance or security of the product. All delivered in time and on time.

Business Model 2: Product and Connected Digital Services

The next major step in software business models was to connect to the computers that ran the software. This enabled even more personal and more relevant information on how to maintain or optimize the performance, availability and security of the software product. These digital services are designed to assist IT workers in maintaining or optimizing the product (e.g., database, middleware, financial application). For example, knowing the current patch level of the software enables the service to recommend only those relevant security patches be applied. Traditional software companies charge between 2 and 3% of the product price per month for a connected digital service. The advantage of this model is the ability to target the installed base of enterprises, which have purchased the product in the traditional Model 1.

Now let’s move to the world of machines. If a company knows both the model number and current configuration of the machine, as well as the time-series data coming from hundreds of sensors, then the digital service can be even more personal and relevant and allows the company to provide precision assistants for workers who maintain or optimize the performance, availability and security of the healthcare, agriculture, construction, transportation or water purification machine.

Furthermore, assume you build this digital service product and price it at just 1% of the purchase price of the product per month. If your company sells a machine for $200K and you had an installed base of 4,000 connected machines, you could generate $100M of high-margin, annual recurring revenue. And since digital service margins can be much bigger than product margins, companies who have moved to just 50/50 models (50% service, and 50% product) have seen their margins quadruple.

While this business model has been aggressively deployed in high tech, we are still in the early days with machine manufacturers. There are some early leaders. Companies like GE and a major elevator supplier derive 50% of their revenue from service. Voltas, a large HVAC manufacturer, is an 80/20 company — meaning they derive 20% of their revenue from services. In the healthcare area Abbott has introduced a digital service product called AlinIQ and Ortho Clinical is selling Ortho Care as an annual subscription service. While some of this is lower margin, human-powered, disconnected services the value of a recurring revenue stream is not lost on the early leaders.

Business Model 3: Product-as-a-Service

Once you can tell the worker how to maintain or optimize the security, availability or performance of the product, the next step is to simply take over that responsibility as the builder of the product. Over the last fifteen years we’ve seen the rise of Software-as-a-Service companies (SaaS) such as, Workday and Blackbaud, which all deliver their products as a service. In the past seven years this has also happened with server hardware and storage products as companies like Amazon, Microsoft and Google provide compute and storage products as a service.

All of these new product-as-a-service companies have also changed the pricing to a per-transaction, per-seat, per-instance, per-month or per-year model. We’re likely to see the same with agricultural, construction, transportation and healthcare machines. Again there are some early examples Kaeser compressor is delivering air-as-service and AGCO is selling sugar cane harvesters by the bushel harvested. In the consumer world we’re all familiar with are Uber and Lyft, which provide transportation machines as a service — priced per ride. Of course, the most expensive operating cost of the ride is the human labor, so like those of us in high-tech software and hardware products, they are looking at replacing the human labor with automation.

So why should you care about IoT, edge, 5G, AI and cloud computing? Not because they are cool technologies, but because they will enable you to double your topline revenues and quadruple your margins with high quality recurring revenue. And by the way, all the while building a widening gap with your competition.

For more detail see the five keys to building digital service products and selling them. In addition the 160-page workbook from the executive workshop is available for purchase.

Thanks to Scott Nelson

Timothy Chou

Written by, Lecturer @Stanford, Board Member @Blackbaud, Board Member @Teradata, Chairman @Lecida, Chairman @AlchemistAcc

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