Different from the break-fix service business in which customers are paying you to keep the systems running per their original specifications, the upgrades business is one in which they pay you to make the systems they own do more than they were originally capable of doing. While customers hate paying for break-fix services, they will jump at an opportunity to extend the capability of the systems they have already purchased.
A Near Perfect Business
Upgrades extend the life of your customer’s capital investment and create tremendous value for them. This, in turn, creates one of the best profit opportunities for capital equipment manufacturers. This business has all of the elements of a perfect business.
- Compelling value proposition
- No direct competition
- Very high profitability
Your customers are highly motivated to extend capital life. For many types of capital equipment, acquisition cost is the single biggest driver for total cost of ownership. Therefore, your customers want to avoid purchasing new equipment for as long as possible. Anytime they can extend their existing installed base of equipment to the next generation technology or improve its productivity is an opportunity to avoid another round of acquisition costs. Sometimes customers even demand to see upgrade roadmaps before they will make their initial system purchase. It’s that important to them to ensure long capital life.
The best part for you is that the original equipment manufacturer is usually the only one who can provide these upgrades. Upgrading the productivity or technical capability of complex equipment requires a complete knowledge of the system hardware, controls, and software. That creates a significant barrier to entry for a third party. Without direct competition to drive pricing down to minimum acceptable margins, you’re in a position to achieve pricing anchored to upgrade’s full market value.
For example, suppose your company sold a first generation system for $4M each on average. This Generation I machine could process 100 units per hour. You have since introduced Generation II of that same machine. It can process 125 units per hour. You also have released an upgrade that can bring a customer’s Generation I machine up to Generation II levels. This upgrade is worth one-quarter of a machine. Or said another way, upgrading four machines has the same value to the customer as an additional non-upgraded machine. Your upgrade’s full market value is its added value or $1M. See the figure below.
Upgrades Protect New System Sales and Pricing
Now imagine that one of your current customers has 20 Generation I systems. This customer’s business is expanding, and he now needs an additional 2,000 units per hour of production capacity. That’s 16 Generation II machines running at 125 units per hour.
You want to keep this customer and establish a $4.8M selling price for your Generation II machines. But a competitor has emerged that is willing to sell 16 125-unit-per-hour systems for $4.5M each. The competition’s total proposal for 16 systems is $72M.
You can defend your installed based and shut this competitor out by linking system upgrades to the new systems’ sale. So you put together a proposal shown below.
|Price Each($M)||Total Price ($M)||Equivalent Capacity(Systems)|
Your proposal delivers 16 systems worth of additional capacity for $66.8M. That’s $5.2M lower than your competitor. Your customer gets same capacity, lower acquisition costs, lower facilities cost, commonality, and none of the hassles of changing suppliers. You get to keep the customer and protect system pricing.
Don’t Let Upgrades Be an Afterthought
Creating a successful upgrades business, however, requires some forethought. Products must be planned and developed with the upgrades business in mind. Equipment companies with a successful upgrades business typically have the following attributes:
- Products are derived from a common, multi-generation platform.
- Installed-base upgrades and new product roadmaps are integrated.
- Both systems and upgrade products are managed by expert product and marketing managers.
A robust platform strategy is an essential ingredient for a capital upgrade-business success. A common platform that survives multiple generations of new products facilitates backward compatibility. This means that capabilities developed with new products can easily be packaged into upgrades for the installed base. The longer the platform survives, the larger the upgrades revenue stream. That alone, however, doesn’t ensure success.
The organization must have the discipline to make sure that each new product development program also makes some or all of the new performance capability available as upgrades for the installed base. Designing new capability into a new product is almost always easier if it is not constrained with backward compatibility. The easy way out is to remove the constraint; however, this forfeits the upgrades revenue stream.
To make sure that your organization is making a robust trade-off decision between reducing design constraints and the upgrades business opportunity, force a return on investment review for the potential upgrade including:
- Incremental effort and risk of including backward compatibility as a requirement
- The value that the installed base upgrade would have to your customer
- Target pricing
- The cost of goods sold for the upgrade
- Total available market for the upgrade and expected revenue capture
- Total potential profit
Lastly, you need to think about where in the organization to manage the upgrades business. Sometimes the upgrades business will get assigned to the service organization. In capital equipment companies, service groups are fantastic at executing the customer service function. They excel at managing large organizations, moving spare parts, installing systems, rapid response, and controlling complex cost centers. The capabilities needed to develop your aftermarket business are different. Upgrades-product management is not any different from systems-product management. Both require the skills to evaluate opportunities, create and capture value, and generate demand.
These attributes are likely to be found in your product management and marketing group. Manage your upgrades business from there. You’ll be more likely hire a product management professional with the right skills. He or she will also be under the tutelage of your other product managers. Plus, it’s critical that new systems and upgrades roadmaps are integrated. You have a much better chance of pulling that off when both are managed by the same organization.