# **Section 1: Introduction**

Manufacturing firms are increasingly selling services as well as manufactured products - a phenomenon referred to as servitization.<sup>1</sup> For example, Honeywell, a leading manufacturer in the semi-conductor industry, offers in-flight monitoring of engine systems. Apple offers iPods and iPhones with maintenance and support services, both digital and personal. General Electric, which manufactures a range of products from home appliances to aircraft engines, also offers medical imaging and financing services. In fact, some manufacturing firms have “transitioned” into services firms, such that services activity has become the primary source of revenue.

Even though servitization is not new, and the pattern was evident even in the 1850s (Schmenner, 2009), the emerging literature has only recently begun empirically to address several key questions. Is the trend unique to advanced countries or also visible in manufacturing firms in developing countries?<sup>2</sup> What drives manufacturing firms to sell services? What factors – e.g. technological change, increased competition – have influenced the degree of servitization? Which firm attributes – e.g. size, productivity – are most likely to lead to servitization? Is servitization a pre-curser to, or an aspect of structural transformation? This paper addresses these questions in the context of the manufacturing sector in a developing country, India, which has seen its revealed comparative advantage grow in services at the expense of manufacturing.

In principle, manufacturers may sell services for two broad reasons. _First_ , because of economies of scope in production, i.e. because services offered are a natural extension of the firm’s core strengths. That explains why Apple offers specialized apps which draw on skills and technologies that produce the iPad and iPhone and why an Indian manufacturer such as Asian Paints, belonging to the chemical and chemical products industry, offers interior design and painting services. _Second_ , because of externalities in consumption, i.e. because consumers prefer to buy a manufacturing product and related services from the same firm, and a firm’s bundling the two enhances the appeal of its products.<sup>3</sup> Thus, Apple also offers financial services and personal and recreation services (e.g. iTunes), which are not necessarily an extension of the production capabilities of the firm, but are convenient for consumers to purchase from Apple.<sup>4</sup> In certain cases, servitization happens for both reasons. For example, Apple offers repair and maintenance services for the iPad and iPhone, because it is both well-equipped to and trusted by consumers to do so. Likewise, Bombay Dyeing, an Indian textile firm founded in 1879, offers retail services to its consumers.

Previous empirical work has examined some implications of both rationales for servitization. Breinlich et al. (2014) propose a model where firms allocate their finite stock of accumulated industry expertise in order to augment the productivity of their goods and services production. Using firm-level data from the manufacturing sector in the United Kingdom, they show that accumulated expertise, as embodied by a firm’s stock of research and development, facilitates the transition to more intensive services provision in the face of goods market trade liberalization. In contrast, a larger physical capital stock is associated with a significantly weaker shift into services. Thus, in the case of a shared finite production asset, enhanced goods market competition, whether foreign or domestic, could motivate firms to shift into services. In these circumstances, increasing services revenue is likely to be associated with declining manufacturing revenue.

> 1 The literature on servitization encompasses both the use of services as inputs and their sale as final products by manufacturers (Lodefolk, 2013). In this paper, however, we focus only on the latter aspect, given the unavailability of data on disaggregated inputs.

> 2 Compelling evidence on servitization is primarily drawn from developed countries (Vandermerwe and Rada, 1988; Neely et al., 2011).

> 3 See for example, Mathieu, 2001; Gebauer and Fleisch, 2007; Oliva and Kallenberg, 2003; Wise and Baumgartner, 1999; Mallaret, 2006. To reflect the preferences of consumers’ desire to bundle services with manufactured products, a study on Italian firms shows the strategic relevance of after-sales services for manufacturers of durable goods (Saccani et al. 2007).

> 4 Between 2002 and 2010, Apple sold over 206 million iPods and over one billion songs through the iTunes Music Store (Benedettini et al. 2010).

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