Dual Transformation: How Engineering Firms Can Thrive in Commoditized Markets

Balancing a discipline of efficiency with a discipline of innovation

Competition between engineering firms is intensifying in every market. Each firm is vying to outdo its rivals by offering clients more benefits and lower fees, squeezing its already low margins. Clients then take the added benefits for granted, creating the new basis of competition for those firms while neutralizing any competitive differentiation. Even new initiatives (e.g., program management, bundled/integrated services, change in project delivery system) and business models (e.g., performance contracting, outcome-based pricing, success fee, risk-reward sharing) are quickly copied. To a large extent, technology adoption has led to simplification and modularization of designs, which in turn have given way to commoditized services.

This intense rivalry is accelerating the movement toward a position of ultimate value (from the clients’ perspective) where clients receive a great value deal (more benefits for less), but differentiation and margins of engineering firms are competed away and their profitability eroded. This has the undesirable effect of increasing the depth and severity of commoditization of engineering services. Most firms are forced to compete largely on price, rather than the traditional metrics of excellence in design and execution. When low bidders are close to one another, past relationships become the exception, not the norm. Engineering firms are left battling a destructive commoditization war of their own making with ever diminishing pricing power. With a possible economic downturn looming on the horizon, low bid wars will only intensify, trapping these firms in vicious cycles of never-ending declining fees and margins across the industry. To make matters worse, these challenges are magnified by escalating construction, project risk and complexity, and pursuit costs that firms are unable to pass on to their clients without harming their businesses. Increased project complexity may entail over-budget and/or behind schedule delivery, killing client relationships and margins.

In this harsh bottom-out differentiation environment, engineering firms are forced to either discount their fees to hold on to market share or hold onto their fees but concede share. But neither move can lead to financial health for everyone, given those firms’ relatively high overhead and low utilization rates. In either case, they have lost pricing power for their services. Clients become more powerful, demanding more and more for their money, and in some cases even renegotiating existing project fees to the detriment of engineering firms (as recently seen when the Metropolitan Transportation Authority of New York, seeking a 10% fee cut on current projects, approached its firms wanting to renegotiate their contracts).

Engineering firms that are able to trim their costs (e.g., lower overhead rates, implement more effective project management, outsource IT, relocate their design center to low wage land, etc.) before lowering fees can build momentum and outflank rivals forced to slash their fees before reducing costs. As they continue to drive down project fees, lower cost firms can destroy weaker rivals and increase their scale, further lowering their costs. They can then swallow up those weaker rivals and further build critical mass through acquisition and merger (industry consolidation). Their top- and bottom-line growth becomes driven by volume business. They become mired in the cost-leadership game of one-upmanship, relentlessly reducing their costs and further exacerbating the commodity trap. Because clients are used to dealing with discounters the way they have always dealt with them, they will resist any change from those firms that involves higher fees or lower benefits.

But after a while, even dominant players will fall by the wayside. Evolving competitive conditions, changing market demands, disruptive new services and even standardized products can change how companies plan, design, and execute. And disruption applies to any industry. There are many classic examples of companies forced to succumb to the challenge of disruptive change. In 1921, Ford Motor Company’s low-priced (one color) Model T (launched in 1908 for $825, down to $400 in 1915 and further down to $275), accounted for 56% of passenger cars produced in the U.S. A decade later, GM overtook Ford as the dominant leader with five separate brands and five price ranges for five different types of consumers, in a variety of colors. GM kept this distinction for 70 years before ceding the throne to Toyota. The low-priced Model T did not serve Ford well in a marketplace where customer tastes were changing. Fast forward to 1975, when Kodak owned 90% of the US film market and 85% of its camera sales. Yet, never able to fundamentally shift its business model from silver halide film to digital photography, Kodak filed for Chapter 11 bankruptcy protection in 2012. Fast forward to 2000, when Dell, with its low-cost, high-quality customer-designed computers, appeared to be unstoppable — but later surrendered to Lenovo and HP.

Fast forward a little further to 2007 and take a look at Nokia and Research in Motion (RIM). That year, Nokia emerged from bruising battles with Motorola and others as the clear market leader with a 50% market share in mobile phone handsets and a stock surge of 155%. RIM, best known for its BlackBerry handset, had nine million subscribers, and its stock almost doubled during 2007. But the same year, Apple introduced the iPhone, starting the modern smartphone era … Android was launched the following year … and Nokia and RIM businesses were ripped apart. In 1996, Siebel Systems went public, had a remarkable 782,978% growth over five years (from $8 million to $1.8 billion and a market cap of $30 billion) and became the fastest company to reach $1 billion in sales (7 years vs. 14 years for Oracle and 15 years for Microsoft). Siebel commanded 45% CRM market share in 2002, but was quickly overtaken by new technologies including ERP (e.g., the all-integrated suites of Oracle and SAP) and SaaS (e.g., Salesforce.com) and ended up being acquired by Oracle in 2005 at $10.66 a share, down from a high of $120 in 2000. Other examples include Japanese companies like Toshiba, Sharp, and Sanyo, which once ruled the electronics industry, or supermarket chain behemoths struggling in the face of e-commerce.

The engineering and construction industry is not immune to disruption — it is ripe for it. Because of the harshness of their environment, engineering firms must innovate their way out. No one gets ahead by copying the status quo. Growth through innovation is their best strategy for separating themselves from the consolidated commodity pack. They must create new businesses while simultaneously staving off attacks on core operations that provide vital cash flow and capability to invest in growth. To borrow the words of Louis Pasteur, “Chance favors the prepared.” And the time when engineering firms need to be most prepared to tackle this dual challenge is the moment when they feel they’re at the very top of their game.

Engineering firms focus on optimizing billable staff time and reducing overhead costs. And they sweat the numbers. They must also aggressively focus on building their innovation capability and leveraging their talent pool, domain expertise, client relationships, reputation and intimate knowledge of the market to create new high value, high margin businesses. They must wisely look inward, choosing to monetize (commercialize) their intellectual Property (IP) by launching new technology businesses (newco). But many of these new tech businesses fail. In order to receive and maximize the payback from newco, a philosophical alignment between the mainstream organization and newco is essential — and the mainstream organization’s leader must actively, honestly, passionately and consistently support it.

Firms that have had limited success with innovation are not aligned. The primary reasons for their misalignment include internal struggles between the mainstream organization and newco (e.g., newco’s innovation strategy is at odds with the mainstream organization’s fundamental business strategy; the mainstream organization wanting to heavily discount newco technology to win core projects; the mental attitude that the mainstream organization ‘owns the clients’ and that newco may disrupt these relationships), and newco being stymied by processes and metrics that are inappropriate for the effort and confound the goals of innovation. Other reasons for the high mortality rate include the mainstream organization not allowing its competitors to provide services around newco technology (ironically, the greatest economic value could be gained through this indirect route); newco finding no receptive market with mainstream organization clients, used to dealing with the mainstream organization the way they have always dealt with them, and are unwilling to accept higher newco fees; and the head of newco having little authority, few resources, and not much operational support from the leader or the mainstream organization. As a result, newco and its leader are quickly marginalized and can even become a deterrent to innovation.

It is very easy to get excited about the prospects of profitable new revenue streams (especially ones that unlock and release trapped value), overestimate their value proposition and potential for payback, and seriously underestimate the leadership and alignment efforts and risks involved. It is also all too easy to end up developing a technologically brilliant product for which no market exists.

Long-term success is a function of firms able to compete successfully in both mature and new businesses and to leverage mainstream core assets and capabilities and apply them in the creation of new ones. They must be ambidextrous and design their organizations to simultaneously compete in mature businesses with cost reduction, incremental improvement, close attention to clients, and rigorous execution — and pursue new businesses requiring innovation and experimentation (e.g., agility and tolerance for mistakes).

To succeed, engineering firms need to have a clear understanding of both what to do and how to do it. They need to do four things: carefully select critical capabilities, separate the core from the new (create an autonomous organization), strategically manage their interaction, and act as angel investors for the new business.

Aggressive firms that master innovation execution will be able to create an unfair advantage, expand many times faster, generate stronger margins, command significantly bigger valuation multiples, and lead the scope and shape of the industry’s future. They will also ring up impressive profits, revenue growth and gains in stock performance year after year, regardless of economic or industry circumstances. Importantly, they will also become a powerful magnet for top talent — the investment that keeps on giving. 

Engineering firms wanting to break out and profit from commoditization must start by rethinking what client problems their organizations could solve efficiently and effectively, then leverage the firm’s activities and massive domain knowledge in a radically new way. Their legacy business model is a sitting duck. They must convert technological potential into economic value and become active sellers of IP. They must be prepared to take a path the firm never imagined. As Peter Drucker pointed out,” In a commodity market, you can only be as good as your dumbest competitor.” Advantage will go to firms that move early and fast. Engineering leaders must take the helm and understand that doing so trumps all other priorities. They must be ambidextrous and strike a delicate balance between operations and innovation, and shape the rules of tomorrow’s game — before competitors do. The way to stay first is by running faster than anybody else.