The digital revolution is brewing in the industrials sector

The digital revolution is brewing in the industrials sector

By Matt Dallisson, 24/11/2022

Over the past 20 years, industrial players have pursued value creation through a focus on product margin optimization, channel sales excellence, and programmatic M&A. These strategies proved fruitful in the prepandemic era. From 2014 to 2019, traditional financial measures of value creation reflected robust sector-level performance: ROIC rose 13 percent—in excess of the typical sector-level weighted average cost of capital of 8 to 10 percent—and annual growth in total shareholder returns was up by approximately 400 basis points compared with the prior decade. 1 1. Nidhi Arora, Nick Santhanam, Akshay Sethi, and Shekhar Varanasi, “Value creation in industrials,” McKinsey, November 10, 2020. Although the industrials sector is far from monolithic—ranging from aerospace and defense to industrial machinery and automation—most subsectors were able to reap the benefits of the longest economic expansion in US history.

However, the disruptive forces of COVID-19, exacerbated by recent geopolitical developments, have ushered in a new world. While industrial companies have overall experienced a strong rebound from a painful pandemic-driven recession (Exhibit 1), they also have emerged to find a chaotic operating environment with dramatic shifts in customer purchasing behaviors, labor force participation, and global supply chain networks. In the wake of a second consecutive quarter of US GDP contraction, most executives are anticipating another slowdown—but mixed economic indicators make the severity and length of this slowdown difficult to predict. 2 2. “Something’s coming: How US companies can build resilience, survive a downturn, and thrive in the next cycle,” McKinsey, September 16, 2022. 

In June 2022, we conducted a survey of 75 executive-level respondents across roles. The largest portion of respondents directly report to the C-level and have profit-and-loss ownership. Most respondents are decision makers in their organization and have broad knowledge about operational practices. More than 33 percent of our sample works for industrial manufacturers, with substantial representation across automotive, semiconductor, and aerospace companies. The size and reach of the respondent pool allows for a diverse and representative landscape of digital and analytics within advanced industries.

In this landscape of uncertainty, building resilience has become more important than ever. Companies seeking to outperform are reassessing their growth strategies, operating models, and approaches to talent. Leading players are increasingly focusing on a common thread to support this journey of building resilience: digital technologies that, when implemented wisely, can accelerate cross-functional efforts and position companies to excel in the coming years.

Responding to emerging challenges

A recent McKinsey survey of executives at industrial companies identified three critical priorities that have emerged from the past several tumultuous years (see sidebar, “About the research”).

1. Rising costs and inflationary pressure

Eighty-six percent of respondents cited inflation as their top concern. Inflation is at a 40-year high (an 8.3 percent year-over-year rise in the US consumer price index in August 2022), and the outlook remains uncertain. Just as the United States emerged from the COVID-19 pandemic, the global economy was rocked by Russia’s invasion of Ukraine. While the human toll and suffering are paramount in this conflict, the war has also created far-ranging repercussions for commodity prices and supply chains. In an effort to curb inflation, the US Federal Reserve has already implemented four interest rate increases this year, marking the end of cheap access to capital that was a fixture of the prepandemic years.

2. Talent retention and the skills gap

The labor market is a top concern for 81 percent of executives. The pandemic accelerated retirements for many baby boomers and triggered the Great Resignation. The labor participation rate currently remains 1.1 percentage points below prepandemic levels, with limited signs of a rebound in the near term. 3 3. “The employment situation – September 2022,” Bureau of Labor Statistics, October 7, 2022. Furthermore, the nature of work has become progressively more complex. Today’s jobs involve more analytics, automation, agility, and technical content, resulting in a greater mismatch between labor supply and demand.

3. Supply chain disruption

Building a more resilient supply chain is a strategic priority for 50 percent of respondents, who reported intense interest in nearshoring. The threats of continued trade wars and logistics issues loom while the political environment remains unstable, manifesting in sustained parts shortages, extended lead times, and late deliveries. Unsurprisingly, companies are investing in more sophisticated demand forecasting and inventory processes and conducting network analyses to balance logistics spending and delivery performance.

Strategies for long-term resilience

Many companies are still focused on postpandemic top-line recovery and fighting short-term fires to maintain operating margins. However, best-in-class organizations are doubling down on long-term structural changes to how they approach customer interactions, supply chain resilience, and talent acquisition and retention. To sustain value creation for the long run, industrial players should focus on three key priorities.

1. Place customers at the center of solution innovation

Historically, industrial manufacturers have focused on product excellence coupled with a robust distributor program to reach a broad swath of end customers and maintain healthy margins. While a product-focused distribution sales model has served as an effective go-to-market model, it can have drawbacks. Channel-reliant manufacturers often lack direct access to and immediate visibility of end-customer needs, limiting their responsiveness to changing preferences. Consequently, companies often make incremental product changes based on transactional customer requests but remain locked out of attractive broader value pools (for example, software and services) that require a more proactive approach.

Within our sample, 16 percent of respondents cited new products and services as important—but product innovation in a vacuum is no longer enough to unlock the next horizon of transformative growth. As modern-day operations grow increasingly complex, effective innovation requires an intimate understanding of end-customer pain points and operational needs from a comprehensive “solution selling” mindset. Many players that have historically relied on channel relationships will face unfamiliar territory in which they need to build relationships with end customers from the ground up to be perceived as true solution partners rather than transactional suppliers. The sales mindset of customer-centric solutions is not easy to achieve, but the rewards can be well worth the investment—including a larger share of wallet, enhanced customer loyalty, access to a wider ecosystem of value pools, and closer customer partnerships.

In one recent case, a multibillion-dollar manufacturer of passive and active network equipment faced historically flat sales growth. It undertook a transformation from product-focused transactional sales to a solution-oriented, customer-centric sales model. This company established new product and service partnerships to design and deliver manufacturing-automation solutions to end customers. At the same time, the company deployed a comprehensive capability-building program to upskill and proactively coach commercial teams to engage key customer stakeholders on critical operational challenges and business priorities. The transformation has reenergized the sales organization and boosted its profile with customers: in the first year, the company achieved organic growth of more than 30 percent, a dramatic turnaround from its historical challenges.

2. Build a talent factory for the future

Retaining talent and generating excitement among employees should remain a priority. As companies look to get closer to customers, build new services and solutions, and enhance internal productivity, they must also develop or acquire the talent to support digital transformation. Organizations will need to mine new talent pools—not only for data scientists and engineers to build the foundations of the technology stack but also for vertical and solution specialists to forge customer relationships and drive sales execution in the field.

Retaining talent and generating excitement among employees should remain a priority.

Legacy companies often force-fit talent into their current organizational structure rather than reimagining the operating model. For example, if a company is seeking to attract digital-solution consultants and vertical specialists, candidates want to see signs that the organization has committed to doing things differently. Companies will need to align their websites and product information, leadership must aspire to increase sales across both solution and services categories, and functions will need to collaborate on product and service decisions. Because industrial companies tend to organize around products and engineering, this new operating model can represent a significant change.

For example, one company seeking to become a leader in digital manufacturing launched a global transformation radiating from three regional lighthouses in North America, Europe, and Asia. These lighthouses were led by a newly created center of excellence team to develop and scale innovative digital use cases. The company also created a digital academy to upskill more than 3,000 employees with training programs tailored to roles and functions. Within the first 18 months, the company saw an increase of 20 to 40 percent in throughput and productivity across sites and identified more than 100 digital use cases for implementation over the next three to five years.

3. Make digital an imperative

Uncertainty in the current industrial operating environment has reinforced the urgency of digital transformation. Business leaders are facing many complex problems that can be alleviated by digital solutions, dramatically improving performance at a reduced cost. Although some sectors (such as banking, media, and tourism) have already made great strides in digital adoption, the industrials sector is lagging. However, companies are quickly approaching an inflection point, with front-runners poised to achieve outsize impact from digital use cases.

These digital use cases offer industrial companies the potential to overcome today’s headwinds as well as surpass prepandemic performance. For example, one electronics assembly player implemented several high-impact manufacturing digital use cases, such as a real-time machine-learning algorithm to predict assembly issues on the line prior to final testing, which drastically reduced rework and boosted product yields by 30 to 50 percent. Additionally, the company connected more than 80 machines through an Internet of Things (IoT) platform; within days, the action enabled real-time insights into machine overall equipment effectiveness to identify actions to remove bottlenecks in lines. Consequently, this company was able to meet unprecedented peaks in demand during the pandemic without increasing labor.

Implementing a successful digital transformation

Our survey indicates that while most industrials are pursuing the implementation of digital and analytics solutions, only about 20 percent report high levels of success. The top challenges executives face are fragmented data landscapes and complex legacy infrastructure, which increase complexity in developing a robust, secure end-state architecture across both IT and OT systems.

To overcome these challenges, industrials must invest in more sophisticated and coordinated tech stacks. Unsurprisingly, implementation is no small feat—it requires setting the vision and gaining alignment across the business (and, optionally, across industry partners) on architecture design, data governance, and security. In 2020, a leading automotive OEM began a five-year journey to implement an industrial cloud platform to connect and standardize data across more than 100 manufacturing plants, 500 warehouses, and 1,000 suppliers and partners. In addition to the cloud platform, the OEM deployed a store of common apps to be used across factories and an open ecosystem to share with its network of partners.

Industrial executives are arriving at a consensus that a digital transformation has become a critical imperative for building resilience in uncertain times. However, the transformation cannot happen overnight; it is often a multiyear journey that requires careful up-front planning and a relentless focus on execution. Organizations must work collaboratively across strategy, talent, operating model, technology, and data infrastructure and analytics to facilitate adoption and scaling. Now is the time for industrial players to start to create the business impact they are seeking from digital technologies.

This content was originally published here.