It’s easy to look back and ask, “What were they thinking?” but, in truth, IBM’s decision fit well with prevailing orthodoxies, particularly with the idea that companies should outsource all but their core competencies—that is, sell off or outsource any function that another company could do better or cheaper than it could. Indeed, at the time, many observers hailed IBM’s move as a master-stroke of strategy, forward-looking and astute.
Where will attractive profits be earned in the value chain of the future? Under what circumstances will integrated corporations wield powerful competitive advantages? What changes in circumstances will shift competitive advantage to specialized, nonintegrated companies? What causes an industry to fragment? How can a dominant, integrated player determine what to out-source and what to hold on to as its industry begins to break into pieces? How can new entrants figure out where to target their efforts to maximize profitability?
During the early days of the computer industry, for example, when mainframes were not yet powerful or fast enough to satisfy mainstream customers’ needs, an independent contract manufacturer assembling machines from suppliers’ components could not have survived because the way the machines were designed depended on the way they were manufactured and vice versa. Nor could an independent supplier of operating systems, core memory, or logic circuitry have survived because these key subsystems had to be designed interdependently, too.
When a nonintegrated company tries to compete under these circumstances, it usually fails. Stitching together a system with other “partner” companies is extremely difficult when the subsystems and expertise those companies provide are interdependent.
Product performance almost always improves beyond the needs of the general consumer, as companies stretch to meet the needs of the most demanding (and most profitable) customers. When technological progress overshoots what mainstream customers can make use of, companies that want to win the business of the overserved customers in less-demanding tiers of the market are forced to change the way they compete. They must bring more flexible products to market faster and customize their products to meet the needs of customers in ever smaller market niches.
To compete on these new dimensions, companies must design modular products, in which the interfaces between components and subsystems are clearly specified. Ultimately, these interfaces coalesce into industry standards. Modular architectures help companies introduce new products faster because subsystems can be improved without having to redesign everything. Companies can mix and match the best components from the best suppliers to respond to the specific needs of individual customers. Although standard interfaces invariably force compromises in system performance, competitors aiming at overserved customers can comfortably trade off some performance to achieve the benefits of speed and flexibility.
Once a modular architecture and the requisite industry standards have been defined, integration is no longer crucial to a company’s success. In fact, it becomes a competitive disadvantage in terms of speed, flexibility, and price, and the industry tends to dis-integrate as a consequence. The exhibit “The Dis-Integration of the Computer Industry” illustrates how this happened in that field. During its early decades, the dominant companies were integrated across most value-chain links because competitive conditions mandated integration. As the personal computer disrupted the industry, however, it was as if the industry got pushed through a bologna slicer. The dominant, integrated companies were displaced by specialists that competed in horizontal strata within the value chain.
Clearly, companies competing in an integrated market face very different challenges from those competing in a fragmented market—the ball game changes fundamentally once components become modular and customers’ thoughts turn to speed or convenience rather than functionality. Sources of profitability change as well. Our model can help managers, strategists, and investors assess how the power to grab profits is likely to shift in the future. The bedrock principle is this: Those who control the interdependent links in a value chain capture the most profit.
But when the large integrated players overshoot what their mainstream customers can use, the tables begin to turn. Disruptive competitors begin to move upmarket, and the power to make money shifts away from companies that design and assemble the end-use product toward the back end of the value chain to those companies that supply subsystems with internal architectures that are still technologically interdependent.
The exhibit “Where the Money Went in the PC Industry” illustrates how this worked in the desktop computer market in the 1990s. Initially, money flowed from the customer to the companies that designed and assembled computers; but as the decade progressed, less and less of it stopped there as profit. Quite a bit of this money flowed over to operating system maker Microsoft and lodged there. Another chunk flowed to processor manufacturer Intel and stopped there. Money flowed to the DRAM chip makers such as Samsung and Micron Technology as well, but not much of it stopped there. It flowed through them and accumulated instead at companies like Applied Materials, which supplied the chip-manufacturing equipment that the DRAM makers used. Similarly, money flowed right through the assemblers of disk drives such as Quantum and lodged at the stage where heads and disks were made.
Where the Money Went in the PC Industry As PCs became good enough for mainstream users, profits flowed from the customers through the assemblers (the IBMs and Compaqs of the world) to lodge in the component makers—the operating system maker (Microsoft), the processor maker (Intel), and initially to the memory chip makers and disk drive manufacturers. But as DRAM chips and drives became good enough for the assemblers, the money flowed even further up the value chain to DRAM equipment makers and head and disk suppliers.
The implications of these findings are clear. The power to capture attractive profits will shift in the value chain to those activities where the immediate customer is not yet satisfied with the functionality of available products. It is in these stages that complex, interdependent integration occurs—activities that create steeper economies of scale and greater opportunities for differentiation. The power will shift away from activities where the immediate customer is more than satisfied because it is there that standard, modular integration occurs. In most markets, this power shift occurs tier by tier in a way that is quite predictable.
Executives whose companies are currently making lots of money ought not to wonder whether the power to earn attractive profits will shift, but when. If they watch for the signals, quite possibly they can prosper in all cycles, rather than in only one.