The answer begins with the job-to-be-done approach: Customers will not buy your product unless it solves an important problem for them. But what constitutes a “solution” differs across the two circumstances in figure 5-1: whether products are not good enough or are more than good enough. The advantage, we have found, goes to integration when products are not good enough, and to outsourcing—or specialization and dis-integration—when products are more than good enough.
A product’s architecture determines its constituent components and subsystems and defines how they must interact—fit and work together—in order to achieve the targeted functionality. The place where any two components fit together is called an interface. Interfaces exist within a product, as well as between stages in the value-added chain. For example, there is an interface between design and manufacturing, and another between manufacturing and distribution.
An architecture is interdependent at an interface if one part cannot be created independently of the other part—if the way one is designed and made depends on the way the other is being designed and made. When there is an interface across which there are unpredictable interdependencies, then the same organization must simultaneously develop both of the components if it hopes to develop either component.
In contrast, a modular interface is a clean one, in which there are no unpredictable interdependencies across components or stages of the value chain. Modular components fit and work together in well-understood and highly defined ways. A modular architecture specifies the fit and function of all elements so completely that it doesn’t matter who makes the components or subsystems, as long as they meet the specifications. Modular components can be developed in independent work groups or by different companies working at arm’s length.
Companies that compete with proprietary, interdependent architectures must be integrated: They must control the design and manufacture of every critical component of the system in order to make any piece of the system. As an illustration, during the early days of the mainframe computer industry, when functionality and reliability were not yet good enough to satisfy the needs of mainstream customers, you could not have existed as an independent contract manufacturer of mainframe computers because the way the machines were designed depended on the art that would be used in manufacturing, and vice versa. There was no clean interface between design and manufacturing.
Overshooting does not mean that customers will no longer pay for improvements. It just means that the type of improvement for which they will pay a premium price will change. Once their requirements for functionality and reliability have been met, customers begin to redefine what is not good enough. What becomes not good enough is that customers can’t get exactly what they want exactly when they need it, as conveniently as possible. Customers become willing to pay premium prices for improved performance along this new trajectory of innovation in speed, convenience, and customization. When this happens, we say that the basis of competition in a tier of the market has changed.
Modularity has a profound impact on industry structure because it enables independent, nonintegrated organizations to sell, buy, and assemble components and subsystems.
The general rule is that companies will prosper when they are integrated across interfaces in the value chain where performance, however it is defined at that point, is not good enough relative to what customers require at the next stage of value addition. There are often several of these points in the complete value-added chain of an industry. This means that an industry will rarely be completely nonintegrated or integrated. Rather, the points at which integration and nonintegration are competitively important will predictably shift over time.
To succeed with a nonintegrated, specialist strategy, you need to be certain you’re competing in a modular world. Three conditions must be met in order for a firm to procure something from a supplier or partner, or to sell it to a customer
One of the most exciting insights from our research about commoditization is that whenever it is at work somewhere in a value chain, a reciprocal process of de-commoditization is at work somewhere else in the value chain.
At the leftmost side of the disruption diagram, the companies that are most successful are integrated companies that design and assemble the not-good-enough end use products. They make attractive profits for two reasons. First, the interdependent, proprietary architecture of their products makes differentiation straightforward. Second, the high ratio of fixed to variable costs that often is inherent in the design and manufacture of architecturally interdependent products creates steep economies of scale that give larger competitors strong cost advantages and create formidable entry barriers against new competitors.
The natural and inescapable process of commoditization occurs in six steps:
Note that it is overshooting—the more-than-good-enough circumstance—that connects disruption and the phenomenon of commoditization. Disruption and commoditization can be seen as two sides of the same coin.
There can still be prosperity around the corner, however. The attractive profits of the future are often to be earned elsewhere in the value chain, in different stages or layers of added value. That’s because the process of commoditization initiates a reciprocal process of de-commoditization. Ironically, this de-commoditization—with the attendant ability to earn lots of money—occurs in places in the value chain where attractive profits were hard to attain in the past: in the formerly modular and undifferentiable processes, components, or subsystems.
Firms that are being commoditized often ignore the reciprocal process of de-commoditization that occurs simultaneously with commoditization, either a layer down in subsystems or next door in adjacent processes. They miss the opportunity to move where the money will be in the future, and get squeezed—or even killed—as different firms catch the growth made possible by de-commoditization.
Formally, the law of conservation of attractive profits states that in the value chain there is a requisite juxtaposition of modular and interdependent architectures, and of reciprocal processes of commoditization and decommoditization, that exists in order to optimize the performance of what is not good enough. The law states that when modularity and commoditization cause attractive profits to disappear at one stage in the value chain, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.
There are two ways to think of a product or service’s value chain. It can be conceptualized in terms of its processes, that is, the value-added steps required to create or deliver it. ... A value chain can also be thought of in terms of components, or the “bill of materials” that go into a product.