The Innovator's Solution

by Clayton Christensen

  At the time we first published our analysis of this situation in 1999, it appeared that the capacity of 2.5-inch disk drives was becoming more than good enough in the notebook computer application as well—presaging, for what had been a beautiful business for IBM, the onset of commoditization.11 We asserted that IBM, as the most integrated drive maker, actually was in a very attractive position if it played its cards right. It could skate to where the money would be by using the advent of modularity to decouple its head and disk operations from its disk drive design and assembly business. If IBM would begin to sell its most advanced heads and disks to competing 2.5-inch disk drive makers—aggressively putting them into the business of assembling modular 2.5-inch drives—it could eventually de-emphasize the assembly of drives and focus on the more profitable head and disk components. In so doing, IBM could continue to enjoy the most attractive levels of profit in the industry. In other words, on the not-good-enough side of the disruptive diagram, IBM could fight in the war and win. On the more-than-good-enough side, a better strategy is to sell bullets to the combatants.12

  IBM made similar moves several years earlier in its computer business, through its decisions to decouple its vertical chain and to sell its technology, components, and subsystems aggressively in the open market. Simultaneously it created a consulting and systems integration business in the high end and moved to de-emphasize the design and assembly of computers. As IBM skated to those points in the value-added chain where complex, nonstandard integration needed to occur, it led to a remarkable—and remarkably profitable—transformation of a huge company in the 1990s.

  The bedrock principle bears repeating: The companies that are positioned at a spot in a value chain where performance is not yet good enough will capture the profit. That is the circumstance where differentiable products, scale-based cost advantages, and high entry barriers can be created.

  To the extent that an integrated company such as IBM can flexibly couple and decouple its operations, rather than irrevocably sell off operations, it has greater potential to thrive profitably for an extended period than does a nonintegrated firm such as Compaq. This is because the processes of commoditization and de-commoditization are continuously at work, causing the place where the money will be to shift across the value chain over time.

  Core Competence and the ROA-Maximizing Death Spiral

  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. In fact, powerful but perverse investor pressure to increase returns on assets (ROA) creates strong incentives for assemblers to skate away from where the money will be. And having failed to recognize their modular, commoditized circumstance, the firms turn to attribute-based core competence theory to make decisions they may later regret.

  How can firms that assemble modular products meet investors’ demands that they improve their return on assets or capital employed? They cannot improve the numerator of the ROA ratio because differentiating their product or producing it at lower costs than competitors is nearly impossible. Their only option is to shrink the denominator of the ROA ratio by getting rid of assets. This would be difficult in an interdependent world that demanded integration, but the modular architecture of the product actually facilitates dis-integration. We will illustrate how this happens using a disguised example of the interactions between a component supplier and an assembler of modular personal computers. We’ll call the two firms Components Corporation and Texas Computer Corporation (TCC), respectively.

  Components Corporation begins by supplying simple circuit boards to TCC. As TCC wrestles with investor pressure to get its ROA up, Components Corp. comes up with an interesting proposition: “We’ve done a good job making these little boards for you. Let us supply the whole motherboard for your computers. We can easily beat your internal costs.”

  “Gosh, that would be a great idea,” TCC’s management responds. “Circuit board fabrication isn’t our core competence anyway, and it is very asset intensive. This would reduce our costs and get all those assets off our balance sheet.” So Components Corp. takes on the additional value-added activity. Its revenues increase smartly, and its profitability improves because it is utilizing its manufacturing assets better. Its stock price improves accordingly. As TCC sheds those assets, its revenue line is unaffected. But its bottom line and its return on assets improve—and its stock price improves accordingly.

  A short time later Components Corp. approaches TCC’s management again. “You know, the motherboard really is the guts of the computer. Let us assemble the whole computer for you. Assembling those products really isn’t your core competency, anyway, and we can easily beat your internal costs.”

  “Gosh, that would be a great idea,” TCC’s management responds. “Assembly isn’t our core competence anyway, and if you did our product assembly, we could get all those manufacturing assets off our balance sheet.” Again, as Components Corp. takes on the additional value-added activity, its revenues increase smartly and its profitability improves because it is utilizing its manufacturing assets better. Its stock price improves accordingly. And as TCC sheds its manufacturing assets, its revenue line is unaffected. But its bottom line and its return on assets improve—and its stock price improves accordingly.

  A short time later Components Corp. approaches TCC’s management again. “You know, as long as we’re assembling your computers, why do you need to deal with all the hassles of managing the inbound logistics of components and the outbound logistics of customer shipments? Let us deal with your suppliers and deliver the finished products to your customers. Supply chain management really isn’t your core competence, anyway, and we can easily beat your internal costs.”

  “Gosh, that would be a great idea,” TCC’s management responds. “This would help us get those current assets off our balance sheet.” As Components Corp. takes on the additional value-added activity, its revenues increase smartly and its profitability improves because it is pulling higher value-added activities into its business model. Its stock price improves accordingly. And as TCC sheds its current assets, its revenue line is unaffected. But its profitability improves—and its stock price gets another bounce.

  A short time later Components Corp. approaches TCC’s management again. “You know, as long as we’re dealing with your suppliers, how about you just let us design those computers for you? The design of modular products is little more than vendor selection anyway, and since we have closer relationships with vendors than you do, we could get better pricing and delivery if we can work with them from the beginning of the design cycle.”

  “Gosh, that would be a great idea,” TCC’s management responds. “This would help us cut fixed and variable costs. Besides, our strength really is in our brand and our customer relationships, not in product design.” As Components Corp. takes on the additional value-added activity, its revenues increase further and its profitability improves because it is pulling higher value-added activities into its business model. Its stock price improves accordingly. And as TCC sheds cost, its revenue line is unaffected. But its profitability improves—and its stock price gets another nice little pop—until the analysts realize that the game is over.

  Ironically, in this Greek tragedy Components Corp. ends up with a value chain that is actually more highly integrated than TCC’s was when this spiral began, but often with the pieces reconfigured to allow Components Corp. to deliver against the new basis of competition, which is speed to market and the ability to responsively configure what is delivered to customers in ever-smaller segments of the market. Each time TCC off-loaded assets and processes to Components Corp., it justified its decision in terms of its own “core competence.” It did not occur to TCC’s management that the acti
vities in question weren’t Components Corporation’s core competencies, either. Whether or not something is a core competence is not the determining factor of who can skate to where the money will be.

  This story illustrates another instance of asymmetric motivations—the component supplier is motivated to integrate forward into the very pieces of value-added activity that the modular assembler is motivated to get out of. It is not a story of incompetence. It is a story of perfectly rational, profit-maximizing decisions—and because of this, the ROA-maximizing death spiral traps many companies that find themselves assembling modular products in a too-good world. At the same time, it offers another avenue for creating new-growth businesses, in addition to the disruptive opportunities described in chapter 2. The assembler rids itself of assets, but it retains its revenues and often temporarily improves its bottom-line profit margins when it decides to outsource its back-end operations to contract suppliers. It feels good. When the supplier takes on the same pieces of business that the assembler was motivated to get out of, it also feels good, because it increases the back-end supplier’s revenues, profits, and stock price. For many suppliers, eating their way up the value chain creates opportunities to design subsystems with increasingly optimized internal architectures that become key performance drivers of the modular products that its customers assemble.

  This is how Intel became a vendor of chipsets and motherboards, which constitute a much more critical proportion of a computer’s added value and performance than did the bare microprocessor. Nypro, Inc., a custom injection molder of precision plastic components whose history we will examine later in this book, has followed a similar growth strategy and has become a major manufacturer of ink-jet printer cartridges, computers, handheld wireless devices, and medical products. Nypro’s ability to precision-mold complex structures is interdependent with its abilities to simplify assembly.

  Bloomberg L.P. has done the same thing, eating its way up Wall Street’s value chain. It started by providing simple data on securities prices and subsequently integrated forward, automating much of the analytics. Bloomberg has disruptively enabled an army of people to access insights that formerly only highly experienced securities analysts could derive. Bloomberg has continued to integrate forward from the back end, so that portfolio managers can now execute most trades from their Bloomberg terminals over a Bloomberg-owned electronic communications network (ECN) without needing a broker or a stock exchange. Issuers of certain government securities can now even auction their securities to institutional investors within Bloomberg’s proprietary system. Back-end suppliers such as First Data and State Street enjoy a similar position vis-à-vis commercial banks. Venerable Wall Street institutions are being disrupted and hollowed out—and they don’t even realize it because outsourcing the asset-intensive back end is a compelling mandate that feels good once the front end has become modular and commoditized.

  Core competence, as it is used by many managers, is a dangerously inward-looking notion. Competitiveness is far more about doing what customers value than doing what you think you’re good at. And staying competitive as the basis of competition shifts necessarily requires a willingness and ability to learn new things rather than clinging hopefully to the sources of past glory. The challenge for incumbent companies is to rebuild their ships while at sea, rather than dismantling themselves plank by plank while someone else builds a new, faster boat with what they cast overboard as detritus.

  What can growth-hungry managers do in situations like this? In many ways, the process is inevitable. Assemblers of modular products must, over time, shed assets in order to reduce costs and improve returns—financial market pressure leaves managers with few alternatives. However, knowing that this is likely to happen gives those same managers the opportunity to own or acquire, and manage as separate growth-oriented businesses, the component or subsystem suppliers that are positioned to eat their way up the value chain. This is the essence of skating to where the money will be.13

  Good Enough, Not Good Enough, and the Value of Brands

  Executives who seek to avoid commoditization often rely on the strength of their brands to sustain their profitability—but brands become commoditized and de-commoditized, too. Brands are most valuable when they are created at the stages of the value-added chain where things aren’t yet good enough. When customers aren’t yet certain whether a product’s performance will be satisfactory, a well-crafted brand can step in and close some of the gap between what customers need and what they fear they might get if they buy the product from a supplier of unknown reputation. The role of a good brand in closing this gap is apparent in the price premium that branded products are able to command in some situations. For similar logic, however, the ability of brands to command premium prices tends to atrophy when the performance of a class of products from multiple suppliers is manifestly more than adequate.

  When overshooting occurs, the ability to command attractive profitability through a valuable brand often migrates to those points in the value-added chain where things have flipped into a not-yet-good-enough situation. These often will be the performance-defining subsystems within the product, or at the retail interface when it is the speed, simplicity, and convenience of getting exactly what you want that is not good enough. These shifts define the opportunities in branding.

  For example, in the early decades of the computer industry, investment in complex and unreliable mainframe computer systems was an unnerving task for most managers. Because IBM’s servicing capability was unsurpassed, the brand of IBM had the power to command price premiums of 30 to 40 percent, compared with comparable equipment. No corporate IT director got fired for buying IBM. Hewlett-Packard’s brand commanded similar premiums.

  How did the brands of Intel and Microsoft Windows subsequently steal the valuable branding power from IBM and Hewlett-Packard in the 1990s? It happened when computers came to pack good-enough functionality and reliability for mainstream business use, and modular, industry-standard architectures became predominant in those tiers of the market. At that point, the microprocessor inside and the operating system became not good enough, and the locus of the powerful brands migrated to those new locations.

  The migration of branding power in a market that is composed of multiple tiers is a process, not an event. Accordingly, the brands of companies with proprietary products typically create value mapping upward from their position on the improvement trajectory—toward those customers who still are not satisfied with the functionality and reliability of the best that is available. But mapping downward from that same point—toward the world of modular products where speed, convenience, and responsiveness drive competitive success—the power to create profitable brands migrates away from the end-use product, toward the subsystems and the channel.14

  This has happened in heavy trucks. There was a time when the valuable brand, Mack, was on the truck itself. Truckers paid a significant premium for Mack the bulldog on the hood. Mack achieved its preeminent reliability through its interdependent architecture and extensive vertical integration. As the architectures of large trucks have become modular, however, purchasers have come to care far more whether there is a Cummins or Caterpillar engine inside than whether the truck is assembled by Paccar, Navistar, or Freightliner.

  Apparel is another industry in which the power to brand has begun to migrate to a different stage of the value-added chain. As elsewhere, it has happened because a changed basis of competition has redefined what is not good enough. A generation ago most of the valuable brands were on the products. Levi’s brand jeans and Gant brand shirts, for example, enjoyed strong and profitable market shares because many of the competing products were not nearly as sturdily made. These branded products were sold in department stores, which trumpeted their exclusive ability to sell the best brands in clothing.

  Over the past fifteen years, however, the quality of clothing from a wide range of manufacturers has become assured, as producers in low-labor-cost countries have i
mproved their capabilities to produce high-quality fabrics and clothing. The basis of competition in the apparel industry has changed as a consequence. Specialized retailers have stolen a significant share of market from the broad-line department stores because their focused merchandise mix allows the customers they target to find what they want more quickly and conveniently. What is not good enough in certain tiers of the apparel industry has shifted from the quality of the product to the simplicity and convenience of the purchasing experience. Much of the ability to create and maintain valuable brands, as a consequence, has migrated away from the product and to the channel because, for the present, it is the channel that addresses the piece of added value that is not yet good enough.15 We don’t even question who makes the dresses in Talbot’s, the sweaters for Abercrombie & Fitch, or the jeans at Gap and Old Navy. Much of the apparel sold in those channels carries the brand of the channel, not the manufacturer.16

  A View of the Automobile Industry’s

  Future Through the Lenses of This Model

  Most of our examples of commoditization and de-commoditization have been drawn from the past. To show how this theory can be used to look into the future, this section discusses how this transformation is under way in the automobile industry, initiating a massive transfer of the ability to make attractive profits in the future away from automobile manufacturers and toward certain of their suppliers. Even the power to cultivate valuable brands is likely to migrate to the subsystems. This transformation will probably take a decade or two to fully accomplish, but once you know what to look for, it is easy to see that the processes already are irreversibly under way.