Appendix: The Law of Conservation of Attractive Profits

Appendix: The Law of Conservation of Attractive Profits

Appendix: The Law of Conservation of Attractive Profits

Having described these cycles of commoditization and de-commoditization in terms of products, we can now make a more general statement concerning the existence of a general phenomenon that we call the law of conservation of attractive profits. Our friend Chris Rowen, CEO of Tensilica, pointed out to us the existence of this law, whose appellation was inspired by the laws of conservation of energy and matter that we so fondly remember studying in physics class. 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 de-commoditization, 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.[19]

We’ll first illustrate how this law operates by examining handheld devices such as the RIM BlackBerry and the Palm Pilot, which constitute the latest wave of disruption in the computing industry. The functionality of these products is not yet adequate, and as a consequence their architectures are interdependent. This is especially true for the BlackBerry, because its “always on” capability mandates extraordinarily efficient use of power. Because of this, the BlackBerry engineers cannot incorporate a one-size-fits-all Intel microprocessor into their device. It has far more capability than is needed. Rather, they need a modular microprocessor design—a system-on-a-chip that is custom-configured for the BlackBerry—so that they do not have to waste space, power, or cost on functionality that is not needed.

The microprocessor must be modular and conformable in order to permit engineers to optimize the performance of what is not good enough, which is the device itself. Note that this is the opposite situation from that of a desktop computer, where it is the microprocessor that is not good enough. The architecture of the computer must therefore be modular and conformable in order to allow engineers to optimize the performance of the microprocessor. Thus, one side or the other must be modular and conformable to allow for optimization of what is not good enough through an interdependent architecture.

In similar ways, application software programs that are written to run on Microsoft’s Windows operating systems need to be conformed to Windows’ external interface; the Linux operating system, on the other hand, is modular and conformable to optimize the performance of software that runs on it.

We have found this “law” to be a useful way to visualize where the money will migrate in the value chain in a number of industries. It is explored in greater depth in a forthcoming book by Clayton Christensen, Scott Anthony, and Erik Roth, Seeing What’s Next (Boston: Harvard Business School Press, 2004).

This law also has helped us understand the juxtaposition of modular products with interdependent services, because services provided with the products can go through similar cycles of commoditization and de-commoditization, with consequent implications for where attractive profitability will migrate.

We noted previously that when the functionality and reliability of a product become more than good enough, the basis of competition changes. What becomes not good enough are speed to market and the rapid and responsive ability to configure products to the specific needs of customers in ever-more-targeted market segments. The customer interface is the place in the value chain where the ability to excel on this new dimension of competition is determined. Hence, companies that are integrated in a proprietary way across the interface to the customer can compete on these not-good-enough dimensions more effectively (and be rewarded with better margins) than can those firms that interface with their customers only in an arm’s-length, “modular” manner. Companies that integrate across the retail interface to the customer, in this circumstance, can also earn above-average profits.

We would therefore not say that Dell Computer is a nonintegrated company, for example. Rather, Dell is integrated across the not-good-enough interface with the customer. The company is not integrated across the more-than-good-enough modular interfaces among the components within its computers. Figure 6-2 summarizes in a simplified way how the profitable points of proprietary integration have migrated in the personal computer industry.

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Figure 6-2: The Shifting Locus of Advantage in the PC Industry’s Process Value Chain

On the left side of the diagram, which represents the earliest years of the desktop computer industry when product functionality was extremely limited, Apple Computer, with its proprietary architecture and integrated business model, was the most successful firm and was attractively profitable. The firms that supplied the bare components and materials to Apple, and the independent, arm’s-length retailers that sold the computers, were not in nearly as attractive a position. In the late 1990s, the processes of commoditization and de-commoditization had transferred the points at which proprietary integration could build proprietary competitive advantage to the retail interface with the customer (Dell) and to the interfaces within the subsystems (Intel and Microsoft).

We believe that this is an important factor that explains why Dell Computer was more successful than Compaq during the 1990s. Dell was integrated across an important not-good-enough interface, whereas Compaq was not. We also would expect that a proper cost accounting would show that Dell’s profits from retailing operations are far greater than the profits from its assembly operations.

[19]We say “usually” here because there are exceptions (most, but not all, of which prove the rule). We note in the text of this chapter, for example, that two modular stages of added value can be juxtaposed—as DRAM memory chips fit in modular personal computers. And there are instances where two interdependent architectures need to be integrated, such as when enterprise resource planning software from companies such as SAP needs to be interleaved into companies’ interdependent business processes. The fact that neither side is modular and configurable is what makes SAP implementations so technically and organizationally demanding.