Biz model 7 method of strategic control

Method of Strategic Control

A/Prof Jeffrey FunkDivision of Engineering and Technology Management

National University of Singapore

Sources: (Teece, 1986; Trajtenberg, 1990; Pisano and Teece, 2007; Zuckerman, 2008)

Business Model

Value proposition: what to offer and how to differentiate

Customer selection: whom to serve and not serveScope of activities: what activities to carry out and

what relationships to haveValue capture: dominant sources of revenueStrategic control: how to sustain profitability (e.g.,

how to control architecture and standards)

Strategic ControlMethods to ensure profitability for a product/businessSome use the term “competitive advantage” (e.g.,

strategy class)Both deal with factors that enable firms to survive

and achieve above average profitabilitySurvival is one outcome of good strategic controlAbility to be profitable over long period of time (one

measure is market capitalization) is stronger outcomeSome firms have higher profitability than othersSome industries have higher profitability than others

http://www.moaf.org/publications-collections/financial-history-magazine/80/_res/id=File1/ 1896http://listverse.com/2011/08/12/10-oldest-still-operating-companies

OutlineInsufficient methods of strategic controlIntellectual Property and Appropriability

◦Efforts to change appropriability◦Standards and appropriability

Complementary assets◦old emphasis: different functions◦new emphasis: industry architecture [includes level of

vertical (dis)integration]Example of innovation in which complementary

assets/functions played critical role: EMI and the CAT Scanner

IBM in PCs and Services

Insufficient Methods of Strategic ControlHaving a better product/service

◦A better product can be copiedHaving a better product development

process might be sufficient ◦Japanese firms used their short product

development times (and superior manufacturing systems) to create competitive advantage for many years.

◦But then competition changed…..Being a first entrant

◦Many first entrants fail

Better Product Development was Insufficient for Japanese Firms

Other firms copied Japan’s product development process (and manufacturing methods)

Low-cost and efficient manufacturing became available in China

Entrepreneurial startups focused on lucrative niches as vertical disintegration emerged◦Placing vertically integrated Japanese firms at a

disadvantageJapan only has advantages in some hi-

tech industries now

Being a First Entrant is not SufficientEMI lost to GE, Siemens, and Philips in CAT

scannersBowmar lost to many in electronics calculatorsAltair, IMS Associates, South West Technical,

Apple, Radio Shack, and Commodore lost to IBM (now Lenovo), Dell, and HP in PCs

Xerox (PARC) and Apple invented graphical user interface, but Microsoft dominates market

Apple introduced first PDA (Newton) but Palm became dominant player

Nokia and Blackberry released first smart phones but others now dominant the market

Being First Entrant is not Sufficient (2)

Netscape invented browser, but Microsoft dominates it

Early MP3 suppliers lost to Apple’s iPodMerck was pioneer in cholesterol lowering

drugs (Zocor)◦but Pfizer, a late entrant, secured a superior

market position with LipitorExcite and Lycos were first real search

engines, but they lost to Yahoo—◦and Yahoo lost to Google

Why do First Movers Sometimes Fail? (1)

They had reasonably good business models along some elements◦Value proposition: what to offer and how to differentiate ◦Customer selection: whom to serve and not serve◦Scope of activities: what activities and relationships to

have, i.e., level of vertical integration◦Value capture: how to make money

But many were weak in strategic control (how to sustain profitability) and/or because other things changed

Why do First Movers Sometimes Fail? (2)Other firms may enter market unless first

mover◦has strong natural protection against imitation

and/or strong intellectual property protection◦controls complementary assets or industry

architecture/standards◦has first mover advantages in scale or network

effectsThese new entrants may succeed

◦if they have better complementary assets or control industry architecture

◦If they can create scale or network effects in complementary assets

Why do First Movers Sometimes Fail? (3)Few innovations provide value on a stand-

alone basis◦every innovation requires complementary “assets”

such as service, manufacturing, product development, and distribution

◦many innovations require complementary technologies such as components, equipment, materials, etc.

◦network-based innovations, discussed previously, require standards and complementary products and services (Amazon, Facebook, Google, Apple)

◦firms must think of entire value chain when innovating

Outline

Insufficient methods of strategic controlIntellectual Property and Appropriability


Complementary assets◦old emphasis: different functions◦new emphasis: industry architecture [includes level of vertical

(dis)integration]Example of innovations in which complementary

functions played critical role: EMI and the CAT Scanner


AppropriabilityDictionary’s definition of appropriate

◦1) suitable◦2) to take or obtain possession (today’s focus)

Appropriability regime – a regime in which a firm is able to capture profits from an innovation◦Nature of technology: scarce resource, economies of scale,

network effects, tacit vs. explicit knowledge, complexity◦Legal mechanisms of protection: patent (17 years in U.S.),

copyright, trademark, trade secret◦Control of industry architecture or complementary assets

Protecting vs. appropriating benefits ◦You can protect your technology without appropriating the

benefits from it

Microsoft’s OS MySpaceGoogle YouTubeOld newspaper Facebook

IBM Linux Code Linux Kernel Wikipedia Blogging sites Open source S/W

In-house Community-Driven Value Creation

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From Week 6: Another Look at Future of Music and other Media

Source: Chesbrough and Appleyard, 2007

Economies of Scale in R&D and other activities (From Week 2)R&D is a fixed cost in many industries

◦Firms must spend a certain amount on R&D just to participate in industry

Largest firms can spend more on R&D and thus introduce more products and obtain higher shares◦Positive feedback between R&D, new products, and share◦Initially successful firms can spend more on R&D, which lead

to better products, higher profits, more money for R&DEconomies of scale in R&D causes a “shakeout” in the

industry: smaller firms are acquired or exit the industry

Examples of (Relatively) Strong/Tight Appropriability (1)Software

◦specific lines of codes and concepts can be protected by both patents and copyrights in the U.S. and Europe

◦producers can also shield the source code from competitors and users

◦Exceptions: inexpensive copies are available for many popular software programs (plus music, video games, and movies) outside rich countries

Books ◦Steven King and J.K. Rowling do not need to own

a printing press, publication house, or book distributor to make money, but copies are made

Examples of (Relatively) Strong/Tight Appropriability (2)

Chemicals, drugs, and materials◦ Strong patent protection◦ Even without patents, difficult to re-engineer some products

(e.g., Synthetic dyes, cellophane, carbon fiber)For example Pfizer

◦ employs 330 attorneys for intellectual property protection◦ won judgment of $56 million in 1983 involving doxycycline,

an orally administered antibiotic ◦ won $53 million in 1989 involving blood oxygenators◦ won recent dismissal of patent infringement lawsuit

regarding COX-2 inhibitors and lawsuit alleging possible suicidal effects of antidepressant Zoloft®.

Examples of (Relatively) Strong/Tight Appropriability (3)

Mobile phone services in Singapore?Cable television in Singapore?Internet services in Singapore? Why do they (and from other countries)

have strong appropriability?How does this affect their behavior? What might cause changes to this

strong appropriability?

Examples of Weak Appropriability

Mechanical technologies◦Patenting is difficult◦Solutions are observable allowing easy

imitationMusic

◦easy copying◦will video games, books, movies, and

software programs go the same way?

Need Strong Appropriability for “Open Innovation”

The term “Open Innovation” is sometimes used to describe the buying and selling of patents

Strong appropriability regimes ◦enable such buying and selling◦enable firms to specialize in technological

innovation and creation of patentable inventions

Examples◦Qualcomm, UTEK◦Rambus, Dolby

Without Strong Appropriability…

Without patents, trade secrets, or other forms of IP protection, and without some degree of natural protection from imitation◦ the innovator has nothing to license◦potential partners can freely imitate without paying

license feesTherefore, in weak appropriability regimes,

◦ imitation strategies will be viable◦at least until the generator of new technology is

destroyed by free riding from the imitators and innovation slows

Outline


◦Efforts to change appropriability regimes◦Standards and appropriability regimes



functions played critical role: EMI and the CAT ScannerIBM in PCs and Services

First , What do Economists Think of patent protection?

First , What do Economists Think?

What economists think. Protection of IP should balance:◦Benefits from spread of information◦Enable firms to recoup investments in R&D

Firms can try to strengthen patent laws, other forms of IP

European and US firms strengthened IP protection in late 1980s to compete better against Japanese firms

E.g., European mobile phone firms did so in GSM

U.S. and European firms are always trying to do this with respect to China and India

Firms may also try to Weaken Appropriability Regimes (1)

Genes◦Possibility that firms might take ownership of specific genes caused concern in governments, drug companies, and other organizations

◦Why?

Firms may also try to Weaken Appropriability Regimes (2)Open Source

◦make source code for computer programs available to everyone so that other developers can build upon on the code base

◦reduces the profits for providers of basic software such as operating systems

IBM supports Linux in order to weaken Microsoft

Outline


◦Efforts to change appropriability regimes◦Standards and appropriability regimes



functions played critical role: EMI and the CAT ScannerIBM in PCs and Services

Standards and Appropriability

Control of standards enable firms to make above average profits

So competition between firms to make your technology the standard

Due to big impact of standards on competition, Most standard-setting bodies, i.e., committees, insist that technology providers be willing to ◦license relevant IP before the standard-setting

body will adopt a standard that requires the practice of technology

◦license to all interested parties on reasonable and non-discriminatory terms

Standards and Appropriability

But what ◦should the royalty rates be?◦is reasonable and non-discriminatory?

Closed-door debates (and coalitions) in standard setting committees often revolve around these issues◦Mentioned in previous class




vertical (dis)integration]Example of innovations in which complementary



Complementary AssetsWhat are complementary assets?

◦any capabilities or assets needed to commercialize an innovation manufacturing, marketing, sales, service, brand name, distribution complementary products, any new technological capabilities that are

needed to commercialize the innovation

◦accurate description of value chain/network can help us understand these assets

In 1980s and 1990s focus (e.g., 1986 paper by David Teece) was on these kinds of complementary assets:◦Particularly manufacturing◦But also marketing, sales, service, maintenance, development

Complementary Assets (2)

Japanese firms were the leaders in manufacturing and David Teece argued that Japanese firms would thus dominate all hi-tech industries

It didn’t happen………for a variety of reasons

But complementary assets are important as we have already seen in many examples (Apple) ◦More examples shown below







Industry ArchitectureIndustry architectures characterize nature

and degree of specialization of firms and the interfaces between their products

In addition to levels of vertical (dis)integration, industry architecture also ◦specifies interfaces◦who controls them

For a specific industry (for a final product), we can very roughly distinguish between◦modular industry architectures◦integral industry architectures

Industry Architecture, Modular Design, and Profits to Component Suppliers (1)

Modular design often causes most profitable firms to be suppliers of key components. For example, in personal computers◦Microsoft and Intel are most profitable firms◦Much lower profits in disk drives, memory, displays

Why?◦Microsoft and to lesser extent Intel control interfaces

between operating systems, microprocessors, etc.◦Other suppliers of components do not control these

interfaces and thus there is excessive competition and low profits

Rank Company Market Capitalization Type of Business

1 Apple $608 Billion Hardware

3 Google $395 Billion Search

4 Microsoft $395 Billion Software

21 Facebook $201 Billion Content

23 IBM $190 Billion Hardware

27 Oracle $180 Billion Software

33 Intel $171 Billion Integrated Circuits

40 Amazon $153 Billion Online Sales

51 Cisco $128 Billion Hardware

52 Qualcomm $126 Billion Integrated Circuits

68 TMSC $105 Billion Integrated Circuits

85 SAP $92 Billion Software


As noted last, week most of the profits are flowing to modular components: exceptions are Apple, IBM, Samsung


In mobile phones, a bit mixed◦Profits are taken by Apple (hardware and software)

and Apple (no hardware)◦Apple’s advantage is in user interface, touch screen◦Google’s advantages are in advertising, operating

systemsWhy?

◦User interface and touch screens are key technologies in mobile phones

◦Apple controls interfaces between user interface and other technologies

◦Google profits from mobile advertising where it has network effect advantages


Other component suppliers also have big profits◦Many materials such as chemicals, plastics, and

elastomers do not involve interface standards. Similar story with drugs

◦If the materials have a big impact on a system’s performance or stand-alone benefits (e.g., drugs), profits flow to suppliers with best materials or ones with lowest cost

Scale is a major issue◦Production cost is function of scale◦Output from R&D also depends on scale of R&D

Patent protection can raise profits

Industry Architecture, Modular Design, and Profits to Component Suppliers (5)Movies

◦Motion picture studios are assemblers of various resources required to produce a movie actors and actresses director and other specialists finance, technology,

◦Movies make money, but movie studios often do not. Why? rents flow to the bottleneck “modules,” or

“complementary assets” that are in short supply such as star performers

How about Professors?

Industry Architecture, Integral Design, and Profits to System Suppliers (1)

Integral architectures shift the locus of innovation and rent appropriation up to system level◦“owner” of architecture has power to set

interface protocols and to decide which innovations are adopted and which ones are not innovators

◦This bargaining power creates a source of above average profits for the system owner and below average profits for the component supplier

Consider the Automobile Industry (1)

Cars are highly integral systemsE.g., BMW 325ix sedan consists of

interdependent sub-systems◦chassis, body panels◦suspension system, power train◦interior, dashboard◦that are not “plug compatible” with those of for

example, a Toyota Camry

Consider the Automobile Industry (2)

Car companies tightly coordinate integration across development of these systems ◦It is a major driver of high-quality development

performance◦Tight integration limits opportunities for

independent innovation to occurJapanese firms are leaders in automobiles

partly because of need for integral designJapanese firms used to be leaders in other

products when the products required integral design…..but as modular design emerged, their advantages disappeared……..

Market Capitalization of All Automobile Suppliers

http://www2.deloitte.com/content/dam/Deloitte/de/Documents/manufacturing/MFG-Delivering-Exceptional-Shareholder-Value.pdf

Top Auto Parts Suppliers 2012Robert BoschDensoContinental AGMagna InternationalAisin Seiki Johnson ControlsFaureciaHyundai MobisZF Friedrichshafes AGYazaki CorpLearDelphiTRWBASFBaleo SA

Source:

http://www.autonews.com/assets/PDF/CA89220617.PDF

Systems IntegrationComplex and high-value products involve

system integration◦Boeing and Airbus in aircraft◦Alstom in trains and signaling systems◦Thales in flight simulators◦Ericsson in mobile communication systems◦Atkins in baggage handling systems

Although lots of vertical disintegration, the interdependencies between sub-systems require integral design and this enables systems integrators to be very profitable

Source: Charting a Path Toward Integrated Solutions, Andrew Davies, Tim Brady and Michael Hobday, Sloan Management Review, Spring 2006

Integral vs. Modular Design

When is integral design required and thus profits will flow to system suppliers/designers?

When does modular design work and thus profits will flow to component suppliers/designers?

This is one reason why these issues and vertical (dis)integration were covered in previous sessions

OutlineInsufficient methods of strategic controlIntellectual property and appropriability




functions played critical role: EMI and CAT ScannerIBM in PCs and Services

Context (1)First commercially viable CAT (computer-aided

tomography) scanner invented by Sir Godfrey Hounsfield at EMI Central Research Laboratories

EMI was large “conglomerate” in 1970s that did defense, health care, music

Hounsfield conceived idea in 1967, and was publicly announced in 1972. Allan McLeod Cormack of Tufts University in Massachusetts independently invented similar process

Both Hounsfield and Cormack shared 1979 Nobel Prize in Medicine

Source: Capturing Value Through Technology Strategy, Presentation by Ezra Zuckerman, 2008

Context (2): Key Complementary Assets

Success in medical equipment requires specialized sales, manufacturing, and maintenance departments

EMI (record and defense company) did not have these capabilities while Siemens, Phillips, and GE did

None of these assets were externally available in 1970s and service and sales are still not available

Why still not available?

Implications for EMI Should EMI commercialize alone or work with

leaders? If the CT cannot be imitated or replicated, EMI

could do either. If it works with leaders, it would have a lot of leverage◦ Could threaten to go to Siemens (and vice versa)◦ If also large market potential known in advance,

GE and Siemens would have to pay a great deal for license

But if it can be imitated or replicated, ◦ it will be very hard for EMI to go it alone◦ And less negotiating leverage with GE and

Siemens Let’s focus on negotiation with GE or Siemens

Capturing Value from Negotiation: Challenges for EMI

Can they convince GE or Siemens that they have rights to technology?

Can they write an effective license without giving away the innovation?

Can they convince GE or Siemens that the market will be big?

What percentage of profits should EMI give to GE or Siemens in the license?

◦ Give too much, no profits◦ Give too little, and GE has no incentive to

manufacture and sell product

Negotiation scenario

GE: Oh, you have a great innovation, huh? Let’s see it.

EMI: Here it is. GE: Oh, one of those 3-D X-Ray thingies!

We’ve been working on that for years! And we expect to have one out within 12 months. Nice try, record-company guys! But you should leave medical equipment to the big boys

The Upshot

EMI had a great innovation, with temporary uniqueness, and no real ability to capture value through license

But they didn’t succeed in negotiations Just went alone. But to capture value by

themselves, would need to: ◦ Defend uniqueness as much as possible◦ Build (differentiated) complementary assets to compete

once uniqueness disappears But they didn’t do either:

◦ Slow to respond to patent infringement◦ Rather than building complementary assets, they just

sold what they could

As an Aside, Too Much Value-Creation… ?

Ironic: EMI’s strategy made sense if market turned out to be small

But massive demand increased likelihood of entry and increased the importance of complementary assets.◦ Often hard to capture a bigger slice of big pies!

Should have switched to licensing once it became a big market, and once they saw so much entry.◦ Big mistake was thinking they could go alone ◦ Could have built up business to a point where

they had a viable product, and then sold it to GE

Demand Grew QuicklyCumulative orders (hospitals with 100+ beds):

◦1974: 35◦1975: 122◦1976: 450◦1977: 738◦1978: 953◦1979: 1113◦1980: 1183

Diffusion of CT Scanners by Hospital Size(Source: Trajtenberg, 1990)

.. And then too little? EMI was especially ill-prepared for shakeout. Demand decelerates (4% growth from 376 ordered in

U.S. in 1976 to 389 in 1977; and then plummets (-35% decline from to 251 in 1978). – Note: By 1977, half of all U.S. 100+ bed hospitals had

already ordered a scanner. Against large capacity, leads to intense price wars,

product and service competition; $99,000 scanners in the market.

Shakeout: 12 companies drop out between 1976 and 1980, including Searle and Pfizer, and Technicare sells to Johnson & Johnson (good example of economies of scale in manufacturing, service, sales, and R&D)

Outline







Why did IBM have less success than expected in PCs? (1)

A previous session focused on degree of openness◦IBM should have pursued more closed policy ◦Apple should have pursued more open policy

This session (strategic control) tells a broader story◦IBM thought it controlled the:

critical complementary assets in functions (sales force, R&D) IP/architecture (BIOS software and chip)

Why did IBM have less success than expected in PCs? (2)But

◦emergence of computer retail outlets for consumers eliminated IBM’s advantages with sales force

◦imitation of BIOS chip through reverse engineering eliminated IBM’s advantage in software, enabled firms to copy IBM, and led to emergence of IBM compatible clones

◦Other open interfaces, i.e., modular design, enabled other firms to use same external modules and caused R&D to move from computer to components (microprocessor, hard disk drive, operating systems, and application software)

Why was Lou Gerstner able to Make IBM a Leader Again in the Late 1990s?IBM focused on a market segment in which integral

design was needed (in corporate information systems) and IBM had strong complementary assets◦Computer and information services

Complementary assets◦Large installed base of hardware and software◦Large computer services business◦Better understanding of customer needs than any other firm

Lou Gerstner focused IBM on helping users integrate and upgrade systems

IBM is one of the few computer incumbents to succeed in the Internet

Conclusions (1)Innovators, i.e., first entrants, often fail Examples of reasons. They

◦don’t have sufficient protection of IP◦can’t build up sufficient scale in R&D, manufacturing, etc. ◦don’t have as much access to the relevant complementary

assets as do the incumbents/imitators◦Someone else controls the industry architecture

Firms must think of strategic control from the beginning◦they can’t wait until after they have introduced their product◦and must keep thinking of strategic control

Conclusions (2)

Industry architectures are becoming more complex due to increasing complexity of systems and vertical disintegration◦This increases the opportunities to control an interface

Complementary assets are ◦Becoming more available through vertical disintegration,

which increases the opportunities for outsourcing◦But also increases the complexity of the choices

What are the important complementary assets? Which ones are tightly or freely available?

This is one reason why I want you to identify all the collaborators and customers in the “value chain”

For Your Presentations

In addition to other aspects of Biz Model, tell me about “Strategic control: how to sustain profitability”◦IP that is relevant to a specific innovation/technology◦complementary assets that are relevant to the specific

innovation/technology◦Control of industry architecture and who this favors