When should a company build vs. buy?

A widely used theory to guide this decision is built on categories of core and competence. If something fits your core competence, you should do build it. If it’s not your core competence and another firm can do it better, you should rely on them to provide it.

The problem is, what might seem a noncore activity today might become a critical competence to have mastered in a proprietary way in the future, and vice versa.

Instead of asking what their company does best today, managers should ask, “What do we need to master today, and what will we need to master in the future, in order to excel on the trajectory of improvement that customers will define as important?”

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 depending on: 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.

Interdependent vs modular architectures

Interdependent

• 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.
• ‍Interdependent architectures optimize performance, in terms of functionality and reliability. By definition, these architectures are proprietary because each company will develop its own interdependent design to optimize performance in a different way.

Modular

• 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.
• ‍Modular architectures optimize flexibility, but because they require tight specification, they give engineers fewer degrees of freedom in design. As a result, modular flexibility comes at the sacrifice of performance.

When to integrate and build interdependent architecture

• When there is a performance gap—when product functionality and reliability are not yet good enough to address the needs of customers in a given tier of the market—companies must compete by making the best possible products.
• In the race to do this, firms that build their products around proprietary, interdependent architectures enjoy an important competitive advantage against competitors whose product architectures are modular, because the standardization inherent in modularity takes too many degrees of design freedom away from engineers, and they cannot optimize performance.
• ‍To close the performance gap with each new product generation, competitive forces compel engineers to fit the pieces of their systems together in ever-more-efficient ways in order to wring the most performance possible out of the technology that is available.
• When firms must compete by making the best possible products, they cannot simply assemble standardized components, because from an engineering point of view, standardization of interfaces (meaning fewer degrees of design freedom) would force them to back away from the frontier of what is technologically possible.
• 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.
• ‍Examples: it wasn’t just IBM that dominated the early computer industry by virtue of its integration. Ford and General Motors, as the most integrated companies, were the dominant competitors during the not-good-enough era of the automobile industry’s history. For the same reasons, RCA, Xerox, AT&T, Standard Oil, and US Steel dominated their industries at similar stages. These firms enjoyed near-monopoly power. Their market dominance was the result of the not-good-enough circumstance, which mandated interdependent product or value chain architectures and vertical integration. But their hegemony proved only temporary, because ultimately, companies that have excelled in the race to make the best possible products find themselves making products that are too good. When that happens, the intricate fabric of success of integrated companies like these begins to unravel.  

When to modularize and buy commoditized solutions

• 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. The pressure of competing along this new trajectory of improvement forces a gradual evolution in product architecture, away from the interdependent, proprietary architectures that had the advantage in the not-good-enough era toward modular designs in the era of performance surplus.
• Modular architectures help companies to compete on the dimensions that matter in the lower-right portions of the disruption diagram. Companies can introduce new products faster because they can upgrade individual subsystems without having to redesign everything. Although standard interfaces invariably force compromise in system performance, firms have the slack to trade away some performance with these customers because functionality is more than good enough.
• Modularity has a profound impact on industry structure because it enables independent, non-integrated organizations to sell, buy, and assemble components and subsystems. Whereas in the interdependent world you had to make all of the key elements of the system in order to make any of them, in a modular world you can prosper by outsourcing or by supplying just one element.
• Ultimately, the specifications for modular interfaces will coalesce as industry standards. When that happens, companies can mix and match components from best-of-breed suppliers in order to respond conveniently to the specific needs of individual customers.  

Summary of the steps by which modularization takes place

1. The pace of technological improvement outstrips the ability of customers to utilize it, so that a product’s functionality and reliability that were not good enough at one-point overshoot what customers can utilize at a later point.
2. This forces companies to compete differently: The basis of competition changes. As customers become less and less willing to reward further improvements in functionality and reliability with premium prices, those suppliers that get better and better at conveniently giving customers exactly what they want when they need it are able to earn attractive margins.
3. As competitive pressures force companies to be as fast and responsive as possible, they solve this problem by evolving the architecture of their products from being proprietary and interdependent toward being modular.
4. Modularity enables the dis-integration of the industry. A population of nonintegrated firms can now outcompete the integrated firms that had dominated the industry. Whereas integration at one point was a competitive necessity, it later becomes a competitive disadvantage.

How it happened in the Microprocessor-Based Computer Industry:

• 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.
• What happens to the initial leaders when they overshoot, after having jumped ahead of the pack with performance and reliability advantages that were grounded in proprietary architecture? The answer is that they need to modularize and open up their architectures and begin aggressively to sell their subsystems as modules to other companies whose low-cost assembly capability can help grow the market.

How to avoid commoditization

• Many executives have resigned themselves to the belief that, no matter how miraculous their innovations, their inevitable fate is to be “commoditized.” These fears are grounded in painful experience.
• Here’s a frightening example: The first one-gigabyte 3.5-inch disk drives were introduced to the world in 1992 at prices that enabled their manufacturers to earn 60 percent gross margins. These days, disk drive companies are struggling to eke out 15 percent margins on drives that are sixty times better.
• This isn’t fair, because these things are mechanical and microelectronic marvels. How many of us could mechanically position the head so that it stored and retrieved data in circular tracks that are only 0.00008 inch apart on the surface of disks, without ever reading data off the wrong track? And yet disk drives of this genre are regarded today as undifferentiable commodities.
• If products this precise and complicated can be commoditized, is there any hope for the rest of us? It turns out that there is hope.
• 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.
• And whereas commoditization destroys a company’s ability to capture profits by undermining differentiability, de-commoditization affords opportunities to create and capture potentially enormous wealth. The reciprocity of these processes means that the locus of the ability to differentiate shifts continuously in a value chain as new waves of disruption wash over an industry. As this happens, companies that position themselves at a spot in the value chain where performance is not yet good enough will capture the profit.

The commoditisation/de-commoditisation cycle

Integrated companies that design and assemble the not-good-enough end-use products make attractive profits for two reasons:

1. First, the interdependent, proprietary architecture of their products makes differentiation straightforward.
2. 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:

1. As a new market coalesces, a company develops a proprietary product that, while not good enough, comes closer to satisfying customers’ needs than any of its competitors. It does this through a proprietary architecture, and earns attractive profit margins.
2. As the company strives to keep ahead of its direct competitors, it eventually overshoots the functionality and reliability that customers in lower tiers of the market can utilize.
3. This precipitates a change in the basis of competition in those tiers, which…
4. … precipitates an evolution toward modular architectures, which…
5. … facilitates the dis-integration of the industry, which in turn
6. … makes it very difficult to differentiate the performance or costs of the product versus those of competitors, who have access to the same components and assemble according to the same standards. This condition begins at the bottom of the market, where functional overshoot occurs first, and then moves up inexorably to affect the higher tiers.

For businesses who have become commoditised, 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.

The five steps in this reciprocal process of de-commoditisation:

1. The low-cost strategy of modular product assemblers is only viable as long as they are competing against higher-cost opponents. This means that as soon as they drive the high-cost suppliers of proprietary products out of a tier of the market, they must move up-market to take them on again in order to continue to earn attractive profits.
2. Because the mechanisms that constrain or determine how rapidly they can move up-market are the performance-defining subsystems, these elements become not good enough and are flipped to the left side of the disruption diagram.
3. Competition among subsystem suppliers causes their engineers to devise designs that are increasingly proprietary and interdependent. They must do this as they strive to enable their customers to deliver better performance in their end-use products than the customers could if they used competitors’ subsystems.
4. The leading providers of these subsystems therefore find themselves selling differentiated, proprietary products with attractive profitability.
5. This creation of a profitable, proprietary product is the beginning, of course, of the next cycle of commoditisation and de-commoditisation.

An important consequence of these cycles is that we should be careful to never conclude that an industry such as disk drives or DRAMs is inherently unprofitable, whereas others such as microprocessors or semiconductor manufacturing equipment are inherently profitable. “Industry” is usually a faulty categorization scheme. What makes an industry appear to be attractively profitable is the circumstance in which its companies happen to be at a particular point in time, at each point in the value-added chain, because the law of conservation of attractive profits is almost always at work.

Definition: The Law of Conservation of Attractive Profits

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-commoditisation, 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.