Category: Innovation

In a previous post, I wrote about my concerns on how the law of conservation of attractive profits might apply to the next stage of mobile computing, especially in emerging nations.

Here, I would like to describe how the law of conservation of attractive profits helps us to understand the history of personal computing. This is particularly instructive because it strongly suggests that this law will continue to be applicable in the future.

The law of conservation of attractive profits

I quoted a brief description of the law of conservation of attractive profits from Clayton Christensen’s book “Seeing What’s Next” in my previous post.

What it tells us is;

1. When commoditization occurs at a certain stage in the value chain, an adjacent stage will gain the opportunity to earn attractive profits.
2. Attractive profits emerge at the stage which solves the most difficult problems in the industry, typically with an integrated approach.
3. This integration may happen at the product component level, customer interaction level or supplier interface level.

Hence to identify which stage will earn attractive profits, we have to understand what the most difficult problem in the industry is. This is not necessarily a technical problem, but can be any stage in the value chain.

Obviously, different countries, different regions may have different problems in their value chains. In particular, the average spending power is very variable between regions and this will necessitate different approaches to the market. Hence different stages will earn the attractive profits, depending on region.

Application to personal computing history

1. From the late 1970s to early 1980, Apple and IBM were the powers in personal computing. They took components and assembled them into their respective proprietary personal computer platforms. During this age, the attractive profits were in designing the platform and assembling the computer.
2. As technology improved however, this shifted. Compaq reverse-engineered the IBM-PC, creating a clean room implementation in the 1980s. This effectively commoditized the platform design of the IBM-PC. Assembling a PC suddenly became very easy to do. When this happened, the power in the industry shifted to adjacent stages, namely Microsoft (in software) and Intel (in CPUs).
3. In the 2000s, the Internet came and created another layer in the value chain. At the same time, innovation in PCs started to falter partially due to the fact that PCs had become “good enough” for office productivity. The absolute processing power that Intel provided through its new CPUs no longer became important because the old ones or the cheaper ones from AMD were “good enough”. Similarly, the new operating systems that Microsoft released no longer became essential because the old ones had “good enough” features. This created an opportunity for the attractive profits to shift towards Internet service companies (which were in their infancy and not yet “good enough”), and bore behemoths like Google.
4. Apple then came along in 2007, bringing a totally revolutionary product, the iPhone. This caused the whole evolution cycle to go back to the beginning and once again, the company that assembled the final product commanded the most attractive profits (Apple). The most difficult problem in computing was designing and creating smartphones that were small and light, yet powerful. They also had to contend with the dilemma of very limited battery capacity and full-day battery-life expectations. This was the responsibility of the hardware manufacturers.
   Hence similarly in the Android ecosystem, the most profitable company became Samsung, also the company that assembled the device.
5. As technology progresses and solves the most pressing problems in smartphones, the profits move away from the hardware assemblers to adjacent stages. Hence the predicament that Samsung now finds itself in. At this point however, it is not yet clear which adjacent stages will reap the profits. In particular, it should stress that is no by no means obvious whether Google services will become this stage or not.

Which layer could reap future smartphone profits?

I won’t try to reach a conclusion here, but simply point out a few things that I think are important.

Things to consider;

1. A huge problem in the smartphone industry is how to expand customers and how to expand usage in various countries and various market segments. It is increasingly apparent that a one-size-fits-all approach is not going to work.
2. The problems in the industry will significantly differ according to which market segment we are looking at. For example, high-end smartphone users may have issues with sharing links, customizing the user interface, pure Google-ness, continuity with other devices, notifications, maps, etc. On the other hand, low-end users will have issues with ease-of-use and prices. Similarly, price is much more of an issue for users in emerging countries (regardless of tech literacy) than developed countries.
3. Whereas hardware and low-level software affect the experience of every user, the service layer is more specialized. For example, not everyone uses a complex social networking service like Facebook and may be content with SMS. Similarly, people who often visit unfamiliar places will make constant use of maps, but there are also many people who simply go to-and-fro from the same few locations most of the time. The same thing can be said for Google Now. People don’t need to be constantly reminded of things that they do every day of the week.
4. Google actually doesn’t control a lot of the services that are suited to people in emerging nations. For example, their most visited property on mobile devices is YouTube. However, YouTube takes up hideous amounts of bandwidth which will be a problem in these countries. Facebook and WhatsApp either don’t have this issue or have worked hard to fix this.
5. Because emerging countries do not have too many people on credit cards, billing for software and services is a large issue. Carrier billing is seen as a solution for this. Carriers will be able to extract the attractive profits proportionally to the importance of carrier billing in that country.
6. The layer that can customize the solutions to match the different markets is in a good position to gain the attractive profits. For hardware, this would be the local vendors who can now easily create custom hardware with the help of the Shenzen ecosystem in China. For the software and services, carriers traditionally have been the gateway.

In this blog, I have touched on Clayton Christensen’s “law of conservation of attractive profits” a few times (in Japanese: 1, 2)

The law of conservation of attractive profits is briefly described in Christensen’s book “Seeing What’s Next”. Below is a passage from the book;

We have also called the law of conservation of integration the “law of conservation of attractive profits,” because companies make attractive money when they solve the hardest problems. The hardest technical problems mandate solutions that are tightly coupled integrated systems. When modularity and commoditization cause attractive profits to disappear at one stage in the value chain, conservation of integration means the opportunity to earn attractive profits with propriety products will emerge at an adjacent stage.

Conservation of integration explains why it is not accurate to characterize and industry as integrated or disintegrated. There are numerous types of integration in any given industry. Specialists are integrated, just in different ways. Whereas integrated firms might span an entire industry’s value chain, specialist firms might be integrated to produce a single component that itself is not good enough. Or they could be integrated across whatever interfaces drive customization and convenience, which could be the point of customer interaction or the interface with suppliers.

I find that the law of conservation of attractive profits gives us great insight into how personal computing evolved from computers like the Apple II to the iPhone. This is a long topic, and I hope to touch on it sometime in the future.

For the current discussion, I would like to touch on how Google seems to be trying to manipulate the smartphone value chain and whether it will succeed.

To understand the current situation better, I suggest readers listen to two excellent podcasts which describe the different strategies that Apple and Google are pursuing.

1. Cubed Podcast: “Google I/O Takeaways and Implications”
2. Tech.pinions Podcast: “Google I/O, 4K, GoPro”

Regarding Google, what is suggested in these podcasts is that Google is trying to commoditize both hardware and software so that their services will reach the widest audience possible, thereby providing Google with data to feed their machine learning project. They do not seem to care about creating an ecosystem in which their hardware OEMs and application developers can sustain profitable businesses.

Viewed from the law of conservation of attractive profits, this can be explained as Google attempting to commoditize hardware and software, so that the service layer will dominate attractive profits.

The question is, will this work?

Listening to Ben Bajarin in the Tech.pinions Podcast, it dawned on me that there is another layer that actually has a bigger chance than Google of gaining the attractive profits. That is the carrier layer.

Carriers have the following advantages;

1. Carriers are the interface to customers, and importantly, they control the billing, especially in emerging countries.
2. Carriers own the pipe and can control the flow of content through their networks. For example, they can provide unlimited access to WhatsApp and Facebook, while restricting access to YouTube and other sites.
3. Carriers are local. This means that they can tailor pricing and promotions to fit the local situation. This is especially important in emerging countries where the spending power of the average citizen is a fraction of that in developed nations.
4. Before the introduction of the iPhone, carriers had huge power in the ecosystem. So much so that Steve Jobs famously called them “orifices”. It has already been proved that the market structure is such that carriers can command huge profits if the circumstances are right.

Ben Bajarin briefly touched on Cherry Mobile in the Philippines, which is a carrier that is selling its own brand of smartphones.

I am not yet familiar with what Cherry Mobile is actually doing, nor have I spent time thinking about this in more detail. It does appear however, that Google is not the only potential beneficiary from software and hardware commoditization. In fact, it seems totally possible that services will also be commoditized and that the carriers will reap the attractive profits.

This is a theme that I will continue to think and hopefully write about.