slide 1 © carliss y. baldwin and kim b. clark, 2004 designed to evolve: winning strategies for...
TRANSCRIPT
Slide 1 © Carliss Y. Baldwin and Kim B. Clark, 2004
Designed to Evolve: Winning Strategies for Option-Rich, Modular Design Architectures
Carliss Y. BaldwinHarvard Business School
Real Options ConferenceMontreal, CanadaJune 17, 2004
Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2004
Three parts to this presentation
Option-Rich, Modular Design Architecture (ORMDA)
You live in an ORMDA if …
Winning Strategies for ORMDAs
Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2004
Part 1—Option-Rich Modular Design Architectures
Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2004
First, some definitions—
Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2004
D = Designs
Instructions that turn knowledge into things Span all artifacts and human activities
– Tangible, intangible– Transacting, contracting, dispute resolution– Government
The wealth of an economy inheres in its designs
Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2004
The Great Chain of Design and Production
Architecture Procurement
+ Design + Production Product
Use Users' Willingness to Pay
Competition + Price * Quantity
Market Structure – Cost
– Investment
"Free Cash Flow" Discount for Value
Time and Risk $$$
Rational Investment in New Products and Design Architectures
Finance lives here!Must value everything that is made, including designs
Designs are the start of everything that is made
Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2004
Designs are Options
Design process = search under uncertainty New designs may be better or worse than
preceding solutions– Take the ones that are better– Reject the others– That’s a classic option
“Technical potential” of a design = Option value goes up with (naturally)
Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2004
A = Architecture of Designs
Small designs “just get done” by one person or a small team
Large designs require architecture– “The design of the design process”– Forward-looking, future oriented– Analogous to physical architectures
» Create and constrain” movement and search
Major social technology, but not much studied
Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2004
M = Modular Division of knowledge and effort Module = a set of tasks separable from
others – Unit of design architecture
Global Design Rules
Module A Module B Module C Module D
Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2004
Virtues of Modularity 1st Virtue: decentralizes knowledge and
distributes action– Makes more complexity manageable– Enables parallel work
2nd Virtue: tolerates uncertainty – “Welcomes experimentation”– —> Creates Portfolio of Options
Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2004
Modularity Creates a Portfolio of Design Options
Split options, decentralize decisions,fragment control Evolution
System Before Modularization System after Modularization
System DesignOption Rules
Option Option
Option Option
Option Option
Option
Slide 12 © Carliss Y. Baldwin and Kim B. Clark, 2004
OR = Option-Rich
s vary by module and across design architectures
Versions are evidence of option values being realized over time
Global Design Rules v.1
Version 1.0Version 1.2
Version 1.5Version 1.8
Low Medium Zero High
Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2004
Option-rich designs
Have lots of technical potential (High ) Lots of things left to do Modular architectures are VERY valuable
and VERY disruptive in these cases Mature design architectures =>
– Everything conceivable has already been done– Modularity not valuable
More makes more modules more valuable!
Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2004
Life Cycle of a Design Architecture
Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2004
Stage 1—clear thresholds Stage 2—build first minimal system (probably
integral) Stage 3 —discover users’ functional needs/desires Stage 4 —build first modular system
– Modular operators: » Substitution
» Augmentation
» Exclusion
Stage 5 — maturity and stability
Life Cycle of a Design Architecture
Slide 16 © Carliss Y. Baldwin and Kim B. Clark, 2004
Value of a Modular Design Process
V(System) = [Thresholds(All = 1)]
* [V(Stable portion of system) – Cost
+ { max Vj(Substitutions) – Costs } m km
+ { max Vj(Augmentations) – Costs }] n kn
V(System) = [1*1*1…*1] * Stable portion
+ { … }+ { … . }
Substitutable modules
Augmentable modulesOptions
Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2004
Example: Birdseye in the UK Stage 1 — Clearing the last threshold — discover flash-
freezing process for fish
Stage 2 + 4 — construct minimal system– Docks, trucks, cold storage warehouses, refrigerators at the groceries– Naturally modular => Watch out!
Stage 3—grocers discover that customers like frozen beef, vegetables, ice cream and pizza!– Stored in the refrigerators the grocers already own because of Birdseye– Modular augmentation creates value– Much experimentation, competition with new frozen foods
Stage 5 —many frozen foods NOT offered by Birdeye
Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2004
Loss of control, loss of advantage
NOT a winning strategy!
Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2004
Example: IBM System/360 Stage 1 + 2 — Clearing thresholds & finding out what
customers want– Binary compatibility and seamless upgrades of equipment
Stage 3 — construct first modular design architecture– HUGE set of substitutable modules
Stage 4—IBM’s product line expands, BUT many engineers leave IBM to join startup firms making plug-compatible peripherals (PCPs)– Hooked up to IBM installations at the modular interfaces– Modular substitution– Suit and countersuit: Intellectual property vs. antitrust
Stage 5 —a new computer industry: most firms make modules not whole computer systems!
Slide 20 © Carliss Y. Baldwin and Kim B. Clark, 2004
Unconscious strategy…
IBM meant to retain control;
Spent a lot of $$ trying to get it back,
With no success!
Slide 21 © Carliss Y. Baldwin and Kim B. Clark, 2004
5053
5659
6265
6871
7477
8083
8689
9295
737773747373
7372 ex Microsoft
Microsoft
737173703678
3674 ex Intel
Intel3672367035773576357535723571
3570 ex IBM
ADRsIBM
0
20
40
60
80
100
120
140
160
180
$ billion
Option-Rich Modular Architectures
IBM System/360
DEC PDP 11; VAX
Apple 2
IBM PC
Sun 2; 3; Java VM
RISC
Internet Protocols (end-to-end)
Unix and C; Linux
HTML; XML
The Computer Industry 1950-1996
Slide 22 © Carliss Y. Baldwin and Kim B. Clark, 2004
Value Created 1950-1996
0
100
200
300
400
500
600
700
800
900
1000
50 55 60 65 70 75 80 85 90 95
Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2004
ORMDAs are—
“Compelling, surprising, and dangerous…”
End of Part 1
Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2004
How do you know if you “live” in an ORMDA?
Slide 25 © Carliss Y. Baldwin and Kim B. Clark, 2004
You know you are “in” an ORMDA if
Engineers and strategists are always talking about – “the stack”, – “components of the stack”, or – “moving up the stack”
A stack is often a set of nested ORMDAs– New layers become the focus of competition
when the prior/lower layer develops stable standards for interoperability
– “Information hiding” in the components
Slide 26 © Carliss Y. Baldwin and Kim B. Clark, 2004
The Computer Stack, 2004Debugging
Services DistributionRetailTech SupportData Processing
Systems Integration Wired NetworksWireless NetworksAudio-VisualProductivity
Applications Layer PublishingBanking…Browser
Middleware Layer SecurityMessagingMailGraphicsPCs
Operating Systems ServersSearch EnginesEmbeddedPCs
Hardware ServersStorageRoutersComm EquipmentCPU
Components MemoryASICsOpticalAnalog
You live in a BIG ORMDA if:
• Your Stack List seems incomplete;
• The Stack keeps growing
Slide 27 © Carliss Y. Baldwin and Kim B. Clark, 2004
Other signs of an ORMDA:
Industry strategists are talking about:– The “vertical-to-horizontal” transition– Industry fragmentation– Complexity theory– The “ecosystem”
The industry is “turbulent”– Market shares and leadership changing;– Relative values bouncing around
Slide 28 © Carliss Y. Baldwin and Kim B. Clark, 2004
NOT an ORMDA, if
The same 2-3 companies always show up to bid any project
Gaining 1-2 share points in a quarter is cause for celebration (not just noise)
Slide 29 © Carliss Y. Baldwin and Kim B. Clark, 2004
Vertical-to-Horizontal Transitions In 1995, Andy Grove described a vertical-to-
horizontal transition in the computer industry:
“Modular Cluster”
“Vertical Silos”
Slide 30 © Carliss Y. Baldwin and Kim B. Clark, 2004
Andy’s Movie
The Computer Industry in 1980Services S
PSystems Integration E
RR
Applications Layer Y D CVCMiddleware Layer U H E
Operating Systems IBM N P CS
Hardware Y XRCSAMP
ComponentsTI Intel
Top 10 Public Companies in US Computer Industry
Area reflects Market Value in Constant US $
Slide 31 © Carliss Y. Baldwin and Kim B. Clark, 2004
Andy’s Movie
The Computer Industry in 1995SPERRY D CVCU H E
IBM N P CSY XRCSAMP
TI Intel
Top 10 Public Companies in US Computer Industry
Area reflects Market Value in Constant US $
ServicesFirst Data
Systems Integration EDSOracle
I CAApplications Layer B MSFTMiddleware Layer M
Operating Systems
Hardware: Printers HPHardware: Servers IBMHardware: Routers Cisco
Components IntelMicron
Slide 32 © Carliss Y. Baldwin and Kim B. Clark, 2004
Andy’s Movie—the Sequel
The Computer Industry in 2002SPERRY D CVCU H E
IBM N P CSY XRCSAMP
TI Intel
Top 10 Public Companies in US Computer Industry
Area reflects Market Value in Constant US $
ServicesFirst Data
Systems Integration EDSOracle
I CAApplications Layer B MSFTMiddleware Layer M
Operating Systems
Hardware: Printers HPHardware: Servers IBMHardware: Routers Cisco
Components IntelMicron
Services First DataADP
Systems Integration
OracleApplications Layer IBM
Middleware Layer MSFT
Operating Systems
Hardware: Printers HPHardware: PCs Dell
Hardware: Servers IBMHardware: Routers Cisco
Components Intel TI
Slide 33 © Carliss Y. Baldwin and Kim B. Clark, 2004
Turbulence in the ORMDA
Departures from Top 10: Xerox (~ bankrupt) DEC (bought) Sperry (bought) Unisys (marginal) AMP (bought) Computervision (LBO)
Arrivals to Top 10: Microsoft Cisco Oracle Dell ADP First Data
Sic Transit Gloria Mundi … Sic Transit
Slide 34 © Carliss Y. Baldwin and Kim B. Clark, 2004
ORMDAs are —
“Compelling, surprising, and dangerous…”
End of Part 2
Slide 35 © Carliss Y. Baldwin and Kim B. Clark, 2004
Winning Strategies for ORMDAs
Slide 36 © Carliss Y. Baldwin and Kim B. Clark, 2004
Real Options Thinkers have an advantage in ORMDAs
Because real options theory takes “”” seriously
But… real options theory needs to be modified to suit the new context– Few exogenous high-frequency time series– Option is to take max of k experiments where k
is endogenous and unknown– Strategies for value capture are not well
understood
Slide 37 © Carliss Y. Baldwin and Kim B. Clark, 2004
Real Options Theory vs. Five Forces Porter’s Five Forces had
– NO modules; NO complementors; NO “”s
ORMDAs have modules, complementors and a “” on every module– … and the “”s change through time!
– as Augmentable Modules are added and the Module Designs mature
Slide 38 © Carliss Y. Baldwin and Kim B. Clark, 2004
Real Options Theory vs. Five Forces Porter’s Five Forces had
– NO modules; NO complementors; NO “”s
ORMDAs have modules, complementors and a “” on every module– … and the “”s change through time!
– as Augmentable Modules are added and the Module Designs mature
+ { … }+ { … . }
Slide 39 © Carliss Y. Baldwin and Kim B. Clark, 2004
Strategic Games in ORMDAs Architectural Control Microsoft, Intel High / High cost modules Sun vs. Apollo
– ROIC War Dell vs. Compaq High / Medium cost modules Cisco, AMZN
– Buy those who are … – Born to be Bought
High / Low cost modules No profit– Kids rule
Varying Lots of modules Linux, Apache– Voluntary, collective development
– The enemy of my enemy is my friend IBM Low / Lots of modules Toyota
– Learning organization
Slide 40 © Carliss Y. Baldwin and Kim B. Clark, 2004
It’s all about ROIC (Return on Invested Capital)
Game 1: High , High Cost Modules
Slide 41 © Carliss Y. Baldwin and Kim B. Clark, 2004
1965—IBM provided all of System/360’s Modules
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35
1 SLT architecture and standard circuits2 Erich Bloch - August 19613 New Processor Line Architectural Ground Rules4 SPREAD Task Group - 12/28/615 New Processor Line control, product and programming standards6 Corporate Processor Control Group (CPC) - 4/1/62
7 SLT Transistors8 SLT Modules9 SLT Cards
10 SLT Boards and Automatic Wiring11 Processor 1 - Endicott, New York12 Processor 2 - Hursley, England13 Processor 3 - Poughkeepsie, New York14 Processor 4 - Poughkeepsie, New York15 Processor 5 - Poughkeepsie, New York16 Main memories, Corporate Memory Group (1)17 Internal memories, CMG18 Read-only memories for control, CMG19 "Binary-addressed" Random Access Files20 Corporate File Group (2)21 Tape devices running at 5000+ char/sec22 Corporate Tape Group (3)23 Time-multiplex system for switching I/O devices24 DSD Technical Development Group
25 Techniques to measure processor performance, system26 throughput and software efficiency, Group Staff27 A unified Input/output Control Structure (IOCS)28 System Software for Configuration I (4)29 System Software for Configuration II (4)30 System Software for Configuration III (4)31 FORTRAN and COBOL compilers32 A unified programming language
33 Announcement and Marketing34 Production, Testing and Integration35 Shipment, Delivery and Installation
Slide 42 © Carliss Y. Baldwin and Kim B. Clark, 2004
1980—Apollo made less, outsourced more
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30 31 32 33 34 35 36 37 38 39 40 41 42
1 O Processor chip—CPU2 Outsourced—Motorola 680x0 Key:3 O Floating Point Accelerator x= transfer of material or information from column4 Outsourced task to row task;5 O Memory chips DRAMs, ROM T= transaction: sale of good by column owner to row6 Outsourced—Commodity owner;7 O Storage—Disk Drives O= outsourced task blocks;8 Outsourced D= downstream or complementary task blocks;9 O Storage—Tape Drive highly interdependent task blocks with many iterations
10 Outsourced and high within-block mundane transaction costs;
11 O Printed circuit boards Apollo's footprint (tasks performed inhouse).
12 Outsourced—Commodity13 O Display Monitor14 Outsourced15 O Keyboard, Cabinet, Fans16 Outsourced
17 x x x x x x x x x x x x x x x x Aegis proprietary18 Inhouse Operating System19 Design20 x x x x x x x x x x x x x x x x OS DOMAIN proprietary21 Network Network Architecture2223 x x x x x x x x x x x x x x x x Hardware Design24 DN series = 3-4 boards incl.
25 Hardware IO and Display controllers,26 Power supply27 T T T T T T T T T T T T T T T T x x x x Purchase Components28 Component Test x x x x x29 Kits x x x x x x Inhouse30 Board stuff and Solder x x x x x x Manu-31 Test Boards x x x x x x facturing32 Board Assembly x x x x x x33 System Assembly x x x x x x34 System Test x x x x x x35 Quality Assurance x x x x x x36 Consolidate and Ship x x x x x x
37 x x x x x x D38 x x x x x x Many Software Applications D39 x x x x x x D40 x x x x x x x x x x T D41 x x x x x x x x x x Many OEMsT D42 x x x x x x x x x x T D
Smaller footprint was a feature, not a bug!
Slide 43 © Carliss Y. Baldwin and Kim B. Clark, 2004
Then Sun came along…Apollo Computer
Aegis proprietaryInhouse Operating SystemDesignOS DOMAIN proprietary
Network Network Architecture
Hardware DesignDN series = 3-4 boards incl.
Hardware IO and Display controllers,Power supply
x x x x Purchase ComponentsComponent Test x x x x x
Kits x x x x x x InhouseBoard stuff and Solder x x x x x x Manu-
Test Boards x x x x x x facturingBoard Assembly x x x x x x
System Assembly x x x x x xSystem Test x x x x x x
Quality Assurance x x x x x xConsolidate and Ship x x x x x x
And did even less!
How?
x x x x x Customize Unixx x x x x Inhouse Proprietary MMU
x x x x x Design Internal busx x Single Board Layout
T T T T x x x x Purchase ComponentsComponent Test x x x x x O
Kits x x x x T Manu-Board stuff and Solder x x x x x O facturing
Test Boards x x x x TBoard Assembly x x x x x
System Assembly x x x x xSystem Test x x x x x
Quality Assurance x x x x xConsolidate and Ship x x x x x
Slide 44 © Carliss Y. Baldwin and Kim B. Clark, 2004
Then Sun came along…Apollo Computer
Aegis proprietaryInhouse Operating SystemDesignOS DOMAIN proprietary
Network Network Architecture
Hardware DesignDN series = 3-4 boards incl.
Hardware IO and Display controllers,Power supply
x x x x Purchase ComponentsComponent Test x x x x x
Kits x x x x x x InhouseBoard stuff and Solder x x x x x x Manu-
Test Boards x x x x x x facturingBoard Assembly x x x x x x
System Assembly x x x x x xSystem Test x x x x x x
Quality Assurance x x x x x xConsolidate and Ship x x x x x x
And did even less!
x x x x x Customize Unixx x x x x Inhouse Proprietary MMU
x x x x x Design Internal busx x Single Board Layout
T T T T x x x x Purchase ComponentsComponent Test x x x x x O
Kits x x x x T Manu-Board stuff and Solder x x x x x O facturing
Test Boards x x x x TBoard Assembly x x x x x
System Assembly x x x x xSystem Test x x x x x
Quality Assurance x x x x xConsolidate and Ship x x x x x
Design Architecture for performance
Public Standards for outsourcing
Slide 45 © Carliss Y. Baldwin and Kim B. Clark, 2004
Result: Sun gets More Upside- for Less $
Sun workstations interoperate with Unix/Ethernet networks (Standards)
Sun’s boxes are as fast and functional as Apollo’s (Product Architecture)
Sun’s boxes cost the same and use less capital (Process Architecture)
Sun’s downside- -twin never went public— many were started, but only a few survived
Slide 46 © Carliss Y. Baldwin and Kim B. Clark, 2004
Result: ROIC advantage to SunAverage over 16 Quarters: Apollo Sun
Computer MicrosystemsInvested Capital Ratios (Annualized)Net Working Capital/ Sales (%) 29% 15% Low is goodEnding Net PPE / Sales (%) 24% 13% Low is goodInvested Capital/Sales (%) 57% 31% Low is good
ProfitabilityNet Income/Sales 0% 6% High is good
ROICROIC (excl Cash, Annualized) 2% 20% High is good
Sun used its ROIC advantage to drive Apollo out of the market
… Consciously and legally
Slide 47 © Carliss Y. Baldwin and Kim B. Clark, 2004
Dell vs. Compaq 19971997 Compaq Dell
Computer ComputerInvested Capital Ratios (Annualized)Net Working Capital/ Sales (%) -2% -5% Low is goodEnding Net PPE / Sales (%) 8% 3% Low is goodInvested Capital/Sales (%) 8% -2% Low is good
ProfitabilityNet Income/Sales 8% 7% High is good
ROICROIC (excl Cash, Annualized) 101% -287% !!!
Dell started cutting prices; Compaq struggled, but in the end had to exit.
Like Apollo, they were acquired by HP!
Slide 48 © Carliss Y. Baldwin and Kim B. Clark, 2004
Summary of Game 1:
Works for High , High Cost Modules Small footprint in the system
– Design Architecture for performance
– Public Standards to outsource
Competitive product, less Invested Capital per unit Higher ROIC for any price Wage price war until competition exits Then figure out what to do when maturity sets in …
Slide 49 © Carliss Y. Baldwin and Kim B. Clark, 2004
Strategic Games in ORMDAs Architectural Control Microsoft, Intel High / High cost modules Sun vs. Apollo
– ROIC War Dell vs. Compaq High / Medium cost modules Cisco, AMZN
– Buy those who are … – Born to be Bought
High / Low cost modules No profit– Kids rule
Varying Lots of modules Linux, Apache– Voluntary, collective development
– The enemy of my enemy is my friend IBM Low / Lots of modules Toyota
– Learning organization
Slide 50 © Carliss Y. Baldwin and Kim B. Clark, 2004
It’s all about M&A (Mergers & Acquisitions)
Game 2: High , Medium Cost Modules
Slide 51 © Carliss Y. Baldwin and Kim B. Clark, 2004
Joy’s Law
“Most of the bright people don’t work for you—no matter who you are. You need a strategy that allows for innovation occurring elsewhere.”
Quoted by George Gilder circa 1995
Slide 52 © Carliss Y. Baldwin and Kim B. Clark, 2004
The Real Options Approach
Launch inhouse design efforts But don’t exhaust NPV Let VCs fund medium-size experiments in
new designs/technologies Acquire “the winners” Let VCs unwind the rest…
Slide 53 © Carliss Y. Baldwin and Kim B. Clark, 2004
Strategy is almost a Bayesian-Nash subgame perfect equilibrium
IBM’s former “we own it all” strategy is not!
Slide 54 © Carliss Y. Baldwin and Kim B. Clark, 2004
Cisco invented this strategy
History of Cisco acquisitions:
1993 11994 31995 41996 71997 61998 91999 182000 242001 22002 52003 42004 2
85
An equal number of minority equity investments—optional paths to control
(So far)
Slide 55 © Carliss Y. Baldwin and Kim B. Clark, 2004
A new battle is shaping up
Cisco vs. Juniper The market loves Juniper Substantial ROIC advantage to Cisco
Anyone want to bet?
Slide 56 © Carliss Y. Baldwin and Kim B. Clark, 2004
Strategic Games in ORMDAs Architectural Control Microsoft, Intel High / High cost modules Sun vs. Apollo
– ROIC War Dell vs. Compaq High / Medium cost modules Cisco, AMZN
– Buy those who are … – Born to be Bought
High / Low cost modules No profit– Kids rule
Varying Lots of modules Linux, Apache– Voluntary, collective development
– The enemy of my enemy is my friend IBM Low / Lots of modules Toyota
– Learning organization
Slide 57 © Carliss Y. Baldwin and Kim B. Clark, 2004
ORMDAs are —
“Compelling, surprising, and dangerous…”
and a lot of fun if you know what’s going on!
End of Part 3
Slide 58 © Carliss Y. Baldwin and Kim B. Clark, 2004
Questions?
Comments?
Slide 59 © Carliss Y. Baldwin and Kim B. Clark, 2004
Thank you!