2. The Future of Value Creation

“The corporation as we know it, which is now 120 years old, is unlikely to survive another twenty-five years. Legally and financially, yes, but not structurally and economically.”

—Peter Drucker, 2000¹

Overview

Sustaining a business is the act or continual value creation. And value creation occurs via the process of innovation, whether that’s innovation in strategy, business model, products, processes, or services. This chapter walks through the rationale for why a fundamental change in the way value is created—and captured by organizations—must occur. You will examine, using appropriate economic theories, why the modern corporation exists in the first place; and why those same theories predict different organizational structures and different economic models for the future. The early examples of this change can serve not only to support the proposal that “change is inevitable,” but also to provide some suggestion as to its form.

Transaction Costs and Vertical Integration

Ronald Coase was a professor emeritus of economics at the University of Chicago Law School when he won the 1991 Nobel Prize in economics. The economic theories that earned him this distinction centered around a seminal paper he wrote in 1937 entitled “The Nature of the Firm.”² The phenomenon of the corporation had been evident for several decades, and Coase was looking to explain the logic behind its existence. Marketplaces had already existed for centuries, and no doubt millennia, prior to the birth of the corporation. In a marketplace, the raw materials to make a new product are purchased right before the item, whether shoe or carriage, is crafted. The saddle maker purchases leather ready for cutting and sewing into the new desired shape. The new automobile maker could likewise purchase steel, as needed, to assemble its product.

And yet, what was later to be described as vertical integration was evident everywhere. Rather than rely solely upon the marketplace as a source for raw materials, corporations were “diversifying” by acquiring the businesses, from which they would have purchased goods, and manufacturing those goods in addition to the final product they created for the customer.

The explanation for vertical integration was that these businesses were growing in size and complexity and they wanted to further capture the middleman’s profits. But this explanation seemed inadequate. Such an approach often proved dilutive, forcing overall profit margins to decline. According to Coase, the system property responsible for vertically integrated companies was posited to be what Coase initially called “marketing costs” and which we now call transaction costs. These were defined as all those expenses unrelated to the actual cost paid for the raw material and yet necessary for that material’s acquisition. The automaker may have paid $1.00 a pound for the sheet steel that it acquired, but that was not part of the transaction costs. The transaction costs, rather, included the costs associated with searching for and identifying a suitable supplier, with evaluating the quality of that supplier’s product and its capability to supply it consistently. The transaction costs included the professional labor charges associated with negotiating and authoring the supply contract. And the transaction costs included the costs associated with the enforcement of that contract and the ongoing evaluation of the quality of the purchased material.

It is not difficult to imagine that these transaction costs could readily exceed the profit margin earned by the middleman and, in some cases, might even exceed the cost of the material itself. The sum of these costs, which arguably contributed nothing to the value of the ultimate product, should, thus, be minimized. The corporation was argued to exist for the purpose of minimizing these transaction costs. If the organization were, in effect, acquiring the starting materials from itself, these costs were both minimized and controlled. Vertical integration thus occurred up to some limit of reasonableness; that is, most automobile manufacturers did not enter the mining business. That said, it was not unusual for them to enter the businesses of steel, paint, and electronics.

Vertical Disintegration

It is interesting, in the 21st century, to reread Coase’s paper. We might imagine a focus on the transaction costs associated with contract negotiation or maybe even quality control. From a modern-day perspective, it may seem that transaction costs such as search would be near trivial. But the world was a different place in 1937, and search costs were a dominant theme in Coase’s work. It was just hard to find stuff. There were no Googles, yellow pages, 800-numbers, or Internet. Of course, search costs are not the only transaction costs that have dropped over the subsequent decades. Analytical automation and robotics have lowered the cost of quality inspection. Communications technologies have lowered the cost of the negotiation. Even readily available contract templates, and the ease of engaging legal firms on a purely ad hoc basis, reduces the costs associated with contracting. If you take Coase’s work at face value, as economists have for many years and as the Nobel committee did in 1991, you must ask yourself: Would vertical integration have ever occurred to the same degree if the capabilities and technologies of the present had been available to the growing businesses of the past? And this, of course, begs a second, perhaps more relevant, question: Should you anticipate a vertical DIS-integration of old businesses, wherein marketplaces assume the role that has been played by intercorporate transfer of materials, both physical and intellectual? The answer to this second question is yes, and ironically, the organizational outcome is a different result, not for a different reason but for the very same reason. Marketplaces and exchanges will once again lower the transaction costs of doing business. Integration may have obviated the costs of search but it introduced overheads and value chain mismatches. As the ability to transact in cyberspace continues to evolve, transaction costs are driving to zero.

Both this disintegration process, and the failure of startups to integrate in the first place, is happening all around you. Yet most corporate strategies accept it in bits and pieces and do not fully account for it in their long-term planning. Compelling strategic questions would, and should, include the following:

• At what point in the value chain are you most capable of making a profitable contribution?

• How much more narrowly can it be defined than it has been in the past?

• What new marketplaces, and exchanges, should you engage in?

• What new ones may yet evolve, to render obsolete present-day, internal capabilities?

It should already be apparent that many of the new market exchanges will trade in intellectual rather than physical assets. For a great many businesses, and for a host of good reasons, intellectual capabilities have been jealously guarded as the “secret sauce” enabling a competitive advantage. But if and when those sauces become commodities, businesses must rethink their value proposition in addition to rethinking their organizational design in such a way that most actively taps those “idea markets.”

The significance of technology in this transformation is clearly evident. And it would be tempting to assign technology a role as driver. Doing so runs the risk of overlooking an even more fundamental cause for what is going on. Although technology serves as a powerful enabler, it is, itself, a servant to social and economic pressures around the globe.

Globalization and Competition

Thomas Friedman, in his book The World Is Flat, identifies three historical waves of globalization:

• The globalization of nations: Think British Empire at its zenith.

• The globalization of corporations: Think of present-day multinationals of your choosing.

• The globalization of the individual: A desire to reside locally while engaging globally.

At the same time, imagine the shifting values of post-baby-boom generations where lifestyle choices are as much a part of career decisions as the financial realities of survival. In this light, technological advances, such as cell phones and the Internet, enabled changes in the world of work consistent with the choices of people to engage in new ways and often at a distance. Increasingly, in the workplace, “plugging in” is replacing “showing up.”

A second important driver of change is good old-fashioned business competition. With an easily searchable marketplace in specialized skills and services, individuals and small startups realize they can beat corporations at their own game—at least at their “old game.” The highly integrated corporation rarely, if ever, succeeds at doing well all the things it does. And therein lies opportunity. “Sell the mailroom,” the business adage dating back to the ’60s, has expanded its targets and is now regularly encroaching upon the functions and capabilities critical to the entity’s value proposition. Although divesting of the mail distribution capabilities may seem fairly obvious in today’s business world, it was less so right on the heels of corporate integration. But as the mailroom and cafeterias went to contracted services, so followed packaging and printing capabilities, product manufacturing, marketing design, and so on.

For many years, some innovation functions within a corporation, such as R&D, showed a capability to resist the tendency to acquire such services externally. After all, competitive advantage in the innovation arena was seen as the most crucial to the capability to thrive in the marketplace. The last decade has shown this conventional wisdom to be neither conventional nor wise.

Lead Users

Consider, for example, the phenomenon of lead users, ingenious consumers who provoke companies to new iterations of their products. In 2005, Eric von Hippel at MIT’s Sloan School of Management published a book titled Democratizing Innovation.³ In this book, von Hippel segments customers of commercial products—in particular, commercial products with a high degree of complexity and which are new to the market. One key consumer segment is a group von Hippel defined as “lead users,” which are sophisticated innovators in their own right and often acquire a product as a starting material in applications where no satisfactory commercial product exists.

Lead using is not necessarily an unprecedented phenomenon. There are many similarities between a research physician who purchases a medical instrument and rewires it to detect new phenomena, for which it may not have originally been intended, and the gearhead in the 1950s who had torn apart the engine of his Mercury Coupe before it even had a chance to get dirty. What is new is the way in which communication technology enables you to engage with lead users and tap their ingenuity in unprecedented ways. Lead user communities can then be an important, and maybe even a dominant, source of new products for the original supplier. von Hippel’s book provides tangible examples in fields as wide ranging as automotive, medicine, telecommunications, computer hardware and computer software, commercial graphics and design—it’s rather difficult to imagine areas in which this lead user phenomenon is not applicable.

Open Source Software

Bearing witness to the innovation capabilities of nonemployees, external groups, the digitization of products, and the ability of disparate contributors to work collectively through new modes of communication is the open source movement begun in the 1990s. These efforts, which led to such software products as Linux, Apache web servers, and the Perl programming language, seem to have been perfectly suited to both the new technologies and the new work patterns. The ability to migrate such distributed processes to other products is, at times, hampered by the following:

• Intellectual property protection issues

• The lack of a digital version of the task

• Middle management’s reluctance to cede control to the “unruly mobs”

Nevertheless, the quality of the products produced in this manner stand as testament to what can be described as “the new normal” of distributed work and mass collaboration.

Initially, attempts were made to dismiss products produced in this manner as suitable for only the fringes, or of indeterminate quality. Time and widespread adoption appear to have rendered both criticisms moot. There were internal memos from one major software producer leaked to the Internet wherein the house engineers acknowledge the apparent high quality of these products. Although we know of no rigorous studies, it is tempting to put forth a hypothesis that software assembled without centralized guidelines might even be more likely devoid of systematic risks. Such risks arise where a single architectural flaw (grounded in accepted corporate norms) could creep in and cross between modules and subroutines.

As learnings from the open source movement have migrated into other products, some of the barriers mentioned earlier have been tackled, and in some cases obviated. Crowdsourcing approaches now include the ability to migrate intellectual property rights along with the ideas—for example, the InnoCentive platform. And more of the knowledge work, accompanying even highly physical innovations, is appearing online, often with emergent standards and markup languages, such as the “chemical markup language” to manage information and research centered on molecules. It can be expected that this trend will continue, enabling an ever greater openness to the innovation process. These themes and their attendant examples are examined at length in Don Tapscott and Anthony Williams’s best-selling work, Wikinomics.⁴

Problem Solving in Chat Rooms

Even before the current incarnation of the World Wide Web with its user-friendly interface, groups of users were banding together in USENET communities to exchange ideas, practices, fixes to faulty hardware and software, and otherwise share innovations. Chat rooms are a “wikinomical” example familiar to a great many customers and stand in stark contrast to the expert helplines of old. Questions posed within a chat room often seem to get answered more rapidly and with greater reliability than when those same questions are posed to technicians working for the product company and even specifically trained to respond to customer needs. Reasons for why this is so include issues of self-selection and experiential diversity, topics which won’t be expanded on here but receive more discussion later.

Chat room stories are reflected in other social media as well, such as wikis and blogs, and again testify to the capability of such tools to aggregate what might be deemed “collective intelligence,” or more simply, the “wisdom of the crowd.” Although this notion is discussed in Chapter 4, “The Long Tail of Expertise,” the phenomenon of crowd wisdom or intelligence is not described at length for the simple reason that better analyses may be found by reading The Wisdom of Crowds,⁵ Wikinomics,⁶ Social Nation,⁷ salient articles and books by Eric von Hippel, or in the impressive efforts of the Center for Collective Intelligence at MIT under the direction of Professor Thomas Malone. That is not to say that present-day study or knowledge about such phenomena is anywhere near complete, or even well documented. Indeed, it is no doubt in its infancy. This book’s intent is to show how such capabilities change the game of innovation and how businesses that want to effectively compete must forge a deliberate strategy for their adoption and implementation.

Not by Bread Alone: Diverse Utilities

One criticism leveled against such open approaches is that they seem to be inherently “second-rate” and unsustainable. After all, how can an open wiki, such as Wikipedia, ever produce articles of quality commensurate with those produced by hand-picked experts who are compensated for their work and thereby motivated to ensure the article’s scholarship and accuracy.

Frequently, overlooked in these criticisms is the economic concept of mixed utilities. Economics, which has sought to rationally explain the motives behind the exchange of goods and the behavior of markets has, in some sectors, recently devolved into an analysis of monetary policy and corporate financials. In the recent global economic crisis of 2008–2010, much has been written about “the new capitalism.” One characteristic feature of “the new capitalism” is that it involves more than just money. This new economic frontier suggests that people actually work and contribute for reasons other than money, and that sometimes their choice making cannot be rationalized on a monetary basis alone. We read these things not with disagreement, but amusement. The “new economics” smells a lot like the old, old economics. In the 1700s and 1800s, utilitarian economists such as Jeremy Bentham and John Stuart Mill, wrote of maximizing—not cash, but—happiness. Admittedly, happiness is a far more difficult metric than dollars to plug into the latest Monte Carlo simulations.

Dusting off both the oldest and the newest economic theories is necessary to explain the engagement of passionate, but “unpaid,” individuals, whether they are troubleshooting a lens compatibility problem, blogging their perspective on health care, writing an article on solar energy for Wikipedia, or solving a complex challenge to improve the quality of space food posted on InnoCentive. One of several recent phenomena in innovation—but largely closed to closed innovation—is this ability to attract many diverse motives and utilities—held by contributors who more than gladly accept payment on a much broader basis than cash alone. Exploiting those utilities, while not exploiting the individuals, is a crucial part of learning to organize and work in new and unfamiliar ways.

Count What Counts

Albert Einstein once said, “Not everything you can count counts.” To function under this new order, you not only need to organize and work in new ways, but to change the very metrics for reporting and judging performance—both at the corporate and individual level. The present measurements all too often stand as outright barriers to real progress. A simple example will help make this point: In a closed shop, one of several measurements might be total expenses per employee—salaries, benefits, and their consumption of materials such as travel, paper, chemicals, and so on. The efforts of management to pay fairly, but not excessively, to avoid waste, to fully use existing equipment (that is, not replace laptops every year) all suggest that this measurement is a number that should be minimized. And, as such, managers may set expense targets per employee, not to be exceeded.

Yet, in an open environment—in which each internal employee is seen as a point of leverage to multiple external contacts and ideas, each of which represents a variable and not a fixed expense—this measurement of expenses per employee should be maximized. Thus, a company that retains its old metrics of cost-per-employee minimization, while espousing a strategy of openness, is probably doomed to failure. Although this example serves to illustrate the often oxymoronic, and sometimes just plain moronic, conflict between old productivity metrics and new ways of working, maybe one slightly more sophisticated example is in order.

In the world of business, gross profit margin is a percentage where, simply, bigger is seen as better. It is a financial measure often sought out for comparison between corporations, within the same general sector, and another example of a number for which the simple objective of maximization is usually applied. The gross profit margin for any item is the percent of cash obtained on each sale after subtracting the cost of producing that good (many times abbreviated as COGS, costs of good sold). A $200 digital camera, may require $80 of parts and labor to assemble. The $120 is the profit representing a gross profit margin of 60%. A higher gross profit margin is usually perceived as providing greater latitude in the use of the cash (price minus COGS) for purposes of investment in future products, investment in marketing, distribution as profit to shareholders, or for capital acquisitions. Affiliates and sales forces are usually mindful that the gross margin differs from product to product, and thus that the overall corporate gross margin is enhanced by selling a disproportionately larger number of products with the smallest COGS.

Open innovation can often run afoul of this measurement because R&D investments in that product, or even ongoing improvements, are considered a sunk internal R&D expense, and that’s not reflected in the COGS, resulting in exaggerated gross margins. However, externally derived products, in which the R&D investment risk occurred in a different organization, are often acquired with a royalty obligation, on sales, to be paid to the innovator, a number that is usually allocated to the COGS. Consequently, even a beneficially negotiated royalty rate can lead an affiliate, rewarded on the basis of its gross margin, to be motivated to sell the internally derived product even if it represents a net lesser value to the organization and a poorer long-term economic picture. When embarking on program of open innovation, rethink metrics and heed Einstein’s advice.

All of a Sudden

Some of the barriers discussed in this chapter serve to illustrate why there was not, and will not be, a spontaneous disintegration of the corporation under a new environment of significantly altered transaction costs. Of course, over time, the stubbornness of culture, the psychological barriers of control, the unfamiliarity of new IP terms, the incompatibilities of metrics and strategy, the masking of transaction costs as institutionalized costs of doing business, and the mixed utilities complicating both cost and return will get ironed out. The corporate cultures undergo their slow shifts. The bureaucracies cede to competitive realities, and regulators grudgingly yield to the pragmatic wills of consumers. In those instances, it’s important to have an underlying model and understanding of the forces and drivers and the directions that they are pushing.

Recent discussions with Thomas Malone, at MIT, have found him scratching his head and wondering whether or not his crystal ball was on the fritz when, in 2004, he wrote, The Future of Work, predicting many of the changes described here. But changes are underway and we are reminded of an exchange between Hemingway characters in The Sun Also Rises: “How did you go bankrupt?” Bill asked. “Two ways,” Mike said. “Gradually and then suddenly.”⁸ And so cultural change and organizational change often appears to be progressing “gradually” at first, and about the time you are ready to abandon your predictions, the change occurs “suddenly.” During the gradual phase, the reality of the change is doubted by many. It’s all just a matter of “waiting it out.” The good old days are just around the corner. But then, suddenly, the business is gone, the opportunities are gone, and you are left wondering how so much could happen so fast. Looking again at Peter Drucker’s quote, at the opening of this chapter, you can pause and do the math; it is now more than a decade old, and in many ways we don’t seem much closer to his dire prediction that we were in 2000. But 10 or 15 years is more than enough time for the “all of a sudden” phase.

Change is often categorized as evolutionary or revolutionary—the first characterized generally by slowness and subtlety and the second by speed and shock. Is this shift from closed innovation to open innovation—a change that threatens to escalate the vertical disintegration of corporations—evolutionary or revolutionary? The evolutionary argument is made strongly on the basis that the selective pressures, that is, Coase’s transaction costs, are still at work in shaping the emergence of new business species and the extinction of old ones.

But any established corporation that wants to transcend this change and emerge as a competitor for the future is going to have to make radical shifts in the way it organizes, the way it rewards, and in the way it measures its performance, especially in the areas of innovation. To the leaders who have dared to implement such change, at a time when things seem to be evolving slowly, it’s going to feel, indeed, it is going to be, revolutionary.

The simple truth is: You must revolt to evolve.

Case Study: How Orchestration Creates Value for Li and Fung

Each year it produces more than 2 billion toys, consumer items, and articles of clothing, and yet it owns not a single manufacturing facility. It stocks the shelves of many famous retail chains without a shipping department. It is responsible for the continued employment of 2 million persons around the world; and yet, only ½ of 1 percent of those carry a company ID card. Might it be some “new economy” startup, funded out of Silicon Valley, a Threadless 3.0? Actually, it has been in business not only before the Internet existed, but years before the first radio broadcasts by Charles Herrold. It is Li and Fung, founded toward the end of the Qing Dynasty, in 1906, in Guangzhou, China. It brokered trade in its early days, evolved into a Hong Kong-based exporter, and finally became a multinational corporation. In the early ‘80s, it examined its business model and began operating in the unusual manner that characterizes it today.

The approach used by Li and Fung has been described by John Hagel and John Seely Brown as “process orchestration.”⁹ The network that it “orchestrates” includes more than 8,300 suppliers located in more than 40 countries. It was among the first to ship final product labels, showing the actual retail price, direct to manufacturers, who included them with the products, and then shipped directly to the retail outlet, saving weeks over the normal processes of receiving at a wholesaler’s facility, repackaging, and then finally pricing. At the time, the move was radical. Why would any intermediary choose to be so transparent about retail pricing with a supplier who might use the information to squeeze a few extra cents into its wholesale price? Of course, the information, so closely held, was available to any consumer who walked in the store. But the mentality at the time was to play that card close to the vest. However, as Li and Fung began collaborating, instead of competing, with its own supply chain, it shaved time (and cost!) off many steps of the process, much more than the few cents that might arrive in a wholesaler’s hands. In all, it was a more economical process that created greater value for producers, middlemen, and of course, Li and Fung.

Victor and William Fung, along with Jerry Wind, of the Wharton School, captured the elements of its success in the book Competing in a Flat World: Building Enterprises for a Borderless World. Therein they say, “What the discipline of management was to the old vertically integrated, hierarchical firm, network orchestration is to the company working in the flat world. It is an essential capability for this world, from orchestrating virtual networks such as Wikipedia and open-source software to delivering hard goods through global manufacturing,”¹⁰ and “The movement from a traditional firm toward network orchestrator requires a shift in focus from the firm to the network, a shift in management from control to empowerment, and a shift in value creation from specialization to integration.”¹¹ The reality is that the management skills practiced, honed, and rewarded for decades don’t prepare current executives for the shift to the role of orchestrator. And yet it does not lie entirely outside of their grasp, as illustrated by Li and Fung’s long history and deep, cultural traditions prior to its transformation.

John Hagel, Scott Durchslag, and John Seely Brown identify three key steps in a migration path from a traditionally managed firm to a more effective entity employing the art of orchestration: 1) orchestration skill-building, 2) self orchestration, and 3) process network orchestration.¹² It is unlikely that these steps will be undertaken and effectively completed without deliberate decisions by senior management. Senior managers must recognize that their mandate to create value applies not only to the present but also to the future, in which the world becomes increasingly flatter. The time to begin building the organization’s orchestration skills is now.

Even in the most carefully vertically integrated corporation, there will exist supply and value chain mismatches in scale. It is these mismatches that create the opportunity to use those newly acquired orchestration skills to more loosely couple the value chain segments. In other words, allow downstream components to access supply from external sources and internal ones. Compete even. Is the external product outperforming in features, quality, or price? You can recouple the value chain and force your company to use its inferior, internally derived product. But where’s the wisdom in that? And further, allow upstream components to overproduce in circumstances when they can gather value by supplying external users with their product. Taking these steps in the near term can help an executive team prepare for the longer term.