slide 1 © carliss y. baldwin and kim b. clark, 2004 designed to evolve: winning strategies for...

© 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


Three parts to this presentation

Option-Rich, Modular Design Architecture (ORMDA)

You live in an ORMDA if …

Winning Strategies for ORMDAs


Part 1—Option-Rich Modular Design Architectures


First, some definitions—


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


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


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)


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


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


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


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


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


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!


Life Cycle of a Design Architecture


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


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


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


Loss of control, loss of advantage

NOT a winning strategy!


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!


Unconscious strategy…

IBM meant to retain control;

Spent a lot of $$ trying to get it back,

With no success!


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


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


ORMDAs are—

“Compelling, surprising, and dangerous…”

End of Part 1


How do you know if you “live” in an ORMDA?


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


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


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


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)


Vertical-to-Horizontal Transitions In 1995, Andy Grove described a vertical-to-

horizontal transition in the computer industry:

“Modular Cluster”

“Vertical Silos”


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 $


Andy’s Movie

The Computer Industry in 1995SPERRY D CVCU H E

IBM N P CSY XRCSAMP

TI Intel



ServicesFirst Data

Systems Integration EDSOracle

I CAApplications Layer B MSFTMiddleware Layer M

Operating Systems

Hardware: Printers HPHardware: Servers IBMHardware: Routers Cisco

Components IntelMicron


Andy’s Movie—the Sequel

The Computer Industry in 2002SPERRY D CVCU H E

IBM N P CSY XRCSAMP

TI Intel



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


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


ORMDAs are —


End of Part 2


Winning Strategies for ORMDAs


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


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


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

+ { … }+ { … . }


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


It’s all about ROIC (Return on Invested Capital)

Game 1: High , High Cost Modules


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


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!


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


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


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


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


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!


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 …


It’s all about M&A (Mergers & Acquisitions)

Game 2: High , Medium Cost Modules


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


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…


Strategy is almost a Bayesian-Nash subgame perfect equilibrium

IBM’s former “we own it all” strategy is not!


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)


A new battle is shaping up

Cisco vs. Juniper The market loves Juniper Substantial ROIC advantage to Cisco

Anyone want to bet?


ORMDAs are —


and a lot of fun if you know what’s going on!

End of Part 3


Questions?

Comments?


Thank you!

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