Rebalancing the Business Model

Companies won't choose the layered/outsourced route without a more rigorous analysis of the opportunities for value creation.

For the past two years, leading IT suppliers have begun to reintegrate their supply chains in a partial turn from their previous specialization on hardware, software, data base, applications or networking, etc.

The older specialized business model led inevitably to commoditization, lacking enough differentiated customer value to sustain the gross margins necessary for innovation and profit. The new, increasingly integrated model looks more like Apple whose iPhone profitably controls the entire consumer experience from elegantly designed hardware to sparkling user interface to heavily vetted applications to sales channel to convenient payment mechanism.

Does this new business model signal a sea change among businesses as a whole as it sometimes has in the past?

To start, a little background: Thirty years ago, the IT sector underwent a profound transition as the industry's leaders IBM and Digital Equipment collapsed before Intel, Microsoft, Oracle, Sun Microsystems and others.

One apparent catalyst was the old guard's vertical integration of multiple computing "layers" from circuits to boxes to operating systems to sales and support. Enter the new breed with its "open" model: each player specialized on a single layer or two. Intel offered microprocessors. Microsoft initially offered operating systems and a few "horizontal" applications like Word and Excel; Oracle focused on data bases, then added applications; Sun focused on hardware, adding the Solaris operating system only when Unix failed to gain support from IBM, Digital and others.

Personal computer makers like Compaq and Dell pulled the pieces together at gross margins ten to twenty percentage points lower than the traditional computer suppliers. The old guard's uncompetitive business models brought many of them down in the early nineties.

But the layered model had run out of steam fifteen years later. Many of the major players began carefully reintegrating products and components wherever integration could add customer value. Consider their M&A activity since 2008.

  • Network equipment leader Cisco made a frontal assault into servers and "virtualized" data centers through Acadia, its joint venture with EMC and VMware. No one else could produce an equally innovative computing fabric, argued Cisco's leadership.
  • Oracle acquired Sun Microsystems. Its engineers then integrated data base and servers until its Exadata applications appliance could run far faster and more cost effectively than companies working across separate layers. No one else could unlock such powerful customer value through technology integration, reasoned Oracle management.
  • HP acquired EDS to pull product through its outsourcing contracts. It then bought networker 3Com to counter Cisco, and smart phone Palm to enter the mobile Internet market. The potential integration of computers, networks and the mobile Internet would provide customers with an unparalleled extension of conventional computing, HP executives projected.
  • Emulating HP, Dell bought Perot Systems to pull products through its outsourcing contracts. But a more important opportunity was leveraging Dell's leadership position in cloud computing hardware into health care, education and small business where Perot holds major market share. Cloud computing could translate into software-as-a-service (like Salesforce.com) for these fast-growing sectors
  • SAP acquired data base maker Sybase supposedly to enter the fast-growing mobile Internet business popularized by Apple. IBM has always been vertically integrated in product lines where that approach made economic sense.

Clearly the times have changed. These newly integrated offerings can provide customers more differentiated value than had the separate layers, which could, in turn, bring suppliers more pricing discipline.

Reintegration may also begin to resonate in other sectors. Boeing recently acquired Vought's southern plants in a reversal of the excessive outsourcing which delayed the Dreamliner. BP may also have to reverse its extreme reliance on outsourcing and assume a business model closer to rival ExxonMobil. General Motors has acquired Delphi Steering to protect its supply source and American Credit to offer automobile customers a wider range of financing options. And longer term may start moving closer to the business model followed by competitor Ford. In yet another strategic reversal, Coca Cola and Pepsi have acquired their major bottlers to gain control over distribution as their product lines broaden to the point of fragmentation.

There are many reasons to rethink outsourced supply chains, including two that are interconnected -- energy prices and corporate sustainability policies. On balance, it makes less sense to transship heavy components just to lower assembly labor costs. The heightened threats of industrial espionage and theft of intellectual property provide a third incentive. True cyber spies are no respecters of national boundaries or distance. But the tight Internet links that facilitate efficient order processing and inventory replenishment are also a gateway to malware even among "trusted" partners.

For the IT sector at least, the greatest incentive to reverse the layered strategy is the recognition that integration can add more customer value at each layer. Sometimes that value comes from hardware and software more finely tuned to specific applications. Sometimes it results from streamlining the linkages between servers, applications and mobile devices. And elsewhere, it's simply a matter of assuming the burden of strapping together incompatible systems - a cost previously left to the customer. Those evolved priorities are already evident at Cisco, Oracle, HP and Dell.

Obviously, this isn't a monolithic trend. IT firms will continue to depend on their suppliers and independent distribution channels for the bulk of their needs where this strategy makes sense. So will businesses outside the technology sector. But they won't choose the layered/outsourced route without a more rigorous analysis of the opportunities for value creation.

Ernest von Simson is a senior partner of Ostriker von Simson, a consultancy which assists the largest worldwide enterprises in the selection and deployment of advanced technologies. He is co-director of the CIO Strategy Exchange, a private sector think tank serving top CIOs. He is author of "The Limits of Strategy: Lessons in Leadership from the Computer Industry."

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