Architectural Innovation: Taking control of the value chain

January 4th, 2011 by Patrick Stähler

Architectural innovations are often what customers do not see immediately but there are core of any good strategy. While in the last years we saw a trend toward concentration on core activities like marketing and branding, some companies take the opposite route. And that is good.

I was recently in Egypt to give a workshop on business model innovation. I received an invitation from the Executive Institute, a young and upcoming executive education institute based in Cairo. I was absolutely intrigued by the participants and their entrepreneurial drive. We can all learn from them in the so-called developed countries since they are true entrepreneurs and risk-takers. Participants came from different backgrounds ranging from food and telco, real estate development to plumbing and fixings.

Concentrate on the core

The traditional view on the value chain is to concentrate on the core activities. So almost all consumer electronics, computer or mobile equipment firms have outsourced their production to specialized manufacturers, so-called contract manufacturers or electronics manufacturing services (EMS). The western firms like Apple, Dell or IBM concentrate on the design, R&D, marketing and sales of the devices and leave the manufacturing to EMSs like Flextronics(165.000 employees) or Foxconn (113.000 employees).  Outsourcing manufacturing to specialized firms is the norm in their industries. Foxconn manufacturers for Apple and Intel while Microsoft is a customer of Flextronics.

This architectural or operational model looks very convincing since the story line “Concentrate on the core” sounds very plausible. By concentrating on your core capabilities, you focus on what you are strong at. In the case of Apple, that is design, usability, marketing and branding.

The perils of the “core”

However, there is a peril in this model as well, particularly when you are not as strong in core capabilities. E.g. Hong-Ta Corporation was the manufacturer of the innovative Palm Treo 650 or of the Compaq iPaq, one of the first smartphones.  Today, HTC as the firm is known today is very strong in smartphones and was one of pioneers in phones with Google’s operating system Android. Interestingly, Palm and Compaq are today irrelevant in the growing markets for smartphones. And both former pioneers are now part of Hewlett Packard.

Backwards Integration: You can do the opposite as well

At the same time as the IT and electronics industries are following the mantra of “concentrating on core competencies” other firms in other industries do just the opposite. Let’s look at food companies.

Gozour moving into farming

In Egypt fresh milk is a hot topic, but to guarantee the quality of fresh milk is difficult. Therefore, Gozour, a regional multi-category integrated agro-food company, acquired Dina farms, the leading producer of fresh milk in Egypt with a capacity of 45,000 tons and more than 6,000 heads of cattle. At the same time, the firm seized the largest farm in Sudan for sesame seeds to provide a safe and sustainable source for its core supply for some of its products. Both acquisitions are an example for a classical backward integration into real physical assets. The reason for the second acquisition was to hedge its supply from price increases due to speculation in raw material.

This trend towards backwards integration into farmland is widely spread in the food industry. The reason is secure basic food supply. E.g. China is investing heavily into Africa to secure its growing food demand. Interestingly, western companies still divest some of the farmland they own like Unilever that sold its palm oil plantations in Congo in 2009.

Backwards and Forward Integration: American Apparel as a control freak

American Apparel is a strange kid on the block in the fashion industry. While most fashion companies concentrate on the core of its brand (design, branding), American Apparel is a wholly integrated fashion retailer AND manufacturer. American Apparel does not only manufacturer its cloth in its own factories in Los Angeles but also owns and operates its own dye house and knitting facilities in the USA.

Most analysts would call American Apparel crazy to produce in the US and paying an hourly wage of 12 USD vs. .40 USD in China. But, this alleged disadvantage is exactly their biggest advantages for American Apparel. While other fashion companies are just design and branding agencies American Apparel’s value proposition of genuine and fair produced American goods appeal to its customers without too much advertising spending. Producing in the US and treating their workers fair is the unique positioning other fashion companies cannot copy. American Apparel walks its talk. Something very special in an industry that mostly depends on creating illusions (empty brand promises).

Forward integration: Luxury goods companies move into retailing

While American Apparel is wholly back- and forward integrated company, other fashion companies establish their own retail channels. When you scroll through the largest cities in the world, you see that more and single branded shops appear. While in the past, jewelers had a wide choice of the top brands, more and more single branded jewelers appear on Main Street. IWC, the Swiss top watch manufacturer, has its own shops, as do Cartier or Chopard. Or look for Montblanc, Gucci or Hermes shops. They are all copying the concept of Mango or Zara, the Spanish fashion manufacturers and retailers. Even brands for the middle class move into specialist, mono brand shops like Beldona or Triumph in women’s underwear. Or take a look a mono branded shops from Puma, Adidas or Nike.

At the same time, these companies broaden their offering. E.g. Montblanc, once known for its classical writing instruments, moved into watches, jewelry, leather, eyewear and even fragrance to become just an “ordinary” luxury goods company.

The reason why these firms forward integrate is simple: First, they want to control and guarantee the customer experience and their brand promise end-to-end, including in the distribution channel. Secondly, they want to participants in the margin they can earn in retailing. In some industry, retailing contributes to 50% of the end price of a good.

Lessons-learned

  • The longer I work with business model innovation, the more I get bored by “one solution fits all” in a specific industry. The art of management and entrepreneurship is exactly to find a solution that makes you positively unique in the eyes of your customers. By the way, at the same time, I get bored by the mono brand stores and shop in shop concept in large department stores, but that is just my personal opinion 😉
  • In management, we believe too often that there is just one right way to do business. And analysts pressure firms into what everybody else is doing.
  • Actually, the opposite is true, as long as you have a good reason to do so. If you do what everybody else is doing in your industry, you are no different. You have no value proposition your customers will love since they cannot even see a difference between you and your competitors. Be different and have profile. Be brave and accept that being different means also that you expose yourself to criticism.
  • Learn less from your competitors in your close industry but from other industries.

13 Responses to “Architectural Innovation: Taking control of the value chain”

  1. Kay Plantes Says:

    Terrific Patrick. There are no rules for what works and what works well at one point in time (Microsoft being a specialist beat integrated Apple) does not work at other times in an industry’s evolution. What works is a unique business model, in which decisions about integration are driven by your value promise. Here in the US I am very concerned about how we’ve outsourced manufacturing for the very examples your cited about Palm, etc.

    Why do you think leaders seek out and follow management trends without thinking about what really works for them?

  2. Patrick Stähler Says:

    @Kay It is much easier to go with the crowds. You do need a lot of courage to do your own thing. Following the herd is easier in the short run.
    The second reason is that we concentrate too much on competitors and market intelligence. We should spent more time with customers and with what we are doing to make our current and future customers excited. Do less market studies, talk more to your clients and understand their needs better than theirselves!

  3. Mary Poul Says:

    Hi Patrick – I wonder how often the “core strategy” is following the Innovator’s Dilemma as well. If one takes a systems view, the smart management action might not remain smart once all competing companies take the same action. The trick is to take management actions that others would find foolish to follow but are still smart for your business. Quite often this results in a unique and sustaining business model. Think how long Southwest Airlines rode their management decisions before ANYONE decided to follow?

  4. Patrick Stähler Says:

    @Mary The systems view is the right one when looking at management or firms. A business is never alone but interconnected and interwoven with customers, suppliers and competitors. It is a ecosystem where you have to survive. And in this ecosystem not the biggest survives but the fittest. Interesting thoughts you added. Thanks.
    Patrick

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  13. Architect Says:

    Well put.

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