Here is an excerpt from an article written by Michael E. Porter and James E. Heppelmann for Harvard Business Review and the HBR Blog Network. To read the complete article, check out the wealth of free resources, obtain subscription information, and receive HBR email alerts, please click here.

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Information technology is revolutionizing products. Once composed solely of mechanical and electrical parts, products have become complex systems that combine hardware, sensors, data storage, microprocessors, software, and connectivity in myriad ways. These “smart, connected products”—made possible by vast improvements in processing power and device miniaturization and by the network benefits of ubiquitous wireless connectivity—have unleashed a new era of competition.

Smart, connected products offer exponentially expanding opportunities for new functionality, far greater reliability, much higher product utilization, and capabilities that cut across and transcend traditional product boundaries. The changing nature of products is also disrupting value chains, forcing companies to rethink and retool nearly everything they do internally.

These new types of products alter industry structure and the nature of competition, exposing companies to new competitive opportunities and threats. They are reshaping industry boundaries and creating entirely new industries. In many companies, smart, connected products will force the fundamental question, “What business am I in?”

Smart, connected products raise a new set of strategic choices related to how value is created and captured, how the prodigious amount of new (and sensitive) data they generate is utilized and managed, how relationships with traditional business partners such as channels are redefined, and what role companies should play as industry boundaries are expanded.

The phrase “internet of things” has arisen to reflect the growing number of smart, connected products and highlight the new opportunities they can represent. Yet this phrase is not very helpful in understanding the phenomenon or its implications. The Internet, whether involving people or things, is simply a mechanism for transmitting information. What makes smart, connected products fundamentally different is not the Internet, but the changing nature of the “things.” It is the expanded capabilities of smart, connected products and the data they generate that are ushering in a new era of competition. Companies must look beyond the technologies themselves to the competitive transformation taking place. This article, and a companion piece to be published soon in HBR, will deconstruct the smart, connected products revolution and explore its strategic and operational implications.

The Third Wave of IT-Driven Competition

Twice before over the past 50 years, information technology radically reshaped competition and strategy; we now stand at the brink of a third transformation. Before the advent of modern information technology, products were mechanical and activities in the value chain were performed using manual, paper processes and verbal communication. The first wave of IT, during the 1960s and 1970s, automated individual activities in the value chain, from order processing and bill paying to computer-aided design and manufacturing resource planning. (See “How Information Gives You Competitive Advantage,” by Michael Porter and Victor Millar, HBR, July 1985.) The productivity of activities dramatically increased, in part because huge amounts of new data could be captured and analyzed in each activity. This led to the standardization of processes across companies—and raised a dilemma for companies about how to capture IT’s operational benefits while maintaining distinctive strategies.

The rise of the Internet, with its inexpensive and ubiquitous connectivity, unleashed the second wave of IT-driven transformation, in the 1980s and 1990s (see Michael Porter’s “Strategy and the Internet,” HBR, March 2001). This enabled coordination and integration across individual activities; with outside suppliers, channels, and customers; and across geography. It allowed firms, for example, to closely integrate globally distributed supply chains.

The first two waves gave rise to huge productivity gains and growth across the economy. While the value chain was transformed, however, products themselves were largely unaffected.

Now, in the third wave, IT is becoming an integral part of the product itself. Embedded sensors, processors, software, and connectivity in products (in effect, computers are being put inside products), coupled with a product cloud in which product data is stored and analyzed and some applications are run, are driving dramatic improvements in product functionality and performance. Massive amounts of new product-usage data enable many of those improvements.

Another leap in productivity in the economy will be unleashed by these new and better products. In addition, producing them will reshape the value chain yet again, by changing product design, marketing, manufacturing, and after-sale service and by creating the need for new activities such as product data analytics and security. This will drive yet another wave of value-chain-based productivity improvement. The third wave of IT-driven transformation thus has the potential to be the biggest yet, triggering even more innovation, productivity gains, and economic growth than the previous two.

Some have suggested that the Internet of things “changes everything,” but that is a dangerous oversimplification. As with the Internet itself, smart, connected products reflect a whole new set of technological possibilities that have emerged. But the rules of competition and competitive advantage remain the same. Navigating the world of smart, connected products requires that companies understand these rules better than ever.

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Here is a direct link to the complete article.

Find our month long series of articles on the Internet of things here.

For a full discussion of competitive strategy, please click here to check out Michael Porter’s article “The Five Competitive Forces That Shape Strategy” (HBR, January 2008).

Please click here to visit our companion case study and video on how Joy Global’s smart, connected mining equipment transforms mine performance.

Michael E. Porter is the Bishop William Lawrence University Professor, based at Harvard Business School. James E. Heppelmann is the president and CEO of PTC, a Massachusetts-based software company that helps manufacturers create, operate, and service products.