Occasionally, I provide an excerpt from a classic article, in this instance one co-authored by John Hagel III and Marc Singer for the McKinsey Quarterly (in 2000), published by McKinsey & Company. They explain how and why the forces that fractured the computer industry are bearing down on all industries. In the face of changing interaction costs and the new economics of electronic networks, companies must ask themselves the most basic of all questions: what business are we in? To read the complete article, check out other resources, learn more about the firm, obtain subscription information, and register to receive email alerts, please click here.
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In the late 1970s the computer industry was dominated by huge, vertically integrated companies such as IBM, Burroughs, and Digital Equipment. With their vast advantages of scale and huge installed base of users, these companies seemed to be unassailable. Yet just ten years later, power in the industry had shifted: the behemoths were struggling to survive while an army of smaller, highly specialized companies was thriving. What happened?
The industry’s transformation can be traced back to 1978, when a then-tiny company, Apple Computer, launched the Apple II personal computer. The Apple II’s open architecture unlocked the computer business, creating opportunities for many new companies that specialized in producing specific hardware and software components. Immediately, the advantages of the generalist—size, reputation, integration—began to wither. The new advantages—creativity, speed, flexibility—belonged to the specialist.
The story of the computer industry illustrates the crucial role that interaction costs play in shaping industries and companies. These costs represent the money and time expended whenever people and companies exchange goods, services, or ideas.1 The exchanges can occur within a company, among companies, or between a company and a customer, and they can take many everyday forms, including management meetings, conferences, phone conversations, sales calls, reports, and memos. In a real sense, interaction costs are the friction in the economy. Taken together, they determine the way companies organize themselves and form relationships with other parties. All else being equal, a company will organize in whatever way minimizes overall interaction costs.
Apple’s open architecture sharply reduced interaction costs in the computer industry. By conforming to a set of well-documented standards, specialized companies could, for the first time, work together easily to produce complementary products and services. As a result, tightly coordinated webs of companies—such as Adobe Systems, Apple, Intel, Microsoft, Novell, and Sun Microsystems—could form and ultimately compete effectively against the entrenched, vertically integrated giants. Many of the new companies grew very large very quickly, but they never lost their focus on specialized activities.
The moral of the story is that changes in interaction costs can cause entire industries to reorganize rapidly and dramatically. Today, that fact should give all managers pause, for the world economy is on the verge of a broad, systemic reduction in interaction costs. Electronic networks, combined with powerful PCs, are permitting companies to communicate and exchange data far more quickly and cheaply than ever before. As business interactions move on to electronic networks such as the Internet, basic assumptions about corporate organization will be overturned. Activities that companies have always believed to be central to their businesses will suddenly be offered by new, specialized competitors that can do those activities better, faster, and more efficiently. Executives will be forced to ask the most basic and discomfiting question about their companies: what business are we really in? The answers will determine their fate in an increasingly frictionless economy.
One company, three businesses
Beneath the surface of most companies are three kinds of businesses—a customer relationship business, a product innovation business, and an infrastructure business. Although organizationally intertwined, these businesses differ a great deal (see exhibit within article).
Rethinking the traditional organization
The role of a customer relationship business is, obviously, to find customers and build relationships with them—for example, the marketing function of a bank or a retailer’s focus on drawing people into its branches or stores. Another set of employees—loan officers or store clerks, perhaps—assists customers and tries to build personal relationships with them. Still other employees may be responsible for questions and complaints, processing returns, or collecting customer information. Although these employees may belong to different organizational units, they have a common goal: to attract and hold on to customers.
The role of a product innovation business is to conceive of attractive new products and services and figure out how best to bring them to market. In a bank, employees in various product units or in a centralized business development function are responsible for researching new products (such as reverse mortgages) and ensuring that the bank can bring them to market successfully. In a retail business, buyers and merchandisers perform the product innovation role, constantly searching for interesting new products and effective ways of presenting them to shoppers.
The role of an infrastructure business is different again: to build and manage facilities for high-volume, repetitive operational tasks such as logistics and storage, manufacturing, and communications. In a bank, the infrastructure business builds new branches, maintains data networks, and provides the back-office transactional services needed to process deposits and withdrawals and present statements to customers. For retailers, the infrastructure business constructs new outlets, maintains existing outlets, and manages complex logistical networks to ensure that each store receives the right products at the lowest possible cost.
These three businesses rarely map neatly to a corporation’s organizational structure. Rather, they correspond to what are popularly called “core processes”—the cross-functional work flows that stretch from suppliers to customers and, in combination, define a company’s identity.
Managers talk about their key activities as “processes” rather than as “businesses” because, with rare exceptions, they assume that the activities ought to coexist. Almost a century of economic theory underpins the conventional wisdom that the management of customers, innovation, and infrastructure must be combined within a single company. If those activities were dispersed to separate companies, the thinking goes, the interaction costs required to coordinate them would be too great.
Working from that assumption, large companies have in recent years spent a lot of energy and resources reengineering and redesigning their core processes. They have used the latest information technology to eliminate handoffs, cut waiting time, and reduce errors. For many companies, streamlining core processes has yielded impressive gains, saving money and time and giving customers more valuable products and services.
But managers have found that there are limits to such gains. Sooner or later, companies come up against a cold fact: the economics governing the three core processes conflict. Bundling them into a single corporation inevitably forces management to compromise the performance of each process in ways that no amount of reengineering can overcome.
Take customer relationship management. Finding and developing a relationship with a customer usually requires a big investment. Profitability hinges on achieving economies of scope—extending the relationship for as long as possible and generating as much revenue as possible from it. Only by gaining and retaining a large share of a customer’s spending can a company earn enough to offset the up-front investment. Thus, customer relationship businesses naturally offer customers as many products and services as possible, which requires an intensely service-oriented culture.
Contrast that kind of business with a product innovation business, in which speed, not scope, drives the economics. The faster an innovation business moves a product or service from the development shop to the market, the more money the business makes. Culturally, product innovation businesses concentrate on serving employees, not customers. They do whatever they can to attract and retain the talent needed to come up with the latest and best product or service. They reward innovation, and they try to minimize administration.
If scope drives customer relationship businesses and speed drives innovation businesses, scale is what drives infrastructure businesses. Such businesses generally require capital-intensive facilities, which entail high fixed costs. Since unit costs fall as scale increases, pumping large amounts of product or work through the facilities is essential for profitability. As a result, the culture of infrastructure businesses reflects a one-size-fits-all mentality that abhors all customization and special treatment.
The regional Bell operating companies (RBOCs)—local telephone carriers in the United States—provide a good example of how these tensions can play out. An RBOC’s retail telephone operation is a customer relationship business; it focuses on acquiring customers and keeping them happy. By contrast, the wholesale telephone operation is an infrastructure management business; it maintains the RBOC’s physical communications facilities and furnishes specialized support services such as network management. To maximize economies of scale, the RBOCs could lease their wholesale facilities to telephone service resellers, which focus on the customer relationship business. But the telephone companies are wary of entering into such alliances because they fear that resellers will drain customers away from their own retail telephone businesses.
RBOCs have, in other words, deliberately limited the growth and profitability of their infrastructure businesses to protect their customer relationship businesses. That decision has encouraged specialized infrastructure businesses, which operate their own fiber-optic networks, to enter the competitive fray in metropolitan areas, creating a further threat to the RBOCs.
Most senior managers make such compromises because they believe, or assume, that they have no option. How, after all, can a core process be removed from a company without somehow undermining its identity or destroying its essence? Such a mind-set, though historically justified, is now becoming increasingly dangerous.
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Here is a direct link to the complete article.
John Hagel is an alumnus of McKinsey’s Silicon Valley office, and Marc Singer is a principal in the San Francisco office. They are the authors of Net Worth: Shaping Markets When Customers Make the Rules (Harvard Business School Press, 1999), from which this article is adapted. This article originally appeared in Harvard Business Review, March–April 1999, and received Harvard Business Review’s1999 McKinsey Award for best article. Copyright © 1999 President and Fellows of Harvard College. Reprinted by permission. All rights reserved.