How Data is Shifting Value Away From Hardware
The following is a summary of the article "Digital Ubiquity: How Connections, Sensors, and Data Are Revolutionizing Business" by Marco Iansiti and Karim R. Lakhani which appeared in the November 2014 issue of Harvard Business Review. Marco Iansiti and Karim R. Lakhani are professors at Harvard Business School.
Change is the Only Constant
For more than 100 years, General Electric (GE) made its money by selling industrial hardware and associated repair services but, in recent years, it found itself losing out to digital technology companies such as IBM and SAP as well as big data start-ups. The new competition tried to shift the focus of customers from reliable hardware to generating new benefits and efficiencies based on data analytics. GE was faced with the threat of becoming a commodity industrial hardware producer.
To comprehend why digital technology is standing traditional business models on their heads, it is important to understand three fundamental principles. First, digital signals, unlike analog ones, can be transmitted without any errors. Secondly, they can be replicated endlessly without any problems or degradation. Finally, once the infrastructure has been created, the information can be shared with incremental customers at negligible marginal cost. Consequently, operational scalability can be enhanced significantly and new and old business processes can be easily combined.
The process started with software giants like Microsoft, who traditionally generated most of their revenues through licensing, started making large investments in cloud computing and analytics for generating service revenues. The shift is now more prevalent with non-software companies such as Becton Dickinson, the medical device maker, and investment management companies such as Wealthfront, who are creating platforms using digital technology to manage processes.
Digital Drives Change
The essentials of any business model are the ability to create customer value and to make money through the creation of that value. Digital technology is changing business models drastically and to understand the change, you only have to look at GE’s wind farm arrangement with global energy giant E.On. In the past, GE would try and take advantage of increased demand for power by trying to sell more turbines and associated hardware. However, in the wind farm deal, E.On can meet increased demand with relatively small additional hardware investments because it is using software to interconnect all of its turbines and benefiting from real-time analytics and dynamic control. GE learned to create customer value by using the data generated by sensors to optimize hardware performance. By charging a percentage of the incremental revenues generated by customers from improved performance, it may sell less hardware but gains from long-term mutually beneficial partnerships.
When Jeffrey Immelt became GE CEO in 2001, the company, though efficient, was under pressure from declining prices for capital goods as a result of intense competition. He accelerated the move towards contract service agreements (CSAs) in which the company assumed full responsibility for complete operational management of equipment including preventive repairs and maintenance. This generated high marginal revenues over the lifetime of the equipment which could run into decades. By 2005, CSAs were making the same contribution to the bottom line as industrial earnings. The company initiative was transforming value creation. Today, along with sensors and microprocessors, the company has embedded software connecting hundreds of thousands of devices in areas as diverse as power plants, jet engines and hospital and medical systems.
New business models based on outcomes create an entirely new set of risks and opportunities. Businesses will be far more dependent on the successful operations of their customers and be subject to the same kind of business risks. However, opportunity does not come without risk and the situation can be managed with the right risk control techniques.