Digital Transformation

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This lesson is from Digital Transformation by Indian School of Business.

Technology-Enabled Disruption

  • Imagine the year is 1876, your boss comes to you with a deceptively simple question. Alexandre Graham Bell has developed a way to transmit voice over wire, what does this mean to us?
  • The world’s leading communications company of the time, Western Union, called Bell’s innovation a toy. And Western Union was not the first company to miss an innovation that would potentially disrupt its industry.
  • The most consistent pattern in business is the failure of leading companies to stay at the top of their industries when technologies or markets change.
  • Not one of the independent disk drive companies that existed in 1976 exists today.
  • Not one of the many computer companies succeed the personal computer business.
  • BlockBuster and Borders gave way to Amazon and Netflix respectively. They were not the only brick and mortar companies to do so.
  • In some countries, there is a level of regulation that protects against such disruption, but even that protection seems hard to sustain, as evidenced by the rapid growth of companies like Amazon and Uber.
  • To be able to understand how an innovation will impact industry and companies is a technology problem that many of you will face if you haven’t encountered it already.
  • I say technology problem, because that upstart startup that is emerging as competition to your product and business model is more likely to be a technology company.
  • Therefore, while skating to where the park is, that is addressing the current needs of your customers and business partners is an important business objective for firms, equally important is skating to where the park is going to be.
    • Wayne Gretzky, the world class ice hockey player
  • So that when your leadership calls you to the table and asks you, what does this new technology mean for us, should we adopt it or should we ignore it?
  • You are able to make at that point, an informed commentary about the trajectory of a technology, the constraints that act upon your firm in responding to it, and most important, shifting your organization to respond to it.
  • We’ll adapt Clayton Christensen’s Disruptive Innovation Framework to assess the characteristics of a disruptive innovation, including how they disrupt established industries.
    • Most disruptions in most industries today are technology enabled, we’ll examine why that is so. We will then apply this framework to the context of the music industry to understand how this industry was completely transformed by technological innovations and technology companies.
    • The disruptive innovation framework was developed by Clayton Christensen, as he lived in the Boston area and watched the collapse of the world’s leading mini computer company, Digital Equipment.
    • If you read all the articles about Digital in the 70s and early 80s, you would discern this portrait of a company that was widely respected and admired the world over.
    • And almost all of the articles attributed Digital’s success to its astute management. However, in the 90s Digital began to unravel, and it was all attributed to managerial incompetence.
    • The very same people that were in charge of the company in the 70s and 80s were now being brandished as incompetent and incapable of vision.
    • Christensen wondered, how is it that good managers get to be bad managers so fast? And how is it that managers that were being hailed for their effectiveness and understanding customer needs, creating superior products, lost this very effectiveness completely within a decade?
    • Another reason, managerial incompetence was not satisfying as the reason for Digital’s demise, was that every mini computer fell apart in unison at the same time.
    • Digital, Data General, Prime, Wang Laboratories, Edgeview’s minicomputer business, it’s like the entire set of companies got gassed out of the system.
    • Further, Christensen observed that the demise of the minicomputer firms began in the 70s, when they were ironically being applauded for good management.
      • At this time, they were ignoring the PC business and the Unix architecture.

Clayton Christensen’s Disruptive Innovation Framework

four catalysts to disruption of an industry

  • Overserving
    • First, observe that every product of every company in every industry is traversing a performance trajectory.
    • Each point in this trajectory is a bundle of features that speaks to your customer utility and satisfaction, as well as to your margins, and other parameters of financial and market performance.
    • With each movement on this trajectory, what you are doing is providing an enhanced set of features to your customers, and with that enhanced set, you are increasing your margins.
    • For example, early spreadsheet software offered limited computing features, but have progressed over time to build in sophisticated computing and even analytics features.
    • And with each additional feature, with each movement on this trajectory, the company is able to charge a higher price from its mainstream customers and command higher margins.
    • In the case of Digital, they sold minicomputers, sophisticated pieces of computing equipment that retailed at nearly $150,000 a piece, upwards of $50,000 to $200,000.
    • They sold direct to large corporations, and they commanded margins of 35 to 40%. Each new minicomputer, each new version of a minicomputer that they brought in, only increase these parameters, higher prices, higher margins, and hopefully more satisfied customers.
    • However, the acknowledgement of a product’s performance trajectory is accompanied by the acknowledgement that generation’s of improvements to products outstrip the ability of your customers to utilize them.
    • What percent of spreadsheet features do you actually use?
    • I would speculate 5, maybe 10%.
    • In the case of Digital, the question was what percent of these sophisticated computing abilities were mainstream customers using?
    • You had sophisticated analytics capabilities built into these computers, but companies perhaps just didn’t have the technologies to get that volume of data, or even quality data, for the kinds of analytics and data processing that these machines offered.
    • In other words, like Digital, at any point on the performance trajectory, if a product has far more features than the demands of its mainstream customer market, then what the mainstream customer market is capable of absorbing, it is overserving this market.
    • And this overserving of the market is the first precursor to industry disruption.
    • When you are overserving the market, your industry is ripe for disruption. And when your industry is ripe for disruption, there enters an innovation ready to do its job.
  • The second catalyst therefore to disruption is the defining characteristic of that innovation that enters the market.
    • A disruptive innovation is typically inferior to your main stream product, what do I mean by inferior?
    • It has a feature set that does not cater to your main stream customers.
    • It delivers much lower margins than your product. Early personal computers were far, far inferior to minicomputers.
    • Apple sold Apple II as a toy to schools. Inferior not just in terms of features, margins too.
    • While Digital’s products sold at $150,000 a piece earning 35 to 40% margins, the PCs retailed at 1,500 to 2,000 a piece earning, 15 to 20% margins and declining.
    • And this is important to understand, because the question that you face as Digital, when you encounter the personal computer is, should I invest in products that my existing customers are buying and are improving my current margins, or should I invest in a product that none of my existing customers want and which will erode my margins drastically?
    • You don’t even have to be a stellar business leader to answer that question, do you?
    • If it was on your performance trajectory, you would take notice of this as competition, but the disruptive innovation is pushed off your radar, because of it’s inferior nature.
    • Note, this is not a technological problem. The engineers at Digital could have designed a personal computer with their eyes shut, this was a business problem.
    • The parameters of Digital’s existing business, customers, margins, growth expectations, these were the parameters that did not allow the company to focus on the personal computer when it made its entry.
    • However, focus is important, because the disruptive innovation does address a real untapped need in the market.
    • The minicomputer was sold to large corporations, but the personal computer, it brought computing into the homes of people.
    • If you as an individual had computing needs at that time, you would walk into the nearest data center give, them your data processing needs.
    • These would be processed in batch, you would collect the output after a certain period of time.
    • The personal computer changed that. Although it didn’t allow for processing of large volumes of data or research, it did facilitate basic computing at home, bringing individual consumers into this product market, a real untapped need.
  • The third defining characteristic of disruptive innovations is that they rarely stay where they start.
    • The goal product rapidly adds features to improve its performance and intersect with the incumbent’s mainstream performance trajectory.
    • Indeed, as the PC improved and added features of productivity and computing, it became a formidable competitor to the minicomputer business.
    • And remember, the minicomputer business is being overserved. So the computer doesn’t even have to travel very far to intersect with the mainstream trajectory.
  • You can also think about disruptive innovations from a value network perspective.
    • A firm has
      • multiple stakeholders, customers, whose needs it understands and serves,
      • suppliers and other value chain partners that help it create its products and services.
      • competitors, whose offerings it takes into account when designing its products and services.
    • Stakeholders
      • the company draws on a set of resources, processes and values.
    • Digital had invested in to create its minicomputer business.
      • It had a large sales force that sold directly to corporations.
      • This high quality human capital was trained in the complexities and sophistication of the minicomputer.
      • The company had assembly units comprising machinery and engineers that put together the different parts and peripherals of the minicomputer.
      • The company had established key processes, such as purchase to payment, inventory management, working capital management, all in the context of the minicomputer business.
      • And we talked earlier about values.
      • The company had a history of delivering margins of nearly 30 to 35% to its shareholders and investors.
    • In PC
      • customers are individuals, not corporations.
    • Key parts and peripherals to the minicomputer
      • integrated chips, cassette tape units, mini discs, cartridges, cathode ray tubes, many of these done away with in the PC regime.
    • In turn, a minicomputer company like Digital would have to
      • fundamentally revamp its resources, processes and values to respond to the personal computer.
    • The simplicity of the product obviated the need for a
      • direct sales force, or engineers, or more generally the kind of human capital, the sophisticated human capital, that Digital had invested in.
    • Its suppliers and partners changed fundamentally in the PC regime. Then along with this change, key parameters of the business, working capital ratios, inventory ratios would also be altered.
    • The company would have had to take a hit in margins, a decline of nearly 20%
      • In which case, its value of delivering returns to the expectations of shareholders and investors would be compromised.
      • In brief, responding to the personal computer required the creation and leading of a new value network that was fundamentally different from Digital’s existing one.
      • And therefore, the personal computer was disruptive to the minicomputer business, to Digital, and to the entire industry.

This is why incumbents in established industries find it difficult to respond to innovations that are potentially disruptive to their industries.

Nature of Technology Led Disruptions

  • W

    • Why disruptive innovations are largely technology-led in today’s business environment.
    • What are some of the technologies?
    • What are some of the technological innovations that are leading to disruptive products and business models?
  • IT innovations

    • have created several enabling forces for business innovation across a variety of industries and product markets.
  • First, they have helped in digitization or the use of technology to separate information from a physical artifact.

  • Books are no longer bound to a paperback or hardcover, music is no longer bound to the CD, ringtones are no longer bound to a phone, and money is no longer bound to a currency note.

  • All of these items, books, music, ringtones, money, and countless others exist as information that can be manipulated and stored on its own without an accompanying physical artifact.

  • What is the implication of this digitization?

    • Well, to answer that, you have to consider what does it take to create information versus creating and storing a physical good?
    • What does it take to create an MP3 versus creating a CD?
    • The marginal cost of producing digital or information goods?
      • Virtually zero.
      • Therefore, digitization can radically alter your cost structures.
    • It’s not just the marginal costs of creation of digital goods that are near zero, it’s also the marginal cost of storing these goods.
    • Digital goods, such as e-books or MP3 music, do not take up space like physical goods do, and vast advances in computing power render the marginal cost of storage close to zero.
    • This changes the face of retailing. This gives rise to what we know as the long tail of retailing.
    • Since brick and mortar retailers
      • must allocate costly shelf space for each product in each of their locations,
      • their stocking decisions are driven by a limited amount of shelf space and
      • how many consumers in that local geographic area are willing to pay for these products.
    • Given the non-trivial costs of storage, they use their limited shelf space to
      • stock only those goods that are most popular and
      • are most likely to convert into revenue.
    • That is, they stock only to the head of the demand curve.
  • However, the costs of storing digital goods are trivial.

    • Even in the case of physical goods that are being sold on the Internet, the costs of stocking an additional product is much lower since it involves space in a centralized warehouse that is often located on more inexpensive real estate.
    • For products that can be drop shipped from distributors, as is the case of digital products that can be sent over the Internet, almost all it takes to stock an additional product is an additional line in a product database.
    • Therefore, retailers of digital goods and E-tailers carry practically all of the products in circulation, catering not just to popular or mainstream preferences in the head of the demand curve,
      • but the entire tail of niche preferences in the demand curve.
    • Indeed, Amazon and other Internet retailers sell nearly all of the millions of books in print, while a typical brick and mortar store would stock between 40,000 and 100,000 unique titles, depending upon the size of the store.
    • Similarly, whatever your taste in music, you’re likely to find it addressed in the long tail of retailing.
    • And research tells us that
      • serving these consumers with one-in-a million tastes alongside your consumers with mainstream tastes is very valuable.
    • If you analyze Amazon’s sales patterns, you will find that 30 to 40% of sales comes from books that would
      • not be normally found in a brick and mortar store.
      • That’s the contribution of the long tail.
    • Therefore, it’s an important component of online retailing, and very disruptive, as well.
  • As technology has enabled retailing to evolve to address

    • niche and microconsumer preferences,
    • it has also enabled online platforms to evolve alongside,
    • to resolve the trade-off between reach and richness of information that exists in the offline world.
      • Reach is simply the number of people that I can reach to communicate about my product or service.
      • Richness is defined by bandwidth or how much information I can communicate.
        • How customized is that information?
        • And how interactive can I be in communicating that information?
  • Physical delivery of information

    • there is a trade-off between reach and richness.
    • For example, an advertisement on television is far less customized than a personal sales pitch, but it reaches far more people.
    • Richer information through dialogue is possible with a door-to-door salesman, but there’s only so many people he or she can reach.
  • This pervasive trade-off

    • has shaped how companies communicate, collaborate, and conduct transactions internally and with its external stakeholders, customers, suppliers, distributors.
  • This trade-off, however, is eliminated online.

    • A restaurant review site like Zomato or Yelp gives you a pretty rich experience about a lot of restaurants to a lot of people.
    • Reach and richness.
  • Amazon

    • a wide variety of products.
    • But they also provide you with a shopping experience through product reviews, recommendations, and great-quality service.
    • Reach as well as richness, no trade-off.
    • The richness of your marketing platforms are enhanced today by an interactive web, including social media.
    • This has changed how you interact with your stakeholders, such as customers, suppliers.

Music Industry

  • Key stakeholders in the value chain
    • the artists,
    • the recording company, and
    • the consumers.
  • Artists.
    • Composers, lyricists, performing artists provided the raw artistic input for the business.
      • artists were paid a fixed compensation per song, and did not own the music.
      • paid a royalty against the sales of their work
    • Consider the efforts of the legendary artist Prince to escape his contract with Warner Music.
      • The late artist changed his name to an unpronounceable symbol.
      • He claimed that his old contract did not apply to The Artist Formerly Known as Prince.
      • During subsequent disputes, he appeared in public with the word slave inscribed on his cheek to reflect his relationship with Warner Music.
      • Warner released him from his contract in 1995.
      • The artist’s next albums were distributed by his own label and promoted primarily via the internet.
      • Though sales volumes were low, the artist claimed that his net receipts were higher than they had been with Warner before.
      • In 1999, he returned to a major record company signing with BMG.
    • Why this vehement dissatisfaction?
      • In the case of the film genre, the artist’s dissatisfaction stemmed from not owning their creative inputs.
      • In the case of indie artists like Prince, it stemmed from the tight control that recording companies wielded over them
      • Having prominent artists like Prince under contract not only brought greater sales directly, but also helped the recording company gain precious retail shelf space for lesser known acts or new artists that they were trying to break into the industry.
      • Promising new artists tend to be attracted to recording companies, which have the best artists under contract and show a strong history of successful management. Sometimes the demands of premier artists can undermine the profitability of a record company for that specific act.
      • Consequently, product managers have to balance the benefits of an artist’s big name with the costs of holding the artist under contract, read slave.
      • But what were the recording companies doing for the artists that enabled them to wield so much power and control?
      • In order to answer this, let’s look at all the activities performed by the recording company.
      • Each recording company took performing artists under contract.
      • It purchased musical rights from publishing houses, managed the recording process, manufactured CDs and cassettes, distributed CDs and cassettes to retailers and other channels, and promoted products aggressively.
      • During this process, the company paid for all costs associated with launching new music
      • Also note that the bulk of these value chain activities required large up front investments in acquiring and promoting music.
      • There was also significant fixed costs of production facilities, etc that the recording companies incurred.
      • Only large companies could amortize these costs over several products. This was a capital intensive business, and a business of giants.
      • Further, the nature of the business model was that profits are concentrated in a small number of large hits, hits which are very, very difficult to anticipate.
      • So you’re making these upfront investments without knowing or realizing what the expected return on these investments are going to be.
      • The case tells you that four out of five recordings lose money.
      • And the biggest hits sell orders of magnitude, more copies than do flops.
      • Large companies are able to pool the risk associated with each individual album release, and hence, are able to survive the inevitable flops.
      • Promotional channels also leverage this portfolio.
      • So if I had many hits, I would tell the radio channels, I’ll give you the super hit track, give me a discount on air time for this new artist that I’m trying to launch.
      • In other words, the business model of recording companies was all about creating a very large portfolio of music tracks that allowed you to diversify the risk of failure associated with the individual tracks.
      • And for these reasons, the recording business was a game of giants.
      • Consolidation had reduced the number of labels to four majors
        • Universal Music Group,
        • Sony,
        • Warner, and
        • EMI, all giants.
      • So if you were a new artist, where would you go?
        • To the giant that would help you break into this industry.
      • If you were an established artist, where would you go?
        • To the giant that helped you produce and distribute your music.
      • And that’s why the recording company wielded the power that they did over the artists.
      • Did they wield power over you, too, the consumer?
        • To answer that, consider how you consumed music in the pre-internet world, typically CDs. How many songs in a CD, 10, maybe 12? How many did you like, 1, maybe 2, maybe 3. Yet, you were restricted in your purchase where you had to buy the entire album. And innovations and consumption in this industry, who drove them
        • How did the cassette evolve to the CD and so on?
        • The recording companies drove these innovations. So it was safe to say that the recording company was the most powerful entity in the value chain where the customers and artists are a relatively dissatisfied, dis-empowered lot at best.
        • Annual sales in this industry were an all time high of $14.5 billion in the U.S. in 1999.
        • But the first tremors of disruption were felt that very year.
        • By 2008, sales would be down to less than half of the year’s levels.
        • Technology would have disrupted this industry in an unprecedented manner. Let’s see how.
      • The mp3 standard was globally adopted in 1992.
        • The standard allowed for digitization.
        • As I said earlier, separation of music from its physical artifact, the CD.
        • And compression of digital music, while retaining near CD quality sound.
        • The exchange transfer and storage of digital music was made far more convenient than ever before.
        • In the fall of 1998, the very year before the music industry sales would hit an all time high,
      • 18 year old Shawn Fanning enrolled as a freshman at Boston’s Northeastern University.
        • Like many of his peers, Fanning wanted to study computer programming.
        • But aside from some basic programming techniques he had acquired, there was little indication that Shawn Fanning was about to revolutionize the way music was distributed over the internet.
        • At Northeastern, Fanning quickly became bored, skipping classes and returning frequently to his uncle’s company.
        • His lagging interest in college studies was due in part to a growing interest in a novel idea that he had for finding mp3 music files on the internet.
        • Fanning had become frustrated with finding mp3s through search engines such as Lycos, which often led to broken links and missing files.
        • His idea was to combine a music search function with a file sharing system that would let individuals directly trade music files with each other over the internet.
        • By using a tool that combined the file sharing functions of Microsoft Windows with the advanced searching and filtering capabilities of traditional search engines.
      • And so, Napster was born.
        • And this is how Napster grew.
        • What explains this growth?
        • Fewer search costs, greater unbundling of tracks, and lower price of music, of course.
        • Most important, the latent desire for control on part of consumers and users and the sense of resentment that recording companies were ripping them off.
        • That resentment is what led to this significant growth of Napster.
        • The big spurt that you see from 15,000 users to 1 million was a consequence of RIAA’s first suit in December 1999 that gave the company a great deal of publicity.
        • Napster was sued and shut down in July 2001.
        • It was very easy to shut down Napster. There was just one central server that you had to decommission and the platform was done.
        • And that was the end of Napster, but was it the end of P2P music as we know it?
          • No.
        • To the contrary, the newer platforms that emerged addressed the vulnerabilities of Napster, to make it even more difficult to end this phenomenon of disruption.
          • Platforms like gnutella, KaZza, BitTorrent all of these were aimed at fostering the growth of P2P music.
          • And all of these platforms built on the latent resentment of consumers that existed in the pre digital area.
          • Music had been transformed forever.
          • You consumed precisely what you wanted and you didn’t even pay for it.
          • And what were the recording companies doing at this time, you ask?
          • Suing with a sense of urgent desperation.
          • They sued the platforms, they sued their own customers, college students, teenagers, stay at home moms.
          • Nobody was spared.
          • Their entire value network stood to be disrupted in this new environment and they did not even pause for a second to see if they would survive it or how.
        • This wave of chaos continued until the early 2000s. At that point one company came along to bring some order in all this chaos. And that company was what we know as Apple.
      • Apple’s market capitalization shot up from $1 billion in early 2003 to over $150 billion by late 2007.
        • What do you think transformed Apple in the early 2000’s?
        • If you’re saying iTunes ,you may be well on mark. Before the launch of iTunes, Apple was selling an average of 113,000 iPods per quarter. By the quarter ending 2003, that figure had shot up to 735,000 units.
        • The combined contribution of iTunes and iPod to Apple was 45% of sales.
        • What do you think the contribution of iTunes was?
          • Of the $0.99 that it took for a song,
            • $0.70 went to the music label that owned it.
            • $​​​0.20 went towards the cost of credit card processing.
            • That left Apple with about a dime of revenue per track, from which Apple had to pay for its website, other direct and indirect costs.
          • In essence, iTunes gave nothing to Apple. What Jobs had created was a razor and blade business model, only in reverse.
          • The variable element in this case, iTunes, served as a loss leader for a profit driving durable good, the iPod.
          • Of course, Apple had redefined the size, look, and design of the mp3 player, but far smarter than taking a good technology and wrapping it in a snazzy design.
          • It took, in fact I would argue, a good technology, and wrapped it in a great business model.
          • Apple’s value proposition was enabling people to find and legally download high quality music files extremely easily, transfer them to different iPods, make a few copies for their friends by burning a limited number of CDs.
          • This was a major reason why the iPod took off as it did.
          • It was the front end of a very smart and highly differentiated platform that worked for both the music industry and the consumer.
          • And this was the point at which the recording companies began to breathe.
          • Could the recording companies have done this?
            • In order to answer that we need to understand the specific impacts of technology in this industry.
            • Specifically we need to understand how these technological innovation impacted the customers and artists, in addition to the recording company.
            • So now lets place all that we’ve discuss about the music industry In the context of the disruptive innovation framework that we discuss in the earlier sessions.
      • The music industry was creating these very high quality products, specifically CDs that over serve the market.
        • They operated models of recording and production that reflected a need for very high quality audio reproduction.
        • However, the reality of the market was that consumers really did not require this sophistication.
        • In this over-served market, the mp3 made its entry.
        • The mp3 by its very nature was a low quality audio format.
        • The mp3 is created through lossy data compression, a data encoding method that compresses data by discarding some of it in order to create digital files small enough for quick downloads and storage on portable devices.
        • Low quality and way inferior to the CD in terms of audio quality.
        • However, the mp3 addressed some very real needs of consumers.
        • Aligning consumption with preferences for singles instead of albums.
        • Low costs of experiencing music, low costs of buying and storing music and the ability to meet niche tastes.
        • And what we saw was while the early digital music products and platforms were very low quality.
        • The subsequent products and more important, the business models, began to add wrappers and layers to finally intersect the mainstream performance trajectory of the recording industry and disrupt it completely.