Lean by Design

The Open Source Software (OSS) movement of the past decade and half has encouraged a broader shift towards Free based business models. First popularized by Chris Anderson of Wired magazine fame, freeconomics is spreading within the software business and now dominates the Web2.0 space.

The growing influence of China and other Asian economies on innovation (as I noted in my last post), will only further accelerate this trend, with cultural biases and traditions in those countries placing them a good position to understand and exploit freeconomics.

Tool businesses have found themselves at the forefront of this shift in business, due in part to the role of IBM and the OSS Eclipse project. As the CEO of a software development tool startup, it has become apparent that even large established companies are now expecting that tools should largely be free. As one European customer mentioned to me a few months ago, “we want to pay for your DNA, but we resent paying large sums to xxx for basic tool capabilities that we believe will be commoditized” in the near to medium term. Another leading telecom vendor has expressed that they believe that quality OSS solutions will be available for all but the most sophisticated capabilities within the next 5 years. This has had two interesting effects. First, it has obviously altered their perception of value and how they wish to pay for the value that they continue to see in the commercial software space. Second, it has also made them even more weiry of vendor lock-in strategies. The industry has in general (and to my surprise) become increasingly unhappy with the large traditional software tool vendors. They believe that they are unresponsive, that they charge excessively for what they provide, and that they are not operating in the best interest of their customers (ouch!).

Everyone understands that OSS and ‘Free’ is changing business models and presenting opportunities for disruption in the market place. The question that has not been seriously explored is; will this trend drive much of the value out of the industry, making it hard for people to make a good living, or will it just lead to greater innovation as some have predicted? Will the shift lead to the creation of a whole new class of marginalized service workers, donating their software development services in the hopes of hitting it big?

The problem is that most ‘Free’ models involve either upgrade paths to premium services or an advertising model to support the product/service. In both cases, but especially in the latter, this tends to drive a “winner take all” model. That is, the top one or two players end up reaping 90% of the value, leaving a small pittance for the majority to survive on - consider the situation found in the market for art. The few at the top get rich, while the majority struggle to survive. This does not make for a sustainable or prosperous economic model for developed countries.

I know … the market will figure a way out of this conundrum. People will figure out new business models to make money within this context. Absolutely, I am confident of that as well. The question is; will those new business models be as rewarding as the old? Will they provide the opportunity for a substantial portion of the participants to reap those rewards, or will the wealth become further concentrated in the hands of a few? And finally, is this just one more mechanism that will accelerate the race to the bottom for developed economies, as they try to compete with emerging economies?

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Last week I wrote of the changing locus of innovation, highlighting the importance of emerging markets to innovation - something that those in developed markets need to understand, and learn from. Well, an excellent article was posted yesterday in Business Week on this very topic which I highly recommend. The article goes on to reference two pervious articles that are also worth reading. The major focus of these articles is the lessons that US based companies, and automotive companies in particular, could learn from development of the Nano car, as well as the trends in innovation within Asia that it represents. I won’t bother rehashing elements of the articles, they are worth reading in their entirety.

But for those of you who may not have time, here are a few thought provoking quotes:

Measuring progress solely by patent creation misses a key dimension of innovation: Some of the most valuable innovations take existing, patented components and remix them in ways that more effectively serve the needs of large numbers of customers.

… innovations in products and processes come together to support “open distribution” …

This is part of a broader pattern of innovation emerging in India in a variety of markets, ranging from diesel engines and agricultural products to financial services. While most of the companies pursuing this type of innovation are Indian, the U.S. engineering firm, Cummins (CMI) demonstrates that Western companies can also harness this approach and apply it effectively.

Emerging markets are a fertile ground for innovation … these innovations will become the basis for “attacker” strategies that can be used to challenge incumbents in more developed economies. What’s initially on the edge soon comes to the core

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While at dinner last night with a former Nortel colleaque of mine, he reminded me of my recommendation several years ago for improving Product development effectiveness at Nortel. At the time the company was struggling with the telecom crash of 2001 and was desperately searching for ways to reduce costs - and in particular; the huge R&D costs that were burdening telecom vendors.

I was part of the cabinet of the largest of three business units within Nortel, and presented a proposal to change the way we viewed off-shoring of product R&D. At the time, conventional wisdom was that you should off-shore the undesirable activities that typically consume a large portion of R&D investment, but are not considered the most technically advanced. This appealed to the developers at ‘head offices’ since they could then focus on the fun ‘high value’ stuff, while sloughing off the drudgery of activities like software/system support or maintenance and product testing. It also appealed to management, since this was considered less risky - in part because they felt it important to closely oversee the development of all important next generation products, and in part because they were rewarded more for delivering the ‘next big thing’ than maintaining the legacy product.

On the surface these appear to be reasonably good arguments, but they ignored some important considerations representing both additional risks and lost opportunities. It is important to recognize that Nortel was truly a pioneer at off-shoring of development, having been one of the largest early customers of companies like Infosys, and having established two fully capable development labs in China when her competitors were just paying lip service to such actions. By 2001, Nortel had largely mastered the process of managing off-shore development along with its associated risks. So the choice that lay before the company, was to just off-shore more work, or to off-shore more strategically. I thought that the greater opportunity lay with the latter.

Specifically, I argued that we would never be able to compete with the likes of Huawei in the longer term if all we did was increase the percentage of R&D being done in low cost countries. Presumably some significant portion of development would always be performed in our domestic markets, and there were no plans to off-shore the majority of the business leadership, so we would always be at a cost disadvantage. Moreover, the traditional approach to off-shoring ignored an important risk, that is; much of the insight for future products comes from engineering experience with field issues as well as product test. If new product development became more divorced from product support and test, future products would be less successful.

I believe the stronger argument for a different approach, however, revolved around the importance of harnessing innovation in the local markets. Our approach to serving emerging markets was largely based on taking products designed for domestic markets and tweaking them for the emerging markets. Given that emerging markets were generally more cost sensitive, much of this tweaking process involved significant cost reductions. That process is far from optimal. It is like taking a high-end BMW automobile and trying to create a VW from it by stripping away the costs. This doesn’t work and it is not how Honda motors does it with their Acura line of line of products. The problem is that some design decisions embed costs in ways that essentially preclude their removal. It is much more effective to start with a basic platform and then extend it with higher end features and capabilities.

What I observed working in China, is that engineers and product managers thought about solutions differently than their counterparts in the west. They were much better at improvising solutions - an important trait to designing low cost, extensible products. As such it seemed to me that where product cost was going to be the dominant consideration, that those products and product platforms should be developed in emerging markets, especially when the company had established capabilities in those markets, and when they perceived those markets to be critical to the company’s future. Product management, development and support should be provided within that market. This would clearly be more efficient than the complex multi-site arrangements associated with most developments involving off-shore components, and would lead to a further strengthening of the companies emerging market capabilities. There is nothing like offering full end-to-end product responsibility to attract excellent talent and inspire them to superior performance.

Obviously, my initial pitch within Nortel didn’t succeed. That said, it is becoming obvious that effectively harnessing the unique innovations possible within emerging markets will become increasingly important to the success of western based global companies. Companies like GE Health Care appear to be moving in this direction, although they provide a somewhat different (possibly more politically palatable) rationale for this shift.

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