Slide 1 © Carliss Y. Baldwin and Kim B. Clark, 2005 The Power of Modularity: The Financial Consequences of Modular Design Architectures Carliss Y. Baldwin Harvard Business School March 31, 2005

Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2005 Four Points  Designs “need” to become real –They become real by creating the perception of “value”  Designs act as a financial force –In the process of becoming real, they can change the structure of an industry  A Modular Design Architecture creates Options with Option Value –What is an “ORMDA”? –What does an ORMDA need from the economy?  The economy bites back –ORMDAs are dangerous places to make a living

Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2005 What are designs?  Instructions that turn knowledge into things  Span all artifacts and human activities –Tangible, intangible –Transacting, contracting, dispute resolution –Government  The wealth of an economy inheres in its designs

Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2005 Some new designs create “value forces” that can change the structure of an industry Look at the computer industry from

Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2005 Industry Transformation  Andy Grove described a vertical-to-horizontal transition in the computer industry: “Modular Cluster” “Vertical Silos”

Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie The Computer Industry in 1980 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie The Computer Industry in 1995 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2005 Andy’s Movie—the Sequel The Computer Industry in 2002 Top 10 Public Companies in US Computer Industry Area reflects Market Value in Constant US $

Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2005 Turbulence in the Industry Departures from Top 10:  Xerox (~ bankrupt)  DEC (bought)  Sperry (bought)  Unisys (marginal)  AMP (bought)  Computervision (LBO) Arrivals to Top 10:  Microsoft  Cisco  Oracle  Dell  ADP  First Data Sic Transit Gloria Mundi… Sic Transit

Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2005 What changed?

Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2005 Design Architectures Changed  Small designs “just get done” by one person or a small team  Large designs require architecture –“The design of the design process” –Forward-looking, future oriented –Analogous to physical architectures »Create and constrain” movement and search  Major social technology, but not much studied

Slide 12 © Carliss Y. Baldwin and Kim B. Clark, 2005 Short History  System/360: first modular computer design architecture ( ) –Proof of concept in hardware and application software –Proof of option value in market response and product line evolution –First ORMDA = “Option-rich Modular Design Architecture” –System software NOT modularizable »Fred Brooks, “The Mythical Man Month”

Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2005 Short History (continued)  Bell and Newell, Computer Structures (1971) –General principles of modular design for hardware –Basis of PDP-11 design—another ORMDA  Thompson and Ritchie, Unix and C ( ) –Modular design of operating system software (contra Brooks Law) –Over time, general principles for evolvable software design (Unix philosophy)  Mead and Conway, Intro to VLSI Systems (1980) –Principles of modular design for large-scale chips

Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2005 Short History (continued)  IBM PC (1981) –DEC PDP-11 minimalist strategy (exclude and invite) –+ Intel 8086 chip –+ DOS system software –+ IBM manufacturing –+ Lotus (not foreseen) –A mass-market ORMDA

Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2005 ORMDAs and Value Migration in the Computer Industry, Significant Option- Rich Modular Design Architectures IBM System/360 DEC PDP 11; VAX IBM PC Sun 2; 3; Java VM RISC Internet Protocols (end-to-end principle) Unix and C; Linux HTML; XML(?)

Slide 16 © Carliss Y. Baldwin and Kim B. Clark, 2005 This was the puzzle Kim Clark and I began to tackle in 1987 Where was the value shown in the slide coming from? Designs, yes, but what part and why?

Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2005 After studying the designs and correlating their changes with value changes We concluded that modularity held the key…

Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2005 A Modular Architecture “frees up” Design Option Value Split options, decentralize decisions, fragment control Evolution

Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2005 As scientists, we can visualize and measure modularity in design — after the fact DSMs, Design Hierarchies Methods are tedious, non-automated

Mozilla just after becoming open source Linux of similar size Coord. Cost = 30,537,703 Change Cost = 17.35% Coord. Cost = 15,814,993 Change Cost = 6.65% Comparison of different software systems with DSM tools

Mozilla just after becoming open source Linux of similar size Coord. Cost = 30,537,703 Change Cost = 17.35% Coord. Cost = 15,814,993 Change Cost = 6.65% Conway’s Law: Different organizations deliver different architectures One Firm, Tight-knit Team, RAD methods Distributed Open Source Development

Mozilla Before Redesign Mozilla After Redesign !!

Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2005 But modularity is only half the story—options matter, too  “Creates” vs. “Frees up”  The sad story of auto front-end modules  Design options have “technical potential”, denoted   Technical potential, , varies by system and by module Modularity in the absence of high option value is an expensive waste of time

Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2005  Low Medium Zero High Measuring Option Value  Successive, improving versions are evidence of option values being realized over time—after the fact  Designers see option values before the fact  What do they see?

Slide 25 © Carliss Y. Baldwin and Kim B. Clark, 2005 Sources of option value in computer designs  Moore’s Law— –Value of seamless, asynchronous upgrading –Applies to systems of chips  Amdahl’s Law “Make the frequent case fast”— –Value of ex post optimization –Applies to all complex artificial systems (“Build one and throw it away.”)  Wilkes-Alexander-Clark observation “Valid perceptions of desires emerge through use”— –Value of ex post discovery, direct experience, play –Applies to all new artifacts

Slide 26 © Carliss Y. Baldwin and Kim B. Clark, 2005 Where we are in the argument:  Designs “need” to become real –They become real by creating the perception of “value”  Designs act as a financial force –In the process of becoming real, they can change the structure of an industry  A Modular Design Architecture creates Options with Option Value –What is an “ORMDA”? –What do ORMDAs “need” from the economy?  The economy bites back –ORMDAs are dangerous places to make a living

Slide 27 © Carliss Y. Baldwin and Kim B. Clark, 2005 ORMDAs “need”  Lots of design searches  Institutions of Innovation to –Complete the designs –Produce the artifacts –Transport/Distribute the goods  Mechanisms for financing, selection, compensation, reward (an advanced economy…)

Slide 28 © Carliss Y. Baldwin and Kim B. Clark, 2005 Selfish ORMDAs “need” lots of design searches—and promise lots of $$$ Value Landscape of a minor ORMDA— Sun Microsystems Workstation circa 1992

Slide 29 © Carliss Y. Baldwin and Kim B. Clark, 2005 Thus each module has its own “value profile”

Slide 30 © Carliss Y. Baldwin and Kim B. Clark, 2005 Institutions get built to exploit opportunities like these, which are “created” by the design architecture This is where the economy bites back!

Slide 31 © Carliss Y. Baldwin and Kim B. Clark, 2005 What are institutions?  Firms and markets  Transactions and contract types  Rules and rights (eg, property rights)  Stable patterns of behavior involving several actors operating within a consistent framework of ex ante incentives and ex post rewards –Equilibria of linked games with self-confirming beliefs (Aoki and game theorists)

Slide 32 © Carliss Y. Baldwin and Kim B. Clark, 2005 How a “stable pattern” works  Anticipation of $$$ (visions of IPOs)  Lots of investment  Lots of design searches  Best designs made real  Fast design evolution => innovation  Lots of real $$$ (an actual IPO) “Rational expectations equilibrium”

Slide 33 © Carliss Y. Baldwin and Kim B. Clark, 2005 Three ways to frame the institutional analysis  Descriptive: What has actually happened in the ORMDAs we know about?  Deductive: What do our models predict?  Strategic/Normative: Faced with an ORMDA (and access to financial capital), what should “you” do?

Slide 34 © Carliss Y. Baldwin and Kim B. Clark, 2005 Faced with this ORMDA, what would you do? One module or many? In each module you chose, how many design searches? Which modules are most attractive?

Slide 35 © Carliss Y. Baldwin and Kim B. Clark, 2005 Lots of stories  They all make sense  When you see them play out, the moves are logical and in some cases “inevitable”  But our strategic advice for managers and financiers today comes down to: –“plunge in,” –“get lucky,” –“watch out for Microsoft,” and –“get bought by HP”

Slide 36 © Carliss Y. Baldwin and Kim B. Clark, 2005 One story before we close— ORMDAs and New Industries Significant Option- Rich Modular Design Architectures IBM System/360 DEC PDP 11; VAX IBM PC Sun 2; 3; Java VM RISC Internet Protocols (end-to-end principle) Unix and C; Linux HTML; XML(?)

Slide 37 © Carliss Y. Baldwin and Kim B. Clark, 2005 The Bright Side of the ORMDAs

Slide 38 © Carliss Y. Baldwin and Kim B. Clark, 2005 But there was The Dark Side … $ 2.5 trillion appeared then disappeared in the space of four years!

Slide 39 © Carliss Y. Baldwin and Kim B. Clark, 2005 Bubble followed by a Crash A failure, not of the Internet’s design architecture, but of the institutions built on that architecture

Slide 40 © Carliss Y. Baldwin and Kim B. Clark, 2005 Other Cautionary Tales  IBM System/360 and “plug-compatible” peripherals  IBM PC vs. clones  Sun Microsystems vs. Apollo Computer  Dell Computer vs. Compaq Computer Each illustrates Perils of ORMDAs

Slide 41 © Carliss Y. Baldwin and Kim B. Clark, 2005 Unless we turn the ORMDA stories into science…

Slide 42 © Carliss Y. Baldwin and Kim B. Clark, 2005 We will make the same mistakes all over again! Value-seeking design evolution— the good, the bad, and the ugly…

Slide 43 © Carliss Y. Baldwin and Kim B. Clark, 2005 Remember  Designs “need” to become real –They do so by creating perceptions of “value”  Value is a powerful economic force –Which can change the structure of an industry  The most powerful designs are ORMDAs  ORMDAs are dangerous (but interesting) places to live  Designs, institutions and strategies are still evolving

Slide 44 © Carliss Y. Baldwin and Kim B. Clark, 2005 Thank you!

Slide 45 © Carliss Y. Baldwin and Kim B. Clark, 2005 IBM System/360  The first modular computer design  IBM did not understand the option value it had created  Did not increase its inhouse product R&D  Result: Many engineers left –to join “plug-compatible peripheral” companies  San Jose labs —> Silicon Valley “Compelling, surprising, dangerous”

Slide 46 © Carliss Y. Baldwin and Kim B. Clark, —IBM wanted to be the sole source of all of System/360’s Modules

Slide 47 © Carliss Y. Baldwin and Kim B. Clark, — What actually happened: Entry on modules

Slide 48 © Carliss Y. Baldwin and Kim B. Clark, 2005 By 1980, 100s of firms made S/360 “plug-compatible” components

Slide 49 © Carliss Y. Baldwin and Kim B. Clark, 2005 IBM PC, early 1980s  IBM was chasing Apple  Created an ORMDA— for “fast evolution”  Outsourced: –microprocessor to Intel –operating system to Microsoft  Kept for itself: –BIOS –Final-stage assembly

Slide 50 © Carliss Y. Baldwin and Kim B. Clark, — IBM provided few PC Modules

Slide 51 © Carliss Y. Baldwin and Kim B. Clark, 2005 But then …  Compaq reverse engineered the BIOS  Chips and Technologies made “chipsets”  Taiwanese clones had cheaper/better manufacturing  Intel refused to second-source  Microsoft sabotaged OS/2

Slide 52 © Carliss Y. Baldwin and Kim B. Clark, —IBM PC is the standard, but IBM makes no money

Slide 53 © Carliss Y. Baldwin and Kim B. Clark, 2005 Back up to 1980—Apollo Computer did not make the same mistake as IBM PC managers Keeps Design Control

Slide 54 © Carliss Y. Baldwin and Kim B. Clark, 2005 Then Sun came along… And did even less! How?

Slide 55 © Carliss Y. Baldwin and Kim B. Clark, 2005 Then Sun came along… And did even less! Design Architecture for performance Public Standards for outsourcing

Slide 56 © Carliss Y. Baldwin and Kim B. Clark, 2005 Result: ROIC advantage to Sun Sun used its ROIC advantage to drive Apollo out of the market

Slide 57 © Carliss Y. Baldwin and Kim B. Clark, 2005 Compaq vs. Dell  Dell did to Compaq what Sun did to Apollo …  Dell created an equally good machine, and  Used modularity-in-production to reduce its production, logistics and distribution costs and increase ROIC –Negative Net Working Capital –Direct sales, no dealers

Slide 58 © Carliss Y. Baldwin and Kim B. Clark, 2005 Dell vs. Compaq 1997 Dell started cutting prices; Compaq struggled, but in the end had to exit. Like Apollo, they were acquired by HP!