1. Design Rules: How Modularity Affects the Value of Complex Engineering Systems Carliss Y. Baldwin Harvard Business School International Conference on Complex Systems (ICCS 2004) Quincy, Massachusetts May 20, 2004

2. Slide 2 © Carliss Y. Baldwin and Kim B. Clark, 2004 Three Points  Modularity in Design is a financial force –that can change the structure of an industry.  Value and Cost of Modularity –it can increase financial value, –but it is NOT free.  Implications for Organizations and Firms  Open Questions/Applications

3. Slide 3 © Carliss Y. Baldwin and Kim B. Clark, 2004 This is an emergent modular cluster

4. Slide 4 © Carliss Y. Baldwin and Kim B. Clark, 2004 SIC Codes in the Database

5. Slide 5 © Carliss Y. Baldwin and Kim B. Clark, 2004 Virtues of Modularity  1st Virtue: decentralizes knowledge and distributes action –Makes more complexity manageable –Enables parallel work  2nd Virtue: tolerates uncertainty –“Welcomes experimentation” –—> Creates Options –Property of “evolvability”

6. Slide 6 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Bright Side of Modularity

7. Slide 7 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Dark Side …

8. Slide 8 © Carliss Y. Baldwin and Kim B. Clark, 2004 Types of Modularity  Modular in Design –Modern computers –Eclectic Furniture (not “modular” furniture) –Recipes in a cookbook  Modular in Production –Engines and Chassis –Hardware and software –NOT chips, NOT a cookbook  Modular in Use –“Modular” furniture, bedding –Suits and ties –Recipes in a cookbook

9. Slide 9 © Carliss Y. Baldwin and Kim B. Clark, 2004 Designs are Options  Option = “right but not the obligation”  A new design confers –“the ability but not the necessity” to use it –Hence it is an “real” option

10. Slide 10 © Carliss Y. Baldwin and Kim B. Clark, 2004 Three Consequences  More risk is valuable  Seemingly redundant efforts are value- increasing (up to a point)  Modularity creates more options

11. Slide 11 © Carliss Y. Baldwin and Kim B. Clark, 2004 Modularity Creates Design Options Split options, decentralize decisions, fragment control Evolution

12. Design Options are Valuable How Valuable? Ask a financial economist…

13. Slide 13 © Carliss Y. Baldwin and Kim B. Clark, 2004 What is the value of…  Splitting a design into J modular building blocks…and  Running multiple experiments (K of them) on each of the modules… and  Choosing the “best of breed” of each module… and  Combining the best modules to arrive at the system?

14. Slide 14 © Carliss Y. Baldwin and Kim B. Clark, 2004 Robert C. Merton  “Theory of Rational Option Pricing”, –Written for— MIT PhD thesis, 1971; –Published in— Bell Journal of Economics and Management Science, 1973; –Awarded— Nobel Prize in Economics, 1997  “A portfolio of options is worth more than the option on a portfolio.”

15. Slide 15 © Carliss Y. Baldwin and Kim B. Clark, 2004 What is the value of…  Splitting a design into J modular building blocks…and  Running multiple experiments (K of them) on each of the modules… and  Choosing the “best of breed” of each module… and  Combining the best modules to arrive at the system?  Going from one big indivisible block to many smaller building blocks  And trying out a number of designs on each small block  Where each design is a (little) option  That gets recombined with others in a (large) portfolio

16. Slide 11© Carliss Y. Baldwin and Kim B. Clark, 2001

17. Slide 17 © Carliss Y. Baldwin and Kim B. Clark, 2004 The Value of Splitting and Substitution

18. Slide 18 © Carliss Y. Baldwin and Kim B. Clark, 2004 When and if it arrives… Modularity in design is compelling, surprising and dangerous…

19. Slide 19 © Carliss Y. Baldwin and Kim B. Clark, 2004 Dangerous for whom?

20. Slide 20 © Carliss Y. Baldwin and Kim B. Clark, 2004 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”

21. Slide 21 © Carliss Y. Baldwin and Kim B. Clark, 2004 Entry into Computer Industry 1960, 1970, 1980

22. Mapping the Modular Structure of a Complex Engineering System We can “see” a system’s modular structure via a Design Structure Matrix (DSM) Map

23. Slide 23 © Carliss Y. Baldwin and Kim B. Clark, 2004 Design Structure Matrix Map of a Laptop Computer

24. Slide 24 © Carliss Y. Baldwin and Kim B. Clark, 2004 Design Structure Matrix Map of a Modular System

25. A “modularization” (splitting) of a complex design goes from Map A to Map B  Via Design Rules, which specify  Architecture, Interfaces and Module Tests, that provide  Encapsulation and Information Hiding.

26. Mapping Modular Structures over Time  “Modular Design Evolution” (MDE)  John Holland’s theory of CAS

27. Slide 27 © Carliss Y. Baldwin and Kim B. Clark, 2004 Design Hierarchy View

28. Slide 28 © Carliss Y. Baldwin and Kim B. Clark, 2004 Six Modular Operators

29. The Costs of Modularity

30. Slide 30 © Carliss Y. Baldwin and Kim B. Clark, 2004 Every important cross-module interdependency must be addressed via a design rule. This is costly Costs eat up the option value Modularization may not pay

31. Slide 31 © Carliss Y. Baldwin and Kim B. Clark, 2004 Costs of Experiments vary by module

32. Slide 32 © Carliss Y. Baldwin and Kim B. Clark, 2004 Thus each module has its own “value profile”

33. Slide 33 © Carliss Y. Baldwin and Kim B. Clark, 2004 Value Profiles for a Workstation System Sun Microsystems Workstation circa 1992

34. The Perils of Modularity

35. Slide 35 © Carliss Y. Baldwin and Kim B. Clark, 2004 IBM Personal Computer  Highly modular architecture  IBM outsourced hardware and software  Controlled one high-level chip (BIOS) and the manufacturing process Then  Compaq reverse-engineered the BIOS chip  Taiwanese lowered manufacturing costs By 1990 IBM was seeking to exit the unprofitable PC marketplace!

36. Slide 36 © Carliss Y. Baldwin and Kim B. Clark, 2004 Compaq vs. Dell  Dell did to Compaq what Compaq did to IBM…  Dell created an equally good machine, and  Used process modularity to reduce its production, logistics and distribution costs and increase ROIC –Negative Net Working Capital –Direct sales, no dealers By 1990 Compaq was seeking to exit the unprofitable PC marketplace!

37. Slide 37 © Carliss Y. Baldwin and Kim B. Clark, 2004 Applications/Extensions  Science of Design –Mapping DSMs of Large Systems »Calculating Coordination Cost and Change Cost –Formalizing Design Structure using Predicate Logic –Valuing Functions and Functionalities; –Mapping to Functions to Designs Structures –Estimating the Technical Potential of Modules and tracking the evolution of versions and functionalities in large systems

38. Slide 38 © Carliss Y. Baldwin and Kim B. Clark, 2004 Applications/Extensions  Empirical Studies of Modular Clusters –Pricing and profitability of large clusters –Tracking Evolution, Design Dependencies, and Economic Value in Supply Networks—Video games and Software –Modular Operators as Correlates of Mergers & Acquisitions –Mortgage Banking –Electronics

39. Slide 39 © Carliss Y. Baldwin and Kim B. Clark, 2004 Applications/Extensions  Computational Experiments –Impact of local, voluntary mechanisms, eg, bargaining on network formation and efficiency –Innovation and imitation in modular vs. “near- modular” design and task structures –Pricing and profitability of firms in “symmetric” and “asymmetric” modular clusters

40. Slide 40 © Carliss Y. Baldwin and Kim B. Clark, 2004 Applications/Extensions  Management studies/Strategy –Comparing Knowledge Spans to Task Structures –The architecture of self-organizing projects »Game theoretic structures of open source projects »Tools and methods of coordination in open source projects –Competitive strategies for firms in clusters »Managing footprints for maximum ROIC »Design of a design monopoly

41. Slide 41 © Carliss Y. Baldwin and Kim B. Clark, 2004 Applications/Extensions  Public policy/Design of institutions –Impact of intellectual property rights and M&A on entry into design competitions –Impact of tournaments on design effort –Epistemic problems in estimating value »What are sufficient beliefs and how are they supported? »Where do we get valid estimates of “technical potential”? »Bubbles and crashes

42. “Modularity-in-design is not good or bad. It is important and it is costly. And dangerous to ignore.”

43. Just remember— “Compelling, surprising, dangerous…”

44. Thank you!