1. Slide 1 © Carliss Y. Baldwin 2007 Architecture, Innovation and Industry Structure Carliss Y. Baldwin Washington University St. Louis April 9, 2007

2. Slide 2 © Carliss Y. Baldwin 2007 We need new ways to envision the structure of systems industries  Andy Grove’s vision of a systems industry changing structure 1995-“Modular Cluster” 1980-“Vertical Silos”

3. Slide 3 © Carliss Y. Baldwin 2007 The Computer Industry in1985

4. Slide 4 © Carliss Y. Baldwin 2007 It changed— 19851995 Verticals are giving up ground…

5. Slide 5 © Carliss Y. Baldwin 2007 And then some more! 19852004

6. Slide 6 © Carliss Y. Baldwin 2007 Same time period… the auto industry stayed very vertical Why the difference? We don’t know! 19842003

7. Slide 7 © Carliss Y. Baldwin 2007 The PUZZLE  Firms can innovate by changing their product architecture and vertical scope in tandem –Result is changing industry structure and industry boundaries  But “trends” can go in different directions –==> more horizontal industry structure (computers) –stay the same (autos) –==> more vertical industry structure (bike drive trains) Needed: a contingent theory

8. Slide 8 © Carliss Y. Baldwin 2007 Outline of talk  Architectural Knowledge and how it changes  Architectural Innovation based on Architectural Knowledge  Scope, outsourcing, footprints  Competitive dynamics  Evidence from two cases –Sun-Apollo 1986-1989 –Dell-Compaq 1996-2001  Counter-example –Bike Drive Trains 1980-1990 (Fixson and Park)

9. Slide 9 © Carliss Y. Baldwin 2007 Architectural Knowledge  Architecture = entities and relationships –Function-to-component mapping –Interfaces between components –Linkages and interactions (“dependencies”)  Architectural knowledge means knowledge about all these things –The “Ibibidui” paradox –“I built it but I don’t understand it” –Henderson and Clark (1990): architectural knowledge gets embedded in organizational structures –Complexity catastrophes

10. Mozilla Before RedesignMozilla After Redesign Ibibidui in software © Alan MacCormack, Johh Rusnak and Carliss Baldwin, 2006

11. Slide 11 © Carliss Y. Baldwin 2007 Evolution of Architectural Knowledge about Computers  Generation 0—ENIAC –Von Neumann memo (function-to-component mapping)  Generation 1—Integral systems  Generation 2 —Modular systems –System/360, “the first modular computer system” –Bell and Newell text explained how to create modular systems  Generation 3 —Quantitatively measured and optimized designs –RISC, Memory management (cache memory), optimizing compilers, parallel threading –Hennessy and Patterson text explained how it’s done

12. Slide 12 © Carliss Y. Baldwin 2007 2 Questions  Is this progression of architectural knowledge consistent across domains? –Probably –Parts and functions to interfaces to quantitative dependencies  Can we measure it? –“Domain X is in state Y of architectural knowledge?” –The problem of subdomains (modules) and superdomains (compositions)

13. Slide 13 © Carliss Y. Baldwin 2007 3 Conjectures  As knowledge builds in a domain, designers move both search and complexity (hence uncertainty) to subdomains (modules) and superdomains (compositions) –Law of the conservation of architectural ignorance (Ibibidui)  Domains with higher levels of architectural knowledge have lower levels of uncertainty –Predictable trajectories and roadmaps  Domains in which user functions are still being discovered have low levels of architectural knowledge (High Ibibidui) –Functions and component-to-function causal mapping are the first step in design, and the most primitive type of architectural knowledge

14. Mozilla Before RedesignMozilla After Redesign Ibibidui in software © Alan MacCormack, Johh Rusnak and Carliss Baldwin, 2006

15. Slide 15 © Carliss Y. Baldwin 2007 Dynamics —Textbook lags  1962—IBM task group figures out how to build a modular computer system  1974—Bell and Newell publish textbook  1980—Hennessy and Patterson begin to teach graduate students about quantitative approaches to computer architecture  1990 H&P publish first text  1994 H&P publish second text

16. Slide 16 © Carliss Y. Baldwin 2007 From 1962-1974 and 1980-1990 architectural knowledge was asymmetrically distributed Some have it, many don’t

17. Slide 17 © Carliss Y. Baldwin 2007 Architectural Innovation  Generation 1—Integral systems –Build a whole new system  Generation 2—Modular systems –Modular operators: split, substitute, augment, exclude, invert, port –Recombine, link, compose  Generation 3—Quantitatively measured systems –Find a bottleneck and remedy it –“Make the common case fast” (Amdahl’s Law)

18. Slide 18 © Carliss Y. Baldwin 2007 Third-generation architectural knowledge tells you  Where bottlenecks are  How to remedy a bottleneck  How much the remedy is worth in terms of system performance –“Speedup formula”  How to change modular structure –2nd generation knowledge  Can have multiple objectives (cost and speed) –Multiple bottlenecks

19. Slide 19 © Carliss Y. Baldwin 2007 Example—Sun 2  Product = engineering workstation  Bottleneck = memory management

20. Slide 20 © Carliss Y. Baldwin 2007 Example—Sun 2 Bottleneck remedies Patented MMU chip Fast bus

21. Slide 21 © Carliss Y. Baldwin 2007 Scope/Outsourcing  Where product/process design meets strategy  To have a superior product, you only need to control the bottleneck(s) and make them better  All other parts of the system architecture –Have slack; or –Don’t affect performance or cost very much (speedup formula; 80/20 rule) Strategy: Keep control of bottlenecks and let go (outsource) the rest

22. Slide 22 © Carliss Y. Baldwin 2007 Example—Sun 2 Contrast to 2nd generation architecture

23. Slide 23 © Carliss Y. Baldwin 2007 Result => Smaller “Footprint”  Fewer inhouse activities –Relative to competitors that don’t have same architectural knowledge… –Remember textbook lags!  Less invested capital, with no penalty in performance and cost –No penalty because of the optionality of modular designs –Architects can select the best treatment for each module

24. Slide 24 © Carliss Y. Baldwin 2007 Competitive Dynamics  Now we are fully in the world of strategy  Use a simple model of dynamic competition –2 firms, A and B –Make goods of equal quality, same variable cost –Firm A has architectural knowledge, hence a smaller footprint, hence an IC advantage over B »Less invested capital per unit of capacity –Both set prices to utilize all capacity* –Customers buy first from cheapest supplier* –No dividends, no debt, no external equity *Non-strategic behavior … avoids strange mixed strategy equilibrium (Kreps and Scheinkman, 1983)

25. Slide 25 © Carliss Y. Baldwin 2007 Cases to be considered  Base case: myopic value maximization –Firm managers are perfect agents of shareholders  Other cases: –Agency conflicts (empire-building managers) –Foresighted investors (w/ and w/out agency) –External financing (w/ and w/out agency)

26. Slide 26 © Carliss Y. Baldwin 2007 Results  In each period, both firms will charge the same price  Firm A has IC advantage, thus ROIC A (t) > ROIC B (t)  Growth rate g j (t) = ROIC j (t)  In each period, Firm A will grow faster than Firm B: g A (t) > g B (t)

27. Slide 27 © Carliss Y. Baldwin 2007 Dynamic Pattern  Epoch 1: Both firms profitable for a while –Prices fall as firms add capacity –Industry growth = weighted average of firms’ ROICs  Epochs 2 & 3: ROIC B < Cost of capital –If B is a value maximizer => withdraws –If B is an empire builder => stays in  Epoch 4: Somebody exits –If B is a value maximizer => A dominates –If B is an empire builder => it depends (read the paper!)

28. Slide 28 © Carliss Y. Baldwin 2007 Empirical Predictions If A pursues a smaller footprint strategy against B — 1.ROIC A > ROIC B 2.g A > g B 3.Eventually ROIC B < Cost of Capital 4.Possibly ROIC B < 0 5.A can drive B out of the market “B” can be a set of firms, not just one (remember textbook lag!)

29. Slide 29 © Carliss Y. Baldwin 2007 Strategic Implications  If you are a “B” type firm, don’t go to war against an “A”  If you are an “A” type firm –Track bottlenecks »Must know more than you make (Brusoni and Prencipe) »Be prepared to change architecture and shift footprint as bottlenecks move around –Pay attention to strategy details (read the paper!) –Make sure your “B” type competitors know that you are an “A” (publish your ROICs!)

30. Slide 30 © Carliss Y. Baldwin 2007 Evidence—Case Studies  Sun vs. Apollo 1986-1989  Dell vs. Compaq (and others) 1993-2001 Recap Causal Argument

31. Slide 31 © Carliss Y. Baldwin 2007 Comparative Footprints  Apollo  Sun Opportunistic commoditization— Notice selective use of open standards (Ethernet) and open source code (BSD Unix) to make non-bottleneck components into commodities

32. Slide 32 © Carliss Y. Baldwin 2007 ROIC

33. Slide 33 © Carliss Y. Baldwin 2007 Financial Results—Sales Growth

34. Slide 34 © Carliss Y. Baldwin 2007 Apollo was acquired by HP in May 1989 Justification— Economies of scale “the largest engineering workstation company in the world…” HP was 2 nd generation, too, clueless about bottlenecks, footprints and ROIC

35. Slide 35 © Carliss Y. Baldwin 2007 Dell vs. Compaq  This time we are looking at a manufacturing and logistics process architecture  Cannot point to any professor, but there was a crisis in 1993 and another in 1995  And a key person … –Thomas Meredith, former CFO, put “ROIC” on his license plate

36. Slide 36 © Carliss Y. Baldwin 2007 Dell’s Architectural Knowledge about Process Bottlenecks  Inhouse build-to-order assembly based on proprietary software  Maniacal about metrics –Opposite of Ibibidui  Locate manufacturing close to point of sale  “Cross-docking” of peripheral equipment  1100 Patents!

37. Slide 37 © Carliss Y. Baldwin 2007 In 3rd generation process architectures  Power in the Supply Chain is a strategic complement to Architectural Knowledge

38. Slide 38 © Carliss Y. Baldwin 2007 ROIC

39. Slide 39 © Carliss Y. Baldwin 2007 The smallest possible footprint  Creates a negative cash cycle  ROIC may be negative (!) and not meaningful  Still a good incentive measure

40. Slide 40 © Carliss Y. Baldwin 2007 Growth Rates

41. Slide 41 © Carliss Y. Baldwin 2007 Compaq was acquired by HP in May 2002 Justification— Economies of scale “the largest personal computer company in the world…” 13 years after Apollo, HP was still clueless about bottlenecks, footprints and ROIC (There was a proxy fight)

42. Slide 42 © Carliss Y. Baldwin 2007 Summary of evidence  Smaller footprint strategy exists  Rests on “3rd generation” architectural knowledge of bottlenecks, remedies, and potential new modules  Power in the supply chain is a complement (Sun used it too!)

43. Slide 43 © Carliss Y. Baldwin 2007 The Dark Side of the “Smaller Footprint” Strategy  What happened to Sun  What is happening to Dell  The Shimano bicycle drive train story

44. Slide 44 © Carliss Y. Baldwin 2007 What happened to Sun  After besting Apollo, they adopted Apollo’s integral product architecture  Developed a proprietary Unix (Solaris) which ran best on Sun workstations/servers  Sold lots of servers as the Internet boom ramped up  Servers were not competitive with cheap PCs made by Dell (smaller footprint), running Linux (open source software)  Sun refocused on very-high-end hardware (eg Blackbox datacenters) and open sourced Solaris

45. Slide 45 © Carliss Y. Baldwin 2007 What happened to Dell  Small footprint leads to quality problems in supply chain  ROIC focus puts lots of pressure on organization  “accounting errors, evidence of misconduct, and deficiencies in the financial control environment”  Has delayed filing its 10-K for 2006

46. Slide 46 © Carliss Y. Baldwin 2007 Comparative judgment of history (to date)

47. Slide 47 © Carliss Y. Baldwin 2007 When the largest footprint won  Fixson and Park (2007): “The Power of Integrality”  Bicycle drive trains –New functionality (index shifting) –Integral product architecture (combining modules)

48. Slide 48 © Carliss Y. Baldwin 2007 In the beginning (1980)

49. Slide 49 © Carliss Y. Baldwin 2007 Introduction of Index Shifting (1985)

50. Slide 50 © Carliss Y. Baldwin 2007 In 1990, only Vertical Silos left

51. Slide 51 © Carliss Y. Baldwin 2007 In Mountain Bikes… Only Shimano

52. Slide 52 © Carliss Y. Baldwin 2007 Summarizing the message of this talk… Architectural Strategy is not a simple game! Thank You! We have lots more to learn … but not today!

53. Slide 53 © Carliss Y. Baldwin 2007 Thus industries evolve into new—and different— structures AutosComputers Something we can’t predict and don’t really understand!