How to avoid commoditization (Part 1)

The Innovator's Solution presents a framework for thinking about what drives commoditization. In the words of the authors, "The process that transforms a profitable, differentiated, proprietary product into a commodity is the process of overshooting and modularization." The idea is as follows:

1. As a new market coalesces, a company develops a proprietary product that, while not good enough, comes closer to satisfying customers' needs than any of its competitors. It does this through a proprietary architecture, and earns attractive profit margins.
2. As the company strives to keep ahead of its direct competitors, it eventually overshoots the functionality and reliability that customers in the lower tiers of the market can utilize.
3. This precipitates a change in the basis of competition in those tiers, which...
4. ... precipitates an evolution toward modular architectures, which ...
5. ... facilitates the dis-integration of the industry, which in turn ...
6. ... makes it very difficult to differentiate the performance or cost of the product versus those of the competitors, who have access to the same components and assemble according to the same standards. This condition begins at the bottom of the market, where functional overshoot occurs first, and then moves up inexorably to affect the higher tiers.

I feel this analysis (which focuses on the dynamics of low-end disruptions to existing industries) overlooks another important source of commoditization: open, widely-accepted standards. While standards can create a great deal of value for the consumer (through interoperability, increased consumer choice and lower prices), they simultaneously drive commoditization in the industry.

I had a recent post on standards and commoditization where I argued that

Standardization can play an important role in speeding up the product lifecycle by tending to remove competition based on features and functionality - as an example, most of the core functionality of a product category such as “WiFi AP” is now standardized and it is very hard for AP vendors to differentiate their offerings. The emergence of a standard also has other visible effects/implications: (1) it signals a broad consensus on specifications, (2) it encourages multi-vendor adoption of the standard, (3) competition between vendors drives down the cost of components, (4) lower costs drive adoption, which leads to even lower costs in a vicious/virtuous cycle, (5) standards significantly lower barriers of entry. When the emergence of the standard is timed well relative to the market, each of these effects reinforces the others. WiFi is a great example of each of these effects.

Standards have the effect of lowering barriers to entry, increasing competition,eroding product differentiation and destroying competitive advantage, exerting downward pricing pressure, and driving commoditization. However, it is possible to avoid the commoditization death-trap and Christensen and Raynor point a way out (in a chapter titled 'How To Avoid Commoditization'):

Whenever commoditization is at work somewhere in a value chain, a reciprocal process of decommoditization is at work somewhere else in the value chain. And whereas commoditization destroys a company's ability to capture profits by undermining differentiability, decommoditization affords opportunities to create and capture enormous wealth. The reciprocality of these processes means that the locus of the ability to differentiate shifts continuously in a value chain as new waves of disruption wash over an industry.

The companies that are positioned at a spot in a value chain where performance is not yet good enough will capture the profit. That is the circumstance where differentiable products, scale-based cost advantages, and high entry barriers can be created.

In other words, one response to commoditization is to alter business models and target and occupy a part of the value chain where the performance is not yet good enough. In a forthcoming post, I will try to apply this analysis to the DVD industry: the emergence of the DVD standard, the opportunities (and challenges) created by wide acceptance/adoption of the standard and the firms that have managed to capture the profit within the industry.