If you could take a time machine back to 1981 and ask everyone on Wall Street who today’s high-tech winners would be, you’d be sur- prised. Let’s say you gave them three choices—IBM, Intel, and Microsoft—and asked “Who do you think is most likely to have maintained ownership of its part of the PC space 20 years from now?” Ninety percent would have said IBM.
At that time, IBM ruled the hardware market. It had every advantage over anyone else competing in that space. Why did it fall and the other two companies prosper?
The Fall of IBM and the Rise of Microsoft
IBM started on the right path; it was really the first PC company to try a horizontal approach. Before PCs, most hardware companies (like Sun, IBM, and Hewlett-Packard) did everything themselves.
They designed the operating systems, the hardware, the micro- processors, and the disk drives; they even had their own memory fabs (factories). This is what’s known as vertical integration.
When the PC revolution hit, most companies thought things would work the same way. Apple, Commodore, and almost everyone else adopted the vertical integration philosophy from the get-go.
IBM was late to the PC party. In order to catch up, it decided that instead of using vertical integration, it would try a horizontal approach and let multiple companies compete for each slice of the pie. With this new open model, a handful of companies would
T H E F O U R T Y P E S O F C O M P E T I T I V E A D V A N T A G E
● The virtual enterprise or increasing feedback loop
● The economic advantage
● A product that can’t be replicated
● The unbeatable brand
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win out in each space—microprocessors, disk drives, operating sys- tems, and so on. IBM would be the big kahuna that negotiated the best deals with each supplier. The model stood to save IBM some serious cash.
It was also better for the companies competing to be suppliers of software, disk drives, and so forth. Before the open model, a company had to design a different product for every single machine. This was extremely expensive, both to produce and to distribute. With the horizontal model, if a company won in a cer- tain space—let’s say the operating system (OS)—it could spread its research and development (R&D) costs over allhardware com- panies, over all machines. If there were 100 million machines with the same open architecture(meaning that anyone could build a PC around a standard, well-documented reference platform), and
$500 million a year was spent on R&D for an operating system, that would be only $5 per computer. On the other hand, with the verti- cal model, if a company like Apple sold 1 million machines and spent just $50 million on R&D for the operating system, it would cost $50 per machine.
With the new open architecture, hardware companies could spend less money per component than they would have if they’d tried to do everything themselves. Of course, all of this was in its infancy 20 years ago. The idea of open architecture was a new one, and the PC frontier had yet to be won.
Microsoft may be a household name today, but at that time, it was a small, relatively unknown company. It entered the fray as a software provider for IBM machines, and IBM only. This monog- amy was great for IBM, but not so great for Microsoft. It wanted to be the software standard. It was determined to win the operat- ing system piece of the open architecture pie. But in order to do that, it needed multiple partners. Microsoft started playing the field.
As mentioned, the company was small. Microsoft knew that it couldn’t beat the big-time competition with money or brand name or advertising, so it took another tack. The company decided to create a virtual enterprise around its operating system—to partner up with every hardware company in the industry and get its oper- ating system on every machine.
At the beginning, this wasn’t easy. Nobody knew about Micro- soft, but that didn’t stop the company. Microsoft realized that it had to get every single computer manufacturer on board in order to become the standard. The company cut whatever deal it needed to in order to do that. It didn’t matter what price Microsoft had to offer, what deal it had to offer—the key first stepwas to become per- vasive. Microsoft knew that if it could create the impression that it was the operating system on every single PC that shipped (or a very large number of them), its software would become the standard.
Apple took the opposite tack. It decided to keep the Mac oper- ating system exclusive to its machines. This catapulted Apple’s operating system to cult status, but it also relegated its products to a small corner in retail stores. Because Microsoft’s operating sys- tem was bundled with virtually every PC on the market, more com- panies decided to develop software for it. This convinced even more customers to migrate to the Microsoft platform. The more customers that migrated, the more floor space was devoted to Microsoft-compatible products in the typical retail store. The more floor space that Microsoft occupied, the easier it was to con- vince more companies to become partners with Microsoft and develop products for its platform.
This is what I mean by a virtual enterprise—a club of partners built around a product. Multiple partners make a product more compelling, because they add to its value. When a customer bought a computer with a Microsoft operating system 15 years ago, there was only a limited amount of software available for it. These days, with so many partners on board, someone who buys a Win- dows machine knows he or she can get dozens of applications made by Microsoft, or any of hundreds of thousands of products made by other partners. Even if the products aren’t as good as those made for the Mac, the sheer number of choices available is compelling. This phenomenon is known in the industry as the increasing feedback loop.
The Increasing Feedback Loop
As more people get involved in a product, it becomes more valu- able, and the more valuable it becomes, the more people get involved. It’s similar to the virtual enterprise, where getting more
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partners for a product increases the value of the product (as evi- denced by the Microsoft example), which gets more people to use it, which makes it more valuable still.
Here’s how the increasing feedback loop works. Let’s say only two people in the world have e-mail, and you’re considering get- ting an account. If you don’t know the other two people who have it, e-mail is not all that beneficial for you. But suppose, as is the case, that there are millions of people using e-mail, and everyone you know has it. Now, getting an e-mail account is important, because it will allow you to communicate with everyone you know.
Let’s use America Online (AOL) as an example. AOL offers anyone using it (or Compuserve, which it owns) as an Internet ser- vice provider a service called the Buddy List. With it, users type in the e-mail addresses of a list of friends, and AOL then notifies them whenever any of those friends are online. They can then chat online by sending instant messages back and forth.
Within the first year it was offered, the service grew so popu- lar that many people, especially teenagers, signed up with AOL just so they could use it. As more people signed up, more and more wanted to get on. This became a huge competitive advan- tage for AOL.
The increasing feedback loop, like the virtual enterprise, is a self-perpetuating phenomenon—the more people that get on board, the more likely it is that others will follow. Because of this, with new technologies it’s often crucial to get up to critical mass as quickly as possible, because getting the numbers up creates an advantage both for the customers and for the product.
Apple versus Microsoft—the Economics
Each year, Microsoft spends about $500 million on R&D for its Windows operating system. Because 100 million people a year buy it, this R&D cost works out to about $5 per unit.
Apple typically sells about 5 million units a year. If it spent the same $500 million (which it can’t, but we’ll get to that later), its R&D cost would be $100 per unit. Microsoft sellsits operating sys- tem to Compaq for approximately $50. If Apple spent the same
$500 million as Microsoft on R&D, it would spend twice as much per unit as Compaq pays for Microsoft’s whole operating system.
The upshot of all this is that, over time, it is virtually impossible for Apple to spend as much as Microsoft on R&D. The economics just don’t work.
For a long time, Apple charged a premium for its machines in order to help float the cost of R&D for the operating system. But at a certain point Apple had to abandon that method in order to be able to compete with the PC. The fact that Microsoft can spread R&D over so many machines gives it an extreme economic advan- tage over Apple.
Being the brilliant marketer that he is, Steve Jobs recently fig- ured out how to get Apple back into the game. At his direction, the company has shed many of its product lines in order to focus its attention and resources on several key areas, like graphics and education, where Apple has traditionally excelled. Jobs realized that dominating a few key areas instead of spreading Apple too thin in multiple ones will give the company a shot at an economy- of-scale advantage.