Open Innovation, page 11
This leasing proposal surmounted the razor-and-razor-blade problem and provided an attractive value proposition for customers. The new business model imposed most of the risk on the tiny Haloid Corporation: Customers were only committed to the monthly lease payment and paid no more unless the quality and convenience of the 914 led them to make more than two thousand copies per month.11Only if the 914 were to lead to greatly increased volumes of copying would this business model pay off for Haloid. The model essentially acknowledged that the ADL analysis was right, but was incomplete. Wilson bet that there was greater potential value in xerography than ADL had judged, but that a different business model would be required to unlock that value.
It proved to be a smart bet. Once the 914 was installed on customers’ premises, the appeal of the machine was intense; users averaged two thousand copies per day (not per month), because of the high image quality and the convenience (no more smudged fingerprints from the wet copying processes, and no more yellowed, curled-up thermal paper). This tremendous surge in usage meant that most machines were generating incremental, per-copy revenues to Haloid by the second day of the monthly lease. This business model generated revenues far beyond even Wilson’s most optimistic expectations, powering compound revenue growth at an astonishing 41 percent rate for a dozen years. As a result, the little $30 million Haloid Corporation turned into a global enterprise (renamed Xerox) with $2.5 billion in revenues by 1972. Thus, the same technology that IBM, ADL, Kodak, and GE had rejected as a niche opportunity created a multibillion-dollar enterprise—through the use of a different business model.
The Cognitive Effects of Xerox’s Business Model
This enormous success had lasting effects on Xerox. The huge success of the 914’s business model—which generated more revenues when more copies were made—established the dominant logic for Xerox’s later copier business. Xerox’s business model motivated the companyto develop ever-faster machines that could handle very high copy volumes, with maximum machine uptime and availability. This resulted in a strong cognitive bias within Xerox, because the model discouraged development of low-speed copiers. As a later Xerox CEO observed:“[O]ur profits came from how many copies were made on those machines. If a copier was slow in generating copies, that was money pluckedout of our pocket.”12
Meanwhile, Xerox’s monopoly of plain-paper copying technology ended abruptly. An antitrust action brought by the Federal Trade Commission forced the company to accept a consent decree requiring it to license its patents on a compulsory basis and to offer its machines for saleas well as on lease. Kodak and IBM entered the high end of the market,with their own high-volume, high-speed copiers, using business models very similar to Xerox’s own. More challenging to Xerox, though, was the entry of a host of Japanese manufacturers at the low end of the market. They employed different pricing strategies, product configurations, and distribution channels to target a different market segment; in other words, they entered with a different business model.
Xerox’s business model as of the early 1980s is summarized in table 4-1 according to the business model attributes just described. It targeted its products and sales efforts to major corporate customers and government organizations. Its value proposition was “high quality copies in high volume, at a low monthly lease rate.” Xerox organized its value chain to deliver completely configured copier systems, sold through its own direct sales organization, and comprehensive maintenance services, provided by its own technicians. The company priced its products and services so that it made some money on its equipment, but made the bulk of its profits from sales of services and supplies (e.g., toner and paper).
This business model did not require partnerships with third-party organizations; indeed, Xerox chose to provide the many elements of its business model itself. Xerox conducted its own research, as we saw in chapter 1. It performed all the required product development activities to launch and support new products. Xerox manufactured its products internally. It distributed all of its products through its own channels of distribution. The company provided its own financing to customers, and its own service and support. Xerox even made its own paper, to provide the optimal feeding characteristics for its machines, though in this respect, Xerox had to be sure to operate with paper from other companies as well.
TABLE 4-1
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Xerox’s Business Model in Comparison with Japanese Low-End Copiers’ Model
Xerox Japanese Copiers
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Identified Market Segment Corporate and government market Individual and small business markets
Value Proposition High-quality copies at a low monthly lease rate Low cost of machine, greater affordability of copiers
Elements of Value Chain Developed entire copier system, including supplies; sold through a direct sales force Internal machine and cartridge; outsourced distribution, service, support, and financing
Defined Cost and Margins Modest profit on equipment, high profit on supplies, or per “click” Modest “box cost” for copier, higher margins on cartridges–a “razor and razor blade” mode
Positioned in Value Network First mover in dry-copy process; did not require or pursue partners Recruit third-party office equipment dealers to expand to national coverage; user-serviceable cartridge
Formulated Competitive Strategy Competed on technology, product quality, product capability Compete on lowest box cost, convenient dealer locations, machine quality/self-service
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Meanwhile, the Japanese entrants identified an Achilles’ heel in Xerox’s model. Xerox’s model performed well when applied to thelargest corporations, which needed high volumes of high-quality copy output. It did not fit as well, though, with the needs of small businesses and individuals. These groups did not need such high volumes of copying, were much more sensitive to the price of the copier, and were willing to compromise on the quality of the image to save money.
The Japanese entrants attacked this segment of the copier market with a different business model (the right-hand column of table 4-1).13 They designed a product that could be serviced without a trained company technician. They accomplished this by making the most frequently failing parts of the copier into a replaceable cartridge. Doing so allowed the companies to reapply the earlier razor-and-razor-blade model, because the copier machines could be priced at a more modest gross margin, while the replacement cartridges could be priced with very high gross margins. They then created an indirect distribution channel of dealers and distributors to sell this equipment and to provide servicing and financing as required. An indirect distribution channel saved the Japanese companies the cost of creating a direct sales force. It also enabled them to build a nationwide distribution capability very rapidly and allowed potential customers the convenience of walking into a local storefront to try out the new machines before purchasing.
The Japanese entry proved to be a daunting challenge to Xerox. Xerox’s engineers could design far more elaborate and impressive copiers, but responding to this challenge required them to abandon the dominant logic of the hugely successful company they had created. It meant that engineers who had previously excelled in moving paper faster through complex mechanical equipment now had to create much simpler products, at much lower costs. The sales department had to determine how to manage an indirect sales force alongside a direct sales force and spent countless hours arguing over whether and when a customer should be served through direct versus indirect channels. And marketing had to decide how to promote the Xerox brand at the low end of the market (which earned lower gross margins per machine) while still main-taining the high-end, high-margin sales that had catapulted Xerox to prominence. It took a decade for Xerox to cope with the threat of the Japanese entry into the home-office and small-business market. In 2001, under pressure across its copier businesses, Xerox abandoned this part of the market, deciding that it wasn’t worth its effort and resources.
The effects of Xerox’s business model and the dominant logic inherent within it would cast a second shadow as well, a shadow over the commercialization of new technologies in new business areas for the firm.14In 1968, Peter McColough, who had led the sales and marketing effort of the 914, was appointed chief executive of Xerox. As the rapid rate of growth of copier revenues began to slow at the end of the 1960s, McColough knew that Xerox would need to expand its business into new areas to maintain its historic rate of growth. He set a new direction toward the architecture of information. Yet even as McColough articulated this vision for Xerox’s future, its management of that future would be constrained by the logic of its successful business model from its past.
Commercializing PARC Technologies
McColough’s first steps toward realizing this vision were to enter the computer business in 1969 through the billion-dollar acquisition of Scientific Data Systems (SDS). This was an astounding sum to pay for an acquisition in 1969, and it would prove later to be a disastrous move.As we saw in chapter 1, Xerox established the Palo Alto Research Center (PARC) in 1970 to lead the way technologically into the computer industry and to feed new technologies into the SDS unit. Sadly, SDS soon collapsed and was shut down in 1975.
Despite SDS’s failure, the research community within PARC flourished during the 1970s, with generous budgets and few restraints on its freedom to explore new boundaries. The first commercial payoff from PARC technology emerged in 1977, as Xerox entered the electronic printing business with a high-speed laser printer. Xerox’s high-speed copier business model worked beautifully with the new printer technology. Laser printing enabled Xerox to make copiers that copied even faster, with even higher image quality. These technologies created anew, large, and profitable business for Xerox. The company’s business model was able to quickly convert these powerful new technologies intodditional sales and enhanced gross margins.
The same year, Xerox took the first steps toward building a major line of business intended to serve the office of the future. An Office Products Division, newly established in Dallas, marketed a stand-alone electronic word processor in 1977, but took this product primarily to Xerox’s current customers and served them through Xerox’s current marketing channels. In 1979, Xerox offered the first “office system,” which used Ethernet technology to link word processors and printers. In 1981, the Star workstation was introduced as the centerpiece of an integrated system for office automation. Xerox did not offer these technologies as individual pieces; rather, they were offered exclusively as an integrated system.15
The latter move set a pattern for the business model that Xerox used to evaluate PARC’s innovations in computing. Xerox applied PARC technologies to create complete computing systems, which constituted a value chain of proprietary technologies, with no option to use third-party equipment or software. Xerox initially offered the Star work-tation for purchase at $16,995; the requisite network facilities and shared printer raised the total cost for a three-user system to more than $100,000. These systems were then sold primarily to Fortune 1,000 companies through a direct sales force and supported by a field service organization.16Xerox took this revolutionary technology to market via the business model that had worked so well for its copiers.
It is instructive to compare Xerox’s business model with that employed by IBM when it first marketed a new, microprocessor-based personal computer (PC) (table 4-2). The target market was different for the two companies. Xerox restricted its Star office systems to its customer base of large corporations and government departments. Although IBM also sold its PCs to this market, it crafted a strategy to take its PCs well beyond these traditional customers to individuals and small businesses as well. It created a very successful Charlie Chaplin–esque advertising campaign to position these machines for the individual. IBM offered aversion of its PC for $2,995 and created a retail distribution channel of over two thousand outlets through Sears, Computer Land, and Businessland to reach individuals and small businesses. As we now know, IBM also created a technical architecture that outsourced the microprocessor and operating-system portions of the value chain—to Intel and Microsoft, respectively. The decision would change the course of the computer industry, and not to IBM’s long-term advantage.17The point here, though, is that IBM did not constrain its entry into the PC industry by slavishly extending its own hugely successful business model in its mainframe business. By contrast, Xerox’s commercialization of its PARC technologies never escaped the confines of its copier businessmodel and associated business logic.
Although Xerox had some incredible technologies in its Star networked office systems, these superior computing technologies were no match for the vastly superior business model of the IBM PC. For example, the Star had a wonderful word processor; beautiful, laser-quality output; and an electronic mail capability far better than those available on the IBM PC. But the IBM open systems architecture enabled third parties to develop hardware and software products that greatly enhanced the value of IBM’s systems. For example, the Xerox Star never developed a capable spreadsheet package, whereas IBM’s PC sales were boosted tremendously by Lotus 1-2-3. Similarly, the IBM PC could run Ashton Tate’s dBase program, but the Star had no such database offering.
TABLE 4-2
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Xerox Star Workstation Business Model versus IBM PC Business Model, Around 1981
Xerox Star IBM PC
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Identified Market Segment Corporate and government market Corporate, government, individual, and small business markets
Value Proposition Leading Edge performance; high-quality documents onscreen and in print; ability to share and send documents; state-of-the-art Personal computing made affordable, fom the best-known name in the industry; ability to run third-party hardware and software; ability to buy from local retailer
Elements of Value Chain Developed entire Star system, brom basic chips through manufacturing, distribution, service, financing, and support Internal design and manufacture of PC systems; external sourcing for microprocessor, operating system, and third-party application software and hardware; direct and indirect distribution
Defined Cost and Profit Margins Modest volumes, high unit gross profit margins High volumes, moderate gross profit margins
Positioned in Value Network In order to do anything, we must do everything Recruit third-party dealers and hardware and software developers; outsource microprocessor and operating system; allow vendors to sell to “compatibles”manufacturers
Formulated Competitive Strategy Win on engineering, state of-the-art functionality and performance Win on leading market share, control of PC architecture; ability to enlist thousands of independent developers to extend capabilities of PC
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What’s more, the IBM PC’s own hardware capabilities were often enhanced by the addition of third-party hardware. This additional hardware greatly assisted the PC in performing useful tasks and in running some third-party software. For example, companies like Hercules extended the graphics abilities of the PC, so that it could display Lotus 1-2-3 graphs.Intel and others, like AST and Quadram, marketed boards that expanded working memory. Plus Development, a company I was involved with from its beginnings, even created an add-on board with a built-in hard-disk-drive that could easily increase the hard-disk storage on a PC. The Hayes modem, 3Com’s Ethernet board, and IRMA’s 3270 emulation board enabled the PC to connect to a variety of other computers. The Star system, on the other hand, could only connect to another Star system.
The differences in the value chain extended to distribution as well. The Star was only available through Xerox’s sales force, whereas the IBM PC could be obtained at more than two thousand retail stores around the United States, as well as from IBM’s own sales force. This retail distribution channel was also available to companies who wanted to sell “IBM-compatible” hardware and software products. There was, however, no easy way for third-party developers to reach Xerox’s workstation customers.
As the PARC scientists watched this competition, they sensed that Xerox could do more with the technologies they were creating than to simply commercialize them with the Xerox Star offering. They questioned the pace at which Xerox was pursuing the commercialization of their inventions, or disagreed with the company’s commitment to proprietary standards and “systems” marketing.
Some of the researchers eventually chose to leave Xerox to pursue commercial versions of their ideas. Instead of applying the Xerox systems model for computing, though, they chose to start new companies to exploit individual component technologies, in a different, more open architecture of computing. The departure of some of these employees created a situation in which, during the 1980s and 1990s, several new PARC technologies were being exploited simultaneously by Xerox within its integrated systems (usually in Xerox copiers and printers) and by independent entrepreneurial spin-off companies as stand-alone innovations.
This natural experiment afforded an unusual opportunity to compare commercialization practices in a setting where similar technologies were taken to market with sharply different business models. These models provide a comparison between a Closed Innovation paradigm (within Xerox) and an Open Innovation paradigm (the spin-off companies). Chapter 1 discussed some aspects of this coevolution, with the example of SynOptics. Here, we will examine three other spin-offs and compare them explicitly with Xerox’s business model.
