How Not To Get Stuck In the 'Commodity Trap'

You have said that innovating in today’s environment requires being open. Please explain what you mean.
In an open innovation model, firms use both internal and external sources of knowledge to turn new ideas into commercial products and services that can have internal or external routes to market. These routes depend on the firm’s business model: projects that fit  the current business model flow through internal channels,  while those that don’t need to go to market through external channels.  Open innovation can reduce the cost of innovation, help a company share its risks and rewards and accelerate the time required to deliver it to the market. It can also help turn a business into a ‘platform’ for others to build on.  

The new motivation for being open is a reaction to an earlier period where companies relied on innovation through vertical integration. From the laboratory bench all the way through to the market, everything was done within the company’s four walls. Openness entails making much greater use of ideas and technologies from outside your walls, and equally, allowing your ideas to be shared with others. A related benefit of this type of innovation comes from the participation of many more individuals and firms in the market.  A greater number of people can experiment in parallel with possible ways of using and combining knowledge. Make no mistake, no single person or company can hope to compete with this external explosion of potential offerings by relying exclusively on their own internal knowledge.

Failure to embrace open innovation can lead to a dangerous phenomenon known as the Commodity Trap. Please explain this term.
I didn’t come up with the concept -- Dartmouth professor Richard D’Aveni did, and he wrote a book about it last year. A Commodity Trap is created by the convergence of three forces. First, manufacturing and business-process knowledge and insights are now being widely distributed, which means it is getting harder for companies to differentiate their products and sustain that differentiation over time. Second, computers and networks are spreading product designs and process tools around the world, where products can be manufactured very cheaply.  And third, the amount of time a product lasts in the marketplace is shrinking. Anyone who has purchased a cell phone in the past year can vouch for how quickly product life cycles are moving in that market: new designs and capabilities are emerging every four to six months, which means that even successful, differentiated products quickly lose their lustre. Beyond individual organizations, these three forces create a significant challenge to the economic prosperity of advanced economies throughout the world.

To escape the Commodity Trap, you believe that a large percentage of a firm’s growth must now come from innovative services for developing economies.  Why is that?
Services have been the growth vehicle in advanced economies for some time: in the U.S., they have risen from a very small percentage of the economy a century ago to more than 80 per cent of GDP today, and they comprise more than 60 per cent of the GDP of 35 of the top 40 economies in the OECD. Without question, growth will come from services in the future, and it will come from developing countries.  Some people say it’s become a misnomer to talk about ‘developing’ economies, because in some respects, these economies are now developed; there are parts of coastal China where the standard of living is every bit as high as the standard of living in the West, for example.  Particularly in the last three years, with the economic struggles in the West, economies in China, India, Brazil, South Africa and Turkey have all surged. The global economy is rebalancing -- away from the traditional centres of wealth to a more globally-distributed concept of wealth, whereby the West will remain prosperous but there will now be new prosperity in all these other areas, too. These areas, in turn, will need a lot of growth to sustain and support that, and much of that will come from new services:  as peoples’ time becomes increasingly valuable, they will have an interest in getting more and better experiences to make use of the time that they have.  That’s why firms have to stop thinking like product manufacturers and start to think about their business from a service perspective.  

You believe that knowledge-intensive services, in particular, will be the engine of growth for the global economy.  What do these services look like?
When people think about services, they think about things like getting their hair cut, or hiring someone to maintain their yard – which aren’t knowledge-based services at all.  Knowledge-intensive services incorporate, increase and reuse knowledge so that over time, things get increasingly productive through a learning process. For example, when you buy a book from Amazon, it can tell you -- thanks to the knowledge it has – that ‘people who liked that book often liked these other books as well’. You won’t always buy the recommended books, but once in a while you will say, ‘Sure, that sounds interesting’. As a result of its knowledge base, Amazon  creates larger transactions, and in turn, customers often get a better experience out of it – all because of the extra knowledge that Amazon has collected over time.

You write that, “As networks and telecommunications move bits around the globe at ever faster speeds, the knowledge that doesn’t move fast – tacit knowledge – becomes increasingly valuable.” Please explain.
This is one of the fundamental underpinnings of open innovation. In the days of vertical integration, companies could really have a ‘knowledge advantage’ over their competitors. There wasn’t a way for others to access the knowledge that companies had built up internally. But thanks to advances in communication and the Internet, most of this is now ‘codified knowledge’ -- knowledge that can be written down and transmitted, and it is now available at the click of a mouse, to people all over the world.

In a world where so much knowledge is freely available, the knowledge that is going to confer the greatest advantage is the kind that can’t be distributed via a computer screen: experiential or ‘tacit’ knowledge. This knowledge can only be gained and valued by going through an experience. A quick example is learning how to ride a bike. I have two daughters, and when I was teaching them to ride, they had a really hard time. I was able to tell them what to do -- the codified part -- but the experiential part, they had to experience on their own. The thing about learning to ride a bike is, if you go a little faster, it’s actually much easier to stay upright than if you’re trying to go slowly. It was very hard for them to trust themselves until they had gone through a number of falls and realized that going slow really wasn’t working.

What is a ‘utilization differential’, and why is it important?
This is a source of hidden value for organizations that are thinking of either launching a new service or shifting the focus of their business from a product to a service. The idea is that in the course of building a business, you have to make investments in certain fixed assets. These might include a manufacturing plant, your brand, the patents and other intellectual property that you own. All of these things are fixed and ‘lumpy’, in that the more transactions you do, the more they are utilized and the more affordable they become per transaction or per unit.

The utilization differential seeks to boost the utilization of a fixed asset.  For example, most adults own a car.  You might only drive that car five per cent of the time each year, yet you bear 100 per cent of the costs for everything from the purchase of the vehicle to the licensing, the insurance, the maintenance and upkeep, gas and parking.  Models that allow you to increase the utilization of that car spread these fixed costs over more use, making it more affordable in the long run. For example, you can find ways to ‘pool’ the usage of the car – as companies like Zipcar and taxi companies have done, taking advantage of the utilization differential.  Another example is a sailing club near where I live in Berkeley. They give sailing lessons there, and initially, they owned their own sailboats. But they came to understand that it actually made more sense for them to have people who owned sailboats make them available for rent from the sailing club. The sailing club pays the owners every time the boat is used, and the boat owners get free upkeep on the boat each time it is used. As with cars, most sailors don’t use their boat all that often, so the club is now able to supply many more and different kinds of sailboats without having to pay to own them.

Describe how companies like financial services firms can become ‘platforms’.
This is one of the strongest takeaways about open innovation: to escape the Commodity Trap, you have to be able to leverage the knowledge-based services we’ve been talking about, but to make that really sustainable and scalable, you need to open it up, and that means turning it into a platform. A platform is a system where others invest and innovate alongside and on top of your offering, and their innovations make your offering more attractive to your customers. So it’s good business for them, but it actually enhances the value of your business as well.  Amazon is an example of such a platform. When you buy a book from them, it comes from an Amazon warehouse; but when you buy jewellery from them, it actually comes from a third-party merchant who has been allowed to use the same web page design tools that make the jewellery page look just like the rest of the website. This platform approach enables Amazon to broaden its economies of scope and provide more choices for its customers, without having to take on the inventory and merchandising risks of providing additional inventory in the jewellery category.

What is your advice for organizations that want to open up, but aren’t sure how to get started?
My first piece of advice would be to open up internally before you attempt to open up externally.  Many companies still have different functions or departments that operate as silos: within each function, information is shared, but between functions, information is rationed very carefully and there isn’t much sharing of knowledge.  Open innovation simply cannot be practiced in such an environment. When you offer a new service to your customers, they often need to interact with different functional areas of your business: your credit department might have to confirm that they can pay for it, another department might have to make sure a product is in stock, or the Marketing department might have to confirm whether there’s a warranty or some kind of a discount available.  Companies that don’t share such information well internally will have a much harder time moving to an open model.

Henry Chesbrough is an adjunct professor and executive director of the Program on Open Innovation at the Haas School of Business, University of California at Berkeley. He is the author of Open Services Innovation: Rethinking Your Business to Grow and Compete in a New Era (Jossey-Bass, 2011) and Open Business Models: How to Thrive in the New Innovation Landscape (Harvard Business Publishing, 2006).

The Four Keys to Open Services Innovation
Combining these four concepts provides the essential perspective required to move to open services innovation:
1.    Think of your business as a service in order to sustain profitability and achieve new growth.
2.    Innovators must co-create with customers. This requires developing ways to manage tacit knowledge.
3.    Open innovation accelerates and deepens services innovation. Use internal and external sources of knowledge to turn new ideas into commercial products and services.
4.    Business models are transformed by services innovation.

[This article has been reprinted, with permission, from Rotman Management, the magazine of the University of Toronto's Rotman School of Management]