In Business, The Weakest Link Makes The Most Money
How to find the most profitable part of the value chain
It’s ironic. In a business value chain (i.e. the set of companies that work together to create a product), you would think that the strongest links are the ones that earn the most money. But it’s actually the opposite.
The late Clayton Christenson, a renowned business strategy professor and thinker, was the one who came up with this theory, which appeared in the first part of his Law of Attractive Profits. From Mr. Christenson:
“Formally, the law of conservation of attractive profits states that in the value chain there is a requisite juxtaposition of modular and interdependent architectures, and of reciprocal processes of commoditization and de-commoditization, that exists in order to optimize the performance of what is not good enough.” — Clayton Christensen, The Innovator’s Solution
That’s quite a mouthful. Let me translate:
Most products are made from putting a bunch of component pieces together. Usually there’s one (or two) component that is the weak link or bottleneck — meaning it’s not good enough. Left alone, it would create a drag on the performance of the whole product. Since no one wants to buy a bad product, the other pieces around the bottleneck have no choice but to fit extremely well with it. This means the other pieces must maximize their fit to the bottleneck, commoditizing themselves (and becoming more replaceable), while the bottleneck gets to focus on optimizing itself (making it more specialized and harder to replace).
Intel
Mr. Christenson used the PC industry and Intel as an example (as did Ben Thompson, who was one of the inspirations for this post) so let’s do that here too. Before reading and thinking about this, I had always wondered what allowed Intel to earn such massive and disproportionate profits in the PC value chain. Mr. Christenson’s theory explains how this came to be.
In the 1990s and 2000s, CPU performance was the weak link in the PC value chain (not true with smartphones and tablets). In order to maximize the performance of the CPU, the manufacturers of the other parts (both hardware and software) designed around the CPU. In other words, other companies bent over backwards to conform to CPU manufacturers’ standards and boost the CPU’s performance.
When you design your product to conform with and optimize someone else’s, it’s a pain. You likely only have the time and money to do this with one maybe two firms. This gave the leading CPU manufacturers a huge advantage and meant that there ultimately was just room for a few players in the space. It also meant that a small lead would balloon into a huge one. Intel just needed to establish a small performance and popularity lead over its competitors — then the other manufacturers would optimize around its CPU design. This optimization would make Intel’s chips appear to perform much better than those of its competitors, allowing Intel to further cement its market share lead. And that’s exactly what happened.
It also made Intel irreplaceable. Because makers of other components were forced to conform to Intel, they became commodities. PC makers could easily swap out one company’s memory chips for another’s without missing a beat because they were all optimized to work best with an Intel CPU. But PC makers could not swap out an Intel processor — because even if another processor offered the same stand alone performance, once integrated into the system its performance would lag Intel’s because everyone optimized their components around Intel’s design. And if you’re the most irreplaceable part of the value chain, naturally you can demand and receive biggest portion of the financial pie.
So if you’re looking for companies that have the potential to earn high, sustained profits, look for bottlenecks — or in other words, the strongest player in the weakest link of a value chain.