The Conservation Of Attractive Profits
How shifts in the value chain create losses for some but victories for others
(This post was inspired by my desire to better understand the insights written about in this Ben Thompson post from his blog Stratechery.)
Last time I explained why attractive profits flow to bottlenecks in a particular business value chain (see linked post below). This time we will dive into the second half of Professor Clayton Christensen’s the law of conservation of attractive profits which states:
“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. The law states that when modularity and commoditization cause attractive profits to disappear at one stage in the value chain, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.”
— Clayton Christensen, The Innovator’s Solution
In plain English, it means that when an existing bottleneck gets alleviated due to a market shift, the profits usually don’t just vanish. Rather, the profits move to other points on the value chain giving smart (and lucky) companies a chance to capture them.
Continuing the previous example (which both Christensen and Thompson discuss in their writings), Intel lost its processor dominance when the smartphone ascended. In the PC world where power consumption didn’t matter (most PCs and laptops are plugged in during use), the processor was the bottleneck and everyone else optimized around it. This allowed Intel to earn very attractive profits as the most irreplaceable component in the PC and the component that everyone else was forced to optimize around.
In the smartphone world, power consumption and cost matter more than raw speed and performance — you neither want your phone to die in two hours nor want to pay $2000 for it. The easiest way to control both power consumption and cost is via an SOC (System On a Chip), which is an integrated circuit that contains everything (CPU, GPU, memory, modem, etc.) needed to run a smartphone. Squeezing everything on a single chip increases power efficiency and lowers manufacturing costs.
The technical aspects of why are not important to our discussion. Rather, the key is that in the smartphone world, the CPU is no longer the bottleneck. Now the bottleneck is the entire system, and all the components of the SOC, including the CPU, need to be standardized and optimized. This meant that smartphone CPUs just needed to be good enough in terms of processing power, and the technological lead that Intel had spent years developing no longer mattered quite so much.
In the smartphone value chain, the better you could build a fully integrated system (and device) where everything fit optimally and efficiently with everything else, the better your product would be and the more money you stood to make. An SOC manufacturer like Qualcomm could earn attractive chip design profits due to its skill in designing these integrated circuits and the willingness of vendors like ARM and Micron to commoditize and optimize their chips around Qualcomm’s SOCs. This optimization boosted the performance of Qualcomm’s SOCs relative to weaker competitors and made it indispensable to non-Apple smartphone manufacturers. In the smartphone ecosystem, the power had shifted from the leading CPU makers (who were commoditized along with everyone else) to the leading SOC makers.
Apple took it one step further by not just designing the SOC (and its own processor) but layering on its own software (iOS) as well — where both the hardware and iOS were integrated and designed to work optimally with each other. This integration produced an unparalleled combination of functionality and UX that combined with Apple’s iconic brand to propel the company to an early lead (and chokehold over profits) that it never relinquished in the smartphone race.
It was the software (and its integration with the hardware) that really separated Apple from lower-end smartphone manufacturers, especially early on. Other smartphone manufacturers were just hardware assemblers that competed almost exclusively on cost (everything else like a trendy design was easily copied). Thus outside of their lowest-end smartphones, these manufacturers couldn’t afford to not have a high quality SOC from a leading vendor like Qualcomm — that was table stakes. In the non-Apple and non-Samsung portion of the smartphone value chain, both Qualcomm’s suppliers and customers were commoditized and forced to optimize around it.
Bottlenecks are important because they give companies opportunities to earn outsized profits. But those same bottlenecks also provide new entrants the incentive and opportunity to disrupt and shift the value chain (and bottleneck) causing a redistribution of profits. You can never get too comfortable.
