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  • Disruption, disintegration and thedissipation of differentiability

    Clayton M. Christensen, Matt Verlinden and George Westerman

    This paper proposes a deductively derived model to help managers who preside

    over decisions to integrate or outsource to assess ex ante whether, when and why it

    might be strategically and competitively important to develop internal capabilities

    to perform certain activities in-house, and when it would be sensible and safe to

    outsource elements of value-added. Among the papers conclusions are that the

    competitive advantage from vertical integration is strongest in tiers of the market

    where customers are under-served by the functionality or performance available

    from products in the market. Vertical integration tends to be a disadvantage when

    customers are over-served by the functionality available from products in the

    market. Vertically integrated firms will therefore often dominate in the most

    demanding tiers of markets that have grown to substantial size, while a horizon-

    tally stratified, or disintegrated, industry structure will often be the dominant

    business model in the tiers of the market that are less demanding of functionality.

    1. IntroductionWhether to become or remain vertically integrated is a question of vast strategicimportance in many industries. In recent years, firms such as Alcoa, Lucent and GeneralMotors, for whom vertical control over most steps in their value chains had historic-ally constituted an important basis of competitive advantage, have sold upstreambusinesses that produced components or intermediate materials, in order to focus onthe portions of their value chains that they consider to be core to their business. Others,like IBM, continue to own but are de-coupling upstream from downstream operations,tasking the former to sell components openly in the market, and the latter to procurecomponents from external suppliers when necessary to maintain competitiveness. Incontrast, Microsoft is aggressively integrating downstream from its initial operatingsystem products into a variety of applications software markets; Intel has integratedinto chipsets and motherboards using its microprocessors; and telecommunicationsand entertainment companies have integrated together in bewildering ways.

    Some business experts have praised these actions, while other reputable observershave reacted with skepticism. For example, IBMs management have been criticizedfor having outsourced the microprocessor and operating system of their personalcomputer from Intel and Microsoft, choosing to participate primarily in the design and

    Industrial and Corporate Change, Volume 11, Number 5, pp. 955993

    ICC Association 2002

  • assembly stages of value-added in their product. While history has proven the decisionto have been unfortunate for IBM, at the time the decision was made it was judged by

    many as the right thing to do.1 It has indeed been difficult to predict, a priori, which ofthese moves toward or away from vertical integration would be judged in retrospect as

    having been managerially astute, and which would be viewed as strategically flawed. Toooften for decisions as important as these, their wisdom can only be judged with thebenefit of history.

    This paper proposes a deductively derived model to help managers who preside overdecisions to integrate or outsource to assess ex ante whether, when and why it might bestrategically and competitively important to develop internal capabilities to perform

    certain activities in-house, and when it will be sensible and safe to outsource elementsof value-added. Our conclusions are that:

    1. The competitive advantage from vertical integration is strongest in tiers of themarket where customers are under-served by the functionality or performance avail-able from products in the market. Vertical integration tends to be a disadvantage

    when customers are over-served by the functionality available from products in themarket.

    2. As a result of (1), vertically integrated firms will often dominate in the most

    demanding tiers of markets that have grown to substantial size, while a horizontallystratified, or disintegrated, industry structure will often be the dominant businessmodel in the tiers of the market that are less demanding of functionality.

    3. The tendencies listed in (1) and (2) occur in end-use markets for complete productsystems, such as automobiles and computers. But they also can occur in the marketsfor subsystems and components, which themselves comprise multiple constituent

    parts and materials.4. Most often, vertically integrated firms tend to dominate many markets at the outset.

    Because of the patterns observed in our earlier studies, howeverin which the paceof technological progress proceeds at a faster rate than customers in any given tierof the market can utilize that progressthe dominant business model in any given

    tier of the market will tend to shift over time from vertically integrated firms to ahorizontally stratified population of specialized firms.

    5. The generalization in (4) can be reversed, however, when performance gaps emerge

    in markets due to discontinuous shifts in the functionality demanded by customers.When this occurs, the pendulum of competitive advantage is likely to swing back

    toward vertically integrated firms, as companies seek to compete with each other onthe basis of superior product functionality again.

    6. When the dominant business model in a tier of the market shifts from verticalintegration to horizontal stratification, the ability to achieve above-average profit-

    ability tends to transfer from the firms that design and assemble end-use productsthat historically had not been good enough, to those that build those subsystems

    1See, for example, the discussion of IBMs outsourcing decisions in Fortune, 14 April 1997.

    956 C. M. Christensen, M. Verlinden and G. Westerman

  • which limit performance of the end-use system, and which therefore are not goodenough.

    These conclusions began to take their initial shape in studies of the patterns of verticalintegration and disintegration in the disk drive industry, in which the pendulum ofcompetitive advantage swung repeatedly between integrated and non-integrated firms,in various tiers of the market (Christensen, 1993, 1994; Chesbrough and Kusunoki,2001). This papers conclusions have not been built inductively from empirical analysis,however. They have been derived deductively by combining the results of the disk drivestudies with other scholars examinations of technological modularity (Ulrich, 1995;Sanchez and Mahoney, 1996; Baldwin and Clark, 1997), and with concepts of thedrivers of change in the basis of competition (Christensen, 1996; Adner and Levinthal,2001). In this paper we provide some preliminary but promising empirical evidencesupporting the model, and use the model to examine briefly the histories of thecomputer, automobile, software, photonics, financial services and microprocessorindustries, to suggest that the model might be more broadly useful. Our primarypurpose in offering this paper is to invite other scholars to test empirically thesehypotheses, and thereby continue to build deeper understanding of the circumstancesunder which we might expect integration and non-integration to confer competitiveadvantage or disadvantage.

    2. Relationship to prior studies of vertical integrationThe model presented in this paper does not address every rationale for verticalintegration and disintegration. We believe, however, that it builds upon and extends thefoundations laid by several important scholars who have studied the causal driversbehind integration. Stiglers (1951) causal model, echoing Adam Smiths (1776)original analysis of the specialization of labor, asserted that a driver of specializationwas market size. He observed that many industries begin as vertically integrated onesdue to their small size. They then increasingly become populated by specialist firms asthey grow. Stigler posited that later in the life cycle, when demand begins to contract,industries consequently tend to reintegrate. Although we agree that scale is a factor, ourmodel views scale often as an outcome of other factors that drive specialization, ratherthan as a fundamental causal driver of it.

    Coase (1937) and Williamson (1985) introduced the role of transaction costs as thecausal driver of the optimal boundaries of the organization. There are many types oftransaction costs, including threat of intellectual property appropriation (Teece, 1986),lock-in (Williamson 1979), asset specificity (Williamson, 1979; Klein et al., 1978) andthe challenges of coordinating interdependent investments (Chandler, 1977). Demsetz(1988) characterized transactions costs as the costs of search and maintenance, showinghow these vary across the industrial life cycle. A stream of subsequent scholars withinthe transactions cost paradigm, including Teece (1986), Langlois (1994), Becker andMurphy (1992), Sanchez and Mahoney (1996), and Chesbrough and Teece (1996), have

    Disruption, disintegration and the dissipation of differentiability 957

  • identified a specific type of transactions costthe challenge of coordination amongst

    diverse specialistsas a driver of managerial integration across such interfaces.

    Monteverdes (1995) construct of unstructured technological dialogue describes the

    management challenge when an interface between stages of value-added is inter-

    dependent and not well specified. Our model builds most directly upon Monteverdes

    concept.

    Scholars working in a parallel stream have studied in engineering terms the concepts

    of architectural modularity, in order to define more precisely