Microsoft's Strategy for Gaining Strategic Control of Evolving Profit Zones
This series of four posts began with a review of Morris and Ferguson's (1993) seminal contribution to understanding architectural control. In a second post, I summarized the general case of how to achieve strategic control, following Slywotzky and Morrison (1997), who introduced a set of 22 models of the profit zones in various business designs. They concluded that business designs must evolve to keep in step with the customer's priorities as value migrates from one profit zone to the next profit zone. My purpose here is to look at the special case of Microsoft's evolving business design, with its emphasis on creating de facto standards-open, but proprietary-that has led to its outstanding profitability. Microsoft's history is a classic case of adaptive evolution to sustain architectural control. In a fourth post, I try to draw some threads together from Moore, Morris and Ferguson, and Slywotzky and Morrison to integrate ideas about strategic control.
In Chapter 13, Slywotzky and Morrison chose Bill Gates as an exemplary reinventor to illustrate their Create-the-Standard Business Design. Their introductory lead made four key points: (1) Microsoft creates standards because that is what its business is designed to do; (2) the "de facto standard" business design is the most valuable type of design because it generates high margins, high profit protection, and increasing returns to scale; (3) what is less well known is that, although it is most valuable, the create-the-standard design is also the single most difficult business design to create; and, (4) Bill Gates's successful implementation of this design-building, developing, and owning the key elements of the PC industry-has produced the most dramatic value creation in recent corporate history.
According to Slywotzky and Morrison (p. 254-255, my bold):
A standard is more than a physical product or technology. A standard is a fundamental building block around which an industry is built. …In many industries, the establishment of standards has unlocked the market by giving customers confidence in compatibility and technology trajectory.
However, simply creating a standard does not guarantee capturing value from it. …[Examples of IBM's creation of PC architecture, Matsushita's creation of VHS, and Hayes' modem standard were used to illustrate the key point that owning these standards without a business design that met the customer's priorities all failed in the face of competition.]
At the other extreme, a standard can open the door for tremendous value-growth opportunities-if the correct business design is built around it. By making the right choices on customer selection, value capture, additional differentiation, and scope, a company can create a degree of strategic control that allows extraordinary value growth. The technology inherent in a standard can be copied or replicated, but a standards-based business design will be very difficult for the competition to copy. The strategic control is embedded in the business design, not in the technological invention.
The economics of creating a standard can be quite attractive. In technology industries, developing new products often requires enormous sunk costs but low marginal costs. Profit is thus dependent on getting the highest return on the fixed investment. A company with a standards-based business design retains control of its product and its market and has three value capture advantages: (1) high volume, (2) pricing flexibility, and (3) profit opportunities from upgrades. With the right business design, a technological standard can place a company squarely within the profit zone.
In the twenty years (1976-1996) of Microsoft's history that Slywotzky and Morrison reviewed, Gates won several different battles over standards using a common set of strategies to build its classic standards-based business design. According to Slywotzky and Morrison (p. 255, my bold):
First, he realized that to set any product as the basis for an industry, one must involve and deliver for all customer groups-from original equipment manufacturers (OEMs) to application developers, end users, distributors, and those who will use the product as a starting point for their own business. Second, Gates focused on the challenge of value capture. A classic standards-based business design brings enormous profits, but not immediately. The standard had to be secure, and volume high, before Microsoft could begin to offer upgrades and new and improved products. Third, to attain differentiation, he had to give the customer a compelling reason to adopt or switch. Gates knew that the most sophisticated technology in the world would never be adopted if it did not meet customers' needs and priorities, and most important among those priorities would be easy conversion from competitor's offerings to the new standard. Finally, he saw that his scope had to extend far beyond developing or finding new technologies. In the creation of a standard, great marketing is more important than great technology in persuading the key groups that drive the entire industry to adopt a product. The power of the standard is realized when the standard exists in the minds of the customers.
Slywotzky and Morrison (p. 256) presented Microsoft's Standards-Based Business Design in tabular form by describing how it specifically fulfilled each of their four elements of a business design:
Microsoft's Standards-Based Business Design
Customer Selection Immediate customers (OEMs)
Application developers
End users
Value Capture Increasing returns to scale
Pricing Flexibility
Upgrades/New offerings
Core applications
Differentiation/ Create the standard
Strategic Control Meet most important customer priorities for each
major group of customers
OEMs: Customization
Developers: Support
Users: Applications
Scope Development
Licensing
Developer marketing
User marketing
Although constructing a standards-based business design is no easy task, requiring intensely customer-centric and profit-centric thinking, Gates did it four times, for PC BASIC, DOS, Windows, and Applications in his first 20 years. He used the same strategies each time, according to Slywotzky and Morrison (p. 255, my bold):
For each of his standards, he focused on meeting customer's primary needs, whether they were quick delivery, low price, simplicity of use, or cross-platform capability. A second Gates strategy was eradication of the barriers-financial, technical, and logistical-to switching to Microsoft's products. Third, he earned and secured the support of software developers who embraced the Microsoft standard, and ensured the end user's satisfaction with the entire system. Finally, Gates was willing to trade current cash flow for future leadership and profit. He priced low each time, to draw customers into the Microsoft system and to create near universality. The big profits would come later.
Here is an in-depth synopsis of how Slywotzky and Morrison described this set of battles.
Winning Languages: In 1975, when Gates was a sophomore at Harvard, there was no personal computer industry. MITS, an unknown and nearly bankrupt calculator company, announced plans for a computer kit, called the Altair. When Gates and Paul Allen read about the Altair in Popular Electronics, they knew that someone needed to write the code that would make this product useable. Not only that, they realized that to make money, they had to win the contract from MITS. According to Slywotzky and Morrison (p. 256), "Pragmatic from the onset, the Microsoft founders' strategy was: Get the customer first; deliver on the technology later."
Gates and Allen made two key product decisions that remain integral to Microsoft's strategy today. First, they rushed to market, cutting corners, even though it meant that the pared-down product wasn't perfect or elegant but worked-period. Second, Gates and Allen boldly borrowed innovations, cloning BASIC as PC BASIC and limiting Microsoft's scope to adaptation, not creation. This worked, winning the contract.
However, clones appeared and Microsoft could not target them as customers because MITS owned the proprietary rights to license Microsoft's technology. Recognizing this mistake, Microsoft sued to regain control of its technology.
Having learned their lesson, Gates and Allen realized that they must protect not only their proprietary right to their software but also that they must make it a universal solution across hardware platforms: [Achieving strategic control required that its software solutions become universal standards.] Only then would software be freed from the tyranny of the hardware of the OEMs.
Cross-Platform Strategy: To loosen hardware's dominance of the microprocessor industry, Gates realized that he must create a software standard that ran on every hardware platform. This boldly challenged the basic paradigm in the industry-customize the software to optimize the hardware platform.
[The existing paradigm was that hardware was the platform, but if Gates succeeded in getting a critical mass of OEM's to include PC BASIC with every machine sold, insuring network effects, then its broad and just-good-enough nature would become the stabilizing point in the open-system. Microsoft's software would become the new platform with the power that comes from owning the standard being used to control the value chain.]
It was not Gates technology but his aggressive sales and marketing effort that carried the day. As Slywotzky and Morrison (p. 258) put it, "As chief salesman, Gates himself delivered on his famous motto-'Get the business, get the business, get the business'-by pricing as low (and promising as much) as was necessary to close deals. Trying to minimize obstacles to adoption, he targeted a key customer priority-price. He sold on a flat fee basis, encouraging OEMs to include the language with every machine sold."
Gates knew that his primary objective was to become ubiquitous by extending his language across all hardware platforms in the market so that it became the standard. Microsoft's code was designed so that only a few key blocks required any changes to port it to other hardware platforms. By repurposing the product, Microsoft built multiple revenue streams. The product was clunky, buggy, and not optimized. However, it met the customers' needs for adequate functionality, rapid availability, and low cost.
Then, Microsoft met the needs of a second set of customers-application developers. Microsoft's ubiquity meant that the developers could write an application once, using an open interface to Microsoft's PC BASIC, and sell it across 48 Microsoft-compatible hardware platforms. These economics encouraged the programmers to write many applications that created end user acceptance and more pull for Microsoft's language. [A virtuous cycle based on the Microsoft standard was created: more end users wanted more applications that more developers would write based on Microsoft's standard, a cycle of increasing returns in which each new OEM, Developer, and End User added more value to Microsoft's value web.]
Microsoft created a standard that generated large revenues. In 1978, sales rose to $382,000, increasing 600% y2y; sales surpassed $1 million in 1979, propelling Microsoft to leadership that lasted until the mid1980's. According to Slywotzky and Morrison (p. 259), "This early success in languages defined the genetic code of Microsoft's methodology for creating and managing de facto standards in its industry."
Winning DOS: As always, the next act unfolded, shifting the profit zone: IBM decided to enter the PC market. The entry of Big Blue had two immediate effects: (1) it legitimized the PC, and (2) it flattened scores of tiny players. However, the entrance of IBM enabled Microsoft to take its standards-based business design to the next level of operating systems.
In July 1980, the manager IBM put in charge of developing its new PC entrant was handed a mission of developing its PC in less than a year! To meet this goal of rapid entry, both the microprocessor and software development were outsourced. This decision by IBM set the value creation template for the next 20 years, tipping strategic control to Intel and Microsoft.
Following a simple and common strategy, the top software developers for languages, Microsoft, and for operating systems, Digital Research's CP/M, were contacted. The latter company rejected IBM's stringent time schedule. [Hindsight on this value-destroying decision indicates that Digital Research's management did not understand the significance of either customer-centric thinking or the profit-centric creation of a standard.]
"Gates, on the other hand, was ready to respond to any important customer's priorities. He offered to provide both the language and the operating system for the new personal computer." Slywotzky and Morrison, p. 260, continued, "Gates saw the dimension of the opportunity that IBM offered, if Microsoft could deliver the product in an impossible time frame. Winning the IBM contract virtually guaranteed massive distribution in the PC market that IBM would create. Microsoft would sell its language and its new operating system through IBM and become a de facto standard in the new PC market." [IBM demonstrated its failure to understand what PC customers wanted and what they would pay for. Customers wanted the functionality provided by an operating system, and they will pay for the advances in computing power, functionality, and ease of use that only de facto standard platforms can deliver.]
Not having a product, but having secured the business, Microsoft swung into action, making good on every one of its promises. Gates knew that he had three customers to satisfy: (1) IBM, (2) programmers, and (3) end users. Given that IBM wanted the system immediately, Microsoft had to purchase a system, selecting one based on CP/M, called Q-DOS (Quick and Dirty Operating System). Microsoft embraced and extended the existing Q-DOS program, renaming it MS-DOS. Because Q-DOS was based on a CP/M system, Gates could recruit programmers by making it easy for them to adapt their CP/M programs to MS-DOS. To compliment the "push" effect of IBM and the OEMs, Gates wanted end user "pull" that came from the availability of applications.
According to Slywotzky and Morrison (p. 261):
Microsoft made DOS an 'open' system. IBM and Microsoft published programming specifications and encouraged developers to write DOS applications. Third-party application developers catching the IBM PC wave created a burgeoning cottage industry of DOS applications. [Hence, Moore's insistence on the primary significance of catching the technology wave in his hierarchy of competitive advantage.]
History shows that end users overwhelmingly chose IBM PC-compatible applications that were necessarily compatible with MS-DOS.
Slywotzky and Morrison (p. 261) continued, "Cementing the standard, however, meant keeping the standard independent from the hardware." Amazingly, Gates convinced IBM to allow third-party licensing. "Totally comfortable in its leadership of the computer industry," the authors noted, "IBM never imagined the importance of this clause in the Microsoft contract." [This failure to understand a new threat to IBM's hegemony demonstrates how architectural control is lost. Only the paranoid survive.]
According to Slywotzky and Morrison (p. 262):
During Microsoft's market penetration phase, Gates had pursued a low-price strategy to bring in the customers. However, once Microsoft established a leadership position, Gates shifted gears to capture a virtual tax on every new hardware machine. First, he moved from flat-fee pricing to per-machine pricing, and then he began raising prices. Gates had started to create an extraordinary profit zone in the computer industry.
Windows: "Despite the strength of Microsoft's strategic control as MS-DOS became ubiquitous, Gates was constantly challenged to think about the next generation of customer priorities, and the next generation of standards." … "When Gates visited the Comdex computer industry convention in 1982, he was horrified" (p. 262).
VisiCorp, who owned the number one application in the world, the VisiCalc spreadsheet, demonstrated a product called VisiOn that had a mouse-driven GUI for the IBM PC. According to Slywotzky and Morrison (p. 262), "Gates saw that VisiOn had the potential to sew up the application and operating system markets in one move under one standard." Gates believed that the MS-DOS standard was in jeopardy.
The authors continued (pp. 262-263):
Gates leaped into total attack mode. Microsoft's response to VisiOn set the pattern for many later reactive strategies against new challenges to its standards. First and foremost, Microsoft focused on winning mindshare away from VisiCorp. Even without a product, Microsoft had to establish its differentiation in order to stall VisiOn.
When VisiOn announced in October 1983 that it would ship VisiOn, Microsoft was prepared, in one sense, with its own announcement of "Windows." Without a product, Microsoft launched a no-holds barred campaign to win the minds of customers. A mass-market campaign featured Windows everywhere. The world waited and waited and waited for Windows. Fortune magazine predicted that Windows would become the standard without ever seeing a working copy. Gates understood the customer's priorities and simply promised to meet them.
VisiCorp's failure was not VisiOn's technology but its business design. According to Slywotzky and Morrison (p. 263),
VisiOn is an example of the failure of superior technology in the absence of the right business design. It illustrates how a standard is not adopted. VisiCorp's business design made end-user switching costs extraordinarily high. VisiOn was sold in shrink-wrap through VisiCorp's retail channel, so end users didn't receive it preinstalled on their systems. It was introduced at more than $1000, a price point far too high for the retail channel. It could not run on most users' existing hardware setups without costly upgrades. It was a 'closed, proprietary' system like the Macintosh, incompatible with the growing base of DOS software. VisiCorp actually discouraged third-part software development, planning instead to corner its own applications market. It charged developers a hefty fee for programming specifications, and coding required a DEC VAX [workstation], which few of them could access. This lack of applications software left an important end-user priority unmet, and the absence of end-user enthusiasm [and, thus, no network effect] was the final nail in VisiCorp's coffin.
Gates's preemptive marketing and strategic OEM relationships created a more valuable promise than VisiCorp's solution; so, customers waited for Microsoft to give birth to Windows. The two products never competed head-to-head. VisiCorp lost money and was sold to Lotus by the end of 1984. Microsoft finally delivered its phantom product in 1990, with the launch of Windows v. 3.0.
Crafting the Create-The-Standard Business Design: Slywotzky and Morrison (p. 264) indicated that "The success of Windows program was built on two core elements of Gates's strategic business design: (1) maximum distribution and (2) perfect fit with customer's priorities." What were the customer's priorities? They can be summarized simply as ease of use.
First, when Windows launched, Gates drew on his channel of OEMs to ensure that it would be preinstalled on every PC. Second, Gates met the new customer priority of simplicity, providing, with his GUI copied from Apple, point-and-click convenience. Third, he wanted a strong base of applications that would motivate users to adopt the Windows interface. "Microsoft encouraged adoption of Windows by, in effect, creating a new paradigm for how customers interacted with their computers" (p. 264, my bold).
To create a new paradigm, the new standard platform for how customers interacted with their computers, Gates used two significant strategies to gain strategic control. First, Gates embraced and extended a rival's product, porting and adapting a suite of productivity application from Macintosh to Windows-Excel, Word, and PowerPoint. These Windows applications matched competitor's functionality while delivering on Gates's promise of the Windows-format's extensible ease of use.
Two leaders in DOS applications, Lotus and WordPerfect, fearing Microsoft's growing power, opted to standardize their products on IBM's OS/2. This error is judgment [both competitors and value chains must standardize on the controlling platform], to boycott Windows, threw the market wide open.
Second, in 1991, Microsoft leapt into this void by introducing a package of their productivity applications as Microsoft Office; it was a killer application for Windows. [Notice that Windows, as the newly created standard within the Microsoft platform had met the customers' needs so precisely that it fostered a tornado in sales of Windows, and then in its killer app, Microsoft Office. No competitor withstands the power of a product tornado that drives the value chain's open-system solution. The standards-based business design itself (coupled with meeting customers' and the value chain's needs, including the open-systems-need for greatly increased sales) created Microsoft's control over the PC industry, guaranteeing that Microsoft's architecture in its expanding platform would continue to dominate at least until it faced a discontinuity that threatened the PC industry.]
Third, Gates now became the chief evangelist in courting independent software vendors, spending hundreds of millions of dollars cultivating a cottage industry that delivered on the customer priority for more applications. This unleashed an enormous reservoir of technological and entrepreneurial energy that grew market size and market share for Windows, more than repaying Gates's investment.
Fourth, "Microsoft cloned Apple's developer efforts-complete with annual developer conventions, beta-testing assistance, and product briefings-and then expanded and improved on them" (p. 266).
The result was extraordinary growth in Window 3.0 applications. In 1989, fewer than 1,000 applications were available for Windows. By 1996, that number was more than 30,000, with a developer community estimated at 50,000 programmers (p. 266).
In this format war, Slywotzky and Morrison argued that neither technology nor availability of a base of compatible offerings was crucial, but instead the critical variable was mindshare. The average Windows customer used the same three software packages-word processor, graphics, and spreadsheet-that were available from competitors. But both end users and technical buyers chose Windows for the other 29,997 other applications that just might be used. Even though the customer might never exercise these options, the mindshare of "available applications" was decisive [along with Microsoft's growing strategic control through its valuable brand]. Customers wanted Microsoft because it successfully aligned its business design with its customer's priorities. [Microsoft owned the standard, managed the value chain, and was the brand associated with creating PC standards.] As, the authors noted (p. 266), "Once momentum is established in one direction, it is very difficult to reverse" [the law of increasing returns].
According to Slywotzky and Morrison (pp. 266-267):
The launch [of Windows] on May 22, 1990, was spectacular and unprecedented. More than 100 ISVs launched their own Windows products, and 50 PC OEMs enthusiastically announced that Windows would be installed and running on all of their systems. Microsoft spent more than $12 million on marketing, which spurred retail sales of almost 11,000 shrink-wrap copies per day during the first few months. Eight years after the promise of VisiOn, and 6 years after the comparable technology of the Macintosh burst onto the market, the real GUI revolution began-and on Bill Gates's terms. By 1994, the worldwide installed base of Windows exceeded 100 million-not merely surpassing the original penetration of DOS, but opening up the market to new populations of first-time computer users. Windows 95 accounted for more than $1 billion in revenues in 1996.
Applications: The Windows Revolution: Although each PC requires only one OS, the market for applications is much larger. Microsoft next leveraged its value capture by aggressively attacking this market to leverage the power in its installed bases. Product development focused on reducing the switching costs in moving to the Windows platform for its applications. By ensuring file compatibility and delivering familiar command structures, the switch became a mere "upgrade" to Word or Excel as part of the upgrade from DOS to Windows. "Appealing to the same customer priority-ease of use-Microsoft made upgrades simple and established helplines to support users during conversion" (p. 268).
Also, Microsoft applied its pricing lessons [drive network effects to insure ubiquity, then seek profits] by changing the individual application-pricing paradigm: (1) Gates bundled applications into Office suites; (2) Gates offered "bundled Windows upgrades" for a fraction of their old $495 per application price, using low price to drive network effects that would lock-in customers during this narrow window of opportunity; and, (3) Gates initiated concurrent licenses in corporations that were based on the number of uses at one time rather than requiring a copy for each desktop.
According to Slywotzky and Morrison (p. 268, my bold):
This combination of differentiation and value capture strategy created a tidal wave of momentum for Microsoft's applications business. …By owning the standards in the operating systems and the top applications, Microsoft could consistently outdesign its rivals by continuously updating and changing its products as a differentiated barrier against initiators. Doing so, also raises the switching costs involved in retraining personnel, systems costs, and file conversions.
[As a tease, I withhold a table of Microsoft's Business Design Reinventions for my fourth post.]
I hope this helps.
Don |
