Henry Chesbrough is professor and executive director of the Center for Open Innovation at the Haas School of Business at the University of California, Berkeley. Previously, he was a professor at the Harvard Business School. His book Open Innovation was named Best Business Book by Strategy & Business magazine, and the best book on innovation on NPR's All Things Considered. His second book, Open Business Models, was named one of the 10 best business books by BusinessWeek, and Scientific American rated him as one of its Top 50 business and technology leaders.

Henry Chesbrough is professor and executive director of the Center for Open Innovation at the Haas School of Business at the University of California, Berkeley. Previously, he was a professor at the Harvard Business School. His book Open Innovation was named Best Business Book by Strategy & Business magazine, and the best book on innovation on NPR's All Things Considered. His second book, Open Business Models, was named one of the 10 best business books by BusinessWeek, and Scientific American rated him as one of its Top 50 business and technology leaders.

Open Services Innovation

John Wiley & Sons

Chapter One

As I write this chapter, the Western world's leading economies (along with Japan's) are in a terrible state. Even before the recession began in 2008, disruptive new forces were at work transforming the global economy:

? Useful knowledge, information, and technology are now widely distributed around the world.

? Increased global competition and higher rates of growth in the developing world are leading to greater wealth and rising standards of living, while stagnation is taking hold in most developed economies.

? The advanced economics are confronting unsustainably high levels of debt that, ironically, are being financed by lending from poorer developing economies.

Let us consider each of these in turn.

The spread of useful knowledge around the globe seems like a good development at first glance. Alert companies have more places to look for useful technology, and people and companies with ideas have more outlets to which they can offer their knowledge. People who live in economies with lower costs of living can use this knowledge as well as many in more expensive areas. Therefore, the advantage of superior technology that used to be the sole province of wealthier countries has given way to a more level playing field, raising the pressure on companies in the advanced economies.

The Great Recession, as many have called it, that started in 2008 ushered in a new era among the world's economies. Most of the top economies in the Organization for Economic Cooperation and Development (OECD) suffered significant declines in economic output. Some economies, including the United States, lost more jobs than any previous economic downturn since the Great Depression. Other leading economies, including Spain, have witnessed unemployment rates of over 20 percent.

Meanwhile, Brazil, China, and India saw little loss of output from the economic upheaval. Rather, each of their economies has grown significantly during the period. Their concern now is that their economies could over heat, creating a new bubble. This grow this bringing hundreds of millions of new consumers into the global marketplace. It is also creating a similar number of companies and workers in developing regions who are increasingly able to compete for jobs in those global markets.

A great deal of wealth creation has shifted as well, away from the advanced to the developing countries. China, for example, now has 98 billionaires, and India has 58. Much of the growth in the foreseeable future will have to come from the developing economies, a remarkable turn of events since World War II.

In an attempt to stave off a deeper economic downturn, many Western economies have stepped up government spending even as tax receipts declined in the downturn. As a result, sovereign debt is at uncomfortably high and unsustainable levels in many of these economies, including Greece, Japan, and Spain. For these economies, growth is at best meager, and at worst negative, which makes it politically far more painful to execute the macroeconomic policy changes needed to reverse the buildup of this debt.

Among the many consequences of these changes is one of concern over the longer term: the impact on new entrants into the workforce in advanced economies. Today young people in countries with advanced economies are finding themselves excluded from the job market as they graduate and look to start their working careers. Even those who find work often must settle for lower wages than they would have earned in the past. Moreover, research shows that many who make this trade-off will have permanently lower wages than their peers who entered the job market just a few years earlier.

THE COMMODITY TRAP

These disruptive economic forces are creating a phenomenon that I call the commodity trap, which more product-focused companies are finding hard to break out of or avoid. The commodity trap is made up of the following business realities:

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? Manufacturing and business process knowledge and insights are widely distributed. It is getting harder for companies to differentiate their products and sustain that differentiation over time. Products are fighting the tendency to become commoditized (commodities are products that are sold on the basis of their cost, not their value). Commoditization is largely the result of success in an industry or the product sector in general. The knowledge and insights that have been developed from work on design and manufacturing processes like Six Sigma, Total Quality Management, supply chain management, and customer relationship management have led to much higher-quality products. However, these methods and frameworks are now well understood around the world and have been encoded into software that is also widely available around the world. When the same approaches and the same tools are available to everyone, anyone can build a good product. No wonder it is getting harder to remain competitive.

? Manufacturing of products is moving to areas of the world with very low costs. Computers and networks are spreading product designs and process tools around the world, where products can be produced cheaply. Today Samsung, Hyundai, and LG in South Korea are challenging global leaders in automobiles, cell phones, electronics, and other product categories. These firms were far behind the leading edge in the world just a decade earlier. Even they cannot rest on their laurels, however. Haier, Huawei, and Lenovo in China are also rising rapidly and will soon become world-leading companies. Clearly the product world is facing severe pressures to produce and sell on the basis of cost, not value.

? As challenging as the spread of best practices around the world is to product manufacturers, another force compounds their predicament: the shrinking amount of time a product lasts in the market before a new and improved one takes its place. As a result, even successful products can expect to enjoy an advantage in the market for a shorter time than in the past. In the hard disk drive industry where I used to work, our early products typically sold for many years. With the rise of the PC market and the incorporation of hard disks into every PC, disk drives would sell for perhaps two years. By the 1990s, even a very successful disk drive might sell for only nine months. After that, a new and even better product was available.

In pharmaceuticals, the expected lives of new drugs have also shortened. Food and Drug Administration approval now takes eight or more years for typical drugs. Then as soon as successful drugs come off patent protection after twenty years from the patent filing, generic drug companies copy them. In the largest market segments, successful patented drugs now also must share the market with rival patented drugs, even while the patents are still in effect. At least six different patented statin drugs to control cholesterol are on the market, for example.

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 new capabilities are emerging every four to six months, which means that even very successful, differentiated products quickly lose their luster. Competing on such time intervals is like the Red Queen in Alice in Wonderland where one must run as fast as one can simply to stay in place. Even small missteps can cause companies to fall far behind.

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Continuing to run on the treadmill isn't going to get us back to growth. We need to confront the limits of product-focused innovation and rethink how to innovate.

THE WAY OUT OF THIS MESS

In order to reverse these difficult economic conditions, Western economies need to grow again, and that is going to take more than changes in fiscal policy at the macroeconomic level. We must rediscover growth and innovation at the microeconomic level, within specific firms in specific industries. Macroeconomic policies help to create the conditions for growth to occur. But it is the individual firms that run the experiments, take the risks, make the investments, and harvest the results that cause innovation to occur.

In order to grow again and compete effectively, businesses must change the way they approach innovation and growth. They first have to confront, and then transcend, the commodity trap. They have to stop thinking like product manufacturers and start thinking about business from a services perspective. Both companies that make products and those that deliver services must think about their business from an open services perspective to discover new ways to generate profitable growth.

It is worth observing that services have been the growth vehicle in advanced economies for some time. In the United States, they have risen from a very small percentage of the economy a century ago to more than 80 percent of gross domestic product today. Services comprise more than 60 percent of the gross domestic product of thirty-five of the top forty economies in the OECD. Growth will come from services in the future for these economies. It is high time to transcend the limits of product-focused innovation and move to a way of thinking that can point the way to future growth.

THE LIMITS OF PRODUCT-FOCUSED INNOVATION FOR COMPANIES

To see the limits of product-focused innovation and the dangers of the commodity trap, let's examine a highly successful product: Motorola's Razr cell phone. When this product was introduced in fall 2004, it was the slimmest cell phone available, and its cool design made it a hot product. More than 50 million units were sold. By any measure, this was a tremendous success, and Motorola was the top mobile handset manufacturer.

Three years later, however, Motorola's follow-up products and new models of the Razr failed to attract much interest. The reason was that every other handset manufacturer had learned how to make slim, elegantly designed handsets. Motorola continued to develop and market new products with new features, but these didn't seem to catch on the way the Razr had. Today Motorola is struggling in the cell phone industry and has fallen out of the top position to number seven.

It might seem that Motorola was punished severely by the market because it didn't come up with another innovative product to follow up on the success of its Razr. In fact, Motorola's real failure was in its product-focused conception of innovation. Motorola thought about innovation in terms of coming up with another breakthrough product. What it didn't think hard enough about was its customers' experience with its products and what additional services it could wrap around its devices to deliver a superior customer experience.

Nokia, now the leading cell phone manufacturer and the largest handset manufacturer in the world, faces a similar challenge today. Nokia achieved enormous success in the 1990s with its GSM mobile phones. It used its superior products to conquer Europe and then aggressively moved into Asia, Africa, and Latin America. It is the largest handset manufacturer in the world today. Yet what brought Nokia this far will not carry it forward into the future.

For Motorola and for Nokia, coming up with ever better cell phone products is no longer enough. These handset manufacturers face mounting pressures from new entrants like Apple, Google, Palm (now part of HP), and Microsoft, all of them working hard to continue to innovate new handsets, either by themselves or with partners. But each is doing far more than that: they are building platforms that attract thousands of other companies to design applications and services that run on their handsets. Even if Nokia can develop a superior handset (and then continue to lead in producing superior handsets), that is no longer sufficient to provide a superior customer experience. Nokia must focus its innovation efforts on the applications and services (which support its platform) that will enrich its customers' experience with its phones. If it fails to do so, it will risk being supplanted as Motorola has been.

Nokia's approach to innovation will require radical changes. This company that achieved so much with its product design in the 1990s must develop an entirely new set of innovation skills in order to create, develop, and manage a platform—an ecosystem of other companies that build their offerings on top of Nokia's.

GROWTH AND COMPETITIVE ADVANTAGE THROUGH SERVICES

Innovation in services is a clear and sustainable way to grow a business and fight off the pressures that companies are facing with the commoditization of products. By transforming products into platforms that incorporate internal and external innovations and surrounding these platforms with a variety of value-added services, companies can obtain some breathing space from relentless price and cost pressures. Although they must continue to advance their products, the real basis for competition shifts toward the entire constellation of products and services available to their customers through their product.

To see this, consider one of the Razr's challengers, the Apple iPhone. Introduced in 2007, it too captured the public's imagination. To be sure, the iPhone was a neat device. It had a sleek design, an elegant user interface, and a novel touch screen. However, the iPhone was much more than a device like the Razr was; it was a system that attracted many third-party applications and services to provide users with a wide range of experiences with a single device. The iPhone became a platform. More than 100,000 individuals and companies have created "apps" that run on top of the iPhone, and more than 2 billion apps have been downloaded by customers around the world.

Unlike the Razr, the iPhone shows no sign of being overtaken by competitors anytime soon. And other recent entrants like Google, Microsoft, and Palm are also making significant efforts to recruit third-party application and services developers to support their respective innovation efforts in mobile telephony. This race will be won by those who can attract the most support and offer the best experience for customers rather than the one who can design the next cool handset device.

A similar race is on in financial services. As the Internet spreads more information to more places, many services companies now are taking on the role of aggregating this information for their users. Instead of simply creating their own mutual funds or exchange-traded funds, these companies provide up-to-the-second data on a wide variety of such products for users to consider for purchase. Others are offering commentary and analysis on these sites, providing users with a range of opinions and investment advice to guide their actions. In this way, sites such as Yahoo Finance, Mint.com, and Schwab.com are becoming platforms themselves.

Clearly platforms are important for services as well as products, a point we return to in Chapter Nine.

Companies that are making cool products must think beyond the product to turn it into a sustainable, profitable business platform. A veteran Silicon Valley venture capitalist made the point this way: "Whenever we see a business plan for a new device, we immediately ask, 'OK, where's the service associated with that device?'"

THE CHALLENGE OF DIFFERING BUSINESS MODELS

Product-focused companies face another challenge in thinking beyond the product. For companies that already make products in an industry, services may represent a challenge to the traditional product-based business models employed in their industry. The role of the customer, the interaction between customer and supplier, and the design of the supply chain may have to change in a services-oriented business model. This shift toward services, which can be a saving grace from commoditization, can also engender significant conflicts within the organization. As we will see, conflicts can arise between product-based business models and services-based business models. (Apple had an advantage in this regard. It was a new entrant into cell phones, so it was not constrained by legacy business models in that industry.) We examine these conflicts in detail in Chapter Five, but an example can clarify the point.

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Excerpted from Open Services Innovationby Henry Chesbrough Copyright © 2011 by John Wiley & Sons, Ltd. Excerpted by permission of John Wiley & Sons. All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
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