Law of Conservation of Attractive Profits

Discussion Point 2:  Chapter Six: How to Avoid Commoditization

Key passages:  “A company that finds itself in the more-than-good-enough circumstance simply can’t win: Either disruption will steal its markets, or commoditization will steal its profits.” (Page 152) and “The bedrock principle bears repeating: The companies that are positioned at a spot in a value chain where performance is not yet good enough will capture the profit. That is the circumstance where differentiated products, scale-based cost advantages, and high entry barriers can be created.” (Page158)

Key Take-away:  Firms ought to use the law of conservation of attractive profits to identify high profitability areas.

The two sentences in this key passage are very rich in insights, as they really tell us where to dig to strike gold.  In this chapter, Christensen sets up his argument using two extremes on the spectrum of product/service fulfillment of the customers need to help us understand the benefits of one, and the problems with the other.

The More-Than-Good-Enough Circumstance

To delve deeper into this idea, it is useful to refer to Richard D’Aveni’s work on hyper-competition.  He echoes Christensen’s assessment when he writes: “Thus, the process of competition forces firms to offer a line of high-quality, low-priced goods that eventually make high quality and lower prices a necessity for survival.”⁴ This concept relates to what Christensen calls commoditization, and clearly supports the idea of dwindling profitability.  Furthermore, as described in the first discussion point, mature industries are susceptible to creative destruction, which addresses the threat of disruption.  So if well-served markets are problematic, Christensen offers an alternative, which can help both new ventures and established firms to improve their odds of growth and profitability.  He makes a very well supported point that the best avenue for growth and profitability is to deliver quality where quality has been lacking up to this point.  This is consistent with D’Aveni’s price-quality competition escalation ladder, which culminates with a “need to move to a new arena of competition.”⁵ This ladder of escalation when competition is based on cost-quality advantages is similar to the process of commoditization and de-commoditization Christensen describes on pages 151 to 154. 

The Not-Yet-Good-Enough Circumstance

As firms uncover “not-yet-good enough” products of processes, Christensen explains that they can pursue a differentiation strategy, leverage scale-based cost advantages, and establish high barriers to entry.  He is a little short on details here, so let us turn to D’Aveni’s work and develop these ideas further. These three ideas actually parallel his research, as they correspond to the three arenas of competition he identified in addition to cost-quality.  What Christensen calls “differentiated products,” D’Aveni defines as “timing and know-how.”  D’Aveni does a really good job showing how the first mover has the choice between using a “leapfrog strategy” (successive investments in innovation) or moving downstream into higher value-added products. Sony is a good example of former: “Early on, it built tape recorders and used the know-how and resources from that project to fuel it production of transistor radios.  It brought out a pocket-sized transistor radio… Then Sony built on that success with the development of the Trinitron television in the late 1960s… Sony used and extended its skills in miniaturization and audio technology to develop this next innovation.”⁶   Christensen uses the computer industry in the 1990s to illustrate how money can flow when following the latter strategy.  Next, when addressing cost advantages, D’Aveni looks at competitors with “deep-pockets,” where resource escalation is one of the strategic options for the incumbent.  Finally, we get to barriers of entry.  Some strategies that D’Aveni gives to building barriers are customer familiarity, customer loyalty to a local brand, government barriers to foreign entry, control over domestic distribution systems, local customs, unique factor advantages (lower cost of labor or capital), and dominance of domestic market share.⁷   In every case however, D’Aveni, also gives possible course of action for new entrants to address and overcome these tactics.

Law of Conservation of Attractive Profits

Ultimately, Christensen wraps this chapter in the book by giving us law of conservation of attractive profits.  This law, inspired from famous laws of physics, states that: “When the 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 emerge at an adjacent stage.”⁸ This can actually be seen as good news, since this opportunity is equally available to both the incumbent and the new entrant.  

Notes
4.     R. D’Aveni, Hyper-Competitive Rivalries, The Free Press, New York, 1995, p.29 
5.     R. D’Aveni, Hyper-Competitive Rivalries, The Free Press, New York, 1995, p.36 
6.     R. D’Aveni, Hyper-Competitive Rivalries, The Free Press, New York, 1995, p.71 
7.     R. D’Aveni, Hyper-Competitive Rivalries, The Free Press, New York, 1995, p.99-100 
8.     C. Christensen, The Innovator’s Solution, Harvard Business Review Press, Boston, 2003, p. 168