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Managers: Beware the Children of Digitalisation (part two)

The most overlooked digital transformation challenge for managers is not so much digitalisation itself, but its secondary effects.

In part one of this article, we have explored the secondary effects of the fact that digital technology rides on the back of Moore’s Law.

In this part, we want to look at effects of the internet, or more precisely, net neutrality.

What makes the internet different from most other means of contact such as shops, post, or phone calls? It is that the cost of physical infrastructure is disconnected from the degree of usage. Network providers charge users in various forms, but most often they pay for access, not for traffic. And even in the case of traffic (Gigabyte of data downloaded), the tariff does not take into account whether the data package in question has crossed half the globe’s net infrastructure, or come from a server just around the corner. While this fact has some effect for the average consumer, it has massive effects for content providers or over-the-top services such as Skype, who in some cases use more internet traffic than many countries.

What does this imply?

The cost of scaling

Imagine you run a local bakery. You are very successful, therefore you like to scale, and open up subsidiaries in other towns. You need to get permissions, rent a place, buy machinery, hire and train staff – before you have sold a single additional brioche. It is the amount of upfront investment that limits your speed of growth. New subsidiaries have to break even, and contribute to your capital reserve (or justify your next loan), before you can take the next step.

Now imagine that instead of bread, you sell an app that allows people to keep their shopping list on the smartphone. If you sell two hundred copies, and want to scale, your only upfront investment consists in advertising. If your app works, you are capable to go from two hundred to two hundred million with extremely little impediments. This is the reason why companies that can reach out over the App Store, Amazon marketplace or the like, touch a much larger potential than those who are bound to other means of contact.

The death of the experience curve

The experience curve, as developed by PIMS in the Sixties, states that in industrial production, every time you double the volume of pieces produced, you have the potential to reduce the cost per piece by about 20%. This is the economy of scales, the advantage of industrialisation and standardisation, the law of the discounter, the reason why big players beat small players in price wars.

For our little bakery, this may be an advantage of scaling up. If you produce your bread in one big bakery and distribute it to many subsidiaries, you can produce it cheaper. But how does this play out for the shopping list app? Your cost of creating the app, and keeping it bug-free, remains roughly the same, whether you sell twenty or twenty million. The marginal cost of selling another million copies is close to zero.

This explains why digital companies, that can grow very quickly, have such an exponential profitability, and are more often valued based on their growth potential, instead of their actual profit. In 2014, WhatsApp famously was five years old, had 55 employees, 450 million users, and was sold for $ 19 000 000 000.-.

For a digital business model, it therefore becomes essential to optimise for this kind of scalability. Facebook, Twitter, Instagram, even Meetup all have an extremely small part of their value chain outside of digital scalability. By comparison, Amazon, Zappos and Zalando have their real-world logistics. Uber and Lift have to manage real-world drivers, complaints, regulators, and they need to quickly reach critical mass in every new city they take on. Most of’s 13 000 employees are employed in customer service. The more the bakeries in your business model decrease, and the apps increase, the higher your potential to profit from digital scalability. This is the direction of the race.

It’s not about size, but dominance

The dominant predator theory states that an ecosystem organises around the species at the top of its food chain – its dominant predator. Check out trophic cascades, e.g. how the re-introduction of a few wolves in Yellowstone National Park created ripple effects down the food chain, until it changed the very appearance of the geographical landscape. If you take this as an analogy for business, you find that in many cases, economies organise around a product that acts as the dominant predator in their field. Often this product is a platform. Many people use Microsoft office not necessarily because it is the best product of its kind, but because everybody with whom they interact and share documents uses Microsoft office. The same is even more visible with platforms such as the App Store: It makes sense to create apps which are marketed on the App Store, and as a consequence are guaranteed to run on the ecosystem of Apple devices. Therefore, many solutions for contactless payment in taxies and small shops, or for augmented reality in industrial contexts, bind their operators to owning Apple hardware.

A consequence is that investors often seek to finance for market dominance, not size or profitability. Amazon continue to get investment to ensure the dominant predator status, although they hardly ever have been profitable yet.

Connected to the dominant predator situation is the rule of first starter advantage. If you are at the beginning of an innovation S-curve, e.g. a new technology, or a new business model, and are ahead of the competition, you have the best chances of becoming the dominant predator. This is so because once an ecosystem has emerged around you, it is almost impossible to remove you from its centre. The race may be fierce for this reason. You may remember the triumph of VHS as the system for video cassettes (another platform). Sony’s BETA system produced better quality video, but VHS won the race to become dominant predator, not the least because they, contrary to Sony, allowed for porn videos to be sold on their technology.

I once had the following discussion: Imagine your business consists in collecting and selling a particular kind of specialist data, and algorithmic evaluations of it. You are the largest player in the market, but under fierce competition from companies that are backed by large investors. Also, you suffer from data theft: many competitors use copies of the data you have tediously collected, because somewhere, dubious clients illegally forward the data to the competition. At this point, here’s a suggestion: make the raw data publicly available for free. Are you shocked by the idea? It does make perfect sense from a digital ecosystem perspective: First, your own profit is made mostly with the algorithms, not with the data itself. Second, the competition can no longer sell the stolen data at a profit, and as a consequence goes out of business. And third, you immediately become the industry standard – the dominant predator.

Now, the VHS example dates from before the times of the internet, and the Microsoft Office phenomenon may depend on email more than the web itself. What the scalability of internet-based services adds to this is the speed and easiness of growth, together with the potential connectivity of user networks. It is in the nature of internet-based ecosystems to form around dominant predators, and it is easier for internet-based solutions to transform first starter advantages into dominant predator positions. Due to the nature of the internet, many new markets tend to be the-winner-takes-it-all-games. In such conditions, it is often more intelligent to become the platform of an exponentially scaling market, than to do everything yourself. Let the users do the growing for you – and profit in their wake.

Platforms – the inequality of mass participation

The scalability of internet connections also means that, like a large flock of small birds can chase the eagle away, it becomes possible to organise things with many small players, which sometimes work better than a few big players. Let us look at one of them: crowdfunding.

If you are a startup in need of investment, you can go to venture capitalists or similar investors. Or you can go to platforms such as Kickstarter, and collect a very large number of very small investments. What is the difference? The few investors have joined your endeavour with large sums each. Even if you are only a piece in their portfolio, they consider their investment substantial, and interact with you accordingly. The crowdfunders may have invested a few dozen, or a few hundred Euro in most cases, and this may have a different impact as to how they think about risk.

However, the most fundamental difference appears at the end of the engagement. If your startup fails, both the investors and the crowdfunders lose their money. There is no difference in how they participate in your risk. But what if your startup succeeds and becomes exponentially more valuable? The investors’ share participates in the exponential growth: they still own a large part of your company. The crowdfunders, on the other hand, get their perks and disappear. The exponential part of your success belongs to you alone.

It is called individualised gains at distributed risks.

A similar situation is created by platforms such as the App Store. For all profitable apps, Apple takes a substantial chunk of their sales. All successful non-profit apps help grow the ecosystem at a very low additional cost to Apple. All failed apps are a loss to their developers, but not to Apple. The same goes for Etsy, Amazon marketplace, Alibaba and the likes.

Service over product

The ease of contact over the internet shatters many of the more brittle forces that create customer loyalty. Think about where you regularly spend your money. Your supermarket and other shops, your car dealer, cinemas and restaurants. Imagine you found a better one, but further away. How much further are you ready to drive to substitute your old choice once and for all? Maybe it’s different for a new car than it is for grocery shopping, but still we tend to let our preferences be heavily influenced by convenience of access: distance, means of traffic needed, time, risk of ending up in a traffic jam etc.

On the web, a less convenient access means a few more clicks.

A side effect of this phenomenon is the rise in importance of user experience design – starting with eliminating unnecessary clicks and keystrokes, for example to re-enter your shipping address, and ending with sophisticated search engine optimisation. But in times when a small shop and a multinational retailer can have the same visibility on Amazon or Ebay, the more fundamental question is how to create solid ties with a customer, that last beyond the single visit or sale. Sometimes this can be achieved with modular products – think how Lego become more interesting as long as a kid continues to buy more toys to integrate with what they’ve got. But the ease of the web is best beaten by the ease of the web: from re-ordering supplies to help with design and application, in the face of an evasive customer’s ease of choice, the importance of additional services to bind them to the supplier has increased fundamentally.

Why did Dollar Shave Club, the no-fuss subscription service for shaving blades, got from 0 to 18% US market share in 5 years, and was sold for $ 1bn? It was not only for its viral advertising on youtube, but mostly because their customer base consists in a growing, multi-million number of – subscribers.

The fragmented supply chain eats the customer

The ease of data exchange over the web is an open invitation to outsourcing. From software development to graphic design to recruiting, many steps in a company’s activities may be executed by third parties. One of the more interesting outsourcing partners is the customer. On the one hand, as Gunter Dueck put it nicely, the digital transformation brings about the end of the consultant-to-the-backside-of-their-screen, i.e. the person who reads out the content of their computer screen to the customer who sits on the other side of it.

On the other hand, with self service come responsibilities. Imagine you want to print a poster in an online print-shop. You may enjoy to preview the format, or a frame. But interesting enough, many providers ask the customer to deliver specific formats (transfer png to pdf), and leave the responsibility for the correct application of printers marks and bleeds, or choice of paper thickness, with the often inexperienced customer (do you know what printers marks and bleeds are? I didn’t.). Or think about the best choice of ticket fare in a complicated ride – Deutsche Bahn are famous for their maze of options. Or who of us knows exactly what we are choosing when asked to make a credit card payment abroad in local vs. home currency? In the name of self-service, and in a careful balance between less tedious access and more value-adding steps in the workflow, today’s online customers are ready to take over an ever growing part of the remaining work.

The inherent libertarianism of platforms

Some situations have an inherent bias. In the world of work, this bias plays out in favour of internet-based business, simply because connections between demand and supply are easily established, and can easily circumvent impediments which appear outside the web: physical distance, average wage level, regulatory environments. The ease of global reach through the internet has created occasions for business models to bypass existing organisations by connecting demand and supply on a global basis, thus creating micro-entrepreneurs in a libertarian marketplace. Think Uber instead of taxi drivers. AirBnb instead of hotels. TaskRabbit instead of movers. Upwork instead of admin employees. Ebay vendors instead of shop assistants. Etsy instead of gift shops.

But it is also a great entry for the secondary effects we have observed about platforms. Platforms have the tendency to individualise gains and distribute risks. Globally mobile digital services are flexible to choose preferred regulatory environments. What are inherent biases of such a system? The five-day-work-week micro-entrepreneur competes against the seven-day-work-week micro-entrepreneur. The one with health insurance and pension plan against the one without. The one who obeys safety regulations against the one who doesn’t. The inherent bias of the digital transformation points away from what many of us, at least in Europe, consider achievements of civilisation in labor protection, and towards libertarianism. At the other end of the stick you will find a growing income gap between those who offer their services on platforms, and those who own them, and as a consequence, a growing precariat.

Where does this put corporate social responsibility in your digital business model?

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