Part 1: The Reasoning

Collaboration and new ecosystems made possible by technology are in vogue today, but they usually involve either some form of tighter integration along a value chain (supplier to customer), better project oriented cooperation within companies or the coalescing of industry participants around a central platform provider to access that provider’s market and customer base. However, another possibility might be for smaller organizations coming together to strengthen their competitive position collectively. An interesting segment of such SMEs may be independent technical/industrial B2B service providers (ISPs).

As noted elsewhere in this blog*, for both competitive and market reasons, there is a strong trend among manufacturers and OEMs to servitize. The strategy has both offensive and defensive elements: Servitization enables new technology driven offerings and closer relationships with customers. OEMs that don’t provide such offerings risk commoditization, if they get cut-off from data required to deliver improved outcomes to customers on an on-going basis. But in the process of OEM servitization relationships between them and companies they cooperate with for purposes of servicing the installed base (e.g. authorized service providers of various types) is bound to change: ISPs may get dislodged; Their activity mix may change (lower value), their pricing power reduced or, in some cases, as the service capabilities of OEMs are extended through technology, they might find their business volumes declining. In such an environment ISPs must either find new sources of revenue or find new ways to compete. Cooperating may be one such way.

In a defining article (The Nature of the Firm) in 1937, Nobel Laureate Ronald Coase ascribed the existence of firms to the costs of transactions in the market place, which, in total, can often exceed the value of a good or service. Examples of such costs include search and information costs, obtaining and policing intellectual property and trade secrets or costs of procurement. A firm’s primary function is to internalize these activities and therefore reduce the associated transaction costs. Furthermore, many costs are fixed so it makes sense for companies to grow to be better able to spread these fixed costs over a larger number of products and customers and keep prices low. Coase did not think that it made sense for firms to grow indefinitely however, as at some point the cost of complexity associated with size would overcome the advantage of size (what Coase called “decreasing returns to the entrepreneur function” or the propensity of managers to make mistakes in resource allocation, something closely related to company size). A short article by the Economist provides a good explanation of the need to balance “economies of scale” with the “diseconomies of complexity”.

Over the past 80 years however, technology has helped make increasing complexity ever more manageable and therefore companies have grown to sizes that are far larger than Coase could probably have imagined. In addition, technology has fueled businesses and markets where “network effects” are pronounced and “winner takes all” conditions prevail – providing ever more incentives for size, internalization of value chains and market domination. For example, platform companies (Google, Facebook, Amazon) may be upended through technological innovation or if they run out of market (unlikely). But they don’t seem to be constrained by complexity economics.

The question here however, is can smaller companies in today’s environment come together to become more competitive in their markets in a form of horizontal collaboration to, in some way, punch above their individual weight? In other words, can collaboration lead to a situation, where smaller companies reap the benefits of being one “firm” in the sense of Coase (internalizing more activities and reducing transaction costs) and size (reduce unit fixed costs) without becoming too complex and compete against larger companies as equals -without, it might also be added, sacrificing their independence (as in a merger)? And can that collaborative group be more than purely the sum of its parts, i.e. can it create additional value?

The idea is not new. For example, one form of “natural” collaboration -industrial clusters- has existed for centuries. The physical proximity of firms in the same industry, along the value chain, increases the competitiveness of all. Key drivers are access to deep pools of skills and expertise as well as to information channels which make understanding of developments in markets, as well as innovation far easier. Critical mass in customers and product sold or installed create a reinforcing feedback loop. Clusters abound in almost all industries, historically from the flower growers in the Netherlands, to the watchmakers of Switzerland, to the mechanical engineering and automotive clusters in southern Germany. Modern high profile clusters include the City of London, Silicon Valley and Hollywood.

In an influential article (Clusters and the New Economics of Competition) in 1998, Michael Porter, a Harvard economist famous for the “Five Forces” competition model, suggested that clusters are key sources of value creation and competitive advantage in all economies. He defined clusters as geographic concentrations of interconnected companies and institutions in a particular field. They encompass an array of linked industries and other entities important to competition.

According to Porter, clusters represent a kind of “spatial organization form” in between arm’s-length markets on the one hand and hierarchies, or vertical integration, on the other, so a cluster is an alternative way of organizing the value chain.

“Compared with market transactions among dispersed and random buyers and sellers, the proximity of companies and institutions in one location—and the repeated exchanges among them—fosters better coordination and trust. Thus clusters mitigate the problems inherent in arm’s-length relationships without imposing the inflexibilities of vertical integration or the management challenges of creating and maintaining formal linkages such as networks, alliances, and partnerships. A cluster of independent and informally linked companies and institutions represents a robust organizational form that offers advantages in efficiency, effectiveness, and flexibility.  A cluster allows each member to benefit as if it had greater scale or as if it had joined with others without sacrificing its flexibility.”

Porter placed significant emphasis on the fact that clusters are geography based, the physical proximity creating multiple advantages, so for example:

Better access to employees and suppliers: Not only do clusters provide deep skills pools and reduce search and transaction costs. But because a cluster signals opportunity and reduces the risk of relocation for employees, it can also be easier to attract talented people from other locations, often a decisive advantage. Sourcing locally instead of from distant suppliers lowers transaction costs. Not only does it streamline the supply chain by minimizing the need for inventory or eliminating importing costs and delays, but, importantly, because local reputation is important, it lowers the risk that suppliers will overprice or renege on commitments. Even when some inputs are best sourced from a distance, clusters offer advantages: Suppliers trying to penetrate a large, concentrated market will price more aggressively, knowing that as they do so they can realize efficiencies in marketing and in service.

Linkages among cluster members results in a whole greater than the sum of its parts: In a typical tourism cluster for example, the quality of a visitor’s experience depends not only on the appeal of the primary attraction but also on the quality and efficiency of complementary businesses such as hotels, restaurants, shopping outlets, and transportation facilities. Because members of the cluster are mutually dependent, good performance by one can boost the success of the others.

Local rivalry is highly motivating: Peer pressure amplifies competitive pressure within a cluster, even among noncompeting or indirectly competing organizations. Pride and the desire to look good in the local community spur companies to attempt to outdo one another.

Companies inside clusters usually have a better window on the market than isolated competitors: They can identify customer needs and trends with a speed difficult to match by companies located elsewhere. The ongoing relationships with other entities within the cluster also help companies learn early about evolving technology, resource availability or service and marketing concepts. Such learning is facilitated by the ease of making site visits and frequent face-to-face contact. Furthermore, clusters not only make opportunities for innovation more visible. They also provide the capacity and the flexibility to act fast. A company within a cluster can often source what it needs to implement innovations more rapidly. Local suppliers and partners can and do get closely involved in the innovation process, thus ensuring a better match with customers’ requirements.

Porter wrote the article because he was wondering why in an era where companies can quickly source capital, goods, information, and technology from around the world, location still matters so much. In theory, more open global markets and faster transportation and communication should diminish the role of location in competition. But if location matters less, why, then, is it true that the world’s best mutual-fund companies are located in Boston, a large chunk of the world’s pharmaceuticals industry is located in a corridor spanning southwestern Germany and German-speaking Switzerland, high-performance auto companies are based in southeastern Germany and the heart of the world’s leather fashion industry is located in northern Italy?

Nevertheless, much has happened in the intervening 18 years since Porter published his article. The advantages of clusters undoubtedly still apply. But is “location” only a physical or can it now also be deemed a virtual concept? Might technology have advanced so far so as to enable virtual clusters to emerge?

Consider a platform like Upwork, a virtual location mainly for IT professionals to sell their services. Essentially it provides a marketplace where potential clients can post projects or jobs that potential suppliers can bid on. In reality however, it is much more than that. It also provides access to information: Both clients and vendors can scan the site to see what is happening: Who has won what project; How suppliers and clients are rated; What clients are demanding (applications, technologies); What technologies are offered; What prices are charged; What is the approximate productivity (hours per job); and so forth. While the platform does not provide the explicit means, there is nothing to stop suppliers from getting to know each other, assess each other’s reputation, experience, skills and cost levels and, eventually, collaborate. Of course it is not the same (yet) as being in the same location, but it is an improving approximation. Numerous social and task oriented tools are today available to enable cooperation across distances between cooperating vendors and between vendors and customers. Cloud technology is making a mockery of distance. Not only that, but is even providing an advantage to geographically dispersed teams that can work cooperatively on a project on “follow-the-sun” principles: When one goes to bed, the other starts working.

In Part 2 we’ll look at how value can be created through virtual collaboration and how a framework for collaboration can be established.

 

* See for example

Technology is servitizing the World (Example 1: Auto Industry)

Digitization; A Challenge not well understood by Non-Digital Natives

Digitization: How to know whether an industry is being disrupted

Disruption, Servitization and the Value of Winning (Part 1)

 

 

Titos Anastassacos is Managing Partner at Si2 Partners, a consultancy helping clients leverage services to win in industrial markets

Further articles on this and other topics can be found in the Si2 Partners Resources Page and the Si2 Knowledge Center

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