Key Principle
Attractive profits are conserved across value-chain stages: when modularity and commoditization destroy margins at one stage, proprietary/interdependent architectures emerge at an adjacent stage where performance is not yet good enough, and profits migrate there. This operates as a four-step predictive mechanism:
- Modular products commoditize at one value-chain stage (assemblers lose differentiation).
- Those modular assemblers, racing up-market, demand ever-better performance from subsystems.
- Subsystem suppliers are thrown back to the not-good-enough side, where interdependent/proprietary designs command attractive margins.
- Profit migrates from the commoditizing stage to the adjacent de-commoditizing stage.
"The law states that when 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 usually emerge at an adjacent stage." (Chapter 6)
Why This Matters
Most executives anchor on where profits have been rather than where they are going. The Law of Conservation provides a forward-looking diagnostic: identify which stages are commoditizing and look to adjacent stages for emerging profit pools. Without it, firms divest the stage where money is migrating to in order to double down on the stage where money is migrating from -- repeating the IBM/Intel/Microsoft pattern a generation later.
The ROA-maximizing death spiral compounds this error. Each outsourcing step feels rational because return on assets improves when the denominator shrinks. But the firm systematically transfers future profit potential to suppliers -- from circuit boards to motherboards to assembly to logistics to design -- until it is left with brand and customer relationships but no ability to differentiate.
Good Examples
- Intel ate its way from microprocessors to chipsets and motherboards, capturing profits as PC assembly commoditized. Intel moved toward the not-good-enough stage rather than away from it. (Chapter 6)
- Bloomberg integrated from data to analytics to trading to securities auctions, hollowing out Wall Street institutions by capturing the de-commoditizing stages adjacent to commoditized financial data. (Chapter 6)
- IBM 2.5-inch drives (integrated, not good enough): 40% margins, 80% share. IBM 3.5-inch desktop drives (modular, more than good enough): less than 3% unit volume. Same company, opposite circumstances, opposite outcomes. (Chapter 6)
Counterpoints
- GM and Ford spun off Delphi and Visteon -- divesting the stage where the money was going to stay where the money had been. They repeated IBM's original mistake, treating past profitability as a guide to future strategic importance. (Chapter 6)
- The ROA trap: A component supplier offers to take over circuit boards, then motherboards, then assembly, then logistics, then design. Each step improves the assembler's ROA. The assembler celebrates improving metrics while systematically hollowing itself out. (Chapter 6)
- First 1GB 3.5-inch disk drives (1992): 60% gross margins. Drives 60x better earned only 15% margins -- demonstrating that commoditization destroys profits even as absolute performance improves dramatically. (Chapter 6)
Key Quotes
"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." -- Christensen & Raynor, Chapter 6
"The challenge for incumbent companies is to rebuild their ships while at sea, rather than dismantling themselves plank by plank while someone else builds a new, faster boat with what they cast overboard as detritus." -- Christensen & Raynor, Chapter 6
"In the value chain there is a requisite juxtaposition of modular and interdependent architectures, and of reciprocal processes of commoditization and de-commoditization, that exists in order to optimize the performance of what is not good enough." -- Christensen & Raynor, Chapter 6
Rules of Thumb
- When your stage commoditizes, look to adjacent stages for de-commoditization -- that is where profits are migrating.
- If outsourcing improves your ROA but reduces your ability to differentiate, you are in the death spiral.
- Never use past profitability to decide what to keep vs. divest; use the not-good-enough test to predict future profit pools.
- The firm that controls the not-good-enough stage controls the profits; position there or acquire there.
Related References
- Organizational Capability and Disruptive Growth - RPV framework explains why firms struggle to reposition toward de-commoditizing stages
- Managing the Strategy Development Process - Resource allocation filters systematically favor the commoditizing stage where current revenue lives
- Good Money and Bad Money - Capital misallocation accelerates the death spiral by starving adjacent-stage investments