How Smart, Connected Products Are Transforming Competition

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PORTER M.E., HEPPELMANN J.E., How Smart, Connected Products Are Transforming Competition, Harvard Business Review, November 2014

Type Article
Topics Business Model, Competition, Contract, Data Protection, Property, Security, Information Security, Technology, Interoperability, Transparency


Competition is transformed by IT (Information Technologies). Currently, we are in the third wave of IT Driven competition: the first wave (60s-70s) caused automation in the value chain; the second (80s-90s) caused cooperation in the value chain; but neither of them changed the nature of products; the current third wave, on the contrary, is affecting the nature of products themselves.

In fact, products are becoming smart, connected products, composed by three kinds of elements: physical components (mechanical and electric parts), "smart" components (" sensors, microprocessors, data storage, controls, software, and, typically, an embedded operating system and enhanced user interface") and connectivity components (ports, antennae and protocols enabling wired and wireless connections with the product). "Smart components amplify the capabilities and value of the physical components, while connectivity amplifies the capabilities and value of the smart components and enables some of them to exist outside the physical product itself.".

Connectivity could be one-to-one, one-to-many or many-to-many, and it serves a dual purpose:

  • it allows the exchange of information between products and their operating environment, maker, users and other products and systems;
  • it "enables some functions of the product to exist outside the physical device, in what is known as the product cloud" (the product cloud is a "software running on the manufacturer's or a third-party server", and it contains "the product-data database, a platform for building software applications, a rules engine and analytics platform, and smart product applications that are not embedded in the product").

We normally say that IoT products are different from dumb products mostly because of their connection to the Internet, but per se this connection doesn't really revolutionize the product nature. What transforms products is what the Internet (i.e. connectivity) combined with other features of IoT products enables: four main kinds of capabilities, which are monitoring, control, optimization and autonomy.

The IoT products enable business models alternative to product ownership models:

  • product-as-a-service business models: they " allow users to have full access to a product but pay only for the amount of product they use";
  • product-sharing services (see for example they are a variation of the product-as-a-service model (think about the car or bike sharing enabled by the smart and connected capabilities that the IoT allows): "(p)roduct sharing, a variation of the product-as-a-service model, focuses on more efficient utilization of products that are used intermittently. Customers pay for the use of the product (such as cars or bikes) when they need it, and the company (such as Zipcar or Hubway) is responsible for everything else. Product sharing is spreading to nonmobile products such as houses".

See below for further discussion about. See also here.

With the IoT, hardware components are often replaced by software components (behaviour which also decreases cost for firms): "As the smart and connectivity components of products deliver more value relative to physical components, the physical components can be commoditized or even replaced by software over time. Software also reduces the need for physical tailoring and hence the number of physical component varieties". "For example, whereas John Deere used to manufacture multiple engines with different levels of horsepower to serve different customer segments, it now can modify the horsepower rating on the same engine using software alone". Some companies even decide to not deal with physical components, and they provide software services which don't need the possession of a dedicated device.

After-sale service: it enable timely and remote repair; product usage data provide firms with more and more accurate information about consumers' needs and therefore provide insights about how future product could be designed; moreover, "(p)roduct usage data can also be used to validate warranty claims and identify warranty agreement violations".

Local or remote smartness? "Once a company has decided which capabilities to offer, it must decide whether the enabling technology for each feature should be embedded in the product (raising the cost of every product), delivered through the product cloud, or both. In addition to cost, a number of factors should be taken into consideration": response time (if there is need for a quick response time, it is better for the software to be embedded in the product: in this way, we should also avoid that lack of connectivity slows down response); automation (fully automated products usually require that greater functionality be embedded capabilities); network availability, reliability, and security (embedding software minimizes dependence on network availability; moreover, if data doesn’t have to move from device to cloud or vice-versa, there are less threats to data security); location of product use (when the products are locate din dangerous locations, remote storing of data could be a good idea); nature of user interface (if it is complex and changed frequently, it is better to locate it on the cloud); frequency of service or product upgrades (when we have cloud-based interfaces and applications, upgrades and changes can be made easily and automatically).

Open or closed system? In the IoT world, we often have "systems encompassing multiple products". If the firm chooses a closed system, this approach is normally aimed to have customers purchase the entire system from it (technical tying): "(k)ey interfaces are proprietary, and only chosen parties gain access". If, on the contrary, an open system is chosen, the end customer is enabled to assemble the parts of the solution (both the products involved and the platform that ties the system together) from different companies: "the interfaces are open and standardized, allowing outside players to create new applications". "Closed systems create competitive advantage by allowing a company to control and optimize the design of all parts of the system relative to one another. The company maintains control over technology and data as well as the direction of development of the product and the product cloud. Producers of system components are restricted from accessing a closed system or are required to license the right to integrate their products into it. A closed approach may result in one manufacturer’s system becoming the de facto industry standard, enabling this company to capture the maximum value. A closed approach requires significant investment and works best when a single manufacturer has a dominant position in the industry that can be leveraged to control the supply of all parts of the smart, connected product system". "A fully open system enables any entity to participate in and interface with the system. The open approach enables a faster rate of applications development and system innovation as multiple entities contribute. It can also result in a de facto industry standard, but one from which no company gains a proprietary benefit" (Philips Hue light bulb is an example). When we have systems of systems, it is difficult to maintain a complete closed system, because often one firm doesn't have the capability of managing the entire system of systems: therefore, her we have firms (for example Whirpool) that try to maintain control on its product features, but enable those products to connect with other systems: hybrid approach.

What data must be collected? To answer this question, we must find an answer to a series of other questions: "How does each type of data create tangible value for functionality? For efficiency in the value chain? Will the data help the company understand and improve how the broader product system is performing over time? How often does the data need to be collected to optimize its usefulness, and how long should it be retained?". "For companies seeking leadership in the product system, there is a need to invest in capturing and analyzing more-extensive data across multiple products and the external environment, even for products the company does not produce. [...] Different strategies involve different data-capture choices. Nest, which aims to lead in energy efficiency and energy cost, gathers extensive data on both product usage and peak demand across the energy grid. This has enabled the Rush Hour Rewards program, which raises residential customers’ air conditioning thermostat temperature to reduce energy use during peak demand periods and precools a home before peak demand begins. By partnering with energy providers, securing the data they provide, and integrating it with customer data, Nest enables customers to earn discounts or credits from their energy provider and to use less energy when everyone else is using more".

Who owns the data? "As a company chooses which data to gather and analyze, it must determine how to secure rights to the data and manage data access. The key is who actually owns the data. The manufacturer may own the product, but product usage data potentially belongs to the customer. (...) There is a range of options for establishing data rights for smart, connected products. Companies may pursue outright ownership of product data, or seek joint ownership. There are also various levels of usage rights, including NDAs (non-disclosure agreements, ed.'s note), the right to share the data, or the right to sell it. Firms must determine their approach to transparency in data collection and use. Rights to data can be laid out in an explicit agreement or buried in small print or hard-to-understand boilerplate documents. Although we are seeing the early stages of a movement toward more transparency in data gathering across industries, data disclosure and ownership standards often have yet to be established. Another option for handling data rights and access includes the establishment of a data-sharing framework with component suppliers for providing information about the component’s condition and performance but not about its location. Limiting suppliers’ access to data, however, could reduce potential benefits if the supplier lacks a full understanding of how products are being used, slowing innovation. Customers and users want a say in these choices. Some customers today are much more willing than others to share data on their product use. For example, part of Fitbit’s value proposition is its ability to share via social media the personal fitness information it collects. But not every customer wants to share this data. Likewise, cautious drivers may be willing to share data on their driving habits with insurance or rental car companies as a way to lower premiums or fees, but others may resist. Firms will need to provide a clear value proposition to customers to encourage them to share usage or other data. As consumers become more aware of the value that data generates across the value chain, they will become more active and demanding participants in decisions about what data is collected, how it is used, and who benefits. Today it’s common to see “click through” agreements giving broad consent to collect product data the first time a smart, connected product is used. This consent allows companies to indiscriminately collect product data and use it with few constraints. In time we expect that more-stringent contractual frameworks and mechanisms governing those rights will emerge to define and protect intellectual property associated with smart, connected product data. It behooves companies to get ahead of this trend, especially on the product data they truly need to collect in order to drive value.

A change in the business model? "Manufacturers have traditionally focused on producing a physical good and capturing value by transferring ownership of the good to the customer through a sales transaction. The owner is then responsible for the costs of servicing the product and other costs of use, while bearing the risks of downtime and other product failures and defects not covered by warranties. Smart, connected products allow the radical alteration of this long-standing business model. The manufacturer, through access to product data and the ability to anticipate, reduce, and repair failures, has an unprecedented ability to affect product performance and optimize service. This opens up a spectrum of new business models for capturing value, from a version of the traditional ownership model where the customer benefits from the new service efficiencies to the product-as-a-service model in which the manufacturer retains ownership and takes full responsibility for the costs of product operation and service in return for an ongoing charge. Customers pay as they go, not up front. Here, the value of product performance improvements that reduce operating cost (such as better energy efficiency) and service efficiencies are captured by the manufacturer. Smart, connected products create a dilemma for manufacturers, particularly those that make complex, long-lived products for which parts and service generate significant revenue and often disproportionate profit. Whirlpool, for example, currently has a healthy business selling spare parts and service contracts—a model that can dull incentives to make products more reliable, more durable, and easier to fix. If, instead, Whirlpool moved to a product-as-a-service model, in which it maintained ownership of the product and the customer simply paid for the use of the machine, the economic incentives would be turned upside down. The profitability of product-as-a-service models depends on the pricing and terms of contracts, which are a function of bargaining power. Product-as-a-service models can increase buyers’ power, because customers may be able to switch after the contract period (if the product is not embedded as with an elevator), unlike with perpetual ownership.Companies can also pursue hybrid models between the extremes of product-as-a-service and conventional ownership, such as product sales bundled with warranty or service contracts, or product sales bundled with performance-based contracts. Service contracts allow the manufacturer to keep service in-house and capture more of the value from service efficiencies. In a performance-based contract, the manufacturer sells the product along with a contract that promises that the product will perform to certain specifications (such as percentage of uptime). Here, ownership is transferred, but the manufacturer maintains responsibility and bears the risk of product performance.