Implications for Strategy

The path to competitive advantage ultimately rests on strategy. Our research reveals that in a smart, connected world companies face 10 new strategic choices. Each choice involves trade-offs, and each must reflect a company’s unique circumstances. The choices are also interdependent. The company’s entire set of choices must reinforce one another and define a coherent and distinctive overall strategic positioning for the company.
1. Which set of smart, connected product capabilities and features should the company pursue?

Smart, connected products dramatically expand the range of potential product capabilities and features. Companies may be tempted to add as many new features as possible, especially given the often low marginal cost of adding more sensors and new software applications, and the largely fixed costs of the product cloud and other infrastructure. But just because a company can offer many new capabilities does not mean that their value to customers exceeds their cost. And when companies get into a features and capabilities arms race, they end up blurring strategic differences and creating zero-sum competition.
Tesla

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A Tesla vehicle in need of repairs can autonomously call for a corrective software download, or, if necessary, send a notification to the customer with an invitation for a valet to pick up the car and deliver it to a Tesla facility.

How should a company determine which smart, connected capabilities to offer? First, it must decide which features will deliver real value to customers relative to their cost. In residential water heaters, A.O. Smith has developed capabilities for fault monitoring and notification, but water heaters are so long-lived and reliable that few households are willing to pay enough for these features to justify their current cost. Consequently, A.O. Smith offers them as options on only a few models. In commercial water heaters and boilers, however, adoption of such capabilities is high and rising. The value of remote monitoring and operation to commercial customers that often cannot operate without heat and hot water is high relative to their cost, and so these features are becoming standard. Note that the cost of incorporating smart, connected product features will tend to fall over time, as is the case in water heaters and boilers. When deciding what features to offer, then, companies must continually revisit the value equation.

Second, the value of features or capabilities will vary by market segment, and so the selection of features a company offers will depend on what segments it chooses to serve. Schneider Electric, for example, makes building products as well as integrated building management solutions that gather volumes of data about energy consumption and other building performance metrics. For one segment of customers, Schneider’s solution involves remote equipment monitoring, alerts, and advisory services in reducing energy use and other costs. For the segment of customers that want a fully outsourced solution, however, Schneider actually takes over remote control of equipment to minimize energy consumption on customers’ behalf.

Third, a company should incorporate those capabilities and features that reinforce its competitive positioning. A company competing with a high-end strategy can often reinforce differentiation through extensive features, while a low-cost competitor may choose to include only the most basic features that affect core product performance and that lower the cost of operation. For example, A.O. Smith’s Lochinvar boiler unit, which competes using a highly differentiated strategy, has made extensive smart, connected product features standard on its core products. In contrast, Rolex, the luxury watch maker, has decided that smart, connected capabilities are not an area in which it will compete.
2. How much functionality should be embedded in the product and how much in the cloud?

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.

A feature that requires quick response times, such as a safety shutdown in a nuclear power plant, requires that the software be embedded in the physical product. This also reduces the risk that lost or degraded connectivity slows down response.
Automation.

Products that are fully automated, such as antilock brakes, usually require that greater functionality be embedded into the device.
Network availability, reliability, and security.

Embedding software in the product minimizes dependence on network availability and the amount of data that must flow from the product to cloud-based applications, lowering the risk that sensitive or confidential data will be compromised during transmission.
Location of product use.

Companies that operate products in remote or hazardous locations can mitigate the associated dangers and costs by hosting functionality in the product cloud. As discussed above, Thermo Fisher’s chemical analyzers, used in hazardous or toxic environments, have cloud-based capabilities and connectivity that enable the instantaneous transmission of contamination data and allow the immediate initiation of mitigation efforts.
Nature of user interface.

If the product’s user interface is complex and is changed frequently, the interface may be best located in the cloud. The cloud offers the ability to deliver a much richer user experience and potentially to take advantage of an existing, familiar, and robust user interface like a smartphone.
Frequency of service or product upgrades.

Cloud-based applications and interfaces allow companies to make product changes and upgrades easily and automatically.

Home audio equipment maker Sonos, a smart, connected products pioneer, takes advantage of cloud-based capability to “reinvent home audio for the digital age,” putting a premium on convenience, variety of music, and ease of use. The company’s wireless systems place both the music source and the user interface in the cloud, enabling Sonos to simplify its products’ physical design: The portable device, which is controlled from a smartphone, contains only the amplifier and speaker. With this offering, Sonos attempted to disrupt the home audio market. The trade-off? Wireless streamed audio systems do not deliver the level of sound quality that true audiophiles demand. Competitors such as Bose will make different choices and trade-offs to secure their competitive differentiation.

We believe that as smart, connected products evolve, more human-machine interface capabilities may well move out of the product and into the cloud. However, the complexity facing users in operating these interfaces will increase. User interfaces may often overshoot in complexity, and user backlash may drive firms to restore simpler, easy-to-use interfaces for common functions, including on/off controls.
3. Should the company pursue an open or closed system?

Smart, connected products involve multiple types of functionality and services, and are often systems encompassing multiple products. A closed system approach aims to have customers purchase the entire smart, connected product system from a single manufacturer. Key interfaces are proprietary, and only chosen parties gain access. The operating data that GE gathers from its aircraft engines, for example, is available only to the airlines operating the engines. An open system, by contrast, enables the end customer to assemble the parts of the solution—both the products involved and the platform that ties the system together—from different companies. Here, the interfaces enabling access to each part of the system are open or standardized, allowing outside players to create new applications.
Wind Turbine

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When smart wind turbines are networked, software can adjust the blades on each one to minimize impact on the efficiency of turbines nearby.

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. If either Philips Healthcare or GE Healthcare were the dominant manufacturer of medical imaging equipment, for example, it could drive a closed approach in which it could sell medical imaging management systems that included only its own or partners’ equipment to hospitals. However, neither company has the clout to restrict hospitals’ choice of other manufacturers’ equipment, so both companies’ imaging system platforms interface with other manufacturers’ machines.

A fully open system enables any entity to participate in and interface with the system. When Philips Lighting introduced the hue smart, connected lightbulb, for example, it included a basic smartphone application that allowed users to control the color and intensity of individual bulbs. Philips also published the application programming interface, which led independent software developers to quickly release dozens of applications that extended the utility of the hue bulbs, boosting sales. 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.

While a closed system is possible for individual product systems, it is often impractical for systems of systems. Whirlpool, for example, realizes that its strong position in home appliances will not be sufficient to become the leader in the “connected home,” which includes not only connected appliances but also automated lighting, HVAC, entertainment, and security. Therefore, Whirlpool designs its appliances to be readily connectable to the variety of home automation systems on the market, seeking to retain proprietary control only over its product features. A hybrid approach, in which a subset of functionality is open but the company controls access to full capabilities, occurs in industries like medical devices, where manufacturers support an industry standard interface but offer greater functionality only to customers. Over time, closed approaches become more challenging as technology spreads and customers resist limits on choice.
Babolat

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Babolat’s Play Pure Drive product system puts sensors and connectivity in the tennis racket handle, allowing users to track and analyze ball speed, spin, and impact location to improve their game.
4. Should the company develop the full set of smart, connected product capabilities and infrastructure internally or outsource to vendors and partners?

Developing the technology stack for smart, connected products requires significant investment in specialized skills, technologies, and infrastructure that have not been typically present in manufacturing companies. Many of these skills are scarce and in high demand.

A company must choose which layers of technology to develop and maintain in-house and which to outsource to suppliers and partners. In utilizing outside partners, it must decide whether to pursue custom development of tailored solutions or license off-the-shelf, best-of-breed solutions at each level. Our research suggests that the most successful companies choose a judicious combination of both.

Companies that develop smart, connected products in-house internalize key skills and infrastructure and retain greater control over features, functionality, and product data. They may also capture first-mover advantages and the ability to influence the direction of technology development. The company gets on its own, steeper learning curve, which can help maintain its competitive advantage. For example, while software skills are not well developed in most manufacturing companies, Jeff Immelt recently said that “every industrial company will become a software company.” The nature of technology for smart, connected products makes it clear why that might well be true and why building internal software capability is crucial.

Early pioneers AGCO and Deere have both taken a largely in-house route to develop smart farm equipment solutions for those reasons. GE has created a major software development center to build in-house capabilities it sees as strategic across business units.

However, as with the two previous IT waves, the difficulty, skills, time, and cost involved in building the entire technology stack for smart, connected products is formidable and leads to specialization at each layer. Just as Intel has specialized in microprocessors and Oracle in databases, new firms that specialize in components of the smart, connected products technology stack are already emerging, and their technology investments are amortized over many thousands of customers. Early movers that choose in-house development can overestimate their ability to stay ahead and end up slowing down their development time line.

But outsourcing can create new costs, as suppliers and partners demand a larger share of the value created. Companies that rely on partners also compromise their ability to differentiate going forward, and their ability to build and retain the in-house expertise required to set overall product design strategy, manage innovation, and choose vendors well.

In making these build-versus-buy choices, companies should identify those technology layers that offer the greatest opportunities for product insight, future innovation, and competitive advantage, and outsource those that will become commoditized or advance too quickly. For example, most companies should strive to maintain solid internal capabilities in areas such as device design, the user interface, systems engineering, data analytics, and rapid product application development.

These choices will evolve over time. In the early stages of smart, connected products technology, the number of capable and robust suppliers has been limited, and so companies have been faced with the imperative of in-house or custom development. Already, however, best-of-breed vendors with turnkey connectivity solutions and product clouds, secure high-performance application platforms, and ready-to-use data analytics are emerging. This makes it increasingly challenging for in-house efforts to keep up and can turn an early lead into a disadvantage.
Ralph Lauren

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Ralph Lauren’s Polo Tech Shirt, available in 2015, streams distance covered, calories burned, movement intensity, heart rate, and other data to the wearer’s mobile device.
5. What data must the company capture, secure, and analyze to maximize the value of its offering?

Product data is fundamental to value creation and competitive advantage in smart, connected products. But collecting data requires sensors, which add cost to the product, as does transmitting, storing, securing, and analyzing this data. Companies may also need to obtain rights to the data, adding complexity and cost. To determine which types of data provide sufficient value relative to cost, the firm must consider questions such as: 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?

Companies must also consider the product integrity, security, or privacy risks for each type of data and the associated cost. The less sensitive data a company collects, the lower the risk of breaches and transmission disruptions. When security requirements are high, companies will need capabilities to protect the data and limit transmission risk by storing data in the product itself. (We will discuss security more extensively in part two of this series.)

The types of data a company chooses to collect and analyze also depend on its positioning. If the company’s strategy is focused on leading in product performance or minimizing service cost, it must usually capture extensive “immediate value” data that can be leveraged in real time. This is especially important for complex, expensive products for which downtime is costly, such as wind turbines or jet engines.

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. For example a smart, connected product system might need to capture traffic data, weather conditions, and fuel prices at different locations for an entire fleet of vehicles.
Medtronic

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Medtronic’s implanted digital blood glucose meter connects wirelessly to a monitoring and display device and can alert patients to trends in glucose levels requiring attention.

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.
6. How does the company manage ownership and access rights to its product 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. For example, who is the rightful owner of the data streaming from a smart, connected aircraft engine—the engine supplier, the airframe manufacturer, or the airline that owns and operates the planes?

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, 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.

Careful stewardship of data will also be essential, especially in highly regulated industries such as medical devices. Regulatory standards for data access and security are already in place in many such fields. Biotronik has created infrastructure that allows it to securely gather patient information, such as arrhythmia events or pacemaker battery status, and share it only with a specified audience—the patient’s physician. Regardless of the industry, however, stewardship of data will be an essential capability, and data breaches will lead to serious consequences regardless of who is at fault. Ongoing security risk is part of the business case for which data to collect and how to manage it.
7. Should the company fully or partially disintermediate distribution channels or service networks?

Smart, connected products enable firms to maintain direct and deep customer relationships, which can reduce the need for distribution channel partners. Companies can also diagnose product performance problems and failures and sometimes make repairs remotely, reducing reliance on service partners. By minimizing the role of the middlemen, companies can potentially capture new revenue and boost margins. They can also improve their knowledge of customer needs, strengthen brand awareness, and boost loyalty by educating customers more directly about product value.

Tesla, for example, has disrupted the status quo in the automotive industry by selling its cars directly to consumers rather than through a traditional dealer network. This has simplified the firm’s pricing—consumers pay full sticker price, avoiding the haggling common at dealerships—greatly improving customer satisfaction. By eliminating third-party involvement in repairs, Tesla captures revenue and deepens its relationship with customers. The firm transmits software upgrades to its cars, continually improving the customer experience and giving drivers the equivalent of the “new car smell” with each update. When monitoring detects that a Tesla vehicle is due for repairs, the car either autonomously calls for a remote repair via software or sends a notification to the customer with an invitation to request that a valet deliver it to the Tesla facility. The firm was recently rated number one in customer satisfaction by Consumer Reports.

While disintermediation has definite advantages, some level of physical proximity to customers is still required and desirable in most industries. Customers must take delivery of and sometimes install a physical product, and some types of service visits are still necessary. In addition, customers may have strong relationships with resellers and channels that offer them a broader product line and deep and local field-based expertise. When manufacturers diminish the role of valuable channel partners, they risk losing them to competitors whose strategy is to embrace partners. Also, assuming roles formerly handled by partners—such as direct selling or service—can be challenging, involving high start-up costs and major new investments in value chain functions such as sales, logistics, inventory, and infrastructure.

The choice of whether or not to disintermediate a channel or service partner will depend in large part on the type of partner network the firm manages. Do partners simply distribute products, or are they critical to delivering training and service in the field? What percentage of partner activities can be replaced through smart, connected product capabilities? Do customers understand the value of eliminating the middleman? Do customers understand that traditional relationships with established channels are no longer necessary and involve extra cost?

8. Should the company change its 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.

Product 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.

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.

9. Should the company enter new businesses by monetizing its product data through selling it to outside parties?

Companies may find that the data they accumulate from smart, connected products is valuable to entities besides traditional customers. Companies may also discover that they can capture additional data, beyond what they need to optimize product value, that is valuable to other entities. In either case, this may lead to new services or even new businesses.

Data about the performance of a product’s components, for example, could be valuable to suppliers of those components. Data about driving conditions or delays gathered by a fleet of vehicles could be valuable to other drivers, to the operators of logistical systems, or to road repair crews. Data about driving characteristics could be valuable to fleet operators or insurance companies.

Again, in choosing how to capture new value from product data, companies must consider the likely reaction of core customers. While some of them may not care how their data is used, others may feel strongly about data privacy and reuse. Companies will need to identify mechanisms to provide valuable data to third parties without alienating customers. For example, a company might not sell individual customer data but rather blinded or aggregate data on purchasing patterns, driving habits, or energy usage.
10. Should the company expand its scope?

Smart, connected products not only transform existing products but often broaden industry boundaries. Products that have been separate and distinct can become parts of optimized systems of related products, or components of systems of systems. Shifting boundaries mean that companies that have been industry leaders for decades may find themselves playing more of a supporting role in a broader landscape.

The emergence of product systems and systems of systems raises at least two types of strategic choices about company scope. The first is whether a company should expand into related products or other parts of the system of systems. The second is whether a company should seek to provide the platform that connects the related products and information, even if it does not make or control all the parts.

Companies may be tempted to enter into related products in order to capture the big opportunity, but entry into related products always involves risk and the need for new capabilities. Companies must identify a clear value proposition before entering. Expanding product scope will be most attractive where there are major performance improvement opportunities through co-designing the related products to optimize the system. Alternatively, if optimization is not dependent on individual product designs, a company may be better off sticking to its knitting and providing open connectivity to related products produced by others. Success is less a function of traditional product design than systems engineering.

Companies whose products (and associated technological capabilities) are central to overall product system operation and performance, such as Joy Global’s mining machines, will be in the best position to enter related products and integrate the system. Manufacturers that produce less system-critical machines, such as the trucks that move the material extracted from underground, will have less capability and credibility in customers’ eyes to take on a broader system provider role.

The choice of whether or not to develop the technology platform that connects a product system or system of systems depends on some related questions. The first is whether the company can assemble the necessary IT skills and technology, which are quite different from those required in product design and manufacturing. Another key question is where system optimization takes place. “Inside product” optimization involves integrating individual product designs so that products work better together. “Outside product” optimization takes place through the algorithms that connect products and other information, where products themselves are modular. Inside product optimization creates the strongest rationale for expanding into related products and offering a proprietary platform. Outside product optimization favors an open platform, and the platform may be offered by a company that does not produce products at all.

Carrier Corporation offers an example of these choices. It has a 100-year history of innovation in the design of a full range of HVAC equipment such as furnaces, air conditioners, heat pumps, humidifiers, and ventilators. Carrier optimizes its HVAC product system performance by integrating individual designs across products, and its smart Infinity heating and cooling system platform connects them. However, HVAC is part of a broader home automation system. Carrier has not entered other product areas within home automation because of the need for very different capabilities. Rather, its Infinity platform provides interfaces to allow the HVAC product family to be integrated into the system of systems.

Finally, as smart, connected products expand industry scope and the boundaries of competition, many companies will need to rethink their corporate purpose. The focus is shifting to the broader need companies meet, rather than their traditional product definition. For example, Trane has moved from seeing itself as an HVAC equipment producer to a company that makes high-performance buildings better for everyone inside. As products continue to communicate and collaborate in networks, which are expanding both in number and diversity, many companies will have to reexamine their core mission and value proposition.

A company must make a clear choice in each of these dimensions of strategy but ensure that each choice is consistent with and reinforces the others. For example, a company pursuing product system leadership will enter related product categories, pursue inside product design integration, capture extensive product usage data, and develop more intensive internal capabilities across the technology stack. In contrast, a company that focuses on a single part of a product system will need to become best-of-breed in terms of features and functionality and provide transparent and open interfaces so that its product can be readily integrated into and becomes a valuable part of other companies’ systems and platforms. Ultimately, competitive success will arise not by imitating rivals but by defining a distinctive value proposition that the company can realistically achieve.