Value Chain Orchestrators & Networked Companies: their immediate future and why they will surpass their competitors

Value Chain Orchestrators and Networked Companies:
their immediate future and why they will rapidly
surpass all their competitors (part one of two parts)

August 17, 2001

Study done by the McKinsey Quarterly

When Cisco Systems announced a $2.2 billion inventory write-down in the second quarter of 2001, skeptics immediately proclaimed the fall of the network business model that Cisco exemplifies. Superior information technology and real-time management, the critics reminded their readers, were supposed to have enabled networked companies to avoid precisely such setbacks.

During the past decade, big corporations learned to dismantle (unbundle) themselves into their component parts, while they sold off others. In so doing, they encountered a discomfiting question: If they were not exiting the business but would continue to deliver a complete product or service to customers, what would be their relationship with their former subsidiary or its marketplace counterparts ?

Cisco’s vaunted supply-chain systems were meant to provide greater notice of impending demand slowdowns. But reports of the demise of the network model--in which companies go far beyond outsourcing and collaborate in the delivery of products and services to customers--are exaggerated. "Network orchestrators" like Cisco might be experiencing their first real taste of adversity, but the network strategies they deploy look stronger than ever.

Indeed, Cisco outperformed its peers not only during the boom years of 1995 to 2000 but also during the first-quarter '2001 downturn. By most measures, its fellow network orchestrators did so as well. Our analysis shows that network orchestrators have reached their market milestones more quickly and earned greater value per employee than have their peers. Because they own fewer assets and leverage the resources of partner companies, network orchestrators require less capital and return higher revenue per employee than do conventionally run companies, and they are better able to weather the damage usually inflicted by market volatility.

We also compared the network orchestrators’ performance with that of market leaders in six industry segments (commercial airlines, consumer products, financial services, high technology, industrial products and retailing). This group was then culled for sector leaders in the period from 1996 to 2000, when networked companies took root. Network orchestrators far outperformed these industry standard-bearers in both shareholder value creation and revenue per employee. And as we have already mentioned, almost every measure of performance suggests that the leading network orchestrators, including Cisco, maintained their advantage even in a broad market decline.

This is how particular companies fared:
From 1995 to 2000, Schwab’s net income grew by 27 percent a year, though the firm made no large acquisitions. At the end of the year 2000, Schwab’s market-to-book ratio was 8.9--more than double the ratio of almost all of its competitors. As of March 2001, this ratio was still almost twice that of the rest of the industry.

During the same period, Cisco’s revenue grew by an average annual rate of 57 percent, and its market value per employee more than tripled--to $8.1 million, from $2.3 million. As of March 2001, Cisco’s revenue per employee was still more than twice that of other industry leaders.

The revenue of eBay grew by an annual average of 92 percent from 1996, when its revenue stood at $32 million, to 2000, when its revenue had risen to $431 million. At the end of 2000, eBay’s market-to-book ratio of 9.1 was the highest in the retail industry. As of March 2001, eBay’s market-to-book ratio had grown to 9.6, almost twice the industry norm.

During the past decade, big corporations learned to dismantle, or "unbundle," themselves into their component parts, while they sold off others. In so doing, they encountered a discomfiting question: If they were not exiting the business but would continue to deliver a complete product or service to customers, what would be their relationship with their former subsidiary or its marketplace counterparts ?

As Cisco morphed into a virtual corporation, it answered that question by creating a "gated network" of contract manufacturers and suppliers connected to one another and to itself by a powerful set of network applications running on its proprietary extranet. Cisco itself was disintegrating, but that didn’t mean it was disengaging from the manufacturers, subcontractors, resource planners and other companies on which the delivery of its products to customers depended.

Network orchestrators
Network orchestrators begin by undertaking a self-appraisal in which they identify those activities they do well enough to become the preeminent players in their markets. Orchestrators then set about establishing a platform across which the network participants will interact. For Cisco, this platform is the Cisco Connection Online, a Web-based channel for organizing and circulating information generated by the company’s customers and partners. For eBay, the platform is the auction software that brings into being a community of sellers and buyers. In effect, eBay provides the product-management and distribution links of the value chain, while the company’s specialist partners handle direct payment, shipping and other services.

For Schwab’s network, the platform is an online system that refers customers to some 6,000 independent financial advisers and provides transaction services to those advisers. Networks are not the only set of institutional relationships shaped by information technology. Microsoft’s Windows operating software places it at the center of an "economic web" composed of companies that produce Windows-based software applications and related services for users of personal computers. The market position of a given company will determine which form suits it better. Companies more fitted to the role of network orchestrator do, however, enjoy certain advantages over those choosing to become shapers of economic webs.

Economic webs are the creatures of a Darwinian struggle in which companies vie to establish a user base for their technologies. The technology that current users embrace becomes the "standard" and thereby the choice of most new users. The sheer weight of the market preference for the platform is the source of its influence over the economic web’s existing members and of its ability to attract new ones. Network orchestrators, by contrast, can control the circle of companies on which they depend even before achieving market acceptance. Demand for the manufacturer’s products and their number and complexity determine the proper size of the network as well as its proper scope. Cisco maintains a well-defined network that mirrors a traditional manufacturing value chain; eBay, a service business with more diverse offerings and a larger number and assortment of customers, manages a more fluid, open-ended network.

Unlike economic webs, networks are not open to all comers; rather, companies are invited into the network by the orchestrator. While size is not an end in itself, larger networks do have an easier time attracting additional partners. The presence of a greater number of participants in turn lowers transaction costs, amortizes risk, reduces the cost of tangible and intangible assets, and improves productivity. The key tactical step for an economic-web shaper is to share the technology it wants to see become a standard with companies that will stimulate demand for the technology by developing valuable applications. "Sharing the standard" has become a revered New Economy precept: winning companies do it; losing companies do not.

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