The Innovator's Cookbook Part 3

Listen carefully to what your customers want and then respond with new products that meet or exceed their needs." That mantra has dominated many a business, and it has undoubtedly led to great products and has even shaped entire industries. But slavishly obeying that conventional wisdom can also threaten a company's ability to compete.

The difficulty is that fully understanding customers' needs is often a costly and inexact process. Even when customers know precisely what they want, they often cannot transfer that information to manufacturers clearly or completely. Today, as the pace of change in many markets accelerates and as some industries move toward serving "markets of one," the cost of understanding and responding to customers' needs can easily spiral out of control.

In the course of studying product innovation across many industries, we have discovered that a number of companies have adopted an intriguing approach, which at first seems counterintuitive. Essentially, these companies have abandoned their efforts to understand exactly what products their customers want and have instead equipped them with tools to design and develop their own products, ranging from minor modifications to major new innovations. The user-friendly tools, often integrated into a package we call a "tool kit for customer innovation," deploy new technologies like computer simulation and rapid prototyping to make product development faster and less expensive.1 A variety of industries use this approach. Bush Boake Allen (BBA), a global supplier of specialty flavors to companies like Nestle, has built a tool kit that enables its customers to develop their own flavors, which BBA then manufactures. In the materials field, GE provides customers with Web-based tools for designing better plastic products. In software, a number of companies let people add custom-designed modules to their standard products and then commercialize the best of those components. Open-source software allows users to design, build, distribute, and support their own programs-no manufacturer required. Indeed, the trend toward customers as innovators has the power to completely transform industries. In the semiconductor business, it has led to a custom chip market that has grown to more than $15 billion.

Tapping into customer innovation can certainly generate tremendous value, but capturing that value is hardly a simple or straightforward process. Not only must companies develop the right tool kit, they must also revamp their business models as well as their management mind-sets. When companies relinquish a fundamental task-such as designing a new product-to customers, the two parties must redefine their relations.h.i.+p, and this change can be risky. With custom computer chips, for instance, companies traditionally captured value by both designing and manufacturing innovative products. Now, with customers taking over more of the design task, companies must focus more intently on providing the best custom manufacturing. In other words, the location where value is both created and captured changes, and companies must reconfigure their business models accordingly. In this article, we offer some basic principles and lessons for industries undergoing such a transformation.

A COSTLY PROBLEM-AND A RADICAL SOLUTION In a nutsh.e.l.l, product development is often difficult because the "need" information (what the customer wants) resides with the customer, and the "solution" information (how to satisfy those needs) lies with the manufacturer. Traditionally, the onus has been on manufacturers to collect the need information through various means, including market research and information gathered from the field. The process can be costly and time-consuming because customer needs are often complex, subtle, and fast changing. Frequently, customers don't fully understand their needs until they try out prototypes to explore exactly what does, and doesn't, work (referred to as "learning by doing").

Not surprisingly, traditional product development is a drawnout process of trial and error, often ping-ponging between manufacturer and customer. First, the manufacturer develops a prototype based on information from customers that is incomplete and only partially correct. The customer then tries out the product, finds flaws, and requests corrections. The cycle repeats until a satisfactory solution is reached, often requiring many costly and time-consuming iterations.

To appreciate the extent of the difficulty, consider product development at BBA (now International Flavors and Fragrances). In this industry, specialty flavors are created to bolster and enhance the taste of nearly all processed foods because manufacturing techniques weaken the real flavors. The development of those added flavors requires a high degree of customization and expertise, and the practice remains more an art than a science.

A traditional product development project at BBA might progress in the following way: A customer requests a meaty flavor for a soy product, and the sample must be delivered within a week. BBA marketing professionals and flavorists jump into action, and the sample is s.h.i.+pped in six days. A frustrating three weeks ensue until the client responds with, "It's good, but we need it less smoky and more gutsy." The client knows precisely what that means, but BBA flavorists find the request difficult to interpret. The result is more frenzied activity as BBA struggles to adjust the flavor in a couple days. Depending on the product, BBA and the client could go back and forth for several more iterations. This represents a huge problem because clients often expect BBA to get the flavor right the first time, or within two or three iterations.

To make matters worse, BBA bears most of the development risk. The company collects revenue only after both the client and consumers are fully satisfied. R&D expenses could be just $1,000 for tweaking an existing flavor, but they could go as high as $300,000 for an entirely new family of flavors that require not only chemists and flavorists but also sales, marketing, regulatory, and quality control expertise. On average, the client eventually accepts only 15 percent of all new flavors for full market evaluation, and only 5 percent to 10 percent make their way to the marketplace. Meanwhile, margins in the flavor industry have been falling because of increased compet.i.tion and cost pressures from customers.

In response, BBA's CEO Julian Boyden and VP of Technology John Wright investigated the option of s.h.i.+fting more innovation activities to customers. The company developed an Internet-based tool containing a large database of flavor profiles. A customer can select and manipulate that information on a computer screen and send his new design directly to an automated machine (perhaps located at the customer site) that will manufacture a sample within minutes. After tasting the sample, the customer can make any adjustments that are needed. If the flavor is too salty, for instance, he can easily tweak that parameter on the profile and have the machine immediately produce another sample.

It is important to note that outsourcing product development to customers does not eliminate learning by doing-nor should it. What it does is make traditional product development better and faster-for two reasons. First, a company can bypa.s.s the expensive and error-p.r.o.ne effort to understand customer needs in detail. Second, the trial-and-error cycles that inevitably occur during product development can progress much more quickly because the iterations will be performed solely by the customer. (For a basic ill.u.s.tration of the customers-as-innovators approach, see the exhibit "A New Approach to Developing Custom Products.") But developing the right tool kit for customers is hardly a A New Approach to Developing Custom Products Traditionally, suppliers have taken on most of the work-and responsibility-of product development. The result has been costly and time-consuming iterations between supplier and customer to reach a satisfactory solution. With the customers-as-innovators approach, a supplier provides customers with tools so that they can design and develop the application-specific part of a product on their own. This s.h.i.+fts the location of the supplier-customer interface, and the trial-and-error iterations necessary for product development are now carried out by the customer only. The result is greatly increased speed and effectiveness.

When Customer Innovation Makes Sense From our research, we have identified three major signs that your industry may soon migrate to a customers-as-innovators approach: 1. Your market segments are shrinking, and customers are increasingly asking for customized products. As you try to respond to those demands, your costs increase, and it is difficult to pa.s.s those costs on to customers.

2. You and your customers need many iterations before you find a solution. Some customers complain that you have gotten the product wrong or that you are responding too slowly. You are tempted to restrict the degree to which your products can be customized, and your smaller customers must make do with standard products or find a better solution elsewhere. As a result, customer loyalty starts to erode.

3. You or your compet.i.tors use high-quality computer-based simulation and rapid-prototyping tools internally to develop new products. You also have computer-adjustable production processes that can manufacture custom products. (These technologies could form the foundation of a tool kit that customers could use to develop their own designs.) simple matter.2 Specifically, tool kits must provide four important capabilities. First and most important, they must enable people to complete a series of design cycles followed by learning by doing. Computer simulation, for example, allows customers to quickly try out ideas and design alternatives without having to manufacture the actual products. When the simulation technology lacks the desired accuracy, it can be supplemented with rapid prototyping methods. Second, tool kits must be user-friendly. They should not require customers to learn an entirely new design language. (Flavorists, for example, think in terms of formulations and chemical compounds, whereas customers think of tastes such as smoky, sweet, fresh, and so on.) Third, they must contain libraries of useful components and modules that have been pretested and debugged. These save customers from having to reinvent the wheel. Instead, people can focus their efforts on the truly novel elements of their design. Fourth, tool kits must contain information about the capabilities and limitations of the production process that will be used to manufacture the product. This will ensure that a customer's design will in fact be producible.

AN INDUSTRY TRANSFORMED.

To understand the major impact that the customers-as-innovators approach can have, consider the history of the custom computer chip industry. The story holds several profound lessons about how the right tool kit can turn a market on its ear.

During the late 1970s, suppliers of custom chips experienced the same types of market dynamics that BBA has more recently encountered. (See the sidebar "When Customer Innovation Makes Sense.") At the time a typical user of custom semiconductors, such as a toy manufacturer that needed circuitry to operate its robotic dog, might have hired a chip company to develop a custom design. Because that process was complicated and costly, the chip company could afford to undertake projects only for high-volume customers.

Then a handful of start-ups turned everything upside down. Companies like LSI Logic Corporation and VLSI Technology provided both large and small customers with do-it-yourself tools that enabled them to design their own specialized chips. Customers could benefit by getting what they wanted through their own experimentation, and the fledgling chip companies could profit by manufacturing those customer designs. The win-win solution was right on the money. Between the 1980s and today, the market for such custom-integrated circuits has soared from virtually nothing to more than $15 billion, with the number of customers growing from a handful of high-volume buyers to hundreds of thousands of companies with very diverse end-user applications.

A key to that $15 billion market is the tool-kit technology. In principle, outsourcing custom design to customers can help slash development times and costs, but customers are not experts in a supplier's business. So how could customers be expected to create custom designs that can be produced on a manufacturer's sophisticated process equipment? The answer to that was found in a major s.h.i.+ft that had been taking place in the semiconductor industry.

Traditionally, specialized information used by a manufacturer to design and build custom products has been locked in the minds of the company's development engineers. This knowledge acc.u.mulates over decades of experience. In recent years, companies have been able to incorporate a considerable amount of this human expertise into computer-based tools. These CAD/CAM programs have grown increasingly sophisticated, and many now contain libraries of tested and debugged modules that people can simply plug into a new design. The most effective tools also enable rapid testing through computer simulation and provide links to automated equipment that can build prototypes quickly. This leading-edge technology, which manufacturers had been using internally, has become the basic building block for customer tool kits.

When LSI was founded in 1981, R&D engineers at large semiconductor companies were already using many elements of the customer tool kit, but there was no integrated system that less-skilled customers would be comfortable with. So LSI bought some of the pieces, made them customer-friendly by adding graphical user interfaces, and integrated them. The result was a packaged tool kit that let customers design their own chips with little support from LSI.

The brilliant insight that made possible a tool kit for less skilled customers was that the design of the chip's fundamental elements, such as its transistors, could be standardized and could incorporate the manufacturer's solution information of how semiconductors are fabricated. Then all the information the customer needed about how the chip would function could be concentrated within the electrical wiring that connects those fundamental elements. In other words, this new type of chip, called a "gate array," had a novel architecture created specifically to separate the manufacturer's solution information from the customer's need information. As a result, all customers had to do was use a tool kit that could interconnect a gate array based on their specific needs. For its part, LSI had to rethink how to make its production processes more flexible so that it could manufacture the custom chips at low cost.

Customer tool kits based on gate-array technology offer the four major capabilities described earlier. They contain a range of tools, including those to test a design, that enable users to create their own prototypes through trial and error. They are customer-friendly in that they use Boolean algebra, which is the design language commonly taught to electrical engineers. They contain extensive libraries of pretested circuit modules. And they also contain information about production processes so that users can test their designs to ensure that they can be manufactured. Interestingly, more recent technology-chips called field programmable gate arrays (FPGAs)-enable the customer to become both the designer and the manufacturer. Essentially, FPGA tool kits contain design and simulation software and equipment that customers use to program chips for themselves.

THE BENEFITS AND CHALLENGES.

Well-designed customer tool kits, such as those developed for the creation of custom semiconductor chips, offer several major advantages over traditional product development. First, they are significantly better at satisfying subtle aspects of customer need because customers know what they need better than manufacturers do. Second, designs will usually be completed much faster because customers can create them at their own site. Third, if customers follow the rules embedded in a tool kit (and if all the technological bugs have been worked out), their designs can be manufactured the first time around.

There are also ancillary benefits. Tool kits enable a company to do business with small customers that might have been prohibitively expensive to work with before, thus expanding the accessible market-and the number of product innovations. By serving these smaller clients, tool kits also reduce the pool of unserved, frustrated potential customers who might turn to compet.i.tors or to new entrants into the market. Furthermore, they allow companies to better serve their larger, preferred customers. That's a benefit most suppliers wouldn't expect, because they'd a.s.sume that their bigger customers would want the traditional hand-holding to which they're so accustomed. Experience shows, however, that such customers are often willing to use a tool kit, especially when fast product turnaround is crucial.

Of course, tool kits will not satisfy every type of customer. For one thing, they are generally not able to handle every kind of design. Also, they create products that are typically not as technically sophisticated as those developed by experienced engineers at a manufacturer using conventional methods. So manufacturers may continue to design certain products (those with difficult technical demands) while customers take over the design of others (those that require quick turnarounds or a detailed and accurate understanding of the customer's need).

The business challenges of implementing a tool kit can be daunting. Turning customers into innovators requires no less than a radical change in management mind-set. Pioneers LSI Logic and VLSI Technology were successful because they abandoned a principle that had long dominated conventional management thinking at leading companies like IBM, Intel, and Fujitsu. For many years, these companies had a.s.sumed that their interests would best be served by keeping design expertise, tools, and technologies away from customers. In contrast, LSI, VLSI, and the other industry upstarts understood that they needed to do just the opposite by putting robust, user-friendly tool kits into customers' hands.

Such a dramatic s.h.i.+ft in mind-set required a thorough rethinking of well-entrenched business practices. In essence, a company that turns its customers into innovators is outsourcing a valuable service that was once proprietary, and the change can be traumatic if that capability has long been a major source of compet.i.tive advantage. For example, a common problem is resistance from sales and marketing departments, which have traditionally been responsible for managing relations.h.i.+ps with customers and providing first-cla.s.s service to them. With tool kits, computer-to-computer interactions replace intense person-to-person contact during product development. In other words, customers who design products themselves have little need for a manufacturer's sales or marketing department to determine what they need. If this change affects the compensation of sales representatives in the field, it could easily derail any efforts to alter the company's business model. As a result, senior management needs to face these issues head-on-for example, by determining how the sales and marketing functions should evolve and by using specific incentives to induce employees to support the transformation. (For more on how to adapt your business practices, see the sidebar "Five Steps for Turning Customers into Innovators.") To better understand these issues, consider GE Plastics, which recently made the bold move of introducing some elements of a Web-based customer tool kit. Doing so required GE Plastics to rethink its sources of compet.i.tive advantage and to develop new business models that forced major changes, including the ways in which its sales and marketing staff acquired new customers. The company's story holds several valuable lessons.

GE Plastics does not design or manufacture plastic products but sells resins to those that do, and the properties of those resins must precisely match the properties of both the end product (a cell phone, for instance) as well as the process used to manufacture that product. With the formation of the Polymerland division in 1998, GE Plastics allowed customers to order plastics online and later took the step of making thirty years of its in-house knowledge available on a Web site. Registered users were given access to company data sheets, engineering expertise, and simulation software. Customers could use that knowledge and technology to conduct their own trial-and-error experiments to investigate, for example, how a certain grade of plastic with a specific amount of a particular type of reinforcement would flow into and fill a mold. The approximate cost of bringing such sophisticated tools online: $5 million.

GE Plastics, of course, did not make the investment simply to be magnanimous. Through the Web site, the company identifies and tracks people likely to become customers. That information is then relayed to an e-marketing staff. Today, the Web site attracts about a million visitors per year who are automatically screened for potential sales; that information accounts for nearly one-third of all new customer leads, thus fueling much of GE Plastic's growth. And because the cost of acquiring new business has decreased, GE Plastics can now go after smaller customers it might have ignored in the past. Specifically, the sales threshold at which a potential customer becomes attractive to GE's field marketing has dropped by more than 60 percent.

Five Steps for Turning Customers into Innovators 1. Develop a user-friendly tool kit for customers.

* The tool kit must enable customers to run repeated trial-and-error experiments and tests rapidly and efficiently.

* The technology should let customers work in a familiar design language, making it cheaper for customers to adopt your tool kit.

* The tool kit should include a library of standard design modules so customers can create complex custom designs rapidly.

* The technology should be adapted to your production processes so that customer designs can be sent directly to your manufacturing operations without extensive tailoring.

2. Increase the flexibility of your production processes.

* Your manufacturing operations should be retooled for fast, low-cost production of specialized designs developed by customers.

3. Carefully select the first customers to use the tool kit.

* The best prospects are customers that have a strong need for developing custom products quickly and frequently, have skilled engineers on staff, and have little experience with traditional customization services. These customers will likely stick with you when you are working out the system's bugs.

4. Evolve your tool kit continually and rapidly to satisfy your leading-edge customers.

* Customers at the forefront of technology will always push for improvements in your tool kit. Investments in such advancements will likely pay off, because many of your customers will need tomorrow what leading-edge customers desire today.

5. Adapt your business practices accordingly.

* Outsourcing product development to customers will require you to revamp your business models to profit from the s.h.i.+ft. The change might, for instance, make it economically feasible for you to work with smaller, low-volume customers.

* Tool kits will fundamentally change your relations.h.i.+p with customers. Intense person-to-person contact during product development will, for example, be replaced by computer-to-computer interactions. Prepare for these changes by implementing incentives to reduce resistance from your employees.

The online tools have also enabled GE Plastics to improve customer satisfaction at a lower cost. Before the Web site, GE Plastics received about five hundred thousand customer calls every year. Today, the availability of online tools has slashed that number in half. In fact, customers use the tools more than two thousand times a week. To encourage the rapid adoption of its tool kit, GE Plastics runs about four hundred e-seminars a year that reach roughly eight thousand customers. The company hopes that this effort will help encourage product engineers to design parts made of plastic (and GE resins) when they might otherwise have opted for metal or other materials.

A PATTERN OF MIGRATION.

Perhaps the most important lesson to be learned from GE Plastics is that a company that adopts the customers-as-innovators approach must adapt its business accordingly. Furthermore, we've found that because the value that tool kits generate tends to migrate, a company must continually reposition itself to capture that value.

When a supplier introduces a tool kit, the technology first tends to be company specific: the designs can only be produced in the factory of the company that developed the tool kit. This creates a huge short-term advantage for the pioneering supplier, which can reduce its custom design costs because they are partially outsourced to customers. That, in turn, enables the supplier to serve more customers. And because the customer's designs must be produced on the supplier's system, the supplier doesn't risk losing any business.

But the loss of leverage by customers represents a fundamental s.h.i.+ft. Traditionally, in the field of specialized industrial products, companies interested in a customer's business develop a custom design and submit it for evaluation. The customer picks the proposal from one supplier, and the others are saddled with a loss for their time and investment. A tool kit tied to a single supplier changes that dynamic: a customer that develops a design using the tool kit cannot ask for competing quotes because only one company can manufacture it.

Of course, customers would prefer the advantages of a tool kit without the a.s.sociated loss of leverage. In the long run, this type of solution tends to emerge: customer pressure induces third parties to introduce tool kits that can create designs to fit any supplier's manufacturing process. Or, in a slight variation, customers complain until a company that owns a dominant tool kit is forced to allow a spin-off to evolve the technology into a supplier-neutral form. Then customers are free to shop their designs around to competing manufacturers.

In other words, one long-term result of customer tool kits is that manufacturers lose a portion of the value they have traditionally delivered. But if the conditions are ripe for the technology to emerge in a given industry and if customers will benefit from it-and our research shows that they will-then suppliers really don't have a choice. Some company will eventually introduce a tool kit and reap the short-term advantages. Then others must follow. In the case of custom chips, Fujitsu initially resisted making its in-house design technology available to customers, thinking the move was too risky. (See the exhibit "Creating Value with Customers as Innovators.") But after LSI introduced a tool kit and began to establish itself in the market, Fujitsu and others were forced to play catch-up.

QUESTIONS OF VALUE.

Predicting where value will migrate-and knowing how to capture it-will be crucial as customer tool kits become more widespread. So far, the customers-as-innovators approach has mainly emerged in the B2B field, but numerous signs indicate that it is also spreading to the B2C arena. Many companies already offer so-called product configurators that enable consumers to obtain a ma.s.s-customized version of a standard product. Dell customers, for example, can select various components (a disk drive, monitor, memory modules, and so on) from a menu to a.s.semble the computer best suited to their needs. Eyegla.s.s frames, automobiles, and even Barbie dolls can be similarly configured. In fact, no application seems too trivial. General Mills is planning to introduce a Web site that will allow consumers to mix and match more than a hundred ingredients to create their own breakfast cereal. Although such product configurators are currently limited in what they can do (for one thing, they don't allow a user to try out a design, either through a prototype or a computer simulation), future versions could approach the functionality of true customer tool kits and allow for radically new innovations. (See the sidebar "What Ma.s.s Customization Is-and Isn't.") Creating Value with Customers as Innovators*

In the electronics market, suppliers have traditionally been the designers of full-custom and application-specific integrated circuits (light gray, with a compound annual growth rate of about 12 percent). During the 1990s, tool kits based on gate-array and standard-cell technologies (medium gray, with a CAGR of about 13 percent) enabled customers and third parties to also become product innovators. With field programmable technology (dark gray, with a CAGR of about 29 percent), customers take on primary responsibility for custom circuit design, creating great value in the industry.

Producers of information products, especially software, will perhaps feel the biggest impact. Companies like Microsoft have What Ma.s.s Customization Is-and Isn't Imagine a ma.s.s manufacturer that could customize products for each of its customers. Economically, that would require two things: first, learning how to design specialized products efficiently (the R&D problem), and second, learning how to manufacture those goods cheaply and quickly (the production problem).

The second problem has been addressed by the popular concept of ma.s.s-customized production. In that approach, computerized process equipment or flexible a.s.sembly procedures can be adjusted quickly and inexpensively so companies can make single-unit quant.i.ties of one-of-a-kind products at a cost that is reasonably compet.i.tive with the manufacture of similar, ma.s.s-produced items. The cla.s.sic example is Dell Computer: Consumers can buy a Dell computer by picking the major components they want (the size of the hard drive, the kind of monitor, the number and types of memory modules, and so on) from a menu on a Dell Web site. The company a.s.sembles and delivers the custom products in days.

But Dell's ma.s.s-customization approach does not address the first problem: learning how to design novel custom goods efficiently. The company's customers have only a limited number of standard components and combinations to choose from, leaving them little room for creativity or real innovation. What if someone wants a computer that cannot be a.s.sembled from those standard components, or what if that person is uncertain that a particular product will actually fulfill her needs? For instance, will the computer she's a.s.sembled be able to run the latest game software without cras.h.i.+ng? Unless customers can test a computer design that they've a.s.sembled before placing the order, they can't perform the trial-and-error experiments needed to develop the product best suited to their needs. In other words, with ma.s.s customization, the cost of manufacturing unique products has dropped, but the cost of designing such items has not.

The approach presented in this article-using tool kits that enable customers to become innovators-targets the first problem; its goal is to provide customers with enough creative freedom to design innovative custom products that will truly satisfy their needs.

long relied on customers to beta-test new products. Now other companies have taken that concept to the next level. Stata, which sells a software package for performing complex statistical a.n.a.lyses, encourages its customers to write software add-on modules for performing the latest statistical techniques; the company then adapts and incorporates the best of those into its next release.

The danger to software companies is that production is essentially free, so the customer might one day ma.s.s-distribute copies of a custom program with the simple press of a b.u.t.ton. If that practice becomes widespread, a truly effective tool kit might itself become the product, forcing companies to adapt quickly to the dramatic change. Or users might abandon their status as customers altogether, collaborating to design and build their own tool kits as well as their own specialized programs.

The growing popularity of open-source software could touch off such a revolution. Consider what has happened to companies that sell software for Linux, an operating system that is virtually free. Recently, IBM took the bold step of placing $40 million of in-house tools for developing software into the public domain to encourage people to write programs that run on Linux. IBM is hoping that the move will help make Linux a widespread standard and that the company will make money by selling specialized Linux software applications, the hardware to run them, and consulting services. Other Linux companies like Red Hat are focusing on packaging, distribution, and support.

Outsourcing a portion of the innovation task to customers can be an effective approach for speeding up the development of products better suited to customer needs. The approach also holds the power to turn markets topsy-turvy, creating and s.h.i.+fting value at three separate levels: the industry as a whole, companies that implement the technology, and customers that take advantage of it. Exactly where that value will be generated and how it might best be captured are the multimillion-dollar questions facing companies competing in industries that are being transformed by customers as innovators.

NOTES.

1 Stefan Thomke, "Enlightened Experimentation: The New Imperative for Innovation," HBR, February 2001 2 Eric von Hippel, "Perspective: User Toolkits for Innovation," Journal of Product Innovation Management, July 2001.

Innovation Blowback: Disruptive Management Practices from Asia JOHN SEELY BROWN AND JOHN HAGEL III.

In the days of the rudimentary pistol, unlucky shooters were now and then hurt when unburned gunpowder escaped back toward their faces. They came to describe this unpleasant experience as "blowback," a term that has subsequently gained wider application in military affairs-to any event that turns on its maker.

Blowback is an apt term for the unexpected consequences of the investments that Western companies have made in emerging markets. Since first entering them several decades ago, and to a remarkable extent today, these companies have tended to view them in what Kenneth Lieberthal and C. K. Prahalad1 call "imperialistic" terms: as a beguiling mix of increasingly prosperous consumers and limitless pools of low-cost labor. Here, the thinking goes, companies can expect to harvest the fruits of the R&D and innovation skills painstakingly developed in their home countries.

That view is dangerously complacent. The very presence of Western intruders and the compet.i.tion they create have inspired the emerging world's companies to raise their game in response. Far from being easy targets for exploitation, emerging markets are generating a wave of disruptive product and process innovations that are helping established companies and a new generation of entrepreneurs to achieve new price-performance levels for a range of globally traded goods and services. Eventually, such companies may capture significant market share in Europe and the United States.

To be sure, these trends are in their early development, and most companies in emerging markets face formidable obstacles to competing effectively at home, let alone penetrating the developed world. Furthermore, most Western companies haven't yet begun to serve the emerging world's low-income segments, where crucial learning takes place. Even so, early indications suggest the "innovation blowback" from emerging markets could come soon: * Wal-Mart Stores' imports from China already account for 1 percent of its GDP. Along with other value-conscious retailers, the company stands ready to help a new breed of manufacturer target its wares at shoppers in the United States and Europe.

* Citigroup's Chinese M& A unit reports that outbound deals make up the lion's share of its pipeline-a sign that companies in China are moving abroad.

* Still more significant, mounting evidence suggests that farsighted vanguard Western companies are not only acquiring key capabilities by serving low-income customers in emerging markets but also preparing to use that experience to attack the growing value segments of developed markets. These companies, wielding advantages based not on factor cost differences but on superior management, show that blowback is as much an opportunity as a threat.

Most of the developed world's companies must urgently reposition themselves to deal with this offsh.o.r.e challenge. The solution isn't just to bring their products and business practices to the developing world, where they will invariably fail to penetrate beyond small segments of relatively affluent consumers and miss out on the vast purchasing power of less affluent ones.2 Nor can Western companies simply strip costs from existing products. They must instead redesign their products and processes from a "clean-sheet" perspective-one that amplifies their own distinctive capabilities and those of other companies-by partic.i.p.ating in and orchestrating networks of highly specialized businesses. In fact, they can acquire the capabilities they will soon need at home only if they face the intense compet.i.tive pressures of serving the ma.s.s market in emerging economies.

EMERGING-MARKET HOTBEDS.

Emerging markets are well known for their role in activities such as a.s.sembling consumer electronics products and providing lowlevel customer support through burgeoning call centers. They will become even more significant as catalysts for product and process innovation.

Two powerful factors are converging to transform them into catalysts of this kind. One is the low incomes of consumers in China and India-a total of 457 million households in 2002, with an average annual income of less than $6,000 a year. The other is the spending behavior of this immense group of consumers, who, by Western standards, are unusually youthful, demanding, openminded, and adventurous. One study cited by Lieberthal and Prahalad, for instance, showed that Indian consumers sample an average of 6.2 brands a year of a given consumer product for every 2.0 brands their US counterparts buy.3 These demographics and consumer traits set a stern precedent. To penetrate this vast market, companies must charge prices that the majority of its consumers can afford. Furthermore, the climate of openness implies diminished loyalty to established brands and greater receptiveness to new partic.i.p.ants and product features. Both will force companies to rethink the way they develop and deliver their offerings.

Mobile technology demonstrates both the opportunity and the challenge. China and India, thanks to their army of early adopters, have become two of the world's largest markets for mobile phones. But these markets differ from Western ones in important ways. According to Mouli Raman, the chief technology officer of OnMobile, an entrepreneurial company spun out of Infosys Technologies three years ago, the cost of equipment for mobile-telephone networks must fall by a factor of five for it to succeed in the Indian market. Pricing for mobile-network operators must also be restructured, with smaller up-front license fees and more emphasis on performance-based payments.

Established technology vendors such as Nokia or Sony Ericsson must decide whether products designed for more developed countries will succeed if merely adapted for Asia's emerging markets or a radical new approach to product and process design is required. A growing number of such companies now acknowledge that going back to the drawing board is the only choice in Asia. Products like mobile phones comprise many interdependent systems and subsystems. When the products are designed, their features require trade-offs and agreements about diverse systems and components. Companies that attempt, say, to incorporate fewer features find that the second-order effects ripple across these previous trade-offs and agreements.

THE NEW MODELS TO FOLLOW.

As Western companies strip costs from their products, they will have to rethink the processes they use to design and deliver their offerings. Many will discover that their home-market organizations are no longer the primary locus of innovation. Big global companies, after specifying the performance parameters they expect, may outsource the innovation process entirely. Contrary to the belief that multinationals must enter the emerging world in a vertically integrated fas.h.i.+on to ensure quality, they may begin to disintegrate vertically there-not just to a.s.sembly but all the way to product design. To some Western executives this might seem like a radical notion, but the practice of outsourcing innovation is gaining ground. Gateway and Hewlett-Packard, for example, recognizing that they couldn't move quickly into consumer electronics markets, have turned to original-design manufacturers in Asia for their new consumer product offerings.4 Companies have many ways to manage product and process innovation in emerging markets, but three are especially promising. Although presented separately, they are not mutually exclusive; a company can amplify the impact of its own capabilities, and deliver greater value at much lower cost, by combining them. The first approach is described through a cautionary tale about how j.a.panese motorcycle makers went to China only to get beaten at their own game. But like the cases ill.u.s.trating the other approaches, this one also describes an opportunity for Western companies: to turn blowback to their advantage by building distinctive capabilities in the low-income segments of emerging economies before other companies do.

Production-Driven Modularity Few Westerners could find Chongqing on a map. Yet this central Chinese city is home to a network of companies whose vibrant new way of designing and manufacturing motorcycles is a prototype for disruptive innovation. The network uses a distinctive management process that economists at Tokyo University, who have studied such networks in great depth, call "localized modularization"-a loosely controlled, supplier-driven approach that speeds up a company's time to market, cuts its costs, and enhances the quality of its products. The heart of this new system is a series of "process networks" mobilizing specialized companies across many levels of an extended business process. Entrepreneurial and privately owned motorcycle a.s.semblers such as Dachangjiang, Longxin, and Cixi Zongshen Motorcycle orchestrate the networks.

These companies got their start by competing against established state-owned a.s.semblers that had partnered with leading j.a.panese motorcycle makers such as Honda Motor, Suzuki Motor, and Yamaha. The private a.s.semblers refined the j.a.panese companies' tightly integrated product architecture into one that was more flexible and modular but just as functional. The Chinese system makes it possible for the a.s.semblers to modularize production in parallel by outsourcing components and suba.s.semblies to independent suppliers. In contrast to more traditional, top-down approaches, the a.s.semblers succeed not by preparing detailed design drawings of components and subsystems for their suppliers but by defining only a product's key modules in rough design blueprints and specifying broad performance parameters, such as weight and size. The suppliers take collective responsibility for the detailed design of components and subsystems. Since they are free to improvise within broad limits, they have rapidly cut their costs and improved the quality of their products.

Locating major suppliers and a.s.semblers in the same city helps to mobilize the appropriate specializations. Informal social networks, developed in crowded teahouses and restaurants, supplement more formal efforts to coordinate suppliers and a.s.semblers. Throughout India and China, such emerging local business ecosystems play a major role in speeding up product and process innovation. In this production-driven form of modularization, suppliers of components and suba.s.semblies-the frame, the engine, the suspension-take much of the responsibility for coordinating their work. Solving problems by combining people from diverse fields makes the solution more creative.

Thanks to these innovations, China has made rapid gains in motorcycle export markets, especially in Africa and Southeast Asia, and now accounts for 50 percent of all global production of motorcycles. The average export price of Chinese models has dropped from $700 in the late 1990s (already several hundred dollars less than the cost of equivalent j.a.panese models) to under $200 in 2002. The impact on rivals has been brutal: Honda's share of Vietnam's motorcycle market, for instance, dropped from nearly 90 percent in 1997 to 30 percent in 2002. j.a.panese companies complain about the "stealing" of their designs, but the Chinese have redefined product architectures, in ways that go well beyond copying, by encouraging significant local innovation at the component and subsystem level.

It isn't all upside for the Chinese. Price compet.i.tion has eroded the profit margins of both a.s.semblers and suppliers, jeopardizing their ability to invest in further product innovation. Some consolidation by a.s.semblers-plus a move into marketing and service-seems likely.

Customer-Driven Modularity Over the years, consumer packaged-goods companies have reduced their products' unit size in emerging markets to unlock demand among consumers who can't afford bigger portions. Coca-Cola, for example, began selling 200-milliliter bottles of c.o.ke in India in 2003; Britannia launched Tiger Biscuits in 20-gram packages in 1999. What if companies took this approach with more expensive purchases, such as mobile phones, or even with products for low-income businesses?

c.u.mmins, the producer of diesel engines and power generators, recently did just that in India. By modularizing a product for the distinct needs of different kinds of customers and channel partners, the company cut the total cost of owners.h.i.+p and of sales in the channel. The result: higher demand for c.u.mmins products.

HOW c.u.mMINS DID IT.

By 2000 the company had already captured 60 percent of the high-horsepower end of the Indian market. But it was only a marginal player in the large and rapidly growing low-horsepower (under one-hundred-kilowatt) end, where buyers include small retailers, regional hospitals, and farmers requiring an a.s.sured power source in a country where outages are frequent. This big market was potentially lucrative, but its demands are daunting: each segment needs slightly different features. Farmers, for example, want engines protected against dirt, while noise is a bigger issue for hospitals. c.u.mmins realized that it needed a low-horsepower engine that could affordably meet the needs of all these customers.

The company realized that it couldn't afford direct distribution, given the need for low prices. Instead it would have to use third-party distributors, all of them less skilled than its direct sales force and less able to help customize the product for the needs of particular end users. The solution was to create a series of smaller, lower-powered, modularized engines and to combine them with add-ons called "gensets" (generation sets) that could be customized for different segments. By packaging components in ready-to-a.s.semble gensets, c.u.mmins broadened the product's appeal to both customers and distributors. Customers liked the gensets because the product came tailor-made; the hospital version, for instance, had a noise-abatement hood that was omitted from the farm kit, which had dust and dirt guards not included in the hospital version. Gensets also appealed to distributors because they didn't have to source these add-ons themselves-something that would have been beyond their means and skills.

Modularizing the product to meet the needs of customers and channels also helped solve operational dilemmas. Customized products ordinarily mean smaller manufacturing runs, so c.u.mmins faced an increase in the average unit cost of production for an offering that had to be cheap. By modularizing it, the company increased production runs of common subsystems and components, thus keeping overall costs low. It also pressed suppliers of peripherals, such as the noise-abatement hood, to standardize designs and cut costs.

Compared with the radical process innovations of the Chinese motorcycle a.s.semblers, which outsource more of their core production, c.u.mmins's strategy may seem familiar (see sidebar, "Beyond Big-Bang Innovation"). Western companies, after all, have long grappled with customization and "segment-of-one" challenges. Yet these efforts often end at the factory door. When modularization reflects only the need to cut manufacturing costs-rather than the problem of reaching small, dispersed segments of low-income customers through third-party channels-it typically fails to cut the cost of owners.h.i.+p for customers and the cost of sales in the channel.

BEYOND INDIA.

The new genset engines have been an unqualified success in India, where c.u.mmins has won 40 percent of the market over the past three years. Genset sales now account for 25 percent of the company's total power generation sales there. Despite the much lower unit prices of the new range, its net profitability is comparable to that of the high end. Exports began in 2002 to other parts of Asia and were later extended to Africa, Latin America, and the Middle East. Can it be long before c.u.mmins introduces its low-horsepower generators in more developed markets?

If it does, it could leverage another advantage derived from competing in Asian ma.s.s markets: the high levels of reliability it had to design into the engines not only because its customers can't depend on the local power supply but also because the low prices they demand mean that its margins can't sustain an after-sales service unit. This higher reliability could prove compet.i.tively devastating in developed countries, where many vendors have competed away margins on their products and now depend on profitable aftermarkets. An attacker selling products that don't require after-sales service could dry up that profit pool.

Process-Driven Services Innovation in emerging markets won't be limited to manufactured goods. The desire to reach vast low-income segments of Asia's population is also pus.h.i.+ng service organizations to new levels of achievement. One vivid example comes from the Aravind Eye Care System, at Madurai, in the south Indian state of Tamil Nadu. The Aravind system-dedicated to eradicating "needless blindness by providing appropriate, compa.s.sionate, and high-quality eye care for all"-includes a chain of hospitals and a manufacturing center for sutures, synthetic lenses, and eye pharmaceuticals.

Aravind, which occupies a highly specialized health care niche, developed efficient processes by treating huge numbers of extremely poor patients in a country where 12 million people are totally blind and an additional 8 million are blind in one eye. Its hospitals perform two hundred thousand operations a year-nearly 45 percent of all such operations in Tamil Nadu and 5 percent of those throughout India. High volumes are dictated by the affliction's scale and by the need to make the network's nonprofit hospitals viable and to generate funds for expansion.