Section 16.1. Software as Commodity

16.1. Software as Commodity

In his essay, "Some Implications of Software Commodification," Dave Stutz writes:

The word commodity is used today to represent fodder for industrial processes: things or substances that are found to be valuable as basic building blocks for many different purposes. Because of their very general value, they are typically used in large quantities and in many different ways. Commodities are always sourced by more than one producer, and consumers may substitute one producer's product for another's with impunity. Because commodities are fungible in this way, they are defined by uniform quality standards to which they must conform. These quality standards help to avoid adulteration, and also facilitate quick and easy valuation, which in turn fosters productivity gains.

Software commoditization has been driven by standards, in particular by the rise of communications-oriented systems such as the Internet, which depend on shared protocols, and define the interfaces and datatypes shared between cooperating components rather than the internals of those components. Such systems necessarily consist of replaceable parts. A web server such as Apache or Microsoft's IIS, or browsers such as Internet Explorer, Netscape Navigator, or Mozilla, are all easily swappable, because to function, they must implement the HTTP protocol and the HTML data format. Sendmail can be replaced by Exim or Postfix or Microsoft Exchange because all must support email exchange protocols such as SMTP, POP, and IMAP. Microsoft Outlook can easily be replaced by Eudora, or Pine, or Mozilla mail, or a web mail client such as Yahoo! Mail for the same reason.

(In this regard, it's worth noting that Unix, the system on which Linux is based, also has a communications-centric architecture. In The Unix Programming Environment, Kernighan and Pike eloquently describe how Unix programs should be written as small pieces designed to cooperate in "pipelines," reading and writing ASCII files rather than proprietary data formats. Eric Raymond gives a contemporary expression of this theme in his book, The Art of Unix Programming.)

Note that in a communications-centric environment with standard protocols, both proprietary and open source software become commodities. Microsoft's Internet Explorer web browser is just as much a commodity as the open source Apache Web Server, because both are constrained by the open standards of the Web. (If Microsoft had managed to gain dominant market share at both ends of the protocol pipeline between web browser and server, it would be another matter! See "How the Web was almost won" [http://salon.com/tech/feature/1999/11/16/microsoft_servers/print.html] for my discussion of that subject. This example makes clear one of the important roles that open source does play in "keeping standards honest." This role is being recognized by organizations like the W3C, which are increasingly reluctant to endorse standards that have only proprietary or patent-encumbered implementations.)

What's more, even software that starts out proprietary eventually becomes standardized and ultimately commoditized. Dave Stutz eloquently describes this process in an essay titled "The Natural History of Software Platforms" (http://www.synthesist.net/writing/software_platforms.html):

It occurs through a hardening of the external shell presented by the platform over time. As a platform succeeds in the marketplace, its APIs, UI, feature-set, file formats, and customization interfaces ossify and become more and more difficult to change. (They may, in fact, ossify so far as to literally harden into hardware appliances!) The process of ossification makes successful platforms easy targets for cloners, and cloning is what spells the beginning of the end for platform profit margins.

Consistent with this view, the cloning of Microsoft's Windows and Office franchises has been a major objective of the free and open source communities. In the past, Microsoft has been successful at rebuffing cloning attempts by continually revising APIs and file formats, but the writing is on the wall. Ubiquity drives standardization, and gratuitous innovation in defense of monopoly is rejected by users.

What are some of the implications of software commoditization? One might be tempted to see only the devaluation of something that was once a locus of enormous value. Thus, Red Hat founder Bob Young once remarked, "My goal is to shrink the size of the operating system market." (Red Hat, however, aimed to own a large part of that smaller market!) Defenders of the status quo, such as Microsoft VP, Jim Allchin, have made statements such as "open source is an intellectual property destroyer," and paint a bleak picture in which a great industry is destroyed, with nothing to take its place.

On the surface, Allchin appears to be right. Linux now generates tens of billions of dollars in server hardware-related revenues, with the software revenues merely a rounding error. Despite Linux's emerging dominance in the server market, Red Hat, the largest Linux distribution company, has annual revenues of only $126 million, versus Microsoft's $32 billion. A huge amount of software value appears to have vaporized.

But is it value or overhead? Open source advocates like to say they're not destroying actual value, but rather, are squeezing inefficiencies out of the system. When competition drives down prices, efficiency and average wealth levels go up. Firms unable to adapt to the new price levels undergo what the economist E.F. Schumpeter called "creative destruction," but what was "lost" returns manyfold as higher productivity and new opportunities.

Microsoft benefited, along with consumers, from the last round of "creative destruction" as PC hardware was commoditized. This time around, Microsoft sees the commoditization of operating systems, databases, web servers and browsers, and related software as destructive to its core business. But that destruction has created the opportunity for the killer applications of the Internet era: Yahoo!, Google, Amazon, and eBayto mention only a feware the beneficiaries.

And so I prefer to take the view of Clayton Christensen, the author of The Innovator's Dilemma and The Innovator's Solution. In a recent article in Harvard Business Review, he articulates "the law of conservation of attractive profits" as follows:

When attractive profits disappear at one stage in the value chain because a product becomes modular and commoditized, the opportunity to earn attractive profits with proprietary products will usually emerge at an adjacent stage.^[3]

^[3] Clayton Christensen, Harvard Business Review, Feb. 2004 (http://www.tensilica.com/HBR_feb_04.pdf).

We see Christensen's thesis clearly at work in the paradigm shifts I'm discussing here.^[4] Just as IBM's commoditization of the basic design of the personal computer led to opportunities for attractive profits "up the stack" in software, new fortunes are being made up the stack from the commodity open source software that underlies the Internet, in a new class of proprietary applications that I have elsewhere referred to as "infoware" (http://www.oreilly.com/catalog/opensources/book/tim.html).

^[4] I have been talking and writing about the paradigm shift for years, but until I heard Christensen speak at the Open Source Business Conference (http://www.osbc2004.com) in March 2004, I hadn't heard his eloquent generalization of the economic principles at work in what I'd been calling business paradigm shifts. I am indebted to Christensen and to Dave Stutz, whose recent writings on software commoditization have enriched my own views on the subject.

Sites such as Google, Amazon, and salesforce.com provide the most serious challenge to the traditional understanding of free and open source software. Here are applications built on top of Linux, but they are fiercely proprietary. What's more, even when using and modifying software distributed under the most restrictive of free software licenses, the GPL (http://www.gnu.org/copyleft/gpl.html), these sites are not constrained by any of its provisions, all of which are conditioned on the old paradigm. The GPL's protections are triggered by the act of software distribution, yet web-based application vendors never distribute any software: it is simply performed on the Internet's global stage, delivered as a service rather than as a packaged software application.

But more importantly, even if these sites gave out their source code, users would not easily be able to create a full copy of the running application! The application is a dynamically updated database whose utility comes from its completeness and concurrency and, in many cases, from the network effect of its participating users.

(To be sure, there would be many benefits to users were some of Google's algorithms public rather than secret, or Amazon's One-Click available to all, but the point remains: an instance of all of Google's source code would not give you Google, unless you were also able to build the capability to crawl and mirror the entire Web in the same way that Google does.)

And the opportunities are not merely up the stack. There are huge proprietary opportunities hidden inside the system. Christensen notes:

Attractive profits...move elsewhere in the value chain, often to subsystems from which the modular product is assembled. This is because it is improvements in the subsystems, rather than the modular product's architecture, that drives the assembler's ability to move upmarket towards more attractive profit margins. Hence, the subsystems become decommoditized and attractively profitable.

We saw this pattern in the PC market with most PCs now bearing the brand "Intel Inside"; the Internet could just as easily be branded "Cisco Inside."

But these "Intel Inside" business opportunities are not always obvious, nor are they necessarily in proprietary hardware or software. The open source Berkeley Internet Name Daemon (BIND) package used to run the Domain Name System (DNS) provides an important demonstration.

The business model for most of the Internet's commodity software turned out not to be selling that software (despite shrinkwrapped offerings from vendors such as NetManage and Spry, now long gone), but in services based on that software. Most of those businessesthe Internet Service Providers (ISPs), who essentially resell access to the TCP/IP protocol suite and to email and web serversturned out to be low-margin businesses. There was one notable exception.

BIND is probably the single most mission-critical program on the Internet, yet its maintainer has scraped by for the past two decades on donations and consulting fees. Meanwhile, domain name registrationan information service based on the softwarebecame a business generating hundreds of millions of dollars a year, a virtual monopoly for Network Solutions, which was handed the business on government contract before anyone realized just how valuable it would be. The "Intel Inside" opportunity of the DNS was not a software opportunity at all, but the service of managing the namespace used by the software. By a historical accident, the business model became separated from the software.

That services based on software would be a dominant business model for open source software was recognized in The Cathedral & the Bazaar, Eric Raymond's seminal work on the movement. But in practice, most early open source entrepreneurs focused on services associated with the maintenance and support of the software, rather than true software as a service. (That is to say, software as a service is not service in support of software, but software in support of user-facing services!)

Dell gives us a final lesson for today's software industry. Much as the commoditization of PC hardware drove down IBM's outsize margins but vastly increased the size of the market, creating enormous value for users and vast opportunities for a new ecosystem of computer manufacturers for whom the lower margins of the PC still made business sense, the commoditization of software will actually expand the software market. And as Christensen notes, in this type of market, the drivers of success "become speed to market and the ability responsively and conveniently to give customers exactly what they need, when they need it."^[5]

^[5] Clayton Christensen, Harvard Business Review, Feb. 2004 (http://www.tensilica.com/HBR_feb_04.pdf.

Following this logic, I believe that the process of building custom distributions will emerge as one of the key competitive differentiators among Linux vendors. Much as a Dell must be an arbitrageur of the various contract manufacturers vying to produce fungible components at the lowest price, a Linux vendor will need to manage the everchanging constellation of software suppliers whose asynchronous product releases provide the raw materials for Linux distributions. Companies like Debian founder Ian Murdock's Progeny Systems (http://progeny.com) already see this as the heart of their business, but even old-line Linux vendors such as SuSe and new entrants such as Sun tout their release engineering expertise as a competitive advantage.^[6]

^[6] From private communications with SuSe CTO, Juergen Geck, and Sun CTO, Greg Papadopoulos.

But even the most successful of these Linux distribution vendors will never achieve the revenues or profitability of today's software giants such as Microsoft or Oracle, unless they leverage some of the other lessons of history. As demonstrated by both the PC hardware market and the ISP industry (which, as noted earlier, is a service business built on the commodity protocols and applications of the Internet), commodity businesses are low margin for most of the players. Unless companies find value up the stack or through an "Intel Inside" opportunity, they must compete only through speed and responsiveness, and that's a challenging way to maintain a pricing advantage in a commodity market.

Early observers of the commodity nature of Linux, such as Red Hat's founder, Bob Young, believed that advantage was to be found in building a strong brand. That's certainly necessary, but it's not sufficient. It's even possible that contract manufacturers such as Flextronix, which work behind the scenes as industry suppliers rather than branded customer-facing entities, may provide a better analogy than Dell for some Linux vendors.

In conclusion, software itself is no longer the primary locus of value in the computer industry. The commoditization of software drives value to services enabled by that software. New business models are required.