Functional Integration: a strategic growth model for the digital age
My research has been inspired by the work of R/GA with leading innovative brands such as Nike, and a book by Barry Wacksman, Connected by Design, in which he argues that today's fierce global competition and rapid technological change has made traditional growth strategies of horizontal and vertical integration less effective.
In the industrial age, growth meant constantly expanding into new products and services, broadening the portfolios of businesses and continuously finding new things to sell to consumers. This was the process known as horizontal integration, which since the 1880s has seen countless companies bankrupted or acquired by larger corporations looking to find economies of scale.
The beginning of vertical integration, by contrast, started with the advent of new hardware technologies focused on increasing efficiency, thereby decreasing production and distribution costs. These new technologies allowed companies to improve the allocation of resources across the vertical chain.
In other words, companies’ competitive growth strategies consisted of horizontal integration to drive top-line growth, and vertical integration to drive cost reductions and profitability.
In order to explain the current situation, we need to understand and frame the new strategic approach dictated by the power of digital technologies and their transformational nature. The digital, social, and mobile age in which we live now has transformed traditional companies into interactive and interconnected ecosystems. This evolution has helped digital pioneers like Amazon, Apple and Google as well as mainstream players like Nike, GM, BMW and McCormick to effectively outperform other more traditional players. New opportunities are emerging for startups to use these principles for themselves, or digitally enable other existing players.
The conception, design and execution of interactive and interconnected ecosystems represents a completely new dimension of growth enabled by transformative technologies. The intent of my research is to investigate this phenomenon and understand in deeper detail the benefits of new growth strategies, and to explain the model in a more specific framework capable of being measured and applied by most brands.
Barry Wacksman, Chief Growth Officer at R/GA named this new strategy ‘Functional Integration’ and introduced it to the market at the 58th Cannes Lions International Festival of Creativity in 2011. The term ‘functional integration’ refers to the two dimensions of the strategy: the functionality of new pieces of the ecosystem (products and or services), and their integration within the ecosystem itself. He argues that when these two dimensions work perfectly together, the ecosystem will expand, and the company will grow in market share and profits at a rate far faster than traditional horizontal or vertical integration. He has also proposed a graphical representation of the model, as seen in figure 1 below, which logically merges the vertical and horizontal dimension to form an interconnected circle similar to the visual representation of DNA.
According to Wacksman, functional integration’s massive competitive edge is supplied by the transformational skills of the technologies used to design disruptive new services. When I speak of technologies, I refer to a collection of techniques, skill, methods and processes used in the production of goods or services. Technology can be the knowledge of techniques, processes, and so on, or it can be embedded within machines, computers, devices and factories, which can be operated by individuals without detailed knowledge of the workings of such things. Thus the correct assumption is that new technologies such as cloud computing, wireless sensors, big data and mobile services enable innovative techniques and processes to transform the way we operate.
I have tried expanding the model and the theory of functional integration, driven by a few observations I find useful.
Firstly, I have looked at the first part of the definition proposed by Wacksman, also referred to as the first dimension: the functionality of the new piece of the ecosystem, being a product and/or a service. I have given this dimension a specific interpretation, adapting it to the recent literature on digital transformation which often refers to the ‘experience economy.’
I consider the product or service’s ‘functionality’ to be an extension of the brand into a new ‘user function,’ which facilitates the way a user experiences its and the brand itself. The objective is to add value to the experience of the user; rather than the traditional growth in market share pursued by horizontal integration. I have represented this dimension in figure 2 below, in which the user becomes the centre of the ecosystem and the ecosystem becomes the mix of ‘functions’ and needs, addressed by brands.
To take Amazon as an example: it started as a book online store, it expanded into multi-product e-commerce; it diversified into cloud services, and it then started producing its own hardware to enter our homes in the shape of Alexa. The question I would like to answer is: to what extent could a brand extend its line of products and services into a user’s individual life experience, while still creating added value? Would we be open to buying everything from one brand, purely due to simplicity of experience and perceived trustworthiness?
Secondly, I have looked at the second part of the definition, also referred to as the second dimension: the integration within the ecosystem itself. I interpreted Wacksman’s use of the word ‘ecosystem’ in the way it refers to the brand or corporation or firm, not meaning an industry ecosystem or any other form of ecosystem (there are many different meanings for the term).
I interpreted ‘integration’ as the synergy between the different products and services within the company portfolio. I argue that Wacksman has used the term ‘ecosystem’ because modern digital technologies create a ‘dynamic relationship’ between the pieces which has to be included in the strategic framework; they are no longer viewed as individual products or services but as interconnected touch points with a user. Indeed, technologies such as cloud computing, data and smartphones enable a much higher level of integration between the products and services offered to users, and also a new relationship with the users themselves. This dimension could be seen as an extension of the vertical integration model since it still aims at efficiency of resources allocation but it reaches a higher layer, driven by the multi-industry effect, in turn driven by the functionality extension.
Returning to the Amazon example, vertical integration would be very useful when looking to increase profitability within the e-commerce business unit; while a higher level of integration would be required between logistics, cloud computing and artificial intelligence units to create extra value for the user which sees the brand as a more suitable experience provider matching more functions than others. This is the argument for choosing the word ‘ecosystem’ to describe the portfolio of products and services of a modern brand: a dynamic relationship enabled by the technologies shared between the products and services in the portfolio. I have represented this dimension in figure 3 below; it looks the same as the visual representation of the functional dimension, but it this case the centre of the ecosystem is the brand and the ecosystem becomes the mix of products and services a brand offers to its target user.
I use the term User Functional Value to describe the relationship between 'function' and 'product or service,' and Business Integration Ratio to describe the relationship between different 'products or services'.
User Functional Value is an external variable dependent on the user’s propensity to extend the relationship with a brand by buying new products and services which offer extra added value to the whole experience. The Business Integration Ratio is an internal variable dependent on the extendibility of core competencies to match the requirement of user functionality and create extra added value for the brand. Figure 4 below represents the extended model visually.
The main objective of this research is framing functional integration as a useful model in corporate strategy.
The new framework should serve to screen new products and services and decide which innovation initiatives to pursue in an economic environment where internal labs and R&D initiatives are failing and open innovation is instead showing promising results.
The easiest way to explain the problem is by using example, and I will use Technogym as a brand which needs to develop an innovation strategy.
Technogym is suited to being a simple brand which was founded to manufacture wellness equipment, selling either to wellness providers (gyms, hotel, etc.) or directly to private individuals. The current economic environment is pushing the brand to extend its offering and figure 5 below shows the options available. The violet circles are options closer to user experience functions, which would allow the brand to improve engagement and use of its core product; but they are very far from its core competencies, since they would require technological skills different from the ones required to build equipment. The blue circles are more traditional options which could be executed with traditional partnerships, and are less focussed on user experience. The grey circle is an acquisition option, which is a very traditional step.
How should the management decide which route to pursue? Would DCF model to measure the ROI suitable to match expanding user functional needs?
This research should help a brand to measure User Functional Value and compare it to Business Integration Ration to develop a comprehensible strategic functional matrix.
In order to build on this, I have plotted the Figure 4 diagram into a traditional bi-dimensional graph, with the User Functional Value on the X-axis and the Business Integration Ratio on the Y-Axis (figure 6). This model allows us to represent existing products and services on the graph, together with new projects, and evaluate how to configure the portfolio.
The two variables can be measured with a score, for example between 0 and 100, then the model would be useful to a brand aiming to strategically select which existing products and services to improve. It could also be used to score new products to integrate: the higher the mix of User Functional Value and Business Integration Ratio, the higher the value created both internally and externally. The graph could also be translated into a classic matrix to show the result of the study and the data collected, as in figure 7.
The word ‘ecosystem’ is taking on a bi-dimensional meaning: internal and external. The internal perspective is the one described above and it refers to the dynamic relationship between a user and the brand’s products and services (figure 4); the external perspective refers to the relationship between the brand and other players involved in open innovation initiatives aimed at designing new products and services which satisfy the functional matrix. It can be argued that within the external ecosystem we can find User Functional Value and Business Integration Ratio when evaluating the skills of the players (figure 8).
Bill Joy, co-founder and CTO of Sun Microsystems, argued that 'for any problem, the people outside of your company are collectively smarter than the people inside your company.' This supports the view that startups are more capable of Creating User Functional Value, being closer to individuals and having perfected their skills at the ideation and product development stage. On the other hand, large firms are generally stronger at the commercialisation stage, since they own a solid infrastructure with which to distribute value effectively.
As a final point, could it be argued that User Functional Value must be created externally, and then matched tothe Business Integration Ratio, to develop the most powerful acquisition strategy? These are precisely the type of questions that can only be answered by a functional value analysis.