Open source and the commoditization of software

“So, how do you make money from free software?”

If the open source movement represents the commoditization of software, how can the challengers of today’s software industry utilize its commoditizing power to unseat the incumbents, and Microsoft in particular? Perhaps more importantly, if this strategy succeeds, is there money to be made in a software industry that has been commoditized? Finally, are there lessons that can be applied from past commoditization events, particularly the events that reshaped the hardware industry in the 1980s?

For a textbook example of how to turn the commoditization of an industry into business advantage, one need look no further than Dell Computer. Dell, of course, was one of the companies that started life in the mid-1980s to build IBM clones. Dell’s initial claim to fame was “build to order,” taking advantage of the fact that a PC was not really a product in itself, but rather an assemblage of numerous products that any individual with a moderate amount of skill could assemble himself—a direct lineage from IBM’s decision to base the original IBM PC on off-the-shelf parts.

Unlike some of its competitors, Dell saw itself for what it truly was: an assembler of off-the-shelf components and a distributor of these components in a form their customers found useful—namely, a complete PC. Dell gave its customers choice—not an overwhelming amount of choice, but enough choice to give those with the skill to build their own PCs reason to buy from Dell rather than building themselves. Its competitors, on the other hand, attempted to mold the PC into a monolithic, unchangeable product, a collection of specific components from specific vendors with the occasional bit of proprietary technology added to the mix—a thinly veiled attempt to decommoditize the PC standard and own it all to themselves.

To accommodate its new approach to selling hardware, Dell had to develop a new kind of business model. Over the years, the Dell model became more about the assembly of product than the final product of that assembly process. Dell became remarkably good at assembling components from a multitude of suppliers into cohesive wholes, and in negotiating with those suppliers to get the lowest possible price. It stuck to commodity components, allowing the market to pick winning technologies and resisting the temptation to invest heavily in the R&D required to play the proprietary lock-in game its competitors were playing. It employed unusual tactics on the sales side, most notably selling directly to the consumer rather than going through wholesalers and resellers, each of whom took a substantial slice of the profit margin.

As a result of its streamlined processes and lower cost structure, Dell was able to sell PCs at a much lower price than its competitors could. As the PC market grew, and as the market commoditized further with each failed proprietary extension to the PC standard, Dell’s position grew stronger. As the PC began to move upmarket, it simply became less expensive to “outsource” the assembly of the PCs to a supplier that specialized in assembling them, and Dell was extremely well positioned to play this new role. Today, as the commoditization of PCs extend to other parts of the hardware market—servers, storage, printers, handheld devices—Dell continues to be extremely well positioned, and its entry into a new market is often taken as impending doom for that market’s established firms.