Sustainable business models for the Internet of Things

Are companies ready for billions of everyday objects to join the Internet?

By Tayfun Keskin, Fehmi Tanrısever and Haluk Demirkan

Internet of Things

There is an emerging market at the gate: the Internet of Things (IoT), which is expected to generate $14 trillion revenue in the next decade [2]. The IoT refers to the equipping of all objects and people in the world with some form of identifying devices or sensors that can be networked together (such as refrigerators and thermostats using the Internet) [5]. Even though the technologies required to enable IoT have been available for more than 10 years, managers are still in need of innovative business models to monetize IoT-enabled markets. According to a recent MIT Technology Review Business report titled “The Internet of Things” [8], the IoT is planning to reshape the market with the network effects. A number of large enterprises, such as Google, Amazon, Uber, Apple, GE, Cisco and Philips are making large amounts of investments to IoT to get benefits from “platform economics” and “network effect.”

Despite the so-called “first mover advantage,” history shows that first movers of disruptive information technologies typically have had problems with monetizing their leadership role. Although these leaders might have a good grasp of the technology, they may fail to understand market dynamics, complementarities and the multi-sided nature of an IT-enabled industry. For example, AltaVista, one of the earliest search engines, could not recognize that sponsored links could be the key for monetization before Google took over the lead. Similarly, Netscape failed to identify strategic complementarities between the Internet browser and an operating system.

These examples demonstrate that firms may fail regardless of their technological purview unless they develop a viable business model. In other words, a technological invention may not be enough to succeed in the long term; and a well-developed business model is needed for sustainable growth.

The main objective of this article is to examine opportunities and challenges of different business models in the IoT-enabled markets, and provide a basic roadmap to managers for sustainable growth.

Components of the IoT Market

IoT has potential to create never-before-seen synergies between three primary markets: durable goods, software and consumable goods [7]. The “Things” part is conventionally classified as durable goods. These are everyday objects we use, such as refrigerators, televisions and thermostats that include IoT products. Typically, vendors of these durable goods only receive a one-time payment from the consumers because they generally do not anticipate other revenue streams from the sales of durable goods. However, IoT-enabled durable goods create synergies with the consumable goods market. Consumable goods can range from a simple basket of groceries to complex information services. For instance, a smart fridge can order groceries without the need of conventional human intervention. This synergy between smart fridge and groceries creates a two-sided market where one side of the market has the potential to subsidize the other.

Figure 1: IoT-enabled durable goods supply chain.

Figure 1: IoT-enabled durable goods supply chain.

Figure 2: Proposed business models.

Figure 2: Proposed business models.

Companies such as Amazon.com are already offering this service with Amazon Fresh. However, it is also possible for any store to offer the same product or service to the IoT-enabled grocery market. It would not surprise us to see an Amazon-branded fridge connected to the Amazon.com ecosystem in the near future. These connections between the markets become more complex when we factor in the software that runs on the durable good. For example, a smart fridge can run on a proprietary or an Android operating system.

The software industry has substantial competing experience in two-sided markets [4]. Research on two-sided network effects and competitive platforms in markets enabled by information systems [3] includes one of the first studies that review the benefits and risks from network effects of IoT-enabled three-sided markets. Firms can benefit from these network effects in terms of scalable revenues once they recognize the synergistic connections, while consumers benefit from subsidized goods and services.

Business Models for the IoT

The introduction of IoT markets has realigned the parties in supply chains, reinforcing new business links and relationships among them as shown in Figure 1. Firms can create different business models by offering different combinations of software, durable goods and consumable goods. In the paragraphs that follow, we discuss the economics of various business models and integration strategies in IoT markets from the perspective of the durable goods manufacturer (DGM).

Supply

Technology
Development

Demand

A. Backward Integration: Integrated Software and Durable Goods (ISD) Business Model

Risks

Inflexibility to adapt to the changes in the software supply market (e.g., switching cost for third-party software in the market).

Limited ability to benefit from disruptive technological developments and competition in the software market.

Reduced ability to adapt successful software in the market. If consumers decide to use generic software in the market, ISD may not be able to adapt fast.

Benefits

Secured supply for the development of a specific product.

Facilitated technology development through enhanced information sharing and access to capital.

Increased ability to respond to customer's changing expectation about the features of the IoT product.

B. Cross Integration: Integrated Durable and Consumable (IDC) Goods Business Model

Risks

Increased risk of not finding a good third-party software that works well with an integrated manufacturer retailer eco-system.

Reduced control on the supply side of the technology development. The success of the business model hinges on the development of the third-party software market.

Inflexible to adopt changes in demand if the consumers change their preferences and start shopping from different consumable goods providers.

Benefits

Increased motivation for the supply market to develop products specific to the integrated system.

Facilitated technology development through enhanced information sharing between durable goods manufacturer and consumable goods provider. Tailoring IoT to the specific needs and the configurations of the CGP.

Better information about consumer demand and expectations for the IoT. It enables DGM and CGP to better align and optimize their supply chains, and may result with better customer experience.

C. Full Integration: Integrated Software, Durable Goods and Consumable (ISDC) Goods Business Model

Risks

Very high inflexibility to respond to the developments in the third-party software market.

High risk of asset specificity. Scalability is a major problem; this business model provides a highly customized product for the consumers who are willing to shop from a particular CGP.

High inflexibility to respond to the customer's changing shopping preferences.

Benefits

Secured supply for the specific IoT product.

Facilitated technology development through enchanted information sharing across the supply chain.

Increased efficiency in assessing and meeting customer demand through a highly customized product.

D. Disintegration: Disintegrated Software, Durable Goods and Consumable Goods Business Model

Risks

High supply risk due to loss of control in the software market.

High risk of delays in technology development due to lagging software and consumable goods markets.

Possible misalignment of the IoT product and customer expectations if the generic software developed in the market does not integrate well with the durable and consumable goods market.

Benefits

Increased flexibility to switch to successful third-party software providers.

Increased competition in the software market, which may facilitate technology development.

High flexibility to adapt to the changes in the customer's preferences for the IoT software and the consumable goods providers.

Table 1: Possible risks and benefits of proposed business models.

    A. Backward integration:
    Integrated software and durable goods
    (ISD) business model
DGM chooses to vertically integrate with a software provider (SP) and jointly develop an integrated durable good and software (Figure 2A). This enables DGM to in-house the development of software and optimize its features based on the provided durable goods and consumer market (CM). The integrated approach can better exploit the resources and create more compelling products and services to the consumers, possibly expanding the market for IoT solutions as well.

The IoT markets are characterized by high levels of technological and market uncertainty, as well as informational asymmetries about the prospects of the new venture. The supply market (software developers) is at its very infancy and is subject to unpredictable shocks and changes. In a disintegrated market, the development of an IoT solution requires the right set of components provided by both the SP and the DGM. A successful technology development hinges on information sharing between the supplier and the manufacturer about customer expectations and technological capabilities of the respective parties. Without such information, the final product will suffer from design and marketing issues (Table 1A).

    B. Cross integration:
    Integrated durable and consumable (IDC)
    goods business model
DGM integrates IoT product with consumable goods provider (CGP) but uses generic software (Figure 2B). This model is similar to forward vertical integration in economics; however, CGP and DGM are not directly vertically aligned in the value chain. DGM sells durable goods with IoT capabilities to the CM, and then the consumers shop from CGP using the installed IoT product. Based on the agreement between DGM and CGP, as the customers shop from CGP it creates a secondary revenue stream for DGM such as advertisements and any fees for using IoT solution and customer-usage data.

Cross integration does not mean that DGM and CGP are merged, and a single firm manages both manufacturing of durable goods and sales of consumable goods. Yes, Amazon does that sometimes. In our case, cross integration refers to the customization of IoT to operate between DGM and CGP, to reduce any information sharing issues (Table 1B). Cross integration helps to mitigate informational problems. As Harrigan [6] points out, managing customer expectations and information sharing can be more important than access to capital in this case.

    C. Full integration:
    Integrated software, durable and
    consumable (ISDC) goods business model
This model (Figure 2C) represents the fully integrated business case in which the DGM provides a durable good that is integrated to operate with customized software and a certain CGP. The capabilities of the IoT value chain are fully optimized and customized (Table 1C).

    D. Disintegration:
    Disintegrated software, durable and
    consumable goods business model
This business model (Figure 2D) represents the unbundled approach in which the DGM designs its product to operate with any software and CGP. The unbundled approach enables the consumers of the durable goods to freely choose among different IoT software and consumable goods providers to maximize his/her utility from the service. This business model provides the consumer with the highest flexibility when configuring his or her IoT product. For instance, the consumer may keep updating his or her IoT software as new features become available, similar to installing apps in smart phones, as well as switching between different consumable goods providers (Table 1D).

Technological and Managerial Challenges

Each of these business models face a number of technological and managerial challenges and also create opportunities. Technological challenges may include massive scaling, openness, security and human interface [9]. Managerial challenges may include pricing, market presence, network effects and ever-present threat of envelopment. For example, smart fridges enable automatic grocery purchases. This is not only convenient for the consumer but also has the potential to change consumer valuation both for groceries and for the smart fridge.

IoT’s disruption provides opportunities for firms to become important players. The secret is to predict “profit” and “subsidy” sides of the networked market correctly, and then shape the future network through network effects.

Durable goods manufacturers have always struggled with inherent properties of their products: long life expectancy and elastic demand. Once a durable good is sold, it would take years, if not decades, for the same consumer to generate income for the firm. IoT offers continuous and relatively inelastic demand for a durable good manufacturer in a networked market.

Finally, focusing on the core competency gets another meaning in a multi-sided market. IoT creates synergies for markets and complementarities between products like never before. Firms face the risk of envelopment if they do not utilize these opportunities outside their core competencies.

Roadmap and Conclusion

In the future, we expect the IoT industry will contain a few select firms that utilize the multi-tiered market. For example, a startup firm may dominate the market with a new smart fridge by selling it considerably under its cost, subsidized by future grocery sales.

Figure 3: Roadmap from fully integrated to disintegrated business model.

Figure 3: Roadmap from fully integrated to disintegrated business model.

The future direction of the IoT-enabled industry depends on how the market will evolve; which sides will be subsidized and which sides will bring revenues. If previous examples in the IT market are an indicator, software platforms have the biggest potential to set standards and disrupt other IoT-enabled markets such as durable and consumable goods.

We expect that players in the IoT market must be flexible in terms of their business processes. Therefore, our final recommendation is as follows: Be flexible, and prepare yourself to change your firm’s business model as this networked market evolves.

IoT markets are in their infancy and are subject to high: (1) informational problems, (2) technology development risks, (3) market adaption risks, and (4) hurdle rates at the software development side. Compared to risks in the market, costs associated with integration and making an investment to develop asset specificity are not high. This implies that a fully integrated business model, as depicted in the top-right quadrant of Figure 3, is attractive for the firms. Indeed, Amazon entered the market with this model.

As the market matures and the risks above are mitigated, firms will need to expand their market shares, which require making IoT solutions compatible with other consumable goods providers. In the long run, firms will need to move to a fully integrated business model for sustainable growth.

Tayfun Keskin (keskin@uw.edu) is an assistant professor of management information systems at the School of Business, University of Washington Bothell. He has a Ph.D. from the University of Texas at Austin’s McCombs School of Business.

Fehmi Tanrısever (tanrisever@bilkent.edu.tr) is an assistant professor of business administration at Bilkent University. He has a Ph.D. in supply chain and operations management from the McCombs School of Business.

Haluk Demirkan (haluk@uw.edu) is a professor of service innovation and business analytics at the Milgard School of Business, University of Washington Tacoma. He has a Ph.D. in information systems and operations management from the University of Florida. He is a longtime member of INFORMS.

References

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