• 20 Jul 2009
  • Research & Ideas

Markets or Communities? The Best Ways to Manage Outside Innovation

No one organization can monopolize knowledge in any given field. That's why modern companies must develop a new expertise: the ability to attract novel solutions to difficult or unanticipated problems from outside sources around the world. A conversation with Harvard Business School professor Karim R. Lakhani on the keys to managing distributed innovation. Key concepts include:
  • Many organizations find they cannot monopolize knowledge in any given field of endeavor.
  • Firms need to consider three key factors in deciding to pursue either a community- or market-based external innovation model.
  • Successful models developed by Apple, InnoCentive, SAP, and TopCoder create incentives for many entrants to generate a variety of products and services on a platform. The firm's role is to define the boundaries of the platform and then encourage entry and innovation by outsiders.
by Sean Silverthorne

Thanks to technology and instant global communication, it has never been easier for companies to seek solutions to problems or find new ideas from sources outside their own corporate walls.

But the art of managing these external innovation models is far from mastered—just ask Boeing. The airline manufactuer's 787 Dreamliner, designed and built using more than 100 outside partners, is perhaps the most-watched example of the use of innovation networks. But already almost two years late, the project was dealt another blow last month when Boeing again delayed the first flight of the aircraft after identifying a structural weakness.

“Apple has shown the way in how to build a market of external innovators.”

According to Harvard Business School professor Karim R. Lakhani, Boeing's approach is an excellent example of how not to manage external innovation. The right way to do it is the subject of an article in the current issue of MIT Sloan Management Review by Lakhani and collaborator Kevin J. Boudreau (London Business School), "How to Manage Outside Innovation" (free registration required).

The right model to follow depends on a number of factors, according to the authors, including the nature of the innovation problem at hand, the motivation of the external developers, and the firm's platform business model. Depending on these factors, the outside innovation might be fed and managed either by creating collaborative communities (think of the open-source software movement), or by using market incentives (Apple's program to draw independent developers to its iPhone/iTouch platform.)

We asked Lakhani to discuss in more detail the strategic options available to managing outside innovation.

Sean Silverthorne: Organizations seem more interested in using external innovators to solve problems or create value in some way. What's driving this trend?

Karim Lakhani: The main driver is accessing knowledge that is widely distributed in the world. Many organizations are now finding they simply do not have the ability to monopolize the knowledge in any given field of endeavor inside their four walls. Lots of critical knowledge resides with customers, suppliers, and academia; in other countries; and even with those that may not necessarily believe feel they are affiliated with the problem at hand.

The solution then is to connect with external innovators and invite them to participate with you on your critical problems. Of course, the Internet and the massive reduction in communication and computation costs have made accessing external innovators a much easier task than what was possible 10 or 15 years ago.

Q: What are the advantages to organizations that decide to work with outside innovators?

A: The first main advantage is the presence of multiple parallel paths to solve an innovation problem. In both markets and communities, external innovators will explore innovation landscapes that are often unknown and unexpected by the organization. A high-performing solution often comes by this type of exploration.

Second, external innovation also appears to be more cost-effective, because the cost of failure is typically not borne by the host organization. If an external innovator fails in its attempt to solve an innovation problem, then it alone bears the costs (and benefits of learning) from that attempt.

Finally, external innovation appears to be fast—solutions arrive quite quickly and can often exceed the capacity of the seeker.

Q: And potential downsides?

A: The main concerns about working with outside innovators relate to intellectual property and the potential loss of secrecy. Many worry that core intellectual property (IP) might be compromised by working with outside innovators. While this is a theoretical possibility, the advantages gained in terms of speed, quality, and cost of solution can typically outweigh such worries.

“Boeing did not build a market or a community for its suppliers.”

More practically, working with outside innovators does not mean that all the "keys to the kingdom" have to be given away. Instead, firms can become intelligent about selectively revealing core issues in ways that their IP is protected. Firms like Procter & Gamble and IBM have learned to do this—others can learn as well.

In a similar way there is concern about loss of secrecy. The reality in most industries is that most firms have a reasonably good idea about the core products, services, and personnel of their key competitors; there are not too many "secrets." Instead of invoking secrecy every step of the way, firms may want to ask, "Why are we not more open about this issue?"

Finally, it's important to note that external innovation systems do not produce deterministic results: They are more geared toward probabilistic outcomes. So good outcomes are not guaranteed, and poor performing outcomes are also likely. Thus, if a firm has a clear idea of what it wants and knows how to do it, it may be better to do it internally instead of enabling external innovators to think outside the proverbial "box."

Q: Your article, written with Kevin Boudreau, presents companies with a framework to think about how to organize outside innovators, such as the decision to follow a community/collaboration model versus a markets/competition approach. What are the lessons you hope that readers will take away?

A: Firms need to consider three key factors in deciding between pursuing a community- or a market-based innovation model:

  1. The nature of the innovation problem at hand. Where the firm is in its technology life cycle may drive its choices. Mature technologies are amenable to markets, while nascent technologies can be better developed through communities.
  2. The motivation of the external innovators. Those motivated by extrinsic rewards like money and career may choose markets. Those motivated by intrinsic motivations like intellectual challenge and identity may prefer community.
  3. The business model embraced by the firm. As soon as a firm decides to open up for innovation, it transforms itself from a strictly product or service business into a platform business. Depending on the type of platform business model (integrated, product, or two-sided), the host firm has a choice about the amount of control it exerts over outside innovators. While markets and communities coexist in all three platform business models, there is a tendency for communities to prefer platforms that exert less control, and for external innovators in markets to trade off tight control for a larger share of the profits.

Finally, the cutting edge in this space is represented by firms like Threadless.com and TopCoder.com, which have figured out how to use markets and communities concurrently.

Q: Apple's iPhone, which provides a platform and a large potential market for application developers to address, emerges several times in the article as an exemplar. What does Apple's experience with the iPhone teach us in this regard?

A: Apple has been masterful in recognizing that a lot of innovation in regard to potential applications for the iPhone and iTouch could and should be done by external developers.

This recognition was not instant, but as soon as the iPhone was "jail broken"—allowing developers to create homegrown tools for writing applications for the iPhone—it became quite apparent that there was a significant untapped need among thousands of developers to create applications. Apple quickly followed through with a software development tool kit and an infrastructure to host the marketplace.

The numbers are simply staggering: in the space of one year, over 50,000 applications and over 1 billion downloads. Apple has shown the way in how to build a market of external innovators. Of course, Microsoft has done this in the past with the Windows platform. The core insight here is to create incentives for many entrants to generate lots of variety of products and services on the platform. The firm plays a very light gatekeeper role.

Q: Who inside a firm should be involved in making these key decisions regarding external innovation?

A: This has to be a CEO-level decision. Embracing external innovators does not come naturally to most firms—we don't have a course (yet) on this topic at HBS! But the CEO has to mandate this approach.

Procter & Gamble's CEO A.G. Lafley (HBS MBA '77) was prescient in figuring out the importance of external innovation to the firm, and then drove change among its managerial and technical staff by making everyone accountable for sourcing half the innovations from outside P&G. An important element in P&G's effort was to create an infrastructure for external innovation that would enable the various business units to access the outside world. For established firms, CEO interest and commitment is necessary to make this happen.

Q: The design of Boeing's 787 Dreamliner involved more than 100 outside firms collaborating for years on the new aircraft—a major change for Boeing, which had prided itself as an "invented here" company. But the 787 introduction has been delayed several times because of design and other glitches. Lessons to be learned here about organizing external innovation?

A: This is a great question on how not to do external innovation.

Boeing failed on two critical counts. One of the key tenets and advantages of external innovation is that you have access to multiple parallel approaches to solve the same problem. For example, during the development of the Apollo program, NASA would often create twin projects with different suppliers for the same problem to account for the contingency that there might be failure. It appears that Boeing did not do that and thus did not gain the benefit of external innovation.

Second, my read of the situation from media reports is that Boeing kept a very long arm's-length relationship with suppliers. So problems that came up with various modules were not recognized until much later. In an ambitious project like building the next-generation airplane, it's critical for suppliers to inform Boeing and each other about problems. This did not happen either.

Boeing did not build a market or a community for its suppliers and got the worst of both worlds.

Q: What are you working on currently?

A: I am furthering my understanding of markets and communities for innovation by conducting field experiments in software development. My colleagues and I hope to provide experimental evidence behind the efficacy of these innovation regimes.