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Summary:

I’m all for a revolution in energy and cars, but it can happen faster if we understand the dynamics of how these sectors work.

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There seems to be a misunderstanding out there about why Google and some other internet companies do so much experimentation and innovation (like Google X and its autonomous cars), while other sectors like energy, automotive, or materials usually do a lot less. It’s not just because internet companies are smarter or cooler or more fun than companies in these sectors (though some are). I’ve been thinking about this idea after talking it out over drinks with energy entrepreneur Matthew Scullin (founder and CEO of Alphabet Energy).

The differences in experimentation can have a lot to do with the profit margins a company can earn on what they’re selling, or the profits as a percentage of the sales. Profit margin is influenced by a variety of metrics, including how much the product costs to make (both in terms of materials and cost of labor), and how much a company can sell the product for.

Recurrent Energy_Victor Phelan_2

Low and high margins can contribute a lot to why companies that make commodities like energy, materials, chemicals, and even non-commodities like cars, generally do a lot less experimentation and, in turn innovation, compared to companies selling software and Internet services. They quite simply can’t afford it — their margins are so low that they have to be much more strategic when it comes to figuring out R&D, new product lines, startup acquisitions, or even testing out new technology that could involve risks or downtime of factories or production.

Check out this chart on Fortune of the top sectors with the highest margins (profits as percent of revenues, and yes it’s from 2008, but I’m just making a point). The sector with the second highest profit margin is “Internet Services and Retailing” at 19.4 percent. Oil production and mining falls to 11.5 percent, gas and electric utilities drop to 8.7 percent, electronics and electrical equipment comes in at 6.5 percent, chemicals with 5 percent, energy production is 0.9 percent, and making cars is all the way down to number 46 (out of 50) on the list with negative .07 percent. Given this was 2008 and there was a crisis in the automotive sector, but still, you get my point.

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Look at some of the biggest companies in the U.S. in 2013 on the Fortune 500 list, and this was still true. Last year Apple was the sixth largest company in the U.S. and their average profit as percent of revenue for the year was 26.7 percent. . . and it has been getting worried about that. One notch below on Fortune’s biggest companies in 2013 list is General Motors, with a profit as percent of revenue for last year of 4.1 percent. And Ford, the 10th largest company on the list, was similar at 4.2 percent. Other big Internet and IT companies on the list are IBM (15.9 percent), Microsoft (23 percent) and Google (20.6 percent).

Many of the Internet and IT companies have had margins like these for years, and as a result they’ve developed a culture of, and a strategy around, doing the kinds of experiments that Google does. Even after Larry Page cleaned up Google a bit – killing various unprofitable products — it still has the Google X experimental lab, all sorts of products outside of of its core that have a niche user base, and it still has a culture of allocating 20 percent of employee time for personal projects (even if the official program was killed).

Rochester Optical Google Glass frame

Yes, there are exceptions to the rule. Amazon showed an average profit as percent of revenue for 2013 as negative 0.1 percent, and its one of the more innovative companies around (drones!). But Amazon seems like an outlier and a different beast than its Internet peers.

But the IT sector, and the internet world, moves so fast (thanks Moore’s Law) that it needs this type of Google-like experimentation to figure out the next big thing. While Google makes the bulk of its revenue off of search and ad revenue, it’s now a very different company of years ago, and is a data company, a design company, a mobile company and more.

The automotive and energy sectors don’t move this fast — energy expert Vaclav Smil says they’ll take many decades longer to transform than we expect. Their margins also tend to be so low that they’ve got to place their bets and choose their experiments much more wisely than Google does.

There’s also other factors within the energy and auto sectors that hurt innovation and experimentation. The strict regulatory environments that auto companies and power generation and distribution companies face holds back innovation in those industries.

Tesla Model S

That said, there is a transformation under way where older sectors like cars and energy are having to transform and innovate at a faster rate. It’s actually startups like Tesla, which are disrupting the auto sector, and solar companies like SolarCity, which are starting to affect the energy sector (thanks Elon Musk for these).

But the next time you think about the automotive sector or the energy sector and you think the people at these companies are not creative or don’t want to innovate, think about how these industries actually work. I’m all for a revolution in these low margin sectors, but it can happen faster if we understand the dynamics.

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  1. I am not sure it is a function of profitability. I believe it is a lot more to do with whether these organizations holistically “get” technology. Most of the companies that were making things have an IT department that did all things technology for them, and in many cases outsourced it. In essence they believed technology was not a differentiator (hence the outsourcing). Most of the modern innovations that come in products today are in the ability to integrate software into whatever you already made. And this is not part of the DNA of these organizations.

    There are a number of automobile, materials, energy companies that have understood and making major shifts by recruiting talent, bringing technology at the core of their R&D, Operations etc. Then comes the DNA shift, this takes time.

    Google is not making new cars, it is taking existing cars and putting software (with some hardware) on it. FORD and GM have to first research and build that car for the market and Google simply buys 500 units of the same. I believe, these companies will become as innovative once they understand that going digital and software will be a key part of future innovations and take hard steps in changing their DNA.

  2. You take an exception, Google and try to generalize.
    Google has high margins and does experiment but not just because of margins.
    Apple has very big margins and does nothing ,their R&D spending is ridiculously low.
    M$ doesn’t turn any R&D into actual products ,when was the last time they had something original?
    Then you got to look at how do they get to those margins. M$ and Google are pretty much monopolies while Apple gets free advertising from the US press and is able to sustain ridiculous prices.
    Truth is ,many listed companies are too afraid to innovate and then innovation is not always all that visible.. You have many chip makers that put 20-25% of revenue in R&D but you don’t think of how much they innovate and you also have Apple with under 3%. And ofc there is the matter of how efficient that spending is. M$ gets next to nothing out of it while Apple’s ROI is more than huge.
    And if you look at the energy and car sectors. Well, in energy there is no competition in general and if they experiment with greener tech they might get punished by some suppliers. In cars there might be more innovation than we give them credit for, design cycles are very long and they do experiment plenty with crazy concept cars. Them not going for other sectors should be mostly about culture.

  3. These industries (energy, automotive) are not going to start experimenting once WE (capitalizing on purpose) understand the dynamics of how THEY work. That is a ridiculous point. They are more likely to start experimenting once they feel the competitive threat from other industries that are trying to enter their turf (e.g., Google) and new entrants (e.g., Tesla). Another point is that it is not net margin but GROSS MARGIN that indicates how potentially profitable an industry is. When the direct cost of producing an additional unit (e.g., software) is close to zero, the gross margins are incredible. The cost of producing an additional car or refrigerator cannot be zero :) Also, Silicon Valley seems to have a certain arrogance about why it has this unique superiority in terms of how well it innovates, how well it experiments etc. Yes, there is a lot of tech innovation in Silicon Valley, but it can learn a lot from other industries about business processes (e.g., supply chain management which I am sure our latest poster boy Nest will agree with), customer service (e.g., Southwest Airlines, Singapore Airlines) etc.

  4. Experimentation or no experimentation is a function of culture. And remember: budget for experimentation translates to absolute figures not to %s of revenue. So it could well be the case that industries with lower margins over revenue can actually spend more in R&D in absolute terms.

    The issue here is how they spend it. In McKinseys? Or in real stuff getting done and tested with no fear of failing and trying again?

    It is amazing what different people can do with the same money. Different corporate cultures produce very divergent results.

  5. Electronic gear switching, higher efficiency engines, clean diesel power trains, composite and carbon fiber manufacturing, hybrid technology, smart headlamps, radar collision detection, lane watch, remote start and stop, biofuel compatibility, hydrogen fuel cell incorporation, smarter traction control, assisted parking, tyre fill alert, hydrophobic windows, airless tyres, smart airbags ……

    Are you sure that the auto industry does nor experiment and innovate?

    1. I’d add – all these for a product with a single simple function, e.g., to get you from point A to point B.i

  6. Innovation is state of mind and culture. What about the sales process? Buying or leasing a vehicle is the worst customer experience, in retail.

    The irony in disrupting that element would increase the margins you suggest are not high enough.

    However,the industry is locked into a herd mentaility that is unable to see customer engagment, as a discovery and education process, with little investment required. http://bit.ly/1nANrUV

  7. there is no exit Thursday, March 6, 2014

    most technology companies are a play on patent rent seeking.

    the problem is that the capital markets misallocate financial resources to companies like Facebook which are just wasting the user’s time. Other tech companies are basically ruining real companies businesses by “opening” the businesses to everyone (eg, travel agencies). Most of valley tech (except M$, Apple, IBM, maybe Google) is a con, from the entrepreneur to the VC to the investment banks. The one conned is you.

    So you could say that capital market’s obsession with financing tech is a way to hollow out the real economy.

  8. I couldn’t disagree more with the author. Simply from the table, we have

    1 Network and Other Communications Equipment
    3 Pharmaceuticals
    4 Medical Products and Equipment
    5 Railroads

    In all these industries, the high margins can be explained by rent from patent portfolios or regional monopolies for historical reasons and high costs of entry.

    It is common knowledge that communications/network operators and pharmaceuticals are the worst innovators since their profit margins are de facto guaranteed by such protections. Medical products suppliers are not far behind. As for railroads, our blessing is that there is a little competition from trucks and boats. The amount of research on this topic is overwhelming, and a much more compelling case could be made by arguing the exact opposite of what the author wrote.

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