There seems to be a misunderstanding out there about why Google (s GOOG) 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.
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.
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).
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.
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.