A decade ago, MercadoLibre, the Argentinian online marketplace and e-commerce giant outsourced delivery to third-party companies, barely touching the packages customers purchased on its platform. Today, the company has built a logistics business that handles 93% of its e-commerce packages. To build trust on its platform, the company also built its own payment system, MercadoPago. In 2022, MercadoPago processed more than $100 billion in payments, according to an article in The Economist.
Why would an e-commerce company operating in Argentina, Brazil, Chile, Colombia, Mexico, and a dozen other Latin American countries invest in logistics, payments, and other infrastructural components of its business and not simply outsource these operations to other companies? In the United States for instance, many e-commerce companies simply outsource logistics to companies such as UPS, FedEx, and the United States Postal Service. Companies such as VISA and Mastercard manage payments. So, why did MercadoLibre–and other successful companies operating in growth markets–have to build these components of its business itself?
Understanding Modularity Theory sheds light on this question.
Modularity Theory is a helpful framework that managers can use to understand which activities in their business model should be done internally, and which can be reliably outsourced to a supplier or partner. The theory explains that businesses (even entire industries) have architectures that dictate how various components in the value chain should fit together. We call the place where any two components of the value chain fit together an interface, and interfaces can either be interdependent—meaning the activity is typically done in-house and controlled tightly by the company—or modular—where the activity is outsourced.
According to the theory, a product’s architecture should employ an interdependent interface when two components do not fit together predictably, and a modular interface when two components fit together seamlessly. Interdependent architectures are necessary when markets are being created by companies because many of the components in the product or industry are still new and not yet defined. As a result, finding reliable suppliers will not only be difficult, but often results in poor customer satisfaction. As markets mature, modularity becomes possible because more predictable interfaces and standards exist between components.
In the case of MercadoLibre, outsourcing logistics to third-party companies in a region where infrastructure is not well developed and could cause delivery companies to struggle will not only impact the customer experience, but also the company’s brand. Payments presented another challenge. At the onset, fraud was a real fear for many users on the platform who may have been experiencing e-commerce for the first time. Outsourcing such an important component of its business to a third party could have backfired.
Building an interdependent architecture–or an organization wrapping its arms around a particular component in its business model–can also reduce cost. But this can only happen when the organization is targeting nonconsumers.
For example, when Henry Ford decided to build a car for nonconsumers, Ford Motor Company built coal mines, glass, paint, and tire factories, and even managed rubber plantations. This enabled Ford to reduce the price of the Model T over time. In our book, The Prosperity Paradox: How Innovation Can Lift Nations Out of Poverty, we write about many other innovators who make similar strategic decisions when targeting nonconsumers.
No organization’s business model is entirely modular or interdependent; it’s usually a mix of both. But for organizations looking to invest in market-creating innovations, especially in growth markets, integrating across unreliable and unpredictable interfaces is the norm. Although modularity standardizes the way in which components fit together and can be easily scaled, it’s important to note that modularity is only possible after predictability is achieved.
At the onset of market creation, interdependent architectures are almost always required. Interdependence is key precisely because companies don’t yet exist at the necessary scale to provide reliability and predictability at a low enough cost to serve nonconsumers.