Facing the Innovator's Dilemma
Sustaining Innovation - Failure - Incumbents and Disruptors - Staying at the top - Disruptive Innovation
Hello, I am Nicolas Bustamante. I’m an entrepreneur and I write about building successful startups.
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I have recently re-read the excellent The Innovator's Dilemma by Clayton Christensen. It's one of the rare books in which you get as much the second time reading than the first time. I was so hooked that I went on to read his others books, such as The Innovator's Solution and Competing Against Luck.
These books are about great companies' failure to stay at the top when they confront certain types of market and technological change. These businesses invest a lot, listen to their customers, have excellent managers, a dominant market position, yet they fail. This problem is particularly acute today. A McKinsey study found that the average lifespan of companies listed in Standard & Poor's 500 was 61 years in 1958 and less than 18 years today. Christensen argues that best management techniques kill companies.
Problems start when companies reach maturity on their market, meaning that their growth has stalled. Because no one accepts below-the-average growth, investors and managers alike push for new investments. The company spends a lot of resources, thus reducing its profitability, to generate substantial growth. Yet, most innovative products fail when they reach the marketplace. Managers are often blamed by investors and even fired. The common perspective is that a more prescient manager could have succeeded. People are questioned, not processes and frameworks. The company then stops investing and starts restructuring to restore its profitability. In the long run, this kind of company is overthrown by more innovative ones.
Most companies, especially incumbents, are good at dealing with sustaining innovation. It means creating products that complement its core business and reinforce its competitive moats. Sustaining innovation targets high-end customers to offer them a better product, often at a higher price. Established corporations have strong motivations to invest in this kind of product that offers higher margins and new sales. They, however, usually struggle with disruptive innovation. A disruptive product offers lower margins, lower sales volume, attracts the least profitable market segment while having, too often than not, an average technology. And worse, the profitable customers see no use in using the disruptive product. Disruptive products don't bring a better product to current customers. They offer a different, often average, value proposition to new or less demanding customers. A company with a long tradition of listening to its best customers and identifying new products with a high margin doesn't want to invest in such disruptive products!
Research and development teams at incumbents companies often conceive disruptive products, but the organization fails to launch them in the market. Marketing analysts and managers are trained to create detailed reports about the potential of a new product. However, it's impossible to grasp the prospect of a disruptive product. First, the technological landscape is uncertain, and so it's impossible to know how the product will improve over time. Second, the market is often small, and there is no way to tell if it will grow big enough to support the company's needs. Say a business makes $2bn in revenue, it needs to make $200m only to grow at 10%; no new and uncertain market is that significant at the beginning. The new market doesn't solve the growth needs of large companies. Adding to that, the profit margin of a disruptive product is often lower than established products. For all these reasons, managers at incumbent corporations reasonably refuse to invest in disruptive innovations.
The paradox is that managers are using the same processes that led previously to success. They carefully analyze the risk-adjusted return of new initiatives and weed out the ones not contributing significantly to the bottom line. Managers demand financial projections, market size predictions, and financial prospects before investing. Managers are paid and rewarded to avoid spending money for below-the-average initiatives. Every proposal to compete in a disruptive market offering a low hurdle rate will be thus rejected. And yet, disruptive products are the ones who overthrow established companies. What are the solutions to this paradox?
The key is undoubtedly for a company to invest in sustaining innovations as long as it generates above-the-average growth. When it comes to sustaining innovation, incumbents always dominate because they have enormous resources and good distribution. Christensen suggests dedicating a small allocation of the total investment to disruptive innovation while the overall business still generates healthy profits. Yet, he warns that investing in the disruptive initiative is very different than investing in sustaining innovation.
Disruptive innovation comes from a specific organization. It needs a small team of entrepreneurial-minded people who will tinker until they find a product-market fit. Because of the high uncertainty regarding the market or the technological landscape, only optimistic people with a high tolerance for randomness can operate in this environment. They should design their processes and embrace values that ought to be different from the parent company. Methods define a company. If one is operating in a high-end established market, there is no chance to successfully use the same processes in the low-end market. Furthermore, the cost structure has to be different so that the new organization can survive in a low-margin environment. Projects to develop disruptive technologies in organizations small enough to get excited about small opportunities and small wins. The team will fail early, often, and inexpensively in the search for the disruptive market opportunity. Nothing is planned; they rely on an iterative process of trial and error.
Incumbents are rarely afraid of disruption because it targets new-market, non-customers, or the low end of the value chain that doesn't contribute significantly to the bottom line. It often feels good because incumbents move upmarket faster after having lost the low-end of the market. They trade low-margin revenues against disruptors for higher-margin revenues from sustaining innovations. Managers are rewarded for choosing such a strategy. Unfortunately for them, disruptors often move up the value chain when the product is good enough and take over the market. Established corporations lately jumped on the bandwagon to defend their customer base, but it's too late. They don't have the processes and the cost structure to be competitive in the marketplace. Christensen wrote: "There are times at which it is right not to listen to customers, right to invest in developing lower-performance products that promise lower margins, and right to aggressively pursue small, rather than substantial, markets."
I find the Innovator's dilemma fascinating. Many companies are spending exponentially more to achieve modest incremental innovations while missing on breakthrough innovations critical to long-term success. I grew up when Nokia and Blackberry were still a thing until Apple took over the market. I admire Apple's ability to bring disruptive products to the market. The iPhone was so disruptive, and it even killed the iPod that was a highly profitable product. I'm also amazed by Facebook and Google's ability to acquire disruptive companies such as Android, Youtube, Occulus, Instagram, Whatsapp. It's a core competency of the Intelligent CEO - who is a master at allocating capital - to invest in disruptive innovation.
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