Saturday, February 23, 2013

Review of The Innovator's Dilemma: The Revolutionary Book That Will Change the Way You Do Business by Clayton M. Christensen

Clayton Christensen says that after Intel blew Cyrix and AMD out of the water with the Celeron processor, its CEO Andy Grove gave a speech at the Academy of Management conference where he held up The Innovator's Dilemma and said, "I don’t mean to be rude, but there’s nothing any of you have published that’s of use to me except this." I agree that this is a 5/5 book.

There are two types of technological innovations: sustaining and disruptive. Sustaining innovations appeal to an existing customer base by improving existing products on those products' traditional measures of value: performance, capacity, reliability, price per unit, etc. They are the gradual improvement of dominant technologies with a focus on selling higher margin products to the biggest customers, because these customers are willing to pay for incremental performance.

Disruptive innovations produce products that, while technologically inferior from the perspective of the existing customer base, include improvements that hold potential for new markets. These technological shifts are so profound that previous technologies go out of business: sailing ships, wagons, telegraphs, vacuum tubes etc.

The puzzle, or dilemma, that this book seeks to solve is why established companies almost never introduce or survive these disruptive innovations. The dearth of examples of big firms surviving radically new technologies demands an explanation. His theory is that established firms miss the chance to capitalize on disruptive technologies because in their early stages the technologies are not good enough for their most profitable customers.

The book focuses primarily on the hard disk industry because it went through multiple disruptive innovations in a period of a couple decades. Smaller personal computer hard drives with lower capacity and higher price per unit of data were initially inferior to minicomputer hard drives, and notebook computer hard drives were initially inferior to PC drives in the same way.

Similarly, steamships could not initially compete with clippers and started out transporting only in inland waterways. Hydraulic excavators likewise were inferior to cable-driven shovels.

Established firms selling sustaining technologies do not feel threatened by the inferior disruptive technologies, even as those disruptive technologies are clawing up the learning curve, because the attributes offered by the disruptive technologies are valued only in markets that are remote from and unimportant to the established firms. Eventually, the disruptive technologies improve to the point of competing with and then overtaking the existing technologies.

The notion of products competing on the basis of some attributes and choosing not to or failing to compete on others reminds me of the book Blue Ocean Strategy (3/5). One of the things it argues is that companies should occasionally shift focus from customers to non-customers and consider whether some attribues of products (what Christensen calls "dimensions") should be eliminated, reduced, or perhaps raised or created.

One interesting question that both books raise is whether products been over-designed; that is, optimized along one dimension beyond the point of marginal utility to customers, since managers will blindly continue to pursue sustaining progress in the dimensions that an industry traditionally competes on. For example, both mention the insulin industry, which had traditionally competed on the purity of the product. By the 1980s, one competitor had created at great cost a perfect replica of human insulin while Novo found a "blue ocean" by creating an automated "Novopen" for injections that changed basis of competition from product purity to convenience of injecting.

Dimensions of value and the blue ocean concepts may be helpful in shedding light on a puzzle from last year about business models, where we were trying to figure out how an average business can be a great investment. A commenter on Nate Tobik's blog recently pointed out that,

"Rational entrepreneurs seek out gaps and niches in the market which means that businesses which are already operating are left undisturbed for no other reason than that they were already there. It's only when entrepreneurs behave irrationally that they enter a market and cause industry wide returns to fall below the cost of capital. From a business school perspective this behavior is random because it does not follow rational principles. From observation it tends to happen in industries that people think are exciting or that people get into for no other reason than that everybody else is doing it. A business being in a boring, obscure and uneventful industry can therefore be a lasting source of excess returns on capital."
An education in economics can cripple businessmen by teaching that perfect competition drives profits to zero. The truth is that most products have some degree of differentiation and price is rarely the primary consideration in purchasing (especially for B2B).

Recently, hedge fund manager Andy Redleaf inverted the disruptive innovation concept to make an interesting prediction:
"Christensen’s concern was with why great incumbent frms fail to develop the technologies that will eventually send them to their graves. Flip the argument around, however, and we get a pretty clear picture of eras in which small firms can be the driving force of the economy, eras in which disruptive innovation dominates sustaining innovation. The invention of the integrated circuit created such an era. Tiny new microelectronics firms became great microelectronics firms because those tiny firms invented microelectronics; tiny new software firms became great firms because they invented the software firm model. [...]

We have entered an era of incumbency. [T]he biggest changes are behind us — at least until the next technology with the disruptive power of the integrated circuit comes along. For now and the foreseeable future, innovation will sustain the incumbents of the microelectronic economy, not disrupt them. The question for investors and for us is which of the nation’s great operating firms will excel as the investment bankers of sustaining innovation and which will prove unequal to the task."
There's a grain of truth to this. Christensen himself points out that,
 "[S]tart ups which propose to commercialize a technology that is essentially sustaining in character have a far lower likelihood of success than start-ups whose vision is to use proven technology to disrupt an established industry with something that is simpler, more reliable, and more convenient."
Because the startups competing with sustaining technologies will be competing against incumbents. To say that the era of disruptive innovation is over seems off. First, we obviously have no idea when the next technology with broadly disruptive power will be invented. It could be thorium power. It could be better batteries allowing for widespread adoption of electric vehicles.

But even if "everything that can be invented has been invented," and there are to be no inventions akin to the integrated circuit, it hardly seems true that there is no more room for disruptive startups. In fact, the disruptive innovations that Christensen covers are pretty micro in nature.

I should mention a competing explanation for failures to switch to distuptive technologies when they arrive: the failure of companies to know what business they are truly in. For example, Studebaker was smart enough to understand that he was in the transportation business, not the wagon business, and he made the transition. Meanwhile, big box stores like Borders and Circuit City did not realize that their customers ultimately wanted products, not stores to visit, and have gotten crushed by Amazon.

Actually, it is a bit difficult to understand why the in-store bookseller vs Amazon fits with the framework of Christensen's theory. Did Amazon start out inferior to the brick and mortar booksellers? I suppose that it did in several respects: ability to preview, and immediacy of order and receipt. It is hard to remember, but Amazon was much less impressive before "search inside this book", before you could order books on your iphone, and receive them via free two-day shipping.

Amazon is a data point in support of Redleaf's thesis on incumbency, because it is a giant with a $120 billion market cap yet it is disrupting and upending other industries.
"More than any other corporation of the Internet age, Amazon embodies the emerging culture of business strategy. It is the General Electric of our times, and Bezos is the Jack Welch. When the definitive book on corporate strategy for the early Internet era is written, Amazon will be the main example, not Google, Apple, Microsoft or Facebook. Those are great companies too, but their greatness lies in other departments. As far as corporate strategy goes, they are mediocre players, not grandmasters."
And it is true that Amazon will probably be the disruptor and not the disruptee for a while. But back to the competing explanation: why wouldn't managers know what business they are in? Wouldn't competition select for firms that understood this, and wouldn't some firms get it right, even by accident?

Yes, and this makes me think that Christensen is right for a reason that he touched on but did not delve into thoroughly: the principal-agent problem [also 1,2].  He notes that because of the severe career blemish of being associated with a product that fails because of lack of demand, managers back projects for which demand seems most assured. They are risk averse, just like bureaucrats in a bureaucracy.

The disruptive technologies seem uncertain because they would have to be marketed to unfamiliar and possibly nonexistent customers. If the disruptive technology did work, in the end it would cannibalize the existing technology. What is Bob down the hall at HQ, who has been working with the existing technology for 20 years, going to say about that? Political ick factor!

So the managers bury their heads in the sand because it's the shareholders' money anyway. They are focused on maximizing the present value of their salaries, which means making sure Bob's division doesn't try to get you fired. Barnes & Noble sued Amazon in 1997 for claiming to be the "world's largest bookstore", aruing that Amazon "isn't a bookstore at all... It is a book broker making use of the Internet exclusively to generate sales to the public." OK!!

This would predict that owner/operator firms, and firms with fewer layers of management, would be less likely to get pushed aside by distuptive innovations that manager/agent firms. Score another notch for reasons that owner operators outperform.

2 comments:

Unknown said...

What happened to Sears? They became a giant through catalog sales, then transitioned to department stores. The internet is just like the old catalog sales model. They should have still had enough history to recognize that. They should have been Amazon.

CP said...

I guess they didn't? It must've seemed pretty different.

How many of the best online retailers now were startups and how many came from catalog/brick and mortar retail?