The Innovator’s Dilemma

By Clayton M. Christensen

The Innovator’s Dilemma answers the question why outstanding companies who did everything right, still lost their market leadership when confronted with disruptive changes in technology and market structure.

In the book which was first published in 1997, Clayton coins the phrase ‘Disruption’.

This book..is about well-managed companies that have their competitive antennae up, listen astutely to their customers, invest aggressively in new technologies, and yet still lose market dominance.

For example, Sears Roebuck was regarded for decades as one of the most astutely managed retailers in the world and pioneered supply chain management, catalogue retailing & credit card sales. Yet no one speaks about Sears that way today. Sears let arrogance blind it to basic changes taking place in the marketplace.

One of the common themes to all the failures analysed was that “the decisions that led to the failure were made when the leaders in question were widely regarded as among the best companies in the world”.

Christensen argues that an explanation for there failures is that “there is something about the way decisions get made in successful organisations that sows the seeds of eventual failure”.

Precisely because these firms listened to their customers, invested aggressively in new technologies that would provide their customers better products, and because they carefully studied market trends and systematically allocated investment capital to innovations, the lost their positions of leadership…What this implies at a deeper leel is that many of what are now widely accepted as principles of good management are, in fact, only situationally appropriate. 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.

This is what leads us to the Dilemma: the logical, competent decisions of management that are critical to success of their companies are also the reasons why they lose their positions of leadership.

What is the answer?

The advice is quite simple, but very hard to execute. When you see a disruptive technology enter the bottom of the market, you should not tear down the existing business and make radical changes. Instead, you should create a separate entity in which the new technology can be pursued, outside of the existing value network and cost structure. Resources must be allocated, and not put at risk of being pulled back onto the core business. Expectations on short-term returns should be low.

The conclusion by established companies that investing aggressively in disruptive technologies is not a rational financial decision for them to make has is based on the fact that:

• Disruptive products are simpler and cheaper and therefore promise lower margins and not greater profits.
• Tend to first be commercialised in emerging or insignificant markets.
• Firm’s most profitable customers generally don’t want the product.
• Small markets don’t solve the growth needs of large companies. Large companies are not interested in small emerging markets, and they wait too long.
• Markets that don’t exist cannot be analyzed. “Not only are the market applications for disruptive technologies unknown at the time of their development, they are unknowable”.
• An organization’s capabilities define its disabilities.

Successful companies want their resources to be focused on activities that address customers’ needs, that promise higher profits, that are technologically feasible, and that help them play in substantial markets. Yet, to expect the processes that accomplish these things also to do something like nurturing disruptive technologies — to focus resources on proposals that customers reject, that offer lower profit, that underperform existing technologies and can only be sold in insignificant markets — is akin to flapping one’s arms with wings strapped to them in an attempt to fly.

Disruptive Technologies initially offer a lower performance according to what the mainstream market desires. At the same time it provides some new performance attributes which are valued by niches in the market (smaller, faster, quieter). Over time, it rapidly improves and takes over the old market as it has the same features as the old technology + new ones. In essence, the smaller markets are the guinea-pigs and test labs that help the technologies advance enough to play in the big boys league. In many cases the entry-point markets are left behind as the new technologies move into higher margin upmarket territory disrupting due to their superior performance. (Remember that existing firms move upmarket to gain greater margins as time goes on — later on this means that they develop a value structure which can only function on high margins!) Technology leaders evaluating whether to invest in new and immature technologies must do so with a futuristic frame of reference. The key question is, if these technologies found new customers and new markets which may in themselves be small and insignificant (now and in the future), could they mature enough to make inroads into our playing field and have our lunch? And if so, does investing in them today at the risk of cannibalising ourselves make sense in the longer term? Hence, the innovator’s dilemma.

An example would be mobile phones vs landlines. At first mobile phones had terrible sound quality but were portable. Mainstream customers did not fully appreciate these qualities and did not adopt the technology. However, it rapidly improves and eventually had the same sound quality as landlines + portability.

Hence, most companies with a practiced discipline of listening to their best customers, focusing on profitability and growth are rarely able to build a case for investing in disruptive technologies until it is too late.

Disruptive technologies change the value proposition in a market. When they first appear, they almost always offer lower performance in terms of the attributes that mainstream customers care about…But disruptive technologies have other attributes that a few fringe customers value. They are typically cheaper, smaller, simpler and frequently more convenient to use. Therefore, they open new markets…(as performance improves) they are able to take over the older markets.

As Henry Ford said, “If I asked people what they wanted, they would of said faster horses”.

Technological Change

Clayton argues that they are 2 kinds of innovation:

• Sustained — Technology which sustained the rate of improvement in existing product performance. The industry’s dominant firms always led in developing and adopting these technologies as they have the size and value structure to enable them to effectively improve the existing technology.
• Disruptive — These innovations redefined products and consistently resulted in the failure of the industry’s leading firms. This technology solves a problem in an entirely new way or for a new group of people.

Taking the example of the 8-inch disk drive, the author asks why the large drive makers did not enter this market until it was to late when they had the capacity to do so? The answer was that they were held captive by their mainframe customers who wanted higher performing 14-inch disks. Established firms in this industry were innovative in their approaches to sustaining innovations in every sort. But the firms did not find new applications and markets for these new products once they have secured themselves in the market. “It was as if the leading firms were held captive by their customers, enabling attacking entrant firm to topple the incumbent industry leaders each time a disruptive technology emerge.”

Why do leading firms frequently stumble when confronting technological change?

Organisational & Managerial Explanations Of Failure

• Many argue that the this failure is a simple result of bureaucracy, complacency or a “risk-averse” culture.
• Henderson & Clark conclude that companies organisational structure facilitates component-level innovations, because most product development organisations consist of subgroups that correspond to a product’s components.
• The organisational structure would be designed simply to facilitate the production of its dominant product, severely limited its ability elsewhere.

Radical Technology As An Explanation

• It is argued that established firms tend to be good at improving what they have long been good at doing.
• Entrant firms seem better suited for exploiting radically new technologies, often because they import the technology into one industry from another.
• Tushman & Anderson found that firms failed when a technological change destroyed the value of competencies previously cultivated and succeeded when new technologies enhanced them.

Value Networks + New Perspective On The Drivers Of Failure

• A value network is the context in which a firm identifies and responds to customers’ needs, solves problems, procures input and strives for profit. A firm’s value network is made up of its Resources, Processes and Values (RPV).
• Within a value network each firm’s competitive strategy determines its perceptions of the economic value of a new technology.
• These perceptions shape the rewards different firms expect to obtain through pursuit of innovations which drives the allocation of resources toward sustaining innovations and away from disruptive ones.
• Competition and customer demands in the value network shape the firm’s cost structure, the size required to remain competitive, and the necessary rate of growth.
• The value structure of a firm is very hard to change especially in the short term. This is why you need to spin of different units into separate entities or acquire new businesses.
• Established players can get ousted by new comers as they do not have the cost (value) structure to compete with lower gross margins.

Sustaining projects addressing the needs of the firm’s most powerful customers almost always preempted resources from disruptive technologies with small markets and poorly defined customer needs.

Principles Of Disruptive Technology

1. Companies depend on Customers & Investors for resources. In order to survive, companies must provide customers and investors with the products, services and profits that they require….the highest performing companies have well-developed systems for killing ideas that their customers don’t want. As a result, these companies find it difficult to invest adequate resources in disruptive technologies until their customers want them. And by then, it is too late.
2. Small Markets don’t solve the growth needs of Large Companies. As companies grow it becomes progressively more difficult for them to enter the newer, smaller markets that are destined to become the large markets of the future.
3. Markets that don’t exist can’t be analysed. Companies whose investment processes demand quantification of market size and financial returns before they can enter a market get paralysed when faced with disruptive technologies because they demand data on markets that don’t yet exist.

Downward Mobility

Clayton describes how after companies enter a market successfully they “leave their disruptive roots in search of greater profitability in the market tiers above them, they gradually come to acquire the cost structures required to compete in those upper market tiers”.

Project Size

The problem of project size is described when a large company sees little point in entering a small market due to the fact that it would add little to the bottom line.

5 Principles Of Disruption

Clayton suggests that to solve the problems listed below an independent organisation should be created to build disruptive technology.

1. Resource Dependence: Customers effectively control the patterns of resource allocation in well-run companies. Good managers will embed projects to develop these disruptive technologies within an organisation whose customers need them increasing the probability that the project will get the resources it needs.
2. Small markets don’t solve the growth needs of large companies. A $4b company seeking to grow 20% must find $800m of new revenue, and emerging markets initially aren’t large enough to provide that growth. By the time they are large enough, it’s already too late.Place the project in an organisation small enough to get excited about small wins and opportunities.
3. Ultimate uses for disruptive technologies are unknowable in advance. Failure is an intrinsic step toward success. They plan to fail early and inexpensively.
4. Organisation’s capabilities reside in their process and their values and the very processes that constitute their core capabilities within the current business model also define their disabilities. People are surprisingly flexible. You can take an individual out of a large company and put them in a small startup, and they can adapt and survive. But a company has processes and values — the way it produces output, and the way it makes decisions on resources and pursuing ideas. These processes and values are not flexible, they cannot easily change to support a different low-margin product, when they are organised effectively around producing a high-margin product.They utilised some of the resources of the mainstream organisation to address the disruption, but they were careful not to leverage its processes and values.
5. Supply may not equal market demand. The attributes that make disruptive technologies unattractive in established markets are the very ones that constitute their greatest value in emerging markets.

On Listening To Customers

Pace of progress that markets demand or can absorb may be different from the progress offered by technology. This means that products that do not appear to be useful to our customers today may squarely address their needs tomorrow. Therefore, whole keeping close to our customers is an important management paradigm for handling sustaining innovations, it may provide misleading data for handling disruptive ones.

On Capabilities

The capabilities of organisations are far more specialised and context-specific than most managers are inclined to believe. This is because capabilities are forged within value networks..They have the capability to make money when margins are at one level and not another…

On Failure

In many instances the information required to make large and decisive investments in the face of disruptive technology simply does not exist. It needs to be created through fast, inexpensive and flexible forays into the market and the product.

On The Need To Be a First Mover

A crucial strategic decision in the management of innovation is whether it is important to be a leader or acceptable to be a follower. Volumes have been written on first-mover advantages, and an offsetting amount on the wisdom of waiting until the innovation’s major risks have been resolved by the pioneering firms. “You can always tell who the pioneers were,” an old management adage goes. “They’re the ones with the arrows in their backs.” As with most disagreements in management theory, neither position is always right.

Each of the other sustaining technologies in the industry’s history present a similar picture. There is no evidence that any of the leaders in developing and adopting sustaining technologies developed a discernible competitive advantage over the followers.

In contrast to the evidence that leadership in sustaining technologies has historically conferred little advantage on the pioneering disk drive firms, there is strong evidence that leadership in disruptive technology has been very important. The companies that entered the new value networks enabled by disruptive generations of disk drives within the first two years after those drives appeared were six times more likely to succeed than those that entered later.

The numbers beneath the matrix show that only three of the fifty-one firms (6 percent) that entered established markets ever reached the $100 million revenue benchmark. In contrast, 37 percent of the firms that led in disruptive technological innovation — those entering markets that were less than two years old — surpassed the $100 million level. Whether a firm was a start-up or a diversified firm had little impact on its success rate. What mattered appears not to have been its organizational form, but whether it was a leader in introducing disruptive products and creating the markets in which they were sold.

The result is quite stunning. The firms that led in launching disruptive products together logged a cumulative total of $62 billion dollars in revenues between 1976 and 1994. Those that followed into the markets later, after those markets had become established, logged only $3.3 billion in total revenue. It is, indeed, an innovator’s dilemma. Firms that sought growth by entering small, emerging markets logged twenty times the revenues of the firms pursuing growth in larger markets

The difference in revenues per firm is even more striking: The firms that followed late into the markets enabled by disruptive technology, on the left half of the matrix, generated an average cumulative total of $64.5 million per firm. The average company that led in disruptive technology generated $1.9 billion in revenues. The firms on the left side seem to have made a sour bargain. They exchanged a market risk, the risk that an emerging market for the disruptive technology might not develop after all, for a competitive risk, the risk of entering markets against entrenched competition.

On Learning Vs Planning

These spun off firms shouldn’t be pressured into being right the first time. In fact, they should be considered to be taking bets, and the most important factor should be reducing sunk costs in case of a failed bet, in order to make pivoting cheap. “Business plans” should instead be “learning plans”.

“Guessing the right strategy at the outset isn’t nearly as important to success as conserving enough resources (or having the relationships with trusting backers or investors) so that new business initiatives get a second or third stab at getting it right. Those that run out of resources or credibility before they can iterate toward a viable strategy are the ones that fail.”

“Careful planning, followed by aggressive execution, is the right formula for success in sustaining technology. But in disruptive situations, action must be taken before careful plans are made. Because much less can be known about what markets need or how large they can become, plans must serve a very different purpose: They must be plans for learning rather than plans for implementation.”

The Example Of Johnson & Johnson

In order for firms to maintain longevity, they should establish smaller sub-organisations that act independently. These organisations are not to be pressured into making a short term profit, but should instead be given a unique identity and allowed to create their market.

“Though its total revenues amount to more than $20 billion, J&J comprises 160 autonomously operating companies, which range from its huge MacNeil and Janssen pharmaceuticals companies to small companies with annual revenues of less than $20 million. Johnson & Johnson’s strategy is to launch products of disruptive technologies through very small companies acquired for that purpose.”

“This recommendation is not new, of course; a host of other management scholars have also argued that smallness and independence confer certain advantages in innovation.”

“Establishing independent organizations to pursue disruptive technology seems to be a necessary condition for success.”

“Woolworth’s organisational strategy for succeeding in disruptive discount retailing was the same as Digital Equipment’s strategy for launching its personal computer business. Both founded new ventures within the mainstream organisation that had to earn money by mainstream rules, and neither could achieve the cost structure and profit model required to succeed in the mainstream value network.”

The Example Of The Digger

The case study that shows the process in the most transparent form is the evolution of excavator market. First, the excavator producer switched successfully from steam to gasoline engine — no major player in the market disappeared. This was a sustaining technology — it benefited current customer of the established firms. Then, hydraulic power became a disruptive technology. At first, it was not good enough to satisfy needs of existing excavator market — the size of bucket was not large enough. However, small bucket size was perfect for a new market — building contractors — who now could use these excavators instead of digging small trenches by hands. As the technology developed, the companies established in pre-hydraulic era did not survive the change…