The sequence repeated itself when the leading minimill, Nucor, attacked the sheet steel business. Its market capitalization now dwarfs that of the largest integrated steel company, US Steel. Bethlehem Steel is bankrupt at the time of this writing.
This is not a history of bungled steel company management. It is a story of rational managers facing the innovator’s dilemma: Should we invest to protect the least profitable end of our business, so that we can retain our least loyal, most price-sensitive customers? Or should we invest to strengthen our position in the most profitable tiers of our business, with customers who reward us with premium prices for better products?
The executives who confront this dilemma come in all varieties: timid, feisty, analytical, and action-driven. In an unstructured world their actions might be unpredictable. But as large industry incumbents, they encounter powerful and predictable forces that motivate them to flee rather than fight when attacked from below. That is why shaping a business idea into a disruption is an effective strategy for beating an established competitor. Disruption works because it is much easier to beat competitors when they are motivated to flee rather than fight.
The forces that propel well-managed companies up-market are always at work, in every company in every industry. Whether or not entrant firms have disrupted the established leaders yet, the forces are at work, leading predictably in one direction. It is not just a phenomenon of “technology companies” such as those involved in microelectronics, software, photonics, or biochemistry. Indeed, when we use the term technology in this book, it means the process that any company uses to convert inputs of labor, materials, capital, energy, and information into outputs of greater value. For the purpose of predictably creating growth, treating “high tech” as different from “low tech” is not the right way to categorize the world. Every company has technology, and each is subject to these fundamental forces.
The Role of Sustaining Innovation in Generating Growth
We must emphasize that we do not argue against the aggressive pursuit of sustaining innovation. Several other insightful books offer management techniques to help companies excel in sustaining innovations—and their contribution is important.8 Almost always a host of similar companies enters an industry in its early years, and getting ahead of that crowd—moving up the sustaining-innovation trajectory more decisively than the others—is critical to the successful exploitation of the disruptive opportunity. But this is the source of the dilemma: Sustaining innovations are so important and attractive, relative to disruptive ones, that the very best sustaining companies systematically ignore disruptive threats and opportunities until the game is over.
Sustaining innovation essentially entails making a better mousetrap. Starting a new company with a sustaining innovation isn’t necessarily a bad idea: Focused companies sometimes can develop new products more rapidly than larger firms because of the conflicts and distractions that broad scope often creates. The theory of disruption suggests, however, that once they have developed and established the viability of their superior product, entrepreneurs who have entered on a sustaining trajectory should turn around and sell out to one of the industry leaders behind them. If executed successfully, getting ahead of the leaders on the sustaining curve and then selling out quickly can be a straightforward way to make an attractive financial return. This is common practice in the health care industry, and was the well-chronicled mechanism by which Cisco Systems “outsourced” (and financed with equity capital, rather than expense money) much of its sustaining-product development in the 1990s.
A sustaining-technology strategy is not a viable way to build new-growth businesses, however. If you create and attempt to sell a better product into an established market to capture established competitors’ best customers, the competitors will be motivated to fight rather than to flee.9 This advice holds even when the entrant is a huge corporation with ostensibly deeper pockets than the incumbent.
For example, electronic cash registers were a radical but sustaining innovation relative to electromechanical cash registers, whose market was dominated by National Cash Register (NCR). NCR totally missed the advent of the new technology in the 1970s—so badly, in fact, that NCR’s product sales literally went to zero. Electronic registers were so superior that there was no reason to buy an electromechanical product except as an antique. Yet NCR survived on service revenues for over a year, and when it finally introduced its own electronic cash register, its extensive sales organization quickly captured the same share of the market as the company had enjoyed in the electromechanical realm.10 The attempts that IBM and Kodak made in the 1970s and 1980s to beat Xerox in the high-speed photocopier business are another example. These companies were far bigger, and yet they failed to outmuscle Xerox in a sustaining-technology competition. The firm that beat Xerox was Canon—and that victory started with a disruptive tabletop copier strategy.
Similarly, corporate giants RCA, General Electric, and AT&T failed to outmuscle IBM on the sustaining-technology trajectory in mainframe computers. Despite the massive resources they threw at IBM, they couldn’t make a dent in IBM’s position. In the end, it was the disruptive personal computer makers, not the major corporations who picked a direct, sustaining-innovation fight, who bested IBM in computers. Airbus entered the commercial airframe industry head-on against Boeing, but doing so required massive subsidies from European governments. In the future, the most profitable growth in the airframe industry will probably come from firms with disruptive strategies, such as Embraer and Bombardier’s Canadair, whose regional jets are aggressively stretching up-market from below.11
Disruption Is a Relative Term
An idea that is disruptive to one business may be sustaining to another. Given the stark odds that favor the incumbents in the sustaining race but entrants in disruptive ones, we recommend a strict rule: If your idea for a product or business appears disruptive to some established companies but might represent a sustaining improvement for others, then you should go back to the drawing board. You need to define an opportunity that is disruptive relative to all the established players in the targeted market, or you should not invest in the idea. If it is a sustaining innovation relative to the business model of a significant incumbent, you are picking a fight you are very unlikely to win.
Take the Internet, for example. Throughout the late 1990s, investors poured billions into Internet-based companies, convinced of their “disruptive” potential. An important reason why many of them failed was that the Internet was a sustaining innovation relative to the business models of a host of companies. Prior to the advent of the Internet, Dell Computer, for example, sold computers directly to customers by mail and over the telephone. This business was already a low-end disruptor, moving up its trajectory. Dell’s banks of telephone salespeople had to be highly trained in order to walk their customers through the various configurations of components that were and were not feasible. They then manually entered the information into Dell’s order fulfillment systems.
For Dell, the Internet was a sustaining technology. It made Dell’s core business processes work better, and it helped Dell make more money in the way it was structured to make money. But the identical strategy of selling directly to customers over the Internet was very disruptive relative to Compaq’s business model, because that company’s cost structure and business processes were targeted at in-store retail distribution.
The theory of disruption would conclude that if Dell (and Gateway) had not existed, then start-up Internet-based computer retailers might have succeeded in disrupting competitors such as Compaq. But because the Internet was sustaining to powerful incumbents, entrant Internet computer retailers have not prospered.
A Disruptive Business Model Is a Valuable Corporate Asset
A disruptive business model that can generate attractive profits at the discount prices required to win business at the low end is an extraordinarily valuable growth asset. When its executives carry the business model up-market to mak
e higher-performance products that sell at higher price points, much of the increment in pricing falls to the bottom line—and it continues to fall there as long as the disruptor can keep moving up, competing at the margin against the higher-cost disruptee. When a company tries to take a higher-cost business model down-market to sell products at lower price points, almost none of the incremental revenue will fall to its bottom line. It gets absorbed into overheads. This is why, as we discuss in chapter 7, established firms that hope to capture the growth created by disruption need to do so from within an autonomous business with a cost structure that offers as much headroom as possible for subsequent profitable migration up-market.
Moving up the trajectory into successively higher-margin tiers of the market and shedding less-profitable products at the low end is something that all good managers must do in order to keep their margins strong and their stock price healthy. Standing still is not an option, because firms that stop moving up find themselves in a rebaresque situation, slugging it out with hard-to-differentiate products against competitors whose costs are comparable.12
This ultimately means that in doing what they must do, every company prepares the way for its own disruption. This is the innovator’s dilemma. But it also is the beginning of the innovator’s solution. Disruption does not guarantee success, but it sure helps: The Innovator’s Dilemma showed that following a strategy of disruption increased the odds of creating a successful growth business from 6 percent to 37 percent.13 Because the established company’s course of action is mandated so clearly, it is also clear what executives who seek to create new-growth businesses should do: Target products and markets that the established companies are motivated to ignore or run away from. Many of the most profitable growth trajectories in history have been initiated by disruptive innovations.
Two Types of Disruption
For the sake of simplicity, The Innovator’s Dilemma presented the disruptive innovation diagram in only two dimensions. In reality, there are two different types of disruptions, which can best be visualized by adding a third axis to the disruption diagram, as shown in figure 2-3. The vertical and horizontal axes are as before: the performance of the product on the vertical axis, with time plotted on the horizontal dimension. The third axis represents new customers and new contexts for consumption.
Our original dimensions—time and performance—define a particular market application in which customers purchase and use a product or service. In geometric terms, this application and set of customers reside in a plane of competition and consumption, which The Innovator’s Dilemma called a value network. A value network is the context within which a firm establishes a cost structure and operating processes and works with suppliers and channel partners in order to respond profitably to the common needs of a class of customers. Within a value network, each firm’s competitive strategy, and particularly its cost structure and its choices of markets and customers to serve, determines its perceptions of the economic value of an innovation. These perceptions, in turn, shape the rewards and threats that firms expect to experience through disruptive versus sustaining innovations.14
FIGURE 2 - 3
The Third Dimension of the Disruptive Innovation Model
The third dimension that extends toward us in the diagram represents new contexts of consumption and competition, which are new value networks. These constitute either new customers who previously lacked the money or skills to buy and use the product, or different situations in which a product can be used—enabled by improvements in simplicity, portability, and product cost. For each of these new value networks, a vertical axis can be drawn representing a product’s performance as it is defined in that context (which is a different measure from what is valued in the original value network).
Different value networks can emerge at differing distances from the original one along the third dimension of the disruption diagram. In the following discussion, we will refer to disruptions that create a new value network on the third axis as new-market disruptions. In contrast, low-end disruptions are those that attack the least-profitable and most overserved customers at the low end of the original value network.
New-Market Disruptions
We say that new-market disruptions compete with “nonconsumption” because new-market disruptive products are so much more affordable to own and simpler to use that they enable a whole new population of people to begin owning and using the product, and to do so in a more convenient setting. The personal computer and Sony’s first battery-powered transistor pocket radio were new-market disruptions, in that their initial customers were new consumers—they had not owned or used the prior generation of products and services. Canon’s desktop photocopiers were also a new-market disruption, in that they enabled people to begin conveniently making their own photocopies around the corner from their offices, rather than taking their originals to the corporate high-speed photocopy center where a technician had to run the job for them. When Canon made photocopying so convenient, people ended up making a lot more copies. New-market disruptors’ challenge is to create a new value network, where it is nonconsumption, not the incumbent, that must be overcome.
Although new-market disruptions initially compete against non-consumption in their unique value network, as their performance improves they ultimately become good enough to pull customers out of the original value network into the new one, starting with the least-demanding tier. The disruptive innovation doesn’t invade the mainstream market; rather, it pulls customers out of the mainstream value network into the new one because these customers find it more convenient to use the new product.
Because new-market disruptions compete against nonconsumption, the incumbent leaders feel no pain and little threat until the disruption is in its final stages. In fact, when the disruptors begin pulling customers out of the low end of the original value network, it actually feels good to the leading firms, because as they move up-market in their own world, for a time they are replacing the low-margin revenues that disruptors steal, with higher-margin revenues from sustaining innovations.15
Low-End Disruptions
We call disruptions that take root at the low end of the original or mainstream value network low-end disruptions. Disruptions such as steel minimills, discount retailing, and the Korean automakers’ entry into the North American market have been pure low-end disruptions in that they did not create new markets—they were simply low-cost business models that grew by picking off the least attractive of the established firms’ customers. Although they are different, new-market and low-end disruptions both create the same vexing dilemma for incumbents. New-market disruptions induce incumbents to ignore the attackers, and lowend disruptions motivate the incumbents to flee the attack.
Low-end disruption has occurred several times in retailing.16 For example, full-service department stores had a business model that enabled them to turn inventories three times per year. They needed to earn 40 percent gross margins to make money within their cost structure. They therefore earned 40 percent three times each year, for a 120 percent annual return on capital invested in inventory (ROCII). In the 1960s, discount retailers such as Wal-Mart and Kmart attacked the low end of the department stores’ market—nationally branded hard goods such as paint, hardware, kitchen utensils, toys, and sporting goods—that were so familiar in use that they could sell themselves. Customers in this tier of the market were overserved by department stores, in that they did not need well-trained floor sales-people to help them get what they needed. The discounters’ business model enabled them to make money at gross margins of about 23 percent, on average. Their stocking policies and operating processes enabled them to turn inventories more than five times annually, so that they also earned about 120 percent annual ROCII. The discounters did not accept lower levels of profitability—their business model simply earned acceptable profit through a different formula.17
It is very hard for established firms not to flee from a low-end disruptor. Consider, for example
, the choice that executives of full-service department stores had to make when the discount retailers were attacking the branded hard goods at the low end of department stores’ merchandise mix. Retailers’ critical resource allocation decision is the use of floor or shelf space. One option for department store executives was to allocate more space to even higher-margin cosmetics and high-fashion apparel, where gross margins often exceeded 50 percent. Because their business model turned inventories three times annually, this option promised 150 percent ROCII.
The alternative was to defend the branded hard goods businesses, which the discounters were attacking with prices 20 percent below those of department stores. Competing against the discounters at those levels would send margins plummeting to 20 percent, which, given the three-times inventory turns that were on average inherent in their business model, entailed a ROCII of 60 percent. It thus made perfect sense for the full-service department stores to flee—to get out of the very tiers of the market that the discounters were motivated to enter.18
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