The Innovator's Solution

by Clayton Christensen

  The RPV model can illuminate Daimler-Benz’s acquisition of Chrysler and its subsequent efforts to integrate the two organizations. Chrysler had few resources that could be considered unique in comparison to its competitors. Much of its success in the market of the 1990s was rooted in its processes—particularly in its heavyweight-team product design process, which could create classy new designs in twenty-four months. Chrysler’s values were also worth a lot, because it could design and produce a car with one-fifth as many overhead employees as Daimler. What would have been the best way for Daimler to leverage the capabilities it acquired in Chrysler? By keeping it independent and infusing Daimler’s resources into Chrysler’s processes and its cost structure. Instead, as Wall Street began its demanding drumbeat for cost savings, analysts with little sense for processes and even less for values pressured Daimler management into consolidating the two organizations in order to cut costs. We suspect that integrating the two companies will compromise many of the key processes and the values that made Chrysler such an attractive acquisition.

  In contrast, many of Cisco Systems’ acquisitions worked well—because, we would argue, it has kept resources, processes, and values in the right perspective. Most of the companies that Cisco has acquired were small firms less than two years old: early-stage organizations whose market value was built primarily upon their resources, particularly their engineers and products. Cisco has a well-defined, deliberate process by which it essentially plugs these resources into the parent’s processes and systems, and it has a carefully cultivated method of keeping the engineers of the acquired company happily on the Cisco payroll. In the process of integration, Cisco throws away whatever nascent processes and values came with the acquisition, because those weren’t what Cisco paid for. On a couple of occasions when the company acquired a larger, more mature organization— notably its 1996 acquisition of StrataCom—Cisco did not integrate. Rather, it let StrataCom stand alone, and infused its substantial resources into the organization to help it grow at a more rapid rate.26

  The Costs of Getting It Wrong

  Great opportunities can be missed and millions of dollars wasted when managers have high-potential ideas but place them in an organizational context that is not suited to the task. Two high-profile examples of this are Bank One’s effort to create WingspanBank.com in the late 1990s, and F. W. Woolworth’s effort to build Woolco into a leading discount retailer in the 1960s. Let’s look at them through the lens of this theory.

  Bank One’s Wingspan

  Bank One’s credit card division, First USA, worked with a leading management consulting firm to launch an online bank called Wingspan in the late 1990s. They set Wingspan up as a wholly owned but autonomous organization that would have separate customers and a separate brand; it therefore was free to pillage Bank One’s business. The authors of the strategy apparently felt that the newness and disruptive nature of online banking meant that Wingspan had the best chance of success as a separate company.

  The litmus tests in chapter 2, however, suggest that online banking is a sustaining innovation relative to the business models of the leading retail banks. Online banks cannot compete against nonconsumption, because almost all computer owners and users in the United States already have bank accounts. Hence, a new-market disruption just isn’t possible: Online banking can only compete against consumption. The other disruptive alternative, crafting a low-end attack, would require first finding a set of customers who are overserved by the functionality and reliability of current banking products and services and, second, entail creating a business model that can earn attractive profits at the discount prices required to win the business of customers in the least-demanding tiers of the market. Given the high advertising costs of attracting customers and with no cost advantage in the cost of money, this also is not feasible.27

  Because disruption is impossible, Internet banking can only be deployed as a sustaining technology relative to the business model of retail banks. A significant portion of their best customers in fact want the convenience, and in most instances the cost per transaction is lower when it is done over the Internet than when done in a branch or via an ATM. Hence, there was no reason why Bank One needed to set this effort up separately. Indeed, in a sustaining battle the established firms almost always win.

  F.W. Woolworth and Discount Retailing

  In 1962 F.W. Woolworth, one of the world’s leading retailers, established its discount department store arm, Woolco, as a wholly owned but autonomously managed, free-standing division—and well it should have. Discount retailing was disruptive from a values standpoint, and it required fundamentally different operating processes. Woolworth’s variety stores averaged 35 percent gross margins and turned inventories over about 3.4 times per year. Discount retailing entailed average gross margins of only 23 percent, and to earn acceptable returns these retailers needed to turn inventories about 5 times per year.28

  In 1971, Woolworth’s corporate executives decided to integrate the management, buying, and logistics functions of Woolco back into the mainstream of Woolworth in order to leverage these fixed costs across the volumes of both businesses. The result? Within a year, the values of the mainstream business had forced Woolco’s margins up to 34 percent, and Woolco’s inventory turns declined to four times—both mirroring the profit model of the F. W. Woolworth stores. Woolco ultimately had to be closed. Very quickly, just as we saw with Merrill Lynch’s implementation of Internet brokerage, the business model of the potentially disruptive business simply had to conform itself to the processes and values of the organization in which it was housed. As a general law of organizational nature, there is no other possible outcome. Organizations cannot disrupt themselves. Managers can only do what makes sense to them, given the context in which they work. As a disruptive opportunity, Woolco needed to remain separate. As a sustaining opportunity, Internet banking needed to be integrated within Bank One’s mainstream.

  Managers whose organizations are confronting opportunities to grow must first determine that they have the people and other resources required to succeed. They then need to ask two further questions: Are the processes by which work habitually gets done in the organization appropriate for this new project? And will the values of the organization give this initiative the priority it needs? Established companies can improve their odds for success in disruptive innovation if they use functionally oriented and heavyweight teams where each is appropriate, and if they commercialize sustaining innovations in mainstream organizations but put disruptive ones in autonomous organizations.

  A primary reason successful innovation seems difficult and unpredictable is that firms often employ talented people whose management skills were honed to address stable companies’ problems. And often, managers are set to work within processes and values that weren’t designed for the new task. Instead of accepting onesize-fits-all policies, if executives will spend time ensuring that capable people work in organizations with processes and values that match the task, they will create a major point of leverage in successfully creating new growth.

  Notes

  1. One of the most important studies on this topic is summarized in Dorothy Leonard-Barton, “Core Capabilities and Core Rigidities: A Paradox in Managing New Product Development,” Strategic Management Journal 13 (1992): 111–125.

  2. The concepts in this chapter attempt to build on a respected tradition of scholarship about the capabilities of organizations that is known in academic circles as the “resource-based view” (RBV) of the firm. This tradition sees resources as the defining asset of a firm, and seeks to explain interfirm differences in performance and growth in terms of differences in resource complements. See, for example, K. R. Conner, “A Historical Comparison of Resource-Based Theory and Five Schools of Thought Within IO Economics: Do We Have a New Theory of the Firm?” Journal of Management 17, no. 1 (1991): 121–154. The seminal works in this stream are E. T. Penrose, The Theory of the Growth of the Firm (London: Basil Blackwell, 1959)
; and B. Wernerfelt, “A Resource-Based View of the Firm,” Strategic Management Journal 5 (1984): 171–180. More recent work includes M. Peteraf, “The Cornerstones of Competitive Advantage: A Resource-Based View,” Strategic Management Journal 14, no. 3 (1993): 179–192; and J. Barney, “The Resource-Based Theory of the Firm,” Organization Science 7, no. 5 (1996): 469.

  We have defined “resources” far more narrowly than many RBV researchers, using additional concepts—namely, processes and values—to capture other important constituent elements of firms’ capabilities that some have chosen to include in the category of resources. See, for example, D. Teece and G. Pisano, “The Dynamic Capabilities of Firms: An Introduction,” Industrial and Corporate Change 3, no. 3 (1994): 537–556; R. M. Grant, “The Resource-Based Theory of Competitive Advantage,” California Management Review 33, no. 3 (1991): 114–135; and J. Barney, “Organizational Culture: Can It Be a Source of Sustained Competitive Advantage?” Academy of Management Review 11, no. 3 (1986): 656–665. Our belief is that what has become in many cases a debate over definitions of the phenomenon is actually a failure of categorization. The framework and theory presented in this chapter were summarized in preliminary form in a chapter added to the second edition of The Innovator’s Dilemma. This model was initially published in Clayton Christensen and Michael Overdorf, “Meeting the Challenge of Disruptive Change,” Harvard Business Review, March– April 2000.

  3. Findings reported by managerial psychologists RHR International corroborate this estimate. RHR recently reported that up to 40 percent of newly hired senior executives either quit, significantly underperform, or are fired within two years of assuming their new positions (Globe & Mail, 1 April 2003, B1).

  4. Tom Wolfe, The Right Stuff (New York: Farrar, Straus, and Giroux, 1979).

  5. Consistent with our statements in chapter 1 about how robust theory can bring predictability to an endeavor, much early research about how to hire the right people into the right jobs has categorized potential managers by their attributes. Remember that the early researchers in aviation observed a high correlation between the possession of attributes such as wings and feathers and the ability to fly. But they were only able to make statements about correlation or association, not causality. It is only when researchers identify the fundamental causal mechanism, and then understand the different circumstances in which practitioners might find themselves, that things can become highly predictable. In this case, possession of many right-stuff attributes might be quite highly correlated with success in an assignment, but it is not the fundamental causal mechanism of success.

  6. Morgan McCall, High Flyers: Developing the Next Generation of Leaders (Boston: Harvard Business School Press, 1998). This book offers a refreshing, intellectually rigorous way of thinking about how managers learn, and of assessing whether a manager is capable of successfully addressing challenges that lie ahead. We highly recommend that practitioners who are interested in learning more about how to get the right people into the right place at the right time read the book in its entirety.

  7. At a later point in the venture’s development, of course, it will need executives who have taken these courses in the school of experience that relate to scaling a business—and later still, to efficiently operating an organization. One reason many new ventures flame out after an initial, single-product success is that the founders lack the intuition and experience in creating processes that can repeatedly create better products and produce and deliver them reliably.

  8. The most logical, comprehensive characterization of processes that we have seen is in David Garvin, “The Processes of Organization and Management,” Sloan Management Review, Summer 1998. When we use the term processes, we mean for it to include all of the types of processes that Garvin has defined.

  9. Under various labels, many scholars have explored at length the notion of “processes” as the fundamental building block of organizational capability and competitive advantage. Perhaps among the most influential of such works is R. R. Nelson and S. G. Winter, An Evolutionary Theory of Economic Change (Cambridge, MA: Belknap Press, 1982). Nelson and Winter refer to “routines” rather than processes, but the fundamental concept is the same. They establish that firms build competitive advantage by developing better routines than other firms, and that superior routines are developed only through the faithful replication of effective behaviors. Once established, good routines are difficult to change. See, for example, M. T. Hannan and J. Freeman, “The Population Ecology of Organizations,” American Journal of Sociology 82, no. 5 (1977): 929–964.

  Subsequent work has explored and demonstrated the power of the concept of processes (called, variously, organizational capabilities, dynamic capabilities, and core competencies) as a source of competitive advantage. Examples of this work include D. J. Collis, “A Resource-Based Analysis of Global Competition: The Case of the Bearings Industry,” Strategic Management Journal 12 (1991): 49–68; D. Teece and G. Pisano, “The Dynamic Capabilities of Firms: An Introduction,” Industrial and Corporate Change 3, no. 3 (1994): 537–556; and C. K. Prahalad and G. Hamel, “The Core Competence of the Corporation,” Harvard Business Review, May–June 1990, 79–91.

  Our view is that although this stream of research has been extremely insightful, like the work on the resource-based view to which we referred in note 3, it suffers from the limitation either of expanding the definition of “process” to include all possible determinants of competitive advantage or, in the interests of intellectual integrity, of excluding important elements of firms’ capabilities from its scope of analysis. For more on this, see A. Nanda, “Resources, Capabilities, and Competencies,” in Organizational Learning and Competitive Advantage, eds. B. Moingeon and A. Edmondson (New York: The Free Press, 1996), 93–120.

  10. See Leonard-Barton, “Core Capabilities and Core Rigidities.”

  11. See C. Wickham Skinner, “The Focused Factory,” Harvard Business Review, May–June 1974.

  12. Chet Huber, who was the founding president of General Motors’ OnStar telematics service, reflected for us on how critical the distinction is between resources (people) and processes: “One of my biggest lessons has been realizing that the company needed to be entrepreneurial and not the individuals within the company. [The individuals] needed to act more like synchronized swimmers to keep the organization very well aligned.” Clayton M. Christensen and Erik Roth, “OnStar: Not Your Father’s General Motors (A),” Case 9-602-081 (Boston: Harvard Business School), 12.

  13. The concept of values, as we define the term here, is similar to the constructs of “structural context” and “strategic context” that have emerged in scholarly work about the resource allocation process. Important works in this tradition include J. L. Bower, Managing the Resource Allocation Process (Homewood, IL: Richard D. Irwin, 1972), and R. Burgelman, “Corporate Entrepreneurship and Strategic Management: Insights from a Process Study,” Management Science 29, no. 12 (1983): 1349–1364.

  14. chapter 8 examines in much greater depth the effect that values have on resource allocation and strategy making.

  15. For example, Toyota entered the North American market with its Corona model, a product targeting the lowest-priced tiers of the market. As the entry-level tier of the market became crowded with look-alike models from Nissan, Honda, and Mazda, competition among equally low-cost competitors drove down profit margins. Toyota developed more sophisticated cars targeted at higher tiers of the market in order to improve its margins. Its Corolla, Camry, 4-Runner, Avalon, and Lexus families of cars have been introduced in response to the same competitive pressures—Toyota kept its margins healthy by migrating up-market. In the process, Toyota has had to add costs to its operation to design, build, and support cars of this caliber. It subsequently decided to exit the entry-level tiers of the market, having found the margins it could earn there to be unacceptable given its changed cost structure.

  Toyota recently introduced its Echo model in an attempt to reenter the entry-level tier with
a $14,000 car—reminiscent of American automakers’ periodic attempts to reestablish positions at the low end of the market. To be successful, Toyota management will have to swim against a very strong current. It is one thing for Toyota senior management to decide to launch this new model. But to implement this strategy successfully, many people in the Toyota system—including its dealers—will have to agree that selling more cars at lower margins is a better way for the company to boost profits and equity values than selling more Camrys, Avalons, and Lexuses. Only time will tell for certain whether Toyota will be successful at bucking the company’s evolved values.

  16. See Edgar Schein, Organizational Culture and Leadership (San Francisco: Jossey-Bass, 1988). Our description of the development of an organization’s culture draws heavily from Schein’s research.

  17. Professors Michael Tushman of Harvard and Charles O’Reilly of Stanford have studied deeply the need to manage organizations in this way to create what they call “ambidextrous organizations.” As we understand their work, they assert that it is not enough simply to spin off an autonomous organization to pursue important but disruptive innovations that don’t match the mainstream organization’s values. The reason is that too often, executives spin it off to get the disruption off their agenda so that they can focus on managing the core business. To create a truly ambidextrous organization, Tushman and O’Reilly assert that the two different organizations need to be located within a business unit. Responsibility for managing the disruptive and sustaining organizations needs to be at a level in the organization where the two are not treated as businesses in a portfolio. Rather, they should be within a group or business unit whose management has the bandwidth to pay careful attention to what should be integrated and shared across the groups, and what should be implemented autonomously. See Michael L. Tushman and Charles A. O’Reilly, Winning Through Innovation: A Practical Guide to Leading Organizational Change and Renewal (Boston: Harvard Business School Press, 2002).