The Innovator's Solution

by Clayton Christensen

  In addition to these powerful, direct determinants of the values that guide senior executives’ priorities in resource allocation, other criteria that are subtly embedded in diffused processes throughout the company influence what lower-level employees are able to prioritize. These combine to exert additional influence on which initiatives can pass through the resource allocation filter. An example of these factors is the short tenure in assignment that is typical in the career path of high-potential employees. Management development systems in most organizations move high-potential employees into new positions of responsibility every two to three years in order to help them master management skills in various parts of the business. This practice is critical in management development, but its effect is to influence midlevel managers to accord priority to projects that will pay off within the typical tenure that they expect in their jobs. They want to produce improved results that will merit attractive promotions.

  Other factors are embedded within the sales force’s incentive compensation system. Salespeople’s decisions about which customers to focus on and which products to emphasize are critical elements of the diffused resource allocation process and are heavily influenced by how they are compensated. Customers also exert a powerful influence on the sorts of initiatives that survive the resource allocation process. You can’t build a business around a product that your customers don’t want, because the customers pay the bills. Although managers think that they control the resource allocation process, customers often exert even more powerful de facto control over how money can and cannot be spent. Competitors’ actions likewise exert powerful influence. When a competitor’s action threatens to steal customers or growth opportunities away, managers have almost no choice but to push a response through the resource allocation filter.

  The resource allocation process, in other words, is a diffused, unruly, and often invisible process. Executives who hope to manage the strategy process effectively need to cultivate a subtle understanding of its workings, because strategy is determined by what comes out of the resource allocation process, not by the intentions and proposals that go into it.

  An Illustration of Resource Allocation in

  Strategy Making: The Case of Intel

  Intel began as a manufacturer of semiconductor memories, and its founding engineers developed the world’s first commercially viable dynamic random access memory (DRAM) chips.7 In 1971 an Intel engineer serendipitously invented the microprocessor during a funded development project for a Japanese calculator company, Busicom. Although DRAMs continued to account for the lion’s share of company sales through the 1970s, Intel’s sales of microprocessors grew gradually in a host of small, emerging applications.

  Every month Intel’s production schedulers met to allocate the available production capacity across their products, which ranged from DRAMs to EPROMs and microprocessors.8 The sales department would bring to this meeting its forecast shipments by product, and accounting would bring a rank ordering of those products by gross margins per wafer start. The highest-margin product would then be allocated the production capacity needed to meet its forecast shipments. The next-highest-margin product would then get the capacity it needed in order to meet its forecast shipments, and so on, until the product line with the lowest gross margins was allocated whatever residual capacity remained. Gross margins per wafer start, in other words, constituted the values of the organization that were used in this critical resource allocation decision.

  Japanese DRAM makers attacked the U.S. market in the early 1980s, causing pricing levels to drop precipitously and relegating DRAMs to the lowest ranking by gross margin of Intel’s products. Because there was less intense competition, microprocessors consistently earned among the most attractive gross margins in Intel’s product portfolio. The resource allocation process therefore systematically diverted manufacturing capacity away from DRAMs and into microprocessors. This occurred without any explicit management decision to change strategy. Senior management, in fact, continued to invest two-thirds of R&D dollars into the DRAM business even as the resource allocation process was executing a systematic exit from DRAMs.9

  Finally, by 1984, when the company had plunged into financial crisis and DRAMs had contracted to just a fraction of Intel’s volume, senior management recognized that Intel had become a microprocessor company. They stopped DRAM R&D spending, and Gordon Moore and Andy Grove made their storied exit through the company’s revolving lobby door as managers of the old company, and reentered as managers of the new company.10 But it was the resource allocation process that transformed Intel from a DRAM company into a microprocessor company. Intel’s remarkable strategy shift was not the result of an intended strategy articulated within the executive ranks; rather, it emerged through the daily decisions made by middle managers as they allocated resources.11

  Once this new business opportunity had become clear, then it was time to manage strategy in an assertive, deliberate mode—which Intel management did masterfully. By keeping a strong and sometimes ruthless hand on the resource allocation filter, management screened out bubbling-up initiatives that did not directly support the microprocessor business. Both strategy processes were crucial. A viable strategic direction had to coalesce from the emergent side of the process, because nobody could foresee clearly enough the future of microprocessor-based desktop computers. But once the winning strategy became apparent, it was just as critical to Intel’s ultimate success that the senior management then seized control of the resource allocation process and deliberately drove the strategy from the top.

  Match the Strategy-Making Process to

  the Stage of Business Development

  Intel’s history illustrates that strategies rarely follow a simple sequence from formulation to implementation. Furthermore, strategy is never static. Most companies must at the outset chart their course in a deliberate direction because they need to start going somewhere. We hope that the theories in this book will help those who create new businesses to deliberately target a viable strategy with much more accuracy than was possible in the past. But even with this guidance, there will be much to be discovered.

  Research suggests that in over 90 percent of all successful new businesses, historically, the strategy that the founders had deliberately decided to pursue was not the strategy that ultimately led to the business’s success.12 Entrepreneurs rarely get their strategies exactly right the first time. The successful ones make it because they have money left over to try again after they learn that their initial strategy was flawed, whereas the failed ones typically have spent their resources implementing a deliberate strategy before its viability could be known. One of the most important roles of senior management during a venture’s early years is to learn from emergent sources what is working and what is not, and then to cycle that learning back into the process through the deliberate channel. As Mintzberg and Waters advise, “Openness to emergent strategy enables management to act before everything is fully understood—to respond to an evolving reality rather than having to focus on a stable fantasy. . . . Emergent strategy itself implies learning what works—taking one action at a time in a search for that viable pattern or consistency.” 13

  Effective managers eventually recognize the viable pattern that constitutes a successful strategy. At this point, with a firm hand on the criteria used as filters in the resource allocation process, managers need to make strategy formulation much more deliberate. Rather than continuing to feel their way into the marketplace, they need to boldly execute the strategy that they have learned will work. Intel, Wal-Mart, and a host of other companies each saw a viable strategy emerge that was substantially different than their founders had envisioned. But once the model was clear, they executed that strategy aggressively.

  Managing Two Fundamentally Different

  Strategy Processes: A Rare and Tricky Skill

  In most waves of disruptive growth, a host of competitors are drawn to the opportunity. Firms that do not emerge from the p
ack as leaders fail in one of two places. First, many of the initial entrants fail because they spend their money aggressively implementing a deliberate strategy in the nascent stages when the right strategy cannot be known. The second point of failure occurs after the market and its applications become clear to the firms that have managed the emergent strategy process most effectively. The firms that then get left in the dust are those whose executives do not seize deliberate control of resource allocation and focus all investments in executing the race up-market.

  The switch from an emergent to a deliberate strategy mode is crucial to success in a corporation’s initial disruptive business. But the CEO’s job in managing this process does not end there, because the deliberate strategy process often becomes a subsequent impediment to a company’s efforts to launch new waves of successful disruptive growth. This happens in two ways. First, the filters in the resource allocation process of successful companies become so well attuned to the successful strategy that they filter out all but the initiatives that sustain the existing business—causing them to ignore the disruptive innovations that create the next waves of growth. Just as important, once deliberate strategy processes have become embedded within organizations, they find it difficult to employ emergent processes again when launching new businesses.

  A company’s efforts to catch new waves of disruptive growth need to be guided through emergent processes. Simultaneously, however, because the corporation’s established businesses typically have many years of profitability remaining even while the disruptive new-growth business is getting underway, the mainstream business needs to be driven by deliberate strategy processes to guide the sustaining innovations that will keep it competitive and profitable.

  In our studies we have found a good number of companies whose executives have perceived the need to allocate resources to create new disruptive growth businesses before it is too late. But very, very rarely have we seen executives who have consistently demonstrated the ability to manage the strategy development process appropriately across a range of businesses in various stages of maturity. After they have entered a deliberate strategy mode they find it very difficult to let new businesses be guided through an emergent process.

  For example, Prodigy Communications, a joint venture between Sears and IBM, was a pioneer in online services in the early 1990s. The managers of Sears and IBM were extraordinarily bold in resource allocation: They invested over a billion dollars in what was a very uncertain, potentially disruptive innovation. But they weren’t as successful in managing the strategy process—in helping Prodigy define a viable strategy through emergent processes even while the parent companies were managing their mainstream businesses deliberately.

  Prodigy’s original business plan envisioned that consumers would use online services primarily to access information and make online purchases. In 1992, management realized that Prodigy’s two million subscribers were spending more time sending e-mail than downloading information or making purchases online. The architecture of Prodigy’s computer and communications infrastructure had been designed to optimize transactions processing and information delivery, and Prodigy consequently began charging extra fees to subscribers who sent more than thirty e-mail messages per month. Rather than seeing e-mail as an emergent strategy signal, the company tried to filter it out, because in a deliberate mode, management’s job was to implement the original strategy.

  America Online (AOL) luckily entered the market later, after customers had discovered that e-mail was a primary reason for subscribing to an online service. With a technology infrastructure tailored to messaging and its “You’ve got mail” signature, AOL became much more successful.

  In light of our model, Prodigy’s mistake was not that it entered the market early. Nor was it a mistake that management targeted online information retrieval and shopping as the primary attraction of an online service. Nobody could know at the outset precisely how online services would be used.14 The executives’ mistake was to employ a deliberate strategy process before the strategy’s viability could be known. Had Prodigy kept strategic and technological flexibility to respond to emergent strategic evidence, the company could have had a huge lead over AOL and CompuServe (the third major online service provider). A similar challenge confronted the set of companies that responded in the early 1990s to the widely held view that a large market for handheld personal digital assistants was about to emerge. Many of the leading computer makers—including NCR, Apple, Motorola, IBM, and Hewlett-Packard—targeted this market, along with a few start-up firms such as Palm. All sensed that the market wanted a handheld computing device. Apple was one of the most aggressive of the innovators in this space. Its Newton cost $350 million to develop because of the technologies, such as handwriting recognition, that were required to build as much functionality into the product as possible. Hewlett-Packard also invested aggressively to design and build its tiny Kittyhawk disk drive for this market.

  In the end, the products just weren’t good enough to be a substitute for notebook computers, and each of the companies scrapped its effort—except Palm. Palm’s original strategy was to provide an operating system for these personal digital assistants.15 When its customers’ strategies failed, Palm searched around for another application and came up with the concept of an electronic personal organizer.

  What were the strategic mistakes here? The computer companies employed deliberate strategy processes from the beginning to the end. They invested massively to implement their strategies, and then wrote the projects off when the strategies proved wrong. Palm was the only firm that shifted to an emergent strategy process when its original deliberate strategy failed. When a viable strategy emerged, Palm shifted back toward a deliberate process as it migrated up-market.

  Clearly, this is not simple stuff.

  Points of Executive Leverage in the Strategy-Making Process

  The resource allocation process is the filter through which all strategic actions must flow. Because it is so complex and diffused throughout a company, it is rare that senior executives can simply devise a new strategy and “implement” it. Rather, defining and implementing strategy entails managing the conditions under which the strategy and resource allocation processes operate so that the strategy process can work efficiently, given the circumstances that each of the company’s organizations is in. Effective, appropriate processes will generate the needed strategic insights. The remainder of this chapter focuses on three points of executive leverage on the strategy process. Managers must:

  Carefully control the initial cost structure of a new-growth business, because this quickly will determine the values that will drive the critical resource allocation decisions in that business.

  Actively accelerate the process by which a viable strategy emerges by ensuring that business plans are designed to test and confirm critical assumptions using tools such as discovery-driven planning.

  Personally and repeatedly intervene, business by business, exercising judgment about whether the circumstance is such that the business needs to follow an emergent or deliberate strategy-making process. CEOs must not leave the choice about strategy process to policy, habit, or culture.

  Create a Cost Structure that Finds the Right Customers Attractive

  Note that we didn’t identify “memos from the executive office” as a way of influencing the organization’s values. That is because the power of a venture’s cost structure overwhelms “being strategically important” as a criterion that drives resource allocation decisions.16 Executives must pay very careful initial attention to creating a cost structure and business model within which orders from the kinds of ideal customers we described in chapter 4 will appear to be profitable. Otherwise, it will be impossible to build a business with those customers as a foundation.17

  Let us illustrate by bringing things close to home, recounting Clayton Christensen’s own experience in running a venture capital–backed company that he founded with several MIT professors in the early 1
980s, before he retreated to academia. The company was formed to exploit exciting technology to make products with a class of remarkable materials called advanced ceramics, and the history is recounted in a set of cases under the disguised name Materials Technology Corporation (MTC).18

  MTC’s strategy was to become a major manufacturer of products made from these advanced ceramic materials. Because the materials business is capital intensive, Christensen and his colleagues knew from the beginning that MTC would need lots of capital to carry the company to break-even—they estimated about $60 million. In the early 1980s this was a lot of money to raise. What drove the amount needed was not just the cost of the physical facilities, but also the length of the product development cycle. Because of MTC’s position at the beginning of the value chain, it needed to win contracts to develop new components for its customers, who would then use those advanced components to make next-generation products of their own. Developing and testing the components easily took one to two years. When MTC succeeded, then and only then could the customers initiate their own cycle to design and test the new products that MTC’s advanced materials had enabled. The customers’ development processes typically took two to four additional years. In other words, MTC’s strategy entailed enduring a lot of expense before the revenue could begin rolling in.19

  Christensen decided to cover the cost of MTC’s research and development staff by negotiating multimillion dollar joint development contracts from major corporate partners, in much the same way that many biotechnology companies have funded their protracted development processes. When MTC sold a major development contract to create the technology required to manufacture the products that its strategy envisioned, it then had to hire the scientists and engineers to do the work.