Now might seem an odd time to talk about growth. Some signs are promising, but corporate planning is complicated by unknowns involving economic prospects, capital markets, geopolitics, terrorism and pandemics. Shouldn’t we be hunkering down and just trying to survive? In a word, these authors say “No.”
Why is it that as soon as the business horizon turns cloudy so many companies get timid about investing for growth? We believe it’s because growth has long seemed a largely random process. Such a belief is perfectly understandable: the results of several recent studies suggest that no more than one company in 10 creates sustainable, profitable growth (see box).
With the outcome of investments in new businesses this uncertain, there’s very little cushion to absorb any bad-news outcomes. So it’s reasonable to pull in one’s horns as general economic conditions sour. We believe growth doesn’t need to be the kind of gamble that most seem to assume. It is possible to bring a new level of predictability to innovation-driven growth, the kind of predictability that makes it possible to keep investing for growth when everybody else has gone into a defensive crouch. The potential for succeeding with any given growth opportunity can be assessed by answering three questions: is the opportunity disruptive? can you profit from the opportunity? and do you have the capabilities to pursue this opportunity? Our firm belief is that by answering these questions, you can predict with confidence which growth opportunities will be successful and which won’t.
Is this opportunity disruptive?
Perhaps the most powerful determinant of the growth potential of an innovation is whether or not it is truly disruptive. Disruptive innovations beat leading products and providers at their own game, but get their start by appealing to those customers whom incumbents are happy to ignore or relieved to walk away from. Disruptors then improve their products over time, moving upstream to challenge established firms. Table 1 (in the Appendix) provides a summary of some notable disruptions over the past 100 years.
The kinds of innovations that successful companies are good at are typically sustaining in nature; that is, high-performing firms are usually highly proficient at delivering the sorts of improvements and products that are valued by their existing customers.
For example, when electronic cash registers appeared in the 1970s, they were a radical but sustaining innovation that undermined the market for electromechanical cash registers, which was dominated by National Cash Register. NCR managed to survive on service revenues for over a year, then introduced its own electronic cash register and rapidly regained lost ground. The attempts that IBM and Kodak made in the 1970s and 1980s to beat Xerox in the high-speed photocopier business are another example. They were far bigger and yet failed to outmuscle Xerox in this established market, where the name of the game was delivering a succession of sustaining innovations.
Sustaining innovations are enormously important, and they can generate real wealth. But the very fact that incumbents are so adept at seeing and exploiting sustaining innovations means that investors expect and demand that they do so. As a result, share prices typically have built into them the expectation that firms will, at a minimum, achieve the levels of growth that can be realized by exploiting opportunities for sustaining innovation.
In contrast, innovation that creates the sort of growth that delights investors is innovation that is genuinely disruptive. Disruptive innovations typically underperform established products along those dimensions of performance that define competition in existing markets. At the same time, they gain a foothold by overperforming along other dimensions that are valued by market segments but unprofitable to incumbent firms because they are small, generate thin margins, or (as is usually the case) both. Over time, improvements on the dimensions of performance that are valuable to large, profitable markets enable disruptive innovations to capture market share from incumbent firms. The disruptive products eventually provide competitive levels of performance on the traditional dimensions, but maintain the benefits that gave them a foothold in the first place.
Consider the attack on the low end of department stores’ market by discount retailers such as Wal-Mart and K-Mart in the 1960s. The discounters offered nationally branded hard goods such as paint, hardware, kitchen utensils, toys and sporting goods that were so familiar there was no need for well-trained floor salespeople to assist customers. The discounters’ business model enabled them to make money at gross margins of about 23 per cent, on average. Their stocking policies and operating processes enabled them to turn inventories more than five times annually, so they also earned about 120 per cent annual ROCII. The discounters did not accept lower levels of profitability; their business model just earned acceptable profit through a different formula.5
Over time, in product category after product category, the discounters found ways to sell through their lower-cost business model the products to which established retailers were always retreating. The result, in Wal-Mart’s case, has been 25-per-cent annual growth for over 25 years. All that remains to the established retailers are very high-margin perfumes and other quasi-luxury goods that seem to depend on very expensive fixed-cost infrastructure like ceramic tile floors, marble countertops and halogen lighting.
The opportunities that hold the most promise for growth for your organization, then, are those that are truly disruptive to established firms. And to be disruptive, you should target customers that incumbents are willing-and even eager-to abandon, using business models that incumbents have no interest in replicating.
Where is the profit in this opportunity?
The value-chain elements that actually command economic profit either through price premiums or defensible cost advantages are rarely the same for sustaining and disruptive innovations in a given market. Whatever activities an incumbent relies upon to justify its profitability in the sustaining arena will likely be of little use when pursuing disruptive growth. So it is critical for you to assess, for a given disruptive venture, which activities generate the bulk of an innovation’s profitability.
It is facile to say that success in a market is at least partly a function of delivering to customers more of what they value in ways that the competition cannot easily imitate. We can go much deeper, however, by observing that different dimensions of performance are valuable to customers at different stages in a product’s life cycle. We’ve found it helpful to think in terms of four categories of product performance.
Initially, customers simply want something that works; that is, those product attributes that define its functionality are what matter most. When functionality matters most, we say that functionality is the basis of competition in a market at that point in time.
There is only so much functionality that customers can use, so once functionality requirements have been met, the basis of competition shifts to a new set of attributes. Typically, once something works well, customers want it to work consistently, and so the basis of competition shifts to reliability.
Once customer needs for functionality and reliability have been met, customer priorities tend to shift to customizability or convenience; that is, customers want this now high-functioning, highly reliable product to be customized to their specific needs, or convenient and easy to purchase and use. When the degree of customizability offered outstrips what customers can use, as manifested in their willingness to pay, they then push hard for lower price.
Optimizing a product or service for different dimensions of performance-in keeping with the basis of competition in a market at a point in time-requires a firm to control different elements of the industry’s value chain. Those firms that figure out which configurations are best suited to the basis of competition in a market are usually the ones that dominate that market-at least for a while-and with that dominance comes the lion’s share of an industry’s profit.
The evolution of the computer industry provides a helpful illustration. From the dawn of the commercial computer industry in the mid-1950s until the early 1980s, the basis of competition was finding ways to knit together the various components of a computer in order to create faster, better, more functional devices. To deliver against that basis of competition required a tightly integrated value chain. IBM dominated the industry by controlling everything from design through many aspects of manufacturing, on to assembly, sales and service. It captured 70 per cent of sales and 95 per cent of profits.
By the time the personal computer had become ubiquitous in the early 1990s, the basis of competition at the level of designing and assembling computers was no longer functionality. Functionality was (and continues to be) determined by critical inputs such as the microprocessor, memory and software, most of which come from Intel, Hitachi and Microsoft.
However, consumers faced trade-offs in deciding whether to spend their money for a faster processor, or more memory, or a bigger screen, or a CD burner, and so on. They quickly came to value very highly the company that mastered this new complexity and was able to meet their product customization needs. In other words, the changing nature of the underlying technological architecture shifted what customers were willing to pay for; it changed the basis of competition to customizability.
The computer-maker that capitalized on this shift most effectively is Dell Computer. They have a very different value chain configuration than did IBM when Big Blue dominated mainframes, but the complexities they have mastered are no less demanding. By tightly integrating their supply chain with their customer relationship management processes, and tying both into their state-of-the-art assembly operations, Dell has been able to provide customers precisely what they want, when and how they want it.
The broader lesson is that to truly profit from a disruptive innovation, your organization has to understand how the basis of competition will be different from what it has been in your established markets. Only by seeing the connection between the new basis of competition that drives the success of a disruptive innovation and activities in the value chain can you hope to deliver against that dimension of performance more effectively than competitors. By staking out the most valuable territory in the innovation’s value chain, you can position your organization to capture the bulk of the profits.
Do I have the capabilities to exploit this opportunity?
To truly exploit the potential of an innovation, your organization needs the right capabilities. We suggest decomposing the notion of organizational capabilities (or “competencies”) into three elements: resources, processes and values. By understanding what each of these is and the relationships between them, you can create an organization that is able to exploit disruptive innovations.
Resources are usually people or things, including such assets as employees, equipment, technology, product designs, brands, information and cash. Most resources are visible and often are measurable, so managers can readily assess their value. They tend to be quite portable as well: it is relatively easy to transport them across the boundaries of organizations.
Of the many and often idiosyncratic resources that any given business needs, we’ve found that the one resource that most consistently trips up businesses focused on disruption is management. Senior executives too often select the wrong people to run organizational units focused on disruptive innovations. We suspect the mistakes happen when firms choose managers based upon an uninterrupted string of past successes, hoping that more successes are in store.
In our view, there is a better way that draws on the work of Professor Morgan McCall (see especially his book High Flyers). McCall asserts that the management skills and intuition that people apply are set by their experiences in previous assignments in their careers. Consequently, managers who have worked their way up the ladder of a stable business unit would likely be weak leading a start-up because the demands are so different. Note that what matters is having grappled with similar problems in the past and learned from the experience, not necessarily having succeeded.
This might seem obvious, yet when a slowly growing firm’s leaders decide they need to launch a new growth business to restore their company’s vitality, they typically tap their own most successful executives-people whose most salient experiences are likely to have little relevance to the challenges they will face.
Consider the experience of Pandesic, the high-profile joint venture between Intel and SAP that was launched in 1997 to create a new market disruption selling enterprise resource planning (ERP) software to small businesses. The explicit plan was to develop and launch a disruptive innovation in the ERP market. To lead this new venture, Intel and SAP hand-picked some of their most successful, tried-and-true executives.
So how did these managers go about seeking Pandesic’s fortune? The firm ramped to 100 employees in eight months, and established offices in Europe and Asia. Within a year it announced 40 strategic partnerships and inked agreements with major IT consulting firms that had so capably sold and implemented SAP’s large-company systems. The product, initially intended to be simple ERP software delivered to small businesses via the Internet, evolved into a completely automated end-to-end e-commerce solution.
Pandesic was a spectacular failure. It sold very few systems, and shut its doors in February 2001 after having spent more than $100 million. The problem here was not managerial incompetence; it was managers with the wrong competence. As a new venture, Pandesic faced uncertainty regarding virtually every aspect of its product design and business model, and needed leadership adept at proceeding by trial and error. McCall’s theory could have predicted this failure. For despite the extraordinary track records of Pandesic’s executives in managing the global operations of very successful companies, none of them had faced any of the challenges associated with managing a disruptive innovation.
Organizations create value as employees transform inputs of resources into products of greater worth. The patterns of interaction, coordination, communication and decision-making through which they accomplish these transformations are processes. Processes include the ways that products are developed and made, and the methods by which procurement, market research, budgeting, employee development and compensation, and resource allocation are accomplished.
When creating a new unit to exploit a particular innovation, the most crucial processes to examine usually aren’t the obvious value-adding processes involved in logistics, development, manufacturing and customer service. Rather, they are the enabling or background processes that support investment decisions. These include how market research is habitually done, how such analysis is translated into financial projections, how plans and budgets are negotiated, how those numbers are delivered, and so on. It is by not tuning these processes to the needs of new growth businesses that many managers unwittingly sabotage their own success.
The case of Prodigy Communications illustrates this principle. Launched as a joint venture between Sears and IBM in the early 1990s, Prodigy did not lack the necessary resources: over $1 billion was invested in what was at the time a very uncertain, but certainly potentially disruptive, innovation.
The original business plan envisioned that consumers would use on-line services primarily to access information and make on-line purchases, and Prodigy’s computer and communications infrastructure were designed for these purposes. In 1992, management realized that Prodigy’s two million subscribers were spending more time sending e-mail than downloading information or making purchases on-line. Rather than seeing this as signal to change strategy, Prodigy’s management sought to discourage the non-conforming behaviour, and charged extra fees to subscribers who sent more than 30 e-mail messages per month.
In contrast, America Online (AOL) entered the market later, after it was clear that e-mail was a primary reason for subscribing to an on-line service. With a technology infrastructure tailored to messaging and its “You’ve got mail” signature, AOL became much more successful than Prodigy.
We would interpret this as a failure of the strategy-making process: management’s job was defined as implementing the original strategy, and there were no mechanisms to capture and act upon feedback from the market. In our view, just as with selecting managers, selecting processes should not be a function of their past results, but the problems they were designed to solve.
The third class of factors that affects what an organization can or cannot accomplish is its values. By corporate values we mean the standards by which employees judge whether a customer’s order is attractive or unattractive, whether a customer is more important or less important, whether an idea for a new product is attractive or marginal, and so on.
When it comes to the values that impinge upon a new growth opportunity, among the most important are the expectations management has for the performance of the new business. It is not uncommon for new ventures to be measured by sales growth in the early going; after all, a start-up can hardly be expected to be profitable, can it? Profits will come later, we tell ourselves.
In our view, this is most often precisely the wrong way to measure success or set expectations. New ventures that are targeted at exploiting disruptive opportunities, almost by definition, are grappling with a host of unknowns. A new venture that is required to generate a profit quickly is forced to pay very close attention to signals from the marketplace about its answers to these questions. Somewhat perversely, driving hard for sales growth in spite of mounting losses is tantamount to ignoring market feedback telling you that the new venture’s strategy isn’t working.
An excellent example of this phenomenon at work is how Honda ended up dominating the American motorcycle market. Initially hoping to introduce “low-cost muscle bikes” to U.S. motorcycle enthusiasts, Honda stumbled badly, unable to marshal the resources necessary to overcome the technological hurdles associated with the long-haul riding that characterized the most profitable customers of Harley-Davidson and other incumbents.
Strapped for cash, Honda had to concentrate on the one product it had that was selling: its small, 50cc Supercub. Initially dubious of the merits of selling such low-priced, low-margin vehicles through, of all places, sporting goods stores (since motorcycle dealerships had no interest in what they considered to be toys), Honda’s management was forced to respond to the market rather than doggedly pursue their original strategy. What emerged was a classic disruption: beginning with unattractive market segments that had never before purchased motorcycles of any kind, Honda was able, eventually, to march upmarket and ultimately dominate the motorcycle industry.
The aphorism we have found that is most appropriate to the challenges of starting new growth ventures is to be “patient for growth, but impatient for profit.” That is, new businesses must follow the money, since that is likeliest to keep them focused on-or, as in Honda’s case, allow them to find-a truly disruptive opportunity. A new venture that can generate profit is likeliest to involve connecting with genuine customer needs, and so likeliest to be able to follow that disruptive trajectory and become a true growth business. In an almost Zen-like irony, the best way to find growth is not to seek it.
Successful growth has typically been seen as a gift from the gods rather than as the fruits of reasoned, careful and repeatable analysis. Therefore, when the outlook is uncertain, there is an understandable but lamentable tendency to restrict investments in growth, even though successful growth would be the best way to effect the desired turnaround. We believe that by answering these three critical questions you can make profitable, consistent growth a defining characteristic of your organization.