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The Innovator's Solution
The Impacts and Benefits of Disruptive Technologies
Michael Raynor, Co-author, "The Innovator's Solution" and Director, Deloitte Research
Apr 17, 2004—ne of the best known of all tales and the Greek Canon is the tale of Sisyphus. Now Sisyphus in addition to being the founder and king of ancient Corinth is also known as perhaps the most cunning of mortals. When he died, as mortals always do, he descended to the underworld and upon arriving at the gates of Hades, he met Persephone, the queen of the dead. In keeping with his reputation, he convinced Persephone that she should let him go back topside and tie up a few loose ends.
Now it wouldn’t be the height of cunning if he had actually kept his words, so it will come as no surprise to you that he spent the next ten years gallivanting about the Greek islands, and who wouldn’t given the opportunity. And the gods, when they finally found him out were so incensed at his deceit that they grabbed him, dragged him back into the underworld across the River Sticks and they set him to his punishment, which was singular in the nature of its cruelty and the nature of that punishment is what makes his tale so memorable. (Download presentation.)
He was of course set to the task of pushing a large boulder up a steep hill to a small plateau only to have that boulder pushed back down to the bottom as soon as he had completed his task, and he was compelled to do this for all eternity. Now, the French existentialist philosopher Albert Camus has decided that this particular legend is actually a pretty good metaphor for all of earthly human existence, namely, entirely pointless. I am not sure I am prepared to go quite that far, but I would suggest that the legend of Sisyphus is remarkably instructive when it comes thinking about the fate of publicly traded companies because publicly traded companies have a unique burden to bear which is that no matter how well they do, they are always compelled to do even better if they hope to deliver ever greater wealth to their shareholders.
The reason that’s true is because, at any point in time, the price of a share reflects expectations for the future and what shareholders tend to do is take any upside surprises and build it into what they expect from you tomorrow. So your reward for doing well is the requirement of doing better. Now, I search high and low for a way to capture this perversity in a single aphorism and generally, I found fairly fruitful fields dealing with Yogi Berea but I have a new favor. Now before you think this is a political statement, understand I’m Canadian, so this is just neighborly good fun. But I am not sure if the 43rd president intended to be insightful with this statement, but I think he got it right, just about right. He said: "I have found that expectations rise above that which is expected." Of course, when it comes to publicly traded companies and their share prices and expectations for the future that’s precisely what happens.
Now the bad news is when you look at the large-scale empirical studies of whether or not any organization can in fact repeatedly push the boulder to the top of the hill, what you find is actually a pretty dismal conclusion. A number of studies were published in 2001. Although the methodologies differ at the margin and the findings consequently are different at the margin, the bottom line is remarkably consistent.
Profit from the core book published by two consultants from Bayne concluded that 13 percent of all companies in their sample had managed to grow persistently and profitably over any meaningful period of time. Good to great, Jim Collins’s book, his number was 9 percent, is fantastic piece of work, but the only thing that’s wrong with it is that it’s still outselling me. The stall point study done by the corporate strategy board, their number was one in twenty and finally two consultants from McKenzie and Company concluded that no company had ever grown profitably for any meaningful period of time. What that suggests then is that organizations that seek to push the boulder up the hill repeatedly or probably what Ambrose Bears would have referred to, as an optimist.
Now, it’s worth understanding why this is the case. Why is it so difficult for companies to grow persistently and profitably over time? You might want to suggest that that’s a fairly involving complex question, and there’s really no one answer. I’d be inclined to agree; there is no one answer. There are, in fact, two answers, and only two and which answer applies depends on which type of failure you’re trying to explain.
Before explaining failure, however, I’d like to go through a way of thinking about how companies actually become successful in the first place. What we’ve graphed here is performance on the vertical axis over time on the horizontal axis. The performance of a product in a product market at a point in time is going to be a function of any number of product attributes and characteristics and the various trade offs that customers make when they make a purchase decision. So in an automobile, for example, the performance would be the conjoint of its acceleration, its top speed, its safety rating, its gas mileage, its roominess, its comfort, its after sales service and so on.
Now the performance that mainstream customers are willing to pay for increases over time but fairly slowly. There is a way to think about that in the extreme. Imagine that somebody had come up with a 300 horsepower mini van in 1915. Wouldn’t be much use because you didn’t have anything drive it on. It would be a mistake, of course, to think of the market as simply a point estimate. There is a distribution of customers with different needs, and we’ve captured that here with a normal curve tipped on its edge. There are some customers in a market that are satisfied with very little at the low end of that distribution and some customers who are extremely demanding, who are not satisfied with even the best that the most sophisticated sapphires can provide them. We’ll go plus or minus one standard deviation and call that the mainstream market. Now when products are first introduced into a market, they tend not to perform particularly well. That’s not because companies aren’t trying hard or because engineers are stupid; it’s simply because products almost always get better once they are introduced into the market. So when they first enter they perform very poorly compared to what they ultimately will deliver.
Now if you’re lucky, an organization can find some small sliver of the market that is willing to pay for a technology as it is introduced into the market and if you find that sliver those least demanding consumers who will pay for what you are able to give them, you get to get on the upward escalator at the birth phase of your product lifecycle. A good example of this would be mobile telephony. When mobile telephony was first introduced in the early 1980s, it performed very, very poorly compared to its alternative, namely, wireline telecommunication services. The coverage was awful; the calls cost a fortune; calls were always getting dropped; the quality was terrible. In some sense, I guess some things never change. That was a line actually given to me by a wireless provider, believe it or not.
Well-managed companies, however, understand by looking up market, if they are able to deliver a series of improvements in their product or service faster than the various segments of the market are able to absorb those improvements, they will be able to build a rapidly growing and profitable business. This is a key cornerstone concept in disruption theory, so it’s worth spending a minute or two on this. Just do the thought experiment in your own minds. Think about the slope of that red line. If the slope of that red line were the same as the dashed straight lines, an organization would spend its entire existence in the birth phase of the product life cycle. It would never catch up with the needs of the mainstream market.
So successful companies, of necessity, improve their products or services faster, since various segments of the market can absorb those improvements. Now the dark side of this particular phenomenon is that eventually and almost inevitably, companies end up overshooting what even the most demanding tiers of the market are willing to pay for. Having built an organization that is a finely tuned machine that is able to deliver year after year a never-ending series of improvements in particular types of performance characteristics, they find themselves in the mature phase of the product life cycle, not because they’ve done anything wrong but because they have continued to do all and only the same things right. In a very real sense, the mature phase of the product life cycle is the mirror image of the birthdays. In the birthdays, you have very few customers because your products are so bad. In the mature phase of the product life cycle you have very few customers because your products are so good.
Now companies move up this trajectory of performance improvement by a series of either small hops forward, what we might call incremental innovations, or sometimes there are giant leaps, what we’ll call breakthrough innovations. But either way they’re what we refer to as sustaining innovations. The reason we say they are sustaining, sustaining innovations sustain an organization‘s movement along a particular trajectory of performance improvements. Now staying on your industry’s sustaining trajectory of improvement is absolutely crucial to the success and indeed the survival of any organization.
It’s impossible to over state the importance of delivering a series of sustaining innovations in order to be a successful company. To illustrate what can happen if you fall off that sustaining trajectory, I’d like to spend a minute or two talking about the tire industry. Now you might not think the tire industry is a particularly exciting industry, but I tell you in 1915, Akron, Ohio was the Silicon Valley of its day. There were over 450 tire companies competing in things like basic rubber chemistry, tread design, all the things that made tires better, and they were competing for the business of the most important customers of the day, namely the OEM Manufacturers of automobiles—Ford, General Motors, the Dodge Brothers, the Chrysler Brothers, the Oldsmobile Brothers and so forth. Inevitably, there was a shake up, you can’t have 450 companies competing in a capital-intensive business when there are very few customers to serve and the best managed and most innovative of those customers became the dominant players in the tire industry. Firestone, Goodyear and Michelin among them.
Now the dominant technology for the next several decades was essentially bias-ply tire technology. Now in the early 1950s, there was a new technology on the horizon, radial tire technology, and there was nothing about radials that wasn’t better that bias-ply. They lasted twice as long, they cost half as much, they were safer, they had better gas mileage everything was better about radials. Recognizing this, Michelin made a big bet on radial tires in Europe. They retooled a lot of their factories; they shut down a lot of their capacity because, after all, if something lasts twice as long per unit, at a stroke you’ve got 100 percent excess capacity.
Michelin made a big bet and rolled up the market in Europe and then decided to come across the pond and take the fight to the tire manufacturers in the U.S. Seeing this Firestone decided that it was going to stick with bias-ply. It felt that bias-ply, in fact, is a technology that still had a lot of miles in it and it made sense to remain committed to that technology in order to provide what it felt the customers wanted. It ignored some pretty obvious signs that, in fact, its most important customers wanted something else.
The following anecdote probably illustrates that in sharp relief. The Ford and Firestone organizations, you may recall, had a relationship going back decades, and the families were in fact intermarried. Indeed, every year the chairman of Ford sent the chairman of Firestone a new Lincoln and one year that Lincoln showed up with Michelin radials on it. Now, you’d think the chairman of Firestone would respond with, "Oh my god, we better figure out how to make radial tires." In fact, the minutes in the board meeting revealed this, his response was, "Get those frog tires off my Lincoln."
The structure of the industry fundamentally changed. Michelin went to the head of the class. Firestone fell to the bottom and indeed Firestone lost its independence as a company and was eventually purchased by Bridgestone. Goodyear is an interesting intermediate case because although it wasn’t first to the radial tire technology party, it in fact bit the bullet, made the changes, retooled the factories, shut down the capacity, did all the things it needed to do in order to stay on the sustaining trajectory that defined its industry’s basis of competition.
I don’t want to underplay the importance of sustaining innovations. They are absolutely critical to the survival and prosperity of any organization. So that’s one way to get beat. You can get out sustained. You can fall off the sustaining trajectory. But there’s another way to get beat, and that’s to get disrupted and getting disrupted plays out in a completely different way.
Note here where I’ve drawn this green arrow. The folks on that red trajectory right then, they are in the sweet spots of their product life cycle. They have caught up with the needs of the mainstream markets, they have built finely tuned machines and every time they deliver a new innovation to the market that innovation is rewarded with either greater market share or higher margin. Life is sweet, and yet they’ve already left behind half the market. That is to say they are already providing a level of performance that is more than good enough for about half of customers, who given a choice would not only take more for less—we would all always take more for less—but those folks would actually be willing to take less for less, if only they have the option.
It’s that fact that allows a new entrant to find its own foothold, to find some fertile soil in which it can explore an alternative way of delivering products or services to essentially over served customers. But once they find their foothold, once they are in the birth phase of their product life cycle exactly the same forces that propelled us up the red curve propel us up the green one. And the new entrant will deliver its own series of incremental and breakthrough innovations as it pursues its own sustaining trajectory of innovation until it finally catches up with the mainstream market even as our erstwhile incumbents have essentially left everyone behind. To give you an example of disruption think about the evolution of Sears.
Sears got its start in store-based retail sometime in the late 1920s or early 1930s, and they had started, of course, in catalogs, and they had built a truly remarkable supply chain management system. They were able to survive on products with 60 percent gross margins because they were able to turn their inventory two to three times a year. Sears had 40 percent gross margins to turn their inventory about three times a year compared to the established retailers of the day who needed 60 percent gross margins and turned one and a half to two times a year.
As a consequence of a truly innovative and truly superior supply chain, Sears was able to roll its business model out to cross all of the U.S., across North America and eventually worldwide. It was able to build a highly successful retailer based on this remarkable set of supply chain innovations. Now in the late 1960s, Wal-Mart got its foothold in Arkansas. It had to develop an entirely new approach to the supply chain in order to sell very low-margin product to essentially largely unattractive segments of the market place. They found a way to build a supply chain that could turn inventory six times a year and survive on 20 to 25 percent gross margin.
As they grew, they presented Sears with a series of rather interesting decision. Wal-Mart would open a location in a small rural area where Sears either had no presence at all, in which case Sears would feel no pain, or they would open a location in an area where Sears had at best a marginal presence. And so Sears had a choice to make. They could either invest money in order to fight against a competitor that had a structural advantage in a market they didn’t really care anything about or they could abandon that market and redeploy the capital in markets where they could in fact make a great deal of money and being smart managers of course they closed down the marginal operations, redeployed the capital to the profitable ones and continued to grow.
But of course that simply gave Wal-Mart the fuel, the oxygen it needed to perfect its business model and find its own up market margin its own way to expand its business model across the U.S. and around the world until finally today, Wal-Mart is $270 billion company and to put it politely Sears isn’t. In other words, Sears has been disrupted. This is a very different way to fail if you will. Firestone failed because it got beat by smarter, better competitors who did a better job at delivering better technology to exactly the same set of customers that Firestone was trying got compete for. Sears got disrupted in the retail space because it made all the right decisions with respect to an upstart entrant competing for markets it really didn’t want anything to do with in the first place.
In other words—and I’m paraphrasing here Andy Grove, the former CEO and current chairman of the board at Intel: “If you want to kill a mediocre company that takes mediocre management. But if you want to kill a great company that takes great management.” What we have here is the cover of Forbes magazine from January of ’99. That’s my co-author and good friend Clayton Christians standing next to Andy. And Clayton had done a number of presentations at Intel and Andy came up to him and said this at the close of one of those talks. He said, “So you’re telling me Clayton that if I build a great company that relentlessly delivers better products to my most profitable and most valuable customers, I’m doomed.” And Clayton said, “Yeah Andy, that’s about the size of it.”
Now I’d like to give you a couple of concrete examples to show how this actually plays out in the real world. I’ve graphed here a dimension of performance, which is storage capacity measured in megabytes and time across the horizontal axis, and I’d like to talk about the evolution of the computer industry and the disk drive industry in particular. For a long time the most important market for disk drive manufacturers was the mainframe computer business and this dash line represents the mainstream markets in the mainframe market for disk drive capacity. Now, the upper limit of what the disk drive makers were able to deliver is represented here by this green line and what you see is that the best disk drive makers were delivering more than the mainframe computer makers could actually absorb. The reason it did that is because of a perfect business sense to do so. That was how you were able to sell the highest priced, highest margin equipment to the most demanding segments of that market.
Now in the late 1970s, the minicomputer market got started, and a couple of engineers of the 14-inch disk drive makers said, “Hey I’ve got a great idea. Why don’t we make these really small 8-inch disk drives and will sell them for a lot less money with lot lower margins to companies you’ve never heard of that don’t have any customers. Does that sound like a good idea?" Well of course, it doesn’t sound like a good idea, and so they were turned down flat. They had to leave their companies and start their own organizations and they started selling 8-inch disk drives to minicomputer makers.
Now of course these minicomputers got better and better and better. They started to displace mainframe computers. In addition to that, the 8-inch disk drive makers continued to improve the capacity of their 8-inch disk drives until finally they intersected with the requirements of the mainframe computer market and they had it all. They disrupted the 14-inch disk drive makers even as minicomputers disrupted mainframes.
This movie has a sequel. The desktop computer market got started in the early 1980s and a number of engineers of the 8-inch disk drive makers said they’ve got a great idea: “Let’s make smaller disk drives that store less data. We’ll sell them for less money with lower margins to companies you’ve never heard of that don’t have any customers. Doesn’t that sound like a great idea?” And once again the answer was no. You think somewhere in the mist of their memory they might have remembered something that happened three years ago, but no, it wasn’t such a great idea and so of course they founded their own firms. They started making 5-1/4-inch disk drive technology in exactly the same scenario played out. The fourth installment was the notebook market and once again exactly the same series of events played out, and people had to leave and start their own organizations in order to build the next form factor and disk drives ultimately disrupting the previous generation of computers.
This doesn’t happen only in high and fast moving hi-tech markets. You see it in basic industries as well. The steel industry has its own measures of quality, things like manufacturability, number of chemical impurities, hardness and so forth and time across the horizontal axis. The various segments of the market are represented here by rebar, that’s reinforcement bar something that gives concrete its structural integrity, other bars and rods angle irons and so forth, structural steel those are I beams things that are used in skyscrapers and so forth and then finally sheet steel that goes into automobiles and appliances.
Now, if you were a manager at an integrated steel mill—an integrated steel mill is a mill which coal and iron ore in one end and gives you flat rolled sheet steel at the other—you would spend all your time trying to figure out how to make better and better steel for the structural steel and sheet steel business because that’s after all where all the volume and all the profit was. As the numbers would suggest here almost 4/5ths of the total volume and well over 4/5ths of total profit lay in those most demanding tiers of the steel market. Now in the late 1970s, mini mill technology really started to make a run and they finally figured out how to make rebar. Mini mills use electric arc furnaces in order to melt down scrap steel, but they really could only make very, very low quality steel, steel that was just good enough to use in rebars. Rebar after all is immediately encased in concrete so it’s very difficult to do after the fact inspection and as a consequence they were able to find their foothold.
Now if you were a senior manager at an integrated mill, and you started to lose your rebar market to the mini mills, what do you think your reaction would be? Not only would you not care, you’d probably send them a thank you card. You only make rebar so that you’ve got a full product line for your structural steel customers anyway. If somebody will take that off your hands and free up that capital so that you could invest it in high margin sheet steel, that’s a god send. But an interesting thing happens. Once that oxygen is given to the mini mill technology, they look up market and say, “Look at that volume in bar and rod, look at all that margin, if only we could figure out a way to improve our technology just enough that we could catch up with the needs of those segments, we would have a healthy growing profitable business."
And so they figured it out. They surmounted the technological hurdles associated with making bars and rods. And they got another thank you card from the integrated mills because, after all, that’s only 8 percent of their total tonnage, far less than 8 percent of their total profitability, and allows them to deploy their capital to more profitable uses. But then the third installment is they figured out how to make structural steel and finally they figured out how to make sheet steel and, by the time that happens, the integrated mills have nowhere left to run. By the late 1980s, Newcore the most successful of the mini mills had a market capitalization that was equal to the market capital of the all the integrated steel mills combined. They had been effectively disrupted. The point here is not that these managers were stupid. The point is they got disrupted because they were so smart. They did all and only the right things right off a cliff.
Now we’ve learned a few things in the years since the Innovator’s Dilemma was published in 1997, and we think perhaps one of the most useful distinctions is between what we’ll call low-end and new market disruption. What we have graphed here is the classic what we call surface to air missile chart, or SAM chart of disruption. We have a single market where an incumbent on the red line essentially overshoots the needs of the mainstream market, a new entrant comes in from beneath and disrupts from below.
Overshoot by the incumbent is a critical antecedent to actually getting disrupted by the new entrant because, after all, until you overshoot the needs of the mainstream market, new entrants can’t come up with an alternative way to serve them because customers are rewarding you for delivering more of what you’re already best at. But once at least some of the market has been left behind, it is possible for the new entrants to gather to find what we call a foothold market. That foothold allows them to perfect a particular way of delivering customers with a different set of performance requirements and so they can effect their up market march, getting better and better and better until finally they are able to compete for mainstream markets from a position of structural advantage.
That’s low-end disruption. And that’s the story of the mini mills because when the mini mills got started, they weren’t selling rebar to people who hadn’t been consuming steel. They went to existing consumers of steel and said, “What do you say we’ll sell you the same thing for 30 percent less?” And then they were able to improve the quality of their steel using their alternative technology.
New market disruption is a little different. Here we come out into the third dimension where we have a different measure of performance and as a consequence, the new market disruption turns on a shift in the basis of competition. But the notions of foothold and up market march are essentially identical. Interesting enough, however, in a new market disruption what happens is that whereas in low-end incumbents see the disruption but don’t care. With the new market disruption, they don’t even see it coming. Eventually the new entrant gets good enough that they start drawing customers across onto their particular platform and disrupt if you will from the side. That’s the disk drive story. When the 8-inch disk drives got started the 14-inch disk drive market continued to grow and be highly profitable for a significant number of years. It wasn’t until the 8-inch disk drives had caught up with the needs of the mainframe market that that market finally collapsed at a stroke.
I’d like to unpack each of these characteristics because I think it provides some additional insight into how disruption plays out. First of all, overshoot by the incumbent is absolutely critical. No overshoot, no disruption. What I’ve graphed here is the decline in price for a number of generations of Intel chips, and you can see that initially those chips actually enjoyed a fairly long life span in the market before they finally were removed. Indeed the 8386GX stayed in the market for 75 months and fell in price 67 percent before it was finally withdrawn.
The Pentium 4 on the other hand was in the market for mere eight months and suffered a similar 67 percent decline in price. Despite the fact that the performance of the chips improved over that time period almost 200 times in both processor speed and processing power. What that suggests to me then is overshoot because customers are no longer willing to pay for the kinds of improvements that Intel was at that time providing. By the time you get to the Pentium 4, there are a few freaks who are willing to pay for a 4-gigahertz chip but once you sold to those twelve people, you’ve got to cut the price to almost nothing before anybody else is interested.
People will take more but don’t expect them to pay for it and that’s the signal of overshoot. This notion of shifts on the basis of competition is also something worth dwelling on for a moment. We’ve illustrated here the threshold of customer needs and we found it useful to think about these needs in terms of functionality reliability in convenience and price and what we found is that when products were first introduced into the market functionality is the basis of competition. People simply want something that works. And so companies compete to deliver more and more functionality.
But as a consequence of the various mechanisms that lead them to overshoot what customers are willing to pay for, what opens up is a shift in the basis of competition from functionality to reliability. Companies must now compete to deliver more and more reliability to their customers. Even if that means giving back some of the functionality because, after all, that was an overshoot anyway. But once you had over shooting, the liability, the basis of competition shifts to convenience, companies compete, overshoot, give back the reliability and then the same thing happens with price.
Now you think once we get to price as the basis of competition we have a classically commoditized industry. Everything is the same; the only thing that matters is what it costs. But remember, what we’re illustrating here is something in cross-section, which is to say we’ve held the threshold of customer need static. Remember that initial chart. That dashed straight line actually had a slope to it. Over time the threshold of customer needs actually increases, and we find ourselves slowing back into a state of affairs where functionality is once again the basis of competition and so companies compete trying to deliver more and more functionality even if that mean they have to charge slightly more.
I’d also like to underline the difference between a foothold and a niche. So you know I work for a consulting firm, I’ve got a 2/2 in the presentation. We’ve got customer performance requirements, low and high, and the cost to serve, low and high. And in the hotel industry these two organizations in their heyday illustrate highly successful segmentation of the market and each served their respective niches extremely well. The Four Seasons was founded by Isadore Sharp in 1960, and he pioneered a lot of the innovations in high-end hotel services that many of us have come to take for granted.
Holiday Inn was founded in 1950 by Joseph Smith as a result of a cross-country road trip where he was faced with highly inconsistent, he felt highly exploitive roadside hotels and motels. So he created the Holiday Inn, which was enormously successful serving the low end of this market. But once Holiday Inn had essentially wrapped up that slice of the market, it decided that it needed to grow, and in order to grow, it tried to serve ever more demanding tiers of the hotel market. But in so doing it was unable to exploit any particular structural advantage and so it ended up simply competing in exactly the same way as other high-end hotel providers competed and it hasn’t been particularly unsuccessful but it hasn’t been particularly successful either. Certainly nothing like a disruption.
Contrast to that was the battle between Canon and Xerox in the copier market. Initially, Xerox had very high performing, very expensive, very large photocopiers. They seemed to invariably called big Bertha. Canon on the other hand had very small desktop photocopiers that were very slow, very low image quality but as they got better, they found themselves able to fundamentally break the trade offs that had defined competition in the copier market. They got to the point where they were able to provide very small copiers that provided very high quality, very fast copying with all kinds of features that previously had only been available on high-end Xerox machines. In other words, a niche exploits a trade off.
A low-end hotel and a high-end hotel are very, very different creatures and a low-end hotel can compete for high-end customer without becoming a high-end hotel it has to deal with the trade offs that define competition in the industry. What Canon did, however, is it managed to break the trade offs that defined competition in the industry. Finally, the up market march. We’ve made it sound as if disruption happens just because, but in fact disruption is fundamentally a choice.
Here I’m talking about established providers of financial services and they compete on the basis of the breadth of the services they offer and national reach that they provide. There’s a new dimension of competition here, a shift in the basis of competition to things like cost and service, and there I think oddly enough credit unions have a very interesting advantage. You see a lot of banks getting back into branches these days, but fundamentally their culture has become largely antithetical of the high-touch low cost service, something that credit unions have never abandoned.
Now the bad news for credit unions is that their traditional market is fundamentally in decline. There’s really no more growth to them there. But what they could do is choose to improve their services in ways that allow them to compete for mainstream financial services companies from a position of structural advantage with respect to their ability to provide high touch comparatively low cost service. That’s not something that comes naturally to credit unions, they’re interested structurally in things like used car loans and Christmas funds getting into brokerage services is not something that they feel particularly comfortable with. But if they were to choose that path they would be on an up-market march seeking to disrupt established players.
I’ll give you a couple of examples that are playing out even as we speak. When it comes to retail gasoline, the basis of competition has long been the quality of the fuel and the convenience of getting it. Ever since Standard Oil from the turn of the century up through British Petroleum today, [companies focused on] ever-higher octane. In Canada, Petrol Canada tells you that you should buy their gas because they pre-add the gas line antifreeze. So that’s the basis of competition.
The overshoot, I think, is evidenced by the fact that ten years ago 60 percent of all fuel in America was high-octane fuel. Today only 40 percent of all fuel sold is high-octane fuel. I had this conversation with oil industry executives, and their response is: "Clearly we need to put more octane in the fuel." That just doesn’t seem right to me. If people aren’t buying the highest octane fuel you’ve got, what makes you think they’ll buy even higher octane fuel. A little company you’ve all heard of called Wal-Mart has its foothold selling much lower quality gasoline in far less convenient locations. Very few Wal-Marts are at the intersections of busy streets. They tend to be on the outskirts of town, fairly cheap real estate not particularly convenient to get to but that’s fine with their customers who are willing to take all of those inconveniences in order to get gas for 14 or 15 cents a gallon less.
Wal-Mart’s up market march will be to find a way to improve the convenience and the range of products provided without sacrificing its structural advantage. And that’s what will allow it to disrupt the established oil majors. Now the oil majors are concerned about Wal-Mart. Today they have about a 170,000 retail outlets. Wal-Mart has around a thousand, I think. I’m not about to tell them not to be scared, but as I suggested, it’s not clear to me that all of them are responding in an entirely optimal way. After all once you’re already in overshoot, trying to compete by giving your customer more of what they already have too much of just doesn’t seem to compute.
And taking disruption to heart, many of you are, I’m sure, familiar with cardiac crash carts—those things you see on ER. You know, the little buggies they wheel down the hallway and somebody else clearing and the body leaps up in the air. Those are enormously sophisticated pieces of equipment. They cost over $20,000, and they have to be operated by highly trained very capable technicians and companies that provide this technology have been improving cardiac crash carts over time to make it possible for them to deal with an ever-broader range of cardiac events.
So the basis of competition was therefore the effectiveness of the machine. But as a consequence of building these things to deal with any kind of myocardial infarction or any kind of defibrillation, they fundamentally got themselves into overshoot because if we deal with 99 percent of everything, well then by definition you’ve overshot just about everybody. As a consequence there is a new type of technology that I’m sure many of you have seen. The shift in the basis of competition here is ease of use, price and compactness and that’s the automatic external defibrillator, the AED.
I’m sure you’ve seen them in airports and convention centers and so forth. The foothold markets are the markets I’ve just described. Where the alternative is not a high-end machine operated by a highly trained technician but rather some good Samaritan who if you’re lucky will only break your sternum in trying to deliver CPR. So the bar is pretty low that as long as an AED does better than that, it’s better than the alternative and so it can get started.
Now AEDs are still worse than cardiac crash carts. With all due respect, if I were having a cardiac event, I would rather have a crash cart and a cardiologist than an AED and one of you, and I’m sure you would all make the same choice. But one day, the AEDs will be good enough and I would argue one day soon. In fact, I don’t think it’ll be too long before instead of having high priced, highly effective crash carts operated by highly trained rare technicians, there’s going to be an AED on the walls of every single examining room and every emergency room in America and everybody but the candy strippers will be able to save your life. That’s disruption.
Now here where we start thinking about RFID because I wanted to put a lot of this vocabulary in place so that we could think about how this theory might shed some light on something that you spent all of your time thinking about. First of all, I’d like to point out that disruption fundamentally is a relative term, and I’d like to illustrate the relativity inherent in something like disruption by talking about a previous technological phenomena and that there is a lot of similarities to RFID namely something that’s been around for decades but all of a sudden seems to be everywhere for the first time and that of course is the Internet.
In the late 1990s, it wasn’t uncommon for people to ask if the Internet disruptive and a lot of people would assert that it was. What I’d like to suggest is the Internet was not inheritably disruptive or sustaining it was simply an innovation and whether it was a disruptive or sustaining speaks to the business model to which it was applied. To see that, think about the nature of the competition between Compaq and Dell in personal computer market. Compaq competed through third party distribution channels and they had enormously difficult time responding to Dell’s innovations with respect to direct consumer retailing, and Dell was doing that on the telephone for years before the Internet came along.
When the Internet arrived, it allowed Dell to do still better all and only the things it had previously been trying to for all and only the customer segments that he had been serving or trying to serve better. When it came to Compaq, however, the Internet was yet another disruption to their established business model and so the Internet was sustaining to Dell as it affected its up-market march and disrupted Compaq.
There’s another way in which, however, the Internet was fundamentally disrupted and that has to do with market making. You can think about classified advertising in newspapers or auction houses like Sotheby’s and so forth where organizations essentially try to make markets by bringing buyers and sellers together and the quality of their market making determined how well they competed with each other. You wouldn’t put a Van Gogh in a classified ad and you wouldn’t take your old sweatshirt and try and sell it to Sotheby’s.
An entirely new mechanism for making markets, however, came along enabled by the Internet and there it was defined by ease of use and the cost required to deliver it. And there eBay was able to use the internet as a way to disrupt established market making mechanisms via a new market approach by bringing into the market people who had previously not thought to ever put things in classified ads or take them to auction houses. A whole new group of consumers was brought into the market and eBay made that possible with the Internet. So here the Internet was used as a fundamentally disruptive innovation. When it comes to thinking about RFID then, what I’d like to suggest, is that it’s applications and not technology that determine whether or not something is disruptive.
Think again about retail, something I’m sure you’ve been thinking a lot yourselves. Service and support are fundamentally the basis of competition or at least one way of thinking about it, and full service department stores have been moving up their own sustaining trajectory. They have been fundamentally disrupted by discount retailers, such as Wal-Mart and Target, and there I would suggest that RFID is fundamentally sustaining to those discounters but disruptive to the full service retailers.
So is RFID disruptive? Well, it depends. The good news is we can tell you what it depends upon and it depends upon the applications to which it is put and the business model in which it manifests itself. In the payment space, I would suggest it’s possible to think about RFID having potentially disruptive applications. If you think about the credit facility and affinity points and so forth that are provided by the credit cards and debit cards, provided by the established mainstream providers Visa and MasterCard and the major banks come to mind. Another is ease of use in convenience, a completely different dimension of performance forming the basis of competition and there you can see a lot small payments being executed using RFID technology.
This is a logo from Dexit, which is a Canadian based service provider that’s just getting off the ground. They’re essentially competing with cash. They’re not trying to be a better debit card or a better credit card. As a consequence if they’re successful the credit cards companies won’t even see their growth because they are taking transactions that the credit cards companies never had in the first place. But if they get better, if they are able to execute their up-market march, eventually they may well get good enough that they can finally disrupt established providers. Now what about the supplier side. We’ve talked about applications there are many companies that supply RFID technology. Can they use disruption theory to think about their growth? There are of course several Goliaths, if you will Texas Instruments.
[tape is inaudible]
But David had a chance. And part of the reason is because historically when small companies have defeated large ones, we get this mythology in our head that somehow their victory was preordained. What we forget is that in many instances there are 50 Davids and one Goliath, and one of those Davids happened to emerge victorious. And it has been very difficult to determine who was going to be the victor. And so what I like to suggest is that it’s possible for organizations to do a much better job of disrupting, on purpose.
First of all when it comes to products, sustaining battles are driven by people delivering better products. But when it comes to disruptive innovations and disruptive strategies worse products carry the day so long as they get better. An example here is Southwest Airlines. Southwest got started providing very low levels of service to people whose only alternative was a greyhound bus. But as a consequence of improving the quality of their service will have sacrificing their structural advantage, they got good enough so they can now compete for mainstream markets from a position of structural advantage.
When it comes to customers, incumbents tend to follow the money because that’s what successful incumbents do. They go after lots of customers who have lots of money to spend. Because that’s what good managers are supposed to do. But if you want to execute a disruptive strategy, that means staying away from the incumbent. And the corollary of that is going where there are very few customers, who’ve very little money to spend. Think about Sony. Sony got started in 1958 selling transistor radios, very low-powered radios with very low sound quality. They were awful radios by every measure. RCA, the dominant player of the times, said, "We can’t use transistors, even though we spent billions trying to figure it out, because our customers want high-powered high quality radios. And besides who else buys radios but our customers? We have almost the whole market."
Well, Sony, of course, found someone who was willing to put up with the low power, low quality radio, namely teenagers looking to listen to rock and roll out of the earshot of their parents. Sony, if you will, found this foothold in the rebar of humanity. They even got better and better and better, until finally they find themselves being incumbents in the consumer electronics base themselves, striking with disruptions. It’s important to understand that when it comes to affecting a disruptive innovation it’s not about digging a deep hole and filling it with cash and hoping for the best. Successful disruptive innovations haven’t been variably profitable from the start because they served a very real need. That is to say, they find the birthdays of their own product life cycle, and they don’t try to short circuit the process.
The way we think about this is as an aphorism is to be impatient for profit but patient for growth. That’s the story of Honda. When Honda invaded the U.S. motor cycle markets in the 50s, it wanted to take on Harley Davidson in muscle bikes, and it spent its effort trying to make better and better high-end muscle bikes to the most demanding consumers of motorcycles in America. But they could never compete with the British and American manufacturers of those high-end bikes.
In fact, what they found themselves doing was constantly selling off Super Cubs that they had brought over more as a joke than anything else. In order to raise cash to fund their efforts to penetrate the high-end motorcycle markets. And after five years of being wildly successful selling bikes they had no intention of selling, someone finally said, "You know what, why don't we just sell the ones they actually wanna buy?" The strategy is never easy but it’s sometimes obvious. And what happens to Honda is that the consequence of making that shift they were able to exploit that foothold and improved the quality of their motorcycles and build the structural advantage that finally enabled them to compete for mainstream market in a way that Harley Davidson had no hope of responding.
Now I have seen bad news for disruption, which is that unfortunately it’s not a recipe for easy money. You still have to solve the hard problem and you have to do it better than your competition. Newcore had competition in the mini mill market, namely Shapiro. And it had to beat Shapiro in the mini mills. And it also had to figure out some very challenging technical hurdles. And furthermore disruption theory allows you to find what’s going to be profitable next, not what’s going to be profitable forever. Believe me, if I had a recipe for finding a very simple problem the answer to which immediately resulted in perpetual wealth, I wouldn’t tell you. So you gotta ask yourself a question: Is disruption really such a good idea after all? Because, somehow we’ve got terrible products that we sell to bad customers with uncertain growth prospects. It’s very hard to do when you have to do it over and over again.
And so I’m reminded of this passage from the New Testament which is that, “It is easier for a camel to go through the eye of a needle”—I’ve changed that a bit—"than for a disruptive business to be approved by the capital budgeting committee. The bad news is there’s simply no other choice. Companies have no choice but to seek to grow. Every company has been dammed by push-ups only, to push that boulder up the hill for all of eternity.
The good news is that repeated disruption makes persistent growth at least possible. And so what Winston Churchill said of democracy I might say of disruption: It is the worst possible form of innovation strategy—save for all the others that have been tried. I’d like to suggest that it is in fact possible to learn new things and to do things that have never been done before. And by way of analogy I’d like to talk of the history of human flight briefly.
I think that human flight has probably been a dream of humans since we’ve been able to dream. And we tried all kinds of crazy things to make it happen. Everything from feather covered wax wings to some more of the more possible schedules from Da Vinci’s notebook. But no matter how hard we tried we couldn’t figure it out. And many centuries, indeed many millennia later, and many tens and hundreds and perhaps thousands of highly innovative would be fliers lying in humble heat at the base of tall church steeples. We still haven’t figured out how to fly, until one day we did. In 1903, in Kitty Hawk, North Carolina, the Wright Brothers did what had never been done before - controlled powered flight, not floating in a balloon, not gliding off a cliff – controlled powered flight. And the question is what changed? Where the laws of Physics suspended such that what had previously been impossible had now become inevitable? Of course not. What changed was they figured it out. They solved the key engineering challenges around lift, and airfoils, and they were able to do what no one had done before.
So I’d like to conclude by suggesting the following, which is that although no one had ever disrupted repeatedly and purposefully in the past, I’d like to think that the disruption theory is beginning to make possible what has never been done before. Most companies had to satisfy themselves with pushing the rock up the hill at once if they are lucky, the very very few perhaps twice. But I firmly believe that some organization is going to figure out how to push the rock up the hill repeatedly. Some organization is going to figure out how to apply disruption theory and do what no company has ever done before.
And so my question to you is: Why can’t it be yours?
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