The Innovator's Dilemma by Clay Christensen

These are the notes I have taken while reading The Innovator’s Dilemma by Clay Christensen. While one of the most influential books in the technology industry, I didn’t take notes the first time I read this book and have a completely different context on the book now in comparison to when I first read it.

Additional notes I’ve taken while reading other books can be found here.

Introduction

Good management was the most powerful reason why they failed to stay atop their industries. Because they listened to their customers, invested aggressively in new technologies that would provide their customers more and better products of the sort they wanted, and because they carefully studied market trends and systematically allocated investment capital to innovations that promised the best returns, they lost their positions of leadership.

Widely accepted principals of good management are, in fact, only situationally appropriate. There are times at which it is right not to listen to customers, right to invest in developing lower-performance products that promise lower margins, and right to aggressively pursue small, rather than substantial, markets.

Insights from the Disk Drive Industry

Manufacturers of 14 inch disk drives were held captive by their customers. Mainframe computer manufacturers did not want an 8 inch drive. They wanted drives with increased capacity at a lower cost per megabyte. However, these 8 inch drives ended up being used in minicomputers - a market that didn’t exist at the time.

The fear of cannibalizing existing products is often cited as a reason why established firms delay the introduction of new technologies.

If new technologies enable new market applications to emerge, the introduction of new technology may not be inherently cannibalistic. But when established firms wait until a new technology has become commercially mature in its new applications and launch their own version of the technology only in response to an attack on their home markets, the fear of cannibalization can become a self fulfilling prophecy.

The established companies were aggressive, innovative and customer-sensitive in their approaches to sustaining innovations. However, they failed to find new applications and markets for their new products - an ability they once had upon entry to the market but then apparently lost.

Value Networks

An organization’s historical choices about which technological problems it would solve and which it would avoid determine the sort of skills and knowledge it accumulates. When optimal resolution of a product or process performance problem demands a very different set of knowledge than a firm has accumulated, it may well stumble.

Value Networks: The context within which a firm identifies and responds to customers’ needs, solves problems, procures input, reacts to competitors, and strives to profit.

Value networks exhibit different rank-ordering of important attributes, even for the same product. Parallel value networks can be built around different different definitions of what makes a product valuable and may exist within the same valuable.

Value networks go beyond the attributes of a product. Examples include a selling directly to end users or a field service network. Both are costs incurred to provide products and services customers in the network value.

Historically 14 inch disk drive makers had to maintain 50-60% gross margins to cover the overhead cost structure that their value network required.

Compared to the PC value network, which is profitable with gross margins in the 15-20% range.

• Built with proven technology component purchased from vendors (no R&D)
• Manufacturing and assembly are handled in low-cost regions
• Sales are via national retail chains or mail order

The attractiveness of a technological opportunity and degree of difficulty a producer will encounter in exploiting it are determined by the firm’s position in the relevant value network.

Technology S-Curves & Value Networks

The Technology S-Curve:

In the early stages of technology, the rate of progress in performance will be relatively slow. As the technology becomes better understood, controlled and diffused, the rate or technological improvement will accelerate. But in its mature stages, the technology will asymptotically approach a natural or physical limit such that ever greater periods of time or inputs of engineering will be required to achieve improvements.

The essence of strategic technology management is to identify when the point of inflection on the present technology S-curve has been passed, and to identify and develop whatever successor technology rising from below will eventually supplant the present approach.

The inability to anticipate new technologies threatening from below and to switch to them in a timely way has often been cited as the cause of failure of established firms and as the source of advantage for entrant or attacking firms.

Back to the disk drive example, the firms that anticipated the eventual flattening of the current technology and then identified, developed, and implemented the new technology that sustained the overall pace of progress were the leading practitioners of the prior technology, not industry newcomers.

Disruptive products stalled with incumbents when it came to allocating scarce resources among competing product and technology development proposals. Sustaining projects addressing the needs of the firms' most powerful customers almost always won out over disruptive technologies with small markets and poorly defined customer needs.

Step 1: Disruptive Technologies Were First Developed within Established Firms

Often engineers at established firms will use bootlegged resources. Seagate went through eighty prototypes of their 3.5 inch disk model before formal project approval from senior management.

Step 2: Marketing Personnel then Sought Reactions from their Lead Customers

Engineering asks marketing if there’s a market for the smaller, less expensive drives. Finding little customer interest, Seagate’s marketers drew up pessimistic sales forecasts. Financial analysts join their marketing colleagues in opposing the disruptive program. Management makes an explicit decision not to pursue the disruptive technology.

Step 3: Established Firms Step Up the Pace of Sustaining Technological Development

In response to the needs of current customers, marketing throws support behind alternative sustaining projects. Although these projects involve greater development expense, they appear far less risky than investments in disruptive technology. The customers existed, and their needs were known.

New Companies were Formed, and Markets for the Disruptive Technologies were found by Trial & Error.

New companies were formed, usually including frustrated engineers from established firms. These startups were as unsuccessful as their former employers in attracting established computer makers to the disruptive new technology. Consequently, they had to find new customers.

The applications that emerged in this very uncertain, probing process were the minicomputer, the desktop personal computer, and the laptop computer. In retrospect, these were obvious markets for hard drives, but at the time, their ultimate size and significance were highly uncertain.

Step 5: The Entrants Moved Upmarket

In contrast to the unattractive margins and market size that established firms saw when eyeing the new, emerging markets for simpler drives, the entrants saw the potential volumes and margins in the upscale, high-performance markets above them as highly attractive.

Step 6: Established Firms Belatedly Jumped on the Bandwagon to defend their Customer Base

By the time incumbents entered to attempt to defend their customer base in their own market, they soon found that entrant firms had developed insurmountable advantages in manufacturing cost and design experience and cost structures set to achieve profitability at lower gross margins.

Implications from the Hydraulics Eruption

At the time, hydraulics were a technology their customers didn’t need - and couldn’t even use.

If they took their eyes off their customers’ next-generation needs, existing businesses would have been put at risk. Moreover, developing bigger, better and faster cable excavators to steal share from existing competitors constituted a much more obvious opportunity for profitable growth than did a venture into hydraulic backhoes.

These companies did not fail because the technology wasn’t available.

They didn’t fail because they lacked information about hydraulics or how to use it.

They failed because hydraulics didn’t make sense until it was too late. This is why disruptive technologies confront innovators with such a dilemma.

Working harder, being smarter, investing more aggressively and listening more astutely to customers are all solutions to the problems posed by new sustaining technologies. But, these paradigms of sound management are useless-even counterproductive, in many instances-when dealing with disruptive technology.

What Goes Up, Can’t Go Down

Rational managers can rarely build a cogent case for entering small, poorly defined low-end markets that offer lower profitability.

Committing development resources to higher performance products that could garner higher gross margins generally offered greater returns and less pain.

Projects that fail because the market wasn't there have far more serious implications for managers' careers. Thus, they tend to back the projects for which market demand seems most assured.

In a tug of war for resources, projects targeted at the explicit needs of current customers or users that a supplier has not been able to reach yet will always win out over proposals to develop products for markets that do not exist.

Disruptive technologies have such a devastating impact because the firms that first commercialized each generation of disruptive disk drives chose not to remain contained within their initial value network. Rather, they reached as far upmarket as they could in each new product generation.

This upward mobility is what makes disruptive technologies so dangerous to established firms and so attractive to entrants.

The US Steel Industry

Minimill steelmaking is a disruptive technology that emerged in the 1960’s using scrap steel. The only market for minimills (reinforcing bars - rebars, for short) was right at the bottom of the market in terms of quality, cost and margins.

It was the least attractive market served by established steel makers. Margins were low. Customers were the least loyal - switching suppliers to whoever offered the lowest price. The integrated steel makers were almost relieved to be rid of the rebar business.

Minimills saw the market differently. It had a different cost structure than that of integrated mills: little depreciation, no R&D costs, low sales expenses (mostly telephone bills), and minimal general management overhead. They could sell by telephone virtually all the steel they could make - and sell it profitably.

While the downmarket rebar territory looked unattractive to their integrated competitors, the minimills had an upmarket view that showed opportunity for greater profits and expanded sales. They worked to improve their metallurgical quality and consistency of their products and invested in equipment to make larger shapes.

The next market (immediately above them) minimills attacked was larger bars, rods and angle irons. This was the lowest margin market in the integrated mills’ product lines. Again, the integrated mills were almost relieved to be rid of this business.

As the integrated mills were ceding the bar and beam business to the minimills, they experienced dramatically improving profit. They were forsaking their lowest margin products and focusing increasingly on high-quality rolled sheet steel, where quality-sensitive manufacturers of cans, cars, and appliances paid premiums. The integrated mills were improving their ability to provide to their most demanding customers with the highest quality product and do so profitably.

It cost ~$2 billion to build a state of the art cost competitive sheet steel rolling mill - a capital outlay too large for any of the minimills.

Thin-slab casting technology appears and a rolling mull could now be built for < $250 million - 1/10th the cost of a traditional sheet mill and a management investment for a minimill.

At the outset, thin-slab casting could not offer the smooth, defect-free surface finish required by the integrated mills’ mainstream customers.

With the integrated competitors busy trying to rob each other’s most profitable business with the large auto, appliance and can companies, it made no sense to target the capital investment at thin-slab casting which could only fulfill the least profitable, most price competitive and commoditized end of their business.

Integrated steel mills Bethlehem and USC elected to invest in conventional thick-slab continuous casters at $250 million to protect and enhance the profitability of the business with their mainstream customers, instead of investing $150 million in thin-slab casting.

Nucor, a minimill, saw the situation differently. Unencumbered by the demands of the profitable customers in the sheet steel business and benefiting from a cost structure forged at the bottom of the industry, Nucor invested in thin-slab casting.

Integrated steelmakers’ march to the profitable northeast corner of the steel industry is a story of aggressive investment, rational decision making, close attention to the needs of mainstream customers, and record profits.

Managing Disruptive Technological Change

The very decision making and resource allocation processes that are key to the success of established companies are the very processes that reject disruptive technologies: listening carefully to customers; tracking competitors’ actions carefully; and investing resources to design and build higher-performance, higher-quality products that will yield greater profit.

1. Customers effectively control the patterns of resource allocation in well-run companies.
2. Small markets don’t solve the growth needs of large companies.
3. The ultimate uses or applications for disruptive technologies are unknown in advance.
4. The processes and values that constitute their core capabilities within their current business models also define their disabilties when confronted with disruption.
5. Technology supply may not equal market demand. The attributes that make disruptive technologies unattractive in established markets often are the very ones that constitute their greatest value in emerging markets.

Give Responsibility for Disruptive Technologies to Organizations Whose Customers Need Them

Most executives like to think they’re in charge of their organizations. In fact, it is a company’s customers who effectively control what it can and cannot do.

The Theory of Resource Dependence: A company’s freedom of action is limited to satisfying the needs of those entities outside the firm (customers, investors) that give it the resources it needs to survive.

Therefore the real role of managers in companies whose people and systems are well-adapted to survival is, therefore, only a symbolic one.

Examples of Innovation outside an incumbent organization

Quantum’s executives financed and retained 80 percent ownership of a spinoff call Plus Development Corporation that was completely self-sufficient with its own executive staff and all of the functional capabilities required in an independent company.

IBM created an autonomous organization in Florida, far away from its New York state headquarters, that was free to procure components from any source, to sell through its own channels and forge a cost structure appropriate to the technological and competitive requirements of the personal computing market.

Kresge (Kmart) and Dayton Hudson (Target) both created focused discount retailing organizations that were independent of their traditional business. Woolworth failed in its venture (Woolco) by trying to launch it from within the F.W. Woolworth variety store chain.

Had HP not set up its ink-jet business as a separate organization, the ink-jet technology would probably have languished within the mainstream laser jet business. HP was also able to join IBM’s mainframe business and integrated steel companies in making a lot of money while executing an upmarket retreat.

Match the Size of the Organization to the Size of the Market

Creating new markets is significantly less risky and more rewarding than entering established markets against entrenched competition. But as companies become larger and more successful, it becomes even more difficult to enter emerging markets early enough. Because growing companies need to add increasingly large chunks of new revenue each year just to maintain their desired rate of growth, it becomes less and less possible that small markets can be viable as vehicles through which to find these chunks of revenue.

The companies that entered the new value networks enabled by disruptive generations of disk drives within the first two years after those drives appeared were six times more likely to succeed than those that entered later.

Firms that sought growth by entering small, emerging markets logged twenty times the revenues of the firms pursuing growth in larger markers.

They exchanged a market risk, the risk that an emerging market for disruptive technology might not develop after all, for a competitive risk, the risk of entering markets against entrenched competition.

It wasn’t until the third iteration of the Macintosh that Apple and its customers finally found “it” - the standard for convenient, user-friendly computing to which the rest of the industry ultimately had to conform.

This wasn’t the case with Newton, where Apple was desperate to short circuit the process of defining the ultimate product and market. It assumed that its customers knew what they wanted and spent aggressively to find out what this was, then give the customers what they thought they wanted.

Discovering New and Emerging Markets

Not only are the market applications for disruptive technologies unknown at the time of their development, they are unknowable. The strategies and plans that managers formulate for confronting disruptive technological change, therefore, should be plans for learning and discovery rather than plans for execution.

Identifying the Market for the HP 1.3 inch Kittyhawk Drive

The Kittyhawk 1.3 inch drive was designed to the customers’ requirements for the imminent personal digital assistants (PDA’s). However, the market didn’t materialize substantially.

The markets that contributed to Kittyhawk sales weren’t computers at all - Japanese language portable word processors, miniature cash registers, electronic cameras, and industrial scanners - none of which figures into the initial marketing plans.

Video game systems had been aware of Kittyhawk for two years, but they reported it had taken some time for them to see what could be done with a storage device so small.

The HP project managers concede in retrospect that their most serious mistake imagining the Kittyhawk was to act as if their forecasts about market were right, rather than as if they were wrong. They had invested aggressively in manufacturing capacity for producing the volumes forecast for the PDA market and had incorporated design features, such as the shock sensor, that were crucial to the acceptance in the PDA market they had so carefully researched.

If they could go back and do it again, they would assume that neither they nor anyone else knew for sure what kinds of customers would want it and in what volumes.

Honda’s Invasion of the North American Motorcycle Industry

Honda had emerged as a supplier of small, rugged motorized bicycles that were used by distributors and retailers in congested urban areas to make small deliveries to local customers.

Honda’s research showed Americans used motorcycles primarily for over-the-road distance driving in which size, power and speed were the most highly valued product attributes. Accordingly, they designed a fast, powerful motorcycle for the American market.

Sales were disastrous, one day the executive in charge of the venture took his bike into the hills east of Los Angeles to vent his anger. It helped, and he felt better after zipping around in the dirt, eventually inviting his colleagues to join him on future trips.

More people started to clamor for their own bikes to join their dirt biking friends, and the potential for a very different market dawned on the Honda US team.

Distribution soon became a problem. No retailers were selling their class of product. In the end, Honda convinced a few sporting goods stores to take on its line of motorbikes.

Honda’s bikes had a very different value network than the established network in which Harley-Davidson, BMW and other traditional motorcycle makers had competed.

From time to time in the 1960’s and 1970’s, Harley attempted to compete head to head with Honda and capitalize on the expanding low end market by producing a smaller engine bike.

A primary cause of Harley’s failure to was the opposition of its dealer network. Their profit margins were much greater on high end bikes, and many of them felt the small bikes compromised Harley-Davidson’s image with their core customers.

In the end of the 1970’s, Harley-Davidson gave in and retreated to the very high end of the motorcycle market - similar to the integrated steel mills.

Interestingly, Honda proved just as inaccurate in estimating how large the potential North American motorcycle market was as it had been in understanding what it was. Its initial aspirations upon entry in 1959 had been to capture 10 percent of a market estimated at 550,000 units per year with annual growth of 5 percent. By 1975, the market had grown 16 percent per year to 5,000,000 annual units - units that came largely from an application that Honda could not have foreseen.

Unpredictability and downward immobility in established firms

Guessing the right strategy at the outset isn’t nearly as important to success as conserving enough resources (or having the relationships with trusting backers or investors) so that new business initiatives get a second or third stab at getting it right.

Discovery Driven Planning: Requires managers to identify the assumptions upon which their business plans or aspirations are based.

They must be plans for learning rather than plans for implementation. By approaching a disruptive business with the mindset that they can’t know where the market is, managers would identify what critical information about new markets is most necessary and in what sequence that information is needed.

How to Appraise Your Organization’s Capabilities and Disabilities

Large companies often surrender emerging growth markets because smaller, disruptive companies are actually more capable of pursuing them.

Startup values can embrace smaller markets. Their cost structures can accommodate lower margins. Their market research and resource allocation processes allow managers to proceed intuitively rather than having to be backed up by careful research and analysis.

Values that focus an organization’s priorities on high-margin products cannot simultaneously focus priorities on low-margin products. This is why focused organizations perform so much better than unfocused ones: their processes and values are matched carefully with the set of tasks that need to be done.

Dell Computer

Dell Computer began selling computers over the phone. The initiative to begin selling and accepting orders over the internet was a sustaining innovation - it helped make more money in a way it was already structured. For Compaq, HP or IBM, marketing directly to customers over the internet would have been powerfully disruptive.

Stock Brokerages

For discount brokers such as Ameritrade or Charles Schwab, which accepted most of their orders over the phone, trading securities online simply helped them discount more cost-effectively - even often enhanced service relative to their former capabilities. For full-service firms with commissioned brokers such as Merrill Lynch, however, online trading represents a powerful disruptive threat.

Performance Provided, Market Demand and the Product Life Cycle

Technologists were able to provide rate of performance improvement that have exceeded the rates that the market has needed or was able to absorb. Historically, when this performance oversupply occurs, it creates an opportunity for a disruptive technology to emerge and subsequently to invade established markets from below.

For example, computer makers had a choice of drives to buy: both 5.25 inch and 3.5 inch drives provided adequate capacity.

Once the demand for capacity was satiated, other attributes, whose performance had not yet satisfied market demands, came to be more highly valued and to constitute the dimensions along which drive makers sought to differentiate their products.

Differentiation loses its meaning when the features and functionality have exceeded what the market demands.

Companies that have succeeded in disruptive innovation initially took the characteristics and capabilities of the technology for granted and sought to find or create a new market that would value or accept those attribute.

Conner Peripherals => Created a market for small drives in portable computers, where smallness was valued

J.C. Bamford & J.I. Case => Built a market for excavators among residential contractors, where small buckets and tractor mobility actually created value

Nucor => Found a market that didn’t mind the surface blemishes on its thin-slab cast sheet steel

The companies toppled by these disruptive technologies, in contrast, each took the established market’s needs as given, and did not attempt to market the technology until they felt it was good enough to be valued in the mainstream market.

Seagate took their early 3.5 inch drives to IBM for evaluation rather than asking, “Where is the market that would actually value a smaller, lower capacity drive?”

Bucyrus Erie => assumed that the market needed the largest possible bucket size and largest possible reach

US Steel => took for granted that the market needed the highest possible quality of surface finish

Companies the keep disruptive technologies bottled up in their labs, working to improve them until they suit mainstream markets, will not be nearly as successful as firms that find markets that embrace the attributes of disruptive technologies as they initially stand.

Disruptive Technologies are typically simpler, cheaper and more reliable and convenient than Established Technologies

Accounting Software

(1) Most accounting software had been created under the close guidance of CPA’s and required users to have a basic knowledge of accounting (and make every journal entry twice).

(2) Most accounting software offered a comprehensive array of reports and analyses, an array that grew even more complicated and specialized with each release as developers sought to differentiate their products.

(3) 85% of SMB’s were too small to employ their own accountant. The books were kept primarily by family members, who had no need for or understanding of most of the entries and reports available from mainstream accounting software.

Scott Cook, founder of Intuit, decided that makers of accounting software for SMB’s had overshot the functionality required by the market. He saw an opportunity to provide adequate, not superior functionality, that was simple and more convenient to use.

The response of established makers of accounting software was to move upmarket and continue to release packages loaded with more functionality - targeted at sophisticated users at loftier tiers of the market.

Performance Oversupply in the Insulin Market

Animal insulins caused a fraction of diabetic patients to build a resistance in their immune systems. Eli Lilly decided to make a genetically altered bacteria that was 100 percent pure.

Despite being a technological miracle, Lilly found it tough to sustain a premium price for this new insulin over the animal insulin.

“In retrospect, the market was not terrible dissatisfied with pork insulin.”

Lilly had spent enormous amounts of capital and energy overshooting the market’s demand for product purity. Only a fraction of a percent of people with diabetes developed the insulin resistance and needed the 100% pure insulin

However, the more disruptive technology was created by Novo - insulin pens - a much more convenient way to take insulin. At the time, people with diabetes were carrying a syringe, inserting the needle into a glass insulin vial, removing air bubbles and then injecting themselves with insulin. This process took 1-2 minutes on average. Novo’s pens took ~10 seconds and were able to carry a 30 percent premium per unit of insulin.

Coming up with purer insulins had always been the formula for staying ahead of the competition. What in Lilly’s history would case its culture based assumptions suddenly to change and its executives to begin asking questions that never before had needed to be answered?

Managing Disruptive Technological Change

Watch carefully what customers do, not simply listen to what the say. Watching how customers actually use a product provides much more reliable information that can be gleaned from a verbal interview or a focus group.

Will the trajectory of electronic vehicle performance ever intersect the trajectory of market demands (as revealed in the way customers use cars)?

By definition, electronic vehicles cannot initially be used in mainstream applications. We don’t know where the market is, but we can confidently say it isn’t the established automobile market segment.

The very attributes that make disruptive technologies uncompetitive in mainstream markets actually count as positive attributes in their emerging value network.

In disk drives, the smallness of the 5.25 inch disk drives made them unusable in large computers but very useful on the desktop.

Where is the market for buyers who have an undiscovered need for a vehicle that accelerates relatively slowly and can’t be driven more than 100 miles?

One potential market is parents of high school students. They might see the simplicity, slow acceleration and limited driving range of electric vehicles as desirable attributes for their teenagers’ cars.

There is a high probability that a better direction will emerge as the business heads towards its initial target. I must therefore plan to be wrong and to learn what is right as fast as possible.

Because no one knows the ultimate market for the product or how it will ultimately be used, we must design a product platform in which feature, function and styling changes can be made quickly and at low cost.

We must hit a low price point. Disruptive technologies typically have a lower sticker price per unit than products that are used in the mainstream, even though their cost in use is often higher.

The capabilities of most organizations are far more specialized and context-specific than most managers are inclined to believe. This is because capabilities are forged within value networks. Hence, organizations have capabilities to take certain new technologies into certain markets. The have disabilities in taking technology to market in other ways.

The information required to make large and decisive investments in the face of disruptive technology simply does not exist. It needs to be created through fast, inexpensive and flexible forays into the market and the product.

Managers who don’t bet the farm on their first idea, who leave room to try, fail, learn quickly, and try again, can succeed at developing the understanding of customers, markets, and technology needed to commercialize disruptive innovations.