Wednesday, October 5, 2011

Disruptive Innovation and how it works

For the last few years I have been fascinated with Clayton Christensen's theory of disruptive innovation and its application to business, politics, education, and insurgency models. What I find most interesting is that his theory, featured in both "The Innovators Dilemma" and "The Innovators Solution" provides a prescription for a small entrant with less resources to compete with and beat a large incumbent.

To understand his theory we begin by looking at a set of customers for a good or service. A simplified segmentation of the market is defined as non consumers, mainstream customers, and higher end customers. The incumbent starts by creating a good or service that appeals to the mainstream consumer. Upon reaching market segment saturation, the company looks up market and innovates on the product to capture the higher end more margin rich segment. Often tech companies competing in the same market play this leap frog game of matching innovation to control more of the commodity market. Clayton defines these as sustaining innovations.

In business the process is called profit maximizing resource allocation and the right competitor can use it to force an incumbent out the top end of the market. By continuing to innovate, the incumbent creates bloated products or services that have more value or performance than the consumer can utilize. The logic is that if I can please my most demanding customers then my main stream customers will be also be satisfied, but in reality it exposes the lower end of the market to the disruptive entrant who can enter in two ways:

- By targeting non-consumers with a simple, less expensive and more convenient product - this is referred to as a new market disruption
- By innovating on the business or manufacturing process so as to reduce costs and provide a product that over served consumers can get at a lower price.

With both the entrant and incumbent competing in the same segment, the entrant has the margin advantage as the price equilibrium is set at the marginal cost of the incumbent. The incumbent is unable to compete, and the strategy becomes to abandon the low end of the market which contains their least profitable, least loyal customer base and refocus the business in the higher margin tiers with more loyal customers. With the incumbent effectively pushed out of the segment, prices fall to the marginal cost of the entrant.

Now competing in a commodity market and faced with the same growth imperative as the incumbent, necessity begets innovation: The entrant must figure out how to apply the new innovation in the business, manufacturing, or product to move up market. Once this happens the incumbent abandonment, segment commoditization, and then entrant up market movement repeats itself through until the incumbent is forced out of the market.

Here is where it gets interesting: by pushing the incumbent out of the market, the entrant becomes the incumbent and is now exposed to the disruptive entrant. So how does the incumbent compete? Clayton makes the case that the company should develop an autonomous business unit to compete at the lower end of the market. He makes a great argument that the cost structure of an organization drives its values and these cost structure based values limit an incumbent from competing directly with an entrant.

While I think this is good solution, I see it as highly reactive. I think an organization should do as Toyota did and implement a clear and hold strategy similar to what the Marines do in their counterinsurgency operations. When competition, demanding customers, and profit mazimazation drive a company to innovate up market, a company should establish an autonomous business unit to move up market much like Toyota did with the creation of Lexus. And even though they were proactive in creating Lexus, sometimes a disruption redefines the market by turning non consumers into customers, forcing an incumbent to be reactive. Ultimately Toyota had to establish Scion to compete with disruptors like Hyundai and Kia. That's a quick look at the Disruptive Innovation model, Thanks for watching and I look forward to your feedback. for more, Check out Clayton's books "The Innovators Dilemma and The Innovators Solution."

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I am the Director of Technology at a K-12 School system.