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How you can benefit by predicting change: senior managers who learn how to spot signals of disruptive change will have much greater insight into the potential and perils of emerging technologies, and will improve their ability to make the right strategic decisions. Useful tools, now available, can help managers sense future events.

Take a step back to the late 1970s and imagine being Ken Olson, the founder and CEO of Digital Equipment Corp. (DEC), the then world's leading minicomputer manufacturer. You make sophisticated, high-end equipment that is sold to the world's leading corporations, and your company has been phenomenally successful over the past two decades. You observe that a series of entrepreneurs have come up with a simple, low-price computer meant to be used by individuals. What does this mean?

How would you answer that question? The personal computer market doesn't exist, so there's no market research report to turn to. And, your current customers aren't much use. Imagine if you went to them and said, "We're going to sell you a product that is much worse than what you currently use. You won't be able to do much with it, but maybe someday you will." What would you expect them to say--or do? Would they rush to purchase this new product?

In this context, then, it is quite natural that in 1977, Ken Olson famously said, "There is no reason anyone would want a personal computer in their home."

This anecdote isn't meant to single out Olson. Back in the '40s, IBM Corp. CEO Tom Watson said, "I think there is a world market for maybe five computers." Microsoft Corp. Chairman Bill Gates in 1980 said that "640 [kilobytes of memory] ought to be enough for anybody." In the 19th century, the CEO of telegraphy giant Western Union dismissed the telephone as an electrical "toy."

The fact is, across the sweep of history, industry leaders have done a poor job identifying the innovations that ultimately have the most transformational potential.

Indeed, identifying transformational technologies is surprisingly difficult. Our natural instincts are to look for data proving that something critical is going on, but unassailable data only exists about the past. Too often, the data and evidence trickling into a market reflects what has already happened, and sometimes even occurred in the distant past. Waiting for conclusive evidence, therefore, consigns people to take action when it is too late. After all, by the time the writing is on the wall, everyone can read it.

But that is not the only way, as now there are useful tools to help executives and analysts understand what will happen in the future. It is now possible to use "disruptive innovation theory" to spot early signals of industry change, confidently predict how those signals will unfold and react appropriately. Executives that learn how to spot the signals of disruptive change will have much greater insight into the potential and perils of emerging technologies, improving their ability to make the right strategic decisions.

The "disruptive innovation theory," first described by Clayton Christensen in the 1997 book The Innovator's Dilemma (see sidebar), holds that organizations have the best chance of creating new growth by bringing disruptive innovations into a marketplace. These innovations either create new markets or reshape existing markets by delivering a new, highly desired value proposition to customers.

There is a simple, important principle at the core of the disruptive innovation theory: companies innovate faster than customers' lives change. Because of this, companies end up producing products that are too good, and too expensive for many customers. This phenomenon happens for a good reason: good managers are trained to seek higher profits by bringing better products to the most demanding customers in the marketplace. But in that pursuit of profits, companies end up "overshooting" less-demanding customers who are perfectly willing to take the basics at reasonable prices. And they ignore "nonconsumers" who lack the skills, wealth or ability to consume at all.

For example, in the 1990s, companies continued to invest to produce higher-quality compact disk technology. However, products were already more than good enough for what customers needed. How did companies create new growth? By using a simple, convenient technology called MP3 that actually had lower audio quality than existing solutions but had new benefits related to customizability and convenience. MP3 is a classic disruptive technology.

Even today, it continues to have limitations along important dimensions such as audio quality. However, it is so much more flexible that people can consume music in entirely new ways, using MP3 players as portable jukeboxes. Companies such as Apple Computer Inc. used the simple, convenient technology to create booming growth.

The situation for Sony Corp. was completely different. MP3 technology looked unattractive to engineers who worked on Sony's product lines that competed based on offering superior sound quality. Consider this comment from a Sony engineer in a recent Wall Street Journal article: "I don't really like hard disks--they're not Sony technology. As an engineer, they're not interesting."

While Apple's success with the iPod is transforming the company, Sony appeared to drag its heels entering the market, only recently releasing a MP3 player.

Disruption Developments Flower

Disruptive developments are beginning to flower in a number of different industries. For example, in healthcare, companies are introducing quick and convenient diagnostic services delivered by nurse-practitioners in kiosks located in retail stores. The leading example of this emerging model is Minnesota-based MinuteClinic. At MinuteClinic kiosks in Target stores, customers can receive diagnostic tests for about a dozen ailments, such as strep throat. The service is sharply cheaper than going to a general practitioner's office, and service is guaranteed in 15 minutes.

Education is another industry where "consuming" typically requires paying steep fees and going to centralized locations. On-the-job training and online adult education providers are delivering extremely relevant, low-cost education in more convenient ways. For example, the University of Phoenix now educates more than 100,000 students, both on traditional campuses and over the Internet. It explicitly targets adult students who lack the wealth, time or test scores to attend traditional programs.

Additionally, more and more corporations are finding it more valuable to train high-potential managers at internal "universities" (such as General Electric Co.'s Crotonville training center) than to send them to expensive on site Masters of Business Administration (MBA) programs.

Disruption is also swirling around the telecommunications industry. A technology known as Voice over Internet Protocol (VoIP) now allows companies to offer cheap, customizable telephony service over the Internet. One company following an interesting model using VoIP is Skype Technologies S.A., a peer-to-peer solution created by the duo that introduced Kazaa (the peer-to-peer file swapping software that gives music and film industry executives nightmares). Kazaa is owned by Sharman Networks Ltd. Customers using Skype's program can send and receive calls from their personal computer to other Skype users around the world. The application is simple (and free) to download and install, and calls are high-quality and free.

In aviation, historical industry leaders The Boeing Co. and Airbus S.A.S are obsessed with their fight for the high end of the industry. Airbus recently unveiled its massive A380 super jumbo jet, which can hold up to 600 passengers and can be modified to include services such as a gymnasium. Meanwhile, regional jet manufacturers like Embraer (Empresa Brasileira de Aeronautica S.A.) and Bombardier Inc. have created big businesses providing smaller planes to regional carriers. And a number of players are racing to create very-low cost airplanes that will enable the birth of a vibrant air taxi industry. Startups such as New Mexico-based Eclipse Aviation Corp. and Colorado-based Adam Aircraft Industries, corporate jet manufacturers such as Cessna Aircraft Co. and automobile manufacturers such as Honda Motor Co. Ltd. are all targeting the space.

These and similar developments, in industries ranging from automotive to financial services to consumer electronics, fit a pattern. A company has found a way to bring a radically different value proposition into an overlooked part of the market. Although these kinds of developments often seem inoffensive at first, as disruptive attackers grow and improve, they often emerge as serious competitive threats. (See sidebar "Seeing What's Next.")

Implications For Finance

Spotting potentially transformational innovations is one thing. Understanding the implications of those innovations is another. One pressing challenge facing many financial managers is allocating scarce investment dollars between innovation opportunities. It is, indeed, tough, as opportunities that seem to have a high probability of creating growth often flop. Acquisitions produce frustratingly inconsistent but typically negative returns.

Mangers can use the disruptive innovation model in three ways to improve their return on innovation investment. They can: 1) limit investment in overshot dimensions; 2) proactively scan for disruptive developments; and 3) use the model to guide investment decisions. More detail on each follows.

LIMIT INVESTMENT IN OVERSHOT MARKETS. Companies should continually monitor whether they have overshot a customer segment, because further investment in overshot dimensions promises to disappoint. How can you identify an overshot segment? Overshot customers begin to complain that products are too complicated and expensive. They stop using and valuing new features. Importantly, they begin to pay decreasing prices for new innovations. Declining prices and margins in a given market tier are often signs of overshot customers.

For example, there are many signs that enterprise software providers have overshot much of the market. Many customers are growing increasingly unwilling to pay for expensive software up-grades because they find that old versions of software are good enough for their needs. They are increasingly turning to low-cost providers such as Salesforce.com.

A company that invests in improving along overshot dimensions is unlikely to realize the full rewards from its innovation effort because customers will not value the enhancements. These kinds of proposals will usually contain data showing the fantastic returns from historical investments to improve products for this product segment. But that data explains what happened in the past, not what will happen in the future.

PROACTIVELY SCAN FOR DISRUPTIVE DEVELOPMENTS. The model implies that financial managers make sure that they continuously scan for threats emerging outside of the core market. When companies have to name their most daunting competitor, they often point to the leading incumbent in their marketplace. Thirty years ago, General Motors Corp. (GM) would point to Ford Motor Corp. Twenty years ago DEC would point to Prime Computer Corp., Wang Laboratories and Nixdorf Computer AG. Today, Boeing would point to Airbus; Harvard Business School would point to Stanford Business School.

These are all sustaining rivals, where companies are fighting for existing customers in existing markets. These battles are important, but companies also need to watch for disruptive innovations incubating outside of the core market. Today, GM's largest threat comes from Toyota Motor Corp., which took root in the lowest end of the auto industry in the 1960s. Tomorrow, GM's largest threat will come from an Asian manufacturer that figures out how to make a $2,500 car.

Keeping tabs on sustaining competitors involves watching so-called "lead" customers and carefully analyzing market data. Watching for disruptive developments involves looking for companies targeting the low-end of existing markets and customer groups seemingly in the market's fringe. It involves looking for companies that fit the established pattern of disruptive innovators.

Companies that need to pay particularly close attention to disruption are those that operate in markets where consumption is limited by having particular skills, a degree of wealth or access to a centralized setting. Competitors with disruptive intentions will inevitably find a way to tackle one of those constraints and reach a group of customers historically locked out of the market.

Although it may take a while, you can predict that the company that has democratized a limited market will improve its solution to the point where it can materially affect existing providers.

When companies identify a legitimate disruptive development, they can, of course, invest to create a rival offering. Doing so must be managed quite carefully, however, because the established ways in which the core business operates often get in the way of creating viable disruptive entrants. Alternatively, a company can acquire one of the emerging disruptive attackers to capitalize on its growth potential.

USE THE MODEL TO GUIDE ACQUISITION TARGETS. Why a company would ever expect to create profitable growth through acquisitions is a mystery to many academics. Study after study has shown that, on average, acquisitions destroy value--the price paid for the acquisition doesn't justify the subsequent performance of the acquired company.

Many companies find that large acquisitions provide stable but lackluster returns, whereas small acquisitions typically have highly variable outcomes, occasionally producing blockbuster returns. Screening for small targets that match identified disruptive patterns can in essence cut the tail off of the returns distribution curve, allowing companies to capture disruptive growth before it becomes fully understood by the marketplace.

For example, Johnson & Johnson's Medical Device and Diagnostics business unit acquired four separate disruptive businesses in the '80s: Cordis Corp. (stents), Lifescan Inc. (blood glucose monitors), Vistakon (disposable contact lenses) and Ethicon Inc. (endoscopic surgery). Those four acquisitions grew at a compound annual rate of more than 40 percent during the '90s, accounting for almost all of the division's growth.

Similarly, in the early '90s, The Washington Post Co. recognized that there were disruptive trends that were poised to change the education industry as education moved beyond the classroom. It acquired Kaplan Inc. and a number of other training companies. The training and education part of The Washington Post Co. now accounts for more than 50 percent of the company's revenue.

Bringing the Future into Focus

Historically, predicting industry change has just seemed to be an impossible task. After all, if the experts get it wrong so frequently, what hope is there for the rest of us?

Using the right theory, however, can help improve our collective ability to see into the future. It can help to separate signal from noise. amplifying the important information that seems to be buried in overwhelming amounts of data. It can help to pinpoint industry-changing firms or business models long before markets and experts recognize that change is afoot. It can help explain who is going to win and who is going to lose when powerful competitors square off. And it can help bring key management decisions into focus, highlighting the levers managers can pull to change competitive actions.

Finally, using the right theory can bring the future into much sharper focus, allowing the senior executive decision-makers to confidently see what's next and act appropriately.

RELATED ARTICLE: Disruptive Innovation Theory

The disruptive innovation theory holds that existing companies have a high probability of beating entrant attackers when the contest is about sustaining innovations: radical or incremental improvements that target demanding customers at the high end of the market who are willing to pay premium prices for better products. Established companies tend to lose to attackers armed with disruptive innovations: cheaper, simpler, more convenient products or services that start by meeting the needs of less-demanding customers.

The figure below illustrates the disruptive innovation theory. The figure has two types of improvement trajectories. The solid lines illustrate company improvement trajectories. They show how products and services get better over time. The dotted line shows a customer demand trajectory--not the quantity customers demand, but the performance they can use. For simplicity, the figure shows a single line, although it shows how in every market there is a distribution of customers based on the performance they demand. As the figure suggests, a customer's needs in a given market application tend to be relatively stable over time.

Sustaining innovations, illustrated by the curved arrows, move companies along established improvement trajectories. They are improvements to existing products on dimensions historically valued by customers. Airplanes that fly farther, computers that process faster, cellular phone batteries that last longer and televisions with incrementally or dramatically clearer images are all sustaining innovations.

Because companies can innovate faster than people's lives change, the pace of sustaining innovation nearly always outstrips the ability of customers to absorb it, opening the door for disruptive developments.

Disruptive products or services initially are inferior to existing offerings, at least along dimensions by which mainstream customers measure value. However, they are typically more affordable and simpler to use than products in the incumbents' product portfolio. They create growth outside of the core market among customers that are delighted with the product or service despite its limitations.

Some disruptive innovations disrupt an existing market from the low end. Dell Inc.'s direct-to-customer business model, Wal-Mart Stores Inc.'s discount retail store, Nucor Corp.'s steel minimill and The Vanguard Group Inc.'s index mutual funds are all examples of this kind of "low-end" disruption.

Other disruptive innovations create entirely new markets by competing against nonconsumption. eBay Inc. democratized the auction process, seizing it from the domain of the wealthy. Similarly, the personal computer liberated computing from the cognoscenti and delivered it to the masses. The Kodak camera, Bell telephone, Sony transistor radio and Xerox photocopier are classic examples of these new-market disruptions.

[ILLUSTRATION OMITTED]

RELATED ARTICLE: Seeing What's Next Process Analyzes Industry Change

Seeing What's Next suggests following a three-part process to use the theories of innovation to spot and interpret disruptive developments and predict industry change.

Part 1: Look for signals of change, for signs of companies emerging to meet the needs of three different customer groups: overshot customers, undershot customers and nonconsuming customers.

Undershot customers are customers for whom existing solutions are not good enough. Signals of undershot customers include customers eagerly snatching up new products, steady or increasing prices and the struggles of specialists. Undershot customers look for sustaining innovations that close the gap between what is available and the job they are looking to get done.

"Overshot" customers are customers for whom existing solutions are too good. Signals of overshot customers include customer reluctance to purchase new products, declining prices and the emergence of specialists. Overshot customers welcome low-end disruptive innovations that offer good enough technological performance at low prices.

Nonconsumers are customers that lack the skills, wealth or ability to "do it themselves." Signals of nonconsumption includes customers that have to turn to someone with more skills or training in order to consume, a market limited to those with great wealth and the need to go to centralized, inconvenient locations to consume. Nonconsumers welcome new-market disruptive innovations that make it easy for them to do it themselves.

Part 2: Analyze competitive battles to see which firms are likely to emerge triumphant. There are two components to this analysis. The first involves identifying each combatant's strengths, weaknesses and blindspots by looking at their resources (what they have), processes (the way they do their business), and values (decision rules that determine how resources get allocated).

The second part requires identifying the company that is taking advantage of "asymmetries," doing what its opponent has neither the skills nor the motivation to do. Pay particular attention to asymmetric processes and values. Whereas resources are extremely flexible, processes and values are inflexible, determining what a company can and cannot and will and will not do.

Part 3: Look at important strategic choices that can help to determine ultimate winners and losers. For entrants, start by looking to see if the company is properly preparing for battle by hiring the right management team, instituting an appropriate strategy-making process and receiving funding from investors that will allow the company to follow a disruptive path.

Finally, assess whether an incumbent has developed the capability to capitalize on disruptive trends. Well-schooled incumbents could respond to a disruptive threat by setting up a separate organization or using an established process to parry the disruptive attacker.

Scott D. Anthony (santhony@innosight.com) is a partner at Innosight, an innovation-consulting firm based in Watertown, Mass. Clayton M. Christensen is the founder of Innosight and a professor at the Harvard Business School. Both are co-authors of Seeing What's Next: Using the Theories of Innovation to Predict Industry Change (Harvard Business School Publishing, 2004).
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Author:Christensen, Clayton M.
Publication:Financial Executive
Article Type:Cover Story
Geographic Code:1USA
Date:Mar 1, 2005
Words:3280
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