The Rules of Innovation

Two decades ago, when I was just out of graduate school and working in the automotive industry, I got my first introduction to the statistical process-control chart. We used this laborious technique to make sure the machines employed in our manufacturing process did not drift out of control. Composed of three parallel horizontal lines, the “SPC” chart has long been an important tool in quality management. The center line represents the targeted value for the critical performance parameter of a product being manufactured. The lines above and below it represent the acceptable upper and lower control limits. If the product were, say, an axle, workers would plot the thickness of each piece they made on the chart. When I asked why there was typically a scatter of points around the target, my managers cited the randomness inherent in all processes.

The “Quality Movement” of the 1980s and ’90s subsequently taught us that there isn’t randomness in processes. Every deviation of the actual value from the target has a cause. It appears to be random when we don’t know the cause. The Quality Movement developed methods for identifying those additional factors-and we discovered that if we could control or account for all of them, the result would be perfectly predictable, and there would be no need to inspect products as they emerged from manufacturing.

The management of innovation today is where the Quality Movement was 20 years ago, in that many believe the outcomes of innovation efforts are unpredictable. The raison d’tre of the venture capital industry is belief in the unpredictability of new businesses. A few ventures will succeed; most won’t, the VCs say. They therefore place a portfolio of bets, extracting premium prices for their capital in order to earn the high return required to compensate for the risk that unpredictability imposes. I believe, however, that innovation isn’t random. Every undesired outcome has a cause. Those outcomes appear to be random when we don’t understand all the factors that affect successful innovation. If we could understand and manage these variables, innovation wouldn’t be nearly as risky as it appears.

The good news is that recent years have seen considerable progress in identifying important variables that affect the probability of success in innovation. I’ve classified these variables into four sets: (1) taking root in disruption, (2) the necessary scope to succeed, (3) leveraging the right capabilities and (4) disrupting competitors, not customers.

Of course, building successful businesses is such a complicated process, involving subtle interdependencies among so many variables in dynamic systems, that we’re unlikely ever to make it perfectly predictable. But the more we can master these variables, the more we will be able to create new companies, products, processes and services that achieve what we hope to achieve.

Take Root in Disruption

The startling conclusion suggested by the research that led to my writing The Innovator’s Dilemma was that many successful companies stumble from prominence not because they’re badly managed but precisely because they are well managed. They listen to and satisfy the needs of their best customers, and they focus investments at the largest and most profitable tiers of their markets. Mastering these paradigms of good management gives established companies, as a group, an extraordinary track record in producing sustaining innovations that bring better products to established markets. It matters little whether the innovation is incrementally simple or radically difficult, as long as it enables good companies to make better products that they can sell for higher margins to their best customers in attractively sized markets. The companies that had led their industries in prior technologies led their industries in adopting new sustaining technologies in literally 100 percent of the cases we studied.

In contrast, the leading companies almost always were toppled when disruptive technologies emerged-products or services that weren’t as good as those already used in established markets. Disruptive innovations don’t initially perform well enough to be sold or used successfully in mainstream markets. But they have other attributes-most often simplicity, convenience and low cost-that appeal to a new, small and initially unattractive (to established firms) set of customers, who use them in new or low-end applications.

The chances a new company could become successful if its entry path was a sustaining strategy-trying to make a better product than the incumbents and selling it to the same customers-were about six percent in our study. The chances of success for firms that entered with a disruptive strategy were 33 percent. The disparity stems from the motivation and position of the leading firms. They have far more resources to throw at opportunities than entrants do. When newcomers attack customers and markets attractive to the leaders, the leaders overwhelm them.

All companies are burdened with “asymmetric” motivations in that they must move toward markets that promise higher profit margins and the most substantial and immediate growth and cannot move down market toward smaller opportunities and profit margins. When new entrants take root with customers in markets that are unattractive to the leaders, they are safer-and it has nothing to do with how much cash or proprietary technology they have. They are safe because the incumbents are motivated to ignore or even exit the very markets that the entrants are motivated to enter. Taking root in disruption, therefore, is the first condition that innovators need to meet to improve the probability of successfully creating a new growth business. If they cannot or do not do this, their odds of success are much smaller.

There are two tests to assess whether a market can be disrupted. At least one of these criteria must be met in order for an upstart to be disruptively successful. If a new growth business can meet both, the odds are even better.

1. Does the innovation enable less-skilled or less-wealthy customers to do for themselves things that only the wealthy or skilled intermediaries could previously do?

When an innovation fulfills this condition, even if it can’t do all the things existing offerings can, potential customers excluded from the market tend to be delighted. For example, many people loved the first personal computers, no matter how clunky the booting process and limited the software the machines could run, because the alternative to which they compared the PC wasn’t the minicomputer-it was no computer at all. Filling such a void reduces the capital commitments and technological achievements required for an innovation to become viable and creates new growth markets. I call the process of finding and nurturing these opportunities creative creation. After a technology takes root in new markets, and after new growth is created, disruption can invade the established market and destroy its leading firms.

Even if innovators succeed in cramming disruptive technology into an existing market application, the incumbents typically win. Digital photography, online consumer banking and hybrid-electric vehicles are examples of potentially disruptive technologies that were deployed in such a sustaining fashion. Billions were spent on these innovations to beat out already acceptable and habitual technology; little net growth resulted, as sales of the new products cannibalized sales of the old; and the industry leaders maintained their rule.

2. Does the innovation target customers at the low end of a market who don’t need all the functionality of current products? And does the business model enable the disruptive innovator to earn attractive returns at discount prices unattractive to the incumbents?

Wal-Mart, Dell Computer and Nucor are examples of disruptive companies that attacked the low ends of their markets with business models that allowed them to make money at discount prices. Wal-Mart started by selling brand-name products at prices 20 percent below department store prices and still earned attractive returns because it turned inventory over much more frequently. Such a disruptive strategy can create new growth businesses but does not create new markets or classes of consumers. It has a high probability of success because the reported profit margins of established companies typically improve if they get out of low-end, low-margin products and add in their stead high-margin products positioned in more-demanding market segments. By assaulting the low end of the market and then moving up, a new company attacks, tier by tier, the markets from which established competitors are motivated to exit.

Pick the Scope Needed to Succeed

The second set of variables that affects the probability that a new business venture will succeed relates to its degree of “integration.” Highly integrated companies make and sell their own proprietary components and products across a wide range of product lines or businesses. Nonintegrated companies outsource as much as possible to suppliers and partners and use modular, open systems and components. Which style is likely to be successful is determined by the conditions under which companies must compete as disruption occurs.

In markets where product functionality is not yet good enough, companies must compete by making better products. This typically means making products whose architecture is interdependent and proprietary, because competitive pressure compels engineers to fit the pieces of their systems together in ever more efficient ways in order to wring the best performance possible out of the available technology. Standardization of interfaces (meaning fewer degrees of design freedom) forces them to back away from the frontier of what is technologically possible-which spells competitive trouble when functionality is inadequate. This helps explain why IBM, General Motors, Apple Computer, RCA, Xerox and AT&T, as the most integrated firms during the not-good-enough era of their industries’ histories, became dominant competitors. Intel and Microsoft (raps about the latter’s supposed lack of innovation aside) have also dominated their pieces of the computer industry-compared to less integrated companies such as WordPerfect (now owned by Corel)-because their products have employed the sorts of proprietary, interdependent architectures that are necessary when pushing the frontier of what is possible. This also helps us understand why NTT DoCoMo, with its integrated strategy, has been so much more successful in providing mobile access to the Internet than nonintegrated American and European competitors who have sought to interface with each other through negotiated standards.

When the functionality of products has overshot what mainstream customers can use, however, companies must compete through improvements in speed to market, simplicity and convenience, and the ability to customize products to the needs of customers in ever smaller market niches. Here, competitive forces drive the design of modular products, in which the interfaces among components and subsystems are clearly specified. Ultimately, these coalesce as industry standards. Modular architectures help companies respond to individual customer needs and introduce new products faster by upgrading individual subsystems without having to redesign everything. Under these conditions (and only under these conditions), outsourcing titans like Dell and Cisco Systems can prosper-because modular architectures help them be fast, flexible and responsive.

Leverage the Right Capabilities

Innovations fail when managers attempt to implement them within organizations that are incapable of succeeding. Managers can determine the innovation limits of their organizations quite precisely by asking three questions: (1) Do I have the resources to succeed? (2) Will my organization’s processes facilitate success in this new effort? (3) Will my organization’s values allow employees to prioritize this innovation, given their other responsibilities?

Beyond technology, the resources that drive innovative success are managers and money. Corporate executives often tap managers who have strong records of success in the mainstream to manage the creation of new growth businesses. Such choices can be the kiss of death, however, because the challenges confronting managers in a disruptive enterprise-and the skills required to overcome them-are different from those that prevail in the core business. Many innovations fail because managers do not know what they do not know as they make and implement their plans. That is, they assume that the same strategies and customer needs that apply in mature, stable markets will apply in disruptive ventures. But this is not the case, and by making such assumptions, managers close themselves off from opportunities to discover what customers really find useful in new, disruptive products.

Innovators must avoid two common misconceptions in managing the other key resource, money. The first is that deep corporate pockets are an advantage when growing new businesses. They are not. Too much cash allows those running a new venture to follow a flawed strategy for too long. Having barely enough money forces the venture’s managers to adapt to the desires of actual customers, rather than those of the corporate treasury, when looking for ways to get money-and forces them to uncover a viable strategy more quickly.

The second misconception is that patience is a virtue-that innovation entails large losses for sustained periods prior to reaping the huge upside that comes from disruptive technologies. Innovators should be patient about the new venture’s size but impatient for profits. The mandate to be profitable forces the venture to zero in on a valid strategy. But when new ventures are forced to get big fast, they end up placing huge bets at a time when the right strategy simply cannot be known. In particular, they tend to target large, obvious, existing markets-and this condemns them to failure. Most of today’s envisioned business opportunities for wireless Internet access, for example, involve big applications such as stock-trading and multiplayer gaming that have already found homes on wired, desktop computers. Billions are being sunk into new wireless ventures committed to taking over these markets before innovators have a chance to learn what applications wireless is really best at delivering.

Resources such as technology, cash and technical talent tend to be flexible, in that they can be used for a wide array of purposes. Processes, however-the central element in our second question-are typically inflexible. Their purpose is not to adapt quickly but to get the same job done reliably, again and again. The fact that a process facilitates certain tasks means that it will not work well for very different tasks. Failure is frequently rooted in the forced use of habitual but inappropriate processes for doing market research, strategic planning and budgeting.

Sony, for example, was history’s most successful disruptor. Between 1950 and 1980 it introduced 12 bona fide disruptive technologies that created exciting new markets and ultimately dethroned industry leaders-everything from radios and televisions to VCRs and the Walkman. Between 1980 and 1997, however, the company did not introduce a single disruptive innovation. Sony continued to produce sustaining innovations in its product businesses, of course. But even the new businesses that it created with its PlayStation and Vaio notebook computer were great but late entries into already established markets.

What drove Sony’s shift from a disruptive to a sustaining innovation strategy? Prior to 1980, all new product launch decisions were made by cofounder Akio Morita and a trusted team of associates. They never did market research, believing that if markets did not exist they could not be analyzed. Their process for assessing new opportunities relied on personal intuition. In the 1980s Morita withdrew from active management in order to be more involved in Japanese politics. The company consequently began hiring marketing and product-planning professionals who brought with them data-intensive, analytical processes of doing market research. Those processes were very good at uncovering unmet customer needs in existing product markets. But making the intuitive bets required to launch disruptive businesses became impossible.

A company’s values-the focus of question three-determine the necessity of spinning out separate organizations for new ventures. Values are even less flexible than resources. Everyone in an organization-executives to sales force-must put a premium on the type of business that helps the company make money given its existing cost structure. If a new venture doesn’t target order sizes, price points and margins that are more attractive than other opportunities on the organization’s plate, it won’t get priority resources; it will languish and ultimately fail.

Nor is it just the values of the innovating company that matter, because suppliers and distributors have values too, and they must put the highest priorities on opportunities that help them make money. This is why, with almost no exceptions, disruptive innovations take root in free-standing value networks-with new sales forces, distributors and retailing channels.

Disrupt Competitors, Not Customers

The fourth factor in successful innovation is minimizing the need for customers to reorder their lives. If an innovation helps customers do things they are already trying to do more simply and conveniently, it has a higher probability of success. If it makes it easier for customers to do something they weren’t trying to do anyway, it will fail. Put differently, innovators should try to disrupt their competitors, never their customers.

The best way to understand what customers are actually trying to do, as opposed to what they say they want to do, is to watch them. For example, when interviewed by the college textbook industry, students say they would welcome the ability to probe more deeply into topics of interest that textbooks just touch on. In response, publishers have invested substantial sums to make richer information available on CDs and Web sites. But few students actually use these innovations, and little growth has resulted. Why? Because what most students really are trying to do is avoid reading textbooks at all. They say they would like to delve more deeply into their subjects. But what they really do is put off reading until the last possible minute-and then cram.

To make it simpler and more convenient for students to do what they already are trying to do, a publisher could create an online facility called Cramming. Like all disruptive technologies, it would take root in a low-end market: the least conscientious students. Semester after semester, Cramming would then improve as a new “cramming-aid” growth business, without affecting textbook sales. Conscientious students would continue to purchase textbooks. At some point, however, learning the material online would be so much easier and less expensive that, tier by tier, students would stop buying texts. This path of innovation has a much higher chance of success than a direct assault that pits digital texts against conventional textbooks.

The observed probabilities of success in innovation are low. But these statistics stem from the sum of sustaining and disruptive strategies, many of which are attempted in organizations whose resources, processes and values render them incapable of succeeding. Many innovators draw lessons from observing other successful companies in very different circumstances and attempt to succeed with just one or a few links in a chain of interdependent values. And many fail after assuming that what customers say they want to do is what they actually would do.

Hence, the observed probabilities of success don’t necessarily reflect what the true likelihood of success can be, if the critical variables in the complex and dynamic process of innovation are understood and managed effectively. Indeed, success may not be as difficult to achieve as it has seemed.