The Dilemma of the "Innovator's Dilemma"

SAN FRANCISCO (01/04/2000) - One of the hottest management fads these days is the "innovator's dilemma."

Clayton Christensen coined the term in his 1997 book by the same title, which is now in its 12th printing and has sold 125,000 copies. Intel Chairman Andy Grove has credited Christensen's ideas with helping to drive Intel to develop the Celeron chip, its microprocessor for the sub-$1,000 personal computer. A few months back, the New York Times and Forbes published gushing profiles about the nerdy Harvard Business School professor. And just this month, Web-software maker Macromedia invited Internet business strategists to a free seminar in San Francisco that promised to reveal the solution to the innovator's dilemma (a Macromedia product, of course) and a chance to receive a copy of the book.

The conundrum behind The Innovator's Dilemma is the phenomenon of well-managed companies that listen to their customers and invest in new technologies but still lose market dominance. They lose because of what Christensen calls "disruptive technologies," meaning those technologies that swoop in under a company's radar to offer low-end customers a far better value.

Christensen thinks that current market leaders who lose at the low end today will lose at the high end tomorrow. Think Encyclopedia Britannica, which lost its print publishing empire to Encarta, a reference CD-ROM published by Microsoft and bundled with computers for free.

To solve the innovator's dilemma, Christensen argues, companies should create a separate subsidiary and free it to attack the parent. But upon closer examination, the theory behind the popular book fails to live up to its hype, especially as it concerns the Internet world. In an attempt to prove his theory, Christensen ignores cases that don't fit his rubric, and he bases his definition of good management on pre-Internet case studies ranging from steam-powered earthmoving equipment firms to disk-drive companies.

Using a straw-man definition of good management, Christensen posits that well-managed companies simply won't be able to profit from disruptive technologies. What his definition omits is that there are many companies with "good management" that are able to profit from disruptive technologies instead of being buried by them. An examination of these cases can provide executives with a more nuanced way of profiting from disruptive technologies, especially those like the Internet.

The Cases of Schwab and Hewlett-Packard

If Christensen's prognosis is always correct, then how does it explain Charles Schwab's success in online trading, Hewlett-Packard's victory in inkjet printers, Microsoft's comeback in browsers or Sapient's successful move from client/server to Internet business consulting? According to Christensen's theory, these firms should not have succeeded.

Let's focus on the first two cases. Online trading and inkjet printers started off as low-end technologies that had no immediate value to the firms' core customers. Schwab and HP did not set up separate subsidiaries to compete with their parent companies, and yet they are both No. 1 in these markets.

Charles Schwab is the leading online brokerage in terms of Internet trading revenues, which account for more than half of the company's trades. According to Christensen, E-Trade, one of the original online trading firms, should have trumped Schwab because it had a significant head start over Schwab in online trading.

In fact, E-Trade provided self-directed traders a wide variety of ways to execute trades, that included the Web, well before Schwab even thought about going online. But because of inferior financial resources and weaker management, E-Trade was unable to sustain its lead against Schwab's persistent and well-financed attack on the online trading market. As a result, E-Trade has tumbled to No. 3.

How Schwab achieved the leading market share in online trading throws Christensen's thesis into question. Schwab's chairman, Charles Schwab, began pushing his firm into online trading in October 1995. He was well aware that the company's rivals - Lombard Securities and E-Trade - were already offering trading on the Web and that low-end customers were using the new services. If it can be believed now, it was actually unclear at the time whether such services would achieve widespread popularity.

In October 1995, Schwab's computer lab developed a prototype online trading system. Schwab was thrilled when he used it to trade 100 shares of stock.

Within six weeks, Schwab had hired Gideon Sasson, VP of IBM's Web business, as executive VP of electronic brokerage.

Schwab pushed Sasson to launch the online trading system in 90 days. For less than $1 million, Schwab's internal team achieved that goal. Since then, the company has struggled to keep up with the tremendous demand for online trading.

Schwab remains No. 1 in online trading, though.

Let's apply Christensen's theory to Schwab. When Schwab began its online efforts in 1995, online trading was a disruptive technology. Contrary to Christensen's prescription, Schwab did not respond to this disruptive technology by establishing a separate online trading subsidiary to compete with the parent. Instead, Charles Schwab hired an executive VP to build what became a successful online trading business at Schwab's core.

Schwab succeeded because it could see that online trading was doing to its discount brokerage business what Schwab had done to Merrill Lynch's full-service brokerage business in the 1980s. Schwab had no intention of letting E-Trade do what it had done to Merrill. So Schwab reinvented itself.

The case of Hewlett-Packard in inkjet printers similarly undermines Christensen's theory. HP discovered the inkjet technology by accident in 1978, literally in a broom closet, at its ailing Vancouver, Wash., division. At the time, the division's primary product was printers. Faced with the choice of either closing down or finding a way to exploit inkjet technology, the Vancouver division built the inkjet technology into a business with more than $6 billion in revenues.

It took HP more than 10 years to figure out how to make inkjet a commercial success. While reviewing market-share charts one day in the fall of 1989, HP execs realized that they had been targeting the wrong enemy. Instead of positioning the inkjet as a low-cost alternative to HP's laser printers, the managers decided to attack the Japanese-dominated dot-matrix market. Dot matrix had poor print and color quality. Furthermore, Epson, the dot-matrix leader, had no competitive inkjet product and was distracted by an expensive and failing effort to sell PCs.

In a nutshell, HP replicated the strengths of Epson's strategy and attacked its weaknesses. The result: Between 1984 and 1994 HP's share of the U.S. printer market grew from 2 percent to 55 percent.

Christensen would have told HP to create a separate inkjet subsidiary to compete with the parent company. In fact, the Vancouver division already existed. HP succeeded by competing with Epson's dot-matrix printers, not by competing with its own laser printer business.

What Executives Can Do To Innovate

These examples suggest that Christensen's theory won't help managers over the long run. To make a profitable transition to electronic commerce, companies are likely to be self-reinventors like Schwab. Christensen's prescription of creating a separate subsidiary and freeing it to compete with the parent has a superficial appeal to managers who may not possess the same traits as Schwab.

The separate-subsidiary concept is a hedge for the manager who wants to appear to be following the latest trend. If the subsidiary fails, the manager can close it down without costing the core business too much money or embarrassment. If it succeeds, the manager looks like a genius.

The problem is that there are no slam-dunk success stories for Christensen's prescription. While Barnesandnoble.com was spun off from Barnes & Noble, it still pales in comparison to Amazon.com in terms of its online market share.

For example, during the week of Dec. 5, Barnesandnoble.com ranked sixth in online traffic with 1.7 million visitors, according to Media Metrix, compared with Amazon, which took the No. 1 spot with no fewer than 6 million visitors.

Furthermore, after climbing to $25 at its IPO, Barnesandnoble.com's stock has hovered around $17 a share for months.

So-called clicks-and-mortar strategies are not consistent with Christensen's prescription, nor are there any compelling success stories here. A typical example is old-line retailer Sears. Its Sears.com division has 50 people committed to making Sears the "definitive online source for the home."

Sears.com just got started in May and its results are not publicly available.

Sears faces some serious challenges in its efforts to compete online. Its store sales have stagnated as competitors like Home Depot and discounters like Old Navy and Wal-Mart have gained market share. It is difficult to see how Sears.com helps address the challenges from these players.

It could cost millions and take years to integrate Sears' order-fulfillment systems with Sears.com. And without offering Sears.com people highly valued pre-IPO shares, attracting and retaining top Web talent could be tough (albeit less so than if Sears.com was located in Silicon Valley instead of in the Midwest).

To help managers cope with the Internet, there's better advice than Christensen offers. The simple reality is that different firms respond to change - be it disruptive technologies or shifting market conditions - differently. My research suggests that the success of e-commerce initiatives in creating change depends on two factors:

The source of the e-commerce strategy. Is the e-commerce strategy coming from internal experimentation or as a response to an external threat?

The extent to which the e-commerce strategy alters the firm's business model.

Does the e-commerce strategy complement the existing business model or does it force the firm into an entirely new way of doing business?

As the chart below indicates, there are four possible scenarios, each of which demands a different approach to managing change. Executives must discover which category best defines their firm to manage change appropriately. Based on these categories, here are the three most interesting change models.

Controlled

High Business Model Change/Internal Source of E-Commerce Strategy Companies in the controlled category are making investments in e-commerce applications that are likely to substantially change an activity that has a significant impact on the relationships with customers. Because the firm directs this change process at its own initiative, the company is in control of the design of the e-commerce application and the pace of its implementation.

The key difference between the controlled and the incremental change processes is that the controlled process involves the resolution of strategic business issues before the implementation process begins.

Examples of the controlled approach include Charles Schwab in online trading, Microsoft in browsers and Sapient in Web consulting.

Reactive

High Business Model Change/External Source of E-Commerce Strategy Firms in the reactive category are making similar customer-focused investments in e-commerce applications, but the impetus for change is an upstart competitor. The key difference between the reactive and the imitative change processes is that the reactive process is much more intense and involves the resolution of strategic business issues, about which there may be serious internal disagreement.

An example of this is Merrill Lynch's effort to take on the challenge of online trading. The broader question for firms like Merrill and others is whether they can survive in the long term without changing their approach to disruptive technologies in a fundamental way.

Incremental

Low Business Model Change/Internal Source of E-Commerce Strategy Companies in the incremental category are making investments in e-commerce applications that are likely to lead to increased efficiency in an internal activity that does not greatly affect the firms relationships with customers.

An example is Microsoft, which has saved more than $100 million using an electronic procurement system called MS Market to purchase office supplies.

While the system has not changed Microsoft's competitive position, it has helped improve efficiency.

The dilemma of The Innovator's Dilemma is that a one-size-fits-all prescription for dealing with disruptive technologies is not the right medicine for managers trying to cope with the Internet. The examples of firms like Schwab in online trading and HP in inkjet printers suggest a more enduring way for managers to profit from the transition to e-commerce.

Ultimately, a more balanced and controlled approach to managing this transition is likely to create the most lasting value for customers and shareholders.

Peter Cohan is a management consultant and the author of Net Profit and The Technology Leaders (Jossey-Bass), as well as e-Profit (Anacom), to be published in April.

More about Amazon.combarnesandnoble.comBarnes & NobleCharles SchwabEncyclopedia BritannicaEpsonHarvard Business SchoolHewlett-PackardHome DepotIBMIntelJossey-BassMacromediaMedia MetrixMicrosoftSapientSchwabWal-Mart

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