Kelvin Hartnall

The Innovator’s Dilemma

For anyone interested in technology and investing, I highly recommend the book “The Innovator’s Dilemma” by Clayton M. Christensen. The following blog entry is my summary of the significant concepts.

The book proposes that there are two types of technological advances: sustaining innovations and disruptive innovations. The majority of advances are sustaining innovations. With sustaining innovations, successful companies with good management practices will be very successful at adopting, mastering and utilising the new technology. The other technologies are disruptive innovations, and it is these technologies that are often the cause of failure of successful leading firms. This is where the innovator’s dilemma arises – it is the good management practices that are the most significant factor that lead to the failure of the firm!

The differentiation between sustaining and disruptive innovations has nothing to do with how radical or discontinuous the technological advance is. The distinction is about how customers value the innovation. A sustaining innovation improves the performance of the existing product in a dimension that is an important to the main market of customers. A disruptive innovation provides worse performance in the dimensions most important to the main market, though improves a different dimension that may be of benefit to only a small fringe market.

To illustrate this distinction by example, consider disk-drive manufacturers such as Seagate or Western Digital. Ten years ago the storage space of the average hard-drive was insufficient for most of the market, so the main performance dimension that disk-drive manufacturers competed on was storage size. Every few months the competitors would improve the technology and produce a hard-drive with even more storage, which are examples of sustaining innovations. Even if a competitor had discovered a way to radically alter the internals of a hard-drive so that it could contain ten times the storage, this would still be a sustaining technology since it still improves the technology in the same performance dimensions. An example of a disruptive technology for the disk-drive market is flash-memory. Flash-memory is a potential substitute storage device, though the technology stores far less than a standard hard-drive and is slower. It is worse than a standard magnetic-storage hard-drive in the important metrics to the majority of customers, but has other improved features such as having no moving parts and surviving sudden jolts. When it was first available in the mid-nineties, flash-memory had very small storage and only appealed to fringe applications such as for PDAs. Therefore flash memory was a potential disruptive technology for the disk-drive market.

So why are disruptive technologies such an issue for successful firms with good management? The issue is with the principles of good management: listening to customers; researching markets; allocating investments to the product improvements most important to customers; and capital investment into the projects that promise the best returns. These are excellent principles to follow and serve the company well for sustaining innovations since the company will follow good management practices and invest and master these new technologies. However, disruptive innovations cause the company problems since good management practices will result in the company dismissing the technology and investing elsewhere. A disruptive technology is not an improvement in the important product dimensions that the main market of customers demand, and they often promise lower margins and lower returns in a small fringe market. Therefore successful companies with good management will not invest in these areas and will continue to innovate along the dimensions that the main customers demand.

A confounding problem is that technology improves rapidly so that any technology will eventually overshoot the market. For example, consider Nvidia, the producer of graphics cards. The original generations of products were good, but every time they were able to double the number of polygons rendered per second it made a significant difference to their customers. However, I suspect they have reached the point of over-shooting the market since the average game player is quite satisfied with the current graphic cards and does not see much benefit in yet better polygon rendering. The problem with the rapid improvement of technologies is that a successful company will continue to innovate and experience increasing profits until their technology over-shoots the market in the important dimension. During the same period the disruptive technology will also improve rapidly until it becomes sufficient to satisfy the general market’s requirements. Since the disruptive technology is an improvement in other dimensions, these dimensions can suddenly become more important and result in a significant shift in the market-place.

To illustrate, I’ll go back to the original example of disk-drive manufacturers. Manufacturers such as Seagate and Western Digital are still continuing to innovate and bring out hard-drives with even greater capacity. For NZ$350 (about USD$175) I can buy a 1.5 TB drive from Seagate! The majority of the market is already well satisfied with 100GB or 200GB and have no use for terabytes of storage. However the technology behind flash-memory has also increased rapidly and I can now buy a 30GB solid-state hard-drive for NZ$314 (about USD$160). As solid-state technology improves and reaches the point that the storage space and speed satisfies the market in the storage space dimension, then other features take priority. Being able to withstand sudden jolts and hence be more portable may become a more important product dimension than storage size, in which case I expect to see disk-drive manufacturers such as Seagate and Western-Digital suffer significant decline.

The book does also discuss solutions to this dilemma. In a nutshell, when a company identifies a possible disruptive technology, it needs to create an independent and autonomous organisation to pursue the technology. And the size of this organisation needs to match the size of the opportunity. Only then will the small low-margin sales be worthy of pursuing.

In summary, disruptive technologies are not adopted by successful companies with good management because: they are not wanted by the majority of the company’s customers; the company’s high-value customers are demanding more innovation in the sustaining product dimension; the disruptive technology may have no market or a market difficult to research; and when comparing various investment opportunities there are far greater returns for investing in sustaining innovations. This leads the companies to continually invest in the sustaining innovations until they over-shoot. By the time that the disruptive technology becomes a threat it is too late to gain competencies in this new market.

Now, my real interest is in identifying small companies that have disruptive technologies, because it is these companies that can displace the leading firms and provide the investors with significant returns!