Guarding Against Disruption -Theory of Disruptive Innovation

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Guarding Against Disruption

Day 18: Theory of Disruptive Innovation

Disruptive innovation has become a popular buzzword in recent years, and it’s a term that’s often used by people who don’t understand it. As we will learn, true disruptive innovation is a little different than popular understanding.

Theory of Disruptive Innovation

These days, virtually every buzzy start-up is classed as a disruptive innovator. But these characterizations are often a misnomer. Incorrectly classing new competitors as disruptive innovators leads managers to misguided overreactions. Equally, brushing off potential disruptors and focusing solely on profitable upmarket niches can have fatal consequences later on. The key to sustained success lies in accurately defining disruptive innovators and monitoring their competitive trajectory.

 

So, what is a disruptive innovator? Disruption occurs when a small company with comparatively few resources is able to successfully challenge incumbent players. Successful disruptors begin in overlooked, low-end market segments. Over time, they improve product quality and move upmarket. As disruptors improve, they deliver comparable performance to mainstream incumbents, while maintaining the competitive advantages that enabled them to gain an initial foothold in the market. Only when mainstream customers begin to embrace this new offering at scale, has disruptive innovation truly occurred.

 

The theory of disruptive innovation, has proved to be a powerful way of thinking about innovation-driven growth. Many leaders of small, entrepreneurial companies praise it as their guiding star; so do many executives at large, well-established organizations.

Unfortunately, disruption theory is in danger of becoming a victim of its own success. Despite broad dissemination, the theory’s core concepts have been widely misunderstood and its basic tenets frequently misapplied. Furthermore, essential refinements in the theory over the past 20 years appear to have been overshadowed by the popularity of the initial formulation. As a result, the theory is sometimes criticized for shortcomings that have already been addressed.

 

There’s another troubling concern: In our experience, too many people who speak of “disruption” have not read a serious book or article on the subject. Too frequently, they use the term loosely to invoke the concept of innovation in support of whatever it is they wish to do. Many researchers, writers, and consultants use “disruptive innovation” to describe any situation in which an industry is shaken up and previously successful incumbents stumble. But that’s much too broad a usage.

 

The problem with mixing a disruptive innovation with any breakthrough that changes an industry’s competitive patterns is that different types of innovations require different strategic approaches. To put it another way, the lessons we have learned about succeeding as a disruptive innovator (or defending against a disruptive challenger) will not apply to every company in a shifting market. If we get sloppy with our labels or fail to integrate insights from subsequent research and experience into the original theory, then managers may end up using the wrong tools for their context, reducing their chances of success. Over time, the theory’s usefulness will be undermined.

 

This article is part of an effort to capture the state of the art. We begin by exploring the basic tenets of disruptive innovation and examining whether they apply to Uber. Then we point out some common pitfalls in the theory’s application, how these arise, and why correctly using the theory matters. We go on to trace major turning points in the evolution of our thinking and make the case that what we have learned allows us to more accurately predict which businesses will grow.

 

First, a quick recap of the idea: “Disruption” describes a process whereby a smaller company with fewer resources is able to successfully challenge established incumbent businesses. Specifically, as incumbents focus on improving their products and services for their most demanding (and usually most profitable) customers, they exceed the needs of some segments and ignore the needs of others. Entrants that prove disruptive begin by successfully targeting those overlooked segments, gaining a foothold by delivering more-suitable functionality—frequently at a lower price. Incumbents, chasing higher profitability in more-demanding segments, tend not to respond vigorously. Entrants then move upmarket, delivering the performance that incumbents’ mainstream customers require, while preserving the advantages that drove their early success. When mainstream customers start adopting the entrants’ offerings in volume, disruption has occurred.

Is Uber a Disruptive Innovation?

Let’s consider Uber, the much-feted transportation company whose mobile application connects consumers who need rides with drivers who are willing to provide them. Founded in 2009, the company has enjoyed fantastic growth (it operates in hundreds of cities in 60 countries and is still expanding). It has reported tremendous financial success (the most recent funding round implies an enterprise value in the vicinity of $50 billion). And it has spawned a slew of imitators (other start-ups are trying to emulate its “market-making” business model). Uber is clearly transforming the taxi business in the United States. But is it disrupting the taxi business?

 

According to the theory, the answer is no. Uber’s financial and strategic achievements do not qualify the company as genuinely disruptive—although the company is almost always described that way. Here are two reasons why the label doesn’t fit.

 

Disruptive innovations originate in low-end or new-market footholds.

 

Disruptive innovations are made possible because they get started in two types of markets that incumbents overlook. Low-end footholds exist because incumbents typically try to provide their most profitable and demanding customers with ever-improving products and services, and they pay less attention to less-demanding customers. In fact, incumbents’ offerings often overshoot the performance requirements of the latter. This opens the door to a disrupter focused (at first) on providing those low-end customers with a “good enough” product.

 

In the case of new-market footholds, disrupters create a market where none existed. Put simply, they find a way to turn non-consumers into consumers. For example, in the early days of photocopying technology, Xerox targeted large corporations and charged high prices in order to provide the performance that those customers required. School librarians, bowling-league operators, and other small customers, priced out of the market, made do with carbon paper or mimeograph machines. Then in the late 1970s, new challengers introduced personal copiers, offering an affordable solution to individuals and small organizations—and a new market was created. From this relatively modest beginning, personal photocopier makers gradually built a major position in the mainstream photocopier market that Xerox valued.

Surviving Disruption

A disruptive innovation, by definition, starts from one of those two footholds. But Uber did not originate in either one. It is difficult to claim that the company found a low-end opportunity: That would have meant taxi service providers had overshot the needs of a material number of customers by making cabs too plentiful, too easy to use, and too clean. Neither did Uber primarily target non-consumers—people who found the existing alternatives so expensive or inconvenient that they took public transit or drove themselves instead: Uber was launched in San Francisco (a well-served taxi market), and Uber’s customers were generally people already in the habit of hiring rides.

 

Uber has quite arguably been increasing total demand—that’s what happens when you develop a better, less-expensive solution to a widespread customer need. But disrupters start by appealing to low-end or unserved consumers and then migrate to the mainstream market. Uber has gone in exactly the opposite direction: building a position in the mainstream market first and subsequently appealing to historically overlooked segments.

 

Disruptive innovations don’t catch on with mainstream customers until quality catches up to their standards.

 

Disruption theory differentiates disruptive innovations from what are called “sustaining innovations.” The latter make good products better in the eyes of an incumbent’s existing customers: the fifth blade in a razor, the clearer TV picture, better mobile phone reception. These improvements can be incremental advances or major breakthroughs, but they all enable firms to sell more products to their most profitable customers.

 

Disruptive innovations, on the other hand, are initially considered inferior by most of an incumbent’s customers. Typically, customers are not willing to switch to the new offering merely because it is less expensive. Instead, they wait until its quality rises enough to satisfy them. Once that’s happened, they adopt the new product and happily accept its lower price. (This is how disruption drives prices down in a market.)

 

Most of the elements of Uber’s strategy seem to be sustaining innovations. Uber’s service has rarely been described as inferior to existing taxis; in fact, many would say it is better. Booking a ride requires just a few taps on a smartphone; payment is cashless and convenient; and passengers can rate their rides afterward, which helps ensure high standards. Furthermore, Uber delivers service reliably and punctually, and its pricing is usually competitive with (or lower than) that of established taxi services. And as is typical when incumbents face threats from sustaining innovations, many of the taxi companies are motivated to respond. They are deploying competitive technologies, such as hailing apps, and contesting the legality of some of Uber’s services.

Why Getting It Right Matters

Readers may still be wondering, Why does it matter what words we use to describe Uber? The company has certainly thrown the taxi industry into disarray: Isn’t that “disruptive” enough? No. Applying the theory correctly is essential to realizing its benefits. For example, small competitors that nibble away at the periphery of your business very likely should be ignored—unless they are on a disruptive trajectory, in which case they are a potentially mortal threat. And both of these challenges are fundamentally different from efforts by competitors to woo your bread-and-butter customers.

 

As the example of Uber shows, identifying true disruptive innovation is tricky. Yet even executives with a good understanding of disruption theory tend to forget some of its subtler aspects when making strategic decisions.

 

We’ve observed four important points that get overlooked or misunderstood:

1. Disruption is a process.

 

The term “disruptive innovation” is misleading when it is used to refer to a product or service at one fixed point, rather than to the evolution of that product or service over time. The first minicomputers were disruptive not merely because they were low-end upstarts when they appeared on the scene, nor because they were later heralded as superior to mainframes in many markets; they were disruptive by virtue of the path they followed from the fringe to the mainstream.

 

Most every innovation—disruptive or not—begins life as a small-scale experiment. Disrupters tend to focus on getting the business model, rather than merely the product, just right. When they succeed, their movement from the fringe (the low end of the market or a new market) to the mainstream erodes first the incumbents’ market share and then their profitability. This process can take time, and incumbents can get quite creative in the defence of their established franchises. For example, more than 50 years after the first discount department store was opened, mainstream retail companies still operate their traditional department-store formats. Complete substitution, if it comes at all, may take decades, because the incremental profit from staying with the old model for one more year trumps proposals to write off the assets in one stroke.

 

The fact that disruption can take time helps to explain why incumbents frequently overlook disrupters. For example, when Netflix launched, in 1997, its initial service wasn’t appealing to most of Blockbuster’s customers, who rented movies (typically new releases) on impulse. Netflix had an exclusively online interface and a large inventory of movies, but delivery through the U.S. mail meant selections took several days to arrive. The service appealed to only a few customer groups—movie buffs who didn’t care about new releases, early adopters of DVD players, and online shoppers. If Netflix had not eventually begun to serve a broader segment of the market, Blockbuster’s decision to ignore this competitor would not have been a strategic blunder: The two companies filled very different needs for their (different) customers.

 

Because disruption can take time, incumbents frequently overlook disrupters.

 

However, as new technologies allowed Netflix to shift to streaming video over the internet, the company did eventually become appealing to Blockbuster’s core customers, offering a wider selection of content with an all-you-can-watch, on-demand, low-price, high-quality, highly convenient approach. And it got there via a classically disruptive path. If Netflix (like Uber) had begun by launching a service targeted at a larger competitor’s core market, Blockbuster’s response would very likely have been a vigorous and perhaps successful counterattack. But failing to respond effectively to the trajectory that Netflix was on led Blockbuster to collapse.

2. Disrupters often build business models that are very different from those of incumbents.

 

Consider the health care industry. General practitioners operating out of their offices often rely on their years of experience and on test results to interpret patients’ symptoms, make diagnoses, and prescribe treatment. We call this a “solution shop” business model. In contrast, a number of convenient care clinics are taking a disruptive path by using what we call a “process” business model: They follow standardized protocols to diagnose and treat a small but increasing number of disorders.

 

One high-profile example of using an innovative business model to effect a disruption is Apple’s iPhone. The product that Apple debuted in 2007 was a sustaining innovation in the smartphone market: It targeted the same customers coveted by incumbents, and its initial success is likely explained by product superiority. The iPhone’s subsequent growth is better explained by disruption—not of other smartphones but of the laptop as the primary access point to the internet. This was achieved not merely through product improvements but also through the introduction of a new business model. By building a facilitated network connecting application developers with phone users, Apple changed the game. The iPhone created a new market for internet access and eventually was able to challenge laptops as mainstream users’ device of choice for going online.

3. Some disruptive innovations succeed; some don’t.

 

A third common mistake is to focus on the results achieved—to claim that a company is disruptive by virtue of its success. But success is not built into the definition of disruption: Not every disruptive path leads to a triumph, and not every triumphant newcomer follows a disruptive path.

 

For example, any number of internet-based retailers pursued disruptive paths in the late 1990s, but only a small number prospered. The failures are not evidence of the deficiencies of disruption theory; they are simply boundary markers for the theory’s application. The theory says very little about how to win in the foothold market, other than to play the odds and avoid head-on competition with better-resourced incumbents.

 

If we call every business success a “disruption,” then companies that rise to the top in very different ways will be seen as sources of insight into a common strategy for succeeding. This creates a danger: Managers may mix and match behaviours that are very likely inconsistent with one another and thus unlikely to yield the hoped-for result. For example, both Uber and Apple’s iPhone owe their success to a platform-based model: Uber digitally connects riders with drivers; the iPhone connects app developers with phone users. But Uber, true to its nature as a sustaining innovation, has focused on expanding its network and functionality in ways that make it better than traditional taxis. Apple, on the other hand, has followed a disruptive path by building its ecosystem of app developers so as to make the iPhone more like a personal computer.

 

4. The mantra “Disrupt or be disrupted” can misguide us.

 

Incumbent companies do need to respond to disruption if it’s occurring, but they should not overreact by dismantling a still-profitable business. Instead, they should continue to strengthen relationships with core customers by investing in sustaining innovations. In addition, they can create a new division focused solely on the growth opportunities that arise from the disruption. A research in this regard suggests that the success of this new enterprise depends in large part on keeping it separate from the core business. That means that for some time, incumbents will find themselves managing two very different operations.

 

Of course, as the disruptive stand-alone business grows, it may eventually steal customers from the core. But corporate leaders should not try to solve this problem before it is a problem.

What a Disruptive Innovation Lens Can Reveal

It is rare that a technology or product is inherently sustaining or disruptive. And when new technology is developed, disruption theory does not dictate what managers should do. Instead it helps them make a strategic choice between taking a sustaining path and taking a disruptive one.

 

The theory of disruption predicts that when an entrant tackles incumbent competitors head-on, offering better products or services, the incumbents will accelerate their innovations to defend their business. Either they will beat back the entrant by offering even better services or products at comparable prices, or one of them will acquire the entrant. The data supports the theory’s prediction that entrants pursuing a sustaining strategy for a stand-alone business will face steep odds.

When new technology arises, disruption theory can guide strategic choices.

Uber’s strong performance therefore warrants explanation. According to disruption theory, Uber is an outlier, and we do not have a universal way to account for such atypical outcomes. In Uber’s case, we believe that the regulated nature of the taxi business is a large part of the answer. Market entry and prices are closely controlled in many jurisdictions. Consequently, taxi companies have rarely innovated. Individual drivers have few ways to innovate, except to defect to Uber. So Uber is in a unique situation relative to taxis: It can offer better quality and the competition will find it hard to respond, at least in the short term.

How Our Thinking About Disruption Has Developed


Initially, the theory of disruptive innovation was simply a statement about correlation. Empirical findings showed that incumbents outperformed entrants in a sustaining innovation context but underperformed in a disruptive innovation context. The reason for this correlation was not immediately evident, but one by one, the elements of the theory fell into place.

Smart disrupters improve their products and drive upmarket.

First, researchers realized that a company’s propensity for strategic change is profoundly affected by the interests of customers who provide the resources the firm needs to survive. In other words, incumbents (sensibly) listen to their existing customers and concentrate on sustaining innovations as a result. Researchers then arrived at a second insight: Incumbents’ focus on their existing customers becomes institutionalized in internal processes that make it difficult for even senior managers to shift investment to disruptive innovations. For example, interviews with managers of established companies in the disk drive industry revealed that resource allocation processes prioritized sustaining innovations (which had high margins and targeted large markets with well-known customers) while inadvertently starving disruptive innovations (meant for smaller markets with poorly defined customers).

 

Those two insights helped explain why incumbents rarely responded effectively (if at all) to disruptive innovations, but not why entrants eventually moved upmarket to challenge incumbents, over and over again. It turns out, however, that the same forces leading incumbents to ignore early-stage disruptions also compel disrupters ultimately to disrupt.

 

What we’ve realized is that, very often, low-end and new-market footholds are populated not by a lone would-be disrupter, but by several comparable entrant firms whose products are simpler, more convenient, or less costly than those sold by incumbents. The incumbents provide a de facto price umbrella, allowing many of the entrants to enjoy profitable growth within the foothold market. But that lasts only for a time: As incumbents (rationally, but mistakenly) cede the foothold market, they effectively remove the price umbrella, and price-based competition among the entrants reigns. Some entrants will flounder, but the smart ones—the true disrupters—will improve their products and drive upmarket, where, once again, they can compete at the margin against higher-cost established competitors. The disruptive effect drives every competitor—incumbent and entrant—upmarket.

 

With those explanations in hand, the theory of disruptive innovation went beyond simple correlation to a theory of causation as well. The key elements of that theory have been tested and validated through studies of many industries, including retail, computers, printing, motorcycles, cars, semiconductors, cardiovascular surgery, management education, financial services, management consulting, cameras, communications, and computer-aided design software.

Making sense of anomalies.

Additional refinements to the theory have been made to address certain anomalies, or unexpected scenarios, that the theory could not explain. For example, we originally assumed that any disruptive innovation took root in the lowest tiers of an established market—yet sometimes new entrants seemed to be competing in entirely new markets. This led to the distinction we discussed earlier between low-end and new-market footholds.

 

Low-end disrupters come in at the bottom of the market and take hold within an existing value network before moving upmarket and attacking that stratum. By contrast, new-market disruptions take hold in a completely new value network and appeal to customers who have previously gone without the product. Consider the transistor pocket radio and the PC: They were largely ignored by manufacturers of tabletop radios and minicomputers, respectively, because they were aimed at non-consumers of those goods. By postulating that there are two flavours of foothold markets in which disruptive innovation can begin, the theory has become more powerful and practicable.

We still have a lot to learn.

The theory will keep expanding and getting refined and much work lies ahead. For example, universally effective responses to disruptive threats remain elusive. Our current belief is that companies should create a separate division that operates under the protection of senior leadership to explore and exploit a new disruptive model. Sometimes this works—and sometimes it doesn’t. In certain cases, a failed response to a disruptive threat cannot be attributed to a lack of understanding, insufficient executive attention, or inadequate financial investment. The challenges that arise from being an incumbent and an entrant simultaneously have yet to be fully specified; how best to meet those challenges is still to be discovered.

 

Disruption theory does not, and never will, explain everything about innovation specifically or business success generally. Far too many other forces are in play, each of which will reward further study. Integrating them all into a comprehensive theory of business success is an ambitious goal, one we are unlikely to attain anytime soon.

 

But there is cause for hope: Empirical tests show that using disruptive theory makes us measurably and significantly more accurate in our predictions of which fledgling businesses will succeed. As an ever-growing community of researchers and practitioners continues to build on disruption theory and integrate it with other perspectives, we will come to an even better understanding of what helps firms innovate successfully.

 

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