When discussing innovation and entrepreneurship, it actually turns out that there are only 4 types of innovation (1-4):
1. New Products Innovation
2. Sustaining Product Innovation
3. Disruptive Innovation, Understanding Disruptive Innovation
4. Efficiency Innovation
5. Which Innovation to Pursue?
6. Choose the Right Metrics
7. Conclusions and Further Readings
This is the type of innovation which revolves around understanding what new products companies need to develop. Historically product development was grounded on Personas, or a marketing approach focusing on profiling consumers. However, as discussed in this post, the Jobs to Be Done Theory is able to do a much better job at assisting entrepreneurs and businessmen more accurately predict where to drive innovation.
In addition, JTBD postulates that even if the products that people hire to get their jobs done change fairly rapidly, the jobs themselves tend to stay the same for a very long amount of time.
IKEA is often mentioned as a company which has structured its marketing efforts in terms of coming to the consumer’s mind when the ‘job to be done’ is purchasing good cost\quality furniture.
Once we have a product that does the job well, the next thing we need to do is improving on the product. This type of innovation represents the most common form of innovation that happens around us. Sustaining Innovation is the typology of innovation that helps companies maintain healthy profit margins. However – cynically speaking – all these products do, is replacing older products with new ones, not creating any actual growth.
This is in fact, a type of innovation which actually creates growth. To explain how disruptive innovation works, Prof. Clayton Christensen actually uses the image of three concentric circles. The innermost circle represents customers who have the most money, the mid circle represents the upper class, the last circle represents more economically challenged individuals.
Disruptive innovation is the type of innovation that turns products which are initially available only to the first circle of individuals, into products available to the other circles too.
Most industries, always begin in the centre, or with products that are initially are very expensive so that they can be made accessible to wider and wider circles of the population.
Moreover, this approach allows companies to compete against non-consumption, meaning that people who would not have been interested in a particular market before because of its entry point, are now compelled to become consumers.
Moreover, in every industry, there is a tendency for products to increase in sophistication, while at the same time consumers’ needs tend to stay the same. Over time this leads to an unfortunate consequence: end consumers may be outstripped of the ability to use certain products because they overcomplicate an easy solution.
So when contemplating which type of innovation to pursue, the following considerations can be made:
If one the one hand starting a business with sustaining innovation borders impossibility, on the other hand starting a business with disruptive innovation is much more doable. This is because disruptive innovation amplifies the number of people who access a market, or industry, therefore creating growth.
This relates to the concept that Clayton Christensen calls ‘The Innovator’s Dilemma’, which states that when a disruptive company comes around, making products which have historically been very expensive and turning them into affordable commodities to the wider public, established companies have to face a dilemma.
On the one hand, they can keep doing what they are doing, retaining their premium market segment, making better cars, and selling their products to more wealthy customers for better margins, or start competing on the disruptor’s market, by selling cheaper-to-make products, to a market that is not part of their marketing strategy, will very little margin.
The solution seems simple: go for the first alternative. Unfortunately, that’s wrong, as your unchallenged competitor will build a larger consumer base and eventually build the momentum that will lead to going after your premium market segment, disrupting your company.
So can a company who retains the high end of the market, become a disruptor of a new wave of businesses? Yes! This can happen, but it’s rare.
IBM and HP were able to maintain market share, but by completely revolutionising their business by creating products engineered to have lower costs, and lower margins, but still capable of maintaining a share of the low-end market.
This is the type of innovation which allows us to do more with less. This type of innovation is able to increase cash flow, but as a counterpoint efficiency tends to decrease jobs.
Understanding these 4 types of innovation can assist us in understanding the 4-innovation step process which can be pursued by companies, which can be broken down in the following:
Hypothetically this would create a growth loop, but unfortunately, this does not happen. The reason why growth is hard to sustain is due to issues which Prof. Christensen blames on the world of finance. He is actually able to pinpoint this to mainly two reasons:
Ratios are fractions, which have a numerator and a denominator. One of the ratios which are mostly used is called RONA or Return on Net Assets, another widely used ratio is the IRR internal rate of return.
RONA (net income/ fixed assets + net working capital) measures a company’s financial performance. The Net income is the money left in the company after operating expenses, preferred stock and dividends are deducted. Fixed assets are a company’s long-term, tangible equipment or property used to produce the company’s products (real estate for instance). Net Working capital is a company’s assets minus its liabilities.
As a manager, if you want to take the RONA value up, then you have two options: either increasing the numerator or decreasing the denominator. In other words, you could be more profitable, by being more innovative, so that I can focus on the innovation OR you could just decrease the denominator, by outsourcing all assets. Either way, RONA goes up, as it’s easier to outsource and reduce costs than to make more profit. As a consequence, in the pursuit of RONA, we outsource more and we stop innovating.
IRR (internal rate of return) is also a ratio: the numerator is profit, and the denominator is how quickly I get my money out after I’ve put my money in. In order to increase this value – instead of making more money – you could simply focus on short-term returns which pay sooner. In which case I’m only growing the company on paper and not in the real world.
As a result, efficiency innovation is more profitable than disruptive innovation for investors, as disruptive companies take much longer to become profitable and pay off in 5 to 10 years.
If capital is invested in efficiency innovations, we are likely to get our money back sooner but this leads to a vicious circle whereby investment does not lead to actual growth, but to the creation of more capital.
As a result of the metrics that investors have chosen, businesses will lead to economies to flat-lining growth. This is because their metrics suggest investing in efficiency innovation, or in other words to use capital to create capital rather than to grow the economy.
So what metrics should we use? None of the ones that currently exist, because in terms of assessing success there is no one-size-fits-all approach. The best approach is to create our own.
If you’d like to read more on this topic, these are some publications I’d recommend.
Or Other sources from our blog:
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