By now, hopefully Jill Lepore’s excellent takedown on The Innovator’s Dilemma (“What the Gospel of Innovation Gets Wrong”) has entered the public consciousness, at least among those who care about such issues. For those who don’t, it’s an immensely popular business book that essentially proposes that established companies will get overtaken by upstarts selling worse quality and cheaper products at a lower margin. In Clayton Christensen’s reckoning, the author of The Innovator’s Dilemma, these upstarts then slowly devour a company from the bottom up, starting with the lowest-margin and moving to the highest-margin items.
This, Christensen posits, is a scientific fact. He mentions in his defense of the book in Bloomberg Businessweek (“Clayton Christensen Responds…”) that a Tuck Business School professor improved this theory mathematically, as if the theory was like Newton’s laws just waiting for Einstein to develop relativity.
Unfortunately, what Mr. Christensen doesn’t seem to understand is that scientific theories must not only be supported rigorously (which, as Ms. Lepore points out extensively, is hardly true for The Innovator’s Dilemma) but it must be falsifiable. Any scientific theory that can survive an onslaught of contrary facts by simply evading them, as Christensen does by loosening his definitions of established companies, upstarts (which he calls “entrants”), and even success and failure, is hardly a theory at all. It’s no more so a theory than the natural health industry’s focus on “removing toxins” is.
But I don’t want to spend this post attacking The Innovator’s Dilemma, especially as Ms. Lepore has done such an excellent job already. Rather, I’d like to examine the consequences of this felling of a giant. I don’t mean the consequences for Christensen and his status as “the Number One Management Thinker in the World”, as his website triumphs (Christensen’s Homepage), nor his undoubtedly impressive annual paycheck. Given the slipperiness of the theory, it would be positively embarrassing if the prime promoter weren’t just as slippery, or just as able to keep up his speaking fees.
No, instead, I’d like to focus on what this means for business as a whole. Much of the thinking (and therefore, the capital allocation) of business since the publication of The Innovator’s Dilemma has been shaped by Christensen’s theory. My thinking about business, as well, has been shaped by The Innovator’s Dilemma, although of course I will now strive to make it less so. “When my information changes, I alter my conclusions. What do you do, sir?” (quoted from John Maynard Keynes)
Of course, “disruption” as a buzzword has been misused even by Christensen’s standards for a long time, now. Timothy B. Lee at Vox, commenting on Lepore’s very article, supposes that Vox and even Buzzfeed are disrupting the New York Times (Vox’s Response to Lepore), as if the New York Times has abandoned the “commentary on what other people have written” and “listicle” sections of their newspaper to focus on higher-margin reporting. No, Mr. Lee, you may be successfully stealing advertising revenues, but you are hardly disrupting.
True disruption is something closer to what Amazon does, when they are willing to ship heavy, low-cost (and presumably low-margin) items anywhere in the US for free with an annual payment of $99, such as this 1 pound group of drywall screws (Drywall Screws). It’s a business that likely any hardware store would not remotely be interested in, as I’d be surprised if Amazon doesn’t make a loss of it.
According The Innovator’s Dilemma, this is a mistake on the part of the hardware stores. Amazon will take progressively higher and higher margin products from hardware stores until they are the last company standing in this area (which, unfortunately, is somewhat ill-defined, as are all Christensen’s disrupted fields. Hardware? Hardware shipping? Hardware supplies? Hardware supplies shipping?). The only thing for a hardware store to do would be to fight back on Amazon’s terms, disrupt their own business before Amazon gets a chance to.
Proponents of Amazon point to the defunct bookstore chain Borders as an example of a company that did not heed this warning. From their point of view, Amazon’s relentless focus on low costs and order fulfillment drove Borders out of business. Of course, the theory doesn’t fit neatly, especially as the ladder structure imagined by Christensen doesn’t apply to Amazon (for one thing, while they’ve moved into different spaces, I wouldn’t say Amazon has attacked higher-margin areas).
But what if the hardware stores were right in the first place? What if it was never a good idea for Amazon to ship items at a loss, especially not such esoteric ones? Companies are frequently vulnerable in their higher margin areas, not their lower. While it’s not a company, the US Postal Service provides a good example of this.
The Postal Service has never had an issue with competitors attacking their lowest-margin business, which is delivering mail to remote regions of the US. They have frequently attempted to defend their highest margin businesses, such as delivering packages and delivering mail in populated areas, both legally (through their granted monopoly) and competitively (through rates). Far from the Postal Service’s existence being threatened by companies who want their lowest-margin businesses, its existence is threatened by companies, like FedEx, and technologies, like email, which threaten their highest-margin businesses.
In the same vein, the New York Times is threatened by companies which can virtually instantaneously republish and comment upon their expensive investigative reporting. While this has always been an issue (Time, for instance, was started as a collection of newspaper reporting), the speed and ease at which this is done now is a potentially mortal threat to the newspaper industry.
Now, with that in mind, the success of Amazon can be looked at in a different light. It’s undeniable that some of Amazon’s success comes from its ability to make a profit off of low margin items. Walmart, for instance, has become one of the biggest companies in the world in precisely that manner. But that’s only because retailing has always been about low costs (with exceptions such as Nordstrom). Walmart was able to offer more items at a lower cost because of improved technology and organization. The basic idea of it was never revolutionary, only the implementation was excellent.
However, Walmart didn’t enter into those areas because they were low-margin, or because they were serving a previously ignored demographic (after all, which retailing executive was surprised that people would want lower cost paper towels?). Instead, Walmart entered into those areas because Sam Walton knew he could apply technology and organization to make an overall profit while lowering retail prices.
Amazon, to the extent which it has succeeded on its own merits (and not simply its insane valuation, a valuation that is so detached from cash flow it might as well be a license to do anything), has only succeeded where it is able to apply technology and organization to sell products for less.
Therefore, any company which wishes to “disrupt” an industry must either have superior technology, superior organization, or both, or they will fail. Companies based on “disruption” that rely on using investor capital to survive in low-margin areas in order to get to higher-margin areas will never escape those low-margin areas. They will burn through capital until there is none left, and then they either be forced to increase their margins (and thus compete with established companies on their own terms) or they will fail.
So, when examining whether to invest time or money in a company that promises to “disrupt” an existing industry, it is necessary to determine whether or not that company has superior technology or organization. If they do not (and it must be a substantial technological advantage, an Android app is not enough), then do not invest. This is a lesson that Square investors, for instance, are now learning the hard way (Square’s Financial Difficulties).
It is not and it has never been enough to simply enter into an existing space and offer lower-margin products. The chickens must eventually come home to roost.