Business Theory of Disruptive Innovation

The theory of disruptive innovation, introduced by Joseph L. Bower and Clayton M. Christensen in 1995 , deals with the question how an organization can drive growth through innovation. The theory of disruptive innovation builds on the jobs to be done and aims to help organizations focus on innovation-driven growth

While the theory extends much further than described in this post, I find it particularly helpful when evaluating new opportunities. Although the theory will help you understand how to appropriately allocate the organization’s resources, I feel the topic fits the Opportunity question as outlined in the Strategic Blueprint Structure better.

innovation in business
Innovation in business

Consumption vs Non-Consumption

A first important topic in the theory of disruption of innovation is recognizing there are different type of consumers and non-consumers. Whereas traditional businesses think of a market as the amount of people buying a specific product or service, it’s more useful to think of your market as everyone who needs to get a certain job done. From that perspective, you can separate four types of people

  • Consumers: people who are using your product or service to get the job done
  • Non-consumers (A): people who are not able to use your product or service, but would like to if they had the means to acquire or hire
  • Non-consumers (B): people who refuse to use your product or service because it does not meet their needs or desires
  • Non-consumers (C): people who have no idea your product or service exists and are currently using a different product to get the job done

Note that while we recognize a distinct difference between the groups, they do share certain characteristics. For example, the group of consumers, non-consumers (A), and non-consumers (B) have in common that they all know about your product. They are either a customer already, or feel your offer either over-serves or under-serves them. Similarly, the group of all non-consumers share the fact they’re not using your offer, however they all have a different reason.

The theory of disruptive innovation states that organizations benefit most when they compete against non-consumption. This seems logical as the group of non-consumers would typically be much larger than the group of consumers. However, in day-to-day operations we often get caught up in trying to sell more or newer to those people who are already buying our solutions.

The terms under- and over-served will return later in the post but for clarity purposes let’s define them as follows:

Under-served customers are people for whom the product offer does not meet the desired performance while over-served customers are people for whom the product provides too much performance. Product or service performance, in this context, is measured against the set of specific attributes and values a customer is willing to pay for. You can read more about this topic here: Attributes and Values: Business Strategy Core.

Sustaining and Efficiency Innovation

In his theory of disruptive innovation, Clayton Christensen distinguishes three type of innovation in business: sustaining, efficiency and disruptive innovation. The fundamental difference between both types of innovation is easily understood. Simply put, sustaining innovation is making a good product better while efficiency innovation is making the same product using fewer resources.

Product Development Sustaining InnovationEfficiency InnovationDisruptive Innovation
Capital Required+++++++++
Free Cash Flow++++
Jobs Created+++++++++

The key difference between the different types of innovation lies in the capital requirements and its uses, and its impact on the free cash flow.

Product Development (“Empowering Innovation”)

When a new product is developed for a certain job to be done, it demands a lot of capital. In fact, often starting the business requires much more capital than is available to the founders of the business. That’s why we would get a bank loan or venture capital firms to invest in our business. Both the bank and the investor help us obtain the capital required to start the business. Christensen refers to this phase as “empowering innovation” because it creates jobs for people who build, distribute, sell and service these products.

Sustaining Innovation

Once a product is in the market and establishes itself as a profitable business, a big driver to engage in sustaining innovation is the rivalry that takes place in the marketplace. Different firms will try and compete for the same customers by improving their offer vis-à-vis your offer. While significant re-investment in the business is of course necessary to survive in the marketplace, the amount of capital necessary for the re-investment is not that large. You can usually rely on the same people who made the product to also improve its attributes and performance. You can often use the same facilities and factories although maintenance and upgrading may be needed. Your inventories will not drastically expand either since people who buy the new product are not also buying the old product.

Efficiency Innovation

At a certain point, the sustaining innovation will reach a point of diminishing returns. The product improvements are not significant enough to convince customer to buy the new product. This will hamper the revenue growth potential and it is at this moment the financial folks will step in. The focus shifts from re-investing to improve the product, to re-investing to improve the gross, operating and net margins. The idea is that by improving the margins the business generates more free cash flow, which then can be reinvested in new projects or opportunities. The financial folks have plenty of efficiency measures at their disposal to determine what’s the best way to improve margins, but usually it boils down to either outsourcing operations to a business with lower operating costs.

“Efficiency innovations pay off really quickly. Empowering innovations take five or more years to pay off. So, they invest in efficiency innovations, and more capital comes out.”

Clayton Christensen, 2013 (source)

Clayton Christensen is very specific in his criticism of efficiency innovation. While jokingly referring to the “invention of the spreadsheet” as the root cause of the demise of economies, fundamentally the criticism is that companies get used to the short-term profits of efficiency innovation. In addition, instead of using those profits to invest in innovation businesses choose to re-invest further in the efficiency optimization practices in order to realize even more profit. The efficiency cycle repeats itself, until there’s no more efficiency to squeeze.

Disruptive Innovation

Disruptive innovation is similar to empowering innovation in the sense that disruptive innovation also ends with a new product or service offered on the market. However, the disruptive innovation theory distinguishes two types of innovation as particularly powerful: low-end disruptive innovation and new market disruptive innovation.

Low-End Disruptive Innovation

low-end disruptive innovation
Low-end disruptive innovation

Low-end disruptive innovation begins with offering low-cost products to over-served customers using a lower cost business model than established players. As the product improves over time through sustaining innovation, the product will eventually over-serve the initial customers. However, you’ll find that up-market there are now under-served customers with greater performance demands you can serve with the lower-cost business model.

A couple of clarifications are necessary.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “over-served” indicates that the performance demanded by the customer is lower than the value that is offered by the product. Thus, the customer is paying for things they don’t really need, and the customer may prefer a lower quality but cheaper solution.

Generally, fueled by rivalry and associated drive for sustaining innovation, the performance offered by the market increases at a much faster pace than the performance demands by the customer base. This causes companies to look for market segments that are willing to pay more for higher product performance. This is called going “up-market”.

Not only are the customers in this segment willing to pay more, generally the profit margins are also higher in the up-market segments. So, companies find it natural to dispose of their lower-margin business and prefer the higher-margin new customers. However, the more up-market you go, the more you find yourself catering to a niche market with niche demands.

The disruption takes place every time the low-cost business model enters a new market. The disrupting company is able to take on the incumbents thanks to the cost advantages inherent to its low-cost business model. It can repeat this every time it moves up-market as incumbents are usually slow to adapt to new business models.

Notice how the low-end disruption model appears cyclical in nature. As the low-cost business models improve the product performance and moves up-market it will eventually over-served certain customers. Those over-served customers will eventually be looking for cheaper alternatives. New low-cost disruptive businesses can then take their piece of the market.

New Market Disruptive Innovation

new market disruptive innovation
New market disruptive innovation

New market disruptive innovation focuses on under-served or non-served customers (non-consumption). Typically, this requires a low-cost business model combined with a new value chain as non-consumption performance demands are different from existing customers.

The term “performance” refers to the specific offering level of the set of attributes or values offered by your product or service. The performance evaluation of a product is entirely dependent on the customer needs and desires. The better the value offered by your product matches the performance demanded from the customer, the less likely the customer will switch to a different solution.

The term “under-served” indicates that the performance demanded by the customer is higher than the value that is offered by the product.

Often, this under-served market is interpreted as a low-end market segment with cheap customers. This is wrong. The customers in this segment are misunderstood as cheap because they are not willing to pay for the attributes offered by the company, regardless how low the price is. Their willingness to pay is low because they don’t value those specific attributes. They value different attributes; attributes which the company isn’t offering.

For an existing business to venture in new market disruption, it’s often required to establish an entirely new team separate from the current team. Everything is different: the customers, their needs, the profit-formula, the value and supply chain, the volumes, and so on.