Theory of Innovation

Four different types of innovations:

• Potential innovation - by understanding the job to be done.

• Sustaining innovation - Making good products better.

• Efficiency innovations - Help us do more with less.

• Disruptive innovations - Fuel growth, disrupt the incumbent by starting at the bottom.

• Do the job perfectly/experiences:

  • i.e. Implementation done timely, within budget, meet business objectives
  • How do you build brand-awareness that when this problem arises you think of this company?

• Models of developing products and businesses:

  • JTBD -

    • Create a new invention

    • It is much better when the current alternatives do a poor job

    • You’re able to charge a premium because of the risk involved in switching or trying out a different alternative

      • (think of the risk of not using Ikea for a similar price range and job)

  • Sustaining products (sustaining innovation):

    • Make existing products better
    • Help keep margins safe
    • They replace older products with new ones, but don’t create growth.
    • If you buy this year’s product, you won’t buy last year’s best product
    • Replaceable in character
    • Most innovations we think about are of this type
    • **Even dramatic breakthrough innovations can be and mostly are sustaining innovations.
    • ** Incumbent leaders find themselves still on top of the industry in battles of sustaining innovation.
    • Beating incumbents is hard. Better products with better profits against incumbents — going after their best customers is hard. Really hard. Almost always the incumbent wins.
    • If you are going head to head they will kill you. The evidence is very strong that you will loose if you think you can beat incumbents this way.

  • Disruptive innovation:

    • What makes disruptive innovation?

      • A dramatic technological improvement is not disruptive.
      • Almost always it’s built into the business model
      • Not by developing the best technology
      • Deployment (business model) is what drives disruption

    • Drive growth

    • Transform products which in the middle were too complicated and expensive. Disruption makes it more affordable and accessible such that many more people are able to use those products and services, and almost always entrant companies typically win at disruption.

    • Makes something accessible that was previously cost prohibitive or complicated - goes from accessible by a customer with the most money and most access to large populations with proportionally less money

    • At first the margins, and the market are small - so small that it doesn’t make sense for incumbents to go down to your level and beat you.

    • Example: Digital Equipment Corp. was like Google in its heyday. Widely admired company in the world. In 1988 it fell off a cliff.

      • Wins = Excellent management

      • Loss = Poor management

      • The stupid manager hypothesis doesn’t work.

      • Everyone that made minicomputers had problems. Fell in unison.

        • Honeywell
        • HP
        • Data General
        • Prime Wayne

      • Is it possible they could have cahoot on pricing? But cahoot to collapse?

      • Mini computers were a complicated product. Sold direct to consumer. A lot of training and support was required along with software.

      • All those costs (training, software, support) meant margins of 45% on very expensive mini computers.

      • Some people came up with ideas and innovation such that some of these mini-computers were so good that they could do some of the lighter work that mainframes did.

      • Mainframes generated 60% margins and could be sold for twice as much money.

      • In 1970s and 80s everyone was buying personal computers while mini-computers makers were deciding if they should enter mainframes.

      • Personal computers were way underpowered and could not be used by mini-computer customers. For example Apple II could not be used.

      • It took 10 years of innovation to catch up to mini-computers.

      • It’s worth noting they got no signal from their customers that personal computers mattered because, in fact, they didn’t to them.

      • The business economies made little sense. Lower margins, 40% moving to 20% with lower per sale price.

      • Samsung and Waiwei are in the process of disrupting Apple.

      • Koreans are going after Toyota (Hundai and Kia)

        • Pinto and Chevelle tried to sell subcompacts, finance people would look at the margins, vs. the margin of the SUVs.
        • Chinese manufacturers are coming next.

  • Disruptive innovation from within:

    • Only a few examples.

    • A completely independent business unit

    • With different profit formula

    • and different processes

    • IBM dominated mainframes

      • They made mini computers in different headquarters in a different business unit with different unit economics.

    • HP - Laserjet vs. Inkjet.

      • Setup inkjet seperately in Vancouver with a different salesforce.

• Efficiency innovations

  • Keep us competitive
  • Reduce jobs
  • Free up resources and cash flow
  • Important because they help to stay competitive, delay getting killed
  • Wallmart is an efficiency innovation
  • The Toyota production system is an efficiency innovation.

Why are companies not able to keep growth?

• Take care of what’s costly

• Waste what is abundant

• In finance, careful use of capital because capital was costly and scarce.

• Now it is abundant and cheap.

• The world has really changed on this.

• Second element — The use of ratios instead of whole numbers.

  • In the 1970s finance was taught in whole numbers. Starting in the mid 1980s, shortly after Dan Drickland developed the spreadsheet.
  • The analyst that got the spreadsheet wanted to be able to compare two companies. The numbers didn’t make much sense, unless they measured by ratios. This allowed to compare Google to say Microsoft.
  • ** What is hapenning as a nation is we are loosing our growth because of what finance has thought us to do.
    • ** It’s easier to outsource than it is to make more profit.
    • So in the pursuit of RONA you outsource more and more
    • IRR = Profit / How quickly you get money out after initial investment
    • Either way - profit is harder.
    • So they go after short-term payout projects. Because that’s the way to get IRR up.
  • Efficiency innovations ⇒ Free up cashflow ⇒ ASk analysts to tell us where to put money ⇒ Create disruptive companies (but you can’t because payout worsens ARR), Instead you end up investing in efficiency innovations.
  • RONA goes down because you need assets, IRR goes down because payout is 3-5 years. These are the capital requirements of disruptive innovations, so they do another round of efficiency innovations.
  • It’s what happened in Japan, Europe, and increasingly in North America.
  • Measuring success by ratios:

    • In the 1960s, 70s and 80s - Japan was growing at an unprecedented rate.

      • Toyota made cars affordable for mankind
      • Honda made motorcycles affordable for mankind
      • Sony made a ten transistor pocket radio
      • Canon disrupted Xerox with printers

    • In the late 1980s analysts started measuring success as gross margins, and net present values, and internal rate of return.

    • Now Japan’s economy has been flatlined for 25 years.

    • They have capital everywhere. The cost of capital is nearly zero and yet they can’t grow.

    • In the U.S. increasingly, analysts are causing us to use capital to create capital.

    • There is no metric that an analyst has developed or is motivated to develop to get out of this cycle. (Moody’s, S&P have very short-term metrics)

    • ** This means we have to develop our own metrics.