A while ago, I wrote an article (link) on the need for any serious investors to watch out for disruptions. However, in that article, I only listed one type of disruption – technological.
Since then I’ve read more on disruptions and came upon a fantastic book by Clayton Christensen – the author of best-selling books on "The Innovator’s Dilemma" as well as "The Innovator’s Solution." This book is called "The Innovator’s Prescription – A Disruptive Solution for Health Care."
Christensen has done a fantastic job in terms of providing a great framework for thinking about disruptions. Below are some of the notes I took from the book.
Christensen lists three enablers of disruptive innovation:
1. Technological enabler. Typically sophisticated technology whose purpose is to simplify, it routinizes the solution to problems that previously required unstructured processes of intuitive experimentation to resolve.
2. Business model innovation. Can profitably deliver these simplified solutions to customers in ways that make them affordable and conveniently accessible. Generally speaking, there are three types of business models:
- Solution shops – These shops are businesses that are structured to diagnose and solve unstructured problems. Consulting firms and advertising agencies fall into this category. Solution shops often charge their customers in the form of fees for service.
- Value-adding process (VAP) businesses – These are businesses that take in incomplete or broken things and then transform them into more complete outputs of higher value. Retailing, restaurants, auto manufacturing and petroleum refining fall into this category. VAP businesses typically charge their customers for the output of their processes.
- Facilitated networks – These are enterprises in which people exchange things with one another. WebMD (WBMD, Financial) and EBay (EBAY, Financial) are examples of this type of business model. They typically make money through membership or user fees.
3. Value network. A commercial infrastructure whose constituent companies have consistently disruptive, mutually reinforcing economic models. This is the coalescence of an independent value network around the new disruptive business models through which products or services are delivered.
One specific type of disruption is called out by the author – supply chain interruption. Its form: vertically integrated companies that have long dominated the industry began outsourcing many of their functions of specialists companies. Those to whom this work is being outsourced are integrating to add more and more value to their offerings, eventually competing against the incumbent. The driver of this interruption – the leaders improve their profitability by getting out of the least profitable of their activities while focusing on the most profitable.
There are a few lessons from the history of disruptive innovation.
- Business model innovations rarely emerge from the leading institutions in the industry.
- Disruption rarely happens piecemeal, where stand-alone disruptions are plugged into the existing value network of an industry. Rather, entirely new value networks arise, disrupting the old.
- Always, the technological enablers of disruptions are successfully deployed against the industry’s simplest problems first. They then build commercial and technological momentum upon that foothold and improve, progressively displacing the old, high-cost approach application by application, customer by customer, disease by disease.
Christensen gives many fabulous examples in the book.
Let’s see how this framework can be applied to Amazon (AMZN, Financial), specifically to the book retailing business.
Obviously the technological enabler is the Internet-based platform. What’s not obvious is that book and music retailing historically were value-adding process businesses. However, with its rating system, discussion groups and a network of resellers, Amazon pushed these VAP activities toward a network facilitator business model. Once the new business model took off, a new value network that includes a vast network of resellers, logistic companies, and online payment platforms emerged.
Another example involves ASUSTeK (TPE:2357, Financial) and Dell (DELL, Financial). ASUSTek started out making the simplest of the circuit board within a Dell computer. Then ASUSTek came to Dell and made value propositions that would improve Dell’s profit margin – ASUSTek would make the motherboard for Dell, and Dell could save 20%. And it did. ASUSTek then came to Dell again and again making the same value proposition from assembly to logistics to product design. Each time it saved cost for Dell and made Dell’s profit margin look better. Then one day ASUSTek went to Best Buy (BBY, Financial) and took share from Dell.
A current example that’s still evolving can be found in the pharmaceutical industry. Big pharma companies have begun actively outsourcing many of their functions to specialty companies, ranging from the discovery and development of new drugs to the administration of clinical trials to manufacturing. Those to whom this work is being outsourced are integrating to add more and more value to their offerings. Christensen predicted that in the future, today’s major pharmaceutical companies will find they have inadvertently leveled the playing field in their industry, so that entrants can overcome what historically been high barriers to entry.
Disclosure: No position in any of the stocks mentioned in the article.
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