Why should anyone care about disruptive innovation? (2/2)

Disruptive innovation is a term that may convey very different meanings. As a consequence, CEOs don’t always consider how disruptive innovation can help them transform their business, create new growth engines and develop a sustainable competitive advantage. More importantly, many decision-makers fail to understand that there’s no real alternative to disruptive innovation. The choice is between leading disruptive innovation or going bankrupt. Here’s why.

The competitive dynamics operating in minimills shows why to care about disruptive innovation

Last week, I talked about the steel industry, in which they are two competing technologies:

• Integrated mills provide high quality steel at high price points.
• Minimills provide lower quality steel at lower price points.

One may believe that all is well: integrated mills focus on high margin market segments interested in buying high quality steel, while minimills focus on the lower end of the market. But, in fact, in the 1990’s, minimills put integrated mills out of business. Here’s how.

I/ Minimills moved upmarket to ensure profitability

In the beginning, minimills were in a specific market segment, called the “rebar” market segment where margins were low. Being unable to make profits on the rebar market segment, the minimills started looking upmarket and found a new market segment. In the angle iron market segment, integrated mills were making 12% margin and volumes were twice as large. If minimills could improve the quality of its products, it could make handsome profits. So, minimills invested massively in R&D in order to improve the quality of their products. Then, they penetrated the angle iron market segment. And for a time, integrated mills were competing against minimills, whose cost structure were 20% lower than that of integrated mills. But, it turns out that, while minimills were only able to address two market segments, the integrated mills could address many more market segments including market segments where margins and volumes were more attractive. Why should integrated mills defend their positions in the angle iron market segment, when other market segment offered higher margins and larger volumes? Staying in the rebar market segment made little sense for integrated mills. As a result, a few integrated mills started moving upmarket to address more profitable market segments, such as the structural steel market segment. While numerous integrated mills exited the angle iron market segment, minimills invested the angle iron market segment powerfully. Boasting a lower cost structure, the minimills were making handsome profits on the angle iron market segment.

II/ Minimills weren’t able to make profits anymore

But, in 1980, industry structure was dramatically altered. The nature of competitive advantage changed. The last integrated mill still competing in the angle iron market segment decided to exit the market.  So, again, minimills were now competing against one another. Having a lower cost structure was a real competitive advantage when they were competing against integrated mills whose cost structure was inherently higher. But now, cost-leadership strategies were no longer sustainable: similar cost structures were competing against one another. Minimills, striving to keep their market share, reduced their prices by 20%, thereby destroying profitability. What were the minimills to do now? How could the minimills create a sustainable competitive advantage?

Being unable to make profits on the angle iron market segment, the minimills started looking upmarket and found a new market segment. In the structural steel market segment, integrated Mills were making higher margin on larger volumes. Minimills penetrated the structural steel market prompting integrated mills to exit in favor of a higher margin market segment. This process continued on and repeated itself in the sheet steel market segment.

III/ Upmarket moves may lead to a company’s downfall

But, one day, integrated mills did not find any new market segments where profitability and volume were higher. Facing minimills whose cost structure was 20% lower, integrated mills, once leading the steel industry, failed to find new growth drivers on the steel market. Some, such as Bethlehem Steel, went bankrupt, while others, such as US steel, penetrated niche markets where profitability was high the volumes in very low. This led to a significant reduction in their overall sales and their market capitalization decreased significantly. At the same time, market capitalization of minimills increased. In other words: upmarket moves work if a company that exits a given market segments can find a new market segment where margins and volumes are more attractive. If these two conditions are not met, then upmarket moves innovation fails.

The most striking thing here is that integrated mills made rational decisions: they invested in the most promising, most profitable, and largest market segments in order to maximize profit. They invested powerfully in innovation to penetrate new markets and yet, these rational decisions ultimately led to their own downfall. In many ways, upmarket moves, because of its linear and predictable nature, leads to intensifying competition, according to Clayton Christensen. This ultimately leads to the company’s own downfall. Upmarket moves come with a share of risks and the only way to mitigate these risks is disruptive innovation. Therefore, disruptive innovation is a necessary component of any growth strategy.

I hope this show why disruptive innovation is relevant to CEOs, Innovation VPs, Investors and Financial analysts. How would you show that disruptive innovation is relevant?

Further readings on why to care about disruptive innovation:

• For a great presentation of what disruptive innovation is, please refer to Clayton Christensen’s article here.
• For another discussion of how minimills upended integrated mills, please refer to Clayton Christensen’s Innovator’s Dilemma, chapter 4