CHAPTER 7

Business Unit Strategy: Contexts and Special Dimensions

Introduction

Generic strategies are useful for identifying broad frameworks within which a competitive advantage can be developed and exploited. However, to forecast the relative effectiveness of different options, strategists consider the context in which a strategy is to be implemented. To see how such analysis is done, in this chapter we examine six types of industry settings. First, we look at three contexts that relate to the various evolutionary stages of an industry: emerging, growth, mature, and declining. Next, we discuss four industry environments that pose unique strategic challenges: fragmented, deregulating, hypercompetitive, and Internet-based industries. Because hyper-competition is increasingly characteristic of business-level competition in many industries, we then discuss two critical attributes of successful firms in dynamic industries: speed and innovation.

One Cause to Reconsider an SBU Strategy

As we discussed in the introduction of Chapter 4, the ongoing implementation of the Affordable Care Act (ACA), has immersed the healthcare industry in widespread, disruptive changes. These changes provide growth opportunities for some firms, but they also threaten established firms that may be unseated by competitors who adapt to market changes more quickly or who find innovative new ways to deliver services.

Consequently, every competitor in the disrupted industry must consider the strategic consequences of the ACA at its SBU levels. McKinsey& Company has identified three basic strategies that companies in other industries have used effectively to adjust to disruptions that they faced.¹ The hope is that modeling SBU strategies on the success of companies in similar situation in other industries will be instructive to healthcare firms.

The first basic strategy to consider is for the company to refocus its business portfolio, shifting its attention to those business activities that will benefit from industry changes or will be unaffected by them. Proctor & Gamble (P&G) used this strategy successfully to shift its focus from food products, where profit margins were falling, to branded home, health and beauty products where margins were more attractive. It sold Jif and Crisco in 2002, and Sunny Delight and Punica in 2004, and it continued selling off its remaining food and beverage brands, including Pringles and Folgers. Almost simultaneously, it re-launched its Oil of Olay skincare brand, expanded the product lines under its Mr. Clean brand, launched Swiffer, expanded its fragrance offerings, and acquired Gillette.

A second SBU strategy requires the company to transform its core business model. Charles Schwab, which had made its name as a low-cost stockbroker, undertook such a transformation when online brokers undercut its price. Schwab responded with cut prices and a new online trading platform, but kept its existing offices and customer service staff as competitive advantages against the new online brokers.²

The final strategy for dealing with a disruptive industry is to build a new SBU in a different market to make up for losses in the disrupted one. In the early 1990s, IBM, a force in the PC industry that sold end-to-end computing systems to businesses, found itself threatened by low-cost PC manufacturers. The corporation responded by using its connections with clients and its knowledge of company computer systems to develop a services division whose success counterbalanced the declining earnings from IBM’s hardware business. It created the IBM Consulting Group, which over the succeeding decade, grew to make up half of IBM’s revenue. Growth in the division, known as IBM Global Services, was sparked by its acquisition of PricewaterhouseCoopers management consulting and technical services businesses in 2002.

Emerging, Growth, Mature, and Declining Industries

Strategy in Emerging Industries

New industries or industry segments emerge in a variety of ways. Technological breakthroughs can launch entirely new industries or reform old ones, as in the case of changes to the telephone industry with the advent of cellular technology. Sometimes changes in the macro environment spawn new industries. Examples are solar energy and Internet technology.

From a strategic perspective, new industries present new opportunities. Their technologies are typically immature. This means that competitors will actively try to improve existing designs and processes or leapfrog them altogether with next-generation technology. A battle for standards might ensue. Costs are typically high and unpredictable, entry barriers low, supplier relationships underdeveloped, and distribution channels just emerging.

Timing can be critical in determining strategic success in an emerging market. The first company to come out with a new product or service often has a first mover advantage. First movers have the opportunity to shape customer expectations and define the competitive rules of the game. In high-technology industries, first movers can sometimes set standards for all subsequent products. Microsoft was able to accomplish this with its Windows operating system. In general, first movers have a relatively brief window of opportunity to establish themselves as industry leaders in technology, cost, or service.

Exercising strategic leadership in the emerging market can be an effective way to reduce risk. In addition to the ability to shape the industry structure based on timing, method of entry, and experience in similar situations, leadership opportunities include the ability to control product and process development through superior technology, quality, or customer knowledge; leverage existing relationships with suppliers and distributors; and leverage access to a core group of early, loyal customers.

Strategy in Growth Industries

Growth presents a host of challenges. Competitors tend to focus on expanding their market shares. Over time, buyers become knowledgeable and can better distinguish between competitive offerings. As a result, increased segmentation often accompanies the transition to market maturity. Cost control becomes an important element of strategy as unit margins shrink and new products and applications are harder to find. In industries with global potential, international markets become more important. The globalization of competition also introduces new uncertainties as a second wave of global competitors enters the race.

During the early-growth phase, companies tend to add more products, models, sizes, and flavors to appeal to an increasingly segmented market. Toward the end of the growth phase, cost considerations become a priority. In addition, process innovation becomes an important dimension of cost control, as do the redefinitions of supplier and distributor relations. Finally, horizontal integration becomes attractive as a way of consolidating a company’s market position or increasing a firm’s international presence.

Competing companies that enter the market at this time, often labeled as followers, have different advantages than early market leaders. Later entrants have the opportunity to evaluate alternative technologies, delay investment in risky projects or plant capacity, and imitate or leapfrog superior product and technology offerings. Followers also tap into proven market segments rather than take the risks associated with trying to develop latent market demand into ongoing revenue streams.

Firms that consider entry into a growing industry must also face the strategic decision of whether to enter through internal development or acquisition. Entry into a new segment or industry through internal development involves creating a new business, often in a somewhat unfamiliar competitive environment. It is also likely to be slow and expensive. Developing new products, processes, partnerships, and systems takes time and requires substantial learning. For these reasons, companies increasingly are turning to joint ventures, alliances, and acquisitions of existing players as strategies for invading new product–market segments.

Two major issues must be analyzed as part of the decision process to enter a new market: (1) What are the structural barriers to entry? (2) How will incumbent firms react to the intrusion? Some of the most important structural impediments are the level of investment required, access to production or distribution facilities, and the threat of overcapacity.

Potential retaliation is more difficult to analyze. Incumbents will oppose a new player if resistance is likely to pay off. This is more likely to occur in mature markets if growth is low, products or services are not highly differentiated, fixed costs are high, capacity is ample, and the market is of great strategic importance to incumbents. However, the likelihood of competitor resistance at any stage of the life cycle suggests the important issues in the search for new markets. What industries are experiencing disequilibria, where incumbents are likely to be slow to react? In what industries could the firm influence the industry structure? Where do the benefits of entry exceed the costs, including the costs of dealing with retaliation by incumbents?

Strategy in Mature and Declining Industries

Carefully choosing a balance between differentiation and low-cost postures and deciding whether to compete in multiple- or single-industry segments are critically important issues as maturity sets in and decline threatens. Growth tends to mask strategic errors and let companies survive; a low- or no-growth environment is far less benevolent.

Firms earn attractive profits during the long maturity stage of an industry lifecycle when they do the following:

Counterbalancing these opportunities, mature and declining industries contain a number of strategic pitfalls that companies should avoid:

Exit decisions are often extremely difficult, in part because exiting might be actively opposed in the marketplace. Possible exit barriers include government restrictions, labor and pension obligations, and contractual obligations to other parties. Even if a business can be sold, in part or as a whole, a host of issues must be addressed. The negative effects of an exit on customer, supplier, and distributor relations, for example, can ripple throughout the entire corporate structure if the firm is an SBU of a larger corporation. In this case, shared cost arrangements can produce cost increases in other parts of the business, and labor relations can become strained, thereby diminishing the strategic outlook for the corporation as a whole.

Fragmented, Deregulating, Hypercompetitive, and Internet-Based Industries

Strategy in Fragmented Industries

Fragmented industries are those in which no single company or small group of firms has a large enough market share to have a strong effect on the industry structure or outcomes. Many areas of the economy share this trait, including retail sectors, distribution businesses, professional services, and small manufacturing. Fragmentation seems to be most prevalent when entry and exit barriers are low; there are few economies of scale or scope; cost structures make consolidation unattractive; products or services are highly diverse or need to be customized; and close, local control is essential.

Thriving in fragmented markets requires creative strategizing. Focus strategies that creatively segment the market based on product, customer, type of order/service, or geographic area, combined with a “no frills” posture, can be effective. Sometimes, scale and scope economies are unrecognized or await new technological breakthroughs. In such instances, a creative strategy can unlock these hidden sources of advantage and dramatically change the dynamics of the industry.

Strategy in Deregulating Industries

Deregulation has reshaped a number of industries. Some interesting competitive dynamics take place when artificial constraints are lifted and new players are allowed to enter. Perhaps the most important dynamic has to do with the timing of strategic moves. U.S. experience shows that deregulating environments tend to undergo considerable change twice: Once when the market is opened and again about five years later.⁴

Deregulation in the United States became a major issue in 1975 when the Securities and Exchange Commission abolished the brokerage industry and eliminated fixed commissions, which profoundly affected several industries, including airlines, trucking, railroads, banking, and telecommunications. In each instance, a more or less similar pattern developed:

Strategy in Hypercompetitive Industries

Hypercompetitive industries are characterized by intense rivalry. Successful strategies are often based on taking the competitor by surprise (e.g., by introducing a product when least expected) and then moving on as the competition tries to recover. Hypercompetitive strategies, therefore, are designed to enable the company to gain an advantage over competitors by disrupting the market with quick and innovative change. The goal is to neutralize previous competitive advantages and create an unbalanced industry segment.⁵

The intense rivalry in a hypercompetitive environment often results in short product life cycles, the emergence of new technologies, competition from unexpected players, repositioning by current players, and major shifts in market boundaries. Personal computers, microprocessors, and software all frequently experience the effects of hypercompetition. The telecommunications industry also provides many examples. Commonly, hypercompetitive strategies involve the bundling of services (e.g., local calling, long-distance calling, Internet access, and even television transmission) to retain current customers and acquire new ones.

In a hypercompetitive market, successful companies are able to manipulate competitive conditions to create advantage for themselves and destroy the advantages enjoyed by others. Within their dynamic and ever-changing environment, firms that stand to benefit are those possessing three major qualities: rapid innovation and speed, superior short-term strategic focus, and market awareness.

Speed and innovation are the foremost requirements for success in a hypercompetitive environment. The focus of companies is on gaining temporary advantage, achieving short-term profitability, and then quickly shifting their strategic focus before competition can react effectively. It is crucial that hypercompetitive companies be able to innovate rapidly and then follow up on that innovation with equally quick manufacturing, marketing, and distribution of their products. In this manner, they are able to rapidly shift the industry dynamics and gain market share at a pace that exceeds that of the competition. Without speed, a company is at a severe disadvantage because its competitors will be first to market, costing it valuable market share.

The second characteristic of successful firms in hypercompetition is superior short-term strategic focus. Firms that have the ability to manipulate the competition into making long-term commitments will find the hypercompetitive marketplace beneficial.

The final requirement for success in a hypercompetitive environment is strong market awareness. Firms must be able to understand consumer markets to deliver high-impact products and provide superior standards of customer support. Having strong customer focus allows firms to identify a customer’s needs while uncovering new and previously untapped markets for their products. Once the needs of the customer are identified, firms win temporary market share through a redefinition of quality.

The traditional concept of sustainable competitive advantage centers on the belief that long-term profitability can be achieved through segmented markets and low to moderate levels of competition. However, strategists now recognize another requirement: Over the long term, sustainable profits are possible only when entry barriers restrict competition. Continuous erosion and re-creation of competitive advantage characterize many industries with companies seeking to disrupt the status quo and gain a temporary profitable advantage over larger competitors.

Competitive Reactions Under Extreme Competition

The pace of competitive change continues to quicken with increasing globalization, technological advancement, and economic liberalization. The consequences include high rivalry in mature undifferentiated industries that results in shrinking profits; shaky dominance by dominant market share firms that are pressured by smaller, more flexible and often more innovative competitors; and shrinking industries with endangered leaders and struggling niche players.

This characterization of extreme competition led Huyett and Viguerie to suggest six actions that established companies could consider to counter the innovative moves of competitors:⁶

Strategic Planning for Internet-Based Industries

Businesses approach Internet-based industries in one of two ways: as pure players that conduct all business online or as click-and-mortar operations that have a physical facility and use the Internet to expand their reach and supplement their activities.

Pure play businesses confront the obstacle of the inability of the customer to examine their product prior to making a decision. This problem can be somewhat offset by a virtual storefront and often counterbalanced by the Internet firm’s convenience of being “open” 24/7. Pure play companies are able to interact directly with their customers through the Internet and benefit from the ability to gather information easily about customers and competitors as a means to keeping their prices competitive.

There are special start-up costs that must be considered when launching a company in an Internet-based industry. Most significantly, there are extremely high marketing costs in building a customer base, and most Internet companies do not have an established distribution system to get their products to consumers.

Without a retail presence, pure play companies typically look to build a competitive advantage by becoming “efficiency machines” serving broad markets or “niche leaders” targeting narrow markets.⁷ Efficiency machines are characterized by high marketing costs, innovative Web sites, and a highly efficient sourcing and fulfillment process. This set-up creates extremely high fixed costs. Therefore, they must generate very high revenue streams from the very beginning of operations. This model is most competitive in low-margin/high-volume industries.

A good example of an “efficiency machine” is Amazon, which began as a virtual bookstore that generated about $5 million in revenues in their first year of operations. For its first few years, Amazon’s focus was on reinvesting to grow sales rapidly. The company then worked to become more efficient, and, in 2003, it had its first profitable year.

Niche players, by contrast, are more limited in number because their business model is built around selling high-priced products or services, including high-end jewelry and travel services. The most successful niche players adapt the traditional direct marketing model into one that can successfully leverage the Internet’s advantages. Because most niche leaders are too small to afford large marketing campaigns, they need to rely on targeted online and direct mail campaigns to drive customers to their Web site or catalog.

Strategic Planning for Click-and-Mortar Businesses

The click-and-mortar model is a hybrid of a pure play online model, where all business activity is conducted online, and a traditional brick-and-mortar model, where all business is done through a physical store. It is estimated that the click-and-mortar model is responsible for 52 percent of all online revenues.⁸ The advantage of this strategy is that the physical side of the company has strategic resources that provide a basis for competitive advantage, such as established brands, traditional distribution channels, and vendor relationships.

In the pure play model, technology is the primary driver of growth, forcing many firms to invest heavily in this area to stay ahead of the curve. Click-and-mortar firms are less dependent on technology for competitive position, allowing them to spread their investments to develop a number of strengths. They are also able to allocate their resources more efficiently by choosing to have a product available online and in the store, or through just one option, as is commonly done in disposing of clearance items. Customers also benefit by gaining the ability to choose how they are most comfortable interacting with the company. Examples include the ability to return products in the store versus having to ship them back, and the opportunity to view products in the store and then order the item online if a size or color they like is not available.

Customer Service

Customer service has applications to the three business models in an Internet-based industry. Pure play firms like Expedia.com, the world’s largest leisure-travel agency, can use the Internet as a differentiator or as their core competency. Because there are no inventories to manage and no physical locations to maintain, firms are able to operate efficiently.

Future e-commerce strategies are expected to move from the current focus of online sales to increased engagement with customers. Such a shifting of the focus from sales driven to service driven will allow companies that are not typically users of the Internet to leverage their capabilities to meet the customers’ needs. In new customer service-centered e-commerce models, strategies include marketing, selling, customer decision support, and retail partnership components.⁹ Dell has developed a system that breaks customers down into subsets such as home and small business customers to match them with the appropriate product line. Once customers are in the correct subset, Dell is able to direct them to an appropriate product line based on their computer use in areas such as multimedia or basic word processor functions.

Other companies are also finding ways to leverage their online capabilities to help support their customers and improve efficiency. Metalco, a manufacturer of specialty metal products, uses the Internet to enable customers to make inquiries and requests, receive quotations, place orders, and manage the ongoing manufacturing and billing process. The system was designed to automate the process between Metalco and their customers, thereby improving efficiency, reducing errors, and increasing customer loyalty. This system is consistent with a marketing-driven approach designed to focus on a niche market. Metalco differentiates its product offerings through improved customer service.

Competitive Superiority

While the evidence available indicates there is little difference between the profit performance of click-and-mortar and brick-and-mortar models, there does appear to be an advantage of click-and-mortar firms over pure play firms in an Internet-based industry. Customers favor the click-and-mortar model since it provides them with options in where they conduct business—on the Internet or at a physical store.¹⁰ Research has shown that mere presence of an Internet alternative to traditional stores is a significant marketing advantage. An e-commerce element of a company strategy is necessary because of the accessibility benefit the Internet provides to customers.¹¹

Internet-Based Business Models

Supply Chains of Internet Business Models. Internet businesses can be distinguished by the way they sell through the supply chain, including direct sales channels, intermediary channels, or marketplace channels. In direct sales channels, product and service providers deal directly with their customers during Internet business transactions. In intermediary channels, portals serve to build a community of consumers and play a role in driving traffic to the Web sites for product and service providers. In a marketplace channel, market makers build a community of customers or suppliers of products and service and facilitate secure business transactions between the buyer and the supplier.

Revenue Business Models. Revenue business models generate sales through the direct transaction of goods or services, where a business adds value by acquiring products and reselling them to consumers, or through production-based methods where companies manufacture, customize, and sell products to consumers. Companies can also provide free content or services to visitors and earn revenue by selling advertising to businesses that want to reach those visitors.

Business-to-Business and Business-to-Consumer Models. Internet businesses can be distinguished through the markets they serve, whether the markets are business-to-consumer (B2C) or business-to-business (B2B) models. B2C involves the marketing and delivery of a service directly to a customer, while B2B involves the marketing and delivery of goods and services to other businesses.

Internet-Based Firm Inventory and Fulfillment

The Internet has enabled firms to separate the sales process from inventory management and fulfillment through drop shipping. Internet drop shipping is the method where Internet firms receive customer orders and send the customer orders to the supplier over the Internet using vendor software, and the supplier packages and ships the orders to the customers using the Internet firm’s logo and label. Internet firms benefit by saving warehouse space, reducing inventory carrying costs, and gaining time to spend on other business functions.

A drop-shipping method is most appropriate for younger firms with larger, low-margin products, higher levels of variety, and higher levels of demand uncertainty.¹² The study also found that firms making inventory and fulfillment decisions within these guidelines were less likely to go bankrupt, suggesting that the firm’s inventory and fulfillment decisions are related to its economic performance.

eBags.com is an Internet firm that uses drop shipping due to its great variety of products and low demand certainty. The company sells 8,000 different bags, including backpacks, purses, and suitcases. Offering a large variety of bags is important to the business, but holding all of the items in physical inventory would result in unacceptably high inventory holding and handling costs. Therefore, the company adopted drop shipping. eBags advertises the bags, but its suppliers actually keep them in their possession until orders are placed by eBags to have them shipped to customers. This tactic enables eBags to be almost free of inventory while offering a larger selection of bags than the small specialty bag stores with whom they compete.

Business Unit Strategy: Special Dimensions

Speed

Speed in innovation, manufacturing, distribution, and a host of other areas is emerging as a key success factor in a growing number of industries, especially those characterized by transitional or habitual hypercompetition.¹³ Coupled with trends toward globalization, the multiplying business applications of the Internet have led to the elevation of speed as a strategic priority. The unprecedented growth in B2C and B2B Internet connections made speed almost as important as quality and a customer orientation in some markets. Yet, it is the newest and least understood of the critical success factors.

In a competitive context, speed is the pace of progress that a company displays in responding to current or anticipated business needs. It is gauged by a firm’s response times in meeting customer expectations, innovating and commercializing new products and services, changing strategy to benefit from emerging market and technological realities, and continuously upgrading its transformation processes to improve customer satisfaction and financial returns.

Responding to industry challenges to increase their customer responsiveness are speed merchants who built their strategies on the rapid pace of their operations. Their accelerated change activities become a hallmark for the progress of the industry. Speed merchants modify their environments to convert their core competencies into competitive advantages. Therefore, competitive landscapes are altered in their favor. The public images of a growing number of firms are synonymous with the speed that they exhibit: AAA with fast emergency road service, Dell with fast computer assembly, Domino’s with fast pizza delivery, and CyberGate with fast Internet access. A critical assessment of the strategies of these high-profile companies provides three important insights: (1) distinct and identifiable sources of pressure that create the demand on a company to accelerate its speed; (2) an emphasis on speed places new cost, cultural, and change process requirements on a company; and (3) several implementation methods to accelerate a firm’s speed of operations.

There are four elements of a model to guide executives in the acceleration of their companies’ speed. They are the (1) pressures to increase speed, (2) requirements of speed, (3) methods to increase speed, and the (4) consequences of speed. Taken together, these elements remind us that pressures to increase company speed can be generated both externally and internally. Firms can assume a reactive posture and await an increase in speed by competitors before making their own investment, or they can gamble on a payoff from a proactive “move to improve.”

Pressures to Increase Speed. Speed is almost universally popular. Customers in nearly every product–market segment seek immediate need satisfaction, and they reward quick-acting companies with market share growth. Because employees of speed-oriented companies enjoy the job flexibility and heightened individual responsibility that are required to maintain the strategy, they reward their employers with the loyalty and commitment that is so highly prized in competitive environments. Suppliers to fast-moving companies are willing to bear extra costs and responsibilities to earn partnerships with firms that seem destined to overtake competitors that conduct business in time-tested rather than time-conscious ways.

Pressures for speed come from customers’ expectations, from competitors who accelerate their own pace, from the company itself when it seeks to establish a new competitive advantage, and from the adjusting priorities of a changing industry.

Requirements of Speed. As a strategic weapon, a speed initiative requires that every aspect of an organization be focused on the pace at which work is accomplished. Executives must foster a “fast” culture within their organizations. The agility that comes from a speed orientation and carefully tailored resource investments provides the prerequisite competitive means to change and accelerate a firm’s strategic course. Specifically, action must be taken on the following issues: refocusing the business mission, creating a speed-compatible culture, upgrading communications within the business, focusing business process reengineering (BPR), and committing to new performance metrics.

Methods to Increase Speed. The development of speed as a competitive advantage begins with an internal analysis by a firm to determine where speed exists and where it does not. Companies then look to eliminate any “speed gaps.” Three categories of methods dominate corporate option lists: streamlining operations, upgrading technology, and forming partnerships.

Streamlining Operations. Many companies enter new markets with a level of competitive information that would have traditionally been labeled as insufficient to support investment. However, most of these firms are not marginalizing quality; they have adopted a new strategic schema. With a speed-enhanced ability to obtain quick post-implementation feedback from the marketplace and respond with unparalleled speed in making adjustments, successful innovations no longer need to be flawless at introduction.

Upgrading Technology. Using the latest informational technologies to create speed, companies are able to roll out new product information faster. The common goal of speed-focused IT is to connect manufacturers with retailers to enhance information sharing and streamline, and accelerate product distribution. In turn, shortening pipelines speeds products to shelves and satisfies customers with less costly inventories. Doubling back, technology enables companies to learn customers’ buying patterns to better anticipate their preferences.

Forming Partnerships. Sharing business burdens is a proven way to shorten the time needed to improve market responsiveness (i.e., “partners collapse time”). Ford Motor Company’s partnership with General Motors and DaimlerChrysler provides a front-page example. The three major auto manufacturers joined to develop an Internet portal that links their purchasing organizations with 30,000 raw material suppliers. These Web-based exchanges also increase the speed with which the automobile companies respond to customer inquiries at every stage along the supply chain.

The evidence from business practice supports the emergence of speed as a critical success factor as a primary element in business unit strategy. The company goal of accelerating speed to satisfy consumer needs is becoming less of an option and more of a mandate for financial survival. Fortunately, businesses can be systematic in evaluating the pressures and requirements for change that they face in accelerating their speed. Methods available for implementing upgrades are gaining widespread acceptance and are backed by the records of success that faster firms enjoy.

Consequences of Speed. In planning to increase the company’s speed, executives need to consider the consequences of a successful implementation. The firm’s pre-emotive capability will improve, but demands on the firm to innovate will simultaneously increase—since innovation both creates and justifies the need to invest in speed.

The firm’s response time will improve, with a result that its competitive defensive capability will be strengthen, but to be able to produce and maintain the new level of speed, executives will need to enlist fast-moving and responsive suppliers and distributors. Furthermore, when the benefits of speed are essential but not distinguishing characteristics of a company in hypercompetitive arenas that are characterized by rapid and diversified change, executives need to view increased speed as essential benefit, but not necessarily as an advantage.

With consumer expectations in many industries constantly on the rise, a company’s ability to increase rates and forms of speed in the future is critical. However, no challenge should be more appealing to executives that use speed to leverage a firm’s core competencies than to operate in a competitive arena where success is based on a high rate of change.

Innovating to Gain or Retain an Advantage

Innovation is the initial commercialization of invention that is achieved by producing and selling a new product, service, or process. Because every product has a lifespan that flattens out and eventually declines, creating new products that are able to backfill a company’s revenue streams is vital to sustaining a successful business model.

Innovation can come in the form of a breakthrough that revolutionizes and creates new industries. Sony’s Bravia LCD TVs, Blu-ray Disc products, and Playstation 3 gaming consoles allowed consumers to experience 3D in their homes.

The goal of companies that pursue a breakthrough innovation is to create a disruptive product that revolutionizes an industry or creates a new one. In 2010, Microsoft Office offered a free Web-based version of their software. The software was stored on Microsoft’s servers and delivered to end users online. This concept is “cloud computing” and goes against Microsoft’s historical business model. Cloud computing is the concept of assigning computing tasks to a remote location rather than a desktop computer, handheld machine, or a company’s own servers. Traditionally, Microsoft sold their software programs to consumers and the software was stored directly on the consumer’s computer. This new business model required Microsoft to provide a higher level of support to their customers after the initial sale of the software package. This innovation can be seen as self-destructive, but Microsoft chose to treat it as an opportunity to tackle the next big innovation in software.

Breakthrough innovations can require substantial investment in R&D and patience. As an alternative, many companies pursue cost-saving approaches to developing innovations that attempt to minimize the risks involved. For example, joint ventures can be utilized as a means of cost savings when two or more companies are looking to share the costs of an investment that may yield an innovation. Hulu.com, which is a joint venture between GE’s NBC and News Corp., provides an online, streaming Web television service that is supported by advertising. It allows consumers to watch television shows from a variety of networks on their computers.¹⁴ Hulu.com dramatically increased its revenues and gave its partner companies a chance to share in a product that could be an innovation in the way consumers watch television shows, while only bearing partial risk of the investment.

Outsourcing innovation can also be used to reduce the risk of failure of innovation. U.S. firms have pursued this strategy in the electronics and retail markets, and a 2009 survey found that 90 percent of all innovations in the service industry were generated by outsourcing.¹⁵ For example, half of Proctor & Gamble’s (P&G) new product ideas are generated from outside resources.¹⁶

Creating Value Through Innovation

Value creation greatly depends on innovation. Sustained profitable growth requires more than judicious acquisitions or careful “subtraction” by shedding unprofitable operations or downsizing. Many companies recognize their need to generate more value from core businesses and leverage their core competencies more effectively. These strategic initiatives, in turn, increase the demand for innovation.¹⁷

Innovation is a major strategic challenge for most companies. Clayton Christensen coined the concepts of disruptive and sustaining innovation to describe what he calls the “Innovators’ Dilemma”—how successful companies with established products can keep from being pushed aside by competitors with newer, cheaper products that will, over time, get better and become a serious threat.¹⁸

He notes that incumbent industry leaders and competitors mostly engage in sustaining innovation—innovation that focuses on improving their existing products. Some sustaining advancements are simple, incremental, year-to-year improvements; others are dramatic, breakthrough technologies, such as the transition from analog to digital and from digital to optical. The effect of these technological advances was to bring a better product into the market that could be sold for higher margins to the best customers served by the industry leaders.

New entrants and challengers have greater freedom to launch products that may have all of the attributes of the existing products and, therefore, not attractive to current customers, but that are simple, and often more affordable. These new entrants find acceptance in undemanding and underserved segments of the market and create a beachhead for competition for mainstream customers with improved products later. Christensen calls this disruptive innovation not because it defines a technological breakthrough, but because it disrupts the established basis of competition.

The computer hardware industry offers many examples of disruptive innovation. The introduction of the minicomputer disrupted the mainframe industry. The personal computer disrupted minicomputer sales. Wireless handheld devices, such as Blackberries and Palm Pilots, disrupted notebook computers.

Sustaining innovation can keep a company viable for many years; targeting current customers exclusively can be damaging in the long run. To start a new growth business, noncustomers often are the most important customers to understand. Discovering why they are not customers encourages innovation and stimulates growth.

A focus by incumbents firms on profit rather than growth can impede innovation, thereby inhibiting growth.¹⁹ Public companies, under pressure from Wall Street to produce steady returns, face a particularly strong challenge. Investors and industry analysts are likely to expect the company to generate more of its earnings growth from profitability, whereas company executives tend to prefer earnings to come from increasing revenue. However, there is empirical evidence that the more a company’s earnings come from either profitability improvement or revenue growth at the expense of the other, the more likely it is that the company’s strategy is inherently flawed.²⁰ The differing emphases between investors and executives suggest why private companies often have better opportunities to invest for the long term and pursue disruptive innovations, which require a long time to develop and mature and might produce short-term losses in the early stages of development.

Creating a culture of innovation eludes many companies because it transcends traditional strategic planning practices. Strategic planning too often centers on existing or closely related products and services rather than on opportunities to drive future demand. In contrast, innovation is a product of anticipating, assessing, and fulfilling potential customer needs in a creative manner. Sometimes innovation is technology based, but often it springs from the firm’s recognition of explicit or latent customer needs. Innovation can be directed at any point in the customer or company value chain, from sourcing raw materials to value-added, after-sale services.

Although many businesses pursue innovation, for almost 100 years Minnesota Mining & Manufacturing (3M) has succeeded because its business model is based on a culture that is geared to producing innovative products. Best known for Post-it Notes, Scotch Guard, and Scotch Tape, 3M’s business segments include industrial, transportation, graphics and safety, health care, consumer and office, electronics and communications, and specialty materials.

Because of the company’s unparalleled success as an innovator, its approach deserves broader consideration. Fundamentally, six mandates drive innovation at 3M:

Fostering a culture of innovation takes time and effort. Although there is no universal model for creating an innovating environment, a look at successful companies reveals certain common characteristics. First, a business needs a top-level commitment to innovation. Commitment to innovation is evident in the attitudes of top executives, through their communication of their belief to all levels of the organization in the benefits of innovation, and in their willingness to sponsor and guide new product activity.

Second, a business needs a long-term focus. “Quarteritis,” the preoccupation with the next quarter’s results, is one of the most common stumbling blocks to innovation. Innovation is an investment in the future, not a rescue mission for current top- or bottom-line problems.

Third, a business needs a flexible organization structure. Innovation rarely flourishes in a rigid structure, with complicated approval processes or with bureaucratic delays and bottlenecks.

Fourth, a business needs a combination of loose and tight planning and control. Allocating all direct, indirect, overhead, and other costs to a development project virtually guarantees its demise. Few innovative ideas immediately translate into commercial ventures that cover all of their own costs or meet conventional payback requirements.

Finally, to create an environment for innovation a business needs a system of appropriate incentives. Reward systems in many companies are oriented toward existing businesses, with short-term considerations outweighing longer-term innovation and market development objectives. Innovation can flourish only when risk taking is encouraged, occasional failure is accepted, and managers are accountable for missing opportunities as well as exploiting them.

Framework for Innovation

A company’s approach to innovation differs depending upon its product–market strategy. Low-cost leaders often focus their innovation efforts on new production and delivery processes and procedures, while differentiators primarily work on product innovations.

The “first movers” in an industry also benefit from product and technology efforts, while industry “followers” are best served by innovation in services and supply chain upgrades, and industry “laggards” need to focus on operational process innovation to help assure low costs.

A firm that emphasizes innovation usually takes a portfolio approach in which it undertakes an array of R&D projects that promote the company’s strategic objectives. The firm will mix projects that focus on core improvements, logical extensions of current brands, and new growth initiatives in a way that will meet its risk and growth targets. Both incremental innovations and breakthroughs are important to the firm because incremental innovations extend the current revenue streams from prior innovations and breakthroughs create a new product life cycle that will provide a strong competitive advantage.²¹

Leveraging External Partners as a Part of Overall Innovation Strategy

Historically, a company that emphasizes innovation maintained large patent portfolios to bolster growth and discourage competitors. However, adopting a more selective approach, Hitachi will only file for a patent if it can clearly define the value that the patent will provide for the firm. One result is that the number of patent applications Hitachi has submitted has declined steadily over the past two decades, while its income from licensing patents has more than doubled.²²

Another way for innovating firms to derive value from their R&D investments is to give away free access to patented technology. IBM earns more than $1 billion per year from licensing a select subset of its patents, but it allows free access to most of the technology that it has patented, so that other technology companies can build systems that are compatible with IBM’s products and thus create a user environment that is readily adaptable to IBM’s core products.

A third way for businesses to optimize their R&D investment is to partner with companies that are interested in sharing a high-risk, high-reward undertaking. For example, Apple benefited from a joint venture with AT&T, which became the sole service provider of the iPhone. The terms of the agreement provided that both companies would share the cost and risk of the innovation. Because of this JV, Apple could focus on providing a world-class phone, and AT&T could focus on using their expertise as a service provider to handle customers’ service requirements.

Proctor & Gamble

P&G began a strategic intent program called “Connect and Develop” in 2002. It was designed to transform a company that had been highly secretive and protective of its technologies into a company that was openly looking for partners to develop cutting edge solutions to business problems. P&G doubled its revenue in the eight years following this initiative by committing to this new strategy that aimed to develop 50 percent of all innovations from collaborative efforts with external firms.²³

In addition, P&G has a group called FutureWorks that is dedicated to investing in breakthrough technologies, a fund to provide supplemental capital above the budget for investment in innovation, and a training group that works with engineers to focus on disruptive technologies. P&G makes and commits 4 percent sales to innovation projects.²⁴ The company attempts to spend two times as much on innovation as its competitors, which has helped it build a product portfolio of 23 brands, each with a value of at least $1 billion, and another 20 brands that are each worth at least $500 million. These brands drive approximately 90 percent of P&G’s profit, which was in excess of $4.6 billion in 2009.²⁵

Over 50 percent of P&G’s products utilize at least one component that was developed in conjunction with an external partner. This collaboration drives profits because most all of its organic sales growth comes from new brands or improved products. P&G uses only 10 percent of its patents, but spends millions of dollars each year to renew the other 90 percent in hopes that the technology will be of later use or will block to progress of its competitors.²⁶ In 2004, the company partnered with Clorox on Glad Press’n Seal bags to maximize the revenue from a then unused patent that P&G held for a plastic wrap. Since Clorox’s Glad brand was too strong to make a new product launch worthwhile, the two companies formed a joint venture that allowed each to profit handsomely by making full use of its strengths.²⁷

By 2010, P&G was promoting efforts to make its products more environmentally sustainable through innovation. It targeted products for the “sustainable mainstream,” which consists of consumers that are interested in improvements to sustainability but are not willing to sacrifice value or features. The company estimates this segment makes up 75 percent of the global marketplace, in comparison to 15 percent of “niche” consumer who are willing to give up one of those two factors for improved sustainability, and the 10 percent of “basic living” consumers who do not make any decisions based upon sustainability factors.

Innovation and Profitability

Innovating is difficult, as evidenced by the 50 percent of executives who say that they are not pleased with their companies’ return on investment from innovation initiatives due to long development times, a risk adverse corporate culture, difficulty in choosing the right products to commercialize, and lack of coordination within the company.²⁸

Research suggests that executives lack confidence in their companies’ ability to use innovation to drive profits. In a Forrester Research study, 67 percent of respondents from manufacturing firms considered themselves more innovative than competitors, but only 7 percent identified themselves as very successful in meeting their innovation performance goals.²⁹ Respondents in the BCG Innovation survey questioned the effectiveness of their R&D spending; 48 percent of those surveyed were unsatisfied with the financial returns on their companies’ investments in innovation.

The reason for the lack of success in translating innovation into profitable performance surfaced in a study of the growth records of the Fortune 50 sponsored by HP and the Corporate Executive Board. The study concluded that the single biggest growth inhibitor for large companies was “mismanagement of the innovation process.”³⁰

When R&D investments fail to generate successful products and financial gains it is attributed to one of three main reasons: failure to develop truly innovative products, failure to commercialize innovative products successfully, and failure to market innovative products in a timely manner. Statistics differ but research indicates that the probability of success with innovations is small:

Recommendations for Improving Performance Through Innovation. An overall evaluation of the research on the impact of innovation investments on company financial performance leads to six recommendations for strategic managers: