Clayton Christensen: Innovation Is The Answer

What do CEOs do so that they can start to focus on these bigger opportunities, these market-creating innovations?

Christensen: Well, remember that we’re going after non-consumption first. In the process of allocating resources in a corporation, just remember that the corporation is organized to prevent disruption to occur because we’re going after non-consumption. Try to figure out where in this place that we live is there non-consumption going on and where do people have a job to do?

Ojomo: There’s a company in Rwanda that saw an opportunity where most people would not. About 80 percent of people in the country don’t have access to cement floors, they can’t afford it. So instead of looking at that and saying, “These guys are poor, they can’t afford it,” they looked at it through the lens of non-consumption and said, “Look at how much of this cement they’re not consuming.” They knew there was an opportunity there. So they’ve developed these earthen floors that are very similar to cement floors but at about a quarter of the cost, and now they’re creating a new market for affordable flooring that is not just in Rwanda, it has now spread to Uganda and they are looking to go into Kenya.

Christensen: I never thought about cement as being high-end. But it turns out that it’s actually very costly there to get cement. A capital-intensive effort.

Ojomo: So they’re using a completely different product. It’s clay, a composite product that they were able to create out of a lab at Stanford. It’s not cement at all, but it’s hard, it does the job of cement, but it’s not cement.

Christensen: If you go back in any history that we’ve studied, always it’s, ‘This solution was the simplest solution and at the bottom of the market.” Then we could go up.

What mistakes do you see company leaders make that get in the way of having these insights and seeking out these real market-making innovations?

Christensen: They don’t think through all the other steps in the process that need to be in place in order for it to be viable. In the noodle story, they had to go upmarket to provide the right kind of wheat and then you turn around and go downmarket: “Where will we get the trucks? Where can we overcome dishonesty? Where are we going to get the roads?” Almost always innovation is successful at the point of innovation that we’re looking at—but it fails a step above and a step below.

CEOs and boards tend to have data-driven processes for allocating capital and resources. So when looking at market-creating opportunities where it’s non-consumption and the data doesn’t exist, do they have to adjust their decision-making process to reflect that? Do they need to recognize it will involve more risk and there won’t be enough data and adjust their process?

Christensen: That’s right—and it’s the process that needs to be changed. In the history of retailing, Marshall Field’s was the first retailer. The way they were structured, they turned their capital three times every year and they had to generate gross margins of 40 percent to cover their capital. They earned 120 percent return on capital invested in inventory, and that’s their model. Field’s, Macy’s, that’s their model.

Then Sears comes in and their business model was a catalog company. Their model allowed them to serve the market with 4x turns and they could achieve 30 percent return on capital invested in inventory, so they earned 120 percent return on capital invested. And then Kmart and Walmart came along and they could turn their inventory over [faster]. They targeted the low-end and their margins were 20 percent and that meant that they had to turn the inventory over six times. So they earned 30 percent six times every year so they got 120 percent return.

Then Amazon came in with who knows what kind of margins, but they turned the inventory. Anyway, that’s the simple model. So a board of directors, the stupid thing to do would be to say, “We have to reduce turns, have a target.” That’s not the way it works. There’s a process by which the profit formula is implemented. The board has to think of themselves as they own this but they need to view these other options so that we can achieve this.

What advice would you have given to the Sears board of directors to prevent their demise? What could their CEO and/or their board, what should they have done?

Christensen: Well, number one, they should take the time to study the good theory about this problem. We actually wrote a piece about this when Sears was right at the top of their game, recognizing that Kmart and Walmart are already going to disrupt them from the bottom of the market and they would have to set up a different business company in order to survive.

Dayton Hudson set up a completely separate organization in Minneapolis and they called it Target. As they separated it out, and as the old one, Dayton Hudson, hit its demise going after the top of the market, from the bottom of the market came Target and so they’ve been very successful. The board of directors needs to understand both that there is an economic model that they are responsible for—and they hold themselves to the wrong model, I think. Wall Street, when it holds itself to the wrong model, they teach a board the wrong thing.