Sunday, October 30, 2016

Leading Amidst Change: Why Strategy Matters

You’ve probably heard people compare the Fortune 500 from a few decades ago with today, noting how fallen greats like Sears, American Motors, and Zenith Electronics have been eclipsed by innovators. The reason seems clear enough. We’ve seen considerable technological and regulatory change over the past 50 years, so the rules of the game keep changing in business and there appears to be no end in sight. In fact, globalization may even be accelerating the rate of change we see around us.

For business leaders, these changes can be daunting. Companies routinely take their leadership teams off-site to discuss the challenges and opportunities implied by the latest innovations. How will augmented reality affect the gaming market? How will mesh computing affect the financial technology space? How will the internet of things affect, well, everything? The idea seems to be that if we can forecast future technology, we will be more likely to survive or even prosper from the changes to come.

Not so. It turns out that often the very technologies that seem to have upended the great firms of the past were well understood, and sometimes even created, by those very firms: the Swiss invented quartz watches; Kodak invented the digital camera; Sears was a pioneer in inventory and brand management; and the list goes on. A number of different theories have been proposed to explain this puzzle. This note briefly summarizes a few of the major theories, and offers a way that business leaders can constructively think about leading amidst change.

Discontinuous Innovation Theory

As early as the 1960s, writers on technology management distinguished between continuous and discontinuous technological changes (albeit using various terms for the same idea). Continuous, incremental advances happen all the time, gradually improving the state of a given technology. Such changes are typically straightforward for existing firms to accommodate. Discontinuous changes, by contrast, represent a radically different approach to a technology, and often bring about an order-of-magnitude improvement in performance. For instance, adding functionality to an old-style “feature phone” would be a continuous innovation, while the invention of the smart phone could be seen as a discontinuous innovation.

This idea has appeared in hundreds of published academic articles since the 1960s, but its implications for business leadership were best explained in a classic article by Professors Michael Tushman and Phillip Anderson.[1] The breakthrough in Tushman and Anderson’s study was to note a key distinction between different types of discontinuous innovations. Some of these changes, while quite significant in technological terms, build nicely on the capabilities of existing firms. Such “competence enhancing” discontinuities retrench the status quo, giving incumbents even more of an advantage over new, upstart organizations. By contrast, other discontinuities render irrelevant, or even counter-productive, the capabilities of existing firms. These “competence destroying” discontinuities are difficult for industry incumbents to employ profitably, since by doing so they harm their existing operations. For that reason, such changes are more likely to be brought to market by new entrants to a business.

Using discontinuous innovation theory as her lens, a business leader will pay attention to how new technologies either enhance or destroy the value of her firm’s existing capabilities. For example, consider the iconic case of the Bank of America confronted by new innovations in electronic funds transfer technology. This technology would be at the heart of many new innovations in retail banking, including the spread of distributed networks of ATM machines. Prior to this discontinuous change, the Bank of America was the unparalleled leader in geographically distributed retail banking, operating a massive brick-and-mortar branch system across California’s 900 miles and hundreds of cities. Decades of experience honed the bank’s capabilities, as it daily cleared millions of paper transactions into its system regardless of where they originated across the state. With over 2,500 branches, the bank had a branch in every town in that state, and so attracted customers wanting convenient access to their accounts. The spread of ATM machines dramatically reduced the unique value of this system, making widespread geographic access to bank accounts commonplace. Although ATM technology was embraced by Bank of America, its competitive standing clearly was set back in the new era. By the late 1980s, the bank saw record losses in part due to its outdated brick-and-mortar system – the very system that had been key to its competitive advantage – and so it laid off tens of thousands of employees, closed branches, and consolidated functions into regional centers. In this way, electronic funds transfer technology can be understood as a competence destroying discontinuity from the perspective of incumbent banks in the era of brick-and-mortar branching. 

Structural Inertia Theory

Large, well-established organizations are notoriously difficult to change. The leading theory to explain this fact is known as “structural inertia theory,” pioneered by sociologists Michael T. Hannan and John Freeman in their seminal 1984 article[2], and since then supported and developed by a large body of research.[3] In this theory, the authors assume that modern society favors the creation and development of organizations that perform reliably and that can account for their actions rationally. Further, they assume that accountability and reliability are greater for organizations that have reproducible structures – meaning routinized, bureaucratic structures. Finally, they assume that such structures are more difficult to quickly change, that is, more inert. These premises lead them to the essence of their theory: Modern society favors the development of inert organizations.

Hannan and Freeman further argue that when inert organizations do change, these changes are hazardous to their performance and their life chances. Especially as they age, grow, and become complex, increasing inertia renders attempts to change difficult and fraught with risk. If the organization survives the change, it may be better off – at least as long as the change keeps pace with the demands of the environment. Stated in terms of a large-scale strategic change, this basic prediction is illustrated below:

Structural-Inertia Theory:
The Effect of Change at time T1 on Organizational Performance

In this illustration, an organization makes a large scale strategic and organizational change as of time T1, and as a result suffers a dramatic decrease in performance. (In fact, Hannan and Freeman state this prediction in terms of the organization’s likelihood of outright failure.) But over time, if the organization does survive, its performance improves. And, if the organization’s new strategy is better aligned to its situation, then its performance may even be better than at the start of the ordeal.

The evidence suggests that two distinct effects can be usefully separated when looking at this theory empirically.[4] The initial decrease in performance has been widely documented, and can be thought of as the “process effect” of change. This effect captures the various difficulties that come up as large-system changes cascade through an organization, creating various misalignments along the way. As these difficulties are worked out, eventually the organization reaps the “content effect” of the change – the improvement in performance due to the new strategy being better aligned with the environment.

Structural inertia theory highlights a problem inherent to strategic leadership. If leadership does a good job aligning the different aspects of organization and strategy, then changing that complex, aligned system will be especially difficult. And even if leadership does manage to change that system, the consequential drop in performance is likely to be extreme. Looking again at the Bank of America example, many pundits criticized the company for taking so long to shift away from the earlier strategy and structure centered on brick-and-mortar branches, skilled loan officers in every location, and decentralization to allow for extreme localization. Only after nearly failing did the bank’s leadership manage to break with that strategy and structure. Yet, when seen through the lens of structural inertia theory, this resistance to change is precisely what one would expect from such a well-managed organization. Years of fine tuning had created a complex organization including various, well-aligned features that made the bank particularly good at geographic localization. In this way, the difficulties involved with changing Bank of America were more a measure of its excellence than an indictment – albeit excellence that had become outdated. And this example suggests a caution to business leaders: Your good work aligning your strategy and organization today is precisely what will make changing that strategy so difficult and hazardous tomorrow.

Disruption Theory

By far the most popular theory of strategic and organizational change these days is disruption theory, developed by Professor Clay Christensen and his colleagues beginning with its introduction in 1995.[5] The theory restricts its attention to change involving technologies and innovations, and assumes a market context with differentiation between a low-end of the market, a mainstream market, and a high-end. The product performance, expectations of customers for product performance, willingness to pay for performance, and potential for profitability are all assumed to be low at the low end, middling for the mainstream, and high at the high end. Incumbent firms are assumed to use a well-established technology and focus on the mainstream market. Over time, they are assumed to improve their technologies gradually in an attempt to serve the high-end of the market, where profitability is greatest. In so doing, they are assumed to “overshoot” the needs of the low end and middle of the market. Furthermore, focusing on profitability, they are assumed to largely ignore the low-end of the market.

Under these assumptions, new entrants can enter with completely different technologies. These technologies assumedly will not initially perform as well as the established technologies used by incumbents, but they are good enough to give the new entrant a foothold market: either serving the underserved low-end of the market, or serving previously unserved “non-consumers” in a new-market foothold. Incumbent firms, meanwhile, pay no attention to the new entrant, because they are serving different customers. As time passes, however, the new entrant’s technology improves greatly, ultimately moving the firm into the mainstream and high-end of the market. At that point the new firm gains an advantage over the incumbent, often because the new firm’s technologies are part of a business model that is incompatible and superior to that of the incumbent.

Disruption theory is extremely popular, and this popularity leads to some problems for the theory’s use. For many business leaders, especially in information technology businesses, the pattern described by Christensen and his colleagues reflects their context well. For these leaders the theory is useful – at least if they can spot potential disruptors while still in the “foothold” stage. (A theory is not helpful if you must wait until you see a success to then identify it.) In many other instances, however, the term “disruption” is widely used to mean any change that has a big effect on business regardless of whether the change resembles that addressed by the theory. In these instances, the theory will not apply and in fact could be misleading. Christensen and his colleagues have recently voiced concern about this. In a recent article, they explain that many big, important business changes are not disruption as the theory defines it.[6] Uber, they note, is not a disruptor (based on their understanding of Uber).

For business leaders, the lens of disruption theory directs attention to those start-ups just getting a foothold either in a new market segment or in an underserved low end of an existing market. And the theory helps to evaluate these new entrants not on the basis of how well their technology performs when it starts out, but rather in terms of its potential to become disruptive as it improves over time. To some extent, the theory also directs attention to the new business models that often accompany such start-ups. 

Leading Amidst Change

For you as a business leader, all three of these theoretical perspectives direct attention, first and foremost, to what makes your organization compete well. Discontinuous innovation theory highlights the importance of knowing the capabilities that give your organization a strategic advantage, and how a given technological change affects the value of those capabilities. Structural inertia theory directs your attention to the complexity and intricacy of your organization in order to understand the cascade of misalignments that moving to a new strategy will trigger – if even temporarily. And, for some, disruption theory directs your attention to potential threats that, while benign in their infancy, have the chance to mature into something strategically significant.

One way to sum up these implications is to note that they draw attention to the importance of strategy, and in particular to the logic of your firm’s strategy. Big changes that leave the logic of your strategy intact are not a threat. Discontinuous innovation theory calls such changes “enabling.” Structural inertia theory notes that such changes do not require a fundamental alterations to your organization. And disruption theory would say that such changes are not likely to be problematic for you as an incumbent. But when a change threatens the logic of your firm’s strategy, it is time to act. The changes you set in motion will be difficult and costly for your organization, especially if you have done a good job aligning your strategy and organization around a clear and compelling logic. But the alternative is to become yet another example in the failure lexicon of business school professors.

What’s more, looking to see how changes affect your strategy’s logic gives you a way to identify and diagnose what matters before your performance suffers. As a leader, you do not have the luxury of waiting until changes play themselves out. You must make the call early on in the game, while there is still a chance to affect the outcome. Going back to the Bank of America, the logic of their branch strategy was crystal clear, even as technological changes were afoot that would threaten that logic. Had their leadership honestly reviewed how those changes were likely to affect the bank’s strategic logic, steps could have been taken long before red ink ultimately drove action. This lesson applies to every business leader. The logic of your strategy can be identified today, as can the implications of the changes you see around you for that logic. Use your strategy’s logic as the lens through which you understand and manage change.

[1] Tushman, Michael L. and Philip Anderson. 1986. “Technological Discontinuities and Organizational Environments.” Administrative Science Quarterly, 31: 439-465. 
[2] Hannan, Michael T. and John Freeman. 1984. “Structural Inertia and Organizational Change.” American Sociological Review, 49: 149-164.
[3] Carroll, Glenn R. and Michael T. Hannan. 2000. The Demography of Corporations and Industry. Princeton: Princeton University Press.
[4] Barnett, William P. and Glenn R. Carroll. 1995. “Modeling Internal Organizational Change.” Annual Review of Sociology, 21:217-236.
[5] Bower, Joseph L. and Clayton M. Christensen. 1995. “Disruptive Technologies: Catching the Wave.” Harvard Business Review, Jan-Feb.
[6] Christensen, Clayton M., Michael E. Raynor, and Rory McDonald. 2015. “What Is Disruptive Innovation?” Harvard Business Review, December.

Saturday, October 15, 2016

Differing Without Dividing

Variety is great for innovation. For instance, consider the case of Seymour Cray, the “father of the supercomputer.” In the 1970s, Cray left Control Data to start Cray Research, a company devoted to creating the world’s fastest computer. Cray approached the problem with a revolutionary architecture, so called “vector processing.” By 1976 he and his team introduced the Cray 1, and Cray Research was seen as the Mecca of high-speed computing. John Rollwagen became company President in 1977, bringing business leadership alongside Cray’s technological prowess.

In 1979, Rollwagen brought in another technology genius, Steve Chen, to lead the design of a completely different approach to supercomputing. So as Seymour Cray’s team worked on the Cray 2, Chen’s team worked on the Cray X-MP. Chen’s design built on Cray’s initial innovation, but did so using a revolutionary architecture featuring multiple processors operating in parallel. Released in 1982, the X-MP set a new standard for supercomputer performance, and significantly raised the bar for the team working on the Cray 2.

When we do not know what the future holds, variety helps our organization to discover what is possible. This truth is one reason why we often hear people saying that they want to increase the diversity of their employees. Just like the biosphere, organizations evolve better if they sustain variety.

Yet examples like Cray and Chen’s are rare. One reason is that sustaining variety is expensive. How inefficient to run multiple projects that are trying to do the same thing. But another, bigger problem is that sustaining variety threatens to divide a company. People object to having others in their company working at cross purposes. How can we encourage differences without being divisive?

One way is to live by the adage “disagree and commit.” Here in Silicon Valley people attribute the saying to Intel. The idea is that you should encourage disagreement during the decision-making process, in order to improve the quality of your decisions. But once a decision is made, everybody needs to fully commit to its implementation. Unfortunately, in practice this saying often is used to silence those who see things differently. Often managers say “disagree and commit,” but they are really saying “disagree and shut up.”

I prefer “switch and commit.” The goal is still to end up committing at the end of the process, but during the decision I want the participants to switch roles. The person disagreeing with you needs to take your position and argue it well. Similarly, you must argue the other’s view well. You can think of the approach as devil’s advocacy taken seriously by both sides.

I first tried “switch and commit” when teaching a controversial topic here at Stanford. For the first assignment, the students had to state their position on the topic. For the second, big assignment, they had to write an essay taking the opposite view. (They did not hear about the second assignment until after they handed in the first.) The end results were some fantastic essays, because the authors were legitimately skeptical.

Since then, I have tried “switch and commit” when facilitating hard-hitting business meetings among top managers. The results have been mixed. Many people cannot get their head around a different perspective. But now and then you find an exceptional leader who appreciates the value of differing without dividing.

A readable review of related academic work is Scott Page’s book The Difference.