innovation killers

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Innovation KillersHow Financial Tools Destroy Your Capacity toDo New Things

by Clayton M Christensen Stephen PIaufman andWilly C Shih

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Innovation KillersHow Financial Tools Destroy Your Capacity toDo New Things

by Clayton M Christensen Stephen RIaufman and

Willy C Shih

For years weve been puzzling about why so

many smart hardworking managers in wellrun companies find it impossible to innovatesuccessfully Our investigations have uncovered a number of culprits which weve discussed in earlier books and articles These

include paying too much attention to thecompanys most profitable customersthereby leaving less demanding customers

at risk and creatiog new products that donthelp customers do the jobs they want to doNow wed like to name the misguided application of three financial analysis tools as anaccomplice in the conspiracy against successful innovation We allege crimes against

these suspectsThe use of discounted cash flow DCF

and net present value NPV to evaluate investment opportunities causes managers tounderestimate the real returns and benefits of

proceeding with investments in innovationThe way that fixed and sunk costs are con

sidered when evaluating future investmentsconfers an unfair advantage on challengers

and shackles incumbent firms that attempt to

respond to an attackThe emphasis on earnings per share as

the primary driver of share price and hence ofshareholder value creation to the exclusion of

almost everything else diverts resources awayfrom investments whose payoff lies beyondthe immediate horizon

These are not bad tools and concepts we

hasten to add But the way they are commonly wielded in evaluating investmentscreates a systematic bias against innovationWe will recommend alternative methods that

in our experience can help managers innovate with a much more astute eye for future

value Our primary aim though is simply to

bríng these concerns to light in the hope thatothers with deeper expertise may be inspiredto examine and resolve them

Misapplying Discounted Cash Flowand Net Present Value

The first of the misleading and misappliedtools of financial analysis is the method of

HARVARD BUSINESS REVIEW JANUARY 2oo8 PACE 1

Innovation Killers

Clayton M Christensen cdvistenser@hbsedu is the Robert and Jane Cizik Professor of Business Administration at

Harvard Business School in Boston

Stephen P Kaufman skaynanhrsaua senior lecturer at Harvard

Business School is the retired chairman

and CEO of Arrow Electronics Willy CShih rshihuhsedu a senior lecturer

at Harvard Business School held execu

tive positions at IBMSilicon Graphics andKodak

discounting cash flow to calculate the net

present value of an initiative Discounting afuture stream of cash flows into a presentvalue assumes that a rational investor would

be indifferent to having a dollar today or to

receiving some years from now a dollar plusthe interest or return that could be earned

by investing that dollar for those yearsWith that as an operating princaple at malees

perfect sense to assess investments by dividingthe money to be received in future years byi r where r is the discount ratethe annual return from investing that moneyand nis the number of years during which the investment could be earning that return

While the mathematics of discounting is log

ically impeccable analysts commonly committwo errors that create an antiinnovation bias

The first error is to assume that the base case

of not investing in the innovationthe donothing scenario against which cash flowsfrom the innovation are comparedis that thepresent health of the company will persist indefinitely into the future if the investment isnot made As shown in the exhibit The DCF

rapa the mathematics considers the investment in isolation and compares the presentvalue of the innovations cash stream less

project costs with the cash stream in the absence of the investment which is assumed tobe unchanging In most situations howevercompetitors sustaining and disruptive investments over time result in price and marginpressure technology changes market sharelosses sales volume decreases and a decliningstock price As Ealeen Rudden at Boston Consulting Group pointed out the most likelystream of cash for the company in the donothing scenario is not a continuation of the statusquo It is a nonlinear decline in performanceIts tempting but wrong to assess the value

of a proposed investment by measuringwhether at will make us better off than we are

now Its wrong because if things are deteriorating on their own we might be worse offthan we are now after we malee the proposedinvestment but better off than we would have

been without at Philip Bobbitt calls this logicParmenides Fallacy after the ancient Greeklogician who claimed to have proved that conditions in the real world must necessarily beunchanging Analysts who attempt to distillthe value of an innovation into one simple

number that they can compare with other

simple numbers are generally trapped byParmenides FallacyIts hard to accurately forecast the stream of

cash from an investment in innovation It is

even more difficult to forecast the extent to

which a firms financial performance maydeteriorate in the absence of the investment

But this analysis must be done Rememberthe response that good economists are taughtto offer to the question How are you It is

Relative to what This is a crucial questionAnswering at entails assessing the projectedvalue of the innovation against a range ofscenarios the most realistic of which is

often a deteriorating competitive and financialfuture

The second set of problems with discountedcash flow calculataons relates to errors of esti

mation Future cash flows especially those

generated by disruptive investments are difficult to predict Numbers for the out yearscan be a complete shot in the darle To copewith what cannot be known analysts oftenproject a yearbyyear stream of numbers forthree to five years and then punt by calculating a terminal value to account for everything thereafter The logic of course is thatthe yeartoyear estimates for distant years areso imprecase as to be no more accurate than aterminal value To calculate a terminal valueanalysts divide the cash to be generated in

the last year for which theyve done a specificestimate by rg the discount rate minus the

projected growth rate in cash flows from thattime on They then discount that single number back to the present In our experienceassumed terminal values often account for

more than half of a projectstotal NPVTerminal value numbers based as they

are on estimates for preceding years tendto amplify errors contained in earlyyear

assumptions More worrisome still terminalvalue doesnt allow for the scenario testingthat we described above contrasting the result of this investment with the deterioration

in performance that is the most likely resultof doing nothing And yet because of marketinertia competitors development cycles and

the typical pace of disruption at is often in thefifth year or beyondthe point at whichterminal value factors inthat the decline

of the enterprise in the donothing scenario

begins to accelerateArguably a root cause of companies persis

HARVARD BUSINESS REVIEW JANUARY 2008 PACE 2

innovation Killers

tent underinvestment in the innovations

required to sustain longterm success is the

indiscriminate and oversimplified use of NPVas an analytical tool Still we understand thedesire to quantify streams of cash that defyquantfication and then to distill those

streams into a single number that can becompared with other single numbers It

is an attempt to translate cacophonous articulations of the future into a language

numbersthat everyone can read and com

pare We hope to show that numbers arenot the only language into which the value offuture investments can be translatedand

that there are in fact other better languages

that all members of a management teamcan understand

Using Fixed and Sunk CostsUnwiselyThe second widely misapplied paradigm offinancial decision making relates to fixed andsunk costs When evaluating a future course ofaction the argument goes managers shouldconsider only the future or marginal cash outlays either capital or expense that are required for an innovation investment subtractthose outlays from the marginal cash that islikely to flow in and discount the resulting netflow to the present As with the paradigm ofDCF and NPV there is nothing wrong with the

mathematics of this principleas long as thecapabilities required for yesterdays success

are adequate for tomorrows as well When

The DCF Trap

new capabilities are required for future success however this margining on fixed andsunk costs biases managers toward leveragingassets and capabilities that are likely tobecome obsolete

For the purposes of this discussion welldefine fixed costs as those whose level is inde

pendent of the level of output Typcal fixedcosts include general and administrative costs

salaries and benefits insurance taxes and soon Variable costs include things like raw ma

terials commissions and pay to temporaryworkers Sunk costs are those portions offixed costs that are irrevocably committedtypically including investments in buildingsand capital equipment and RD costs

An example from the steel industry illustrates how fixed and sunk costs make t diffi

cult for companes that can and should investin new capabilities actually to do so In thelate 196os steel minimills such as Nucor and

Chaparral began disrupting integrated steelmakers such as US Steel USX picking off

customers in the leastdemanding producttiers of each market and then moving relent

lessly upmarket using ther 20 cost advantage to capture first the rebar market andthen the bar and rod angle ron and structural beam markets By 1988 the minimills

had driven the highercost integrated mills

out of lowertier products and Nucor hadbegun building its first minimill to roll sheetsteel in Crawfordsville Indiana Nucor esti

mated that for an investment of 26o million

Most executives compare the cash flows from innovation against the default scenario of doingnothing assumingincorrectlythat the present health of the company will persist indefinitely iftheinvestment is not made For a better assessment of the innovationsvalue the comparison should be

between its projected discounted cash flow and the more likely scenario of a decline in performance inthe absence of innovation investment

Projected cash stream dMF ua NPVfrom investing in an

tvr lniasginnovation

A 1 lapliclti in aki

Y p

C Assumed cash

sasa aE a he stream resultingMore likely cash sa asil sa s from doingstream resulting eaamsarrra nothingfrom doing nothing

HARVARD BUSINESS REVIEW JANUARY 2008 PAGE 3

Innovation Killers

it could sell 800000 tons of steel annually ata price of 350 per ton The cash cost to produce a ton of sheet steel in the Crawfordsville

mill would be 270 When the timing of cashflows was taken into account the internal ratoof return to Nucor on this investment was

over 20 substantially higher than Nucors

weighted average cost of capitalIncumbent USX recognized that the min

imills constituted a grave threat Using a newtechnology called continuous strip production Nucor had now entered the sheet steelmarket albeit with an inferior quality product at a significantly lower cost per ton AndNucors track record of vigilant improvementmeant that the quality of its sheet steel wouldimprove with production experience Despitethis understanding USX engineers did noteven consider building a greenfield minimilllike the one Nucor built The reason It

seemed more profitable to leverage the oldtechnology than to create the new USXsexisting mills which used traditional technology had 3o excess capacity and the marginal cash cost of producing an extra ton ofsteel by leveraging that excess capacity wasless than 50 per ton When USXs financialanalysts contrasted the marginal cash flow of300 35o revenue minus the 5o marginalcost with the average cash flow of 8o perton in a greenfield mill investment in a newlowcost minimill made no sense Whats

more USXs plants were depreciated so themarginal cash flow of 300 on a low assetbase looked very attractive

And therein lies the rub Nucor the at

tacker had no fixed or sunk cost investmentson which to do a marginal cost calculation ToNucor the full cost was the marginal cost

Crawfordsville was the only choice on itsmenuand because the IRR was attractive

the decision was simple USX in contrast hadtwo choices on its menu It could build a

greenfield plant like Nucors with a loweraverage cost per ton or it could utilizo morefully its existing facility

So what happened Nucor has continued toimprove its process move upmarket and gainmarket share with more efficient continuous

strip production capabilities while USX hasrelied on the capabilities that had been builtto succeed in the past USXs strategy to maximize marginal profit in other words causedthe company not to minimize longterm aver

age costs As a result the company is lockedinto an escalating cycle of commitment to afailing strategy

The attractiveness of any investment can becompletely assessed only when ít is comparedwith the attractiveness of the right alternatives on a menu of investments When a com

pany is looking at adding capacity that isidentical to existing capacity it makes sense

to compare the marginal cost of leveragingthe old with the full cost of creating the new

But when new technologies or capabilitiesare required for futuro competitiveness margining on the past will send you down thewrong path The argument that investmentdecisions should be based on marginal costs

is always correct But when creating new capabilities is the issue the relevant marginalcost is actually the full cost of creatingthe new

When we look at fixed and sunk costs from

this perspective several anomalies we haveobserved in our studies of innovation are ex

plained Executives in established companiesbemoan how expensive it is to build newbrands and develop new sales and distributionchannelsso they seek instead to leveragetheir existing brands and structures Entrants

in contrast simply create new ones The problem for the incumbent isnt that the chal

lenger can outspend it its that the challengeris spared the dilemma of having to choosebetween fullcost and marginalcost options

We have repeatedly observed leading established companies misapply fixedandsunkcost doctrine and rely on assets and capabilities that were forged in the past to succeed inthe futuro In doing so they fail to make thesame investments that entrants and attackers

find to be profitableA related misused financial practice that

biases managers against investment in neededfuturo capabilities is that of using a capitalassets estimated usable lifetime as the periodover which it should be depreciated Thiscauses problems when the assets usable lifetime is longer than its competitive lifetimeManagers who depreciate assets according tothe more gradual schedule of usable life oftenface massive writeoffs when those assets be

come competitively obsoleto and peed to bereplaced with newer technology assets Thiswas the situation confronting the integratedsteelmakers When building new capabilities


Innovation Killers

Knowing that the equitymarkets willpunish them

for a writeoffofobsolete

assets managers may

stall in adopting new

technology

entails writing off the old incumbents facea hit to quarterly earnings that disruptiveentrants to the industry do not Knowingthat the equity markets will punish them fora writeoff managers may stall in adoptingnew technology

This may be part of the reason for the dramatic increase in private equity buyouts overthe past decade and the recent surge of interest in technology oriented industries Asdisruptions continue to shorten the competitive lifetime of major investments made onlythree to five years ago more companies findthemselves needing to take asset writedownsor to significantly restructure their businessmodels These are wrenching changes that

are often made more easily and comfortablyoutside the glare of the public markets

Whats the solution to this dilemma

Michael Mauboussin at Legg Mason CapitalManagement suggests it is to value strategiesnot projects When an attacker is gainingground executives at the incumbent companies need to do their investment analyses inthe same way the attackers doby focusing

on the strategies that will ensure longtermcompetitiveness This is the only way they cansee the world as the attackers see it and the

only way they can predict the consequencesof not investing

No manager would consciously decide to

destroy a company by leveraging the competencies of the past while ignoring those required for the future Yet this is precisely whatmany of them do They do it because strategy

and finance were taught as separate topics inbusiness school Their professors of financialmodeling alluded to the importance of strategy and their strategy professors occasionallyreferred to value creation but little time was

spent on a thoughtful integration of the twoThis bifurcation persists in most companieswhere responsibilities for strategy and financereside in the realms of different vice presidents Because a firms actual strategy is

defined by the stream of projects in which itdoes or doesnt invest finance and strategyneed to be studied and practiced in anintegrated way

Focusing Myopically on Earningsper ShareA third financial paradigm that leads established companies to underinvest in innovation

is the emphasis on earnings per share asthe primary driver of share price and henceof shareholder value creation Managers

are under so much pressure from variousdirections to focus on shortterm stock performance that they pay less attention to the com

panys longterm health than they mighttothe point where theyre reluctant to invest ininnovations that dont pay off immediately

Wheres the pressure coming from Toanswer that question we need to look brieflyat the principalagent theorythe doctrinethat the interests of shareholders principalsarent aligned with those of managersagents Without powerful financial incen

tives to focus the interests of principals andagents on maximizing shareholder valuethe thinking goes agents will pursue otheragendasand in the process may neglect to

pay enough attention to efficiencies or squander capital investments on pet projectsatthe expense of profits that ought to accrue tothe principals

That conflict of incentives has been taught

so aggressively that the compensation of mostsenior executives in publicly traded companies is now heavily weighted away from salaries and toward packages that reward improvements in share price That in turn hasled to an almost singular focus on earningsper share and EPS growth as the metric forcorporate performance While we all recognize the importance of other indicators suchas market position brands intellectual capital and longterm competitiveness the bias istoward using a simple quantitative indicatorthat is easily compared period to period andacross companies And because EPS growth isan important driver of nearterm share priceimprovement managers are biased against investments that will compromise neartermEPS Many decide instead to use the excesscash on the balance sheet to buy back thecompanysstock under the guise of returningmoney to shareholders But although contracting the number of shares pumps up earnings per share sometimes quite dramaticallyit does nothing to enhance the underlyingvalue of the enterprise and may even damageit by restricting the flow of cash available forinvestment in potentially disruptive productsand business models Indeed some have

fingered share pricebased incentive compensation packages as a key driver of the share


Innovation Killers

price manipulation that captured so manybusiness headlines in the early 2000s

The myopic focus on EPS is not just aboutthe money CEOs and corporate managers whoare more concerned with their reputationsthan with amassing more wealth also focus onstock price and shortterco performance measures such as quarterly earnings They knowthat to a largo extent others perception oftheir success is tied up in those numbers leading to a selfreinforcing cycle of obsession Thisbehavior cycle is amplified when there is anearnings surprise Equity prices over the

short term respond positively to upside earnings surprises and negatively to downside surprises so investors have no incentivo to look

at rational measures of longterm performance To the contrary they are rewarded forgoing with the marketsshortterm model

The active leveraged buyout market hasfurther reinforced the focus on EPS Companies that are viewed as having faíled to maximize value as evidenced by a lagging shareprice are vulnerable to overtures from out

siders including corporate raiders or hedgefunds that seek to increase their nearterco

stock price by putting a company into playor by replacing the CEO Thus while the pasttwo decades have witnessed a dramatic in

crease in the proportion of CEO compensation tied to stock priceand a breathtakingincrease in CEO compensation overalltheyhave witnessed a concomitant decrease in

the average tenure of CEOs Whether youbelieve that CEOs are most motivated by thecarrot major increases in compensation andwealth or the stick the threat of the company being sold or of being replaced youshould not be surprised to find so many CEOsfocused on current earnings per share as thebest predictor of stock price sometimes tothe exclusion of anything else One studyeven showed that senior executives were rou

tinely willing to sacrifice longterm shareholder value to meet earnings expectations orto smooth reported earnings

We suspect that the principalagent theoryis misapplied Most traditional principalsbywhich we mean shareholdersdont them

selves have incentivos to watch out for the

longterm health of a company Over 9o ofthe shares of publicly traded companies in theUnited States are held in the portfolios of mutual funds pension funds and hedge funds

The average holding period for stocks in theseportfolios is less than io monthsleading usto prefer the term share owner as a moreaccurate description than shareholder Asfor agents we believe that most executives

work tirelessly throwing their hearts andminds into their jobs not because they arepaid an incentivo to do so but because theylove what they do Tying executive compensation to stock prices therefore does not affectthe intensity or energy or intelligence withwhich executives perform But it does directtheir efforts toward activities whose impactcan be felt within the holding horizon ofthe typical share owner and within the measurement horizon of the incentiveboth of

which are less than one year

Ironically most socalled principals todayare themselves agents agents of other peoples mutual funds investment portfoliosendowments and retirement programs Forthese agents the enterprise in which they areinvesting has no inherent interest or value

beyond providing a platform for improvingthe shortterm financial metric by which theirfunds performance is measured and their

own compensation is determined And in afinal grand but sad irony the real principalsthe people who put their money into mutualfunds and pension plans sometimes throughyet another layer of agents are frequentlythe very individuals whose longterm employment is jeopardized when the focus onshortterm EPS acts to restrict investments in

innovative growth opportunities We suggestthat the principalagent theory is obsoleto inthis context What we really have is an agentagent problem where the desires and goals ofthe agent for the share owners compete withthe desires and goals of the agents runningthe company The incentivos are still misaligned but managers should not capitulateon the basis of an obsoleto paradigm

Processes That Support or SabotageInnovation

As we have seen managers in establishedcorporations use analytical methods that

malee innovation investments extremely difficult to justify As it happens the most common system for Breenlighting investmentprojects only reinforces the flaws inherent inthe tools and dogmas discussed earlier

Stagegate innovation Most established

HARVARD BUSINESS REVIEW JAN UARY 2oo8 PAGE 6

Innovation Killers

companies start by considering a broad rangeof possible innovations they winnow out theless viable ideas step by step until only themost promising ones remain Most such processes include three stages feasibility development and launch The stages are separated bystage gates review meetings at which project

teams report to senior managers what theyveaccomplished On the oasis of this progress

and the projects potential the gatekeepersapprove the passage of the initiative into the

next phase return it to the previous stage formore work or kill it

Many marketers and engineers regard thestage gate development process with disdainWhy Because the key decision criteria ateach gate are the size of projected revenuesand profits from the product and the associated risks Revenues from products that incrementally improve upon those the company iscurrently selling can be credibly quantifiedBut proposals to create growth by exploitingpotentially disruptive technologies productsor business models cant be bolstered by hardnumbers Their markets are initially smalland substantial revenues generally dontmaterialize for several years When theseprojects are pitted against incremental sustaining innovations in the baffle for fundingthe incremental ones sail through while theseemingly riskier ones get delayed or die

The process itself has two serious draw

backs First project teams generally knowhow good the projections such as NPV needto look in order to win funding and it takesonly nanoseconds to tweak an assumptionand run another full scenario to get a faltering project over the hurdle rate If as is oftenthe case there are eight to io assumptions underpinning the financial model changingonly a few of them by a mere 2 or 3 eachmay do the trick It is then difficult for the se

nior managers who sit as gatekeepers to evendiscern which are the salient assumptions letalone judge whether they are realistic

The second drawback is that the stagegatesystem assumes that the proposed strategyis the right strategy Once an innovation hasbeen approved developed and launched allthat remains is skillful execution If afterlaunch a product falls seriously short of the projections and 75 of them do it is canceled

The problem is that except in the case ofincremental innovations the right strategy

especially which job the customer wantsdone cannot be completely known inadvance It must emerge and then be refined

The stagegate system is not suited to the

task of assessing innovations whose purposeis to build new growth businesses but mostcompanies continue to follow it simply because they see no alternative

Discovery driven planning Happily thoughthere are alternative systems specificallydesigned to support intelligent investments infuture growth One such process which RitaGunther McGrath and Ian MacMillan call

discovery driven planning has the potential togreatly improve the success rate Discoverydriven planning essentially reverses thesequence of some of the steps in the stage

gate process Its logic is elegantly simple If theproject teams all know how good the numbersneed to look in order to win funding why go

through the charade of making and revisingassumptions in order to fabricate an acceptable set of numbers Why not just put theminimally acceptable revenue income and

cash flow statement as the standard first pageof the gate documents The second page canthen raise the critical issues Okay So we allknow this is how good the numbers need tolook What set of assumptions must prove truein order for these numbers to materialize

The project team creates from that analysis an

assumptions checklista list of things thatneed to prove true for the project to succeedThe ítems on the checklist are rankordered

with the deal killers and the assumptionsthat can be tested with little expense towardthe top McGrath and MacMillan call this areverse income statement

When a project enters a new stage theassumptions checklist is used as the basis of

the project plan for that stage This is nota plan to execute however It is a plan tolearnto test as quickly and at as low a costas possible whether the assumptions uponwhich success is predicated are actually validIf a critical assumption proves not to be validthe project team must revise its strategy untilthe assumptions upon which it is built are allplausible If no set of plausible assumptionswill support the case for success the projectis killed

Traditional stagegate planning obfuscates

the assumptions and shines the light on thefinancial projections But there is no need to


Innovation Killers

More often than not

failure in innovation is

rooted in not having

asked an important

question rather than in

having arrived at anincorrect answer

focus the analytical spotlight on the numbersbecause the desirability of atiractive numbershas never been the question Discoverydrivenplanning shines a spotlight on the place wheresenior management needs illumination

the assumptions that constitute the keyuncertainties More often than not failure ininnovation is rooted in not having asked animportant question rather than in havingarrived at an incorrect answer

Today processes like discovery driven planning are more commonly used in entrepreneurial settings than in the large corporationsthat desperately need them We hope that byrecounting the strengths of one such systemwe11 persuade established corporations toreassess how they malee decisions aboutinvestment projects

We keep rediscovering that the root reason for

established companies failure to innovate isthat managers dont have good tools to helpthem understand markets build brands findcustomers select employees organize teamsand develop strategy Some of the tools typically used for financial analysis and decisionmaking about investments distort the valueimportance and likelihood of success ofinvestments in innovation Theres a better

way for management teams to grow theircompanies But they will need the courage tochallenge some of the paradigms of financial

analysis and the willingness to develop alternative methodologies

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