Fight or flee? Big business versus disruptors

UNDERSTANDING the dynamics of disruptive innovation can help rescue Zimbabwe’s blue chip firms from the spectre of unexpected and often ignominious demise.

The Human Capital Telescope with Brett Chulu

What may cause the implosion of blue chip firms, ironically, run by brilliant business minds can be a series of seemingly smart financial decisions.

Disruptive innovation, a business phenomenon discovered by Clayton Christensen, occurs when competitors enter an industry at the bottom of the market with new products or services that are much simpler and more affordable than the incumbent’s offerings.

Alive in Zimbabwe

Disruptive innovation is well and alive in Zimbabwe. Just a few examples; WhatsApp, a low-cost mobile messaging product is disrupting the SMS segment of mobile phone operators; mobile money transfer is disrupting traditional banking products; Voice over Internet Protocol (VoIP) is disrupting traditional mobile voice-call business.

What makes the phenomenon of disruptive innovation a chilling prospect to Zimbabwean firms’ fortunes, is that where it has occurred, regulation has almost always failed to curtail it.

Happy to exit low margins
It is often that blue chip firms have a portfolio of products yielding varying profit margins.

Typical disruptive innovators almost always target the least profitable product in the incumbent’s product portfolio. As an entering wedge, disruptive innovators come up with innovative ways to drastically reduce the cost of producing an offering. To reduce cost, disruptors simplify the production process by developing alternative technologies and/or business models. With a newly minted cost advantage, disruptors attack the incumbent’s low- margin product business.

Confronted by a disruptive attack, incumbents are faced with two options; either defend the least profitable business or exit.

Financial analysis is done to inform the eventual choice and typically this decision analysis leads to the conclusion that exiting the least profitable market segment constitutes a sound business decision. By loping off the least profit margin product and redeploying productive assets to the remaining higher margin products, the overall profitability of the incumbent’s business increases.

The resultant improvement of profitability metrics such as Return on Net Assets (RONA) justifies the decision to leave the low –margin business to disruptors. Thus the business leaders from established firms are happy to co-exist with the disruptor.

Generally, established firms see no reason to adopt the new technology and/or business model of the disruptors. This false sense of security enables disruptors to perfect their technologies and business models as they begin to search for higher margin business.

Once more, disruptors target the next least profitable product offering of established firms. Again, established firms are faced with the decision to fight or flee. Once more, financial analysis points to the desirability of the flight option. In essence, financial analysis warns against adopting the business models of the disruptors as exiting the least profitable segment actually increases profitability as measured by standard metrics. If slicing off the least profitable part of your business raises overall profitability why should a business bother copying the disruptor’s technology and low-cost model?

In the most dramatic of disruption scenarios, this ‘happy-to-exit-low-margin-business’ cycle continues until the established firms are left concentrating on the most profitable product. From this point onwards, it gets more interesting insofar as good financial analysis misleads established firms to hold onto their old business models, resulting in their sudden if not spectacular demise.

Marginal analysis
The process we have been describing thus far has happened repeatedly in many industries.

One industry where this has produced dramatic business failure is the US steel industry. A well-known former US steel giant employing integrated steel-manufacturing technology (much like the production technology used by our own erstwhile Ziscosteel) progressively loped off steel products offering profit margins as low as 7% until they remained producing those yielding margins of 20%.

The steel industry disruptors systematically attacked least profitable steel segments using a new steel-production technology known as mini-mill that gave disruptors a 20% cost lever.

With the US steel giant having fled to the last and most profitable segment, the mini-mill disruptors found ways of extending their low-cost steel-production technology to this lucrative segment. The steel giant had no more segments to flee and thus the only strategic option available in the short-term was to take the disruptors head on.

As the most reasonable strategic measure, the steel giant launched a price war.

But for how long can you fight using price cuts against competitors producing steel at 20% lower cost using a totally different technology? Seeing the unsustainability of a protracted price war given a comparatively high cost base, engineers of the giant steel producer came up with a plan to adopt the new mini-mill technology and their plan showed a huge improvement in absolute profits.

Everyone was happy except the Finance Director (FD).
The FD rubbished the plan to adopt the mini-mill technology.

Engineers were basing an investment decision using total costs and revenues to compute profit and according to classical financial analysis that was a cardinal error.

The FD argued that as per accepted financial wisdom, decisions either to invest in a project or not are done through marginal cost and marginal revenue analysis. This marginal decision analysis model ignores fixed costs and investment costs borne in the past (sunk costs). As per the FD’s marginal cost analysis, adopting the mini-mill technology would lead to serious marginal losses.

Instead of adopting new production technology, the steel giant needed to make use of idle capacity, the FD argued. It would appear the FD was oblivious of the fact that the idle capacity was a result of the decision of the firm to exit the production of lower margin steel products each time they were faced with low-cost competition from the mini-mill disruptors.

Swayed by the FD’s ‘convincing’ marginal profit analysis, the steel giant stuck with the expensive and uncompetitive integrated steel making technology. Predictably, they went out of business. Seemingly sound financial decisions had led to the sudden death of the blue chip firm.

Cheered on by investment analysts
Each time established firms leave the low margin business to disruptors, the profitability numbers improve, much to the delight of investment analysts and investors, who reward with increased share price. This reward by the investment market for making ‘sound’ strategic decisions buttresses later decisions by established firms to focus on the remaining higher margin segments.

As disruptors extend their low-cost capability to the incumbent’s remaining segment, investment analysts begin to downgrade the blue chip, warning of inevitable but unsustainable price wars.

Here is a lesson for Zimbabwe’s business leaders: Under a disruptive innovation threat circumstance, traditional financial analysis is not appropriate.

Reflect on it
Your potential disruptor might not even be in your industry.

Chulu is a strategic HR consultant who has worked with both listed and unlisted companies.

brettchulu@consultant.com.

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