Mastering Disruptive Change: A Manager's Challenge

Disruptive change looms large, and history hasn't favored their track record in dealing with it effectively. Even before the era of the Internet and globalization, adapting to major disruptions was a formidable task. Only a select few managed to thrive; others stumbled or fell by the wayside.

Take the example of department stores, where just one—Dayton Hudson—transitioned successfully into discount retailing. None of the minicomputer companies succeeded in the personal computer realm. Even prestigious medical and business schools have struggled to revamp their curricula to meet evolving market demands. The list goes on.

It's not that these managers lack foresight; often, they do foresee disruptive changes on the horizon. Nor is it a scarcity of resources. Large companies typically boast talented teams, impressive product portfolios, cutting-edge technology, and substantial financial resources. What many managers overlook, however, is the need to scrutinize their organization's capabilities as meticulously as they assess individual talents.

While adept managers excel at matching the right person to the right job and providing the necessary training for success, they often assume that assembling a team of well-suited individuals guarantees the organization's success. Unfortunately, this assumption can be misleading. Organizations, independently of their constituents, possess inherent capabilities, which are often overlooked. The same group of equally capable individuals placed in different organizations may yield vastly different outcomes. This divergence arises because organizations themselves have unique abilities and limitations. To consistently succeed, effective managers must evaluate not only their team members but also their organization's collective strengths and weaknesses.

This article offers a framework to aid managers in comprehending their organization's capabilities. It will elucidate how an organization's weaknesses become more pronounced as its core strengths expand. It will provide insights into recognizing various types of change and deploying the appropriate organizational responses to capitalize on emerging opportunities. Additionally, it will challenge a prevailing notion in our proactive business culture: when confronted with significant change, such as disruptive innovation, making sweeping adjustments to the existing organization might be the worst possible approach. In the quest to transform an enterprise, managers risk dismantling the very capabilities that sustain it.

Prior to embarking on a transformation journey, managers must gain precise insights into what types of change their existing organization can handle and what it cannot. To assist in this endeavor, we will systematically explore how to identify a company's core capabilities on an organizational level and delve into how these capabilities evolve as companies grow and mature.

Where Do Capabilities Reside?

Our research suggests that three factors influence what an organization can and cannot accomplish: its resources, its processes, and its values. When contemplating the innovative potential of their organization, managers should consider how each of these factors might impact the organization's adaptability to change.

Resources: Typically, managers first scrutinize the resources available to their organization when assessing its capabilities. These resources encompass tangible assets such as personnel, equipment, technology, and financial reserves, as well as intangible assets like product designs, information, brands, and relationships with suppliers, distributors, and customers. Undeniably, access to ample, high-quality resources enhances an organization's ability to navigate change effectively. Nevertheless, resource analysis alone doesn't offer a comprehensive perspective.

Processes

The second factor influencing a company's capacities is its processes. Processes encompass the patterns of interaction, coordination, communication, and decision-making that employees employ to transform resources into more valuable products and services. Notable examples include the processes governing product development, manufacturing, and budgeting. Some processes are formal, explicitly defined and documented, while others are informal, evolving as routines or work methods over time. The former tend to be more visible, while the latter remain less conspicuous.

In the realm of management, processes inherently aim to ensure consistency and efficiency. These processes are designed to remain unchanged, and when alterations are necessitated, they must occur through tightly controlled procedures. While adhering to these processes enhances efficiency when addressing tasks for which they were created, attempting to apply the same processes to markedly different tasks typically results in subpar performance. This dilemma confronts many established firms as they grapple with disruptive changes.

Consider the example of companies focusing on gaining FDA approval for new drug compounds. Such companies might excel in this specific domain but may struggle when venturing into the development and approval of medical devices. These distinct tasks demand fundamentally different approaches and ways of working. The processes optimized for one task can become detrimental when applied to the other, as they define an organization's capability to execute one task while concurrently limiting its capacity to perform another.

Interestingly, the most critical capabilities and concurrent disabilities within organizations often reside in less visible background processes. These are the processes that influence resource allocation decisions, shaping how market research is typically conducted, transforming analysis into financial projections, and navigating internal negotiations related to plans and budgets. It is within these processes that organizations often harbor their most significant impediments to managing change effectively.

Values

The third influential factor in determining what an organization can and cannot accomplish is its values. While “corporate values” may commonly evoke ethical connotations, they encompass a broader scope in this context. Here, values denote the standards employees employ to prioritize tasks, enabling them to assess orders, customer importance, product concepts, and more. These prioritization decisions occur across all levels of an organization. For salespeople, it involves daily choices regarding which products to promote and which to downplay. At the executive level, it entails decisions to invest in new products, services, or processes.

As organizations grow larger and more complex, senior managers must impart the ability to make independent decisions aligned with the company's strategic direction and business model to employees throughout the organization. A hallmark of effective management lies in achieving this consistency and clarity in values throughout the organization.

However, these consistent, broadly understood values also dictate what an organization cannot do. An organization's values reflect its cost structure and business model, establishing rules that employees must adhere to for the company's prosperity. For instance, if an organization's overhead costs require a minimum gross profit margin of 40%, a value or decision rule emerges that encourages middle managers to reject ideas promising margins below this threshold. Consequently, the organization becomes incapable of pursuing projects targeting low-margin markets, even if another organization's values, driven by a different cost structure, might enable the same project's success.

Two sets of values tend to evolve predictably within most companies, rendering them progressively less adept at navigating disruptive change. The first set dictates acceptable gross margins and transforms as companies add features and functions to their products and services, subsequently raising overhead costs. In response, once-attractive gross margins become unattractive. For example, Toyota entered the North American market with the lower-end Corona model, but competition led to declining profit margins, prompting Toyota to invest in more sophisticated cars, like the Camry and Lexus. This shift in strategy changed the company's cost structure and, consequently, its values. Toyota recently attempted to re-enter the entry-level market with the Echo model, but this move requires aligning its values with a focus on selling more cars at lower margins—a challenging shift against its existing corporate values.

The second set of values that tend to evolve in companies pertains to the size of a business opportunity deemed interesting. As a company grows, its stock price reflects the discounted present value of its projected earnings stream. Therefore, there is often pressure to not only maintain growth but also maintain a consistent rate of growth. For example, a $40 million company aiming for 25% growth must find $10 million in new business the following year. Conversely, a $40 billion company pursuing the same growth rate needs to secure $10 billion in new business, indicating that opportunities that excite small companies may not be substantial enough to pique the interest of large companies. Consequently, as companies expand, they tend to lose the ability to enter emerging, smaller markets—a shift driven by changes in values rather than resources.

This problem becomes amplified when companies undergo significant growth through mergers or acquisitions. Executives orchestrating megamergers between already sizable firms need to acknowledge this effect. While the combined research capabilities may have increased resources for new product development, the commercial organizations often become less inclined to pursue anything other than major blockbuster offerings. This creates a tangible challenge in managing innovation. The issue is not limited to pharmaceutical companies but also extends to high-tech industries. Hewlett-Packard's recent decision to split into two companies partly stems from recognition of this problem.

The Migration of Capabilities

In the early stages of an organization, success primarily hinges on resources, particularly people. The presence or absence of a few key individuals can significantly impact the organization's trajectory. However, over time, the center of an organization's capabilities shifts toward its processes and values. As individuals address recurring tasks, processes take shape, and as the business model matures, values solidify. This shift has implications for companies, particularly in managing innovation.

Some young companies experience rapid growth and market success based on a single breakthrough product but falter after an IPO because their initial success is resource-driven, often relying heavily on founding engineers. These companies may fail to establish processes capable of consistently producing a sequence of successful products.

For example, Avid Technology, known for its digital-editing systems for television, initially achieved high stock valuations based on its innovative product. However, it struggled when faced with market saturation, increased competition, and challenges related to quality, delivery, and service. Avid's early success was resource-dependent, but it failed to develop robust processes to sustain innovation.

In contrast, highly successful firms like McKinsey & Company rely on well-established processes and values, making it relatively less reliant on specific individuals. McKinsey can deliver high-quality work consistently, despite the annual influx and departure of hundreds of MBAs, because its core capabilities are rooted in processes and values.

Founder's Impact: During a company's formative years, the founder often exerts a significant influence. The founder's opinions shape how employees work and the organization's priorities. Successful founders with sound judgments set the stage for employees to validate problem-solving and decision-making methods, thereby defining processes. Additionally, if the founder guides the company to financial success by allocating resources in line with specific criteria reflecting their priorities, the organization's values coalesce around those criteria.

Cultural Evolution in Successful Companies: In mature, successful companies, employees often come to assume that the processes and priorities they've consistently used are the correct approaches. Over time, employees start following these processes and determining priorities automatically, rather than through deliberate choices. Consequently, these processes and values become deeply ingrained in the organization's culture. As companies grow from small teams to larger workforces comprising hundreds or thousands of employees, ensuring alignment on tasks and approaches becomes a formidable challenge. Culture emerges as a powerful management tool in this context. It allows employees to operate autonomously while ensuring consistency in their actions.

The factors defining an organization's capabilities and limitations evolve over time, progressing from resources to visible, articulated processes and values, and ultimately culminating in culture. As long as an organization continues to confront problems aligned with the processes and values it was designed around, managing the organization remains relatively straightforward. However, these factors also delineate what an organization cannot do, rendering them disabilities when the fundamental nature of the challenges shifts. When an organization's capabilities primarily reside in its people, adapting to address new issues is relatively simple. However, when capabilities become entrenched in processes, values, and especially culture, change becomes exceedingly challenging.

Digital's Dilemma: The challenge of adapting to disruptive change is particularly pronounced in the digital age, as demonstrated by the sidebar “Digital's Dilemma.” Established companies with deeply rooted cultures, processes, and values often struggle to pivot and innovate rapidly to remain competitive in the face of digital disruption. Their inability to adapt becomes a significant liability as the business landscape evolves.

Sustaining vs. Disruptive Innovation

Sustaining Innovations: These innovations enhance existing products or services in ways that appeal to mainstream customers and align with their current preferences. For example, Compaq adopting Intel's 32-bit 386 microprocessor instead of the 16-bit 286 chip was a sustaining innovation, as was Merrill Lynch introducing its Cash Management Account.

Disruptive Innovations: These innovations introduce entirely new markets with products or services that initially may not match the performance metrics valued by mainstream customers. For instance, Charles Schwab's initial entry as a bare-bones discount broker was disruptive to full-service brokers like Merrill Lynch, as it didn't cater to the needs of Merrill Lynch's best customers. Early personal computers were disruptive compared to mainframes and minicomputers.

Why Established Companies Struggle with Disruptive Innovations

Resources-Processes-Values Framework: Established industry leaders excel at developing and introducing sustaining innovations because they have well-established processes and values aligned with these innovations. However, disruptive innovations are less predictable, don't offer high margins initially, and don't cater to the best customers' needs. As a result, established companies often struggle with them.

Smaller Companies' Advantage: Smaller, disruptive companies are more capable of pursuing emerging growth markets because they can embrace small markets, accommodate lower margins, make intuitive decisions, and adapt to disruptive change.

Creating Capabilities to Cope with Change

When an organization needs new processes and values to address either sustaining or disruptive innovations, managers must create a new organizational space to develop these capabilities. There are three possible approaches:

• Create New Organizational Structures: Develop new processes within the existing corporate boundaries by creating new organizational structures that allow for experimentation and innovation.
• Spin Out an Independent Organization: Establish an independent organization separate from the existing one and cultivate the required processes and values within it to address the new challenge.
• Acquire a Different Organization: Acquire an organization with existing processes and values that closely align with the demands of the new task, essentially bringing in the necessary capabilities through acquisition.

Creating New Capabilities Internally

When a company's capabilities reside in its existing processes, and new challenges require entirely different processes involving different teams and ways of working, managers can create new organizational structures. These structures, often referred to as “heavyweight teams,” are dedicated to the new challenge and have distinct characteristics:

• Team members are physically located together.
• Each member takes personal responsibility for the project's success.
• Team boundaries facilitate new working patterns, which can evolve into new processes.

For instance, Chrysler created heavyweight teams to shift its focus from components to automobile platforms like minivans and trucks, leading to the development of more efficient processes for integrating subsystems into new car designs. Other companies, such as Medtronic, IBM, and Eli Lilly, have used heavyweight teams to create new processes for developing products more effectively.

Creating Capabilities Through a Spinout Organization

When the mainstream organization's values or cost structure prevent it from allocating resources to an innovation project, the company may consider spinning it out as a new venture. This approach is particularly relevant when:

• The disruptive innovation requires a different cost structure to be profitable.
• The opportunity's current size is insignificant compared to the growth needs of the mainstream organization.
• The spinout organization can be physically separate or simply independent from the mainstream organization's decision-making criteria for resource allocation. The key is to prevent the project from competing for resources with mainstream projects that are inconsistent with the disruptive innovation's requirements.

Organizational Structures for Different Innovation Challenges

Organizational structures should be tailored to the specific innovation challenge a company faces.

• For sustaining innovations, existing processes within the corporate boundaries can be used.
• For disruptive innovations, heavyweight teams or spinout organizations may be more suitable, depending on the nature of the challenge.

Managing Disruptive Change with Two Businesses in Tandem

When facing disruptive change, managers should consider running two businesses in parallel—one that maintains processes tuned to the existing business model and another geared toward the new model. This approach allows the organization to leverage its existing capabilities while developing new processes and values to address the disruptive challenge.

For example, Merrill Lynch expanded its institutional financial services through existing processes like planning, acquisition, and partnerships. However, to adapt to the online world, it needed to operate with increased speed in these areas. Instead of changing the processes that worked well for its traditional investment banking, Merrill Lynch should retain those processes for the existing business and create additional processes to address the new challenges posed by online services.

Personal CEO Oversight for Successful Transformation

In cases of disruptive change that challenge mainstream values, the personal, attentive oversight of the CEO is crucial. Only the CEO can ensure that the new organization receives the necessary resources and has the freedom to develop appropriate processes and values for the new challenge. CEOs who view spinouts solely as a way to remove disruptive threats from their agendas often face failure.

Creating Capabilities Through Acquisitions

When acquiring companies to gain new capabilities, it's essential to assess where those capabilities reside in the acquisition—whether in resources, processes, or values. This assessment helps determine the best integration strategy.

• If the acquired capabilities are primarily embedded in processes and values, it's advisable to let the acquired business stand alone and infuse the parent company's resources into its processes and values.
• If the acquisition's success is primarily due to its unique resources, integrating it into the parent organization to leverage existing capabilities may make sense.

The decision should be based on the specific nature of the acquired capabilities and how they contributed to the acquisition's value.

Avoiding Compromised Capabilities in Mergers

Integrating two organizations without considering the impact on their respective processes and values can lead to compromised capabilities. If an acquisition's processes were a key reason for its success, forcing it to adopt the buyer's processes can undermine its capabilities.

For example, in the DaimlerChrysler merger, Chrysler's success was rooted in its processes for product design and subsystem supplier integration. Integrating the two companies might compromise these processes and undermine Chrysler's value as an acquisition.

Successful integration should be driven by a deep understanding of where the acquired company's capabilities reside and how they can be preserved or leveraged within the parent organization.

The Case of IBM's Acquisition of Rolm

IBM's 1984 acquisition of Rolm, a telecommunications company, serves as an example of the importance of understanding the value of processes in acquisitions. Although IBM already had most of Rolm's resources, it was Rolm's processes for developing and finding new markets for PBX products that were valuable. Initially, IBM recognized the value in preserving Rolm's unconventional culture, which contrasted with IBM's more methodical style. However, in 1987, IBM decided to fully integrate Rolm into its corporate structure. This decision proved unwise, as IBM attempted to push Rolm's resources through its own processes designed for large computers, leading to problems. Additionally, IBM's values, shaped by higher profit margins, couldn't align with Rolm's lower-margin products. This integration destroyed the original value of the acquisition.

The story highlights the difference in perspective between financial analysts, who often focus more on the value of resources, and the value of processes. Analysts may emphasize efficiency savings through integration, but this approach can lead to problems when processes and values don't align.

Cisco Systems' Successful Acquisitions

In contrast, Cisco Systems' acquisitions have been successful because they have maintained the right perspective on resources, processes, and values. Cisco primarily acquired small, early-stage companies between 1993 and 1997, focusing on their valuable resources, particularly engineers and products. Cisco then integrated these resources into its own efficient development, logistics, manufacturing, and marketing processes. When acquiring a larger, more mature organization like StrataCom, Cisco chose not to integrate but allowed it to stand alone while providing additional resources for growth.

In summary, managers facing the challenges of disruptive change should follow a structured approach:

• Assess Resources: Determine whether your organization has the necessary resources required for success in the new situation.
• Evaluate Processes and Values: Ask whether the existing processes and values within the organization are suitable for addressing the new problem. Are they aligned with the goals and priorities of the initiative?
• Honest Self-Assessment: Be honest in your assessment. If the processes and values aren't appropriate, acknowledge it. Recognizing the problem is the first step toward finding a solution.
• Avoid Wishful Thinking: Don't succumb to wishful thinking. Trying to innovate within structures that aren't designed for the task can lead to frustration and roadblocks.
• Align Capable People with Capable Organizations: Ensure that your highly capable employees are placed within organizations that support their efforts. Capabilities and disabilities are intertwined, and effective management involves matching people with suitable organizational structures.

This framework underscores the importance of not only having the right resources but also the right processes and values in place to address disruptive change effectively. By understanding this interplay, managers can better navigate the challenges of innovation in established companies.

Additionally, it's essential to recognize that organizational culture plays a significant role in how processes and values are developed and maintained. Edgar Schein's work on organizational culture provides valuable insights into this aspect of managing change.

Lastly, successful acquisitions require a clear understanding of where the value lies—whether in resources, processes, or values—and integrating the acquired company accordingly. Cisco Systems' approach of integrating resources while preserving processes and values has contributed to its success in acquisitions.