38 innovation killers

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Innovation Killers

How Financial Tools Destroy Your Capacity to Do New Things

by Clayton M. Christensen, Stephen P. Kaufman, and

Willy C. Shih

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Innovation Killers

How Financial Tools Destroy Your Capacity to Do New Things

by Clayton M. Christensen, Stephen P. Kaufman, and

Willy C. Shih

harvard business review • january 2008 page 1

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For years we’ve been puzzling about why somany smart, hardworking managers in well-run companies find it impossible to innovatesuccessfully. Our investigations have uncov-ered a number of culprits, which we’ve dis-cussed in earlier books and articles. Theseinclude paying too much attention to thecompany’s most profitable customers(thereby leaving less-demanding customersat risk) and creating new products that don’thelp customers do the jobs they want to do.Now we’d like to name the misguided appli-cation of three financial-analysis tools as anaccomplice in the conspiracy against success-ful innovation. We allege crimes againstthese suspects:

• The use of discounted cash flow (DCF)and net present value (NPV) to evaluate in-vestment opportunities causes managers tounderestimate the real returns and benefits ofproceeding with investments in innovation.

• The way that fixed and sunk costs are con-sidered when evaluating future investmentsconfers an unfair advantage on challengers

and shackles incumbent firms that attempt torespond to an attack.

• The emphasis on earnings per share asthe primary driver of share price and hence ofshareholder value creation, to the exclusion ofalmost everything else, diverts resources awayfrom investments whose payoff lies beyondthe immediate horizon.

These are not bad tools and concepts, wehasten to add. But the way they are com-monly wielded in evaluating investmentscreates a systematic bias against innovation.We will recommend alternative methods that,in our experience, can help managers inno-vate with a much more astute eye for futurevalue. Our primary aim, though, is simply tobring these concerns to light in the hope thatothers with deeper expertise may be inspiredto examine and resolve them.

Misapplying Discounted Cash Flow and Net Present Value

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

Innovation Killers


discounting cash flow to calculate the netpresent value of an initiative. Discounting afuture stream of cash flows into a “presentvalue” assumes that a rational investor wouldbe indifferent to having a dollar today or toreceiving some years from now a dollar plusthe interest or return that could be earnedby investing that dollar for those years.With that as an operating principle, it makesperfect sense to assess investments by dividingthe money to be received in future years by(1 + r)

n

, where

r

is the discount rate—the an-nual return from investing that money—and

n

is the number of years during which the in-vestment could be earning that return.

While the mathematics of discounting is log-ically impeccable, analysts commonly committwo errors that create an anti-innovation bias.The first error is to assume that the base caseof not investing in the innovation—the do-nothing scenario against which cash flowsfrom the innovation are compared—is that thepresent health of the company will persist in-definitely into the future if the investment isnot made. As shown in the exhibit “The DCFTrap,” the mathematics considers the invest-ment in isolation and compares the presentvalue of the innovation’s cash stream lessproject costs with the cash stream in the ab-sence of the investment, which is assumed tobe unchanging. In most situations, however,competitors’ sustaining and disruptive invest-ments over time result in price and marginpressure, technology changes, market sharelosses, sales volume decreases, and a decliningstock price. As Eileen Rudden at Boston Con-sulting Group pointed out, the most likelystream of cash for the company in the do-noth-ing scenario is not a continuation of the statusquo. It is a nonlinear decline in performance.

It’s tempting but wrong to assess the valueof a proposed investment by measuringwhether it will make us better off than we arenow. It’s wrong because, if things are deterio-rating on their own, we might be worse offthan we are now after we make the proposedinvestment but better off than we would havebeen without it. Philip Bobbitt calls this logicParmenides’ Fallacy, after the ancient Greeklogician who claimed to have proved that con-ditions in the real world must necessarily beunchanging. Analysts who attempt to distillthe value of an innovation into one simplenumber that they can compare with other

simple numbers are generally trapped byParmenides’ Fallacy.

It’s hard to accurately forecast the stream ofcash from an investment in innovation. It iseven more difficult to forecast the extent towhich a firm’s 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 question.Answering it entails assessing the projectedvalue of the innovation against a range ofscenarios, the most realistic of which isoften a deteriorating competitive and finan-cial future.

The second set of problems with discountedcash flow calculations relates to errors of esti-mation. Future cash flows, especially thosegenerated by disruptive investments, are diffi-cult to predict. Numbers for the “out years”can be a complete shot in the dark. To copewith what cannot be known, analysts oftenproject a year-by-year stream of numbers forthree to five years and then “punt” by calcu-lating a terminal value to account for every-thing thereafter. The logic, of course, is thatthe year-to-year estimates for distant years areso imprecise as to be no more accurate than aterminal value. To calculate a terminal value,analysts divide the cash to be generated inthe last year for which they’ve done a specificestimate by (

r

−

g

), the discount rate minus theprojected growth rate in cash flows from thattime on. They then discount that single num-ber back to the present. In our experience,assumed terminal values often account formore than half of a project’s total NPV.

Terminal value numbers, based as theyare on estimates for preceding years, tendto amplify errors contained in early-yearassumptions. More worrisome still, terminalvalue doesn’t allow for the scenario testingthat we described above—contrasting the re-sult of this investment with the deteriorationin performance that is the most likely resultof doing nothing. And yet, because of marketinertia, competitors’ development cycles, andthe typical pace of disruption, it is often in thefifth year or beyond—the point at whichterminal value factors in—that the declineof the enterprise in the do-nothing scenariobegins to accelerate.

Arguably, a root cause of companies’ persis-

Clayton M. Christensen

([email protected]) is the Robert and Jane Cizik Pro-fessor of Business Administration at Harvard Business School in Boston.

Stephen P. Kaufman

([email protected]), a senior lecturer at Harvard Business School, is the retired chairman and CEO of Arrow Electronics.

Willy C. Shih

([email protected]), a senior lecturer at Harvard Business School, held execu-tive positions at IBM, Silicon Graphics, and Kodak.

mailto:[email protected]





Innovation Killers


tent underinvestment in the innovationsrequired to sustain long-term success is theindiscriminate and oversimplified use of NPVas an analytical tool. Still, we understand thedesire to quantify streams of cash that defyquantification and then to distill thosestreams into a single number that can becompared with other single numbers: Itis an attempt to translate cacophonous ar-ticulations of the future into a language—numbers—that everyone can read and com-pare. We hope to show that numbers arenot the only language into which the value offuture investments can be translated—andthat there are, in fact, other, better languagesthat all members of a management teamcan understand.

Using Fixed and Sunk Costs Unwisely

The 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 out-lays (either capital or expense) that are re-quired 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 themathematics of this principle—as long as thecapabilities required for yesterday’s successare adequate for tomorrow’s as well. When

new capabilities are required for future suc-cess, however, this margining on fixed andsunk costs biases managers toward leveragingassets and capabilities that are likely tobecome obsolete.

For the purposes of this discussion we’lldefine fixed costs as those whose level is inde-pendent of the level of output. Typical 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 committed,typically including investments in buildingsand capital equipment and R&D costs.

An example from the steel industry illus-trates how fixed and sunk costs make it diffi-cult for companies that can and should investin new capabilities actually to do so. In thelate 1960s, steel minimills such as Nucor andChaparral began disrupting integrated steel-makers such as U.S. Steel (USX), picking offcustomers in the least-demanding producttiers of each market and then moving relent-lessly upmarket, using their 20% cost advan-tage to capture first the rebar market andthen the bar and rod, angle iron, and struc-tural beam markets. By 1988 the minimillshad driven the higher-cost integrated millsout of lower-tier products, and Nucor hadbegun building its first minimill to roll sheetsteel in Crawfordsville, Indiana. Nucor esti-mated that for an investment of $260 million

The DCF Trap

Most executives compare the cash flows from innovation against the default scenario of doing nothing, assuming—incorrectly—that the present health of the company will persist indefinitely if the investment is not made. For a better assessment of the innovation’s value, the comparison should be between its projected discounted cash flow and the more likely scenario of a decline in performance in the absence of innovation investment.

More likely cash stream resulting from doing nothing

Projected cash stream from investing in an innovation

Assumed cash stream resulting from doing nothing

DCF and NPV methodologies implicitly make this comparison

Companies should be making this comparison

A

B

C

Innovation Killers


it could sell 800,000 tons of steel annually ata price of $350 per ton. The cash cost to pro-duce a ton of sheet steel in the Crawfordsvillemill would be $270. When the timing of cashflows was taken into account, the internal rateof return to Nucor on this investment wasover 20%—substantially higher than Nucor’sweighted average cost of capital.

Incumbent USX recognized that the min-imills constituted a grave threat. Using a newtechnology called continuous strip produc-tion, Nucor had now entered the sheet steelmarket, albeit with an inferior-quality prod-uct, at a significantly lower cost per ton. AndNucor’s 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? Itseemed more profitable to leverage the oldtechnology than to create the new. USX’sexisting mills, which used traditional tech-nology, had 30% excess capacity, and the mar-ginal cash cost of producing an extra ton ofsteel by leveraging that excess capacity wasless than $50 per ton. When USX’s financialanalysts contrasted the marginal cash flow of$300 ($350 revenue minus the $50 marginalcost) with the average cash flow of $80 perton in a greenfield mill, investment in a newlow-cost minimill made no sense. What’smore, USX’s 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 itsmenu—and because the IRR was attractive,the decision was simple. USX, in contrast, hadtwo choices on its menu: It could build agreenfield plant like Nucor’s with a loweraverage cost per ton or it could utilize morefully its existing facility.

So what happened? Nucor has continued toimprove its process, move upmarket, and gainmarket share with more efficient continuousstrip production capabilities, while USX hasrelied on the capabilities that had been builtto succeed in the past. USX’s strategy to maxi-mize marginal profit, in other words, causedthe company not to minimize long-term 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 it is comparedwith the attractiveness of the right alterna-tives on a menu of investments. When a com-pany is looking at adding capacity that isidentical to existing capacity, it makes senseto compare the mar-ginal cost of leveragingthe old with the full cost of creating the new.But when new technologies or capabilitiesare required for future competitiveness, mar-gining on the past will send you down thewrong path. The argument that investmentdecisions should be based on marginal costsis always correct. But when creating new ca-pabilities is the issue, the relevant marginalcost is actually the full cost of creatingthe new.

When we look at fixed and sunk costs fromthis 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 distributionchannels—so they seek instead to leveragetheir existing brands and structures. Entrants,in contrast, simply create new ones. The prob-lem for the incumbent isn’t that the chal-lenger can outspend it; it’s that the challengeris spared the dilemma of having to choosebetween full-cost and marginal-cost options.We have repeatedly observed leading, estab-lished companies misapply fixed-and-sunk-cost doctrine and rely on assets and capabili-ties that were forged in the past to succeed inthe future. In doing so, they fail to make thesame investments that entrants and attackersfind to be profitable.

A related misused financial practice thatbiases managers against investment in neededfuture capabilities is that of using a capitalasset’s estimated

usable

lifetime as the periodover which it should be depreciated. Thiscauses problems when the asset’s usable life-time is longer than its

competitive

lifetime.Managers who depreciate assets according tothe more gradual schedule of usable life oftenface massive write-offs when those assets be-come competitively obsolete and need to bereplaced with newer-technology assets. Thiswas the situation confronting the integratedsteelmakers. When building new capabilities

Innovation Killers


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 write-off, managers may stall in adoptingnew technology.

This may be part of the reason for the dra-matic increase in private equity buyouts overthe past decade and the recent surge of inter-est in technology-oriented industries. Asdisruptions continue to shorten the competi-tive lifetime of major investments made onlythree to five years ago, more companies findthemselves needing to take asset write-downsor to significantly restructure their businessmodels. These are wrenching changes thatare often made more easily and comfortablyoutside the glare of the public markets.

What’s the solution to this dilemma?Michael Mauboussin at Legg Mason CapitalManagement suggests it is to value

strategies

,not projects. When an attacker is gainingground, executives at the incumbent compa-nies need to do their investment analyses inthe same way the attackers do—by focusingon the strategies that will ensure long-termcompetitiveness. This is the only way they cansee the world as the attackers see it and theonly way they can predict the consequencesof not investing.

No manager would consciously decide todestroy a company by leveraging the compe-tencies of the past while ignoring those re-quired for the future. Yet this is precisely whatmany of them do. They do it because strategyand finance were taught as separate topics inbusiness school. Their professors of financialmodeling alluded to the importance of strat-egy, and their strategy professors occasionallyreferred to value creation, but little time wasspent on a thoughtful integration of the two.This bifurcation persists in most companies,where responsibilities for strategy and financereside in the realms of different vice presi-dents. Because a firm’s actual strategy isdefined by the stream of projects in which itdoes or doesn’t invest, finance and strategyneed to be studied and practiced in anintegrated way.

Focusing Myopically on Earnings per Share

A third financial paradigm that leads estab-lished companies to underinvest in innovation

is the emphasis on earnings per share asthe primary driver of share price and henceof shareholder value creation. Managersare under so much pressure, from variousdirections, to focus on short-term stock perfor-mance that they pay less attention to the com-pany’s long-term health than they might—tothe point where they’re reluctant to invest ininnovations that don’t pay off immediately.

Where’s the pressure coming from? Toanswer that question, we need to look brieflyat the principal-agent theory—the doctrinethat the interests of shareholders (principals)aren’t aligned with those of managers(agents). Without powerful financial incen-tives to focus the interests of principals andagents on maximizing shareholder value,the thinking goes, agents will pursue otheragendas—and in the process, may neglect topay enough attention to efficiencies or squan-der capital investments on pet projects—atthe expense of profits that ought to accrue tothe principals.

That conflict of incentives has been taughtso aggressively that the compensation of mostsenior executives in publicly traded compa-nies is now heavily weighted away from sala-ries and toward packages that reward im-provements 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 recog-nize the importance of other indicators suchas market position, brands, intellectual capi-tal, and long-term 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 near-term share priceimprovement, managers are biased against in-vestments that will compromise near-termEPS. Many decide instead to use the excesscash on the balance sheet to buy back thecompany’s stock under the guise of “returningmoney to shareholders.” But although con-tracting the number of shares pumps up earn-ings per share, sometimes quite dramatically,it 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 havefingered share-price-based incentive compen-sation packages as a key driver of the share

Knowing that the equity

markets will punish them

for a write-off of obsolete

assets, managers may

stall in adopting new

technology.

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 short-term performance mea-sures such as quarterly earnings. They knowthat, to a large extent, others’ perception oftheir success is tied up in those numbers, lead-ing to a self-reinforcing cycle of obsession. Thisbehavior cycle is amplified when there is an“earnings surprise.” Equity prices over theshort term respond positively to upside earn-ings surprises (and negatively to downside sur-prises), so investors have no incentive to lookat rational measures of long-term perfor-mance. To the contrary, they are rewarded forgoing with the market’s short-term model.

The active leveraged buyout market hasfurther reinforced the focus on EPS. Compa-nies that are viewed as having failed to maxi-mize value, as evidenced by a lagging shareprice, are vulnerable to overtures from out-siders, including corporate raiders or hedgefunds that seek to increase their near-termstock 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 compensa-tion tied to stock price—and a breathtakingincrease in CEO compensation overall—theyhave witnessed a concomitant decrease inthe 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 com-pany 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 long-term share-holder value to meet earnings expectations orto smooth reported earnings.

We suspect that the principal-agent theoryis misapplied. Most traditional principals—bywhich we mean shareholders—don’t them-selves have incentives to watch out for thelong-term health of a company. Over 90% ofthe shares of publicly traded companies in theUnited States are held in the portfolios of mu-tual funds, pension funds, and hedge funds.

The average holding period for stocks in theseportfolios is less than 10 months—leading usto prefer the term “share owner” as a moreaccurate description than “shareholder.” Asfor agents, we believe that most executiveswork tirelessly, throwing their hearts andminds into their jobs, not because they arepaid an incentive to do so but because theylove what they do. Tying executive compensa-tion 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 mea-surement horizon of the incentive—both ofwhich are less than one year.

Ironically, most so-called principals todayare themselves agents—agents of other peo-ple’s mutual funds, investment portfolios,endowments, and retirement programs. Forthese agents, the enterprise in which they areinvesting has no inherent interest or valuebeyond providing a platform for improvingthe short-term financial metric by which theirfund’s performance is measured and theirown compensation is determined. And, in afinal grand but sad irony, the real principals(the people who put their money into mutualfunds and pension plans, sometimes throughyet another layer of agents) are frequentlythe very individuals whose long-term em-ployment is jeopardized when the focus onshort-term EPS acts to restrict investments ininnovative growth opportunities. We suggestthat the principal-agent theory is obsolete inthis context. What we really have is an

agent-agent

problem, where the desires and goals ofthe agent for the share owners compete withthe desires and goals of the agents runningthe company. The incentives are still mis-aligned, but managers should not capitulateon the basis of an obsolete paradigm.

Processes That Support (or Sabotage) Innovation

As we have seen, managers in establishedcorporations use analytical methods thatmake innovation investments extremely diffi-cult to justify. As it happens, the most com-mon system for green-lighting investmentprojects only reinforces the flaws inherent inthe tools and dogmas discussed earlier.

Stage-gate innovation.

Most established

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 pro-cesses include three stages: feasibility, develop-ment, and launch. The stages are separated bystage gates: review meetings at which projectteams report to senior managers what they’veaccomplished. On the basis of this progressand the project’s potential, the gatekeepersapprove the passage of the initiative into thenext phase, return it to the previous stage formore work, or kill it.

Many marketers and engineers regard thestage-gate development process with disdain.Why? Because the key decision criteria ateach gate are the size of projected revenuesand profits from the product and the associ-ated risks. Revenues from products that incre-mentally improve upon those the company iscurrently selling can be credibly quantified.But proposals to create growth by exploitingpotentially disruptive technologies, products,or business models can’t be bolstered by hardnumbers. Their markets are initially small,and substantial revenues generally don’tmaterialize for several years. When theseprojects are pitted against incremental sus-taining innovations in the battle for funding,the 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 falter-ing project over the hurdle rate. If, as is oftenthe case, there are eight to 10 assumptions un-derpinning 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 stage-gatesystem 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 pro-jections (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 stage-gate system is not suited to thetask of assessing innovations whose purposeis to build new growth businesses, but mostcompanies continue to follow it simply be-cause they see no alternative.

Discovery-driven planning.

Happily, though,there 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. Discovery-driven 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 gothrough the charade of making and revisingassumptions in order to fabricate an accept-able set of numbers? Why not just put theminimally acceptable revenue, income, andcash 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 anassumptions checklist—a list of things thatneed to prove true for the project to succeed.The items on the checklist are rank-ordered,with the deal killers and the assumptionsthat can be tested with little expense towardthe top. McGrath and MacMillan call this a“reverse income statement.”

When a project enters a new stage, theassumptions checklist is used as the basis ofthe project plan for that stage. This is nota plan to execute, however. It is a plan to

learn

—to test as quickly and at as low a costas possible whether the assumptions uponwhich success is predicated are actually valid.If a critical assumption proves not to be valid,the 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 stage-gate planning obfuscatesthe assumptions and shines the light on thefinancial projections. But there is no need to

Innovation Killers


focus the analytical spotlight on the numbers,because the desirability of attractive numbershas never been the question. Discovery-drivenplanning 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 plan-ning are more commonly used in entrepre-neurial settings than in the large corporationsthat desperately need them. We hope that byrecounting the strengths of one such systemwe’ll persuade established corporations toreassess how they make decisions aboutinvestment projects.

• • •

We keep rediscovering that the root reason for

established companies’ failure to innovate isthat managers don’t have good tools to helpthem understand markets, build brands, findcustomers, select employees, organize teams,and develop strategy. Some of the tools typi-cally used for financial analysis, and decisionmaking about investments, distort the value,importance, and likelihood of success ofinvestments in innovation. There’s a betterway for management teams to grow theircompanies. But they will need the courage tochallenge some of the paradigms of financialanalysis and the willingness to develop alter-native methodologies.

Reprint R0801F

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More often than not,

failure in innovation is

rooted in not having

asked an important

question, rather than in

having arrived at an

incorrect answer.

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