Black Swan Farming

Time and people are the scarce resources – not capital!

In a comment on another post, Chris Matts pointed towards a video that I think every manager should watch. The video is of Clay Christensen at the Drucker Forum outlining his categorisation of innovation and presenting an argument that the world of finance has driven us to using the wrong metrics. It’s only 15 minutes – watch it now!

This is why Cost of Delay (and CD3) matters

Christensen’s central point is that we are making bad decisions. Why? Because we have a whole generation of managers who are focused on the wrong things. We are incentivising them to optimise metrics like RONA (Return on Net Assets) and IRR (Internal Rate of Return) and in the process failing to allocate resources to invest in ideas that could generate growth by creating new markets.

To move these flawed metrics, it is far less risky to invest in sustaining innovations (to keep the current market share) while cutting as close to the bone as we can via efficiency innovations. Sadly, a cargo cult style application of Lean Manufacturing’s “eliminating waste” has often been the recipe for achieving this.

Horace Dediu puts his finger directly inside the wound with a statement that would surely be considered apostasy to the church of Finance:

We are obsessed with allocating capital when in fact capital is over-abundant and should be spent freely.

If capital is over-abundant, that leaves two truly scarce resources that we should be primarily concerned with managing carefully: People and Time. This is why Cost of Delay and CD3 matter. Cost of Delay puts a price tag on time for every idea you might want to invest in. CD3 suggests the optimal way of scheduling those ideas. The objective is to achieve the most you can, in any given time period, with a constrained resource: your capacity to innovate.

Of course, what you put in to Cost of Delay also matters, which brings me to my second point…

Mapping Innovation Categories to the Value framework

The three categories of innovation that Christensen briefly outlines is well-aligned with things I have previously written about on the topic of Innovation and Cannibalisation. It’s worth repeating some of that and being explicit about how these three categories of Innovation and the four buckets of Value are related. Hopefully this will prevent us falling into the trap of thinking that Cost of Delay or CD3 somehow perpetuate the problems that Christensen is highlighting.

Here are Christensen’s three categories of innovation, as I understand them:

  1. Market Creating Innovation – creating new customers through new products that either didn’t exist at all before, or are affordable enough that it is accessible to customers who previously could not afford it. Mainframes -> PC -> Smartphones
  2. Sustaining Innovation – making incremental or iterative improvements to an existing product that it’s current customers appreciate (and may deliver additional consumer surplus), but doesn’t really grow the market. Prius OR Camry, not both.

  3. Efficiency Innovation – making incremental or iterative improvements in the way an existing product is made or delivered in order to improve margins to the company. They are effectively selling you a similar product for a similar price but it is cheaper for them to deliver.  Often, these innovations mean fewer people are required to deliver the same product or service, which is the sort of thing a lot of I.T. departments in large organisations have been focused on.

Here are the four buckets of value I have been using for some time:

Hopefully you can see that it is fairly easy to map from one to the other…

Market Creating Innovation would mostly contribute to the Increasing Revenue bucket, in particular the focus on “new customers”, in order to increase market size.

Sustaining Innovation mostly contributes to Protect Revenue bucket, specifically “incremental innovation to  sustain current market share”. Some proportion of “Increase Revenue” may also fall in this category, by “increasing sales”, by which I mean share of wallet, to “existing customers”.

Efficiency Innovation mostly contributes to Reduce Costs and Avoid Costs buckets, which should be fairly obvious.

The point of this is to make clear that Cost of Delay depends entirely on the Value Framework you use to estimate Value. You may not like the four buckets I’ve proposed. That’s ok. You can use whatever framework you like.

Ultimately though, if you are interested in achieving the most you can, with a constrained capacity to innovate then it helps to think in terms of, and make decisions with an understanding of, the Cost of Delay.