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Monday, October 12, 2009

When Innovation Goes Wrong

by Rowan Gibson

Broken InnovationEver since innovation became the buzzword du Jour, a lot of people seem to have lost their ability to tell smart ideas from stupid ones. Case in point: the financial "innovations" (read: stunningly stupid loan products) that kicked off the trillion-dollar economic meltdown mess we're currently in. The simplistic notion that "new equals good" has often been a recipe for grand-scale disaster, just as it was in the dotcom debacle at the turn of the millennium. And when the doo-doo inevitably hits the fan, it's all too easy to level the blame at innovation per se rather than admit to being a bonehead. Here's why many ideas that are labeled "innovations" are just plain stupidity.

Simply put, innovation goes wrong (sometimes big time) when an organization over-commits to an idea before validating the key assumptions on which it is based. Let's take the infamous sub-prime mortgage. The assumption here was that a jobless, homeless person who is just out of jail and doesn't even have a bank account can afford to make mortgage repayments of any description, let alone horrendously overpriced ones.

The idea of selling mortgages to poor people with bad credit was clearly "new" given that banks have traditionally offered 30-year, fixed-rate amortizing home loans to people who looked like they could actually pay the money back. But going after this risky, low-end market segment with a ripoff financial product wasn't exactly what C.K. Prahalad had in mind when he talked about "the fortune at the bottom of the pyramid". And it turns out - duh! - that this particular "financial innovation" wasn't a very smart one (to put it mildly), and even less smart when used as the cornerstone for a multitrillion dollar house-of-cards based on endless derivatives of derivatives.

"Innovation can never be risk-free, but you can certainly make sure you look before you leap."

Financial InnovationIt's precisely big boondoggles like this one that give innovation a bad name. In fact, columnist Paul Krugman wrote in the New York Times that "financial innovation" is a phase that "should, from now on, strike fear into investors' hearts." Yet should the financial services industry - or any industry for that matter - now decide to "throw the baby out with the bathwater" when it comes to innovation? Absolutely not. It's worth remembering that over the last couple of decades, innovation has given us a string of success stories in financial services: Charles Schwab's online equity trading, Commerce Bank's open-all-day, seven-days-aweek business model, First Direct's branchless banking, Grameen Bank's micro-credit lending concept, PayPal's user-friendly, online-payment service, or Umpqua Bank's people-centered retail environments, to name just a few. The difference with these opportunities is that they were all based on very solid assumptions about the viability and sustainability of the business model; they were not built on proverbial sand. That's why these innovations have created significant new value and wealth, instead of destroying it.

Unfortunately, there are all too many cases where companies have overcommitted to an idea that wouldn't even pass the sanity test. These tend to be ideas where the customer benefit is unclear or unimportant to people, or where the technology is not yet up to the task, or where the market is just not there, or where the business model is so stupid that it's dead on arrival. Instead of first checking the validity of critical assumptions on which the idea is based, sometimes a company (or even a whole industry) decides to jump from 10,000 feet without a spare parachute, hoping against hope that the thing will somehow work.

Take Iridium, Motorola's failed satellite telephone venture, which was built on a fundamentally flawed assumption about the size of the target market. Basically, Motorola totally underestimated the speed at which cellular coverage would spread. Their premise was that there would be huge regional gaps in the global network - parts of the world that would have no mobile phone coverage for a long time to come. That would have made Iridium the perfect answer. It turned out quite quickly that those regions would be very few and far between (you would practically have to be an Arctic explorer to need an Iridium phone!), so the target market soon shrank to insignificance. This is something Motorola should have known better.

WebvanOr take Webvan, the "oh-so-dotcom" online grocery business that burned through a billion dollars and went belly-up. There was nothing fundamentally flawed about the idea of online grocery shopping, as a host of other retailers have since proven. Rather, Webvan's massive failure was based on a whole series of flawed and untested assumptions around the customer value proposition, the economic engine, the value of partnerships, and the product and service offering.

Business history is full of such examples: from Coca-cola's infamous "New Coke", to GM's all-electric EV-1 project (which cost a billion dollars and sold only 700 vehicles), to all those other empty dot-com business models in the late 1990s - like Pets.com - that quickly disappeared. The lesson from all these disasters is to look before you leap. A company should first reduce the uncertainty surrounding critical project assumptions before committing irreversible and non-recoverable resources to an idea. The greater the uncertainty surrounding these assumptions, the greater the risk associated with any new opportunity. Therefore, the focus of an innovation project should initially be on learning rather than earning. It should be on launching experiments to test whether a business model makes sense or not, or whether a new technology will work or not, or whether customers would value the new service, or what they would be willing to pay for it, or which product configuration would work best, or which distribution channels would be most effective, and so on.

Clearly, innovation can never be risk-free. But the process of validating or invalidating these critical project assumptions should stop you from ever completely misreading the basic economics of an opportunity. It will make sure that hubris never gets the better of humility.

Rowan GibsonRowan Gibson is widely recognized as one of the world's leading experts on enterprise innovation. He is co-author of the bestseller "Innovation to the Core" and a much in-demand public speaker around the globe. On Twitter he is @RowanGibson.

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Anonymous Jose Baldaia said...

Innovation never goes wrong!

Innovation must be looked for sides, users and innovators.
What are wrong are in fact the assumptions of promoters and clients!

If we believe that it there is no risk when we launch a new product or an innovative model for business we are saying that this “innovation” is already tested by other companies.

A few years ago here in Portugal the Insurance Company where I work, in the late 1980s, launched a financial product called PPR (….). My job at the time was trainee the commercial stuff in “How to deal with objections and how to identify
needs of the clients. The result of the work around that product and during several years, risk management and ethical sales, made the product life longer till our days.
By the other side some Insurance Companies (national and international) with similar products (derivates) don’t achieve their goals. They missed risk and they had non ethical performance.
It’s true “Learn now, earn tomorrow”.
The notion of risk is necessary for both sides: Companies and Customers.
I ask my self, when I see the adoption of some innovations if the promoters know the concept of contextualization. Some things are true in Europe but false for Africa.
As you say is fundamental the validation of critical presumptions of the project and they need to evaluate the impact of negative results in the company image
and at their business partners.

I believe that in Financial Innovation we don’t apply the principle “The whole is bigger than the sum of the parts”. If someone do it, “That’s magic”!

4:34 AM  
Blogger Brad said...

There are two aspects of risk that can lead to the mishandling of innovation, which correlate well with the Type 1 and Type 2 errors of statistical analysis.

First is the misallocation of rewards. When someone is put in a position to innovate, and they know their job is at stake if they fail, but others will receive the reward if they succeed, the chances of a Type 1 error (rejecting a good innovation) go way up. The result is a series of safe, incremental innovations, and lost opportunities for highly rewarding disruption.

Second is the misallocation of the risk. As Thomas Sowell once said, "It is hard to imagine a more stupid or more dangerous way of making decisions than by putting those decisions in the hands of people who pay no price for being wrong." One of the key problems in the financial meltdown was that the people creating the sub-prime loans and derivatives, for various reasons to numerous and complex to discuss here, were not the ones at risk if those loans failed. With little to lose and much to gain, the probability of someone making a Type 2 error (pursuing a bad innovation) increases, resulting in large and painful losses, a la the financial meltdown.

What's the solution? Strategic balance. Innovators must be held accountable for their decisions, thereby bearing some risk, but should be personally rewarded for success. At the same time, as many (including myself) have pointed out in similar blogs, it is critical that failure be celebrated to some extent, to encourage appropriate risk taking. There is no one magic formula for calculating the right balance, just as statistical hypothesis testing does not have one perfect formula.

Let me illustrate with a statistical problem. Say you're conducting a test of a new medicine. Leaving regulatory requirements out for simplicity, let's say you do a trial, and you come up with a 97% chance that the medicine cures the disease. Do you proceed further? At a 1% significance level, no, but at a 5% significance, yes. Which do you choose?

That depends. What are the potential side effects? What is the disease you are curing? If the disease is a benign wart but the potential side effect is a deadly cancer, you probably go with the 1% (or less) significance level and reject. If the opposite is the case, that you're curing a deadly cancer with the possible side effect of benign warts, you go with the 5% (or greater) significance level.

It is similar with innovation. You must analyze the potential costs and benefits, and make a strategic balancing choice accordingly.

12:47 PM  
Blogger Rick said...

The economic meltdown has nothing at all to do with innovation. Greed, deception, theft, and dishonesty would be good starting points. Trying to attach innovation as the cause of the financial crisis is fear mongering to scare ignorant and superstitious management into contracting an expensive innovation consultant. I don't want any of that manipulation around my company.

Otherwise a nice post.

8:51 AM  

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