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What Netflix and IBM Can Teach Us About Disruption

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All disruptions in the tech space can be defined as innovations, but not all innovations are disruptive or come from upstarts set on taking down incumbents. Consider Netflix and IBM. One killed Blockbuster while the other helped to kill its own adding machine and typewriter.

Disruptive Innovation

Netflix is a great example of a disruptive innovation. Disruptive innovations are ones that initially target a market niche, typically one being neglected by incumbents. Because disruptive innovations don't serve the entire market, it's feasible for entrepreneurial firms to introduce them. However, there is typically some critical incumbent resource (entry barrier) the entrants can't access. So, rather than trying to scale the entry barrier, entrepreneurial firms execute an end run. What makes this end-run innovation so formidable to the incumbent (and the reason incumbents are often wrongfully accused of being caught off-guard by the innovation) is that adopting the innovation requires duplicating an existing resource investment, which by definition has negative returns. The end run by the entrants forms an adaptation barrier to incumbents.

(Read more: What Dooms Disruption to the Graveyard?)

In the Netflix example, the initial niche was people who found Blockbuster inconvenient, both because they had to drive there twice within a 24 hour period, and because they had to scan a good portion of the stacks to find movies of interest. Formerly, Blockbuster had an important resource (the store network) that formed an entry barrier. Any firm considering a national chain would find the investment in stores unattractive—they would at best get half the market at lower margins (because the two chains would compete on price). Netflix executed an end run around the entry barrier through an online sales/mail distribution system.

Just as Blockbuster's store network served as an entry barrier, Netflix' end run became an adaptation barrier for Blockbuster. Because Blockbuster could already reach the entire market through its storefronts, the returns to investment in mail distribution were negative. The mail order system wouldn't increase sales (it would cannibalize existing sales). Moreover, it might decrease sales of impulse purchases like popcorn or candy.

Drastic Innovation

In contrast to disruptive innovation, drastic innovations reinforce the value of incumbent resources, and are therefore more likely to be introduced by incumbents. Personal computers were initially purchased by techies, but their real diffusion came when they were introduced to the office market. IBM (an incumbent in office equipment) was the logical candidate to affect this diffusion because PCs were a very technical sale initially. IBM had the technical sales force and the service network to support PCs, as well as the brand to reassure risk-averse commercial clients that the product would be reliable. All three IBM resources (sales force, service network and brand) had previously served as entry barriers to the office equipment market, and would now serve as lubricant for entering the PC market.

(Read more: The Wearable Revolution)

Any other firm wanting to introduce PCs to the office market would need to invest in a national sales force, service network, advertising to build a brand, as well as large-scale production. In contrast, IBM only needed to make the investment in large-scale production (and some retraining and rebranding). Assuming each resource requires a comparable investment, IBM's return would be roughly four times that of any other company contemplating entry. This explains why none of the early manufacturers (including Apple, which was relegated to the education and graphic designer market), ever rivaled IBM's market share.

So here's an example of a lumbering incumbent (IBM) thriving under innovation. Why was IBM willing to make the investment in the new technology, when Blockbuster wasn't willing to make the investment in mail distribution? Because the returns were attractive. First, PCs didn't originally cannibalize typewriter sales, so the investments paid off in new demand. Second, even if PCs did cannibalize typewriters and adding machines (which they ultimately did), the value of each PC sale greatly exceeded that for typewriters. Accordingly, because IBM had slack resources in sales, service and brand, there was minimal new investment (manufacturing), and the returns to that investment were substantial.

(Read more: Recipe for Disruption)

Later, when the PC was so ubiquitous and reliable it didn't need a technical sales force or service network, Dell executed an end run by creating online ordering/mail distribution of semi-custom PCs. At that point, IBM found itself in the same shoes as Blockbuster. The new distribution system wouldn't generate new revenues—IBM already covered the entire market. Thus the returns to the investment in mail order were negative!

The bottom line in disruption

One form of innovation reinforces the world order, while the other transforms it. If you're an incumbent firm or an investor, this distinction is important. The key issues are demand and resources. Does the innovation create new demand or merely replace existing demand? What resources does diffusion require, and who has them?

(Read more: Disruptors Can Delay the Apple iPod Way)

If the innovation creates new demand and relies heavily on costly but slack resources in the hands of incumbents, then it will likely be drastic. If however the innovation targets existing demand and utilizes new resources requiring significant investment, the innovation will have negative returns for incumbents and will therefore be disruptive. An entrant can execute an end run to become the new market leader, and the end-run resources will become the new entry barrier for entrants and adaptation barrier for prior incumbents.

-- Anne Marie Knott is a professor of strategy at Washington University, director at Berkeley Research Group and author of Venture Design.

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