Tuesday, January 4, 2011

Creative Destruction

The first Standard and Poor’s (S&P) index was created in 1920 in USA. 90 major companies were on the original list for a span of 65 years. In 1998, the S&P list was expanded to 500 companies and their average life spans were around 10 years. In 2000s, some studies suggested that the average life span of top companieswould be shortened to 5 years. This shocking trend is mostly caused by the effect of intensified creative destruction.
In a journal article titled Creative Destruction, it  describes interactions between companies and markets in the creative destruction process and implications for management to take advantage of the process. This summary is shown in a mind map at the end of this post.  
Creative destruction theory  explains how the economy evolves in a capitalist environment. This particular theory focuses on innovation aspects of economic development. The key concept of creative destruction is that innovative breakthrough can only be achieved by destroying some of the current economic system and status quo. This simply means that innovation can only created by changing the rules of game. As this happens in a rapid pace in the past 20 years, many companies which cannot catch up and adopt with the new rules, they have to leave the game.  Nowadays, if companies do not have the  ability to embrace creative destruction in their strategies and operations, they will  not survive very long in the game.

Understanding the cause of creative destruction in the modern business environment gives companies enormous advantage to rethink their overall strategies and improve their operations. Creative destruction is created by a misalignment between the market’s wants and company’s capacity of offer. This misalignment gets wider overtime, because markets and businesses are driven by opposite motivations.
Markets constantly look for better and more suitable offers from various sources without any emotional attachment. In contrast, businesses fight to control their internal environment through establishing visions, goals and objectives. These visions, goals and objectives are infused with their creators’ passions and ambitions. These different motivations create conflict situations between objectivity (markets) vs. subjectivity (businesses).  Therefore, markets search for the best options to suit their needs constantly with no mercy, while businesses try their best to run their operations as efficiently as possible to pursue their ideologies. This misalignment situation leads to a more profound polarization between companies and markets. Companies operate on an assumption of continuality; however markets operate on an assumption of discontinuity.
So what does it mean? It means that organizations’ operations are based on calculative predictions of the future.  Most of these predictions come from analyzing their historical data, especially from their most successful periods.  This gives them a sense of stability. Most importantly this type of positive forecast protects companies from generating negative emotions. Negative emotions are always treated as enemies in businesses, because they can damage their operations efficiency. Therefore, management uses “hard data” or “evidence” to encourage positive emotions while ignoring threats in the markets. The “we always know the right answer” and “the future is in our hands” approaches gradually form a mentality of continuity.
On the other hand, markets are lacking of emotions and memories towards companies. They only respond to best offers and care for nothing else. Markets silently allow weaker companies to be put up for sale and leave it to the new owners to shape them up or shut them down.  These actions are taken quickly on early signs of weakness. This allows markets operating in a highly dynamic fashion, therefore markets create more surprise than companies do.  These unpredictable and highly dynamic characteristics are called discontinuity. Markets operate on the assumption of discontinuity and accommodate continuity. On the hand, businesses assume continuity and attempt to accommodate discontinuity. The difference is profound.
Problem arises when businesses don’t realize that their operations cannot catch up with markets’ changes, because their continuity mentality blinds them from the ugly truth. How often does this happen? In my personal experience, I would say very often.  I talked to a number of business owners in Hong Kong and Australia, only one of them could see through his own smoke screen and save his company. Other owners were too complacent with their track records, and ignored or rationalized potential threats in the markets. Even when the threats were affecting their business’ performances, they would say, “It is only a seasonal cycle, though this year is getting tougher. Sales will pick up again, just like in the past.” Or “We have a long history with these customers. They will come back to us.” Almost, all of them were out of business within 6 months to 2 years.
My family business also made the same mistake 15 years ago. We decided to borrow money to expand our operation almost 5 times. Our decision was mostly based on our outstanding track records, expert opinions from accountants, banks’ managers and major customers. Everything was very positive and convincing, so we borrowed huge sum of money from 4 different banks to expand our business. We would expect to pay back the debts in 2 years and became one of the largest manufacturers in Hong Kong. However, one year later, our business profits dropped almost 50% due to technology, political and customer preferencial  changes.  70% o f our customers went bankrupt a year after that. At the end, we had to sell off 90% of the company to new competitors and remained in debt.  Till now, we still cannot recover from this poor decision. The funniest thing is that a CEO of one of our customers had warned us about the threats. We were not only ignored his advice, we even laughed at his timidity.
The force of creative destruction happens in a subtle  , quick and merciless fashion. Therefore, it is essential for businesses to recognize signs of creative destruction in their industries or related industries. There are 2 tips from my experience to embrace creative destruction in businesses.  
1)      Benchmarking data and industry’s standard practices are the reference points for creative destruction. Smart competitors are always looking at this standard and think of a way to break it. As experience lawyers will put big crosses on standard contracts which are given by other parties, and pull out a piece of paper to write down new terms and conditions.  “Rules are meant to be broken” is the perfect summary of this point. Business owners should always look for a way to break standard practices in their industries, because soon or later, other competitors will break them and throw them into the deep end.

2)      End users are always the determining force in the business world.  Businesses must understand their behaviors and preferences inside out. I know a lot of business owners who are too dependent on expert advices or opinions. The irony is that in most of cases, they are not in the customer segments, and yet giving insights about meeting their customer needs. Remember, customers are the real engine to driving creative destruction in the markets. Talking to customers directly and understanding their desires, wishes and dissatisfactions are the keys to embrace creative destruction in business practices.

Creative destruction is an inevitable part of the business world. Nowadays, innovative products and services are introduced  into the market nearly every month. Businesses have to accept that the good old days are long gone.  Businesses have to be flexible in their strategies and practices to accommodate their market needs. The key is to change their mindset from inward looking (continuity) to outward looking (discontinuity).   

Foster, RN & Kaplan S 2001, “Creative destruction”, McKinsey quarterly, no. 3 pp. 41-51

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