Slaying giants: Why disruption works

When a startup talks about 'disrupting' an industry, what are they really talking about, and why does it work? Disruption occurs when a new technology or innovation comes along that undermines the profitability of the established incumbents, often leading to the collapse of the latter. Often this collapse occurs very quickly over the course of just a few years.

Take for instance the mass production of cars at the beginning of the 20th Century. At the turn of the century it would have been almost incomprehensible that horse drawn carriages would be replaced as they were. However, along came Henry Ford and the mass production of cars, and very soon the number of horses plummeted (as well as the various services that existed to serve those horses).

However, why does disruption work so often, even these days? It can't simply be that the large companies can't imagine the technology that is around the corner, just waiting to wipe them out. Some of these companies spend millions or even billions of pounds researching and developing new technologies. The idea that every case of disruption was caused by some genius entrepreneur inventing a technology in his bedroom that would wipe out the competition doesn't seem very realistic.

Certainly there have been some extremely brilliant minds who have disrupted an industry (e.g. Bill Gates), but there have been too many examples of disruption for every one of them to be a genius. Plus, sometimes the millions spent on research do lead to a breakthrough, but doesn't prevent bankruptcy for the incumbent. Look at Kodak who established themselves as producers of film for cameras. Kodak actually invented the digital camera, the technology that would kill of camera film, and they still managed to go bankrupt!

Big companies have all the advantages of established dominance of a market, millions of pounds to spend developing the next big technology, and yet still manage to get displaced. What's the answer?

The Answer

The real reason that disruption occurs is because large companies are not free to think in the long term, and are under immense pressure year on year to deliver profits. When a company comes up with an innovative new idea, they must compare the likely profitability of that new product with their established business model.

Let's consider Kodak again - their core business was in producing and selling camera film, a business with a healthy margin of profit of about 85%. That meant that for every pound someone spent on a roll of Kodak camera film, 85p was profit for Kodak!

When they designed the first digital camera, the proposed profit margin was something more like 15%, much less than the traditional core business. This meant that every year when planning what to focus on, Kodak had to choose which of their options would produce the most profit and so keep their shareholders happy - obviously there was no competition as to which would win.

They chose to keep supporting their camera film, even though they knew that digital cameras were the future of photography, and eventually they ended up going bankrupt.

Another example to help illustrate the theory would be to look at Amazon. They have a very small profit margin on their core business (selling books) and so are much more likely to innovate and seek out more profitable products. This is why today Amazon allows people to sell things second hand through their site, and why they launched the Kindle which has proven extremely successful. When your core business has very slim profit margins it's easy to choose other alternatives and not suffer.

The lesson here is that when large companies behave rationally, they open themselves up to be disrupted. They don't have the freedom to move away from their core business for the sake of the long term because the pressure of delivering profits year after year is so high.

As a result, every mature profitable industry has a space with lower profit opportunities which the 'big guys' won't be interested in. It won't be worth their time focussing on the areas of their business with the lower profit margins and so there is an opportunity for start ups and entrepreneurs to move in.