The paradox of having no assets and it’s implication in corporate innovation strategy
It is still paradoxically how, having less (or no) financial assets at their disposal, smaller organizations find developing innovative new business models being straightforward, where large corporations, with far more financial power, find the same activity to be costly.
There are two main reasons for this paradox. The first one is the marginal cost economic theory which states that:
in relation to a given volume of output, additional output can normally be obtained at less than proportionate cost because within limits, the aggregate of certain items of cost will tend to remain fixed and only the aggregate of the remainder will tend to rise proportionately with an increase in output.
In other words whenever an portfolio investment decision in a corporation is taken, the option offering leveraging existing assets will win over the one, which requires an entirely new full investment — because the first one incurs just the marginal cost. Hence the sustainable innovation trajectory that many corporations are on.
In the case of the much smaller organizations marginal cost theory doesn’t apply, since for them the marginal cost is the same with the full cost associated with building the new business — so for this reason a disruptive path is easier to take.
The second reason behind the fact that corporations find it hard to build new businesses, and when this happens they are far less innovative than their smaller size competitors, lies in the fact that the majority of corporations are listed at the stock exchange and share price is the only instrument used in diagnosing the state of any listed enterprise. Part of the stock price is RONA (return on net assets), a measure of financial performance computed as: net income divided by the sum of fixed assets and net working capital. So in other words to increase RONA and consequently the stock value, corporate executives need to do one of two things: increase net income or lower the lower number of fixed assets employed in delivering the same net income level — hence outsourcing of assets occurs.
In the 1990s Dell Computers pioneered a new disruptive business model around the concept of completely customizable PCs, which were delivered directly to the customer’s doorstep. Everything was happening over the Internet, hence Dell’s profit margins were better than anybody else’s.
One day, one of Dell’s circuit boards suppliers, little company out of Taiwan called AsusTek came to Dell with very tempting business proposition: since they were supplying the simple circuit boards for Dell computers they can also help Dell by supplying the motherboards at a lower price than what Dell was paying to produce them in-house.
After doing the math the managers from Dell decided that this actually is a viable option for Dell since revenue will not be affected by the move, but the assets associated with the production of the motherboards would be taken off the books, resulting in a higher RONA.
Some years later AsusTek came back to Dell saying that since they have such a good business partnership on motherboards Asus can also deliver other components and actually assemble the entire PC in Taiwan and ship it to customers worldwide too. Yet again Dell executives crunched the numbers and realized revenues will not going to be affected, but return on assets will increase since all production and assembly assets are no longer going to be on their books.
Later Asus took over product design from Dell as well, leaving the U.S. company only with the brand. Dell’s RONA was through the roof since now the net income was divided only by the net working capital since there were no more assets owned by Dell.
A few years later what happened was that Asus launched their own PC which was basically the Dell PC but under a different brand name and at a lower price point. From an outsourcing company Asus became a direct competitor to Dell and other players in the PC market.
Trying to reignite their once innovative spirit, in mid 2013 Dell announced that it’s going to go back to being a privately owned company.
So the causal mechanism in the pursuit of profit crystallized in the paradigms of the marginal cost and RONA, which are thought in business schools across the world and preached by strategy consultants, are killing innovation and send large corporations down on a conservatory path.
The focus of executives should be less on hitting the Wall Street analysts’ projections and more on developing new innovative growth avenues, because throughout history hitting the projected numbers never resulted in breakthrough results.
In a capitalist economy the true north of any enterprise is the profit motive; increasing profits and as a consequence shareholder value. This profit motive is sustainability supported by creating value for customers (i.e. making stuff people want). When Motorola CEOs Chris Galvin, and later Ed Zander were ousted from their jobs, it was because the company they were running was facing significant challenges, declining revenues and profits. Several executives have faced similar fates; even the great Steve Jobs once lost his job after struggles with the launch of the Mac. This is the everyday pursuit of most corporations all over the world; where is the next growth in revenue and profits going to come from?
For solutions, read The Corporate Startup book.