Functional Needs and Irrational Wants

The iPhone is like a pocket Porsche -- it comes in iconic, arguably artistic designs like a Porsche. The difference is that it's affordable to a lot more people. Artistic, iconic design leads to strong brand value and purchase decisions driven not just driven by rational, functional needs but also by irrational wants (desire, lust, envy, communicating status, etc.). Some consumer products have an inherent artistic element that goes beyond purely functional needs: cars, smartphones, fashion, furniture, and so on. Conversely, some consumer products are almost entirely functional in nature -- people buy or use them because of functional needs, not because of irrational wants. Some examples of purely functional products/services might be: hard drives (Christensen's famous example from The Innovator's Dilemma), backhoes, commodities like steel or glass, Internet search engines, and artificial intelligence. 

If you're selling a purely functional product, Christensen's "good enough" concept is particularly important. That's because irrational wants don't come into play, and the buyer can easily determine what's good enough by comparing the product's functional, measurable performance attributes with the particular job the buyer needs to get done. So a buyer can look at a hard drive, for example, examine its data retrieval rate and storage capacity, and compare that to his functional needs -- how he'll be using the computer and how many photos, videos, and documents he needs to store -- to determine whether the hard drive is good enough or whether it overserves.

As noted in other posts, the best way to keep functional product elements from overserving is to make sure improvements are meaningful and actually used by buyers.

Another great way to prevent functional overserving is through technological leaps that change consumer expectations of what's good enough. This happens when a company comes up with a breakthrough product that makes consumers think that existing alternatives -- that consumers previously felt were good enough -- aren't good enough anymore. The consumer's perception of what's good enough isn't static: it's relative and changing depending on the latest breakthroughs and what's available in the marketplace.

If a sustaining technological leap or breakthrough creates a large enough performance gap between the breakthrough product and existing incumbent alternatives, it may allow the entrant to establish the beachhead needed to effectively enter an existing market. An entrant with a sustaining improvement/innovation normally doesn't do well because incumbents respond vigorously. The exception may be an entrant with a surprise breakthrough product that catches incumbents off-guard -- you could argue the original iPhone succeeded this way.

Two challenges for an entrant with a breakthrough product may be: (1) the lack of a recognized, trusted brand; and (2) ramping up manufacturing, distribution, and marketing fast enough to take full advantage of the sales opportunity. Incumbents are highly motivated to "fast follow" the entrant's breakthrough product with similar products. The key question here is whether incumbents can quickly acquire the capabilities needed to compete with the breakthrough. In the original iPhone's case, Blackberry and Nokia were unable to fast follow the iPhone with similar products because they lacked Apple's integrated hardware and software capabilities. As a result Apple had the time needed to ramp up iPhone production and distribution. Apple's strong brand also helped.

Returning to this post's original subject, a person buying a Porsche or an iPhone -- or any other product with an inherent artistic element -- considers (1) functional needs but is also influenced by (2) irrational wants like the desire/lust for something beautiful. The good enough standard is highly relevant to the functional needs part, but may not be very relevant to the irrational wants part. And irrational wants become even more of a factor when the product is distinguished by iconic, artistic design. So a product with an artistic element may overserve a buyer's functional needs but still be something the buyer wants to purchase because of irrational wants -- a Porsche or a Ferrari is a good example of this.  

You could almost look at a product on a sliding scale: as a product's artistic/iconic elements go up, the relevance of what's good enough -- and the danger of overserving -- go down. The ideal situation may be a product with improving artistic elements and improving functional elements: the key here is that functional elements must improve in a meaningful way that's valued by consumers (to prevent unused, overserving features that actually end up degrading functional performance and ease of use).

Applying another Christensen concept, when the buyer's "job-to-be-done" encompasses purely functional needs, overserving is a greater risk. When the buyer's job-to-be-done is broad, encompassing both functional needs and irrational wants, there's less danger of overserving. 

Art vs. Algorithms

Industrial design sometimes rises to the level of art, and art doesn't commoditize. Artistic design creates tremendous brand value and is very hard to copy, and close copies are never valued as highly as the original. Examples of companies producing iconic products and industrial art include Braun, Ferrari, Porsche, Apple, and Tesla. Industrial art has driven the brand value of each of these companies. 

Conversely, algorithms and machine learning methods can be copied, and the copy is valued just as highly as the original because the product's appeal is based purely on functional needs. Much of the theory behind algorithms comes from educational institutions and is in the public domain. As noted above, Christensen's good enough concept -- and the danger of overserving -- is much more relevant with purely functional products.

So if you're an investor, it seems to make sense to invest in companies that make products that aren't purely functional. The ideal situation may be a company that makes a product with artistic elements, and that is committed to iconic design. This kind of business model is (1) hard for competitors to copy and (2) reduces the danger of creating an overserving product (since buyers in this kind of market are driven by both functional needs and irrational wants).

This post has been amended since it was first written. 

The author owns stock shares of Apple.

Growing Users Without Growing Profits

A number of popular companies with great products or services don't seem to make much money or are losing money; some of these are closely held, making it hard to determine the extent of losses. These companies include: Uber, Tesla, Amazon, Twitter, and Evernote.

I use Uber, Twitter, and Evernote regularly -- they're invaluable to me. Yet these companies apparently lack the pricing power needed to acquire users, grow sales, and generate/grow profits.

Investors satisfied with profitless sales growth seem to be banking on speculative, undemonstrated pricing power. Many investors believe these companies can turn a profit -- and generate healthy sales and sales growth -- once they stop focusing on the "land grab" effort of acquiring new users. When this kind of speculation doesn't pan out -- either user growth slows and/or profits never materialize -- the stock can really take a beating (a la Twitter). 

Absent aggressive, successful equity fundraising, a company that grows users without growing profits is going to have a hard time investing in its business and improving its product. Uber and Tesla have been very successful fundraisers, allowing them to continue releasing new, improved products/services. At some point though, investors want profits -- they want a return on their investment. Aggressive fundraising won't work forever. If the fundraising music stops and the profits aren't there, an unprofitable company faces major problems like paying its bills and improving its product/service at a rate sufficient to compete. Companies with profitable business models can invest in product/service improvements that unprofitable companies cannot.

If a stand-alone service can't increase its user base without losing money, what alternative business model could work? How could the service still drive profits? Possibly through tight integration with a product that does make money, like an iPhone or iPad or Apple Watch. Tight hardware/service integration creates a more unique, "magical" user experience by making things faster, simpler, and more convenient. As Michael Porter notes, companies should compete to be unique rather than competing to be the best.

It's worth noting that Apple doesn't try to compete within traditional, well-defined hardware or service categories -- they compete by trying to provide the best integrated hardware/software/service experience. This point was recently emphasized in John Gruber's podcast interview of Craig Federighi and Eddy Cue (on Gruber's "The Talk Show" podcast). When questioned about whether the quality of Apple's services was slipping, Federighi and Cue both emphasized that Apple focuses on the integrated, holistic user experience, not on the specific hardware or service component (consistent with Apple's functional organizational structure, its single P&L, and Steve Jobs's advice to focus on the user experience and work backward to the technology).

Apple's in a great position to cherry pick useful services and integrate them into their products, making their products more unique and "sticky." Apple can see how Evernote has become more and more valuable and can use this knowledge to make a more attractive, useful version of Notes. Apple can look at Uber's unprofitable transportation service and find ways to provide a more unique, magical user experience through an integrated hardware/service offering driven by profitable device sales (i.e., iPhone, Apple Watch, and Apple car). Apple can use the unprofitable stand-alone service to complement/strengthen its ecosystem and its profitable hardware.

This article has been amended since it was first posted. 

The author owns stock shares of Apple.

Sustaining Innovations Based on Different Capabilities

Clayton Christensen recently described Uber as a sustaining innovation -- rather than a new market or low end disruption -- since its service is generally better than existing taxicab options. "One More Time: What is Disruptive Innovation?", by Clayton M. Christensen, Michael Raynor, and Rory McDonald (Harvard Business Review, December, 2015). In his books Christensen counsels entrants to avoid competing with incumbents through a sustaining innovation. See Concepts page and discussion of Clayton Christensen. That's because incumbents will aggressively respond to companies that try to enter their markets with a better product. You can currently see this happening in the auto industry, with incumbent luxury car companies offering more electric vehicles to compete with entrants like Tesla.

Christensen believes Uber is an "outlier," and that its success may be due to the regulated nature of the taxi industry. "One More Time," by Clayton Christensen, et al. These regulations make it difficult for incumbent taxi companies to compete with Uber. This seems logical. I think, however, that the biggest problem facing traditional taxi companies is that they lack Uber's (1) resources (infrastructure, employees, capital access, etc.), (2) processes (manufacturing processes, logistical processes, software development processes, etc.), and (3) values (margin goals, priorities/culture, etc.), which together make up a company's capabilities.

Christensen discusses resources, processes, and values ("RPV") in The Innovator's Solution. In this book Christensen says entrants with a sustaining innovation usually lose to incumbents because incumbents have the RPV -- the capabilities -- needed to match the entrant's improvement. The Innovator’s Solution, by Clayton Christensen and Michael Raynor (Harvard Business School Publishing Corporation, 2003). He also says that incumbents normally lack the RPV needed to match a product or service that's a new market or low end disruption. Id. 

Looking at examples like the taxi industry -- and contrary to what Christensen theorizes -- incumbents may not always have the RPV/capabilities needed to match an entrant's sustaining innovation. Regional taxi companies lack the equity capital resources and the refined logistical and software processes needed to effectively compete with a global company like Uber. Uber offers a better service based on fundamentally different capabilities that are constantly refined on a massive scale. These different capabilities -- and their steady improvement -- allow Uber to effectively challenge incumbents despite the sustaining nature of Uber's service. The lesson here is that Christensen's RPV framework is relevant in both a disruption context and a sustaining innovation context.

So an entrant with a sustaining innovation can effectively compete with incumbents when the sustaining, better product/service is based on RPV/capabilities that are non-traditional relative to the pertinent industry. In this situation incumbents will be hamstrung by capabilities tailored around traditional/existing industry offerings, whether it's (1) a taxi company with employee-drivers and a cab fleet (competing with Uber's logistics/software and thousands of independent contractors driving their own cars) or (2) a hotel company with service-related employees and hotel-related infrastructure (competing with Airbnb's logistics/software and thousands of owners renting out their homes). In both these examples you have entrants -- Uber and Airbnb -- offering a different/better service and competing directly against incumbents for existing industry customers (what Christensen calls competing against consumption). Christensen would predict failure because of a vigorous and effective incumbent response, yet both Uber and Airbnb are succeeding because their RPV/capabilities are different from those of incumbents, making it difficult for incumbents to respond.

Applying these ideas to Apple, the original iPhone could be viewed as either a new market disruption (a personal computer for a new context/situation -- your hand or pocket) or a sustaining innovation relative to competing cell phone products from Nokia and Blackberry. See post titled The iPhone Conundrum and New Market Disruption. Regardless of how you class the original iPhone, it was built based on software and hardware capabilities that Nokia and Blackberry seemed to lack, which allowed it to gain a market foothold without a meaningful incumbent response.

One other point: a company that sells a mediocre service/product -- particularly a product that's become a monopoly either through market dominance and network effects or through regulatory protection -- leaves itself open to not only new market and low end disruption, but also sustaining innovations based on different capabilities. An uncompetitive industry environment leads to complacency and deteriorating products and services. 

This article has been amended since it was first posted.

The author owns stock shares of Apple.

Building Great Brands and Disrupting in Reverse

InNOut Burger This is the menu at In-N-Out Burger, which was founded in 1948. Definitely no accident. Simple and affordable by design. Imagine the discipline it took to stick with such limited menu choices, despite years of intense competition from other fast food chains offering a much wider selection. Imagine how many times In-N-Out had to say "no." Come to think of it, the best restaurants usually have limited menus. 

And In-N-Out Burger probably has the best brand of any fast food restaurant in the United States. Its customers are very loyal. http://en.wikipedia.org/wiki/In-N-Out_Burger.

In-N-Out demonstrates how disciplined product focus can lead to great products, loyal customers, and a great brand. Some of the very best brands have this product focus: Apple, Ferrari, Yves Saint Laurent. Very few products. But this approach seems fairly unusual. Most companies have lots of products, lots of choices. Christensen says companies should give customers more choice and customization options as a product becomes "good enough." See Concepts page and discussion of Clayton Christensen. The sustained success of more focused companies challenges that notion. It seems like too much product choice, and too much product customization, often results in average products, an average brand, customer confusion, and poor customer loyalty.

One of my favorite Steve Jobs quotes is the following: "Focusing is about saying no.  And the result of that focus is going to be some really great products . . . ." Focus also results in loyal customers, a great brand, and a differentiated strategy that few companies follow. 

Most companies are uncomfortable with big, you-bet-the-company commitments to just a few great products, so they place lots of bets through a wide selection of average products. As a result they never create a great/amazing product that delights customers, never achieve any meaningful customer loyalty, and never put what Steve Jobs called "a dent in the universe." This may be why Jobs said that "one home run is much better than two doubles." Home runs create customer loyalty and brand value. Singles and doubles don't.

And In-N-Out Burger shows how this approach can work even with really common, inexpensive products. Make a few simple, great products to create customer loyalty and brand value. 

And if you can, make products affordable. Affordability doesn't make a great product less great -- it just makes it more accessible to more people. Companies like In-N-Out Burger and Apple have shown that great products can be affordable without damaging brand value. In the next year or two Tesla is going to do this by making a more affordable electric car. Elon Musk's summary of Tesla's long term strategy sounds remarkably similar to Apple's approach:

"So, in short, the master plan is:

1. Build sports car

2. Use that money to build an affordable car

3. Use that money to build an even more affordable car

4. While doing above, also provide zero emission electric power generation options

Don't tell anyone." http://www.teslamotors.com/blog/secret-tesla-motors-master-plan-just-between-you-and-me.

Tesla and Apple seem to follow a top-down approach to Christensen's disruption theory. They start with a high end, integrated, innovative/superior new product; Apple did this with the original iPhone, skimming high end profits. They then use early profits from the high end product to increase manufacturing capacity and scale. Increased scale eventually allows them to offer a more affordable version of the innovative/superior product, penetrating and disrupting mainstream markets (kind of like new market or low end disruption in reverse). As the iPhone's become more affordable, it's disrupted more and more of the mainstream feature phone market. Michael Porter has noted that disruption can occur from the bottom-up and from the top-down. See Concepts page and discussion of Michael Porter and list of sources.

By starting with an integrated, high end product, Apple and Tesla free themselves to pursue cutting edge, market changing innovations that can later be incorporated into more affordable product versions, or can be used to create an affordable new product category that disrupts overserving modular alternatives (think iPad versus traditional PC). See post titled "How Outsourcing Can Destroy a Company." 

All this might explain why Apple hasn't been disrupted by low end competitors. Apple keeps things simple, great, and as affordable as possible, and creates affordable new product categories when existing offerings start to overserve.

The author owns stock shares of Apple.