Technological innovations have radically transformed the business landscape in many ways over the last two centuries, our research shows how digitization can significantly hurt incumbent firms in many industries, write Jacques Bughin and Tanguy Catlin in Harvard Business Review.
Technological innovations have radically transformed the business landscape in many ways over the last two centuries, from the introduction of steam power to the market conquest of radial-ply tires. Research by McKinsey & Company and the McKinsey Global Institute shows that digitization is having the same radical impact. In particular, our research shows how digitization can significantly hurt incumbent firms in many industries — depleting as much as half the revenue growth and one-third of earnings before interest and taxes (EBIT) growth of companies that neglect to embrace digital innovations.
It is not too late for incumbents to reverse the digital curse and re-create a more profitable growth path if they are willing and able to invest more in digital than their peers and take the offensive by reshuffling their activity portfolios and beefing up remaining activities with new business models. On top of that, incumbents would be wise to choose a “platform play” — creating value by intermediating in transactions between other parties, such as suppliers and consumers — because it opens the way to capture more value in disrupted industry chains.
Despite the demonstrated benefits of this path, which we call “digital reinvention,” only a minority of companies have fully embraced it. In our early research on 2016 data we had found that only 16% of companies had taken steps toward reinvention, meaning they restructured their portfolios (shedding declining businesses and expanding profitable ones) and poured more money than their peers into an aggressive digital strategy based on new platform business models. In more recent research in mid-2017, our data from 1,650 firms around the world still confirms that still less than 20% of companies take the path of “digital reinvention.” We conclude that, despite warnings from ourselves and others, most incumbent firms are failing to adjust to the digital era.
Hence, our new research, which focuses on understanding how to encourage more frequent (and more profitable) digital reinvention. We found six important and statistically robust factors that predict the probability that an incumbent company will choose the path of being a reinventor. They are, in order of importance:
1. Obsess about turbulence on the horizon. In general, incumbents tend to be disrupted because they neglect signals of turbulence. On the contrary, companies that understand the degree of digital turbulence are the most eager to go on the offensive. Those in the most digitally advanced sectors, such as high tech, already feel the pressure of digitization and are more inclined to take the offensive. In our survey, we found that one-fourth of high-tech companies are on the offensive, 2.5 times more than across all firms and sectors. In contrast, the automotive industry has barely half the rate of digital reinventors.
Even more interesting are differences within industries, where the perception of risk drives action. In the high-tech industry, we found that when companies conclude that their current model is not viable and must be fully adapted (versus making only marginal digital adjustments to the existing model), they digitally reinvent themselves 40% more often than the industry average. The tipping point for action is different by industry — in high-tech, companies often make the leap when cannibalization is perceived to hit 25% of their traditional revenue; in banking, the tipping point of perceived cannibalization risk is about 35%. In any case, at those tipping points the decision becomes relatively easy, as digital rules.
2. Understand all risks, not only those from startups. One mistake incumbents often make is to look at turbulence signals only from digital entrants. But for every digital startup in an industry, there also is likely be an incumbent reinventor in the making.
Imagine a firm in an industry with nine competitors. One competitor is a digital startup within the industry, one is a digital startup from an adjacent industry. The remaining seven are incumbents within the industry. These examples aren’t purely hypothetical; they’re estimates of a typical industry structure, based on our data. Companies typically face a mix of traditional competitors, new entrants within their industry, and entrants from adjacent fields. However, we also found that, on average, three of these traditional rivals are likely to have already chosen to forcefully engage in digitization, and one of them is probably already morphing into a digital reinventor.
In total this means the company in question faces offensive attacks from three digital players, not just one, and one of the attackers is a known competitor that has chosen to break from the established conduct of the industry — the so-called “red queen effect.” Furthermore, the more digitized an industry, the more often incumbent companies have jumped into digital reinvention. From an average of three offensive players, we found that grows to 5.5, or more than 50% of total competition in highly digitized high-tech industries.
To become a reinventor itself, a corporation would be wise not only to track new digital entrants but take a good look at traditional competitors that can become digital reinventors and must keep an eye out for established companies crossing their industry border.
3. Deliver a dual offensive: core and diversification. Today, many companies have in mind to defend their core business first and attack via diversification second. A typical incumbent focuses only about 30% of its resources on activities outside its core business. By contrast, true digital reinventors devote an equal amount of resources to revising core business models and investing outside the core.
However, we found that focusing only on non-core activities may be a mistake. First, revenue and, to a lesser extent, profit growth tend to be diluted though diversification as companies take time to build a presence in each new field. Further, companies’ assets and competencies outside the core are not yet as comprehensive and established, as they are in an incumbent market. Second, as discussed, core businesses are still the bread and butter for many companies; a digital reinvention in the core may still lead to a better growth path.
When digital reinventors increase offensive actions in both core and digital, we find that total revenue as well as profit growth is enhanced. The effect is not large, statistically — it is in the range of 0.5% to 1% of yearly revenue growth on top of base line depending on industry — but the effect is three times larger on profit, and further such an increase builds up over the years.
4. Fix leadership skills first. Many incumbents still face major roadblocks in their digitization journeys. In one way, this is natural, as incumbents have succeeded by establishing robust routines and competencies over the years. In general, the more successful those competencies were at providing non-replicable assets, the more difficult it is to let them go. What we find in our statistical analysis, however, is that companies are more likely to take the path of digital reinvention when leaders are committed to taking action, e.g. CEO sponsoring the program heavily, executive board appointing specific managers in charge of the transformation, etc.
5. Prioritize demand-centered business play. We mentioned earlier that incumbents see higher returns when they shift business models to a platform play – this effect is even greater for incumbents who show the other indicators of digital reinvention. Our new survey reconfirms the finding, but we also find two new nuances. The first is that one reason why digital attackers are often more successful than incumbents is that they select the platform play as their top priority two and an half times as often as incumbents choosing to go for digital reinvention. The second is that a platform model re-centered on the demand side increases the chance of being a digital reinventor, and making better profit inroads. This recipe for digital profitability is the consequence of the potential of large demand network effects, as it is emphasized in the management literature of platforms.
6. Experiment with frontier technologies. Digital reinvention only works if companies master the right digital technology architecture. Consistent with findings in parallel research, we found that digital reinventors ensure that they have adopted the full range of digital technologies, and diffused them across their organization to support mission critical applications and processes. Further, they are already investigating emerging artificial intelligence technologies, such as upgrading machine learning algorithms to deep learning ones, or investing in new generation of smart robotics, as a way to have an edge. Surprisingly, we see no evidence of leapfrogging in our data: companies that kickstart AI without mastering the first wave of digital technologies, such as social media or mobile, are not only rare but also do not get full return on their investments. Companies must master each generation of technology, and fast, in order to become digital reinventors and obtain good returns on their technology investments.
Source: Harvard Business Review.