IOSR Journal of Business and Management (IOSR-JBM)

e-ISSN: 2278-487X, p-ISSN: 2319-7668. Volume 17, Issue 2.Ver. I (Feb. 2015), PP 07-12
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Clayton M. Christensen et al (2010). Innovation Killers: How

Financial Tools Destroy Your Capacity to Do New Things
(Boston: Harvard Business School Press), Harvard Business
Review Classics Series, pp. 49, p/b, ISBN 978-1-4221-3655-3
Shiva Kumar Srinivasan
Behavioral Sciences, International Institute of Planning and Management, Chennai, INDIA.

Abstract: This book argues that the better known financial tools invoked by analysts in evaluating the
performance of firms were designed years ago to enable sustaining innovations rather than disruptive
innovations.That is probably why firms have difficulty with innovation in practice even though they find the idea
appealing in theory. It is therefore important to integrate across the functions of strategy and finance so that the
financial tools used to evaluate a firms performance is adequate to the purpose and reflects the contemporary
reality of the financial markets. Likewise firms must be willing to acquire new strategic capabilities rather than
think only in terms of expanding capacities by not only restructuring their value chains when required to do so,
but by spinning-off disruptive innovations into separate units so that the criteria invoked to evaluate their
performance are relevant; and the differences between sustaining and disruptive forms of innovation are not
forgotten in both strategic theory and financial theory.
Keywords: Disruptive Innovation, Financial Metrics, Regulation, Sustaining Innovation, Value Chain

I. Introduction
This book is a reprint of an article that was originally published in the Harvard Business Review (HBR) in
January 2008. It is a part of a paperback series that brings together breakthrough articles from the HBR to a
much wider audience of readers in the world of business; it is itself, needless to say, an important instance of a
disruptive innovation in the context of business publishing on the part of Harvard Business School Press. It
successfully redefines the value proposition,of what a brief book for business readers should be like albeit
without any compromise in the quality of its theoretical offering. The intention of the three authors - Clayton M.
Christensen, Stephen P. Kaufman, and Willy C. Shih - is to find out why firms are enthusiastic about innovation
in theory but inhibited in practice. They point out that there are a number of reasons for this form of inhibition.
We may even go to the extent of saying that this important question addresses one of the most intractable
problems in the theory and practice of innovation within the emerging literature of strategy as innovation (as
opposed to the better-known form of strategy as competition). The main difference though between most
theorists who address this question and Christensen et al is the fact that they identify the main source of the
inhibition at the level of how financial tools are designed by either theorists or practitioners, and subsequently
invoked by financial analysts to make sense of the performance of particular firms.

II. The Telos Of Tools

There is an old saying in management that in order to manage we must first learn to measure; and that
in order to measure, we must first have appropriate tools in place (given the Aristotelian contention that we
think with our tools).The better our tools are in terms of their design and fitness for a given purpose (the
Aristotelian telos), the more likely is it that they will serve our needs and goals effectively. It is important to
remember that the design and function of our financial tools (that are listed in any finance textbook) make
important assumptions about what a firm is and what a firm is notat the level of economic theory, financial
theory, strategic theory, and regulatory theory. It is not necessarily the case that all these theories are talking
about the same thing though they all invoke the term firm to assure themselves that they are referring to the
same theoretical entity. Invoking the term firm to make sense of what entity is being talked about is not the
same as saying that all these theories and theorists are referring to the same entity in theory or even the same
prototypical objectin the world. Innovation in the strong sense therefore becomes possible only if the innovator
is able to integrate the concerns of these four theories into a larger strategic goal for the firm as a whole; and in
the process there is a better understanding of what sort of an entity a firm is in theory and practice.What we
however find in practice is that attempts to integrate the different aspects of a firm constitute the exception
rather than the rule.While there is a lot of talk about integrating across a firms functions in organizational
theory, there is no integrated theory of the firm as such in the existing literature of the theories of the firm that
is adequate to the task of measuring the different aspects or dimensions of a firm effectively.
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Clayton M. Christensen et al (2010). Innovation Killers: How Financial Tools Destroy

III. The Authorial Intent
Whatever maybe the financial tools in contention, it is important to remember from a practical point of
view that there is a huge cost-factor in measuring a firms performance; there is an even bigger cost-factor in not
measuring for financial performance at all or in making a hash of it since that could seriously mislead both
investors and the management who are dependent on these measurements for coming to the right decisions. It is
therefore important to think through the challenges of measurement without making a fetish of financial metrics
irrespective of what tool happens to be important at any point in time. Most financial analysts however get
attached to some metric or the other as fads come and go and wind up over-emphasizing its importance in the
over-all scheme of things. The main goal of this book is to prevent readers from making a fetish of financial
tools merely because we have got used to thinking with particular tools that have proved to be useful in the past.
We must, the authors argue, be willing to move on when better tools become available or when tools get pruned
into their absolute essentials through forms of disruptive innovation that seek to activate not all the attributes or
features of a product, metric, or service, but only those of consequence in a problem-solving solution. It is also
important to be actively on the look-out for better tools in the relentless pursuit of excellence in all aspects of the
firms life, but simultaneously recognize the need to make intelligent trade-offs in generating, measuring, and
analyzing the financials of a given firm since a firm cannot be all things to all customers. In order to do this
effectively, we must be open to the idea of integrating theories and practical insights across all major
functional areas - especially strategy and finance in a firm - for instance rather than take a silo-like approach to
organizational life because our sense of identity as employees has become more important for us than serving
clients and customers. The next section of this review considers what it means to integrate across these
important functions and the implications of not doing so at the levels of both theory and practice.

IV. Integrating Across Finance And Strategy

While the main focus in this book is on the need to integrate financial theory and strategic theory, this
form of integration can also be done using a combination of the four forms of theory enumerated above. This is
because some of the basic assumptions in these theories get incorporated whether we know that to be the case
or not - into regulatory mechanisms through statutory forms of legislation. This makes it difficult for firms to
wish them away should they choose to integrate their functional areas in a way that is different from what is
described in the work of a particular management theorist or in the approaches pushed by a particular consulting
firm to its clients. The reason that firms struggle to integrate the theories listed above relates mainly to how
organizational responsibilities are assigned to different departments or verticals in a firm. The endless
preoccupation with questions of turf and territory also makes it difficult to have an honest discussion of how the
process of integration must proceed in an inter-departmental meeting of Heads in a firm since it is easy to forget
that the silos were put into the design of the firm in order to increase the efficiency of the firm rather than to
keep employees from communicating with each other. The authors therefore argue that in the absence of formal
mechanisms to facilitate give-and-take between strategy and finance in a Heads meeting, or in the everyday
life of a firm, theseconcerns about integration will not lead to anything practical. The conventions of financial
analysis and the metrics in use in most firms rest on theoretical assumptions that turn out to be inadequate on
close examination. These fallacious assumptions must be identified as precisely as possible in order to take
corrective action in areas like organizational behavior, design, and development. It is also important to sensitize
HR personnel on the behavioral implicationsfor employees of resistance to integration across functions in a
firm. The authors start out by identifying three important metrics in use in contemporary firms and then explore
why the underlying assumptions in these metrics dont make sense at all. The three metrics in contention include
the routine invocation of discounted cash flow and net present value to evaluate the pros and cons of a
potential investment; the inability to understand the role played by sunk-costs and fixed-costs in the context
of competitive dynamics; and, finally, the commonplace obsession with earnings-per-share as an indicator of
financial performance in both firms themselves and in the business media.

V. Financial Tools Are Not Kantian Objects

The better part of this book is the attempt to understand why and how these metrics became so
important and what role they actually play in economic theory and financial theory as applied to the observable
behavior of a firm. Once these factors become clear, strategic innovators will have greater clarity on what is it
that needs to be done in their attempts to integrate economic theory with financial theory; the implications of
doing so in terms of how firms will be designed in the future, and the role that will be played by employees and
stakeholders in socializing themselves to prevent the possibility that they will behave merely like agents rather
than as principals. Or, to put it more simply, what the authors are hinting at is the fact that we must think
through well-known financial tools in the context of Michael Jensens work on agency theory.Do these financial
tools increase or decrease the probability that stakeholders and employees will act in their own interests rather
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Clayton M. Christensen et al (2010). Innovation Killers: How Financial Tools Destroy

than those of the shareholders? Is it possible to redesign these financial metrics and incentive systems to ensure
that those who take an ethical position are more likely to prevail in firms rather than those who push their own
interests? It is not necessary for the reader to be interested in areas like innovation and strategy to read this
book; it should even be of interest to those who are more interested in the history of financial metrics, the
importance of agency theory in analyzing and predicting financial behavior, and the theoretical relationship
between contemporary financial metrics in particular and agency theory in general. It is important to remember
that financial metrics are not like scientific or philosophical tools at all. They are not transcendent Kantian
objects of financial analysis. Furthermore, they arenot true, relevant, and useful, as Saul Kripke, the philosopher
of language, might put it in all possible worlds (i.e. in all business scenarios).

VI. Financial Tools And Conventions

Accounting and financial tools, if considered from an epistemological point of view, are only
elementary or advanced conventions for reporting how firms use their capital stock to generate forms of value
that are either retained by the firm, or returned to their respective shareholders, by a firms board of directors.
These conventions are the result of either how firms have spontaneously evolved in a given society or are
mandated from the outside by different forms of financial regulation. These regulations are either formal pieces
of legislation (like the Sarbanes-Oxley Act of 2002 and the Dodd-Frank Act of 2010), ortake the form of
informal agreements (between banks, and firms, for instance to provide overnight loans to each other to clear
their dues on a daily basis). These informal agreements between banks might subsequently have become
markets in their own right, but are eventually brought under the ambit of formal regulation. Resistance to
financial reform from those who dont understand the status of financial tools as objects of regulation does not
only stem from the real or imaginary costs of regulation, but also from not being able to situate a financial tool
as just a tool. These tools - as Aristotle correctly anticipated (though he was not really talking about finance in
particular) - become ingrained habits of mind that are difficult to shake off even when they cease to be useful.
The inordinate fear of the theory and practice of disruption in our business schoolsand business communities is a
symptom of precisely that problem; it is this symptom that can be termed, as Christensen et al do in this book, as
the fallacy of Parmenides. The object of this fallacy is the challenge of doing an effective scenario analysis where risk is either incorporated or not incorporated into a firms strategy in its attempt to do business going
forward. It is therefore important to alert readers to this fallacy since the inability to think clearly about risk
within a theory of innovation bothers Clayton Christensen as much as the inability to think clearly about the
economics of discrimination used to bother Gary Becker within a theory of human capital.

VII.

The Fallacy Of Parmenides

The fallacy of Parmenides canbe best understood by invoking the misunderstanding that results from
invoking the notion of discounted cash flow and net present valuewhere the reigning assumption is that it is
less risky to not innovate than to innovate; this, needless to say, is a huge theoretical assumption and is not
backed with any empirical data. This approach to risk, risk analysis, and the pricing of riskpresupposes that
nothing is changing in the markets, and that a firm will generate a higher cash flow by simply choosing not to
innovate and that the only sensible form of business is business as usual irrespective of how many opportunities
are lost in the attempt to do so.What is so obviously overlooked here is that the do-nothing scenario will not
necessarily guarantee cash flows; it might even lead, as it usually does in fast-changing scenarios, to a
nonlinear decline in performance that can be difficult to reverse for a firm. The assumption that nothing is
changing in the markets; and that a firm can safely keep doing more and more of the same, without any serious
attempts at innovation given the ever present risk to cash flows, is referred to as the fallacy of
Parmenides.Parmenides was a pre-Socratic philosopher who argued that there is no change in the real world,
and so there is no need to do anything that will demand a departure from the way things are at the present. The
risk, for Parmenides, is simply not worth it. Christensenet al however argue that it is important to compare the
value that a firm hopes to generate from an innovation within a range of scenarios in order to determine what it
must do or what it must not do. They are also worried about situations in which firms get their cash-flow
calculations wrong since the consequences of disruptive innovations cannot be modeled easily on a year-on-year
basis in the hope that terminal values at the end of a project period will facilitate a more accurate calculation.
This approach will not permit comparisons across scenarios since the cost of doing nothing (i.e. not innovating)
is assumed to be nothing, but this doesnt account for the possibility of a non-linear decline in performance as a
result of a simply-do-nothing scenario. It will not be possible to generate a single number in such a situation to
put it simply - that can be an effective stand-in for effective financial comparisons or pricing risk in a theory of
disruptive or even sustaining innovation.

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Clayton M. Christensen et al (2010). Innovation Killers: How Financial Tools Destroy

VIII.

Expanding Capacities And Acquiring Capabilities

Christensen et al also argue that financial decision making can be marred by making unwise use of
fixed costs and marginal costs without understanding the strategic or financial implications of doing so. Here
what decision makers in a firm overlook is the problem of strategic capabilities: what capabilities are required
to succeed in the future will not be the same as those on which fixed costs and marginal costs were incurred in
the past in a given firm. Not understanding this may make it difficult to leverage the potential returns to existing
capabilities in the future. It was the unwillingness to acquire new capabilities and the preoccupation with
leveraging fixed costs and sunk costs that made it difficult for companies like US Steel to respond dynamically
to the disruptions created in the steel market by mini-mills like Nucor. Large integrated steel plants are then
highly unlikely to attempt any Greenfield ventures since that will make it difficult for them to leverage on
marginal costs which is a more attractive proposition in the short term than the need to think carefully about the
need to minimize long-term average costs. What is convenient from the marginal cost form of thinking will
turn out to be inconvenient both in terms of long-term costs and of what is strategically required to respond to
the process of disruption in any market. This will almost invariably lead to a situation when the incumbent firm
will be disrupted at almost every level of its product hierarchy as the disruptor firm eventually decides to move
upmarket. The fallacious assumption in such forms of thinking on the part of incumbents is in not understanding
the difference between expanding capacity (where it makes sense to leverage marginal costs on existing
capacity by doing more of the same) andin actually acquiring new capabilities where the relevant marginal
cost is actually the full cost of creating the new capability.Likewise, there is another interesting problem
relating to the depreciation of assets in the firm. In this situation, the usable lifetime and the competitive
lifetime of a capital asset are not the same. It is easy to make the obvious error of trying to depreciate the
former - rather than think in terms of the latter since the former lasts longer. This error will make it necessary to
often face massive write-offs when those assets become competitively obsolete and need to be replaced with
newer technology assets. The preoccupation with quarterly results will also delay the adoption of new
technology that is required to respond dynamically to disruptive forces. The solution that is suggested here is
that managers must move from a preoccupation with projects to thinking in terms of strategy in order to remain
competitive. The reason that they hesitate to do this is their preoccupation with how the equity markets will
respond to asset write-downs.

IX. Restructuring The Value Chain

Unless there is an attempt to integrate financial concerns with a strategic mind-set at this juncture, the
financial health of a firm will become inversely correlated to its strategic potential.So, instead of trying to
integrate across functions, the firm will find that it is disintegrating should there be a disruptive attack in the
markets. In many such cases, the incumbent firms do not even understand what happened - let alone come up
with an integrated response that will help them to recover strategically. This is because the incumbent firms
cannot represent the formal structure of their own value chains if challenged to do so, as Michael Porter might
put it, even in a business-as-usual competitive scenario let alone in a disruptive scenario where the very
definition of what a value chain is what is ultimately at stake. Unless the incumbents understand the
implications of what is involved in restructuring the conventional value chain with a disruptive value chain that
has fewer nodes, they will not be able to correctly identify what is at stake in disruptive innovation. So, to
invoke an immediate analogy: just as a disruptive product will have fewer - and not more features than the
incumbents product so, likewise, a disruptive value chain will manufacture or market with fewer nodes in its
value chain by rethinking the rationale of the product; in the process it will also accrue considerable savings in
cost by eliminating the needless or superfluous nodes in the firms value chain.Or, to invoke a mixed metaphor
from strategy; we must not assume, as the incumbents do, that a value chain is devoid of muda (i.e., slack or
waste from a kaizen point of view).

X. Financial Metrics And Financial Strategy

The third metric that needs to be rethought is earnings-per-share as the lead indicator of a firms stock
valuation. Hereproblems arise from the assumption that principals and agents are not sufficiently aligned with
each other and will always work at cross purposes unless agents are hugely compensated in terms of stock
options. It is this compensation mechanism and the assumptions that warrant it which lead to attempts to keep
stock valuation as high as possible by seeking recourse to buyback mechanisms whenever the firm can afford to
do so. These mechanisms will, needless to say, generate unnecessary cash-flow problems for publicly-listed
companies. So while companies try to avoid innovation as risky from a cash-flow point of view, they dont seem
to realize that boosting stock valuations through artificial means will misalign finance and strategy, and the
company will be endlessly preoccupied with earnings surprises to keep investors excited about their stock
without any real concern about the long-term strategic or financial viability of the company. This approach to
financial strategy without any genuine concern about the over-all competitiveness of the firm will
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Clayton M. Christensen et al (2010). Innovation Killers: How Financial Tools Destroy

eventuallymake it vulnerable to hostile takeovers and leveraged buyouts since there is a limit to managing the
attention span of shareholders through gimmicks like earnings surprises. So, the solution to the problem of a
possible misalignment between the principal and the agent turns out to be worse than the actual problem because
these forms of misalignment turn out to be self-fulfilling prophecies. Again, Christensen et al disagree with the
contention that all managers are merely seeking to maximize their positions as agents though I am not clear
whether there are empirical studies on this subject and how decisive these studies are one way or the other. The
main contention in agency theory in a sense presupposes that there is little or absolutely no fit between a firm
and its employees, all employees are agents who will ruthlessly pursue their own interests unless proved
otherwise on a case-by-case basis, and that firms are completely oblivious of the need to institute HRM
processes to socialize agents effectively so that they dont behave like agents and start behaving like
stakeholders who are answerable to shareholders. Another important problem with the principal-agent approach
to financial governance in companies relates to the changing nature of company ownership. The principals in
contention (i.e. the shareholders since they are the rightful owners of the company) are themselves not
invested long-term in a company given their propensity to speculation, herd-behavior, and financial panics.

XI. Agency Theory

The main contention in agency theory used to be that you cant trust the agent with the long-term
interests of the company unless their behavior has been sufficiently incentivized. Now however that turns out to
be the case for shareholders and investors as well. They have ceased to be shareholders since they often dont
hold stock for even as long as a year and are more rightfully described as temporary share owners. The bulk of
the holdings in publicly-listed firms arecontrolled by different types of mutual funds that are preoccupied with
forms of portfolio optimization using expert systems rather than with getting to know the company and its
management well-enough to be described as principals in the traditional sense of the term. Or, to put it more
simply, neither principals nor agents are what they used to be or what we thought them to be. Neither Wall
Street nor Main Street is morally superior; and, in any case, the bulk of the investments these days are done by
large scale institutional investors and pension funds like CALPERS. It is also important to note that one
companys principal is another funds agent so it not clear how to draw a line, i.e., mark a clear ontological
divide between the principal and the agent; the term that Christensenet alare forced to invoke then is not the
agency problem (where the agent fails to protect the interests of his principal), but rather the agent-agent
problem.Christensen might want to quip that the gains from being an agent are so high that instead of aligning
agents to behave like principals, the latter have decided to become agents themselves; hence the agent-agent
problem. If this is the problem, what pray is the solution? Could we envisage a world of financial markets in
which there is a principal-principal solution to the agent-agent problem?

XII.

Discovery Driven Planning

And, finally, we need to rethink the structure of project financing as well since funds are usually
released for the feasibility, development, and launch of a project in stages. The transition from one stage to
another of the project is structured through the mechanism of stage-gates. This stage-gate mechanism was
originally meant to ensure that funds were used carefully and stem wasteif there is an instance of misuse. It
would also ensure that the release of funds corresponded in an ideal scenario to the scheduling of a linear
sequence of activities. While this approach is sensible to ensure that funds are not misappropriated or wasted,
this model of funding did not envisage the analytic distinction between sustainable innovations (for which it was
designed) and disruptive innovations since both the criteria of evaluation and the burden of risk are not the same
for both forms of innovation. It is much more likely that sustainable innovation will be funded than disruptive
innovation though the long term financial health of a company depends on disruptive innovation.This model of
project financing for sustainable innovation will ensure that an incumbent will not be able to summon a strategic
response to a disruptor not because he lacks strategic agility, but because his model of project financing will not
allow him to spend his resources in way that will make the incumbent truly competitive in a disruptive scenario.
That is why it might be a good idea to spin-off projects into new firms rather than destroy funding for disruptive
innovations using the criteria of evaluation for sustaining innovations. This model of project financing is
probably why incumbent companies cannot fund lower-end products to stall the disruptor in the first place. That
is also why incumbent firms are forced to flee upmarketendlessly to delay disruption to the extent possible until
it is too late for them to respond strategically. An important mechanism thatwill solve this problem in the
context of project financing is known as the reverse income statement; this mechanism works with the
minimum set of numbers that are acceptable if a project is to go ahead. Here there is a greater level of financial
integrity since assumptions are not endlessly tweaked to make the project look good; but, instead, a discovery
driven planning approach is invoked that works with an assumptions checklist. The idea is to ensure that
planners understand what the crucial assumptions are in their projects, and are also willing to make them
explicit so that the assumptions that constitute the key uncertainties in a given project are made known to
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everybody before starting out. This is how disruptive entrepreneurs fund their projects; and this is what the
incumbents must think through if they want to go beyond sustaining innovations, and re-define their value
chains in terms of disruptive innovation.

XIII.

Conclusion

Unless these three financial metrics are analyzed and the differences in assumptions between sustaining
and disruptive innovations brought out into the open for all stakeholders to make sense of, incumbent firms will
continue to struggle to understand the role of disruptive innovation in the financial and product markets.That is
the danger that Christensen et al set out to diagnose and cure in this book. The urgency of their intervention is
also related to the fact that the time required to pull the macro-economy out of a recession has repeatedly
increased in the United States since neither incumbent firms nor policy makers have fully understood the
differences between the policies required for sustaining innovations as opposed to disruptive innovations. This
book, if read in the spirit of its strategic intent, will help them to do so. I couldnt recommend it more highly for
both first time readers of strategy as innovation and for those doing courses in strategy.

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