BY LIISA VALIKANGAS AND GARY HAMEL

How Hierarchies Fail Innovation

et us be clear: Hierarchies do innovate. As long as the innovation is "sustaining" rather than "disruptive" (Christensen, 1997, Anderson and Tushman, 1991) and as long as the exploratory activities are aligned with and exploit existing competencies and routines. Nelson and Winter (1985) described organizations as routine-makers, and authors such as Sorensen and Stuart (2000) have noted how corporations build innovation routines that focus on their know-how. Yet an innovation that is not aligned with such know-how is likely to be ignored as irrelevant or uninteresting. Dougherty (1996) claims that innovation is often simply ignored as the organization lacks effective means to accommodate novelty. Serving existing customer needs at the expense of emerging new markets is another innovation blinder (see e.g. Christensen 1997). Companies often fear innovations may "cannibalize" current business. For instance, Kodak — probably a representative example of a corporate hierarchy — delayed its full entry into digital photography due to its fear of forfeiting revenues from analog films (Financial Times, June 19, 2001). Although a comprehensive cataloging seems to be lacking, the innovation failures of corporate hierarchies have been viewed severely systemic to the extent some authors have recommended nurturing innovation outside the company in a separate organization (Christensen, 1997, Christensen and Overdorf, 2000) or at least in a far-away location (Markides, 1999). This view essentially concedes that non-conformist innovation within a corporate hierarchy will inevitably fail.

We focus here on three immediate ways in which corporate hierarchies seem to fall short of their innovation potential. First, in considering investment options, management seems to be generally limited to an option set that is too narrow. Second, corporate resources appear necessarily mis-priced relative to their value creating potential. Third, ingredients important to innovation — creativity and enthusiasm — cannot easily be captured in top-down managerial processes.

Inadequate Option Set

In our experience, most companies are not very effective at surfacing innovative ideas. Processes for engaging people in the search for innovations don't exist or are heavily biased toward existing product-markets. When ideas do surface, they are easily ignored, particularly if they aren't aligned with existing business interests. Hence, the inadequacy of the initial option set for consideration stems from:
· lack of effective discovery processes in place
· lack of sustained attention paid to emerging ideas
· lack of ownership of (particularly, radical) ideas
· inability to uncover and/or act on "white space" ideas that fall between business units (Hamel and Prahalad, 1994)
· non-rigorous experimentation of emerging ideas to assess their potential (i.e. lack of entrepreneurship).

Mis-Priced Resources

In a corporate hierarchy, pricing of assets and skills is difficult, lacking the diversity of competing perspectives that generally exists in an open market. "Transfer pricing" is notoriously flawed as an indication of transactional or asset value (cf. Eccles, 1983). Vested interests and past resource commitments further distort valuations: there is no "equal playing field" for bidding for resources — those in positions of power are there to ensure the interests of the businesses under their stewardship and are well-positioned to do so as incumbents. A hierarchy typically sells capital and talent at a significant discount for those who already have budgeted privileges — a sort of legacy rights over corporate resources. Lacking an internal market, these resources are rarely contested to assess whether more promising investment opportunities exist. The resource allocation is hence a political process and further subject to the deficiencies of financial accounting as a guide to future wealth creation. Such accounting is quite sensitive to "dollars lost" — budget numbers not met — but totally insensitive to "dollars forgone" — missed opportunities in the market place. As a prototypical example, while doing well by traditional financial standards, Coca Cola missed the sports drink market and let Gatorade gain substantial market share, finally acquiring Mad River Traders, another leading player in the alternative beverages market.

Finally, the most up-to-date and in-depth knowledge does not reside necessarily with the decision-maker(s): those closest to the particular project are not those making the allocational decisions nor always carrying their consequences. Given that managers fear visible failures (March and Shapira, 1987), a conservative bias is likely to discourage resource reallocation toward major emerging opportunities. According to Teece (2000:79), "certainty effects" distort such resource allocation: DuPont focused on improving certain yet diminishing returns on its nylon tire cords while Celanese, a competitor, gained significant market share in "riskier" polyester tire cords (Foster 1986). Yet managerial status commonly requires that resource allocation decisions are the domain of management (cf. Gordon 1996). In the top-down decision making process, there is a chance that top management either (a) taxes a project with an inappropriate risk premium due to ignorance, i.e. top management overestimates the riskiness of the project, or (b) top management over-invests in the project because it has overweighed the opinions of one or two project champions.

Suppressed Creativity

Creativity is a function of enthusiasm and ownership of innovation. Yet in what sense, if any, can a corporation allocate entrepreneurial energy and passion? If creativity is the scarcest resource of all intangible assets that corporations may want to own, top-down allocational processes seem entirely inadequate. Creative passion — a likely necessary ingredient in effective innovation — cannot be allocated or commanded. Hierarchies seem singularly incapable of arousing such passion for the corporate future.

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