The Sources of Organizational Inertia

In business, we often bemoan the inertia of large organizations. We invoke metaphors like the one about the aircraft carrier that requires three hours to turn 180 degrees. Clayton Christensen mentioned organizational inertia in his excellent books, The Innovator's Dilemma and The Innovator's Solution.

In his first book, Christenson goes into some detail on the threats faced by organizations suffering from inertia. In his second book, he discusses how large organizations can overcome their inertia. The causes of inertia were never clear to me. The size of the organization did not seem to correlate with inertia. Large organizations do seem capable of moving rapidly to bring innovations to market and respond to competitive threats. Apple with its iPods and HP with its printers are cases in point. Meanwhile, small organizations seemed sometimes to move and change very slowly.I recall vividly an incident at Intel's last Software Developer Conference. It was the late '90s, and the internet was booming. In the Q&A following a presentation by Andy Grove, an engineer suggested that Intel might enter new, relatively small, businesses focused on software rather than on microprocessors and motherboards. Grove chastised the entire group, comprising hundreds of software engineers, for this suggestion. It stung to be dressed down by our revered CEO, (and the fact that he was addressing us by videoconference, rather than in person, didn't help) but Intel had recently canceled a number of software initiatives that failed to meet a $200 million-a-year revenue objective, despite massive investment.

When a business grows rapidly and exponentially, as the microprocessor business did for Intel, it is only natural for the managers of that business to want that growth sustained. Such an organization becomes resistant to change for a number of reasons:

  • Don't fix what ain't broke. The success of the business is seen as a direct validation of existing behaviors. Faced with the possibility of change, the immediate psychological reaction of managers (especially at Intel, where Only the Paranoid Survive) is suspicion. Their perception is that any change puts ongoing success at risk. This is resistance to change at the individual level.
  • Considering the reality beyond perception, even small changes to the business or its product can have broad-ranging effects across a large organization, customer base, and target market. It is therefore perfectly rational for managers to put proposed changes through a long gauntlet of intense, critical scrutiny before adopting them. Unfortunately, at inception, innovations necessarily have qualities that render them vulnerable in the gauntlet: They embrace a small niche of the customer base. On this basis, their value is challenged by representatives of the rest of the addressable market. They generate only small increments in revenue. On this basis, they are dismissed for 'not moving the needle'. It goes without saying that radical changes to the business or product are summarily nipped in the bud. The result is an organization that is averse to risk and resistant to change at the institutional level.
  • Small new business initiatives may increase revenue and profit, but not enough to sustain historical growth. Rational business managers know that a bird in the hand is worth two in the bush. Their choice is between, on the one hand, allocating resources to incremental improvement of an existing business, with a return that is both certain and amplified by scale, and on the other hand, allocating resources to a new business lacking organizational scale and having a risky return. They will therefore see new initiatives as distractions, diverting resources that could be deployed toward incrementally improving the existing business.
  • Far-sighted managers may understand that historical growth rates in the existing business are unsustainable, and attempt to initiate innovative businesses. However, unless every one else already has the resources they want, they must hide these businesses from scrutiny. Innovative initiatives, even profitable ones, become perceived as skunkworks, some one's "pet projects". Over time, they become increasingly vulnerable to cancellation.

Organizations suffering from inertia are likely to acquire new businesses rather than growing them. The acquired business may yield, immediately, the revenue growth rate desired by the acquiring company. If conditions are right, the acquisition may be possible at a genuine discount to the acquired business's intrinsic value. In such a case, the acquiring business is behaving rationally, building shareholder value. But, in fact, acquisitions are usually destroy value for acquiring shareholders, primarily benefiting the sellers. Why do acquirers usually overpay for revenue growth? Here are some of my thoughts:

  • An internal organization attempting to operate in a different way or to produce different products is perceived to be invalidating the larger organization, possibly even to the extent of cannibalizing its business. Meanwhile, an external organization seeking acquisition is perceived to be validating the larger organization.
  • The financial value of an external, independent organization is easier to ascertain than the value of an internal one. This is because the internal organization’s accounting is necessarily intermingled with the larger organization’s.
  • The instruments by which external organizations are acquired (cash or stock) are perceived to be less valuable than the instruments by which internal organizations are grown (existing personnel). In other words, existing personnel are perceived to be best deployed on existing businesses, while cash and stock are perceived to be best deployed on acquisitions. When a business is highly optimized, this perception may in fact be reality: existing personnel are highly specialized for the business and it may be very expensive to successfully re-train them for a new one.
  • Although the cost of growing a business may be lower than the cost of acquiring one, the former is uncertain, while the latter is fixed at the time of the transaction. In such a case, it is rational to pay for mitigation of risk. Although shareholder value may diminish following the transaction, this is not really the destruction of shareholder value, but the revelation that shareholder value is less than previously thought.
  • Of the irrational behaviors I have observed among businesspeople, many derive from the principle of “earn and grow revenue at all costs”. Indeed, I have been surprised to discover that many high-tech startups are valued by venture capitalists at a multiple of their revenues---without regard to whether the business is making money or losing it. One rationalization seems to be that the cost of the additional revenue can always be cut after the new business is integrated with the old, especially through elimination of “redundant” jobs. However, it is risky to assume that costs will be cut within a known time period and riskier to assume that prior owners have not exhausted cost-cutting options. Another rationalization is that investment in the new business will generate revenue growth that is larger than expense growth, resulting in a profitable business. This is a risky assumption unless the business is truly at a tipping point, where incremental investment will open access to a fertile market.

Tags: Business, Economics, Finance

Created at: 24 December 2007 12:12 AM