JKE2_ch07.qxd 6/6/06 11:15 AM Page 83 7 Creating the Dynamics of Hard-to-Imitate Innovation Hirotaka Takeuchi The increased competition faced by Japanese companies has produced a new think- ing about innovation. Realizing that traditional categories of knowledge were no longer enough, they have reconsidered long-standing habits and sought new mean- ings, fresh ways of thinking about innovation, and a new sense of direction. The economy’s stagnation added to the urgency. Although the 1990s is called a “lost decade” by many observers, even casual familiarity with leading Japanese firms shows that many made significant advances even while struggling with the decade’s disruptions. Japan’s capacity to turn a chaotic situation toward new knowledge creation has been displayed twice before: during the 1970s oil shocks and after the 1985 yen shock. When the price of crude oil quadrupled in 1973, Japan’s economy went into a recession that lasted four years. But the first oil shock was the catalyst for Japan’s global leadership in energy conservation, which has benefited many industries. It triggered extraordinary upgrading as companies invested heavily in energy-con- serving technologies and moved toward higher-value products. The shock was also the impetus for the innovations that established Japanese firms in advanced indus- tries such as automobiles and consumer electronics. The yen shock was the yen’s 100% appreciation in the two years after the Plaza Accord of September 1985. Japanese products became expensive in inter- national markets. Wages (measured in U.S. dollars) reached some of the highest levels in the world, a sharp reversal for an economy where low wages relative to the West for skilled workers had been an important competitive advantage. Faced with such severe pressures, Japanese companies improved productivity enormously, shifting production of less sophisticated, lower-value products to overseas locations and moving to products less susceptible to price competition. Although by no means as acute as the oil shock and the yen shock, Japan has been mired in seemingly endless stagnation and deflation since the collapse of the asset (stock and property) “bubble” in 1990. The economy has muddled through several recessions. There was a severe banking crisis. (However, since mid-2005 there have been signs of a recovery that may well prove sustainable.) In these adverse circumstances, the Japanese companies studied in the previous chapters realized they had to go beyond cost reduction and conventional product upgrading. Instead, they involved their entire organizations in rethinking innova- tion itself. They sought to develop products, services, and systems that are hard to imitate by others. 83 JKE2_ch07.qxd 6/6/06 11:15 AM Page 84 84 Creating the Dynamics of Hard-to-Imitate Innovation This chapter reviews “what” kind of hard-to-imitate innovations Seven-Eleven Japan (SEJ), Toyota, Keyence, Nintendo, Sharp, and Shimano were able to develop, and examines “how” the innovations were developed. Hard-to-Imitate Innovation In the 1970s and 1980s, Japanese companies set the world standard for innovation centered on operational effectiveness—that is, for simultaneously improving quality and lowering cost. This includes such things as total quality management, kaizen (continuous improvement), kanban (just-in-time inventory), lean production, cycle time reduction, best practices, benchmarking, and supplier partnerships, among oth- ers. In many industries, compared to Western competitors, Japanese companies were able to maintain a formidable competitive advantage on both cost and differentiation. Starting in the mid- to late 1980s, however, the gap in operational effectiveness with Western companies began to narrow. U.S. companies, in particular, began to imitate Japanese operational practices and pushed the productivity frontier even further ahead, especially through the use of information technology. (The produc- tivity frontier is the maximum buyer value that a company can deliver at a given cost, using the best available technologies, skills, management techniques, and pur- chased inputs.) Companies in other Asian countries also became able to imitate those opera- tional improvements involving widely applicable management techniques, process technologies, and input improvements. Furthermore, even when Japanese compa- nies developed more sophisticated product varieties, competitors within Japan and outside rapidly matched them, leading to competitive convergence. Firms came to realize that innovating on operational effectiveness and product upgrading alone does not lead to sustainable competitive advantage. New thinking on innovation was in order. The companies featured in the previ- ous chapters realized that the path to gaining sustainable competitive advantage was to push the entire organization to seek innovations that are not easily suscepti- ble to imitation by competitors. This rethinking enabled them to move away from products and services that were being turned into commodities and onto new path- ways to growth. What the Firms Have Done The case-study companies show that hard-to-imitate innovations come in different forms and shapes. Creating a new market is difficult to imitate for competitors (as SEJ has shown). So is establishing a trusting and loyal relationship with dealers (Lexus), making technological development a “black box” (Sharp), competing on the basis of invisible and nondimensional value (Keyence and Nintendo), and offer- ing an integrated system of components to riders (Shimano). Whatever form or shape it may take, companies can accrue clear-cut benefits from hard-to-imitate innovation. At a minimum, it leads to operational improve- ment and product upgrading. Beyond that, it can • reduce the risk of a company falling into the commodity trap, • raise willingness to pay on the part of customers, and • direct companies onto a new pathway of growth. JKE2_ch07.qxd 6/6/06 11:15 AM Page 85 Hirotaka Takeuchi 85 Combining these, it can help companies achieve superior profitability. Thus, a sur- vey of the case-study firms shows that all achieved above-industry profitability lev- els over the five years 1999–2003. SEJ’s average ROIC was 16.1% points higher than for the Japanese convenience store industry as a whole. For Shimano’s Bicycle Components Division, it was 16.3% points higher than the bicycle components industry average.1 Hard-to-Imitate Innovations Are Based on Tacit Knowledge Innovation is a highly subjective process of personal and organizational self- renewal, requiring the personal commitment of employees as well as their identifi- cation with the company and its mission. It is not simply about putting together diverse bits of data and information. Innovations are hard to imitate when they are based on tacit knowledge rather than on explicit knowledge. Explicit knowledge is expressed in words and num- bers, and thus is easily communicated and shared in the form of data, formulas, or codified procedures. This makes it an easy target for imitation. Tacit knowledge, on the other hand, is highly personal and hard to formalize, and thus is difficult to codify, communicate, or share. Subjective insights, intu- itions, and hunches fall into this category. In addition, tacit knowledge is deeply rooted in an individual’s action and experience. It encompasses the kind of infor- mal and hard-to-pin-down skills captured in the term “know-how.” A master craftsperson acts instinctively, almost automatically, and is often unable to artic- ulate the scientific or technical principles behind the skill. Tacit knowledge is also deeply rooted in the ideals, beliefs, values, and emotions an individual embraces. The Japanese approach to innovation is more heavily based on tacit knowl- edge than on explicit knowledge. It should be noted, however, that an over- reliance on tacit knowledge can prevent the SECI process from taking place. The interaction of tacit and explicit knowledge is necessary for new knowledge to be created. As an example, at Shimano, top management accumulates tacit knowledge from direct experience. The tradition dates to when Yozo Shimano mountain- biked down Mount Tamalpais in a business suit, completely staining the trousers with mud. This hands-on experience gave him valuable insights into a completely new type of bike that defied the conventional wisdom of how a bike is supposed to perform. 1. The primary profitability index used is return on invested capital (ROIC). Company-wide data were compiled for single-business companies such as SEJ. Divisional data were compiled for a division of multiple-business companies, such as the Bicycle Component Division of Shi- mano. Due to the proprietary nature of the dataset, disclosure of our findings is only for win- ners of the Porter Prize—SEJ and Shimano’s Bicycle Component Division (1998–2002 data.) The Porter Prize is an annual award bestowed on companies or divisions that have achieved above-industry profitability over an extended period and implemented strategies that are different from other competitors. It was started in 2001 and is organized by Hitot- subashi University Graduate School of International Corporate Strategy. The award is named for Professor Michael E. Porter of Harvard University, a leading strategy expert. More details on the Porter Prize can be found at http://www.porterprize/org/. JKE2_ch07.qxd 6/6/06 11:15 AM Page 86 86 Creating the Dynamics of Hard-to-Imitate Innovation Rethinking the Innovation Process Innovation is a management