The Planning Fallacy and the Innovator’s Dilemma

August 1, 2012 Editor 0

Publishers note (FSG) Emerging Corporations in Africa should take note.

“You have to deliver $300 million in incremental growth by 2015,” the business unit head told the leader of his innovation team. “That’s less than 5 percent of our revenues, so that should be quite doable.”

While $300 million might sound like a ridiculously large number to small business owners or entrepreneurs, leaders in many global giants consider the amount a drop in the bucket. But anyone with near-term innovation targets with nine (or six or even four) digits in them should ensure they are familiar with the concept of “planning fallacy.”

The basic concept, first presented by Nobel Laureate Daniel Kahneman and his partner Amos Tversky in an influential 1979 paper, is that human beings are astonishingly bad at estimating how long it will take to complete tasks. As recounted in Kahneman’s recent book, Thinking, Fast and Slow, one study found that the typical homeowner expected their home improvement projects to cost about $19,000. The average actual cost? $39,000. Despite ample available information, 90 percent of high-speed railroad projects have missed budget and passenger estimates, with an average overestimation of passengers of about 100 percent and underestimation of budget of about 50 percent.

Entrepreneurs often underestimate how long it will take them to produce revenues, and wildly miss how much they will have to invest to commercialize their idea. As investor and pundit Guy Kawasaki notes, “As a rule of thumb, when I see a projection, I add one year to delivery time and multiply revenues by 0.1.”

The same challenge makes it difficult for companies to escape the innovator’s dilemma. To get through the corporate approval gauntlet you have to project big numbers. Then early results disappoint. Often projects or even divisions get shut down. And the company is staring at an even bigger growth gap. (Innosight cofounder Clayton Christensen memorably termed this the “growth-gap death spiral” in his 2003 book The Innovator’s Solution).

One way to avoid planning fallacy is to get — and use — data from comparable efforts. A simple starting point can be historical projects. Few companies look back to see how well past forecasts panned out, let alone seek to understand the markers that identify successful projects. Or consider looking at easily accessible public data. A few years ago I started a small database of disruptive companies, tracking revenue from day one. Consider the data for 10 of the fastest growing companies in recent history: Google, Netflix, eBay, Salesforce.com, Groupon, Zynga, LinkedIn, Facebook, Baidu, and Amazon.com. Remember, these are the best and fastest growing startups. (The number in parenthesis represents the number of companies in each year of the sample.)

How about new product introductions? There are certainly outliers. Apple’s iPad $10 billion in first-year revenue, for instance, would make it about the 250th biggest company in the United States, around the same size of Whole Foods, GameStop and Avon Products. But the basic pattern continues. Out of more than 11,000 consumer product launches in North America between 2008 and 2010, Nielsen found only 34 that were distinct, generated more than $25 million in first-year sales, maintained at least 90 percent of sales volume the next year, and had faster sales velocity than the category average. Only six of those 34 had two-year cumulative sales that exceeded $200 million. That’s only 0.055 percent of all launches.

If hitting your growth targets relies on a once in a lifetime success, it is at least worth considering the following three questions critically:

1. Are we following best in class approaches to ensure that we identify and accelerate our best ideas?
2. Do we need to increase the amount of resources (both human and financial) we are investing in growth?
3. Do we need to increase focus on acquisition as a growth strategy, at least as a way to “buy time” for organic efforts to develop?

It does turn out that uninvolved outsiders often offer more realistic (if somewhat negatively biased) projections than involved experts, so consider having select outsiders help to answer these questions to help balance the unrealistic inside view.

For innovators, careful consideration early helps to avoid death spirals later.

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Categories: Insights

Tags: 300 million, growth, innovator's dilemma, planning fallacy, revenue