With the Surface Tablet, Microsoft Tackles the "Innovator's Dilemma"

Microsoft has become a behemoth known for its plodding pace of innovation and several blown efforts to exploit the huge lead it commands in the PC software business.

But its recent introduction of the Surface table device--which it plans to manufacture itself, through deals with subcontractors--represents a bold new effort to regain leadership in the fast-changing technology universe.

Microsoft has never built a computing device before, focusing instead on its core business of software powering machines built by other companies, such as Dell and Hewlett-Packard. By building the Surface in-house, Microsoft has generated some thorny questions with regard to its usual hardware partners. With consumers shifting rapidly from laptops and PCs to more-mobile tablets and smartphones, the Surface could end up competing with computers and even other tablets built by firms whose machines operate on Microsoft's software. Microsoft could also cannibalize sales of its forthcoming Windows 8 software, since it will power both the new Surface device and computers built by Microsoft partners.

It's an intriguing problem, characterized as the "innovator's dilemma" by Harvard Business School professor Clayton Christensen. This challenge arises when a dominant firm earning a big chunk of its revenue from an established business faces competition from new technology that may eventually make the old business obsolete. Yet junking the old business in order to embrace the new would mean a huge loss in sales and profit for the dominant firm, with no guarantee of similar margins from the new technology.

[Related: Apple Puts Retna Display on MacBook Air]

So big firms tend to try doing everything at once, holding onto their cash-cow business lines while forming "skunk works" meant to act like startups, or simply buying younger competitors. Yet they often end up outflanked by nimbler firms that have nothing to lose if the old technology dies.

Eastman Kodak is a prime example. Managers at Kodak knew in the 1970s that digital photography would someday displace the film products and cameras that had earned the firm a fortune for decades. Kodak even developed some of the earliest digital technology itself. Yet Kodak was such a dominant firm that had it endorsed digital photography early on, it could have jeopardized its core business and sacrificed a huge market advantage. So Kodak waited and tried to hedge its bets. The strategy failed: As digital photography caught on, Kodak lost more and more ground and couldn't keep up, finally declaring bankruptcy earlier this year.

Netflix CEO Reed Hastings tried to solve the innovator's dilemma at his firm last year, because he saw that Netflix's core business--shipping DVDs through the mail--was rapidly losing market share to online streaming, which many competitors could offer. Yet Netflix stumbled by trying to push its customers into streaming too aggressively, with many of them pushing back by quitting Netflix altogether. That comedown hacked about 75 percent off the value off of Netflix stock, demonstrating just how tricky the innovator's dilemma can be.

[See 4 lessons from Kodak's comedown.]

If any company can afford to take risks, it's Microsoft. Though not quite as rich as high-flying Apple, Microsoft has cash and short-term investments totaling nearly $60 billion, giving it a huge cushion to pad against missteps. With a relatively flat stock, many analysts feel Microsoft actually needs to take more risks, to enjoy some of the gains that accrue to hot technology companies instead of bumping along like a boring old bellwether. And with the tablet market growing at roughly 50 percent per year, Microsoft can scarcely afford to sit on the sidelines, as it has been.

Still, the Surface could easily end up submerged. Microsoft has underperformed with other consumer gadgets, such as the Zune music player and smartphones operating on Windows. Apple and competing tablets operating on Google's Android system already dominate the market. The worst outcome might be a Microsoft tablet that flops, but not before causing a destructive row with Microsoft partners still building PCs and laptops.

Those partners might not chuck Microsoft in favor of another software supplier, since there really aren't any other than Apple. But given the migration away from PCs, it would be a bad time for Microsoft to have a falling-out with partners. It's no Kodak, but Microsoft's not getting any younger, either.

Rick Newman is the author of Rebounders: How Winners Pivot From Setback To Success. Follow him on Twitter: @rickjnewman.

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