LEGO announced its annual results for 2014 on February 25, and it was another stellar year for the Danish toymaker. Sales grew 13%, and profits grew 15%. As great as that is, that’s actually a decline from their seven-year average. Since 2007, the company’s sales have been growing at an average rate of 20% and profits at 37% per year. The company has now tripled its sales since 2008, and increased its profits by over 7100% in the same period.
And they’re not cutting prices to boost growth – the company is stunningly profitable. As any parent can tell you, LEGO bricks are expensive – LEGO pays less than a dollar per pound for its raw material, ABS plastic, and sells its finished bricks for over fifty dollars per pound. Yet even with this price premium, the sets fly off the shelves.
What’s even more striking about LEGO’s performance is that they compete in a very tough market. The patent for the LEGO brick expired in the 1980s. Making plastic bricks is relatively cheap and easy to do – anyone can get into the business. Walk into any toy store and you’ll see dozens of competitive toys with near-identical bricks at a fraction of the price. And kids are fickle customers – they’re willing to try any cool new toy. So what’s the secret to the company’s success? What can we learn from a company that was near bankruptcy just a decade ago, and is now one of the most successful companies in the world?
What saved LEGO is the mastery of an innovation approach that is different than the typical strategies you read about in the business press. LEGO has learned through some very hard lessons that you don’t have to choose between “inside the box” innovation—low-risk low-reward incremental improvements—and “outside the box” innovation—high-risk high-reward disruptive innovation. There’s a third strategy that has delivered both low risk and high rewards to the company. But it’s not an easy or obvious strategy – LEGO almost went bankrupt before it discovered this third approach.
LEGO in the 1990s: Innovating Inside the Box
Back in the mid-90s, LEGO’s sales had flattened, profits were suffering, and the company was struggling. The market for play was changing – kids were turning to video games and sales of traditional toys were declining. LEGO responded the way many companies respond to threats and changes – it did more of the same. It tripled the number of new toys it brought to market each year, from 109 in 1994 to 347 in 1998. As a result, complexity in the factories exploded and costs skyrocketed. But all these new boxes of bricks didn’t sway the market – there was only so much demand for LEGO and only so many feet of shelf space in toy stores. Sales stayed flat and profits dropped, producing the first loss in company history in 1998.
Innovating Outside the Box: Disruptive Innovation
What would you do if you were LEGO in 1998? Creating more boxes of bricks wasn’t working; it was clear that something new and different was needed. LEGO decided that it needed to reach higher – the company needed to pursue market-wrenching disruptive innovations and revolutionize the play experience. Having watched profits decline over the five years before 1998 as it created one sustaining innovation after another, LEGO believed disruption was its only remaining option. Kids were moving to new kinds of play. The era of the brick was over.
So, the second way LEGO responded to a changing world was by innovating outside the box, away from the brick. Beginning in 1999, it produced a stream of diverse new products, some big and some small, most of which weren’t brick-based and didn’t include construction. It created LEGO Explore, electronic toys for toddlers, for example. It commissioned TV shows, offered jewelry and clothing, and spent massive amounts developing a virtual brick-building simulation called LEGO Digital Designer. It built theme parks and after-school learning centers. And, even when it made brick-based construction toys, it challenged its designers to try new things. Taking a direction it had never pursued before, it produced lines of toys around two blockbuster movie franchises, Star Wars and Harry Potter.
The result was disaster. Most of the experiments failed. The theme parks, which eventually became popular, drained cash in their early years. And the Star Wars and Harry Potter toy lines, because of the volatility of their demand, almost bankrupted LEGO. While the four Star Wars and Harry Potter movies released between 1999 and 2002 boosted sales of the LEGO toys tied to those films, there were no new movies from either franchise in 2003 or the first half of 2004. Sales of movie-related toys dropped dramatically.
It was as if the tide had gone out and exposed a broad expanse of rocky beach. The 1999-2002 surge in sales from movie-related toys had hidden a harsh reality: LEGO had virtually nothing else to drive sales and profits, despite all the disruptive innovation it had tried. Most of its other toy lines were generating massive losses. So dire was the situation in 2003 that a LEGO executive, Jørgen Vig Knudstorp, told his colleagues, “We’re on a burning platform. We’re running out of cash … [and] we likely won’t survive.”
LEGO’s brush with bankruptcy revealed the dark side of disruption, the side its fervent advocates don’t discuss much. No one doubted that radical change had become more common and that every company constantly had to search for opportunities to change its world. Yet, like all other innovation, disruption failed more often than it succeeded. For sustaining innovation, failure usually didn’t much matter. But it did for disruptive innovation. Yes, disruption’s potential rewards were great, but so was the risk, and the bigger and more radical the change, the more dangerous the potential consequences, as LEGO discovered. Disruption was pushing it into bankruptcy.
LEGO’s experience raises a critical question. Is big, fundamental, risky change the only effective response to a competitive threat? Businesses invest in radical innovation because conventional wisdom tells them that have no other choice! But is that actually true?
This binary thinking about sustaining vs. disruptive innovation can be dangerous. If leaders believe they have only one real option for dealing with competitive threats or market shifts, they’ll feel compelled to exercise that option in spite of the risk and uncertain consequences that come with it – and, often, in spite of their best judgment as well.
LEGO’s success over the past seven years is the result of a third innovation strategy. It is neither more of the same nor out of the box disruptive thinking. Instead, it’s a strategy of offering a family of complementary innovations around a core product. None of those complements are risky or difficult, but together the total package is irresistible to customers. LEGO is neither the first to use this strategy nor will they be the last. But there is no better example of a company that has used this approach superbly and profitably.
Innovating Around the Box: The third approach to innovation
What LEGO discovered in 2003 was that when it created new play experiences without bricks and construction, it confused the typical toy buyer and infuriated core LEGO fans. “You’ve lost your way,” the CEO of Toys R Us told LEGO. “We love this brand more than you do…. We want the brick.” Fans echoed the sentiment. It was time to return to the brick, but how?
When LEGO reviewed the wreckage of its experiments, it found amid the failures and disappointments one consistent success – a quirky construction toy called Bionicle. In many respects it was a typical LEGO toy – a set of plastic pieces that kids assembled into action figures. But Bionicle was different in an important way. Its boxes of plastic pieces were surrounded by a host of little complementary innovations – new packaging, comics, books, a video game, direct-to-video movies, and licensed merchandise – all wrapped around a rich story of heroes battling villains to save the world. None of these complementary innovations was risky or expensive and none would have succeeded by itself. But together, they made Bionicle irresistible to the target audience: boys between six and nine years old. Even better, LEGO owned, controlled, and profited from all of it, unlike what it got from its tie-ins with movies it didn’t own.
LEGO sold over 190 million of the Bionicle figures over the nine-year life of the toy. The profits from those sales were the only bright spot for the company during the crisis years of 2003 and 2004. Bionicle was literally the toy that saved LEGO. Over the next four years, LEGO re-organized to create multiple variations on what had made Bionicle so successful – core characters surrounded by low-risk complementary innovations, brought to market through internal and external partners, and all tied together by the glue of an engaging story.
In a global market with intense competition, no barriers to entry, fickle customers, and no patent protection, this third innovation approach has produced LEGO’s seven-year run of 20% annual sales growth and 37% annual profit growth. Its success demonstrates that multiple low-risk innovations that support a core product – innovating around the box, if you will – can be as powerful as big radical change.
And LEGO used this new approach to perfection in 2014 with The LEGO Movie. There was nothing particularly risky or difficult about a CGI kids movie, but to ensure the movie’s success they hired a producer-director team that had created “Cloudy with a Chance of Meatballs” and other successful movies. At the launch of The LEGO Movie, over a dozen LEGO kits were available that allowed kids to play out scenes from the movie. Happy Meal toys from McDonalds, books, merchandise, and web applications all deepened kids involvement with the story. The kits – those $50-per-pound boxes of plastic – flew off the shelves.
And next year looks equally bright for the company. One of the big toys that LEGO has launched in 2015 is the Bionicle line. Demand for the toy has been high since it was taken off the market six years ago. The company has created another rich story line, and will certainly accompany the toy with books, games, movies, and many other little innovations that will make it irresistible once again.
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Have other companies used this approach? Can other companies adopt it successfully? The answer is yes and yes. Amazon used it to beat Sony in the e-reader market. GoPro used it to succeed in the action camera market. And Disney is using it masterfully today to expand its sales and profits. It’s not an easy strategy to execute – while the innovation risk is lower, the coordination and execution demands are much higher. Few companies pull it off well. But those that do – like LEGO – have seen great results.