How to measure innovation and ROI in a global world

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Change is the law of life. Those who look only to the past or present will undoubtedly miss the future.
John F. Kennedy

We can define Innovation in many different ways. The minimum requirement for innovation is that the innovative product, process, marketing method, or method of an organization must be new (or significantly improved) to the firm. How to measure innovation in a globalized world can be difficult and requires a precise definition of which metrics and indicators to follow. In this article, we will aim at providing a framework on what are the best practices for measuring innovation and ROI.
According to Peter Drucker[1], Innovation is “A change that creates a new dimension of performance.” Clayton Christensen[2] goes one step further and defines ” Disruptive Innovation as a process by which a product or service takes root initially in simple applications at the bottom of a market and then moves upmarket, eventually displacing established competitors[3].”
With a super-aging population, Japan is at the forefront of innovation. Robots and Telemedicine solutions are flourishing and are now entering our homes and hospitals. Somehow, Innovation is not only restricted to products and must be defined and understood before being measured.

WHAT ARE THE DIFFERENT TYPES OF INNOVATION?

We can broadly divide Innovation regarding the extent of the changes they will induce. Incremental Innovation refers to the continuous optimization of a product or process, and Radical or Breakthrough Innovation will produce a significant difference in the organization and to the market.
According to the “OSLO Manual Guidelines for Collecting, Reporting and Using Data on Innovation,” 4th Edition[4], Innovation can classically be divided into four different categories
  • Product innovation:
Here, we concentrate on the introduction of a good or service that is new or significantly improved regarding their characteristics or uses. New projects will be parts of the innovation portfolio
  • Process innovation;
Process innovation is the implementation of a new or significantly improved method of production or a new way of delivery. It includes significant changes in techniques, equipment, and software. Process innovation should have a substantial effect on production cost, product quality, or distribution.
  • Marketing innovation;
It corresponds to a new marketing strategy and new methods.  Marketing innovations align the company with the needs of the customers.
  • Organizational innovation;
Organizational innovation is implementing a new way of organizing the company’s Business practices in employment organization or external company’s relations. The ultimate goal of corporate change is to enhance business performance by reducing administrative and transaction costs or reduce supply costs.
The different types of innovation help illustrate the various ways that companies can innovate.  There are more ways to innovate, and the important thing is to find the type(s) that suit your company best and turn those into success.

IMPORTANCE OF INNOVATION IN THE BUSINESS WORLD

Innovation is one of the most important and most complex issues faced by organizations.
Each year, on average, companies invest 3.5% of their revenues[5] into innovations
More specific industries, such as Manufacturing, Pharmaceuticals, Biotechnology, and High-tech, will spend far higher percentages[6].
Percentage of R&D spending in 2018, by industry
Investments in Innovation is on an increasing pathway. According to the latest report from PwC, the spending on R&D increased by 11.4 percent in 2018 to reach $782 billion. In 2018, Amazon invested $22.6 billion, nearly 13 percent of its revenues. Companies cannot limit themselves to only being reactive to the changes brought forward by the competitors if they want to be and stay successful in an exceedingly open market. They need to be pro-active and initiate changes. Innovation is the key to success for organizations[7]. Investments in ‘science and innovation’ should not only be scientific research and development (R&D). ‘intangible investments’ also help to drive innovation. Implementing a culture of innovation within a company will benefit the company dynamic and will make it more resilient and plastic to the competition and evolution of the market.
Four of the many benefits encountered by innovative companies are the followings[8]
  • Growing the business: Sixty-six percent of respondents in The Deloitte Innovation Survey 2015 stated that innovation is essential for growth. Businesses that innovate can scale up and hire more employees. That allows them to take on more customers and grab a more significant share of the market. Innovation is a fantastic way for companies to grow.
  • Differentiate from Competitors: Most of the companies fit inside of a specific niche or industry. The problem is that the niches are rapidly overfilled.  To be able to differentiate from the competitors, Innovation is the path to follow. Innovation will bring something unique to the customers and will hopefully allow a company to stand out from the crowd.
  • Stay aligned with what the customers want: Customer needs are continually changing. One of the key strengths of a company is to be plastic and to be able to adapt to changes. Innovative companies can respond quickly to the evolution of the market. At the extreme range of the spectrum, innovative companies could even bring disruptive innovation to the market place and create from scratch new market needs.
  • Work with the best: In the early days of Microsoft, the company was famous for both its ability to innovate but also for having one of the best corporate cultures of innovation. For bright and innovative professionals, working in a company that cherishes innovation is the grail. Attracting talented and creative staff will often produce a positive feedback loop that will contribute to the hiring of even more talented people. This virtuous circle will, in return, accelerate the rate and quality of the innovations brought forward by the company. Ultimately, the company will be able to position itself as the leader in a specific market with a culture of meeting and exceeding the expectations of the customers. The innovation snowball will continue to roll and the revenues to grow.
Innovation is also a way for companies to deeply understand the needs of their customers and find solutions on how to address them. Changes should be used as a tool to satisfy customers and grow the company while leveraging on a transparent business model
Leadership teams need to understand the innovation trilogy presented below to implement innovation and leverage on it successfully.


WHY AND HOW TO MEASURE THE INNOVATION ROI

Measuring the components and results of innovation is of critical importance. As for any business component and as said by Business guru Peter Drucker, “If you cannot measure it, you cannot manage it.” Henry Chesbrough, executive director of the Center for Open Innovation at the University of California-Berkeley, invented the term “Open Innovation[9]” and considered that “The traditional accounting measure of R&D only tracks internal spending. In a world of open innovation, it is increasingly inadequate as a measure of innovation ability”.
Finding the rights tools and metrics that will allow precise quantification of innovation is somehow a complicated process. It needs to be tailored to the specific needs and culture of a company. According to a survey conducted by McKinsey, more than 70 percent of the corporate leaders consider innovation as one of their top three priorities, but only 22 percent set innovation performance metrics[10]. In companies that actively pursue change, 16% of the companies that are actively seeking innovation do not use any innovation metrics to measure their efforts.
The company “Innovation Leader” surveyed more than 200 companies regarding the metrics they use to measure how successful their innovation strategy[11]. The top five indicators are:
  • Revenue generated by new products (69 percent)
  • Projects in the pipeline (66.5 percent)
  • Stage-gate process, i.e., projects moving from one stage to the next (57.5 percent)
  • P&L Impact or other financial implications (57 percent)
  • Number of ideas generated (44.5 percent)
Let us analyze the best process to reliably quantify the whole process and not only the results of innovation on the P&L.
Defining a global dashboard to measure innovation
Considering the breadth of innovation activities, using a single metric, or a few can be misleading. Using a tailored innovation dashboard allows management to monitor the company’s performance along with different aspects and stages of innovation. The Dashboard should include both qualitative and quantitative indicators and should cover the various stages of the innovation cycle. The exact number of metrics depends on the project and company. A good rule of thumb is to use between eight to twelve parameters. Too many measures can be overwhelming and confusing. A practical approach is first to identify all the steps considered necessary. Test with measuring a few critical metrics and then expand gradually.

INNOVATION INDICATORS AND HOW TO INTEGRATE THEM IN A COHERENT DASHBOARD [12]

The measure of innovation and ROI are linked to specific challenges. In a world where open innovation is now the norm, R&D investments become more challenging to evaluate precisely. No standard set of metrics applies to all companies[13].
The Innovation Cycle divides into three phases, which will have to be measured using different metrics.
  • Learning stage: Test of the assumptions regarding new ideas and target market.
  • Innovation stage: Put in practice new and validated ideas.
  • Impact stage: Impacts of innovation activities are measured with business or products metrics
Due to the progressive nature of innovation, different indicators will have to be used depending on the stage of implementation of the Innovation project. The various metrics will encompass the three stages of the innovation process. It will allow to precisely quantify the economic outputs but also the inputs and the quality of the innovation process within a company.
  • INPUT METRICS: They will be used to measure the investments and correspond to the “I” in the ROI ratio. The classical ones could be:
    • R&D Spending as a percentage of sales[14]: This measure will relate the spending output to the revenues generated by the project. Interestingly, this measure can be calculated at the product level, business unit level, or company level. It will allow comparing the levels of spending on other projects and to benchmark against the competition. This ratio will help the management in balancing the allocation of financial resources among different business units, or different types of projects
    • Number of employees in R&D
    • Number of ideas generated
    • Number of patent applications
    • Total of R&D Spending
  • PROCESS METRICS: These metrics will allow analyzing the four key factors to be followed during the implementation stage of the innovation, such as Time Management, the Innovation pipeline, the new projects’ performance projection, and staffing against the plan.
    • Time management can be quantified using the Time to Market, tracking the progress and reach of the Milestones, and the Time to break-even.
    • The Innovation pipeline is assessed by evaluating the number of projects in the pipeline, the number of ideas that will ultimately get funded, the sum of the projected Net Present Value (NPV) of the projects in the pipeline. Regarding Open-Innovation, once can measure the flow of ideas from outside the company. This is known as the Procter&Gamble approach.
    • Assessing the New Projects’ Performance Projection is also a commonly used metrics to analyze the Projected vs. Actual Performance of Innovation, defining the New Product forecast accuracy and the number of projects that ultimately meet the planned targets.
  • OUTPUT METRICS focuses primarily on financials and on measuring output and productivity. They correspond to the “R” in the ROI ratio definition. A lot of them can be used to define what are the results of the company’s innovation process. Among them, we can cite the classical:
    • Return On Innovation Investment (ROII)
    • Return on Product development expenses (RoPDE)
    • R&D-to-product (RDP) conversion
    • New-products-to-margin (NPM) conversion
    • The number of new products launched. This metric, in particular, should be used with great caution as the number of products launched does not correlate with the quality of the innovation. Launching one great product will always be better than launching one hundred mediocre ones.
    • Percentage of revenue from new products on the bottom line.
    • Percentage of profit from New products
    • Rate of revenue growth from new products
    • Number of patents granted
    • Number of new products launched
One of the issues of the standard ROII is that it does not precisely measure how a company achieves a particular result. Modifying the DuPont Formula allows us to decompose and ultimately understand the results of an innovation strategy.
This split will help in understanding the different innovation strategies used by companies. Companies that do no take risks will have a high success rate, low magnitude, and high efficiency. A company will be able to achieve the same returns by compensating for lower success rates with higher efficiency or extent.
Leaders or board members who want to assess the company’s innovation capacity will find great value in analyzing this breakdown. This formula can also help in defining what strategies are more (or less) appropriate for a specific company.
  • McKinsey presented two metrics that allow managers to follow up on innovation performance using simple ratios[15].
    • The R&D-to-Product (RDP) conversion is calculated by taking the ratio of R&D spend (as a percentage of sales) to sales from new products. It allows organizations to track the efficacy with which R&D dollars translate into new-product sales.
    • The New-products-to-margin (NPM) conversion considers the ratio of gross margin percentage to sales from new products, which indicates the contribution that new-product sales make to margin uplift.
RDP and NPM can be applied to the portfolio level, where the net effect of individual project investments reflects the results.
  • Finally, the Score Card Institute recently proposed the use of a new indicator, RoPDE[16], for measuring the performance of product/service innovation and development.


To define the RoPDE’s thresholds, a comparison should be made to profitability metrics, such as Operating Income margin, EBIT, or EBITDA. RoPDE is a more robust measure than a traditional ROI approach and does NOT require any additional accounting systems or reports. RoPDE can serve at multiple levels and serves as a drill-down measure for Enterprise or Business Unit, as an operational measure of innovation performance for a product/service and as a measure on a single innovation project within a product/service area.
  • Combining the metrics into a coherent Dashboard
Measuring innovation is just like combining art and science, which is why this is tough to do. Do not overuse the parameters. 3M applied the rigid Six Sigma model to its creative process. Applied to R&D, Six Sigma attempts to turn the innovation process into a repeatable routine were a failure and impaired the renowned innovation culture of the company[17].

A simple initial innovation dashboard that covers most of the innovation cycle could be the following.
This Dashboard allows measuring the effectiveness of the three steps of the Innovation process and gives a perspective about the company innovation philosophy using the Dupont Modified ROII. Every company is unique regarding Innovation; this dashboard could be used as a point of entry and then amended to add or remove metrics more suited for the specific needs of the company. On top of that, this dashboard could be used as a follow up for the BoD.

HOW TO SUCCESSFULLY IMPLEMENT AN INNOVATION PROGRAM

Science and Innovation are driving forces for a whole company. Measuring innovation is not a straightforward process, and it combines art and science[18]. Many breakthrough innovations come by happy, unanticipated accident rather than by plan, but Six Sigma is all about planning, predicting, documenting, adjusting, and improving.
  • Time to market should never be the only critical factor to consider. Lag times between private R&D investments and commercialization yielding economic returns tend to be relatively short, ranging from around 1 to 3 years.
  • These are just a handful of metrics that an organization might choose to measure the success of its innovation program.  The significance of some metrics will change over time, depending on the stage reached by the innovation program[19].
  • For example, if an organization is implementing its first innovation program, it may place more emphasis on metrics around engagement and idea flow compared to an organization that has been engaged in Innovation for quite some time already.
  • The critical element is to be able to define what your key success factors are. These elements will then have to be measured to follow up on the achievements reached.
  • Innovation is a process that is best managed with a long-term perspective, not necessarily measured in long time increments (e.g., months, years) but rather in the completion of targeted goals. It requires separating the innovation process into three implementable stages: 1) identification of goals and exploration activities, 2) short term deliverables and 3) near term development.
  • The paradox of Disruptive innovation addressed in Clayton Christensen’s book “The innovator Dilemma” is that when introduced to the market, they will usually be inferior to the existing solution and will address a minuscule segment of the market. Using traditional metrics might not be the right path to follow. It brings us to the idea that metrics can evolve depending on their development stage and type of innovation.

Pick a man of genius, give him money, and let him alone.

Innovation should be part of the company culture. The whole company and not only the BOD must be willing to innovate and explore new avenues. Employees should be given opportunities and flexibility to explore new ideas and innovate. As stated by Harvard President James Bryant, innovation should also be given the freedom to try, fail, restart, and succeed. To him, the best approach to innovation was to “pick a man of genius, giving him money and living him alone.” Bill George – the CEO and board chairman of Medtronic wrote: “To be successful, companies must be led by leaders – the CEO, top executives and board of directors – who are profoundly and irrevocably committed to innovation as their path to success.” Just making innovation one of many priorities or passive support for change is the best way to ensure that their company will never become a great innovator[20].

CONCLUSION

Innovation is not a “one-size fits all process,” but according to a study conducted by PwC on the most innovative and successful companies, the six characteristics of High-Leverage innovators are[21]:
  1. The close alignment of innovation strategy with business strategy
  2. The Company-wide cultural support of innovation,
  3. The fact that the leadership is intimately involved with the innovation program,
  4. Basing change on direct insights from end-users,
  5. The rigorous control of project selection early in the innovation process and finally and most importantly
  6. The ability to integrate all these characteristics altogether.
The process can be long and cumbersome to be successful as an innovative company. Still, with patience and a global will from all the components of the company, Innovation is the critical component to integrate into a company. Measuring Innovation and ROI is essential to ensure success and understand the value of the innovation efforts. With time and patience, the many benefits of innovation will appear both in the marketplace but also in the company culture. At Hashi Consulting, we aim at helping you identify the products and processes that will drive innovation within your company.

[1] https://www.managementstudyguide.com/innovation-according-to-peter-drucker.htm

[2] http://www.claytonchristensen.com/key-concepts/

[3] https://www.insidehighered.com/digital-learning/blogs/online-education-was-disru

[4] https://read.oecd-ilibrary.org/science-and-technology/oslo-manual-2018_9789264304604-en#page1

[5]http://www.crmsearch.com/innovationbudget.php?utm_source=feedburner&utm_medium=feed&utm_campaign=Feed%3A+crmsearch+%28CRMsearch.com+Feed%29

[6] https://www.strategyand.pwc.com/innovation1000#GlobalKeyFindingsTabs4|VisualTabs2

[7] Potecea, Valeriu & CEBUC, Georgiana. (2011). THE IMPORTANCE OF INNOVATION IN INTERNATIONAL BUSINESS. The Annals of the “Stefan Celmare” University of Suceava. Fascicle of The Faculty of Economics and Public Administration. 10. 157-161.

[8] https://www.inc.com/gordon-tredgold/4-reasons-why-you-need-to-focus-on-innovation.html

[9] Ullrich, André & Vladova, Gergana. (2016). Weighing the Pros and Cons of Engaging in Open Innovation. Technology Innovation Management Review. 6. 34-40. 10.22215/timreview/980.

[10] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/taking-the-measure-of-innovation

[11] https://www.innovationleader.com/benchmarking2018/

[12] Manoocheri, Gus. (2010). Measuring innovation: Challenges and best practices. California Journal of Operations Management. 8. 67-73

[13] https://chiefexecutive.net/examining-the-roi-of-rd/

[14] https://pdfs.semanticscholar.org/3999/c1f8e50283a6dfc8d7ff3b0f1fd1091d8235.pdf

[15] https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/taking-the-measure-of-innovation

[16] https://www.balancedscorecard.org/portals/0/pdf/howtomeasureinnovation.pdf

[17] https://www.inc.com/linkedin/don-peppers/downside-six-sigma-don-peppers.html

[18] https://www.fastcompany.com/3031788/how-to-measure-innovation-to-get-real-result

[19] https://impactinnovation.com/2017/07/24/measuring-roii/

[20] http://www.innovationmanagement.se/2015/10/19/10-best-board-practices-on-innovat

[21] https://www.strategyand.pwc.com/innovation1000#GlobalKeyFindingsTabs4|VisualTabs2



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