Just about every company will tell you that innovation is one of its highest priorities. How can you tell if the company truly means it, or if it's mostly wishful thinking or marketing hype? We can see if the company is putting its money where its mouth is by measuring how much it spends on innovation relative to other companies in its industry. But, this is much easier said than done. There is no consensus as to which budget line items to include in measuring innovation spending. So, as often happens, people will try to use a well defined, concrete line item as a proxy for estimating the measurement they are really after.
Research and development is often used as such a proxy for innovation. Many assume that since both R&D and innovation are supposed to translate into competitive advantage, looking at how much companies spend on R&D equates to how serious they are about innovation. But, as Michael Schrage, a Research Fellow in MIT’s Center for Digital Business wrote in an FT article in November of 2005:
“Any policymaker, chief executive or innovation champion who relies on R&D intensity and R&D budgets as a meaningful or usable metric to assess global competitiveness virtually guarantees shoddy analysis and distorted decisions. Few things reveal less about a company's ability to innovate cost-effectively than its R&D budget. Just ask General Motors. No company in the world has spent more on R&D over the past 25 years. Yet, somehow, GM's market share has declined.”
“The simple fact,” he later added, “is that R&D spending - whether in euros, dollars or as a percentage of sales - is an input, not a measure of efficiency, effectiveness or productivity. Ingenuity, invention and innovation are rarely functions of budgetary investment.”
The report starts out by asking a few edgy questions: “The quest for innovation has long been a faith-based initiative: Spend more, and profit will come. Are you losing out to nimbler competitors? On the high-cost end of globalization? Is your sales growth flattening? Are your margins narrowing? Want to prove to Wall Street you’re serious about growth? Don’t worry; just increase the R&D budget. New products or services will emerge that make the difference - won’t they?”
“Not so fast,” it continues. “The results of our recent study of the Booz Allen Hamilton Global Innovation 1000 - the 1,000 publicly held companies from around the world that spent the most on research and development in 2004 - may provoke a crisis of faith.” It then proceeds to succinctly articulate their overriding conclusion:
“Money doesn’t buy results. There is no relationship between R&D spending and the primary measures of economic or corporate success, such as growth, enterprise profitability, and shareholder return.” It later elaborates:
“The myth that higher R&D spend translates into competitive advantage has been around for decades, but it appears to be particularly strong now. . . . Perhaps this belief is a holdover from the past. When products were simpler, industrial processes less mature, and competition less fierce, companies could make new products and be reasonably certain that their customers would buy them. The R&D, manufacturing, marketing, and sales silos could do their jobs independently with little imperative to manage across departmental boundaries.”
“We no longer live in that world. Shorter product life cycles have led to an ever-faster flow of new offerings. Customer demands for special features have generated enormous complexity. In turn, these factors have increased the competitive value of a fast and effective innovation engine. Yet of all the core functions of most companies, innovation may be managed with the least consistency and discipline.”
So, if money doesn’t necessarily buy corporate success, what does? The Booz team provides insightful answers to this question in their 2010 Global Innovation 1000 study, How the Top Innovators keep Winning.
“Why are some companies able to consistently conceive of, create, and bring to market innovative and profitable new products and services while so many others struggle?,” the 2010 report starts out asking. “It isn’t the amount of money they spend on research and development. After all, our annual Global Innovation 1000 study has shown time and again that there is no statistically significant relationship between financial performance and innovation spending, in terms of either total R&D dollars or R&D as a percentage of revenues.”
“What matters instead is the particular combination of talent, knowledge, team structures, tools, and processes - the capabilities - that successful companies put together to enable their innovation efforts, and thus create products and services they can successfully take to market. This year’s edition of the Global Innovation 1000, our sixth, analyzes the capabilities systems that the most successful innovators have assembled to execute their distinct innovation strategies, and the ways they have aligned those capabilities with their overall business strategies. Innovators that have achieved this state of coherence, we have found, consistently and significantly outperform their rivals on several financial measures.”
The 2010 report is built around a concrete hypothesis: “Companies that can craft a tightly focused set of innovation capabilities in line with their particular innovation strategy - and then align them with other enterprise-wide capabilities and their overall business strategy - will get a better return on the resources they invest in innovation.”
The report identifies four key stages in what they call the R&D value chain: ideation, project selection, product development and commercialization. It asked the 1000 companies they surveyed to identify which of these capabilities were most important in achieving success at innovation.
“. . . all the successful companies depended on a common set of critical innovation capabilities. These include the ability to gain insights into customer needs and to understand the potential relevance of emerging technologies at the ideation stage, to engage actively with customers to prove the validity of concepts during product development, and to work with pilot users to roll out products carefully during commercialization.”
They further analyzed the capabilities of the top 25 percent performers: “The most successful companies, we found, are those that focus on a particular, narrow set of common and distinct capabilities that enable them to better execute their chosen strategy.”
Thus, in the end, it is all about good general management and focus, capabilities that are much harder to measure than R&D spending, except by looking at a company’s financial performance over several years.
This finding about the commercialization stage is particularly intriguing:
“Focusing on a systematic set of capabilities means that companies must first choose the capabilities that matter most to their particular innovation strategy, and then execute them well. Our analysis suggests, however, that although most companies are relatively strong at executing critical capabilities within the areas of ideation, project selection, and product development, they underperform at the commercialization stage.”
“Executives agree consistently that there are three customer- and market-oriented capabilities that matter most: Gathering customer insights during the ideation stage, assessing market potential during the selection stage, and engaging with customers during the development stage. Yet when it comes to the capabilities needed to introduce their products into the market, there is no single one consistently named as a strength. Clearly, there is a substantial gap between most companies’ ability to create innovative new products and their ability to successfully take them to market.”
“In commercialization, the top performers stand out by executing well in two critical areas: global product launches and pilot-user selection and rollout. This should come as no surprise, given that commercialization capabilities are by nature the most cross-functional, and are tied tightly to several other capabilities companies need to succeed in the marketplace, including manufacturing, logistics, sales, and marketing.”
If we look at the four stages of the R&D or innovation value chain - ideation, project selection, product development and commercialization, - the first three are the more classic industrial age capabilities that good R&D companies focus on. Good commercialization means that, - regardless of how good your ideas are, how good your technologies, products and services look in the lab, or how excited everyone is about them in the company’s headquarters, - success is only defined by winning in the marketplace. That’s where the game is played.
Based on my personal experience, I am not at all surprised that being good at commercializing new ideas, products and services is what separates the top performers from everyone else. You cannot successfully manage marketplace success in a silo, as you can R&D and other back-office functions. You have to work outside-in and focus on your clients and the opportunities and/or problems being addressed, not just on your products or internal organization. Market-facing innovation, in particular, requires a cross-functional, multi-disciplinary approach which is difficult for many companies to successfully pull off.
Finally, another fallacy in relying on R&D spending as a measure of innovation is that, for the most part, only industrial companies have labs and plants and measure R&D expenses as explicit line items in their budgets. If you look at the Innovation Top 20 List in Exhibit 9 of the 2010 Booz report, you will notice that they are all industrial companies in pharmaceuticals, automobiles and computing and electronics. That’s because this is really not a Top Innovators list, but rather a list of the Top R&D Spenders.
While the companies on the Booz list se are all excellent, compiling a top innovators list based only on their R&D spending leaves out companies like Apple, Google and Amazon, which most of us consider to be highly innovative. It also excludes companies in the service sector of the economy which we think of as innovation leaders in their industries, such as Walmart, American Express and jetBlue.
These companies are primarily focused on user-oriented, market-facing innovation. While they all have excellent technology capabilities, these capabilities are embedded in their human capital as well as in their information and communications infrastructures. You don’t quite need to have labs full of test tubes, or factories with lots of machines to be among the world’s leaders in innovation.
Let me finish with the concluding observations in the Booz report:
“The virtue of thinking about innovation in terms of capabilities and the capabilities systems that enable companies to be coherent is that it provides a specific way of talking about what companies need to focus on to translate their innovation efforts into sustained success . . . Companies, by focusing on the capabilities they believe are critical differentiating factors in their efforts to conceive of, develop, and sell their product in their particular markets - on what they need to do better than competitors - can gain the coherence necessary to outperform. And that, of course, is what innovation — and corporate strategy — is really all about.”