Innovation of Business

and the
Business of Innovation™
 
Justifying Innovation - Part 2

Economic and Attractiveness Proofs


Investment makes or breaks innovations, whether we develop products or businesses for internal or commercial applications.  As in Part 1 of this series, we’ll focus on R&D justifying development of a new product entering a crowded product pipeline.  The same issues must be faced in each stage of product development, and principles apply also to innovation of businesses.

Six Proofs

R&D enables better business decisions whether in industry, academia, or government.  Complex investment decisions require ranges of information… a business case, not just an R&D proposal.  If management interest can be triggered, they will initiate full due diligence.  Investment justification can be organized around six factors.
Technical Proof: (It works!) 
Control Proof: (We own it!) 
Safety Proof: (We are free of liability!) 
Value Proof: (Customers will want it!) 
Economic Proof: (A sufficient market exists!) 
Attractiveness Proof: (The company needs it!)

In Part 1, we investigated the first four proofs.  R&D proves hypotheses and tests innovations.  Control and safety proofs leverage legal expertise.  The value proof requires marketing.  Fortunately, a powerful and straightforward brainstorming process – “Needs-Benefits Analysis” – uses cross-functional knowledge to define value to key stakeholders, set project scope, and improve the relevance and potential of R&D results.

Economic Proof

The economic proof makes the business case – the revenues, costs, and returns on investment including brand equity and competitive advantage.  To connect to management, R&D needs to speak in language rarely used in science and engineering.

Revenues: Economic proofs require more thought than just estimating the number of purchases times the price per unit.  A few other factors are involved.

1. Market size: A market is a large and distinct group of customers with similar requirements.  A market segment is a piece of a market with common economic, application, and other characteristics.  The number of potential customers is a complex function of those who recognize their needs, those with needs still unaware of their needs, those who will develop needs in the future, those within range of the product’s distribution, and other situation-specific factors.  As potential customers move within the ranges of these factors, market size changes over time.
2. Market share: Each business serving the market owns some share of sales.  Customer loyalty and brand loyalty tend to preserve share.  Timing of new products, quality relative to competition, marketing innovations (e.g., Web 2.0 methods), and other factors make share a variable, not a given.
3. Market penetration: Penetration is the rate of change of market share.  A new product starts at zero share and gains share in ways dependent on the product, its marketing, and competitor activities.  Upgrade or replacement products face a share-within-a-share issue.  Total share depends on both rate of saturation of current share with the new product plus share gained from competitors.
4. Price: Pricing is a competitive strategy more dependent on competition, costs, and corporate goals than on value to customers.  Before competition, price can be set at will.  After competition, price will be influenced by needs to gain or protect market share.  Brand loyalty can enable higher prices for equivalent products, yet only to a degree.

Steps 1-3 estimate the number of units of product sold per year for some time in the future.  Multiply price by units sold to get gross revenues per year.  Estimates by R&D will be rough, yet consideration of these practical issues puts justification into management language.

5. Discounts: Everyone in the distribution chain must make a profit.  Both distributors and retailers take a cut.  Co-developers share revenues.  Inventors get royalties licensed intellectual property.
6. Cost of money: Money in hand is worth more than the same money five years from now because of inflation, interest, and loan fees.  “Opportunity loss” recognizes that money spent in one place can’t be spent other places, and the benefits of those other investments can’t be received.  Net present value (NPV) estimates the value of an investment as if all revenues were paid in one lump sum, adjusted for interest, inflation, and opportunity loss.
7. Internal markets: Direct use of products inside the business has value.  Leadership in a product area gives an edge both in being the first to get to use our own products and in knowing how to be the world’s best users.  Estimate the size and value of internal markets by the same methods used for external markets.
Also consider the dollar value of intangibles.  
8. First mover advantage: Getting to the market first may offer substantial advantage.  Defending a leadership position is easier that striving to take share from competitors.  Good timing can dramatically change the cost of tactical marketing, changing the profit picture.
9. Platforms: Reusable platforms enable rapid development of a range of products.  Justification should consider all of those potential markets.  
10. Brand: Market relationships are a business’ most valuable resource.  Products that improve those relationships deliver customer loyalty that builds corporate image and drives sales of other products.  Reputation impacts abilities to negotiate deals with suppliers, allies, distributors, and major customers.  All contribute to return on investment.  Show management how the new product will enhance brands at corporate and product line levels.

Talking to end users can uncover dramatic value propositions.  Texaco innovated a method to prevent pulling sand up when producing heavy oil.  Sand corroded pipes and valves costing one oil field $10-20 million per year in repairs, yet that was not the key justification.  Further questioning found a far larger benefit – losses of $50 million per year due to delayed production while wells waited for reworking to remove the sand.

Costs: Only an integrated business (with its outsourcing) can produce, deliver, and service products, so consider at least:  Product development (basic & applied R&D, design engineering), manufacturing (set-up, manufacturing, packaging), marketing / sales (direct sales force, advertising, PR, trade shows, demonstration projects, etc.), customer support, technical service, installation, training, and general and administration (opportunity losses, licensing, royalties).

Returns: Return on a specific investment (ROI) can be calculated based on the factors above.  In the big picture of R&D itself over time, annual ROI for innovation looks like an interest rate.  Management sees investment in innovation the same way that shareholders look at investment in the business.  What rate of return does innovation deliver?  How consistently?  How does that compare to other ways to spend money?

If management can get a better rate in the stock market, it’s awfully hard to justify funding of innovation.  If R&D doesn’t understand management’s position and speak the same language, proofs of ROI may seem inadequate.

 

Attractiveness Proof

R&D as a whole and each project must align on corporate focus.  Attractiveness connects each project to both the business and its management.  If management does not publish explicit criteria for successful proposals, then ask key decision makers for help in developing and ranking success factors.  Expect variation (e.g., tactical, short-term view vs strategic perspective).

Analysis organizes primary factors on a matrix with rankings for importance as perceived by decision makers.

Factors: Word success factors so that all are positive and highest scores are most desired.  That is, use “probability of success”, not “risk of failure.”  The top eight factors almost always dominate, so keep the list short, easy to see at a glance.
Ranking and weights: Use weighting to rank each factor by relative importance to decision makers.  Bigger numbers mean that the factor weighs more heavily in their minds.  To simplify comparisons between competing innovations, normalize total weight to sum to 1.0.
Ratings: Rate each project against each decision factor on a scale of 1-5, as decision makers would.  That is, look at projects from management perspectives, leaving developer bias out.
Score: Weight times rating equals the score for each factor.
Relative score:  Projects can be then prioritized by comparing the sum-of-scores for each project proposed during a budget cycle.

Success factors common to high tech businesses include:  strategic relevance, competitive impact, time to impact, capital requirements, potential reward, technical merit, probability of technical success, and probability of commercial success.  Some are make-or-break issues.  If “strategic relevance” is under 4 of 5, for instance, funding is unlikely no matter how other factors rate.  Monitor changes in the business, management, and the marketplace to focus on the most relevant attractiveness factors over time.

 

Innovation as Decision Maker

Understanding the reality of funding decisions helps developers justify investment in projects.  Knowledge gives R&D and the innovation team a measure of control in arenas otherwise yielded to management.

R&D can develop preliminary proofs.  Help from other members of innovation teams delivers more polished and thorough results.  Bringing pre-tested projects to management builds credibility.  Better yet, R&D achieves self-determination by demonstrating the integrity to make tough decisions on business factors, not just technical ones.

When R&D addresses such decisions, we being to think like corporate representatives as well as project advocates.  This mindset results in a culture change that reduces barriers between R&D and other parts of the organization. Over time, R&D will become better integrated with the larger innovation organization and will provide ever greater value.

The time for innovation is now, and it always will be.

 


 

18. "As we look ahead into the next century, leaders will be those who empower others." Bill Gates

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