How do you assess the return on investment of your innovation efforts? While it is often assumed that innovation drives profit, in many companies that is not the case. There innovation is a cost center, that supports the organization’s learning. Instead of the revenue generator that is supposed to be the result of the organization’s exploration and learning efforts. How do you know where you stand?
Cost center or revenue driver?
Creating a return on investment from innovation effort is certainly possible. However, it requires a disciplined approach to innovation. Just launching projects, estimating the return of each, and hope for the best is certainly not going to get you there.
Such an undisciplined approach to innovation leads to failure and huge costs. The common response then, is to abandon all innovation activities. However, that is like throwing out the baby with the bath water. What is needed is a fair and insightful assessment of the cost and benefits.
Assess the portfolio
To be clear, it is counter productive to estimate the return of every single project and make your decisions based on that information. These types of financial metrics will not make your innovation efforts more efficient. Instead, they will kill them. Predicting the return of a single innovation project is a perilous and useless exercise, unless you have a properly function crystal ball that enables you to look into the future. There is simply no way to tell with any certainty, how much a project will return. Therefore, we are talking about the return of the entire portfolio of innovation activities.
While you cannot predict which of your bets will be right or wrong, you certainly can calculate the odds of the sum of your bets being off. It is like looking at the batting average in baseball. A player’s batting average will not tell you whether the next time on the plate he will hit a homerun or strike out. Yet, it is an informative number to assess the overall performance of the player. Te same holds for your innovation portfolio. The performance of the whole, will tell you how good you are at supporting winners and recovering the cost of the sum of your innovation efforts.
So, when we talk about return of investment, we need to look at the return of investment from a portfolio perspective.
The cost of innovation
To calculate the return on investment you need to calculate the investments made in all projects. Not just the few successful ones. All projects also include any failed and short-lived attempts.
You want to know all costs, as that is the total amount of investments made in all of these projects.
How do you know how much was spent on innovation? The innovation department – if there is even such a function – often has a budget to support projects. Do you just add up these costs?
Probably not. Especially for service firms, the most expensive line item for any innovation endeavor are the manhours spent on each project. Rarely, project budgets account for all these hours. It is not uncommon that budgets only cover other expenditures, excluding manhours altogether. To have proper insights in how much innovation activities costs the organization, you will have to take manhours into account. If not just for the fact that they represent opportunity costs.
All costs for all projects can add up to be an unexpected high amount. Don’t be surprised, if you find yourself spending between 1% to 5% of your revenues on innovation. Just know that firms like Google or Amazon spend close to 20% of their revenues on innovation. So having high expenditures is in essence a good thing.
The question is, how much do you get out of that investment?
Calculate the return
In a sense the returns are usually easier to track, as those typically entail just a few successful projects. These projects that were really successful, typically stand out, as those are on everyone’s mind.
However, don’t forget to account for all project that generated a return. Some may have just played even or perhaps produced a small loss. Still, that is better than no return at all.
We advise to include all revenues that benefit from any innovation effort. That leads to an overestimation of the return on investment, for sure. However, how to tell whether you would have won a particular project because of the proposed innovative approach, or how much that contributed to winning the contract? Being aware that counting and including all revenues will lead to a positive bias, is the best you can do. The alternatives are worse. There is simply no good way to tease out the contribution of innovation efforts to future revenue when it comes to service offerings. So we suggest to keep it simple, just add up all revenues of all services that made use of a new innovation offering in the past 3 years.
How far you go back is something that is up for discussion. One year seems too short – as it takes time to push innovations to practice. Five years seems too long and an overreach. By that time, there is nothing innovative anymore to the solution, it has become common practice.
Include other benefits
Besides looking at revenue and profits created, also account for more intangible benefits, such as impact on employee retention rates, employee satisfaction, firm reputation, etc. Innovation activities have the potential to significantly impact these metrics. While difficult to translate into a concrete return, it is valuable to keep track of these intangible benefits too. They matter.
Few successes have to pay for all
Once you do this calculation, you quickly will realize how difficult it is to create a return on investment from these innovation efforts. The very few successes have to pay for all the failed attempts. Without discipline, that balance is difficult to push into the positive for service firms, for the simple reason that even the very successful new service offerings have limited reach. You are never going to reach millions of customers, like product firms can.
It is therefore important that you:
- Make sure that you maximize the return of your success. Scaling is important, even when relative limited. You may never service millions of customers, however, if you can roll out a service 5 times instead of once, that will make a huge difference! If you hit gold, make sure you mine it to the max!
- Kill unfruitful attempts early. If you add up the money spent on innovation attempts, you probably find that early stage projects represent a large part of the costs involved. Having many innovation efforts to start with is good. That is something you want to keep. However, if these projects dwindle on for too long, that is not good. The better you are at vetting projects – that is identifying the most promising projects and project teams early- the higher the return on investment.
- Keep track of all your innovation projects, so you learn over time what the best indicators are that predict future success. Hint, it rarely is the market expectations as presented by the team. As mentioned above, those estimates are usually really far off. Most truly successful endeavors started surprisingly small.
Creating a return on investment
Creating a positive return from your innovation effort is certainly possible, also for service firms. However, it requires a very disciplined approach to innovation. Relying on the enthusiasm of your people and hoping for the best will not get you there. That is for sure.
P.S. Please share below the practices you use for keeping track your innovation costs and returns. We would love to know what you are using to get the best insights in the performance of your innovation portfolio.