Closing the innovation value gap

In order to continue generating valuable intellectual assets and to stay competitive, companies must be committed to expenditure on innovation. The problem for many, however, is that they do not see the returns they expect from this commitment and that can cause trouble with investors.

By Jeff Maddox, CEO of CPA Global North America LLC

White Paper Contents

• Establishing Commitment
• Innovation's Role in Profitability
• Mixed Results
• Managing for Profit
• Tackling IP
• Customer Focused R&D
• Bridging the Gap

Spending in research and development (R&D) has increased steadily over the last decade. Research by the National Science Foundation shows that corporate R&D investment in the US, for example, has doubled since 1994, from US$97 billion in 1994 to US$194 billion in 2003, the latest year for which data are available.

The growth in R&D expenditures is likely to continue, if not accelerate. According to a survey of more than 900 senior executives conducted in late 2004 by BCG, a general management consulting firm, 74% of global companies planned to increase their spending on product, system or process innovation in 2005. Almost one third of the executives described the expected increase as significant.

Increased investment in innovation is a positive trend, reflecting management's efforts to achieve greater levels of growth and efficiency. In the face of increasingly challenging economic conditions most managers agree that spending on innovation is a competitive imperative, integral to their future success, if not survival. Nevertheless, good intentions do not make happy shareholders. The commitment to innovation must be matched by results in the form of profit and competitive advantage. Herein lies the problem. Despite increased levels of investment, the BCG study found that over half the managers were dissatisfied with the return on their innovation expenditures.

Without doubt, managing the innovation process is far from easy and while executives expect to lose money on some initiatives, the overall returns must be positive. All too frequently efforts to turn ideas into profits fall short of expectations, leading to a gap between the amount invested in innovation and the market value that is created as a result. In some cases this innovation value gap can be quite large, confiscating 35% or more of a firm's value.

Investing in R&D is only the first step towards creating market value. Companies need to improve the way they manage their innovation processes and spending if they are to derive significant value from their original expenditure. Ultimately, success depends on execution - without a well-defined execution programme even the best ideas will founder, leading to further management dissatisfaction and a widening of the innovation value gap.

Establishing Commitment

During the 1990s many companies embraced shareholder value creation as a corporate objective, speaking convincingly to investors, employees and analysts about their commitment to this financial goal. While sincere in intent, these pronouncements were often empty slogans in practice since few executives were familiar with the basic tenets of value-based management. Over time, however, the mismatch between what executives were telling stakeholders about value creation and their actual experience with it has diminished. Slogans have given way to better execution, as competition has forced managers to change their practices or fall by the wayside.

It now seems as if innovation is going through a similar sloganeering phase - confident external communications underpinned by uncertain internal execution. Public commitment to innovation abounds, yet privately executives point to numerous challenges in implementation: weak innovation, culture, organisational barriers, imprecise metrics and, ultimately, unsatisfactory results. To be sure, becoming an innovative company remains an elusive goal for many.

These execution deficiencies come at a difficult time. External factors are causing intense competitive and economic conditions which are particularly acute in some markets. In the technology industry, for instance, product life cycles are extremely short, entry barriers low and the emergence of disruptive technologies with protective IP seems to be a daily occurrence. Global competitors further exacerbate the situation, and many of these have outsourced their R&D facilities to India, China and other low cost countries. Competitors who successfully offshore their R&D greatly enhance their strategic options. They can conduct research at a cost advantage of 60% - 80% or, alternatively, increase their overall R&D capabilities fivefold while keeping costs at parity to the competition. Both options fundamentally change the terms of competition, and it is a phenomenon that is here to stay.

Companies that fail to address the twin challenges of execution and external forces do so at their peril. And no company, regardless of size or reputation, is immune. AT&T, an organisation previously considered a standard bearer of innovation and creativity, has struggled with profitability in recent years and will soon be acquired by SBC, a company it spun off in 1983. Similarly, Lucent Technologies, parent of Bell Labs and inventor of the transistor, now finds its future clouded and has - at the time of writing - stock price mired at around US$3.10 per share, down 90% from only five years ago. [Source: www.lucent.com/investor/StockChart.html, July 2005]

Clearly, survival in today's environment demands more than clever slogans. Companies must execute on their innovation processes if they are to generate the growth and profitability necessary to meet shareholder expectations. Ultimately, successful innovation is profitable innovation and sufficient net income must be generated to justify the R&D investment.

Innovation's Role in Profitability

The linkage between innovation and profitability is critical, yet one which is not well understood beyond general intuition. Managers believe innovation is important and are thus reluctant to cut back on R&D, but they are often at a loss to provide substantiation for this belief beyond gut feel. Unfortunately, the lack of precise innovation metrics can undermine execution strategies, lending support to the adage: if you do not measure it, you cannot manage it.

CPA Global conducted research on the R&D-toincome linkage for nine industries (chemicals, machinery, medical devices, electronics, semiconductors, drugs, precision instruments, computers, and software) involving 240 companies over a 10-year period. The industries chosen were those most dependent on innovation as measured by the percentage of a company's annual revenues invested in research and development - also known as R&D intensity, a frequently used indicator of a company's commitment to innovation. Each of the industries studied had an average R&D intensity of 3% or greater, ranging from 3% for machinery to 17% for software, drugs and semiconductors. The study addressed four questions:

• How well do R&D expenditures explain net income in innovation intensive industries?
• How well has management done in appropriating a return on its R&D investment? In other words, what has been its innovation ROI?
• What are the value creation opportunities for those who are able to improve their innovation ROI?
• What are the high potential changes that will best help management to realise missed value creation opportunities?

The importance of innovation to profitability need not be faith based. Quantifiable results exist. Figure 1 depicts the correlation between R&D and net income against R&D intensity for the nine industries in the study. As R&D intensity increases, the importance of R&D in determining net income in an industry also increases and does so predictably along a slope, which we refer to as the innovation Profit Curve. For example, the chemical industry has an average R&D intensity of 3.3%. An analysis of historical chemical industry profitability shows that 69% of the industry's net income is explained by the amount invested in R&D. By comparison, in the software industry, with a higher R&D intensity of 17%, 97% of historical net income can be explained by the level of R&D expenditure.

The fact that these innovation intensive industries demonstrate a link between R&D and net income is not overly surprising. What is surprising is the strength of the relationship, ranging from 52% of industry income being explained by R&D for semiconductor companies to 97% for software. This is not to say that R&D is the only factor in the commercialisation process. In between R&D and net income there are many activities required for profitable commercialisation: IP, manufacturing, distribution, marketing, sales, etc. But we can say that along the innovation value chain, R&D is clearly one of the most, if not the most, important activities.

While past results are no guarantee of future performance, an understanding of historical relationships provides management with insight into strategy options in the future. In the case of innovation dependent industries, the historical R&D to net income relationship poses a clear challenge to management: if the majority of your industry's net income can be explained by innovation, you would probably be well-served developing innovation management as a core competency.

Mixed Results

Although companies within an industry tend to have similar R&D intensity ratios, the returns from their innovation expenditure vary, sometimes widely. We can gain a better understanding of the range of these differences by reviewing each company's innovation ROI, defined as the ratio of net income to R&D expenditure. Innovation ROI provides a good indicator of how well companies within the same industry are appropriating a return on their R&D investment. Inter-industry comparisons of innovation ROI are not relevant.

The variability of innovation ROI within industries, shown in Figure 2, helps explain why many executives are dissatisfied with the return on their innovation investment. Regardless of industry, returns on innovation expenditures fluctuate widely, much more so than would be expected for companies competing in similar markets.

For example, the 33 companies in machinery (R&D intensity of 3%) had an innovation ROI ranging from 106% to 704% with a median of 270%. Alternatively, drugs, with the highest R&D intensity of 17%, had an innovation ROI range of 49% to 213%, with a median of 126%.

Differences in innovation ROI within an industry point directly to differences in how well companies manage and commercialise their ideas. When evaluating options for better execution, management should not limit its thinking by assuming all innovation activities need to be done in-house. Instead, opportunities exist to outsource functions to others who can perform the work more cost effectively. For instance, in the drug industry, declining research success rates andincreasing costs - it takes about 12 years and US$1 billion dollars to bring a drug to market - have caused some big drug makers to look to external sources of innovation, particularly for early stage development. Today about one third of the molecules in development in the drug industry originated in biotech companies. In-licensed molecules allow pharmaceuticals to focus more on what many think they do best: late-stage development and marketing.

Opportunity for improvement Failing to achieve even an average level of innovation ROI can be extraordinarily costly in terms of lost market value. Figure 3 examines the difference between actual and achievable performance or what we refer to as the innovation value gap. The combined market value of those companies falling below their

industry's median innovation ROI totals US$1,100 billion. If these underperformers found ways to improve their commercialisation processes to the median innovation ROI within their industries, their market value would increase 35% or US$400 billion.

And if management wanted to be more than average? Reaching third quartile innovation ROI within an industry, a standard certainly not out of the question as a corporate goal, results in an additional US$600 billion in market value. In total, better executing the ideas to profits process could contribute to a staggering US$1,000 billion in additional value - nearly double the current market value. The main lesson to be learned from this analysis is that there is a large opportunity for success if one pays attention to, and properly manages, the innovation investment. The important question is: what must management do to achieve performance improvement?

Managing For Profit

What separates a company with a high innovation ROI from an underachiever? There are no simple answers; however, our research indicates that there are levers within management's control that can have significant impact on the return achieved on innovation. These include: institutional alignment; idea management; and customer focused R&D.

Institutional alignment is getting everyone on the same page. This process starts with the CEO who establishes the company's commitment to innovation and the specific strategies, tactics and processes necessary for execution. Most importantly, the CEO must articulate the company's approach to overcoming internal barriers to success, particularly organisational structure.

Organisation structure can sometimes act to lessen a company's responsiveness to new market opportunities. All too often, R&D, IP and line management operate as separate functional silos within the organisation. Although silos offer important focus and operating efficiencies for existing business opportunities, they respond less well in rapidly changing markets and can serve to diminish the contribution each area makes to competitive advantage. Management can overcome organisational obstacles by organising product innovation and new business opportunities around product or project teams, rather than functional areas.

Hewlett Packard (HP) uses a flexible organisational structure to respond better to new business opportunities. HP forms five person, multi-disciplinary teams comprised of representatives from marketing, line management, R&D and IP. The multidisciplinary approach specifically recognises that innovation is a process that cuts across all functional areas, and must be managed that way to capture the full benefits.

HP takes special care to integrate its R&D, IP and business strategy at an early stage. With regard to IP, for instance, two types of lawyers are assigned to the multidisciplinary teams: transaction attorneys and development attorneys. The transaction attorneys work closely with marketing and assume responsibility for understanding IP in a competitive context: what does the competition have, where is the industry headed? Transaction attorneys must be business oriented, work well with line management and understand what drives profit. The patent development attorneys have a technology focus and work closely with R&D to identify and analyse new areas of opportunity. These attorneys are often former HP engineers who have joined the legal team to become patent agents. Some even go on to law school. HP has found that incorporating a broad combination of skills and disciplines gets IP and business strategy off to the right start, leading to better long term returns on its R&D investment.

Developing products that the market desires and is willing to pay for requires information technology to integrate R&D and IP seamlessly with product strategy. In the 1970s and 1980s manufacturing companies turned to information technology to help lower inventory costs, reduce manufacturing cycle time and improve customer service. These technologies (Just-in-Time, MRP, ERP) linked forecasted customer demand with production and distribution capacity so that the right products were delivered to the right customers at the right times at the lowest possible cost. This technology proved particularly effective in the automobile industry. Nissan, for instance, reduced inventory levels (raw material, work-inprocess and finished goods) from 12 days to 2.5 days after implementing such a system at their manufacturing plants.

Tackling IP

Inventory management techniques apply to intangible assets as well as to tangible assets, and the benefits can be equally dramatic. One leading global software company believed increasing its patent applications was key to improving its overall innovation strategy. To accomplish this goal, which amounted to a 50% increase over the

current patent application levels, management automated its idea management process, as depicted in Figure 4, to interconnect seamlessly and manage five key stages involved in IP development: idea creation, invention submission, evaluation, review and patent application.

Some companies chose to enhance the management of IP and ideas by using effective software applications, which record and store each of the five IP developmental stages. Similar to the HP multi-disciplinary teams, this company's idea generation involves participants from several areas of the organisation: IP, marketing, line management and R&D. These representatives participate in periodic brainstorming sessions, the results of which are documented and stored on-line through an invention submission module. Subject matter experts then review the submitted invention, providing technical commentary on feasibility and application to the marketplace. Finally, a multi-skilled team provides a final review on market potential and profitability, including a decision on whether to file for a patent.

Every business unit follows the idea management process. Additionally, each business must also follow other process guidelines that include:

• Minimum and maximum annual goals for ideas; maximum goals recognise there are limits to the company's capacity to review the ideas.
• Minimum annual goals for patent filings.
• Quantification of the idea inventory at each stage of the process; that is, at any point in time, management knows how many ideas are in the submission inventory, evaluation inventory and review inventory.
• Monthly reporting of objectives and results.
• Annual idea management budgeting.
• Incentive compensation for the achievement of idea goals.

Customer Focused R&D

In 2005 US corporations will probably invest over US$200 billion on R&D, with 80% of this amount spent on improving the processes and features of existing products. This apportionment of R&D expenditures means most innovation dollars go to satisfying the needs of current customers, those who management knows the most about, and not to the discovery of technological breakthroughs. Successful innovation, therefore, must be understood as a series of small steps rather than one great leap forward: it is not so much about product research as product development.

The most critical part of product development is spent understanding user needs and the only way to get this information is from the customers themselves. Although a basic tenet of marketing, customer research is not typically considered by scientists and engineers. Their imaginations often draw them into a Field of Dreams approach to R&D: "Build it and they will come". Not surprisingly, this approach typically leads to inefficient R&D expenditures and a lower innovation ROI.

Some companies have systematically integrated the customer into their research efforts. IBM, for instance, uses a Beta program to test products at customer sites. This allows them to further develop their product, while at the same time gaining important first-hand customer feedback. It is a win-win situation, as customers get to experience software before competitors can copy their innovations, and IBM can enhance their products before they are distributed to a wider audience.

Bridging the Gap

Given the importance attributed to innovation, why do so many executives experience shortcomings in their companies' ability to execute on this strategic priority? There is no one answer, but better institutional alignment, idea management and customer focused R&D all play a role in achieving better performance. By focusing on these areas, management takes the steps necessary to bridge the difficult divide between outward commitment and internal execution. In doing so, it also minimises the innovation value gap, leading to greater profitability and market value for shareholders.

About CPA Global

With clients in over 100 countries, CPA Global is a leading provider of legal outsourcing services and the world's top intellectual property (IP) management specialist. Founded in 1969, CPA Global provides lifecycle management services for intellectual property such as patent, design and trademark searching, watching, renewals, and portfolio strategy in over 181 jurisdictions. CPA Global is also a leader in the growing market for outsourced contract management and litigation support services, helping law firms and corporations to realize value by managing risk, cost and capacity. CPA Global employs over 1,000 people in 16 offices in 8 countries. www.cpaglobal.com