Episode #115 transcript

Does Innovation Create Value? Sexier isn’t always better

A question that I’m often asked is: “Marty, how do I manage and nurture innovation, without killing it?”. 

Innovation has become a very overused term, which can probably be found in the "bullsh!t bingo" dictionary, somewhere between "agility" and "strategic". The term has become so hackneyed that it can sometimes be almost meaningless. But before the word innovation is banished to the annals of management jargon, I want to explore the concept by stripping away some of the mystique, and giving you some practical guidelines for managing the innovation process in your organisation. 

I’m going to cover three key elements in this article: 

1. Getting a rudimentary understanding of innovation theory and the principles behind it

2. Looking at everyday innovations that need to be managed in every organisation and;

3. Considering the the balances and trade-offs in creating an innovative culture in your organisation

So what is innovation? 

At its most basic, it’s really anything that's perceived to be new, and this includes a lot of things, right? New ideas, new technologies, new products and services, new features in existing products, even new methods, procedures, and processes. Innovation is anything that improves the status quo. 

Now, if we go back to Clay Christensen's defining work, "The Innovator's Dilemma", he talks about two types of innovation. There's disruptive innovation and there's sustaining innovation. 

Disruptive innovations bring products to market in a way that hasn't been done before, and there are two subclasses of disruptive innovation. So the first is low-end disruption, and this basically satisfies an over-serviced customer. These things disrupt the current market with a cheaper product that substitutes for an existing product. Now, the genius here is delivering a product with sufficient quality and features to satisfy an existing need that a customer has, but at a lower price point. The classic example that Christensen uses here is the rise of mini mills in steel-making.

Case study

Mini mills could produce steel much more cheaply than traditional steel making processes. This lower quality steel disrupted the low end of the market first, which is why they're called ‘low-end disruptions’. In the case of mini mills, it was used in rebar, the steel used to strengthen concrete, and when mini mills first started producing this at a lower cost, the big steel companies didn't care. It was the low end of the market and it wasn't particularly profitable, it was only a really small percentage of what the big steel manufacturers sold. They thought, “Well, look, let's not spend time and energy fighting the mini mills. They can have that low end stuff.” So they ceded that market segment to the mini mills, but the mini mills improved their quality over time. Over about a 20 year period, mini mills improved the quality of their product, retaining the lean nature of their processes and capital intensity, and before the big players knew it, mini mills had captured steel bars and rods, and then they moved to producing structural steel. Each time the big steel companies ceded strategic ground, and they couldn't respond!

Eventually mini mills could produce steel across almost all categories at the same level of quality, much more cheaply. Now the most interesting thing is that until 1965, the major steel companies held 100% market share. Then, when the first mini mills emerged, they used scrap steel to give them a significant cost advantage in both capital and operating expenditure, and the initial quality concerns were addressed over the years. Mini mills basically chased traditional steel makers up the value chain. Now the major players in the steel market of the 20th century are all but gone. Bethlehem Steel was de-registered in 2003 and US Steel was removed from the S&P 500 index in 2014. 

The second type of disruptive innovation is new market disruption. These types of innovations deploy new technologies that deliver completely new categories of products. So rather than competing against existing products in established markets, new market disruptions compete against non-consumption. So in other words, whole new markets are created by the introduction of something that didn't previously exist. Now there's some obvious examples of market disruptions, for example, the automobile, which disrupted the horse and carriage. Then there's the entertainment industry where videotapes were disrupted by DVDs, which in turn were disrupted by streaming services brought in by companies like Netflix. And every so often you even see innovations that disrupt multiple product categories and markets. So smartphones, for example, when the iPhone was introduced in 2007, disrupted mobile phones, it disrupted portable GPS units and it disrupted digital cameras.

But not all innovation is disruptive. 

Sustaining innovations are incremental improvements to existing products, and they often come as a result of customer feedback or a perceived opportunity to improve on what's already there. Engineers, designers, sales and marketing people alike tend to have a steady stream of ideas for product enhancements, which would be classified as sustaining innovations. Sometimes products can do both over time. So the iPhone was clearly a market disruption, created a new market that never existed previously. But, since the initial disruption, the iPhone's introduced a range of sustaining innovations with each new release. So cameras with improved pixel counts, larger storage, seamless interface to iCloud backup services and so on. But what we see quite often is that sustaining innovations tend to overshoot the mark. Now remember when we were talking about low end disruption? That actually comes from providing cheaper options for an over-service market, and there comes a time when customers aren't prepared to pay any more for the incremental improvements that are built into a product that they're using. I am personally very aware of this and I'm not prepared to pay for new features that offer no real additional benefit to me. So in the case of the iPhone, I'm not the guy who lines up to get the latest model just because it has a 12 megapixel camera. 

Sometimes companies fall into the trap of feeling as though they need to add features to their products all the time. But, if they can't actually sell more units because the new features are so desirable, or if they can't charge more for those features, it's value destructive for the company to keep doing that. So why is it so hard for most established companies to innovate effectively? Well, there's a few really good reasons.

1. Fear of cannibalisation

A great example of this is Eastman Kodak. Kodak had digital camera technology very early on. In fact, the first digital camera was invented by Kodak in 1975. So why didn't they use it to disrupt the market? Because their cash cow was 35 millimetre film. This was highly profitable and virtually ubiquitous in the world of photography. Kodak figured that if they introduced it to market, it would just eat the profitability in their 35 millimetre film business, so they didn't develop it and bring it to market properly. 

But if we bring in new innovation, do we eat into our customer base? Important considerations that need to be weighed up, especially in the world of short-termism and annual bonus structures. 

2. Uncertainty 

If you have a potential market disruption, there's very little data to support it. Why? Because the market doesn't exist yet.

You can't size profits and market share when there's no comparable market. 

3. Investment rationality 

This is quite ironic. Larger organisations with established products generally have robust investment processes that demand certain financial hurdles are met before an investment can be made. They also have a capital rationing process because there are always more good ideas than there is money to fund them. So in the fight for capital, new ideas and innovations tend to lose out to established product suites that generate healthy returns and predictable profits. It's hard to get funding for high risk business cases that may or may not provide the return on investment a company seeks.

4. Materiality 

I ran into this a few times in my career, even in the energy sector where disruption was obvious and unavoidable. There's no doubt the world will transition, hopefully quickly, away from electricity generated from fossil fuels to cleaner sources. But when you're making a billion dollars in revenue from said, coal-fired power, and you get the choice between investing here and investing in new technologies that are more likely to bring in maybe a few million dollars of revenue, it's a really tough choice. And when the new investment really doesn't touch the sides in terms of materiality, it's tough to go after that. 

That's why the general rule of thumb on innovation is this; incumbent firms tend to win on sustaining innovations and new entrants are the ones that win on disruptive innovations. 

Now of course there are exceptions to this rule. Some industries like biotech, for example, rely heavily on innovation for their futures, and they spend an enormous amount of money on research and development. There are others like tech companies that have to continually innovate. And then there are far-sighted companies like 3M. Now, unlike Lisa Kudrow in Romy and Michele's High School Reunion, 3M actually DID invent Post-it Notes, and 3M reportedly spends around 6% of annual revenue on R&D; that's around $2 billion per annum.

Every day innovations

The types of innovation we've looked at so far are product innovations that are largely customer facing, but not all innovation is about the go-to market piece. The vast majority of industries are relatively boring, predictable, and stable. Harnessing innovation to improve these businesses is important, but it's not like inventing the iPhone or developing a vaccine for COVID-19 or revolutionising space travel. It's in this space that innovation can commonly be found in organisations right across the globe in virtually every industry and market. These are the every day innovations that improve the way work is done inside an organisation. And this is where I'm going to focus for the rest of the episode. We're talking about the type of innovation that improves internal performance. The changes that bring greater efficiency and productivity. The innovation that removes waste, rework, snags, and complexity. Improving methods that remove the barriers to value creation. It's basically the continuous improvement mantra of better, faster, cheaper. 

The market facing disruptive and sustaining innovations we looked at above were born from deliberate, organised, planned efforts to improve product position and market share. But when it comes to the innovations that improve the way you do things inside your organisation, it has to be an intrinsic part of your culture, which means that as a leader, you need to ensure that your people have the right attitude to innovation. Let's look at a few examples. We're largely talking about new ways of doing the same thing, and sometimes these come about by doing work in a more automated way. So there's been a real surge in the last several years of, for example, automated software to process accounts payable. And as this more mundane work is automated, people are redeployed to doing higher value work.

Another really striking example, is the technology we now have to monitor motorised machinery that we didn't have 10 years ago. Cheap, reliable detection units can be attached to an engine to monitor vibration and harmonic frequency resonance. These devices can detect early signs of wear and tear and isolate potential failure. And this is really important, because it enables maintenance to be dictated by the true condition of the asset rather than a one size fits all maintenance schedule. It both reduces maintenance costs and improves the asset reliability and useful life. 

Then there’s drone technology. There are literally hundreds of applications for this. A drone, when combined with GPS and high quality digital imagery, can be used to map and monitor infrastructure like bridges and dam walls, identifying potential slippages or structural deficiencies. 

Most importantly, innovation comes though from a whole swag of really unsexy but critical work, that improves the efficiency of everything you do. What it requires is for people to be constantly looking for bottlenecks and inefficiencies in their day-to-day work. And the reason this feeds into culture so intrinsically is that every individual needs to have a continuous improvement mindset. This not only needs to be created, but also consistently reinforced by every single leader to ensure that people aren't just accepting the status quo, but rather changing the things that simply don't make sense.

Does innovation create value?

I think it’s important to ask if it creates the most value when compared with your other options for optimising your resources. It's clear to see how customer facing innovation can not only create value, but can actually be critical to a firm's ongoing survival. Of course, this depends on the industry, the markets and competitive environment in which a business operates. But in order to work out the optimum balance between the planned work programme and the spontaneous innovation, there has to be a structured approach. The high level organisational strategy has to consider and explicitly define the areas of innovation in which it will invest. It has to determine how much focus and resource is going to be put into the constant renewal of products and services for the market in which it operates, and it has to be explicit about innovation as a value driver.

Now there's always going to be a balance between short-term returns, that come from established products and services, and long-term returns that enable a company to grow, evolve and remain competitive. So I want to finish by talking about the everyday innovations of continuous improvement. 

The better, faster, cheaper types of innovation, and this is more often the type of innovation that leaders at all levels are going to have to learn how to manage. With this type of innovation, you're dealing with one fundamental trade off. On one hand, you have the simplicity and clarity of intent around value creation that comes through your annual strategic planning process. There are clear plans for what needs to be done to create value. There's already approved spend on certain projects and initiatives. And these have the weight of the formal organisational planning processes, as well as the imprimatur of the organisation's senior leadership.

But to balance this, on the other hand, you have the ability and the need to achieve incremental ongoing improvements at the ground level, by tapping into the innovation opportunities that only your people on the ground can unlock. And you certainly don't want to stifle the value that can be created through these day-to-day innovations! 

The clarity, simplicity, and focus that comes with a planned approach to the work programme, can't be underestimated, but you also want to encourage your people to always look for new ways of doing things. If you want any innovation at all, you have to reward people for their efforts in finding better ways to do things. I'm not necessarily talking about financial rewards, but you have to make it clear that this is part of what your organisation wants to be.

I remember years ago, when I did some work for a large airline, they had "WANTED" posters all the way through their offices with a silhouette of a human saying “$50,000 REWARD”.

It was basically advertising that any employee, any staff member at all, who came up with an idea that was then implemented into the airline's operations, was going to receive a $50,000 bonus. This was a pretty big incentive to get people's creative juices flowing, But there has to be some sort of framework for dealing with all of the sorts of ideas that are going to be generated. In my experience of every hundred ideas that are generated, there will be about a dozen that are potentially value accretive, and of those there'll only be a handful that you're actually going to want to implement because they create enough value. That's why it's really important to put a governance framework around any continuous improvement activities.

Make sure that all ideas are actually brought to the table.

You want to generate as many ideas as you possibly can, but then you've got to be able to sort out the dogs from the fleas. So having a limited investment pool is quite important. What I would do is allocate a small amount of investment funding for the day to day innovations that people come up with and they have to compete for that money. Interestingly, once you give your people the freedom to think about how to improve the status quo, there'll be motivated because they'll realise they have the ability to make a real difference. The governance process here is so important in terms of keeping control of the value levers. You don't want to end up with an organisation that's fundamentally distracted from the main value game because of all the rats and mice ideas that are coming up and being pursued. Having explicit approval processes that your frontline and middle management can deploy enables rapid response to continuous improvement ideas, but it enables you to do it in a controlled manner where you're not bleeding value from the main game.

Ultimately, you need to make sure that you have reporting visibility right up to the highest level over what's actually being done and where. Now it's not hard to put forward a case for innovation. But just because the word innovation is sexy, doesn't mean it's your best option for unlocking value. Is a dollar earned from innovation better than a dollar earned from a less risky, lower cost alternative? You know, probably not. There are no simple answers to this, but the frame for leaders should be to focus on value creation. That's it, first and foremost, just value creation. Don't be swayed by the excitement that comes from a love affair with innovation. 

Ultimately, you want to make sure your people are spending their time on the most valuable things, not just on polishing knobs.

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