Think R&D Expenditure is a Barometer of Innovation Success? Here’s What the CEO Entrepreneur Needs to Know

Overview: The first in a two-part series on innovation finance, this article outlines a new approach to the allocation of resources and the organization of innovation financing. The second article in the series, “Digital Solutions Are the Future of Innovation Financing, But There’s One Relic of the Past They Just Can’t Shake,” delves deeper to explain how a new budgeting framework and finance practices can support a transformation for future innovation success.

We’re in a period of incredible change in how you fund innovation, especially entrepreneurial innovation,
— Ethan Mollick, Professor of Management Science at the Wharton School, 2012

There is a belief among some in the C-Suite that R&D and innovation are two halves of a compatible and blissful whole. But, like a failed marriage, the relationship is more complicated. Recent data show that the connection between R&D spending and innovation, or lack thereof, has no statistical relationship with common growth metrics.

The 2016 “Global Innovation 1000” study by PwC Strategy& shows that the ten most innovative companies outperformed the top ten R&D spenders, which refutes traditional theory and past research studies. The study points to the rise of economic nationalism, an inward-looking, domestic, and isolationist approach to growth, as a movement that has thrown the world of innovation into uncertainty.

To illustrate, Apple and Alphabet continue to lead the most innovative list, followed by 3M and Tesla; however, the companies that spent the most on R&D were Volkswagen, Samson Electronics, and Amazon. Apple spent $8.1 billion on R&D, outperforming Volkswagen in innovation, which spent a colossal $13.2 billion.  3M spent just $1.8 billion on R&D and outperformed Samsung, which spent close to $13 billion.

Balancing Finance and Innovation

Finance and innovation have a tempestuous relationship, partly because one espouses discipline and rules and the other wants to transcend norms and boundaries. And, within this contentious union, the finance department is the gatekeeper of a modern company’s strategic direction – or at least its pecuniary resources.

Irrespective of whether an idea offers future market dominance conceptually, the immediate decision to pursue it is almost always made with the following financial question in mind: “How will this affect next quarter’s earnings?”

This is a nearsighted perspective, necessary when keeping to budgets but not conducive to long-term innovation activities. The perspective is a result of governance. CEOs are often pressured to please the shareholders in the short term rather than dig in and plan for a more secure and successful future.

In the finance department, CFOs struggle to commit to long-term innovation funding in this governance context as they study quarterly balance sheets and feel the heat. Compounding the limitations are antiquated legacy tools that have been in use for years to assess ongoing projects with ill-fitting metrics; the finance department has been a back-office function, but it needs to be brought into the modern digital age.

For a company to improve, change, and innovate over time, the finance department needs to be along for the ride. And since the finance department controls the resources necessary for innovation success, a formula that quantifies innovation efforts in a way that keeps both the visionaries and the shareholders happy could be the answer. Is it possible, then, for the risk-averse finance contingent to support the risk-oriented innovation pioneers?

Innovation – Who Does It and Who Pays for It?

When looking at operational spending, it’s easy to focus on cost-cutting and efficiency. After all, efficiency is what boosts the bottom line. It’s also a guarantee that if a cheaper raw material can be used or supply chain kinks can be ironed out, cost savings will boost earnings to the delight of analysts and investors.

But what’s not so easy is allocating resources to future improvements and innovations that have no tangibility or guarantee whatsoever. Planning for the future is always a thought, but how does it translate to the operating budget?

Brad Power, a management consultant in process innovation, and Steve Stanton, co-founder of FCB Partners, created a framework showing choices leaders have when it comes to allocating resources for innovation (Figure 1).

 Source:  Harvard Business Review , 2014

Power and Stanton illustrate that disruptive innovation takes autonomous units, incubators, and venture funding for experimentation. Innovation for the future requires collaboration from many directions. For example, public relations need to be addressed in the age of digital communications and mobile culture; HR management requires a whole new approach that focuses on the employee experience. Resources, then, must be allocated for the pursuit of new value networks, partners, and customers.

Power and Stanton also polled managers from various industries to find out how they were currently allocating resources for innovation. They found that most managers wanted to spend less on day-to-day operations and double the amount spent on big, disruptive innovations.

Leaders are clear that there is a need to invest in the future, but they are unclear as to where exactly to deposit those innovation funds. Who exactly is doing the innovating? Which department is responsible for the expenses?

The traditional method of innovation has always been R&D. While it is true that many Fortune 500 companies have found success while funding robust R&D programs to compete in industries dominated by physical products, conducting great R&D and achieving market success with inventions and technologies are two different things.

Artificial intelligence, for example, was invented back in 1992 when Yann Lecun, a computer scientist, built a computer chip called ANNA, a play on the term “artificial neural network.” But it wasn’t until recently that the technology was developed further, using deep neural networks to perform tasks that can be applied in today’s digital environment, such as facial recognition or language translation.

Thus, an invention is all well and good. To be profitable, however, it must have two additional components – customer value and a business model – and all three components need investment and management.

Innovation = invention + customer value + a business model.
— Tendayi Viki, 2016

Figure 2: R&D Spending Versus Financial Performance

 Source:  Strategy& PwC , 2016

Source: Strategy& PwC, 2016

Figure 2, loosely interpreted, shows that companies that invested more in R&D did not necessarily see better sales growth. If the traditional pairing of R&D investment and innovation is no longer a path to guaranteed innovation, what is?

A Separate Innovation Budget and New Partnerships

One of the biggest problems with not having an obvious innovation head is the use of funds for innovation projects can be a little disorganized.
— Michael Fitzgerald, Senior analyst, celent

Clay Christensen of Harvard Business School, Author of “The Innovator’s Dilemma," discusses disruption in the finance sector in an interview with Aria Lewis of Barclays Bank. The world-renowned innovative thinker explains disruption and, in some cases, how its effect is to slow growth in the short term. Christensen specifically explains how accounting cannot account for this slow growth because the discipline uses traditional metrics – yet this slowing is a necessary part of the long-term innovation process.

In many organizations, there is no clear or single department that “owns” innovation. This lack of ownership has led some companies to create a separate budget solely to fund innovation over the long term and, in some cases, to avoid pilfering from other business areas. A survey by Celent found that almost 70 percent of innovation program leaders said they allocated funds from the technology budget to cover innovation costs. A 2017 Harvey Nash / KPMG CIO Survey found that only around 30 percent of organizations are fostering innovation by funding innovation separately.

The big companies take innovation seriously and allocate appropriate resources to an independent department to achieve a long-term focus. If innovation is done piecemeal, by taking resources from other business areas, the limitations stifle creativity.

Go ahead and do the math on your current allocation; you’ll likely find that more than 90% of your resources are devoted to keeping the lights on.
— Michael fitzgerald, senior analyst, celent

A separate innovation budget protects long-term projects and frees those involved to pursue creative avenues.

According to Michael Fitzgerald, Senior Analyst at Celent, leading IT organizations manage their budgets with three “buckets”: operations, maintenance, and innovation. These firms try to reduce their spending on operations and maintenance from 90 to 60 percent so that the remaining 30 percent can go toward innovation.

Jeremiah Owyang, Founder of Crowd Companies in Silicon Valley, also points to the need for innovation leaders to have a dedicated budget to fund long-term innovation activities rather than having to tie programs with business metrics and ROI.

Startup Partnerships for New Ventures

As industry has transitioned into the digital age, firms are increasingly trying to innovate by creating fast, independent teams to directly address consumer needs. Startups dominate the world of agility and consumer-focused ventures. With agile business models and a customer-oriented approach, startups epitomize the new innovation model of Viki (2016).

Innovation = invention + customer value + a business model.

Moreover, the digital economy has allowed startups to rapidly expand and disrupt incumbents, and successful corporations are interacting with these startups to gain access to talent and ideas, and to gain insights into innovative culture.

Nestlé, for example, dedicates a multi-million-dollar fund to forging partnerships with startups. Stephanie Naegeli, the company’s Senior Global Digital Marketing Innovation Manager, stated that most corporations stall innovation because there is no budget for risky projects. A dedicated budget allows for more “bleeding-edge” initiatives. Which begs the question: have market leaders such as Nestlé benefited from innovation spending and partnership efforts?

In 2016, Nestlé announced a joint venture with R&R, a leading ice cream company based in the United Kingdom. The venture offers products, including those from Nestlé’s European frozen food business, in Europe, the Middle East (excluding Israel), Argentina, Australia, Brazil, the Philippines, and South Africa and chilled dairy business in the Philippines. Nestlé has gained R&R’s competitive manufacturing model and significant presence in retail.

More bleeding-edge projects for Nestlé include a new partnership with Rabobank and RocketSpace for the Terra Food + Agtech Accelerator. The venture will select and coach some of the most innovative and disruptive startups in the food and agricultural industry to create healthier and more sustainable food products.

PayPal is another example of a company forging partnerships and disrupting a major industry. It aced a power play opportunity and a partnership with Apple in July 2017 when PayPal became a payment option in Apple’s services. According to MarketWatch, the partnership will give consumers another payment option when transacting with Apple – an example of a “consumer-choice” approach.

Granted, Apple is arguably not a startup, but PayPal has that space covered, too. In 2017, PayPal announced that it had picked five young fintech startups for its incubation program in Chennai, India. While the startups get access to PayPal’s tech infrastructure, network, and team, PayPal gets a footing and exposure in the burgeoning Indian mobile payments market. Practically anything PayPal touches turns to gold, so their model is not a bad one to follow.

The point made here is that innovation should be a business department all its own, with a budget dedicated to resources, building partnerships, and taking risks. As with any opinion, however, there are dissenters.

Adi Gaskell of Innocentive suggests that a separate innovation department will be too isolated because the perspectives from individuals throughout an organization are required. She suggests an ambidextrous approach where separate innovation teams work alongside “business-as-usual” teams to maximize opportunities for creative input. Gaskell states that even with a separate innovation department, other flexible and temporary teams will be created on new projects. Her idea, then, is to use the “power center” that already exists in an organization –  the group or product that attracts the talent or that delivers profits – as the anchor for innovation activities.

Whatever model a company chooses, there will be struggles. But being aware of the pitfalls of each path is the first step to enabling change and improvement.

The second article in this two-part series, “Digital Solutions Are the Future of Innovation Financing, But There’s One Relic of the Past They Just Can’t Shake” explains how a new budgeting framework and finance practices can support a transformation for future innovation success. Specifically, the article suggests a new financial approach, better metrics, and solutions.

Call it the second marriage between innovation and finance.

Up next in Finance: Digital Solutions Are the Future of Innovation Financing, But There’s One Relic of the Past They Just Can’t Shake