Study on the Value of Innovation

What seems to be a pretty thorough study on how incremental and breakthrough innovations have impact on company value and sustained competitiveness has appeared in the Journal of Marketing. Rather than simply looking at top-line contributions they look at three key factors:

  1. Effect of breakthrough and incremental innovations on a firms’ normal profits
  2. Effect on “economic rents” (profits beyond what’s required to compensate for risk and time value of money)
  3. Effect on firm risk

They come to several conclusions that provide quantification of the issue of balancing incremental and breakthrough innovations. First they find that

…few firms can persistently produce a substantial flow of either breakthrough or incremental innovations. For example, only one firm, Procter & Gamble, had an above-average output of breakthrough innovations each year during our sample period.

 They go on to say:

To CEOs and other corporate officers, we note that incremental innovation keeps firms in business, but breakthrough innovation is the key to achieving sustained long-term growth. Our model allows managers to quantify the average NPV of a breakthrough innovation. Specifically, the estimated coefficient…is .000847, which means that, on average, each breakthrough innovation is associated with a 0.847% increase in the market value of the firm’s equity. This increase accounts for all costs (including a normal equity charge) and thus represents pure economic profit. For the typical firm in our sample with an average market value of equity of $4.9 bioonion, [the profits] associated with a single breakthrough innovation is approximately $4.2 million.

Notably, organizational slack is a significant determinant of breakthrough but not of incremental innovation. A possible explanation is that incremental innovation is more likely to be incorporated into a firm’s baseline investment strategy and less likely to depend on uncertain slack resources. In contrast, breakthrough innovation may be viewed as a more opportunistic activity to be undertaken only when greater slack resources are available.

Another possible explanation: Most companies try to make the most of employees’ time, thus taking slack out of the system. What do they get them to focus on? Mostly next-gen or incremental products. So that squeezes the slack out of the system that appears to be a pre-requisite for breakthrough innovation. (Start-ups are 100% focused on breakthrough in most cases, so their slack is entirely taken up by that. Same thing goes for skunkworks.)

This is a dense article with a lot of math in it, and none of the conclusions are particularly surprising. But the detailed quantification provides a perspective on innovation, particularly the balance between incremental and breakthrough innovations, that is valuable. Sure enough, you can’t rely on incremental innovation to keep you competitive - periodic injections of breakthrough innovation are required for survival.

Download it here