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