How to Measure the ROI of Innovation
By J Schneider, VP, Strategy
Manufacturers across nearly every segment are obsessed with innovation. They pursue it relentlessly in an effort to stay ahead of today’s increasingly competitive marketplace. And they do it because they assume innovation is the surest way to achieve growth.
But the single-minded pursuit of innovation in the manufacturing comes at a literal cost — one that some companies fail to scrutinize as closely as they should. Too often, instead of looking critically at innovation through the lens of a single investment, R&D work is treated as a sunk or blended cost. And if innovation is a fixed cost, then it makes sense not to spend too much time critically measuring the ROI with benchmarks and metrics. But handling it this way can lead to a false sense of innovation success. And that means wasted resources and opportunity.
The unfortunate reality is that not all innovations pay off — even those that are well-received in the market. And if your innovations aren’t driving growth, then your money is better spent elsewhere. But you can’t know the health of your innovations without measuring their vitality first.
It’s time to start comprehensively assessing the ROI of your innovations. Here’s how.
Opportunity Cost and The Importance of Measuring the ROI of Innovation
Manufacturing companies often equate growth with innovation. However, while innovation is often an effective driver of growth, it’s not the only one. For example, manufacturers can also opt to expand the capacity of their existing plants, invest in demand creation and lead generation programs, drive existing products into new markets or pursue an add-on acquisition.
The choice to innovate is just that — a choice. A choice that comes at both a literal and a figurative cost. Not only is it expensive, but, like all the growth tactics listed above, innovation also carries with it an opportunity cost. Money spent innovating is money not spent on other growth strategies. With that in mind, it’s critical to verify that your innovation investment is yielding the expected return.
For example, let’s say you already sell a water valve for $1000 with a net profit of $220 per unit. In an effort to innovate, you produce a new, more efficient version of the valve that retails for $1200. Sounds pretty good, right? You now have a newer, better version of a product that also fetches a higher price.
However, a closer look reveals that your net profit on the new and improved valve is only $200 — $20 per unit less than you were making before. In this case, was the investment in innovation worth it? Unless you have reason to believe that the new valve will sell a significantly higher volume, the answer is no.
The only way to know for sure whether an innovation is money well spent or a waste of resources is to measure the ROI.
Before you can effectively measure the vitality of your firm’s innovation, you must clearly define what counts as an innovation in the manufacturing sector in the first place.
An innovation can take the form of a product (whether new or improved) or an add-on enhancement or service. But for your product or service to count as an innovation, it must provide new or improved value to your end-users. Let’s consider that water valve once more. If you take the same old valve and paint it blue, that’s not an innovation. To truly count as an innovation, you must make your product more effective in some way. It should be quieter, lighter, faster, more powerful and so on.
Note that an innovation doesn’t have to represent the first product or service of its kind within your industry (although it’s nice when that happens). But it does need to add new value to your own brand’s portfolio.
Finally, in order to fully define innovation, you must also consider how long a new product or service counts as an innovation. After a specific, predetermined time, a new innovation should cease to be considered an innovation. It should go on to be measured in the same way as any other product or service within your existing portfolio.
Aligning your organization around a common definition of innovation is key to managing metrics and making informed decisions.
How to Measure Innovation Vitality
Most companies measure the ROI of innovation using a single metric: total revenue divided by new product revenue. This measurement is important, but it doesn’t necessarily tell you the whole story. If you want to gain a full and accurate picture of your innovation program’s vitality, you need to put together a comprehensive set of innovation metrics. These measurements include:
- Gross or net profit as a percentage of total income: How much profit did the new innovation provide the firm? How is it doing as compared with the last product that held that spot?
- Market share as a percentage of total share: Did it go up or down as a result of innovation?
- Development costs: Are the new products easier and more cost-effective to produce and design? What percentage of company resources are needed to support the innovation?
- Innovation life cycle: Is your innovation shelf life short or long? Does it allow you to capture sales over a long period and continuously drive new customers to your product? Or are you constantly having to update new versions to meet a rapidly changing market?
- Incremental sales or new revenue vs. the prior year: How much new revenue did the firm earn as a result of an innovation? If a new product was a hit but failed to increase your firm’s overall revenue, it shouldn’t be considered a success.
Taken together, these metrics can give you a holistic view of your innovation program’s vitality. This critical feedback can guide you in determining how much to invest in innovation — and when other growth tactics are truly the more innovative move.