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Previous: Optimizing for innovation

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Innovation: What's your score?

By Jens-Olaf Berwig, Nathan Marston, Lauri Pukkinen, and Lothar Stein

4 September 2009

Can companies measure the impact of their innovation activities? Can they benchmark their performance on innovation against that of their peers? Can the long-term effects of innovation strategies be tracked systematically? Yes, yes, and yes. In fact, not only can companies objectively assess innovation; we believe they must. Only then will they know how to select the right strategies and execute them well.

Measuring innovation

Because innovation is the holy grail of 21st-century business, it is no surprise that many people have taken a stab at evaluating it. Typically, they focus on indicators regarding inputs (such as R&D spending) or outputs (such as number of patents filed). There are also a number of interview-based innovation assessments and rankings available.

However, these measures have some serious shortcomings. Many of them only provide a narrow view of innovation. Often, the role of successful execution or the evolution of innovation performance over time are not taken into account, and data availability remains a challenge, in particular when comparing between companies. Finally—and perhaps most important—most metrics fail to connect innovation to company performance. Furthermore, interview-based company assessments are often skewed by halo effects ¹ from other areas, such as brand image or specific products.

As a result, we propose a new way to measure innovation. It focuses on objective outcomes, is based upon publicly available data, takes a broad look at innovation, and assesses the power of good ideas over time. We are still in the early stages of applying this new concept, but the results so far have been very promising.

How do we do it? We start with McKinsey’s proprietary granularity of growth database, which contains revenue streams from more than 750 companies across 16 sectors, though the analysis could be applied to any company for which sufficient granular data is available. In many cases, we go beyond the company level by looking at data across business segments, geographies, or some other narrower gauge. We then dissect data, looking for revenue growth attributable to innovation.

To do that, we first look for revenues generated by new reporting segments within a company—either from new initiatives or from acquisitions that go beyond mere geographic expansion. This is what we call market creation (if the segment is new to the world) or market entry (if it is only new to the company). We also take into account revenues from acquisitions that lead to new products and activities, even if they are not broken out as a new reporting segment.

We then compare the revenue growth of the company to the overall market and attribute any out-performance to the company’s ability to innovate. We assume that if the company consistently outgrows the market over a significant period of time (say, five to seven years), it must be introducing new products, processes, or business models that allow it to perform better than its peers. By making these calculations over time, we eliminate the influence of short-term effects such as marketing campaigns or price cuts.

This analysis generates an innovation performance score (IPS), expressed as a percentage, which shows the compound annual growth rate for a specified period that can be attributed to innovation. For instance, in the television industry, top innovators LG, Samsung, and Sharp generated scores well above other well-known innovators. LG generated a score of 13.7 percent from 1999 to 2007, because of early and significant investments in liquid crystal display (LCD) panels, an aggressive culture, and flexibility in adapting to evolving trends.

Perhaps not surprisingly, our research so far (which covers 80 companies, mainly in consumer packaged goods, pharmaceuticals, and consumer electronics) reveals considerable differences in scores among industries. TV and telephone makers, for instance, generally score higher than beer and drug companies. We also found that business model innovation tended to generate bigger gains than product or process innovation, probably because the innovation was harder for competitors to copy and the advantage was therefore longer lasting.

In addition, for the companies we looked at, a strong IPS appears to be a reliable indicator of a company’s stock market performance. We found a relatively strong correlation (with R2 of ~0.3) ² between a company’s IPS and its total return to shareholders (TRS). This correlation is stronger than it is for other growth-related metrics—a result that suggests that innovation performance measured in IPS is strongly correlated with overall company performance.

IPS adds a new perspective to the usual discussions around innovation and growth. Choosing the right markets in which to play is critical for any company’s strategy.³ But so is figuring out how to use innovation to grow faster than competitors. That excess growth is what the IPS measures.

The lessons of IPS

Our research has revealed several insights that cut across industries and are valid throughout the business cycle.

1. We have found that strong innovators do consistently well. They achieve their success in large part (70 percent to 80 percent of IPS ⁴) by outperforming the markets that they are already in rather than by entering or creating new segments.

2, Looking at past economic downturns, such as the burst of the dot-com bubble, we found that top innovators continued to outperform their peers even during the tough times. Their agility and capacity to innovate made it easier for them to cope with the challenges. Indeed, many important products have been introduced during times of crisis. To paraphrase President Obama adviser Rahm Emanuel, these companies didn’t let a good crisis go to waste.

3. The roles of different types of innovation—product, process, and business model ⁵ — are especially interesting. While the relative importance of each will vary across industries, we found that a significant degree of business model innovation seems to be necessary for superior innovation impact.

4. There may be an optimum level of innovation. Companies with the lowest innovation performance clearly suffered in the market. However the players that have the very highest IPS aren’t always rewarded proportionally in terms of higher TRS. So, while companies must make sure that they are well-positioned in the innovation game, it’s unclear whether being a distant leader pays off in higher TRS. We are still working on this intriguing question.

Assessing corporate innovation performance

All this is interesting, but how can it be applied? We have found that understanding the details of innovation performance can help companies determine where they stand in innovation impact vis-á-vis their competition by comparing their respective innovation scores and asking the following questions: Who are the most successful innovators in my industry? Which are the most promising new markets? Are we overlooking any challengers? What has changed in our relative performance in the recent years and why?

Second, IPS can be applied internally to compare innovation performance across business units. That makes it possible to identify best practices that can be rolled out across the company and to allocate resources more productively. Taken together, this analysis provides a valuable fact base for determining future strategic options.

No question, Understanding he full dynamics of innovation performance will require additional study. But we believe that better metrics will enable companies to adjust strategies and investments and ultimately to improve their competitiveness.

¹ The halo effect is the tendency to make specific evaluations based upon other impressions related to, for example, brand, financial performance, and stock market performance. See Phil Rosenzweig, The Halo Effect:…and the Eight Other Business Delusions That Deceive Managers, New York: Free Press, 2007.

² r2 is the proportion of variance explained by a regression.

³ For more, see The Granularity of Growth by McKinsey partners Patrick Viguerie, Sven Smit, and Mehrdad Baghai (Hoboken, NJ: Wiley, 2008).

⁴ Based on a sample of about 40 companies.

⁵ A product innovation is the introduction of a good or service that is new or significantly improved with respect to its characteristics or intended uses; A process innovation is the implementation of a new or significantly improved production or delivery method; Business innovation is the creation of substantial new value for customers and the firm by creatively changing one or more dimensions of the business system, Sawhney, M. et al (2006): The 12 different ways for companies to innovate, MITSloan Management Review, vol. 47, No. 3, p. 3.

Comment [35]

Agree? Disagree? Let us know what you think. Please include your full name with your comment. Comments may be edited.

On first pass, this looks a highly simplistic approach to measuring innovation. Generally speaking, the major profits in any innovation come quite late in its cycle, when it has been adopted by its largest group of customers and the bulk of product development and marketing investment has been made. Any profits/revenues based measurement is therefore likely to be lagging the initial innovation by some years.

Very importantly, innovation is not principally about ideas, it is about execution. As some of your contributors have said, and I have found with many of my clients, there is no shortage of ideas inside companies. Human beings are innovative by nature. What is lacking is the process, senior level support and reward systems for turning these ideas into revenue-generating products and services.

For an excellent overview of innovation in business, read ‘Dealing with Darwin’ by Geoffrey A. Moore, 2006, Capstone Press.

Posted 23 September 2009, 13:30 by Chris Turner
It seems you may not know about Business Innovation Analysis, which offers unique solutions. It originated, at least partly, at McKinsey – but has been brought to fruition at Technology Matters www.techmatt.com

Posted 19 September 2009, 08:39 by Chris Farrell
Company A seeks to measure innovation. Company B seeks to measure profitability in order tro acquire company A and become more “innovative”.

The organic nature of innvoative processes does not offer too many controls for measurement, especially since some corporations are anti-change.

Posted 15 September 2009, 00:39 by Stephen Ozoigbo
Interesting article. I am working with a Biotech project on innovation, and am interacting with Indian firms for this. There are a lot of country specific issues which figure and might make surveys less useful. In India, many firms are having issues with having their accounts computerized, while in Europe we see IP backed securities. Therefore, the way the regions operate are very different just because the base of South East Asia is still far lower than that of developed world. So, country specificities should also be a consideration.

Posted 11 September 2009, 23:44 by Kapil
A complex discussion regarding a very crucial business discipline. True innovation can only be measured from a customer/market outside in approach over time. Revenue and profit should be higher for those companies that really innovate as customers flock to their offerings and are willing to pay more for the perceived value of their products.

A significant ingredient in this equation is TIME. People really pay for “perpetual innovation”……Mercedes, John Deere, IBM…..all companies that have done it over the long haul. They have innovation goodwill tailwind in their businesses…….a very powerful benefit that market leaders typically enjoy.

The challenge for many companies these days is maintaining the commitment to their businesses that creates this phenomenon. Larger companies with diverse P/L’s tend to lose their long term commitment to specific business areas and can behave like internal hedge funds.

Examples…..I like Sony TV’s, John Deere tractors, Mathews bows, and Mercury outboard motors as they have earned their positions by making innovative products and services their religion!

Posted 10 September 2009, 11:32 by John MacQuarrie
Is there any way index innovation eco-system at cluster level?

Posted 10 September 2009, 10:42 by ranjan
This is an interesting model, but perhaps a bit circular and simplistic in that it argues that those companies with above average revenue growth will have above average financial returns. Maybe this is not that surprising. Also such a model by definition is a ‘rear-view’ model – it would be harder to use in a forward facing mode.

Another approach is to use patent filing data as a predictor of innovative activity. While patents do not automatically lead to profits, patent filing data is fairly robust (most innovators file patents to protect their developments) and globally available (most patent applications are published and captured in global databases within 18 months of patent filings). Although the reliability of patent data is thought to vary from industry to industry, it can be shown that at a macro level that it can provide interesting and probably otherwise unavailable information.

Mike Lloyd, Melbourne.

Posted 9 September 2009, 18:52 by Mike Lloyd
Thanks to everyone who has taken the time to comment on our article. Unfortunately, we can’t respond to every comment individually, but thought it might be helpful to group some themes together and try to provide our take.

Inside vs. outside
Several readers have expressed their views on the importance of understanding the root causes of great innovation within a company, be it communication, culture or capability. We agree this is important. Indeed, this inside-out view of innovation is the subject of ongoing work and research of some of our colleagues. The index is the natural outside-in complement to this work. In our work we wanted to have a measure that did not depend on deep access and discussion with a specific company, and one that was less prone to judgement calls on what is ‘good communication’ etc.

The index gives you a powerful way of identifying where to start, but not where to finish. I’ve no doubt the follow-up article is already being prepared on how to complete the swing.

Value of a purely economic measure
For practical measurement reasons, we have stuck with a purely economic measure of innovation. There is no doubt that innovation can have huge impacts on both society and environment – both positive and negative – but converting these impacts in to a comparative measure inevitably introduces a high degree of judgement on part of the observer, or requires a massively broad view of end-to-end impact. For both these reasons, we have stuck with the narrower view of economic impact. Clearly, if over time the market values companies that have a perceived positive impact on society and environment, then this will be reflected in the economics and hence the index

Correlation of innovation to outperformance
One reader has asked why we make the connection between sustained out-performance and innovation. While we have to acknowledge it is not a perfect correlation to ‘innovation’, we believe that it provides a powerful indicator of innovation for the following reasons:

- Firstly we have defined innovation to encompass all “novel activity with impact on company”, i.e. product, process, business model, rather than simply product. This means that any new approach can create value for the company and still be ‘innovation’ in our index. Consequently the index does cover both disruptive (e.g. new killer product) and incremental (say productivity improvements to processes)elements as they all have an impact on growth performance.

-Secondly, we assume that over a sustained time period it would be possible for competitors ultimately to replicate innovations in a fair marketplace, i.e. an innovative advantage will give superior returns vs competition for a time, but will not sustain indefinitely. Therefore, if a company is continually outperforming in its segment over time, there is a good chance that the company is continually leading the pack on new products/processes/models, i.e. they are more innovative. Sadly, this fair market assumption doesn’t always work. Where there are monopolistic or regulatory advantages that can be sustained over a long time period, then – like all benchmarking – you can end up with some odd results that demand further detailed examination to understand

- Thirdly, we deliberately strip out most obvious ways of ‘gaming’ the index, i.e. growth from M&A to gain synergy benefits or access to new geographies as well as the critical underlying growth rate of the segments we are looking at in each company. Just being in, or buying into fast growing segments doesn’t make a company innovative by our definition. It may mean they have superior strategy of course!

As with most benchmarks, the insight from the raw figures is interesting, but ultimately only directional. The real power of the index is to highlight relative position and outliers, which then creates a much more powerful set of insights on why the scores come out as they do

Thanks for your comments and for taking the time to read the article. We look forward to hearing more of your thoughts.

Jens, Nathan, Lauri and Lothar

Posted 9 September 2009, 16:28 by Jens-Olaf Berwig, Nathan Marston, Lauri Pukkinen, and Lothar Stein
thanks for a good article as such but I have some few comments, assumptions is at large on this article and it is quite difficult for me to foresee how you will accurately measure the success of this proposed mechanism.

What are the basis for the benchmarking and variables for predicting the success of this method.

I personally think that innovation is quite difficult to measure. The success of the company mostly depends on the support of the shareholder and the capacity of its leader to introduce such innovative ideas and its quality of handling the business that includes the manpower and the client itself. Each business has different technique and method of handling such important issue.

Posted 9 September 2009, 15:17 by Ana Rowena C. Biugos
Have you looked to see what, if any, apparent relationship exists between sector IPS and Topple Rate? Seems likely there might be one, something like “more innovation causes more market leadership churn.”

Also, please say more about “business model” change from an empirical stance – it seems you have a rich data set. Apart from Sawhney’s taxonomic approach, what kinds of business model change matter more?

Partial disclosure: I’m a big fan of the TPS.

Posted 9 September 2009, 12:25 by Jeff Morrow

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