This article was originally published on Strategic CFO 360, a Chief Executive Group community.
For CFOs, one of the murkiest decisions on a quarterly—and yearly—basis is what they plan to do about their organization’s innovation investments. To really get innovation correct organizations must consistently invest sums of money and time into their efforts—think DARPA’s decades-long push to build what became the Internet, or Nestle’s unorthodox bid to invent what became Nespresso. And for CFOs who prefer to allocate funds in less risky and projectible ways, the prospect of pumping money into long-term projects with no concrete ROI or firm end date naturally makes them nervous.
Unfortunately, this conventional thinking—which implicitly prioritizes incrementalism as the best way to tackle innovation—has led to an innovation standstill at many organizations. In fact, 35 percent of innovation growth projects never meet their original business case, according to Gartner. Despite putting significant resources into a variety of R&D and innovation efforts, many such organizations will one day come to the realization that they have failed to innovate in any meaningful way, and therefore have become obsolete.
What can be done to change this state of affairs, alter innovation financing strategy and empower companies to think about innovation beyond just near-term returns? Here are a few steps that CFOs and their surrounding teams can take both to rethink their approach to Innovation Ops, and to help turn it into the sustainable revenue-generating engine that it should be.
Rethink the Capital Investment Process
To maintain a uniform playing field, CFOs typically determine capital investments in innovation based on the same rubric by which they assess other investments. This includes valuation methods such as internal rate of return, net present value, hurdle rate, payback period and more. The result is an analysis of innovation projects on a per-project basis. In fact, we conducted a survey of 300 innovation executives at $1B+ revenue companies and found that 64% of companies funded innovation activities on a case-by-case basis.
The problem is that given the time and consistent investment required, measuring innovation investments and risks by these staple financial metrics, one project at a time, doesn’t make sense—except in the most predictable (and thus least innovative) of cases. Worse yet, R&D and innovation leaders may fabricate timelines and return rates to force an individual project to meet traditional finance metrics. The result is that many companies pass on the best innovation opportunities or woefully overpromise returns in the short-run.
To model innovation risk and return correctly, CFOs and finance teams need to engage in a broader conversation with R&D and innovation teams. It’s important to rethink and refocus how innovation bets are financed, managed and ultimately measured. This does not mean finance teams should get rid of all budgetary guardrails. Innovation budgets should be ring-fenced so they neither eat away too drastically at the company’s overall margins, nor infect the rest of the company with a sense of loosey-goosey budgeting rules. However, the guardrails and strategy behind them should be applied differently, given that managing innovation is different than business-as-usual.
CFOs and finance teams put high value on their roles as the gatekeepers of an organization’s financial health. It is easy for CFOs to get caught up in whether they are winning each investment battle, rather than focusing on whether they are ultimately winning the war. Yet innovation is a long-term game. With all but the most incremental innovation efforts, the strategic battleground is what matters most.
The truth is that many innovation projects won’t pan out as intended. This sounds like an uncomfortable truth, but it need not be—at least not for forward-thinking CFOs. The best practice is to work alongside R&D and innovation colleagues to plot a strategic course for the company’s innovation efforts. Successful investments manifest through a portfolio of projects designed to advance strategic initiatives, either directly by scoring a clear hit, or indirectly (as in the majority of cases) by further clarifying the playing field. Instead of taking fliers on risky bets, innovation-savvy CFOs can deploy strategic capital with the potential to generate significant growth leverage over time.
Focus on Portfolio Growth
As one might expect, investing strategically in innovation depends on having a strong innovation strategy in the first place. This is where many CFOs get stuck—even those who aspire to be more innovation-savvy. Too often, CFOs make the mistake of expecting the company’s overall growth plan to double as the innovation strategy.
Most exercises in corporate strategy focus on optimizing competitive opportunities in the current world, rather than possible future states. Classic strategy frameworks such as the SWOT or the “five forces” model tend to assume that a company will continue to compete in perpetuity within mostly the same markets, against more or less the same competitors. Yet when key innovations materialize, they carry outsized growth potential specifically because they break the conventional frame.
To get it right, savvy innovation leaders benefit from modern-day access to tremendous, science-based foresight. They use data and insights to develop a broad range of forward-looking scenarios, each based on mid- to long-term extrapolations of current trends in technology, business and society. These scenarios form the basis for mathematical modeling and growth simulations that seek to evaluate possible innovation investments in terms of a real options portfolio.
For example, a large insurance company we work with approached innovation by defining a limited set of innovation strategies, such as “Develop complementary healthy lifestyle technologies to lower total cost of patient care.” The expected ROI to the company is based on modelling the return on each strategy. Individual projects or initiatives proposed for investment are then categorized relative to one of the strategies and subject to a continuous staged review as part of that strategy’s portfolio.
For many, this approach may sound speculative and unproven, but scenario design and the associated modeling has been around since at least the 1980s. In fact, finance and related strategy teams have been the driving force behind some of the most successful modeling projects, including, most famously, Shell’s GameChanger unit. This means CFOs no longer have to take blind guesses into which bets will bear fruit, nor does each innovation project need to be a binary choice of success or failure. Instead, they can project a probabilistic view of future business benefits. This allows the company to make corresponding moves that either protect against the potential for negative outcomes, or double down on promising investments based on added visibility gained over time.
Strategic Boldness
Incrementalism may seem like the safest option for innovation investments, and in the short run, it usually is. However, as many companies hit fast-forward on their innovation efforts as a result of the Covid-19 pandemic, there is an acute possibility that while your organization is investing in incremental product gains or minor infrastructure tweaks, a new entrant (or an established competitor) is well on the way to delivering an innovation outcome that will put it light years ahead. This is a particularly difficult pill to swallow when you realize your company could have done the same if it had taken a strategic innovation approach from the beginning.
The good news is that your organization doesn’t have to be the one missing out. By building a new approach to innovation and following through with consistent, intentional investment and reporting, today’s CFOs can deliver more change and meaningful impact for their organizations than they ever have before.
Image by Dietmar Dorsch from Pixabay
