Innovation's Finance Problem: Why the Math Stacks Up, but Maybe Not Your Decisions

4 years ago
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“If a factory is torn down, but the rationality which produced it is left standing, then rationality will simply produce another factory…There’s so much talk about the system. And so little understanding.”

Robert Pirsig, Zen and the Art of Motorcycle Maintenance

There are a myriad of reasons why organisations fail to innovate. It could be that they’re too focussed on existing customers, and not chasing untapped opportunities. It could be that they’re simply not designing services and products that people want. Ultimately, it could just be that they don’t ‘get’ innovation, which is the organisational equivalent of calling someone ‘un-coachable’.

What we never consider are the impacts of the financial tools we use to value, analyse and calculate the likelihood of project success when deciding the investments we make. In short, your innovation problem might be the result of how you crunch the numbers.

Leveraging on your fixed and sunk costs becomes your stasis

In a conventional financial decision making context, when considering an initiative for the future, you take the future (or marginal) costs for your innovation initiative, subtract this from the cash you anticipate to make, and discount the balance in present value terms.  

Essentially, you are leveraging on your existing fixed and sunk costs to support your future innovation initiative. This might be OK if the resources needed for your future success are the same as your past.

However, innovation rarely works this way, and in an age services context, where we find ourselves needing new skills, processes and technology for future success, relying on your fixed and sunk costs invariably ties you to obsolete capabilities and tools. To avoid locking your organisation to a path of non-linear failure, it’s important to realise that when it comes to creating something new, marginal cost is, in truth, the full cost of your new initiative.

For example, a diversified incumbent provider might lament the high-cost of setting up a new home care business, so they decide instead to leverage on their existing systems, processes and capabilities. Meanwhile, a new company has the benefit of setting up a service with capabilities and technology without the added burden of legacy costs.

The new entrant’s competitive advantage is simply that it doesn’t have to choose or reconcile between the new and the old, and between marginal and full cost. It’s essentially why new entrants are generally faster and more nimble.

When present value stalls your future value

Building on the previous discussion, the process of discounting future cash flows in present tense terms creates an anti-innovation bias for organisations. As disruption theorist Clayton Christensen pointed out:

  • It assumes that the base case of not investing in the innovation—the do-nothing scenario—is that the viability of the company will persist indefinitely into the future regardless of whether the organisation innovates.
  • Predicting future cash flows from innovation are almost impossible to predict. Terminal value calculations, which assumes a business will grow at a set rate beyond the forecast period, are based on past year estimates. This has the effect of underestimating innovation’s impact, in turn favouring a do-nothing position.

Taken together, both points highlight the difficulties in forecasting innovation initiatives. What’s more, tools like discounted cash flow, present value and terminal value calculations are inherently biased towards staying the course, even when performance is already declining.  

Step and do not step in the river

The math and logic in our financial tools are sound, but this hits home the fact that, as industry innovation leaders, we need to be cognisant of their inherent biases for the status quo when it comes to innovative change and transformation.

After all, no one consciously chooses to use old capabilities and tools to meet future changes. Likewise, no one intentionally believes past financial performance can give accurate revenue forecasts on their innovation projects. Yet, this is what invariably happens.

International advisor on education in the arts, Sir Ken Robinson, aptly captured the interplay between numbers and the decisions we make by offering the following:

“The problem is the tail is starting to wag the dog here…If the stats come to dominate your judgement, then you’re not showing any judgement at all.”  

Simply put, innovation isn’t a lottery, but it still takes courage.

Merlin Kong is Head of innovAGEING, Australia’s national innovation network for the age services industry.

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