For many companies, innovation is a sprawling collection of initiatives, energetic but uncoordinated, and managed with vacillating strategies. For steady, above-average returns, firms need a balanced innovation portfolio and the ability to approach it as an integrated whole.
Outperforming firms typically allocate about 70% of their innovation resources to core offerings, 20% to adjacent efforts, and 10% to transformational initiatives. As it happens, returns from innovation investments tend to follow an inverse ratio, with 70% coming from the transformational realm.
Integrating strategy and execution via portfolio management
Uncertainty and rising levels of complexity make it impossible for companies to precisely determine the future. Recent research [Rita Gunther McGrath: The End of Competitive Advantage: How to Keep Your Strategy Moving as Fast as Your Business, Harvard Business Review Press (2013)] indicates that the notion of a sustainable competitive advantage is likely to be abandoned. Strategy today needs to align to a more fluid nature of business environments. It has to be flexible enough to adapt constantly to changing external and internal conditions, even though the aspiration to serve shareholders remains constant.
Key issues for companies to succeed in these highly dynamic and interconnected marketplaces are:
- Continuous integration of strategy development and refinement with execution to deliver tangible results. Many companies struggle, not because they haven’t any suitable strategy in place, but because they fail to translate it into adequate initiatives and integrate it across the organization.
- Allocation of scarce resources and capital across a range of initiatives to maximize value, while reducing risk for the entire company. Due to resource constraints, only 5-10% of project requests can actually be realized in practice.
Establishing a portfolio management system can address these issues. Portfolio management is positioned as a “transmission belt” between qualitative strategy definition and metrics-based project execution. It ensures that the critical requirements of SPM and OPM are integrated.
Like a more conventional strategy, portfolio management is best driven by a corporate center or project management office (PMO) and a supportive senior management. The hallmark of a portfolio management approach is the willingness to continuously assess and optimize the portfolio. Portfolio management can be defined as balanced planning and steering of a portfolio of initiatives, aiming to provide the highest overall value for the entire company.
Using portfolios in the context of innovation management also requires following balances to be managed:
- The innovation portfolio is required to cover both short-term and long-term initiatives.
- It needs to feature a variety of initiatives in the portfolio without losing focus.
Balancing short-term and long-term innovation
Innovation is required to lead to short-term returns through optimization of existing products, services and business models. However, it also plays a central role to secure long-term survival by exploring new territories, whether geographic or new business. Many companies unintentionally harvest their core business through pushing short-term performance while losing out on long-term investments to stay ahead of the game. Sustainable innovation management must therefore be targeted at identifying and developing future businesses in parallel to optimizing current ones.
Strike and Maintain the Right Balance
In contemplating the balance for an innovation portfolio, managers should consider the findings of research we conducted recently. In a study of companies in the industrial, technology, and consumer goods sectors, we looked at whether any particular allocation of resources across core, adjacent, and transformational initiatives correlated with significantly better performance as reflected in share price. Indeed, the data revealed a pattern: Companies that allocated about 70% of their innovation activity to core initiatives, 20% to adjacent ones, and 10% to transformational ones outperformed their peers.
Is There a Golden Ratio?
A second research finding adds more food for thought. In an ongoing study, we’re focusing on more-direct returns on innovation. Of the bottom-line gains companies enjoy as a result of their innovation efforts, what proportions are generated by core, adjacent, and transformational initiatives? We’re finding consistently that the return ratio is roughly the inverse of that ideal allocation described above: Core innovation efforts typically contribute 10% of the long-term, cumulative return on innovation investment; adjacent initiatives contribute 20%; and transformational efforts contribute 70%.
How Innovation Pays the Bills
Most companies are heavily oriented toward core innovation—and must continue to be, given the risk involved in adjacent and transformational initiatives. But if that natural tendency leads to neglect of more-ambitious forms of innovation, the outcome will be a steady decline in business and relevance to customers. Transformational initiatives are the engines of blockbuster growth.
We’re not suggesting that a 70-20-10 breakdown of innovation investment is a magic formula for all companies; it’s simply an average allocation based on a cross-industry and crossgeography analysis. The right balance will vary from company to company according to a number of factors.
Different Ambitions, Different Allocations
One important factor is industry. The industrial manufacturers we studied have a strong portfolio of core innovations complemented by a few breakouts, and they come closest to the 70-20-10 breakdown.
A company’s competitive position within its industry also influences the balance. For example, a lagging company might want to pursue more high-risk transformational innovation in the hope of creating a truly disruptive product or service that would dramatically alter its growth curve. A company that wants to retain its leadership position or believes the market for its more ambitious innovations has cooled may decide to do the reverse, removing some risk from its portfolio by shifting its emphasis from transformational to core initiatives.
A third factor is a company’s stage of development. Early-stage enterprises, especially those funded by venture capital, must make a big splash. They may feel that a disproportionate investment in transformational innovation is warranted, both to attract media attention, investors, and customers, and because they don’t yet have much of a core business to build on. As they mature and develop a stable customer base, and as protecting and growing the core becomes more important, they may shift their emphasis toward that of a more established company.
The point is that a management team should arrive at a ratio that it believes will deliver better ROI in the form of revenue growth and market capitalization, should discover how far its current allocation is from that ideal, and should come up with a plan to close the gap.
Organize and Manage the Total Innovation System
Targeting a healthy balance of core, adjacent, and transformational innovation is a vital step toward managing a total innovation portfolio, but it immediately raises an issue: To realize the promise of that balance, a company must be able to execute at all three levels of ambition. Unfortunately, the managerial toolbox required to keep innovation on track varies greatly according to the type of innovation in question. Few companies are good at all three.
The skills needed for core and adjacent innovations are quite different from those needed for transformational innovations. In the first two realms, analytical skills are vital, because such initiatives call for market and customer data to be interpreted and translated into specific offering enhancements.
Although the right skills are critical, they are not sufficient. They must be organized and managed in the right way, with the right mandate, and under the conditions that will help them succeed. One of the most important decisions will be how closely to connect the skills and associated activities with the day-to-day business.
Most efforts related to core and adjacent innovation are fairly small-scale projects that don’t need major infusions of cash. They can and should be funded by the relevant business unit’s P&L through annual budget cycles.
Any well-managed innovation process includes mechanisms to track ongoing initiatives and ensure that they are progressing according to plan. Companies typically rely on stage-gate processes to assess projects periodically, recalculate their projected ROI according to any changed conditions, and decide whether they should get a green light. But such projections are only as reliable as the market insight the company can glean. In the case of a core product extension, that insight is usually sufficient: Customers can say whether they would like a proposed product variant and, if so, how much they’d be willing to pay for it. However, if the innovation initiative involves an entirely new solution—one that customers may not even know they need—traditional stage-gate processes are dangerous. It’s impossible to predict fifth-year sales for something the world has never seen before.
Finally, there is the question of what measurements should inform management. For core or adjacent initiatives, traditional financial metrics are entirely appropriate. But using such metrics too early in transformational efforts can kill potentially great ideas. For instance, net present value and ROI calculations, commonly used to assess core and near-adjacent initiatives, require assumptions about adoption rates, price points, and other key variables—which in turn require customer input. Such input is impossible to obtain for something the world does not yet know it needs.
Strategic Portfolio Management
Strategic portfolio management translates innovation strategy into an aligned project portfolio. The portfolio is reviewed on the basis of defined criteria. Typically, a Portfolio Management Board (PMB) is in charge for this strategic decision making. The PMB should include those executives that can best decide on the strategic alignment as well as the executives that are responsible for the resources involved. The PMB’s main tasks are:
1. Periodic evaluation and prioritization of the entire innovation portfolio
The innovation portfolio is periodically assessed by means of strategic, financial and risk-related criteria. In most cases, scoring methods are used for this assessment. Based on the evaluated criteria, projects are re-prioritized, or stopped in case minimum requirements are not met. It’s important that evaluation and prioritization is carried out in a transparent and consistent manner for the entire portfolio. However, the evaluation process should also allow for exceptional reasons to fund an initiative that doesn’t meet the required numbers. These reasons and well-informed decisions need to be communicated transparently throughout the organization as well.
2. Strategic and priority-based resource allocation
As the prioritization of the portfolio is supposed to show impact, resources are required to be allocated accordingly. This sounds self-evident – but isn’t always in practice. Portfolio prioritization and resource management (on a strategic level) should be fully aligned. A feasibility check that decisions and priorities are backed with the needed resources is mandatory. Strategic resource management is about including resource availability constraints into the analysis of alternative portfolio compositions.
3. Release and exit of innovation initiatives
The selection of new, strategically-aligned initiatives has to be carried out with due diligence. Particularly in turbulent times or in face of crises this is often not the case, known as: doing things for the sake of doing things. Due to a variety of influence factors, interdependencies and stakeholders, portfolio management features a high complexity. In order to maximize value-creation for the company, the PMB needs to make sure these conditions are properly taken into consideration and initiatives are assessed with relevant and up-to-date criteria. It is also responsible for consequent termination of unattractive or unsuccessful initiatives.
For many companies, innovation will remain a sprawling collection of activities, energetic but uncoordinated. And for many managers, it will remain a source of frustration. For the best managers, however, it represents the most exciting and important challenge of all. By figuring out how to manage innovation as an integrated system within overall portfolio goals, they can harness its energy and make it a reliable driver of growth.