Tuesday, March 19, 2013

ROI: The Innovation Killer

Why is it that established companies seem to have so much trouble with responding to (or developing their own) innovative products and services? Why have so many companies, both big and small, seemingly given up on solving big problems, and are instead happy to make incremental improvements to existing products? One big reason, in my opinion, is the focus in American business on Return on Investment, or ROI. Return on Investment is a measure of how much money, measured as a percentage, a given investment will return over time. The money comes from cost savings, increased sales, or both. Companies evaluate investments against a target Rate of Return that they set. If a proposed investment is expected to meet or exceed the company's Rate of Return, the company makes the investment; otherwise, it doesn't.

It's fairly straightforward to calculate the expected ROI for a new product or capital investment that's very similar to products that you (or others) already sell, or capital investments that you (or others) have already made. If you're Proctor & Gamble and you're considering introducing a new flavor of Crest toothpaste, you have a huge database of historical information about how much it cost to develop new toothpaste flavors, put them into production and market them, and how well they sold over time. If you're Amazon and you're considering building three new warehouses, you know with great accuracy how much it cost to build similar warehouses in the past and how long it took to break even on those investments.

On the other hand, consider what IBM had to deal with when it decided to launch its own personal computer in 1981. Its experience with building mainframe computers was useless in projecting the costs of developing, manufacturing and marketing a personal computer. The personal computers that had sold to date were intended for hobbyists, which was a very small market. IBM had very little information with which to calculate the ROI for its personal computer.

The more innovative a product is, the more it represents a discontinuity (a break from previous technologies, goods and services,) the less reliable are its Return on Investment calculations. To reduce risk, most companies will assign such investments a relatively low ROI. Then, when they compare the ROI with the company's target Rate of Return, they'll kill the project if the ROI is below the Rate of Return. Company managers can guarantee that the project will be killed by deliberately putting conditions on the ROI calculation that will force it to be below the Rate of Return.

Big companies innovate by accepting projects that have risky ROI calculations, or by ignoring the ROI analysis altogether. Bell Labs was able to invent the transistor because there was no requirement that John Bardeen, Walter Brattain and William Shockley work on projects that would generate a predictable amount of revenue in a predictable time. Texas Instruments and Fairchild Semiconductor invented the integrated circuit in parallel, not because they knew what the ROI would be, but because they believed that the opportunity would be tremendous. IBM's decision to move ahead with its PC despite the company's ROI requirements led to market leadership for nearly two decades. On the other hand, Xerox's Palo Alto Research Center invented laser printers, Ethernet and graphical user interfaces but ended up seeing its inventions commercialized by others.

Companies that hold every project to a strict Return on Investment calculation are likely to create only incremental improvements to existing products and processes--lots of "singles and doubles." Companies that are willing to ignore ROI in search of a greater goal are the ones that at least have a chance for true innovation--the "home runs" that can define, or redefine, an industry.
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