Taking the measure of innovation
Don’t overlook the insight
that two simple metrics can yield about the effectiveness of your R&D
spending.
You’ve
probably heard the old joke
about the two economists who saw $20 on the sidewalk. “Look,” exclaimed the
first economist, “a $20 bill!” “It can’t be,” the other economist answered. “If
it were a $20 bill, someone would have already picked it up.”
We were reminded of this story when
we began to notice a pair of innovation metrics that seemed so intuitive that
we assumed they must have been conspicuously applied and rejected before. So
far, however, we’ve found no indication of widespread use—and a reasonable
amount of evidence suggesting that, at least for most industries, the
measurements work.
We call these indicators R&D
conversion metrics: R&D-to-product (RDP) conversion and
new-products-to-margin (NPM) conversion. Their core components—gross margin,
R&D, and sales from new products—are not new, but combining them can reveal
fresh insight on the relative innovation performance of business units, within
an organization and relative to external peers. The first metric, RDP, is
computed by taking the ratio of R&D spend (as a percentage of sales) to
sales from new products. This allows organizations to track the efficacy with
which R&D dollars translate into new-product sales. The second metric, NPM,
takes the ratio of gross margin percentage to sales from new products, which
provides an indication of the contribution that new-product sales make to
margin uplift.
Notably, these metrics can be
gauged outside in, making them ideal for benchmarking. They also apply on the
portfolio level, where the net effect of individual project investments
reflects the results as a whole. That broader perspective accords with how
senior executives and investors typically consider innovation performance. It’s
not the most granular way to consider project value creation, and it doesn’t
aspire to be. In seeking the ideal metric, one should not let the perfect be
the enemy of the good. When a business can convert a high rate of R&D
dollars to new products, and when its new products flow through to higher gross
margins, good things will happen.
As we’d expect, the R&D
conversion metrics show that higher spend does not inevitably translate to
stronger performance. That should come as no surprise to seasoned executives
and analysts. Rather, when we benchmarked companies within select industries,
results varied markedly. The R&D conversion metrics also
demonstrate—sometimes strikingly—where some organizations are falling short and
where opportunities for improvement may be found. Not every company that scores
strongly on RDP is able to follow through to higher margins, and a company
scoring above-median performance on NPM may underperform in RDP.
While the R&D conversion
metrics are useful, context is essential. Benchmarking must be conducted
against comparable firms—pure plays versus pure plays, diversified companies
against companies with multiple business lines, and product-to-product
comparisons with cycle times that are as close in duration as possible. These
metrics also work best in industries where product turnover is higher and the
incremental effect of innovation is both more immediate and more critical to
the business model. For example, in specialty chemicals and consumer goods, two
industries with rapid innovation cycles, the three-year average in gross
margins correlates strongly with the five-year average of NPS. In industries with
markedly longer cycles, such as pharmaceuticals and agribusiness, the
r-squareds are lower.
But in a real sense, those
exceptions help prove the rule: the more that innovation matters with
immediacy, the more insight is to be gained by tracking your innovation
efforts. In our experience, many companies spend too much time looking inward
at measures of activity (for example, number of patents, or progress of ideas
through a pipeline), and not enough scrutinizing the returns on innovation.
Creating value is the name of the game, and these R&D conversion metrics
help you keep score.
https://www.mckinsey.com/business-functions/strategy-and-corporate-finance/our-insights/taking-the-measure-of-innovation?cid=other-eml-alt-mkq-mck-oth-1804&hlkid=c6016c9ccbf346cea94b75a2147c5164&hctky=1627601&hdpid=ee57b820-7d9b-4138-9166-80432e03a152
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