Innovation is one of the most powerful ways for businesses to create shareholder value. While many companies do not view themselves as innovative and do not pursue innovation-driven value creation strategies, there are different innovation models and every company can adopt an innovation approach that best fits its business model, corporate DNA and operating environment.
Value Creation Strategies
A key focus of almost every company, regardless of how large or small it is and what sector it operates in, is the creation of shareholder value. This is a situation in which a shareholder’s return on capital is greater than its cost of capital.
From a cash flow perspective, there are three key ways to build shareholder value. The first way is to cause revenues to increase faster than costs. This can be done in several ways, including by increasing product prices or increasing the number of products sold. The number of products sold can be increased through more efficiently providing products to existing markets or selling products to new markets.
The second way to increase shareholder value is by causing costs to fall faster than any decline in revenues (or of course holding revenues constant or causing revenues to increase). This can be done by directly eliminating expenses, such as employee salaries, or by creating economies of scale or of scope.
Both of these approaches face short as well as long-term challenges. Looking at revenue building strategies first, due to competition there are often limits on how much prices can be increased. Further, in many sectors technological advances and the digital flattening of markets have created significant downward pressure on prices.
While companies today have unprecedented opportunities to enter new markets, the reality is that to be effective these strategies often involve substantial costs, can cause companies to divert focus from their core strengths and expose companies to new competitive threats.
On the cost side, there are of course many ways that costs can be reduced but cost reductions can negatively affect product or service quality or other types of firm assets such as employee morale.
For costs that do not affect a firm’s revenue’s generation ability it is often the case that other market participants will be able to replicate these costs reductions which will create increased competitive pressure. This pressure also tends to limit how much value can be sustainably created through cost reductions.
Costs can be reduced through economies of scale but increased business scale in practice often simultaneously reduces some types of costs on a per unit basis but creates other types of costs. The sum total of cost gains and losses can make substantial value creation difficult.
Shareholder Value and Innovation
The third way to build shareholder value is through innovation.
Innovation, which is often deceptively simply defined as the creation of something new, covers an extremely broad range of possible advances in every aspect of a company’s business. In addition to product and service changes, this can also include improvements to business development and marketing methods, work procedures, information storage protocols and even office layouts.
| Innovation is one of the key pillars of shareholder value creation. |
Despite is importance as a value creation strategy, many firms struggle with incorporating innovation into their strategic plan and creating an environment where innovation-driven strategies can be implemented.
Part of this struggle is due to myths about what innovation involves. There are several reasons why companies often believe that innovation is not part of their DNA, including the views that:
● innovation is only for companies that are involved in “innovative” or “cutting edge” industries, such as technology
● innovation is a process that requires people who are extremely gifted intellectually
● the process of innovation takes a very long time and large expenditures of money
● the concept of innovation lacks sufficient specificity to form part of a business plan and it is better to expend resources on other shareholder value creation approaches
The Innovation Curve and Three Innovation Models
Despite these beliefs, the reality is that any company can be innovative and there are innovation approaches that can fit with any type of business model and corporate DNA.
| All types of innovation fall on an innovation scale representing the relationship between the current product or service and the new product or service. |
While there are many ways to think of innovation, in fact all types of innovation fall on what might be thought of as an “innovation scale” representing the relationship between the current product or service and the new product or service.
On this curve, we can identify three general approaches to innovation: (i) small increments; (ii) leap; and (iii) radical change.
| Three innovation models are small increments, leaps and radical change. |
● Small Increments. The most common form of innovation is by very small steps which are often either self-evident or suggested by the immediate product or service operating environment (PSOE). For example, a pizza maker who only makes sausage pizza may begin using mushrooms as a pizza ingredient because clients request it or because there happen to be mushrooms near the restaurant. Once this innovation is made, the pizza maker may incorporate another, potentially more exotic ingredient. These are small steps.
It is important to note that the process of innovation, even in small increments, is often not linear. Often a small step is taken and depending on the outcome it becomes the basis for further steps or is abandoned and the original starting point is returned to. This experience, however, becomes part of the firm’s knowledge base which affects future innovation decisions.
● Leap. The next type of innovation, which is less common, is innovation by leaps. This involves a significant qualitative or quantitative distance between the old product or service and the new product or service.
The most common form of leap innovations are those where a company incorporates a practice from one PSOE into another. A good example of this type of innovation is the use by the restaurant Zume of robots to prepare pizzas.
Leap type of innovations are often considerably more risky than innovation by small increments because there may be significant questions as to how the new product or service will be received by the market, how it will fit in with a company’s operations and whether the investment in the innovation will be worth it.
● Radical Change. Radical change type innovations are extremely rare because they involve very large quantitative or qualitative leaps that are often not suggested by a PSOE, do not have market parallels and go against the grain of accepted wisdom or habit. Many times these innovations come about as the result of an accident, such as with respect to the discovery of super glue or Teflon.
Corporate Innovativeness
All corporations have different levels of innovativeness based on several factors, including:
● the business and social environment the company operates in
● how necessary innovation is in the sector where the company operates
● the corporate culture of the firm and whether innovation is encouraged
● firm policies and procedures that make innovation more or less likely
● available firm resources
● the skills and talent of the people that work with the firm
Based on these factors, a company can define an innovation strategy that lies on an appropriate point of the innovation scale. Companies with low levels of innovativeness may choose to concentrate on the low end of the small increment innovation scale and dedicate relatively few resources to more aggressive innovation strategies. Companies that are highly innovative may choose to dedicate more resources to more aggressive innovation strategies.
Of course company levels of innovativeness and the innovation scale are not fixed. As the process of innovation continues, advances that at one time represented large leaps or radical changes come to represent incremental changes. Similarly, as companies try to innovate the lessons from the innovation process often lead to rethinking innovation strategy.
Conclusion
For many business models, innovation is central to building and sustaining shareholder value. Rather than only being comprised of single breakthrough events, innovation is an ongoing process that has different forms. While companies have different levels of innovativeness, by matching their levels of innovativeness with the innovation scale it is possible for any firm to use innovation to grow, become more competitive and reduce risk.
The photo for this article was taken from the Unsplash site. The photographer is Sammie Vazquez.