Spotlight On Innovation For The 21St Century Managing Your

For article reprints call 800-988-0886 or 617-783-7500, or visit hbr.orgAnalysis of innovation investments and returns reveals twostriking findings. Firms thatoutperform their peers tend toallocate their investments in acertain ratio: 70% to safe betsin the core, 20% to less surethings in adjacent spaces, and10% to high-risk transformational initiatives. As it happens,an inverse ratio applies toreturns on innovation.Although never the dominantactivity, transformational initiatives are vital to a company’songoing health, and firmsmust recognize that theydemand unique managementapproaches. Talent should include adiverse set of skills and be ableto deal with ambiguous data. Teams should be separatedfrom day-to-day operations. Funding should come fromoutside the normal budgetcycle. Pipeline managementshould focus on the iterativedevelopment of a few promising ideas, not the ruthlessfiltering of many. Metrics should recognizenonfinancial achievements inearly phases.right overall ambition for the company’s innovationportfolio. For one company—say, a consumer goodsproducer—succeeding as a great innovator mightmean investing in initiatives that tend toward thelower left, such as small extensions to existing product lines. A high-tech company might move towardthe upper right, taking bigger risks on more-audacious innovations for the chance of bigger payoffs.Although this may sound obvious, few organizationsThe Innovation Ambition MatrixCREATE NEW MARKETS,TARGET NEW CUSTOMER needsFirms that excel at total innovation management simultaneously investat three levels of ambition, carefully managing the balance among them.TransformationalDeveloping breakthroughsand inventing things formarkets that don’t yet existENTER adjacent MARKETS,serve adjacent CUSTOMERSwhere to playa dry powder), or added service convenience (forexample, replacing pallets with shrink-wrapping toreduce shipping charges), such innovations draw onassets the company already has in place.At the opposite corner of the matrix are transformational initiatives, designed to create new offers—if not whole new businesses—to serve new marketsand customer needs. These are the innovations that,when successful, make headlines: Think of iTunes,the Tata Nano, and the Starbucks in-store experience.These sorts of innovations, also called breakthrough,disruptive, or game changing, generally require thatthe company call on unfamiliar assets—for example,building capabilities to gain a deeper understandingof customers, to communicate about products thathave no direct antecedents, and to develop marketsthat aren’t yet mature.In the middle are adjacent innovations, whichcan share characteristics with core and transformational innovations. An adjacent innovation involvesleveraging something the company does well intoa new space. Procter & Gamble’s Swiffer is a case inpoint. It arose from a set of needs P&G knew welland built on customers’ assumption that the propertool for cleaning floors is a long-handled mop. But itused a novel technology to take the solution to a newcustomer set and generate new revenue streams. Adjacent innovations allow a company to draw on existing capabilities but necessitate putting those capabilities to new uses. They require fresh, proprietaryinsight into customer needs, demand trends, marketstructure, competitive dynamics, technology trends,and other market variables.The Innovation Ambition Matrix offers no inherent prescription. Its power lies in the two exercisesit facilitates. First, it gives managers a framework forsurveying all the initiatives the business has underway: How many are being pursued in each realm, andhow much investment is going to each type of innovation? Second, it gives managers a way to discuss theSERVE EXISTING MARKETSAND CUSTOMERSIdea in BriefFirms pursue innovationat three levels of ambition: enhancements tocore offerings, pursuit ofadjacent opportunities,and ventures into transformational territory.AdjacentExpanding fromexisting businessinto “new to thecompany” businesscoreOptimizing existingproducts for existingcustomersUSE EXISTING PRODUCTSAND ASSETSHow to winAdd incrementalproducts AND ASSETSdevelop NEW productsAND ASSETSMay 2012 Harvard Business Review 7

Spotlight on Innovation For the 21st CenturyIs there agolden ratio?think about the best level of innovation to target,and fewer still manage to achieve it.Strike and Maintain the Right BalanceIn contemplating the balance for an innovationportfolio, managers should consider the findings ofresearch we conducted recently. In a study of companies in the industrial, technology, and consumergoods sectors, we looked at whether any particularallocation of resources across core, adjacent, andtransformational initiatives correlated with significantly better performance as reflected in share price.Indeed, the data revealed a pattern: Companies thatallocated about 70% of their innovation activity tocore initiatives, 20% to adjacent ones, and 10% totransformational ones outperformed their peers,typically realizing a P/E premium of 10% to 20%(see the exhibit “Is There a Golden Ratio?”). Googleknows this well: Cofounder Larry Page told Fortunemagazine that the company strives for a 70-20-10balance, and he credited the 10% of resources thatare dedicated to transformational efforts with all thecompany’s truly new offerings. Our subsequent conversations with buy-side analysts revealed that thisallocation is attractive to capital markets becauseof what it implies about the balance between shortterm, predictable growth and longer-term bets.A second research finding adds more food forthought. In an ongoing study, we’re focusing onmore-direct returns on innovation. Of the bottomline gains companies enjoy as a result of their innovation efforts, what proportions are generatedby core, adjacent, and transformational initiatives? We’re finding consistently that the returnratio is roughly the inverse of that ideal allocationdescribed above: Core innovation efforts typicallycontribute 10% of the long-term, cumulative returnon innovation investment; adjacent initiatives contribute 20%; and transformational efforts contribute 70% (see the exhibit “How Innovation Pays theBills”).Together these findings underscore the importance of managing total innovation deliberately andclosely. Most companies are heavily oriented towardcore innovation—and must continue to be, given therisk involved in adjacent and transformational initiatives. But if that natural tendency leads to neglect ofmore-ambitious forms of innovation, the outcomewill be a steady decline in business and relevance tocustomers. Transformational initiatives are the engines of blockbuster growth.8 Harvard Business Review May 2012Analysis reveals that theallocation of resourcesshown below correlateswith meaningfully highershare price performance.For most companies, thisbreakdown is a good starting point for w innovationpays the billsAmong high performersthat invest in all threelevels of innovation, we findthe following distribution oftotal returns. As it happens,this ratio is the inverse ofthe resource allocationratio we discovered in highperforming companies.10%core20%adjacent70%transformationalLet us be clear: We’re not suggesting that a 7020-10 breakdown of innovation investment is amagic formula for all companies; it’s simply an average allocation based on a cross-industry and crossgeography analysis. The right balance will vary fromcompany to company according to a number of factors (see the exhibit “Different Ambitions, DifferentAllocations”).One important factor is industry. The industrialmanufacturers we studied have a strong portfolio ofcore innovations complemented by a few breakouts,and they come closest to the 70-20-10 breakdown.Technology companies spend less time and moneyon improving core products, because their marketis eager for the next hot release. Consumer packaged goods manufacturers have little activity at thetransformational level, because their main focus isincremental innovation. Of these three sorts of businesses, industrial manufacturers collectively havethe highest P/E ratio relative to their peers, perhapssuggesting that they are closest to getting the balance right—for them.A company’s competitive position within its industry also influences the balance. For example, alagging company might want to pursue more highrisk transformational innovation in the hope ofcreating a truly disruptive product or service thatwould dramatically alter its growth curve. A struggling Apple made this decision in the late 1990s, effectively betting its business on several bold initiatives, including the iTunes platform. A company thatwants to retain its leadership position or believesthe market for its more ambitious innovations hascooled may decide to do the reverse, removing somerisk from its portfolio by shifting its emphasis fromtransformational to core initiatives.A third factor is a company’s stage of development. Early-stage enterprises, especially thosefunded by venture capital, must make a big splash.They may feel that a disproportionate investmentin transformational innovation is warranted, bothto attract media attention, investors, and customers, and because they don’t yet have much of a corebusiness to build on. As they mature and develop astable customer base, and as protecting and growingthe core becomes more important, they may shifttheir emphasis toward that of a more establishedcompany.The point is that a management team should arrive at a ratio that it believes will deliver better ROI inthe form of revenue growth and market capitaliza-

For article reprints call 800-988-0886 or 617-783-7500, or visit hbr.orgDifferent Ambitions, Different AllocationsOn average, high-performing firms direct 70% of their innovation resources to enhancements of coreofferings, 20% to adjacent opportunities, and 10% to transformational initiatives. But individual firmsmay deviate from that ratio for sound strategic reasons. Here are three allocations we have seen thatmade sense for firms in various circumstances.A leadingconsumergoods companyA diversifiedindustrialscompanyA 0%2%10%15%adjacenttransformationaltion, should discover how far its current allocationis from that ideal, and should come up with a planto close the gap.Organize and Manage the TotalInnovation SystemTargeting a healthy balance of core, adjacent, andtransformational innovation is a vital step towardmanaging a total innovation portfolio, but it immediately raises an issue: To realize the promise of thatbalance, a company must be able to execute at allthree levels of ambition. Unfortunately, the managerial toolbox required to keep innovation on trackvaries greatly according to the type of innovation inquestion. Few companies are good at all three.Companies typically struggle the most withtransformational innovation. A study by the Corporate Strategy Board shows that mature companiesattempting to enter new businesses fail as often as99% of the time. This reflects the hard truth that toachieve transformation—to do different things—anorganization usually has to do things differently.It needs different people, different motivationalfactors, and different support systems. The onesthat get it right (GE and IBM are notable examples)have thought carefully about five key areas of management that serve the three levels of ttransformationalTalent. The skills needed for core and adjacentinnovations are quite different from those neededfor transformational innovations. In the first tworealms, analytical skills are vital, because such initiatives call for market and customer data to be interpreted and translated into specific offering enhancements. Procter & Gamble, for example, deploys acadre of 70 senior employees around the world tohelp identify promising adjacencies. These “technology entrepreneurs,” as the company calls them,are responsible for researching a variety of sources,including scientific journals and patent databases,and for physically observing activities in specificmarkets in order to find new ideas that can build onP&G’s core businesses. The company credits its technology entrepreneurs with uncovering more than10,000 potential offerings for review.Transformational innovation efforts, by contrast, typically employ a discovery and conceptdevelopment process to uncover and analyze thesocial needs driving business changes (what’s desirable from a customer perspective), the underlyingmarket trends (what kinds of offers might be viable),and ongoing technological developments (what isfeasible to produce and sell). These activities requireskills found among designers, cultural anthropologists, scenario planners, and analysts who are comfortable with ambiguous data. Thus, when SamsungMay 2012 Harvard Business Review 9

Spotlight on Innovation For the 21st CenturyRather than hoping that their future will emergefrom a collection of ad hoc efforts, smart firmsmanage for “total innovation.”decided to compete on the basis of innovative design, the executive suite, and ideally the CEO) that canit recognized that it needed new and different skills. rise above the fray of annual budget allocation. Butcompanies should avoid the “innovation tax” apThe company moved its design center from a smallproach, whereby the C-suite asks all areas of thetown to Seoul in order to be closer to a valuable poolbusiness to contribute a percentage of their budgetsof young design professionals. It also teamed withto transformational initiatives (under the theory thata number of outside firms with strong design skillsinnovation benefits the whole company, so everyand created an in-house school, led by industrialone should support it). Business units rarely see theirdesign experts, to hone the abilities of designerswho exhibited potential. The results speak for them- “contribution” as going to a good cause; they simplyperceive that the corporate office is siphoning off 5%selves: In a decade Samsung has garnered numerousdesign awards while evolving from a manufacturer of their budgets, and come to regard the innovationteam as the bad guys.of nondescript consumer electronics to one of theCompanies might instead create a completelymost valuable brands in the world.differentfunding structure for transformational inIntegration. Although the right skills are critinovation, one that’s separate from the regular P&Lscal, they are not sufficient. They must be organizedand managed in the right way, with the right man- of the business. An example is Merck’s Global HealthInnovation venture fund, a separate limited liabilitydate, and under the conditions that will help themcorporation that invests in interesting health caresucceed. One of the most important decisions willcompanies operating at the periphery of Merck’sbe how closely to connect the skills and associatedcore pharmaceutical, vaccines, and consumer healthactivities with the day-to-day business.In most companies, the majority of people en- businesses. The main purpose of the fund is to placebets on components of an evolved future businessgaged in innovation are working on enhancementsmodel for the company. It is also used on occasionto core offerings; they’re most likely to succeed ifthey remain integrated with the existing business. to fund organic innovation initiatives, such as MerckBreakthrough Open, a crowdsourcing forum thatEven teams working on adjacent innovations benefitsolicits employee ideas for transformational growthfrom the efficiencies that come with close ties to thecore business, assuming they’re given the appropri- opportunities.ate tools to take their work further afield.Pipeline management. Any well-managedHowever, as Samsung’s move suggests, trans- innovation process includes mechanisms to trackformational innovation tends to benefit when theongoing initiatives and ensure that they are propeople involved are separated from the core busi- gressing according to plan. Companies typicallyness—financially, organizationally, and sometimesrely on stage-gate processes to assess projects pephysically. Without that distance, they can’t escaperiodically, recalculate their projected ROI accordthe gravitational pull of the company’s norms anding to any changed conditions, and decide whetherexpectations, all of which reinforce an emphasis onthey should get a green light. But such projectionssustaining the core.are only as reliable as the market insight the comFunding. Most efforts related to core and adja- pany can glean. In the case of a core product extension, that insight is usually sufficient: Customerscent innovation are fairly small-scale projects thatcan say whether they would like a proposed productdon’t need major infusions of cash. They can andvariant and, if so, how much they’d be willing to payshould be funded by the relevant business unit’s P&Lfor it. However, if the innovation initiative involvesthrough annual budget cycles.an entirely new solution—one that customers mayBold transformational efforts typically requiresustained—and sometimes significant—investment. not even know they need—traditional stage-gateprocesses are dangerous. It’s impossible to predictTheir funding should come from an entity (perhaps10 Harvard Business Review May 2012

For article reprints call 800-988-0886 or 617-783-7500, or visit hbr.orgfifth-year sales for something the world has neverseen before.Moreover, whereas pipeline management forcore or near-adjacent innovation involves gradually finding a small set of winners from among a vastnumber of ideas, the process is very different fortransformational innovation. Here the challenge isto take a small number of possibly game-changingideas and ensure that they emerge from the pipelinestronger. A company must spend sufficient time upfront exploring what’s possible, constantly expanding the options available in pursuit of the right bigidea. In other words, transformational efforts arenot generally managed with a funnel approach; theyrequire a nonlinear process in which potential alternatives remain undefined for a long period of time.This is another reason why a stage-gate process is solethal to transformational innovation: It results inthe rejection of promising options before they areproperly explored.Metrics. Finally, there is the question of whatmeasurements should inform management. For coreor adjacent initiatives, traditional financial metricsare entirely appropriate. But using such metricstoo early in transformational efforts can kill potentially great ideas. For instance, net present valueand ROI calculations, commonly used to assess coreand near-adjacent initiatives, require assumptionsabout adoption rates, price points, and other keyvariables—which in turn require customer input.Such input is impossible to obtain for something theworld does not yet know it needs.Managers should discuss thoughtfully whereeconomic and noneconomic metrics, along withexternal and internal metrics, are most appropriate.Stage-gate systems operate at the intersection ofeconomic and external metrics—they estimate howmuch money the company will make when its innovation is launched in the outside world. And, again,this combination is appropriate for evaluating coreor near-adjacent initiatives on the basis of information that is obtainable and largely accurate.Companies should use the polar opposite—acombination of noneconomic and internal metrics—to assess transformational efforts in their earlystages; this can enhance the team’s ability to learnand explore. For example, what if the only hurdle aninitiative must clear to receive continued investmentis that the company is likely to learn (not earn) fromit? That is how Google has assessed transformationalinnovation from the start.Eventually a company must focus on the hardeconomics of a transformational project. But thatcan wait until there’s something ready to pilot andlaunch.Moving ForwardManaging total innovation will require a significantshift for most companies, which are used to a less orderly approach. But the pathway to such disciplineis clear. The first step is to develop a shared senseof the role innovation plays in driving the organization’s growth and competitiveness. Managers shouldagree on an appropriate ambition level for innovation and find common language to describe it.Next, it makes sense to survey the company’scurrent innovation landscape. A comprehensiveaudit will reveal how much time, effort, and moneyare allocated to core, adjacent, and transformationalinitiatives—and how that allocation differs from theideal ratio for the company in question. With thedifference exposed, managers can identify ways toachieve the desired balance, usually by paring coreinitiatives down to those focused on the highestvalue customers, encouraging more initiatives in theadjacent space, and creating conditions more conducive to breakthroughs in the transformational realm.Through

Igor Ansoff to help companies allocate funds among growth initiatives. Ansoff's matrix clarified the no-tion that tactics should differ according to whether a firm was launching a new product, entering a new market, or both. Our version replaces Ansoff's binary choices of product and market (old versus new) with a range of values.