Costs of Innovation

As we have seen in Why Innovate, innovation is a crucial driver of business growth in many forms, but that growth can have risk associated with it. The risk of innovation is that long-term innovation failure can wreck the profitability of any organisation. Not only can innovation failure increase financial risks and costs, but it can also increase cultural risk and people costs, which we’ll explore later in the chapter.

As we saw in Common Innovation Terms, Innovation failure rates are significant, although varying failure rates abound, and Innovation failure has multiple different definitions. A number of these failed products may be seasonal or limited edition promotions or simple product extensions, all designed to be short term, but their cost of development is still incremental to the existing products, and therefore we should expect a return on those development costs.

For some perplexing reason, the CPG industry – and within that the FMCG industry – is very comfortable with a 90% failure rate  for all its innovation. Over 20 years, the innovation rate failure rate hasn’t changed, and talented individuals still fail more often than they succeed. We see no reason why a 0% failure rate is not achievable in the future, where every new product launched generates a return on investment.

Failure is our current default

When discussing with friends in other industries such as construction or medicine that there is a 90% failure rate in CPG, they are astonished. One friend, a civil engineer, could not comprehend having a tolerance in that kind of range. If he did, nobody would ever enter a building, drive over a bridge or travel on a road. Similarly, if doctors had a 90% failure rate, we would not consult them about whatever ailments we might have and probably view them in the same way as psychics or astrologists.

From our personal experience of being involved with large and small businesses, the failure rate  remains relatively consistent irrespective of the size of the company. However, larger organisations can make a louder bang with their launches and have more extended patience levels (i.e. deeper pockets). All companies we have dealings with have an innovation failure rate over 50%, with most being in the high 70% to 90% range, which hardly inspires confidence that the capability to innovate is somehow linked to scale. It’s rare to see a company be aware of the relevant success or failure rates of its products relative to the category. It’s just not tracked as a measure, as it’s assumed to be wrong, or it’s embarrassing, or perhaps both.

Given that the majority of innovations in FMCG are small tweaks, the costs of innovation are, one would think, probably relatively small. But that’s not the case in our experience. We have found that a simple project to change the packaging on a product might require nearly 100 days of numerous people’s time and tens of thousands of pounds in design and packaging costs.

Stripping down the cost of innovation

In 2015 we consulted for a FTSE 250 consumer goods company on their innovation pipeline, looking at the time recorded on innovation projects for the preceding ten years. Each of the innovation projects was grouped into high, medium and low complexity by the R&D department. Each project recorded the stage in the process reached, including whether it was launched. Some were simply ideas explored to an early stage, whereas some were complex products that required multi-year investment and had a successful launch. In total, we reviewed 163 projects. The average time spent on a launched project was 296 working days, with – unsurprisingly – more simplistic projects such as renovations and line extensions took  less time than the average, and more complex projects took more time. This only included projects that eventually launched, but if we include all innovation projects even those that didn’t launch, it would assume an average of 427 days, with an average of 749 days for complex projects.

With this data, we can calculate costs. We know that people do not work 100% of their time exclusively on one project, so we modelled that an individual would work on three projects at a time. We estimated £600 per day to include personnel costs and fixed costs such as R&D equipment and manufacturing equipment. Thus we reached an average innovation cost for a FTSE 250 company of £177,600 per project that was launched. If we look at the average of all projects irrespective of whether they were launched or not, that rises to £256,200, because of a high number of complex projects that were exhausted before being cancelled prior to launch. If projects are complex, then the costs jump up £449,400. This also does not include any direct sales or marketing costs associated with the launch of the project, such as  advertising, promotional investment, or even listing fees with retailers or channel partners.

Hurdle rates

The above average costs are substantial investments in themselves at a base level. As part of the project, we assumed that for every incremental £1 in cost, the company would have to make an incremental £2 in revenue, meaning the revenue targets for innovation had to be double the costs. Targets for all innovation projects were to achieve at least an incremental £300,000 in revenue or they were deemed not worthy to invest in. For highly complex projects, we recommended at least a £500,000 revenue hurdle rate. 

These hurdle rates generated a great deal of pushback internally, especially from the marketing and sales functions who felt that they would stifle the brand and growth of the company. However, the hurdle rates agreed above were very conservative base numbers using data from launched projects, and we would have recommended a number almost double those proposed to ensure that any innovation investment took account of weighted average costs of capital, with a positive net present value.

This project offers two opportunities for the client and other similar FMCG businesses. Firstly is the benchmark for innovation costs. Initiating our project was the first time that the Exec of this business had considered costs and hurdle rates for innovation, and the daylight that we were able to shine on their innovation cost base helped them change their innovation strategy, becoming more successful overall with innovation. They became more ruthless early on and wasted fewer resources on projects that were unlikely to return a positive impact. Quite understandably, previously innovation had been undertaken by both the marketing and sales community as a way to grow their respective elements in the business, as the costs weren’t precisely tracked or allocated to their budget, but rather were hidden in personnel costs.

Secondly, it highlighted the opportunity costs of innovation to the Exec, that is to say, how else could the people and the costs associated with innovation be used in other parts of the business, and could that return a higher ROI than innovation. People were re-focused onto activities that could drive a higher return, and direct marketing costs for innovation, such as design costs, listing fees etc., were redeployed to more effective sales-driving activities.

The overall innovation budget for this client was in the region of £5m, as stated in its annual report, which corresponds to the average innovation spend for a large organisation, according to UK Government figures. 

Calculating innovation investment

Based on Research & Development figures from November 2020 Companies House data, companies in their latest year of reporting have invested on average 2.9% of their revenue into R&D, or £8.32m per company. Medium and large companies (those in excess of £25m turnover), spent an average of £15m in R&D each in their latest financial year, or 2.7% of their revenue.

Chart, waterfall chart

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Figure 2 Innovation ROI

The level of R&D investment as a % of turnover differs significantly across industries. Manufacturers of food and broad consumer goods only invest 0.8% of turnover in R&D. Sports & recreation services (Standard Industrial Classification or SIC 9300) invest 44% of turnover. Financial services (SIC 6400) invest 23%, and education (SIC 8500) 21% of turnover.

Figure 3 R&D Investment as % of Turnover
Source: Companies House Data November 2020

Size of company also has a part to play, in that the percentage of turnover invested in innovation declines as turnover increases. Large companies with a turnover in excess of £1bn report investment in R&D of 1.7%, whereas companies under £25m turnover report R&D investment of 11.2%.

Innovation return on investment

Again using Research & Development investment data from Companies House in November 2020, companies that invested in R&D five years ago have grown their turnover by 5.0% and their gross margin by 14.9% over the last five years. Using that data, the ROI for innovation is 185%:

Although on the face of it, the ROI of 185% would appear to be healthy, when overlaid with the 90% failure rate, a different view comes into focus. Innovation is a powerful way to grow, but it is hazardous, with a 90% failure rate. Only a small number of products actually generate high sales from innovation. For example, Kantar reported the top ten innovations in FMCG contributed only £114.4m of retail sales in 2019 from a category worth over £110 bn. Finish Powerball Quantum Ultimate was reported by Kantar as the biggest innovation in 2019 with £20.3m of retail sales, or 17% of the Top Ten products. In contrast, the tenth biggest innovation in 2019 was only £6.5m in retail sales value or 6% of the Top Ten total. In other words, big successful innovations drive up the average contribution for innovation, so the 7% contribution of innovation is driven by a small number of highly successful products. With a 90% failure rate, most innovations are likely not to make an incremental profit.

Not only is there high failure with innovation, but those innovations that are successful may not be generating incremental sales or incremental margin, with Kantar reporting that two-thirds of innovations fail to be incremental to existing products.

Relative innovation performance

These numbers start to help organisations understand how they are performing in innovation relative to other companies. Are they generating better or worse ROI on innovation? How does their innovation budget stack up against others? How does their failure rate impact their delivery of innovation?

We drew up this simple matrix to aid the thought process of what to do when you review your innovation spend versus your innovation returns. Chart, treemap chart

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Figure 4 Innovation Performance Matrix

The matrix above uses the average R&D spend of 2.7% (rounded to 3%) of turnover that we found from Companies House on the x axis or horizontal axis. On the vertical axis or y axis, we have used the contribution that innovation makes according to AC Nielsen.

Other costs of innovation

The costs associated with innovation are not solely financial. There are also intangible costs for organisations that cannot successfully innovate, some more damaging than the financial costs.

We’ve met leaders from hundreds of companies, from those that have a strong innovation capability through to those few that have zero innovation capability. 

Where we have found companies that have limited long-term innovation success, their lack of success impacts them in unintended ways. These companies tend to be more conservative in their approach, not just to innovation but also to general management. They defer decision-making to the HiPPO (HIghest Paid Person in the room’s Opinion) in the room, and therefore innovation is slower as it requires the HiPPO to have time to make a decision, and riskier as there has been no diversity of input from a wider audience. It is slower as not everybody has bought into the project but has simply been told what to do. Running all innovation decision-making through or by the HiPPO we find develops a ‘doom loop’: a cycle of negativity in the business that comes from failure, and an attitude that anything attempted will lead to more failure, so therefore we should only do things that are less likely to fail, become more conservative, and invest less in riskier areas such as innovation. However, this results in lower growth, which continues the negative spiral.

These types of businesses become less motivating  to work in, with knock-on effects of lower productivity and higher employee turnover, as nobody wants to work for a losing company. These factors then further increase costs directly, such as through recruitment fees, or indirectly through lower productivity.

Innovation doom loop

It is not just internally that the doom loop can occur, as external stakeholders such as retailers, distributors and suppliers see no advantage in low growth  companies. Retailers and distributors demand higher listings fees and guarantees to clear stock should it fail and are less likely to push distribution to a higher number of outlets, thus reducing the chances of success or the impact of any marketing activity. Shareholders are affected by the doom loop too, as they see their investments and growth decline.

But companies don’t just pin their growth hopes on innovation. Where innovation fails to deliver, they look to invest in shorter-term ways to grow, such as promotions and discounts. Fuelling growth through promotions and discounts over the long term, however, often leads to brand equity challenges and lower accumulated returns, as the uplifts from discounts are lower as consumers become used to them and rebase the perceived value of the product in line with the new lower price. Retailers become expectant of the discounts and fixed costs of promotions to fuel their growth. As a counter-example, consider successful tech innovators – rarely are their products discounted, even the core products.

The costs and risks for innovation are stark: costing between 1% and 15% of turnover, with a failure rate of 90%. And then there are the indirect costs of poor execution such as a gloomy organisational culture. But not doing innovation also has costs – often intangible costs, but costs nonetheless.

From our modelling of ROI, we contend that the ROI for innovation is very precarious. If the sales contribution for innovation drops below 5%, then the ROI turns negative. Also, if the failure rate increases beyond 90%, then the ROI drops too. If the contribution from innovation drops and the failure rate increases, then the ROI is significantly impacted. However, the inverse is also true, that is to say, if the contribution from innovation goes up and / or the failure rate comes down, the ROI goes up.

Innovation as an engine for growth

But innovation doesn’t need to be so precarious. Imagine innovation as an engine for the growth of your company. This engine takes in three fuel units and generates seven units of energy (i.e. 2.7% of turnover and 7% of innovation contribution). And it delivers that seven units of energy even though it only works one time in six. Innovation has consistently been in the 2%–10% growth range for the last 20 years. And we have accepted this for decades as best practice. Frankly, the current innovation process can hardly be a shining beacon when it could be described as a “bit better” than doing no innovation at all.

Over the last 20 or more years, we have ended up in this precarious position for a multitude of reasons. Many companies don’t know (and therefore don’t track) their innovation failure rates. The road to innovation failure is paved with the good intentions of exploiting consumer truth and applying logical scientific rigour, but these are at the whim and favour of confident, charismatic leaders who effectively are working, more often than not, on a hunch or a guess. In our experience, the most common practice for FMCG innovation is – to borrow a phrase from Kevin Costner’s Field of Dreams – ‘build it and they will come’, based on the HiPPO in the room’s wishes, and then go hell for leather, raining incentives down on the teams to make the innovation materialise with little to no tracking of the ROI, as the majority of the costs are hidden costs such as personnel. ‘Build it and they will come’ is how we as an industry end up a vulnerable knife-edge for Innovation’s ROI that could quickly crash into a doom loop.