Why Traditional Metrics like NPV, IRR and RONA Kill Innovation

October 1, 2018
Innovation
Corporate Innovation

That which can be measured can be managed.”

As such, 20th Century management science gave us a number of metrics to monitor the performance of a business venture, including return on investment (ROI), net present value (NPV) and internal rate of return (IRR).

First, a quick refresher!

Net Present Value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows. NPV is used in capital budgeting to analyze the profitability of a projected investment or project.

Internal Rate of Return (IRR) is the interest rate at which the net present value of all the cash flows (both positive and negative) from a project or investment equal zero. Internal rate of return is used to evaluate the attractiveness of a project or investment.

Return on Investment (ROI) measures the gain or loss generated on an investment relative to the amount of money invested. ROI is usually expressed as a percentage and is typically used for personal financial decisions, to compare a company’s profitability or to compare the efficiency of different investments.

Return on net assets (RONA) is a metric which measures a company’s financial performance with regard to fixed assets combined with working capital.

Now if your effectiveness as a manager is being assessed against the aforementioned metrics, then your best path of action to make the numbers look good is to:

  • Keep the denominator low
  • Focus on the short-term
  • Develop more of what makes money today

The Problem

The problem with this approach is that it lends itself to exploring the problems and solutions that are more obvious (and therefore also replicable and less defensible).

It lends itself to investing only in what makes money today at the risk of missing the next big thing, what makes money tomorrow.

Focusing only on Horizon 1 incremental innovation is akin to Nokia working on an improved feature phone when Apple came along with its flagship smartphone, decimating Nokia’s revenues in the process.

However, in order to truly compete in what is a rapidly evolving business and technological landscape (Moore’s law is out of control!) we need to explore Horizon 2 adjacent and Horizon 3 disruptive innovation. The challenge lies in H2 and H3 innovation in particular being considerably riskier than their H1 cousin, presenting us with a number of unpredictable and volatile variables insofar as our business model is concerned, and (only if the cosmos align in our favour) deliver a return on investment three, five or more than seven years out, which incidentally is the average time period a venture capitalist expects to exit in most early-stage startup investments, if at all (good VCs strike gold once out of every ten attempts).

So long as companies use traditional financial metrics such as RONA and IRR to evaluate the success of new product development (NPD) efforts, they will only ever truly back Horizon 1 innovations (they might back the occasional H3 effort but pull the plug a few months in after not delivering a sufficient ROI).

Such metrics made sense in a time when things were changing much slower than they are today and we could plan with relative certainty what the next 5 to 10 years would look like. But today’s reality is a far cry from yesteryear’s.

Brain Drain

To add insult to injury, researchers are leaving corporations in their droves because they want to explore game-changing products, not incremental innovation, and are instead opting to work for startups, progressive large companies or striking out on their own.

Only Stretching the S-Curve

Another problem with Horizon 1 innovation is that it only serves to stretch our existing S-curve, not catch the next S-curve, as smartphones did when they leapfrogged feature phones, as Netflix did when it leapfrogged Blockbuster, as digital did when it leapfrogged analog.

Catching the next S-Curve. Source: Accenture

It’s common sense (which is not so common) that by focusing only on short-term metrics, then we will only deliver short-term results. But today, that is no longer good enough.

The Solution

Companies must adopt a different set of metrics when exploring a different type of innovation. So what kind of metrics might these be?

Read on to learn about innovation metrics which are useful in the early stages of the innovation lifecycle for a H3 product.

Innovation
Corporate Innovation

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Steve Glaveski 2018
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