After achieving “The 80-20 Rule” for effective and efficient Distribution Operations in the 1980s, and the same for Manufacturing Operations by the early 2000s, leading companies are now closing in on Product Development. Industry demand is growing for overall measures of effectiveness, efficiency, productivity, execution, innovation, and R&D-based intellectual property.
While both capital-based measures as well as revenue/income-based measures are being experimented with, and noting that certain capital-intensive industries may be best measured with capital-based measures, two revenue/income-based measures appear to be heading to widespread adoption.
Bleeding-edge companies started optimizing R&D in earnest in the mid-1980s. These companies included Northern Telecom, HP, Corning, Motorola, Apple, and 3M. It was 3M that first recognized the need for an overall measure of innovativeness. They created a metric named the “Vitality Index” in 1988. It measured “new product revenues as a percent of total revenues.” Relatively easy to calculate, the only management decision is how long a launched product remained “new.” The letter “N,” meaning the number of years a product is new, came to represent that decision. Most companies in industry have N = 3. A product is new for 3 years. But, anything goes. I have seen N = 9 months in some Silicon Valley companies to N = 5 or 7 years if you make airplanes or battleships. Companies with long product life cycles that include spare part sales for decades often struggle to separate highly profitable maintenance and spare parts from the newness of the product. If you are weighing a longer vs shorter N, go with the shorter N. A shorter N will never put as big a smile on your face at meetings, but it will always be contributing more to the long term health of your company.
GGI classifies Vitality as a measure of “Effectiveness.” It does not have a denominator. If new products are more profitable than old products at your company, and profit is important to your company, then the Vitality Index is one of the best effectiveness measures available today.
Revenue measures remain the most popular aggregate measures of R&D today. Measures of R&D contribution to profit are rapidly rising over the past five years however. Ultimately, measures of “R&D Profitability” will become equal with “R&D Revenue Production.” For two decades, we have found it useful to utilize more mundane terminology to describe the Vitality Index with that thinking in mind. Vitality is “the current-year sales due to products released in the prior ‘N’ years.” We recommend equally watching “the current-year profits” due to products released in the prior ‘N’ years.” It is this profit measure that became the numerator of the Return On Innovation metric in the early 2000s.
Return On Innovation
Some time in the early 2000s, from no source in particular, a metric with a confusing acronym started to pop up. “Return On Innovation [ROI]” [Figure 1] is often spoken, versus using the acronym, so it is not confused with “Return On Investment [ROI].” The former is an overall measure of R&D. The latter is most often a measure of a specific investment, R&D or not. For this piece, ROI is Return On Innovation.
Figure 1: Equation For Return On Innovation
GGI classifies ROI as as a measure of “Efficiency” or “Productivity.” It satisfies all classical Industrial Engineering definitions of Output divided by Input. ROI may possibly be a measure of “Effectiveness” at the same time, but that is on a case-by-case basis. The only reason to make that point is some corporations are not yet “effective” in R&D. “Efficiency” initiatives are secondary to first achieving effectiveness. This is especially true for R&D which has a disproportionate role in generating the future health of the company.The numerator of ROI is “the current-year profits” due to products released in the prior ‘N’ years,” as described in the last paragraph of the Vitality Index section above. The denominator of ROI is “the R&D Investment for the same “N” length of time.” This all seems simple enough, but industry appears to be calculating this metric at least six different ways. The two variables are whether simply to add revenues and divide by R&D expenses, or to apply Net Present Value to the numerator and Forward Value the denominator to arrive at a singular matching calendar year ROI calculation. Some Net Present Value the numerator but simply add the denominator figures together. The other major permutation in calculations, assuming N=3, is whether the “year 6-5-4” expenditures lead to the “year 3-2-1” revenues and profits. Some companies do it that way. Some companies use 3-2-1 in the numerator and in the denominator. Other companies do things like “year 5-4-3” leads to “year 3-2-1,” or other overlapping approaches.
Companies not already calculating ROI in some fashion should examine the utility of this metric. Just pick an approach that makes sense to your company and measure against yourself. While ROI does not have the twenty-five year familiarity of the Vitality Index, the train is on the tracks for ROI. Smart Wall Street analysts are already asking about the Vitality Index, and so too will they eventually ask about ROI.
Industry Penetration Of ROI & Vitality
GGI has conducted research on industry’s utilization of some 88 R&D-Product Development metrics for over a decade, surveying approximately every other year. We began our primary research activities in 1998.
The Vitality Index is approximately 25 years old. It is used by 56% of companies. It is the 4th most frequently used corporate R&D metric. It is the top “performance metric” used by R&D.
Return On Innovation is approximately 10-12 years old. It is used by 25% of companies. It is the 19th most frequently used corporate R&D metric. It is the 8th most frequently used performance metric by R&D.
Adapting ROI & Vitality To Research & Advanced Development
Usage of the term “Product Development” heretofore, has largely referred to the more deterministic part of R&D related to identifying, defining, developing, and commercializing products. Basic and Applied Research, Technology Development, and Advanced Development are activities that are more “R” than they are “D” [Figure 2].
Figure 2: The Continuum Of Corporate R&D Strategies
Some companies include the expenses for these research-oriented activities when calculating their ROI or Vitality and some do not. It will be a number of years still before there will be a “best practice” or “industry accepted standard” of calculating ROI or Vitality. No surprise there my friends, this is R&D.
What is interesting however, is that with corporate increases in budgets the last few years for more research-oriented activities aimed at increasing overall innovation, is that some companies are adapting ROI and Vitality to try to get a viable measure of their research-oriented expenditures in commercial terminology – dollars and sense. Both metrics are quite easily adapted to get a handle on the contribution of advanced development activities to the commercial product portfolio.
Adapting the Vitality Index is easiest, “% Vitality Index Containing Advanced Development Content.” The counting problems relating to determing the products that contain advance content are managable. Some companies are able to automate counting by intelligently linking project numbers.
GGI was among the first to adapt the ROI metric, we call it “Advanced Development Return On Innovation [ADROI]” [Figure 3]. We have also called it “Research Return On Innovation.” Early adopting companies have been using this metric, and its variations, for about a decade.
Figure 3: Equation For Advanced Development Return On Innovation
Adapting ROI to be ADROI is a bit trickier. The numerator is easy. It is the same as Return On Innovation, but only includes the profits from products with advance content. Again, the counting challenges are manageable. The denominator has multiple considerations. It often needs to be adjusted to include the expenses of these research activities. Enterprising executives work hard to minimize the ROI denominator. And, research-related expenses are sometimes structurally reported separately for several reasons. Then, research precedes Product Development by several years and period and sunk cost issues come into play. Visits to Iron Mountain may be necessary. Finally, it is important to note that all advance expenses should be included and not just the ones with content in the revenue stream. The goal of the metric is to measure the commercial output of all those early and risky bets that were taken by top management with the goal to raise corporate innovation levels.
There are no standards yet for these “advance metrics.” They are in their infancy. If you are up to it, just pick a logical approach for your company and do it consistently. Measure against yourself. If you save your detailed numbers, you will be able to adjust them to benchmark against other companies when industry begins its adoption curve. These areas were “sandbox” and were handled differently for decades. Management science will improve greatly in the decade ahead in the pursuit and refinement of innovation.
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