Innovation expenditure falls primarily under the operating expense (OPEX) of a company. Because OPEX makes up the bulk of a company’s ongoing costs, leaders typically look for ways to reduce OPEX without causing a critical drop in quality or production output. And innovation is always a prime target when OPEX cuts are needed as initiatives with longer-term payoffs will naturally be reviewed critically in challenging times. It is common for leaders to be skeptical of spending too much on long-term opportunities when there is a short-term performance gap that must be closed to assure the survival of the company – therefore understanding the efficiency of the innovation investment (EII) is key. EII answers a critical question for any leader: how well do our ‘innovation dollars’ convert to new revenue?
The answer to this question can always serve as a good justification for ongoing investment in innovation. In particular when facing innovation-skeptical stakeholders.
On top of that, EII is a good complement to your NPVI result. If NPVI is telling you how much you are making today from products you launched in the past X years. EII is here to tell you how much you’ve spent to generate that new revenue.
Therefore the formula for EII is: current year’s total revenue from products launched in the past X years, divided by the sum of the costs of innovation in the same X years. Every company should define the time frame it wishes to compute EII for – however we would advise you to use either a 3 or a 5 years time frame.
Take for example a company that reported at the end of 2020 a total revenue from new ventures of $18 mil. The same company has incurred costs in innovation of $3 mil. in 2020, $1 mil. in 2019 and $4 mil. in 2018, making their total innovation cost for the period 2018-2020, $9 mil. In this case the EII is 18/8 = 2,25 (if you want the result in percentage you can just say that the efficient of the innovation investment is 225%)
In plain English this means that for every dollar of cost incurred for innovation in the period 2018-2020 the company generated $2,25 of new revenue in 2020.
If your EII happens to drop below 1 or 100%, it means that you are paying more for innovation than you are getting back as revenue from it. The innovation theater warning light should now be flashing red.
When computing EII for internal innovation, the costs can be found in the funnel dashboard we’ve discussed in the previous chapter. The cost you need in order to compute EII is the sum of all the costs incurred in the innovation exercise. These are the costs incurred by the: live ventures, ventures that reach the sustain phase and discontinued ventures too. You need to look at these costs for the same time period you want to compute EII for.
Note that no OPEX and CAPEX costs of running the ventures in the sustain phase should be included.
In case you want a more holistic view on EII, you can consider including in the calculation the revenue and costs associated with other innovation related activities such as mergers and acquisitions (M&A), investments made in startups (CVC) or joint ventures, in addition to the internal innovation.
Also if you just want to zoom-in on the EII for a certain innovation vehicle such as CVC for example, you can use the same logic of the EII formula but only applied to the outcomes and costs of CVC.
Corporate leaders should always be reminded that Venture Capital companies investment efficiency is not given by picking only the winning tickets (startups) but by methodically investing and following up several investments. For only a handful will be successful. But these successful ones will ultimately cover the loss incurred in all the other ventures and account for the profit of the fund too. This comes again to highlight the importance of mindset shift when investing and managing innovation.
The efficiency of innovation investment indicator (EII) is a lagging indicator. However this indicator is great for self benchmarking, trends analysis and understanding how the innovation ecosystem is maturing over time and contributing to growth.