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0 Innovation and Performance measurement
Dr. Ashish Garg 9 January, 2009

1 Background – Ashish Garg (Thumbnail Sketch)
Education: Ph.D in Economics from Harvard University (1997); taught graduate and undergraduate classes 7 years with E&Y. Total of 11 years as a management consultant Before E&Y was at McKinsey Inc. (led “R&D” type group on Strategy and Economics) Executive Director at E&Y since July 2008 Focus on Performance Management, Performance Measurement, Cost management , Finance Transformation etc Author of 50 article on Management accounting, Cost management, Performance management Quick introduction to myself Executive director at E&Y Specialist on Performance management, performance measurement , cost management and Finance Transformation Started off as academic. Got my PhD in Applied Microeconomics and Finance Been a management consultant for the past 11 years

2 Practitioner Perspective
Agenda Innovation and Performance Management EY Perspective Importance of Innovation Managing Innovation Role of the CFO in encouraging Innovation Performance Measurement and Innovation Metrics Suggestions on Reasearch Agenda The agenda is in there parts . There are three perspectives that you will hear today. The first perspective is that of E&Y , the 2nd largest professional services in the world, over 125,0000 employees. The perspective you will hear is from a study called balance point nearly 2.5 years ago. Called balance point. The analogy comes from the world of skating where skaters have to tradeoff speed with balance. Companies have to balance innovation spend with financial discipline. Remarkable study of TCE companies. Why did we study TCE companies , well innovation is front and center for them Second perspective is that of practitioner . Based on the advise we have given companies . Based on the practical concerns they provide us. Third perspective is an ex academic. Putting myself in your shoes. 15 years I was searching for thesis topics, research topics. I wish at that time someone had pointed out research ideas. Practitioner Perspective Suggestions for Research

3 EY Study: Balance Point (Innovation) Study Participants
Interviews For our study, we sought a broad diversity of opinion on the state of innovation investment processes in the global technology industry today. We spoke with senior executives who are intimately involved with innovation investment processes on a daily basis and are grappling with the issues surrounding them. We also conducted two executive roundtables in Europe, one in Germany, the other in the U.K., specifically on the topic of technology innovation investments. These interview and roundtable participants represent a good cross-section of European and North American executives across a number of Technology sectors, plus financial stakeholders who drive capital markets. The approximate total Market Capitalization of the ten nonventure capital companies interviewed is $420B, with annual Revenues of $258B. The three venture capital interviewees have approximately $5.7B in assets under management. [Name a few of the companies and financial stakeholders we spoke with—as appropriate to your audience.]

4 Survey Respondent Titles
Senior executives from a variety of backgrounds participated in a global online survey regarding investment in innovation Survey Respondent Titles (Number of Responses) Industry Sector Size—Annual Revenues Geographic Location Source: Ernst & Young analysis; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152)

5 EY Study : Balance Point Bringing Discipline to Investment in Innovation and Growth
Importance of Innovation: Executives confirm innovation remains critical Managing Innovation: Companies struggle to manage investments Role of the CFO in encouraging Innovation : CFOs can bring new rigor to the process Performance Measurement and Innovation Metrics : Helps focus on drivers of success Research Agenda “If we don’t find a good way to address innovation and make use of innovation, then we will immediately fall behind in the competitive race.” Now, on to the study and its findings. In keeping with our speed skating theme, we begin at the ‘starting line’: The first group of slides examines the increasing importance of innovation to the success of technology companies today. [Read quote] Executives confirm that innovation is more intense and critical than ever before. Later we will be examining the how companies are trying to keep pace with the external demands of the market; the internal issues and challenges that they face in managing innovation, and the opportunity that has surfaced for the CFO and Finance organization to help manage the process. But first, let’s examine the increasing importance of innovation to the success of technology companies today. Note: throughout the presentation deck, the executive quotes help to add color to your presentation—so be sure to read some of the quotes on each page—it helps to set the stage Source: Ernst & Young analysis and executive interviews

6 Executives concur that future success depends upon effective product and service innovation
In your opinion, what will be the top three drivers of your company’s success over the next two years? “Innovation is our number one priority as a company.” “The core of what we do and the core of how we generate growth always boils down to big innovations.” “Innovation is always important. Always.” “Innovation is, of course the name of the game in our industry.” Not surprisingly, executive comments and our online survey shows that product and service innovations is the ‘lifeblood’ of technology companies. Survey respondents identified product and service innovations as the top driver of success. Executive comments at right echo the online survey data. [read a quote] What is interesting to note is that these comments are coming from CFOs and senior finance executives. Dr. Chesbrough’s quote at bottom highlights one of the major themes to emerge from our analysis of this study—that the markets of the future will be driven by technology companies that commit the right balance of internal and external resources to innovation. “Markets of the future will be developed by the skilled innovators of today who commit the right balance of internal and external resources to the innovation process.” —Henry Chesbrough Percent of Responses Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses); Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology, Harvard Business School Publishing Corp., 2003

7 Large and small companies have somewhat differing views on the relative importance of innovation, but there is general agreement that it is an essential process In your opinion, what will be the top three drivers of your company’s success over the next two years? Percent of Responses Technology innovation is more important than ever in driving my company’s success Large companies rate customer service higher than innovation, while smaller companies rank innovation as the top priority However, almost 90 percent of surveyed large companies indicate that innovation is more important than ever in driving success “It’s much easier to innovate as a small company because you’re creating your own religion.” We looked at a slice of the same questions by the size of the companies of the survey respondents—those at companies with less than $1 billion in revenues, and those at companies with more than $1 billion in revenue. This slicing turned up a nuance in our study: Larger and smaller companies have slightly different views on the importance of innovation to company success. Smaller companies named innovation as the top driver of their success while larger companies named customer service as the top driver of success and placed innovation as a close second However, that slight difference in the order of importance seems logical: Large companies may place customer service first because they already have products deployed and our focused on retaining those customers and keeping those revenue streams. Smaller companies are trying to get to market with their core innovations and often don’t face organizational resistance and other barriers, as the executive comment at bottom illustrates. However, putting this slight ordering difference aside, there’s an overwhelming consensus, from both large and small companies, that innovation is the key driver of success and a primary focus of technology companies. Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

8 R&D Intensity by Sector R&D Spending as a Percent of Sales
R&D intensity has exhibited considerable volatility within segments of the technology sector over the past five years “In the past, we and most of our competitors would move R&D spending with revenue. The result was choppiness in the product coming out, and your products tended to come out about the same time as your competitors’ because you were all doing the same thing.” R&D Intensity by Sector Communications Equipment Computers Conglomerates Semiconductors Software Sector Averages R&D Spending as a Percent of Sales We wanted to know if companies were backing up their words with dollars—‘putting their money where their mouths are.’ To answer that, we examined R&D intensity, that is, R&D spending measured as a percentage of total sales within each sector, as shown in this graph. The R&D spending (Percent of Sales) analysis was performed on a pool of 36 companies in five sectors. The minimum representation in a sector was five companies. The analysis shows that R&D intensity has been somewhat volatile over the last five years, particularly in the communications equipment and software sectors. FYI: The chart below contains the numbers behind this graph. (NOTE: THESE ARE SAMPLES WITHIN EACH SECTOR ONLY—THEY DO NOT REFLECT THE TRUE TOTALS FOR EACH SECTOR) Note: Software’s 4Q03 R&D intensity was almost 2x higher than any of the other quarters. This activity was driven primarily by one company [Microsoft] and according to their 10Q report was due to a change in accounting policy due to: a) stock-based compensation expense from the employee stock option transfer program, and b) a lesser impact from an increase in headcount related costs. There does not appear to be any merger-related activity driving the numbers. Note: R&D Spending (Percent of Sales) analysis was performed on a pool of 36 companies in five sectors. The minimum representation in a sector was five companies. Source: Ernst & Young analysis and executive interviews; publicly available financial data for selected global technology companies for the years –2004, via FactSet 10.10M, accessed 9 February 2004

9 Surveyed Annual R&D Spending Intensity
Survey participants are committing substantial resources to their R&D activity Surveyed Annual R&D Spending Intensity R&D spending measurements do not include additional sources of innovation, including: Half of survey respondents are spending more than 10 percent of their revenue on R&D spending M&A activity Joint ventures and partnerships Externally sourced innovation and licensing fees recorded as cost of sales Product development expenses not listed as R&D R&D Spending (Percent of Sales) 50% Percent of Responses “R&D spending must be smarter, not just increased. Firms must leverage the R&D investments of others, in addition to their own.” —Henry Chesbrough This graph reinforces the notion that technology companies are making large investments in R&D today and how important innovation is to their overall success. Half of all respondents told us they are spending more than 10 percent of revenues on R&D. And R&D spend only tells part of the story. Companies are also making external R&D investments through M&As, joint ventures, partnerships, licensing fees recorded as cost of sales, and other product development and marketing expenditures. When all the investments are added up, it is apparent that companies are making substantial investments in technology innovation (costs associated from ideation to commercialization.) Therefore, as Dr. Chesbrough’s quote at bottom right suggests—another important theme emerging from our analysis of the study findings. [read quote]. Source: Ernst & Young analysis; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses); Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology, Harvard Business School Publishing Corp., 2003

10 The communications, media, and entertainment industries provide an example of how new technology waves are coming more rapidly 0% 25% 50% 75% 100% 1920 1926 1932 1938 1944 1950 1956 1962 1968 1974 1980 1986 1992 1998 2004 U.S. Adoption Rate of Selected Technologies Internet Digital video recorders Radio Broadband VHS Television Wireless phones DVD player Cable TV + DBS Years to achieve 50 percent 6 9 na 10 16 35 Percent of Households or Population in Year This is a fascinating graph—it shows that new technology waves are coming at a faster and faster pace. Some people try to say that adoption of individual technologies is happening faster, but when you normalize for the size of the population at the time, which we did here by reporting adoption as a percent of the population, you see that the curves are all pretty much the same—they’re all very steep—they’re just occurring with more frequency. Likewise, the widespread adoption of new technologies continues as evidenced by consumer entertainment technologies—Internet, DVD, wireless phones, etc. And, there is no reason to believe that this won’t continue. For example, today’s consumer entertainment ‘hit’ products—digital video recorders, iPods and MP3 players—are just ramping up. So, what’s next? And you see the optimistic quote at the bottom—in other words, the industry keeps finding new ways for us to spend ‘more’ money. “Suddenly, the rate of change has definitely increased. I see different changes and innovation paths all the time; their frequency has exponentially grown.” Note: Adoption rates are all percent of U.S. households with selected technology, except Wireless phone, which is percent of U.S. population; Years to achieve 50 percent is number of years needed to reach 50 percent adoption, beginning when technology was adopted by at least 1 percent of U.S. households or population Source: Ernst & Young analysis; “Statistical Abstract of the United States,” U.S. Census Bureau, various years; “Historical Statistics of the United States, Colonial Times to 1970, Doc 93-78, ,” U.S. Census Bureau; “Falling Through the Net II: New Data on the Digital Divide,” National Telecommunications and Information Administration, 28 July 1998; “Communications Industry Forecast & Report,” Veronis Suhler, July 2003; “Worldwide and U.S. DVR Forecast,” IDC, March 2004; “Media Trends Track,” (citing Nielsen Media Research); “Media Trends,” Kagan, 2004; “Consumer Devices and Services Europe,” Forrester Research Inc., October 2003

11 Technology companies are striving to align investments closely with customer needs, while also balancing the requirements of other key stakeholders My company’s technology innovation investment decisions are aligned closely with the needs of our customers Percent of Responses Surveyed companies believe they are closely aligned with their customers ... ... but it is important to remember that customers are only one (albeit important) component of the entire value chain “If you think only about the end-user and not about the value chain along the way, you might have the best product in the world, but it might never make it to market.” “To get ideas, you ensure that your engineers spend time out with customers, or in our case, our customer’s customers.” “When we talk about customers and being customer-focused, we usually mean the companies that we are selling our technology to. But our role with respect to innovation management is to make sure that we get to the end-user.” The customer is clearly an important part of the Value Chain today and a main driver of innovation investment decisions. In the online survey, 86% agree that they are aligning their innovation investments with customer needs. Customers are an important part of the innovation investment decision process, but they don’t have all the answers. However, executive comments suggest that they are not the only ones that companies need to pay attention to. [read a quote] Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152)

12 Financial analysis indicates a positive relationship between R&D intensity and profitability, with some outliers R&D as a Percent of Revenue ( ) R&D Intensity versus EBITDA Margin R&D intensity (measured as a percent of revenue) appears to be correlated with lagged EBITDA margins “You don’t invest today for revenue tomorrow. You invest today for revenue that’s probably quite a few years out.” “The bill for innovation is getting steeper. I’m getting more anxious about it, and I can’t tell for several quarters whether I’m doing anything right. We’re going to have to wait for a long time to find out.” EBITDA Margin, Two-year Lag to R&D Spending ( ) Companies that spend more on R&D tend to be more profitable. This graph shows the positive relationship between R&D intensity, measured as a percent of revenue and profitability, measured as EBITDA. The results are lagged by two years because R&D investments don’t return profits immediately. Which as the quote on the right suggests, is of concern to some. [read second quote] And the correlation between R&D spending and profitability is even stronger when the two outliers at the bottom right of the chart are removed. They represent communications equipment manufacturers in the post-‘dot com’ era. The R2 of the trend line is This trend line improves significantly to 0.62 if one excludes the anomalous years of 2001 and 2002 from the Communications Equipment industry. Note: Each plotted point represents a sectoral view of profitability for one of five technology industries (computers, semiconductors, communications equipment, software, and conglomerates). Observed EBITDA margin is lagged two years (e.g., 2001 R&D intensity is compared to 2003 EBITDA margin). The R2 of the trend line is 0.40. Source: Ernst & Young analysis and executive interviews; publicly available financial data for selected global technology companies for the years 1998–2004, via FactSet 10.10M, accessed February 2005

13 EY Study: Balance Point Bringing Discipline to Investment in Innovation
Importance of Innovation: Executives confirm innovation remains critical Managing Innovation: Companies struggle to manage investments Role of the CFO in encouraging Innovation : CFOs can bring new rigor to the process Performance Measurement and Innovation Metrics :Helps focus on drivers of success Research agenda “I don’t know that we have any best practices for managing innovation. It frustrates me a great deal.” Managing Innovation—as companies continue their race to differentiate themselves through innovation we find that they are as challenged from within as from the external market forces. Here we discuss the formidable ‘internal’ challenges technology companies face in managing their innovation investments today. This section also highlights another ‘balance point’ our study has uncovered, the need to manage risks and opportunities. By and large, companies admit they are not managing either very well. Executives are frustrated at the current state of innovation investment processes and decision-making capabilities, as expressed in the quote above. [read the quote] We will explore this in more detail in this section. Interestingly, the frustrations are coming in good portion from CFOs—by and large, this is not the CTO or techies talking. Source: Ernst & Young analysis and executive interviews

14 Many companies see room for improvement in their ability to manage investment in technology innovation Grade your company’s current ability to manage its investment in technology innovation Percent of Responses My company uses disciplined processes to manage investment in innovation Approximately 75 percent of surveyed companies indicate they have disciplined processes in place to manage innovation ... ... yet less than half indicate their ability to manage technology innovation investment is above average “We have an integrated risk and opportunity management system.” “We don’t have control of our R&D projects yet.” The survey results highlight a clear disparity between having innovation investment processes in place and being able to manage them effectively. It is difficult to reconcile these responses. Three-quarters of survey respondents agree they have processes in place. However, most rate their ability to manage those processes at average or above average. Only 7 percent rate their ability superior. The contradiction highlights an area where there is definite room for improvement. [read quote on bottom right] Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

15 Technology innovation management is an issue for both small and large companies
Percent of Responses My company uses disciplined processes to manage investment in innovation Grade your company’s current ability to manage its investment in technology innovation Small and large companies report similar levels of innovation process discipline Larger companies are somewhat more confident in their management abilities, but over 40 percent still indicate they are average or below average Our survey also reveals that innovation investment management is an issue regardless of company size. Few companies say their management is ‘superior’—6 percent of small companies and 7 percent of large companies. This is remarkable, considering that innovation is so critical to a company’s success It appears that, although they have processes in place, those processes are not performing at the level needed. Source: Ernst & Young analysis; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

16 There is significant frustration over a general lack of ‘best practices’ with respect to managing innovation investments “I don’t know that we have any best practices for managing innovation. It frustrates me a great deal.” “The go-to-market side is usually forgotten in this industry.” “We are not good at the marketing and selling of innovations, so 80 percent of the patents that are filed never become a product that you’ll see in the market.” “We hide behind the claim that it’s impractical to come up with a process, or even a collection of processes to manage innovation investment effectively. It seems that the judgment of the wise man is just as good as any kind of processes you come up with.” “The hardest thing to do is to figure out return on R&D investment.” “It’s hard to make improvements in managing innovation because there’s an old culture right now that sort of works, so people ask, ‘Why would I change this?’” Many companies report a lack of discipline in their end-to-end control of the innovation process ... ... but there is no clear vision of how to improve control Executives express frustration at the lack of ‘best practices’ for managing their innovation investments. [read quote, top left] They also acknowledge that they don’t have a clear vision on how to proceed. [read a quote] This lack of ‘best practices’ affords the CFO and Finance organization the opportunity to bring new rigor and take a lead role managing innovation investment processes. The frustration over managing innovation investment creates an opportunity for a CFO to participate in the process in new ways Source: Ernst & Young analysis and executive interviews

17 Managing innovation is a challenge when failure is a common—and necessary—outcome
“The biggest problem with internal company innovation is the lack of tolerance for failure. I don’t think corporations are well set up for people to fail at enterprises.” “We have 60 percent failures. If you measure yourself by the number of failures instead of return, you’d feel terrible.” “Going into new areas, you have to start with ten initiatives to have one that’s really successful.” “These are big bets that we’re talking about. And we know they won’t all pay, and that’s OK—they’re allowed to fail.” “Companies that are more sophisticated understand what control can do on the negative side.” “If it were up to me, I would introduce different mechanisms for managing my mature businesses and my new initiatives.” Measurement must reflect the need for a certain amount of failure, especially when pursuing breakthroughs Not all innovation should be managed the same way—or innovation can be stifled If a company is not failing at some of their innovation investments, they may not be spending enough on innovation What’s causing their lack of confidence in the ability to manage their innovation investments? At least a part of the answer is that managing innovation is a challenge when failure is a common and necessary component. Comments on the left side explain why executives say failure is common and necessary. [read a quote] Comments on the right side point out a second challenge that might cause a lack of confidence. [read a quote] Technology companies need to recognize that not all innovation investments should be managed the same way. This is particularly true with ‘breakthrough’ innovations. Source: Ernst & Young analysis and executive interviews

18 Mergers and acquisitions are increasingly a part of technology companies’ innovation strategies
Companies are buying innovation in addition to developing it in-house ... “It used to be that technology companies did not look to acquisitions as a way of growing their portfolio. Now I think it’s an accepted strategic principle.” “Spin-in is another way of innovating, giving the financial motivation to the individuals in the spin-in.” ... but successful integration is the key challenge to merger success. “You’re going to have to learn how to integrate. Adding an acquisition is almost like dealing with high growth.” “You have to be humble when you’re an acquirer. Just because you happen to be fortunate enough to have the money to buy them, the fact of the matter is you didn’t buy them from a position of strength [but] because you couldn’t develop the capability internally.” My company excels at integrating merger and acquisition deals to achieve planned benefits Percent of Responses Less than one-third of surveyed companies agreed that they excel at integrating M&A deals M&As are also an increasingly important part of company innovation investment strategies. However, M&As have proven particularly challenging to integrate. Less than a third of the survey respondents agree that they excel at M&A integration. Factors that executives tell us have gotten in the way of successful M&A integration include: Doing the deal is only the first part of the transaction. The integration process must be monitored before, during, and after the transaction to achieve maximum benefit. Companies have to be humble because if they could do it on their own they probably would have. There is an important cautionary note in the last comment about being humble—that the acquirer should not alienate important personnel in the companies they acquire—because they likely can’t meet their objectives alone. Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

19 Effective risk assessment is a key part of the investment decision process
Understanding and communicating risks is critical to success ... “People at the project levels think their project is the most important. You want them to be that way and have that kind of passion. But they don’t always realize the damage that their lack of success may have on the company, or the risk the company is taking on their behalf.” “Good innovation management processes may not guarantee the best possible outcome, but they can maybe minimize the risk of the worst possible outcome. You can narrow the range of probability of disaster a bit.” ... but risk analysis must go beyond the financials “It’s not just the financial return, it’s also the technology risk, the marketing risk.” “There are companies that partition innovation risks, so they split up risk into market risk, or execution risk, or knowledge risk, and then assign people to assess and manage those risks. For example, the people that execute are most capable of talking about and quantifying execution risk.” Less than half of surveyed companies agreed that they used project-specific risk analysis to evaluate investment opportunities ... My company uses project-specific risk analysis to evaluate each technology innovation investment opportunity The need for ongoing risk assessment is huge. Companies aren’t doing a good job of identifying and managing the myriad of risks that exist throughout the value chain. Just less than half of the survey respondents agree that their company uses project-specific risk analysis. Executives we interviewed told us companies must address risk holistically and systematically. They need to: Examine all the risks in the value chain, from technology to marketing, to financial, shareholder, market, technology, channel, even team risk. Monitor risk throughout the process, not just at one point in time. Realize that effective holistic risk assessment won’t ensure success but it will help avoid disaster. [read a quote] Percent of Responses “To me, if you look across the American economy, there are only two segments of the economy that probably are truly good at managing risk—the insurance industry and the financial and banking industry.” Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

20 Companies seem to be focused on processes to ensure that they are fully compensated for their investments in technology innovation My company has operational and legal processes in place that ensure we are fully compensated for our technology innovation investments Percent of Responses Licensing is an important revenue stream … “One way to manage non-core innovation is to say, ‘It would cost too much to incubate, so let’s license out this technology to anybody, even competitors, who might have an interest.’” … and the choice of business model is critical … “The linkage between innovation and technology is the business model.” “We need different business models to take on different markets.” … to capture the most value from innovation “We have a comprehensive set of techniques to try to create value out of the whole portfolio.” “We are able to translate innovation into bottom-line results, and this, for me as a CFO, is the key target.” Effective operational and assurance processes are needed to ensure that companies are not ‘leaving money on the table’ Now lets take a look at investment compensation Companies are striving to get the most value from their innovation investments. That means, in some cases, they are licensing that technology to others. Companies need the right operational assurances in place to make sure they are not ‘leaving money on the table.’ About two-thirds of the survey respondents agreed that their companies have processes in place to make sure they are fully compensated for their technology innovation investments, such as licensing. The CFO and Finance organization can help improve the identification of IP value--helping to ensure that “money is not left on the table.” However, there do not appear to be uniform measures of IP valuation. Some high tech companies such at IBM and Texas Instruments have leveraged their patent portfolios through licensing and receive substantial royalty revenues. IBM Corporation takes in about $1 billion a year in licensing revenue. Other tech companies, Hewlett-Packard Development, L.P., for example, try to emulate its model [“Licensing's In and the Lawyer's Out,” April 2004].“ [Source: “Is this the start of an IP Armageddon†,” IP Law and Business, 29 November 2004, via Factiva.] Other companies like Intel opt to publish their knowledge instead of patenting it. As Henry Chesbrough states in his book, Open Innovation, “The value of an idea or a technology depends on its business model.” Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

21 Leading edge Analytical tools and techniques to make better decisions are not used to manage innovation My company uses leading analytical tools to help make and track technology innovation investment decisions Percent of Responses “Most companies track the money they spend, and some track the time they spend, but few are tracking the risk they incur. Leading companies deploy analytical tools and control processes that address all three.” —Henry Chesbrough Companies see the need to enhance ‘gut feel’ decision-making ... “In the end, somebody needs to sign on the dotted line, and it comes down to a ‘gut feel’ whether to move forward or not. But you are enriching your ‘gut feel’ by exposing it to various scenarios and various analytical techniques. You are looking at the picture in a multi-faceted way, and hopefully you make a better choice.” ... and look to Finance for help “You need the fundamental tools—transparent numbers—so that somebody can sit down and assess the risk equation.” 47% By using state-of-the-art analytical tools CFOs can add financial discipline to the innovation investment process. However, executives say that many companies are relying on ‘gut feel’ and are not using leading edge analytical tools to help make their innovation investment decisions. Just over half use analytical tools, according to our survey. Executives express the need for more fact-based analysis. Companies need more than ‘gut feel.’ They need to model and detail the decisions. They need to perform sufficient due diligence. Finance can help guide these decisions. Dr. Chesbrough’s quote summarizes another emerging theme of this study: That successful companies need to manage all three—the money they spend, the time they spend, and the risk they incur. Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152); Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology, Harvard Business School Publishing Corp., 2003

22 Companies that utilize leading analytical tools are also likely to have good processes to monitor their investment results The use of leading analytical tools is highly correlated with a company’s ability to effectively monitor investment performance, as survey respondents answered these two questions similarly “When you depend on individual visionaries for innovation decision-making, you have the chance of hitting it big. But even a simple process like collecting the best opinions of the people in the various fields and making a rational, analytical kind of assessment would help—but we do not practice that.” “Thirty years in Finance has taught me to halve the projected return and double the projected cost to estimate the return of a project.” My company’s technology innovation investment results are monitored closely against the original decision analysis, and any variances are understood My company uses leading analytical tools to help make and track technology innovation investment decisions “Financial discipline does not have to stifle innovation. Done well, it will drive it.” —Henry Chesbrough Our survey indicates that using leading edge analytical tools is highly correlated with being able to monitor a company’s innovation investment performance effectively. Read quote. The same people answered these two survey questions similarly. Eighty-three percent of those people who answered one question with a certain response answered the other question with the same response, or a response that was +/- one value (e.g. ‘Strongly Agree’ versus ‘Somewhat Agree’). [summarize by reading Chesbrough quote] Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses); Henry Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology, Harvard Business School Publishing Corp., 2003

23 Many companies do identify underperforming investments and taking action quickly
My company is able to identify and reduce funding quickly for underperforming innovation investments Percent of Responses Innovation portfolio reviews are critical to success ... “The sifting process, the narrowing of the competing technologies, has to occur more quickly.” ... but organizational inertia can prevent tough calls ... “It’s very challenging to cut projects because there are competing groups—sales wants what customers want, engineers are focused on technology, and the CEO and marketing are in between.” ... so fact-based decision processes are key “Sometimes you have to be the enforcer and encourage people to put an end to something that isn’t working by saying, ‘Look, I’m not going to invest any more money—it’s going down a black hole. It doesn’t matter how enthusiastic you are, you don’t have a business case.’” “There’s a real focus on what milestones are going to be accomplished on what amount of money—and the penalty for failure is terminal.” “There should be a healthy yin and yang between the CEO and the CFO, where the CFO can close the office door and say, ‘We’ve got to have a talk about this because this particular piece of the business isn’t going to work.’” Other areas requiring analytical rigor include: identifying questionable investments; investment compensation; M&A integration; and risk assessment. For example, many companies don’t have the tools they need to identify questionable investments. Only about one-half of the survey respondents indicated that they have the analytical tools necessary to make decisions quickly. Read a quote. With the proper tools, the CFO and Finance can: Model businesses accurately. Question all the inputs to the model to make sure the business innovation plan is good and sound. Identify underperforming investments. Overcome organizational inertia and shut down underperforming projects. For all these tasks, executives need the kind of fact-based, unemotional analysis that only the Finance organization can provide. [read a quote] Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

24 EY Study: Balance Point Bringing Discipline to Investment in Innovation
Importance of Innovation: Executives confirm innovation remains critical Managing Innovation: Companies struggle to manage investments Role of the CFO in encouraging Innovation : CFOs can bring new rigor to the process Performance Measurement and Innovation Metrics : Helps focus on drivers of success Research Agenda “The CFO needs to be a business partner, not just a financial person.” Creating the innovation edge: The CFO and Finance organization have an opportunity to improve the organization’s innovation investment processes to make smarter, more accurate decisions, and get a better return. Now we will discuss what the CFO and Finance organization can do to seize this opportunity and lead the way—balancing innovation creativity and financial discipline. Executives are telling us that to truly add value, the CFO and Finance organization must be a business partner—and address the ‘soft’ people related issues of the innovation process as well as provide the financial rigor necessary to control the process and improve the outcome. Source: Ernst & Young analysis and executive interviews

25 The CFO and Finance organization are becoming increasingly involved in the technology innovation investment process Over the past two years, the CFO and Finance organization have become more involved in the technology innovation investment process Percent of Responses The roles of the CFO and Finance organization in technology innovation investment decisions are clearly defined Survey respondents clearly indicate the growing involvement of Finance in investment decisions ... ... however, the role of Finance in these decisions is less clear “Finance should educate us technical people better about what finance does. Most engineers will think it’s just adding up numbers, and if you want to correct that simplistic view, then educate them. Otherwise, it’s just the finance guy saying, ‘We cut the plan this quarter because we’re not going to make as much money, so you can’t spend what you were planning.’” 53% 74% For example, education is key—CFO and Finance must correct the ‘simplistic’ view of their capabilities, as noted in the executive quote at bottom. [read quote] Some progress is being made: Study findings tell us that CFOs and Finance are already becoming more involved in the innovation investment process. As the left graph illustrates, almost three-quarters of the survey respondent say the CFO and Finance have become more involved. However, as the right graph shows, only slightly more than half say that their roles are clear. Defining that role remains an area for improvement. Thus, education remains key. And executives tell us that CFOs who are successfully integrating themselves into the process and adding additional value are working very hard to do so. Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005 (n=152; graphs may not total 100 percent due to rounding and exclusion of ‘not applicable’ responses)

26 The CFO often adds value to the innovation investment process, but there is room for improvement
Technology personnel are looking for a broader level of involvement from Finance ... “A lot of the time companies are flying by the seat of their pants. The CFO is cutting checks, but it’s not clear that they’re adding the kind of value they could.” “The only thing Finance tells us is, ‘We can negotiate costs down,’ and that’s a good thing, but that doesn’t make the decision any better. It could still be a terrible loss, or it could be brilliant.” “Before, Finance was more like bean counters—but now that has changed completely.” ... and for Finance to play the key intermediary role “In the future, the role of the Finance organization is to fit between the product, the support, and the field organization, and aggregate the three points-of-view into a company point-of-view—more financial modeling and advice than financial control.” “The finance person should be the one who really facilitates, monitors, and coaches the management team.” CTOs rate Finance’s contribution lower than CFOs do The CFO and Finance organization add significant value to the management of innovation investments The survey results show that the CFO does add value to the innovation investment process, but the perception is that there’s definitely room for improvement. It is interesting to note the discrepancy between the views of CFOs and CTOs in the survey results. CFOs think they are contributing to the innovation investment process. CTOs think that CFOs are not adding all the value they could to the process. Consider the executive comments at top right. [read a quote] A broader definition of the role of the CFO is required. That broader definition requires the CFO to: Fit between key internal groups or constituencies. Be a neutral, dispassionate party. Be a key intermediary between stakeholders. Percent of Responses “Finance is a good sounding board because they’re totally neutral on technology—they’re not grinding an axe one way or another.” Source: Ernst & Young analysis and executive interviews; “Ernst & Young’s Global Innovation Investment Survey,” 2005

27 ANALYTICAL TOOLS FOR MANAGING INNOVATION
CFOs can bring specific analytical tools to bear on the task of managing innovation “The CFOs participation should be about bringing the right tools to the table.” ANALYTICAL TOOLS FOR MANAGING INNOVATION Game theory Enterprise planning models Simulation models Sensitivity analysis Risk portfolio analysis To test how competitors, customers, suppliers, and other stakeholders might respond to an innovation, and the corresponding impacts to the innovator To provide an integrated view across all dimensions of the company (product, geography, business unit) that can test the impacts of innovation investments successes and failures on the financial performance and valuation of the innovator To test the probable outcomes of innovation investments To test the potential upsides and downsides of innovation investments, and help develop an innovation portfolio with relatively greater upside potential and reduced risk To apply portfolio theory to the balancing of the risks and returns of innovation investments To utilize consistent evaluation criteria and to track investment performance against planned results and gates Business case evaluation templates and performance tracking Leading edge analytical tools can help the CFO and finance add the financial rigor necessary for a successful and sustainable technology innovation investment process. These are a few of the leading-edge analytical tools available that can help a company make smarter investment decisions as well as measure, monitor, and manage the investment process from ideation through commercialization. Game theory—tests reaction to your innovation from the perspective of competitors, customer suppliers, and other stakeholders. Enterprise planning models—offers a view of what could happen if the innovation succeeds or fails. Simulation models—test the probable outcomes of innovation investments. Sensitivity analysis—identifies the upside and downside of each investment—helping you balance risk and opportunity. Risk portfolio analysis—this issue comes up a lot—companies need a way to balance risk and returns across their investment portfolio—they need to see the whole picture. Business case evaluation templates and performance tracking—provide an ability to monitor and track investment performance throughout the process—this is a critical and often overlooked or misunderstood area of the process. The executive quote offers a fitting summary—“The CFO participation [in the innovation investment process] should be about bringing the right tools to the table.”

28 Innovation Creativity
Finding the ‘Balance Point’ across multiple innovation investment processes is the key challenge for technology executives Opportunity Innovation Creativity “It's not a ‘Let’s see what happens’ bet, it’s a ‘Let’s bet the farm’ bet.” “You need the fundamental tools—transparent numbers—so that somebody can sit down and assess the risk equation.” “You want to be in control of your own destiny as much as possible.” “It’s not just the financial return, it’s also the technology risk, the marketing risk.” “Engineers are really focused on delivering the next degree of functionality just for the beauty of delivering it.” “I think that the CFO’s participation should be about bringing the right tools to the table to assess the financial aspects of innovation investment.” “You need to make milestone reviews as objective and as measurable as you can.” “The hardest thing to do is figure out return on R&D investment.” Short-term Return “They want their money tomorrow.” “I can do whatever you want next quarter, but you won’t like the answer a year from now.” “We have an environment these days where innovation is almost being replaced by hectic last-minute improvements.” “An innovation might be a little revenue in three years, but the revenue tail could grow exponentially, not linearly.” Long-term Investment and Risk Financial Discipline As we mentioned at the beginning of this discussion, our study has identified three key ‘balance points’ that provide a framework for improving your organization’s innovation investment processes. As we said at the beginning, a ‘balance point’ is not an either/or’ situation in which two ideas exist in conflict with one another, but rather a yin/yang relationship in which two goals exist and have value only when considered together. Those balance points are: Short-term Return and Long-term Investment: The same stakeholders pressing for short-term returns are also pressing for long-term investments. [read a set of quotes, i.e., “They want their money tomorrow.” and “I can do whatever you want next quarter, but you won’t like the answer a year from now.”] Opportunity and Risk Management: Companies are doing an inadequate job of managing both risk and opportunity. [read a set of quotes] Innovation Creativity and Financial Discipline: Visionaries and ‘gut level’ thinking are as essential to successful innovation investment processes as financial discipline and rigor. [read a set of quotes] Source: Ernst & Young analysis and executive interviews

29 Practioners Perspective
Importance of Innovation: Executives confirm innovation remains critical Managing Innovation: Companies struggle to manage investments Role of the CFO in encouraging Innovation : CFOs can bring new rigor to the process Performance Measurement and Innovation Metrics : Helps focus on drivers of success Research agenda “Provides a tactical understanding of organization’s value drivers” Source: Ernst & Young analysis and executive interviews

30 Measurement of Innovation remains a challenge for Organizations
The kinds of innovation companies take up are diverse. Yet no matter what form of innovation they pursue, far fewer companies measure it than pursue it. Sources: McKinsey Global Survey Results – Assessing innovation metrics

31 Value of Metrics within Business Performance Management
Locks measures into strategy and value Helps define management dialogue upwards and management focus. Forms the basis for performance evaluation Helps to set expectations for reporting and planning level of detail Incent the desired behavior What is Performance Measurement used for ? Delivery of the organizations' strategy and objectives Articulating a clear link between valuation/shareholders expectations and the drivers that influence it – both now and in the future Setting targets and driving desired behaviours at each layer of the business Management and employee performance scorecards & incentives Defining the content of management reports and the management intervention processes that need to be in place to drive performance improvement Developing planning and budgeting process templates and thus ensuring alignment and integration of the key business processes Creating a culture for fact based decision making through linking metrics, decision making processes and incentives Note: The process described above can be part of a client’s performance management cycle as metrics need to be reviewed on a regular basis. It is also the process of EY delivery of performance measurement engagements. Re-Align

32 Cascaded / linked metrics
Metrics Fundamentals Within the organization, metrics are both used to focus the dialogue upward and provide management oversight downward ILLUSTRATIVE Dual Metric Roles “The Street” 1. Management Dialogue – Metrics serve to focus discussion of business results with upper management / the investment community Management dialogue Corporate Cascaded / linked metrics Management dialogue Management focus BUs Management dialogue Management focus Geographies Management dialogue 2. Management Focus - Metrics should focus on critical measures needed to manage your business Management focus Functions Metrics should therefore be cascaded to enhance the dialogue and scorecards are the key performance tracking format for metrics

33 E&Y’s 4 step process of creating and sustaining measurable organizational value through metrics
1 2 3 4 Understand & Articulate Strategy Develop Outcome/Input Metrics Prioritize and Select Metrics Cascade and Embed Metrics Review Mission, Vision, Corporate strategy and operating model Review Company’s industry and review key metrics used by external observers Review Strategic Objectives Value Decompostion Develop Outcome Metric Develop Input Metrics Collect Metric Data - Prioritize rankings and review with group A. Ranking Methodology B. Quantitative Methodology Cascading the metrics across the organization Link to Processes Link to Reporting Link to Incentives Internal Review Review Mission, Vision, Corporate strategy and operating model External Review Understand the Company’s industry Review key metrics used by external observers (eg. industry analysts) to evaluate the performance of industry players (such as ROIC and Economic Profit) Strategic Objectives Review organization's strategic objectives Understand the key activities required to deliver the organizations strategy Develop Outcome Metric Develop current outcome metrics / value drivers and links to strategic objectives Evaluate suitability of outcome metrics to relevant BU, Business Segment, Business Lines or Function Metric Decomposition Decompose selected outcome metrics to identify additional drivers Consult other sources (eg. industry publications / benchmarks) to enhance the list Validation and Selection Validate / enhance the list with stakeholders Finalize approach on how to validate and prioritize the list to the key few metrics Quantitative Analysis (optional) Conduct quantitative analysis to understand: Impact of metric changes on outcome metrics Inter-relationships between metrics Metric Data Collect supplementary information for chosen metrics on internal and external benchmarking data availability Collect supplementary information for each of the chosen metrics to complete a KPI library A. Ranking Methodology Finalize approach, define ranking criteria and weights Have decision group rank each metric Prioritize rankings and review with group B. Quantitative Methodology Analyze impact of drivers metrics on outcome metrics Prioritize rankings and review with group Cascading the metrics across the organization Cascading the metrics from the Corporate level to the BUs/Business Lines and functions Link to Processes Link the validated metrics to planning process (planning, budgeting and forecasting) Link to Reporting Link the validated metrics to Business Performance Reporting Link to Incentives Link the validated metrics to performance incentives

34 Metrics should be derived from Corporate strategic objectives (Step 1)
Metrics Derivation Flow ILLUSTRATIVE Questions Mission Why does Company X exists? Steps / building blocks required to determine metrics What are Company X’s guiding principles? Core Values Step 1 What is Company X’s vision of the future? Vision What are Company X’s differentiating activities and strategic objectives? Strategy & Objectives How can Company X quantify its strategic objectives? Outcome Metrics The "few" measures of success for the company's mission and strategies Step 2 What must be done well in order to implement strategy? What are the key drivers of success? Business Driver Metrics The internal and external factors that directly influence business outcomes Sources: 1) Company X Vision: X.com/About/who-we-are/; 2) Company X Strategies: X.com/About/strategies/; 3) Corporate Scorecard Mockup

35 Measurement of Innovation: Innovation Outcome Metrics
Pros Better aligns with ultimate strategic objecdtives such as Revenue, Earnings and Shareholder Value Cons : Difficult to measure require some subjectivity Examples: Number of new products or services launched Revenue growth due to new products or services Percentage of sales from new products/services in given time period Profit growth due to new products or services Potential of entire new product/service portfolio to meet growth targets Changes in market share resulting from new products/services Net present value (NPV) of entire new product/service portfolio Return on Innovation = (Cumulative 3-year net profits from commercialized new products) / (Cumulative 3-year new product total expenditures for commercialized, failed or killed products) Innovation Revenue Per employee = = total cumulative 3-year annual revenues from commercialized new products / total equivalent full-time employees devoted to innovation initiatives Sources: McKinsey Global Survey Results – Assessing innovation metrics

36 Examples of Companies using Output Innovation Metrics
Pepsi: Number of new products with revenue over $100M launched in the last two years Kellogg’s 17% of sales in 2007 were from products launched in the last 3 years. 3M: 25% of revenue from products introduced in the last 5 years. Increased to 30% and shortened the period to 4 years. (Because this metric was so much a part of the culture of 3M’s innovation teams it took them only 2 years to exceed the new goal.) HP utilizes BET (break-even time) for each new product development project as their innovation metric.

37 Measurement of Innovation: Innovation Input Metrics
Pros : Easy to measure and track Helps manage R&D spend Cons : Might relate poorly with ultimate strategic objective Examples: R&D spending as a percentage of sales Number of ideas or concepts in the pipeline Number of R&D projects Number of approved R&D projects as a percentage of ideas in the pipeline Number of people actively devoted to innovation Percentage of workforce time dedicated to innovation projects Number of innovation tools and methodologies available to employees Number of ideas submitted by employees Sources: McKinsey Global Survey Results – Assessing innovation metrics

38 Innovation Metrics Usage
Sources: McKinsey Global Survey Results – Assessing innovation metrics

39 There are two broad techniques for prioritizing metrics (Step 3)
Guiding Principles ... Structured Process There are two broad techniques for prioritizing metrics (Step 3) Metric Ranking Methodologies ILLUSTRATIVE Ranking Methodology Quantitative Methodology Outcome Metric Sensitivity Analysis Percentage Change in Outcome Metric Return on Invested Capital Capital Expenditures Discretionary Cash Flow Operating Income Margin (%) Gross Margin (%) Operating Income Growth Organic Net Revenue Growth Organic Volume Market Share -15% % % % % % Metrics Qualification Ranking Composite Evaluation Criteria Op. Income Op. Contribution Simple 2.50 3.50 Specific 4.50 4.00 Measurable 2.00 Meaningful Actionable Assignable 5.00 3.00 Relevant Reasonable Timely Average Score 3.61 3.67 Score Timeframe BU and Categories should preferably use a quantitative ranking methodology for selecting metrics

40 Guiding Principles ... Cascaded
BU and Function metrics should include relevant cascaded Corporate metrics (Step 4) Illustrative Metric Cascade ILLUSTRATIVE Corporate Metric Set Corporate Outcome Metric 1 Corporate Driver Metric 1 Corporate Driver Metric 3 Corporate Outcome Metric 2 Corporate Driver Metric 2 Corporate Driver Metric 5 Corporate Outcome Metric x Corporate Driver Metric 4 Corporate Driver Metric y BU Metric Set Function Metric Set BU Driver Metric a Corporate Driver Metric 3 Corporate Outcome Metric 2 Corporate Driver Metric 2 Corporate Outcome Metric 2 Corporate Driver Metric 2 Function Driver Metric a BU Driver Metric b Corporate Outcome Metric x Corporate Driver Metric 4 Function Outcome Metric x Function Driver Metric b Corporate Driver Metric y Function Driver Metric d BU Outcome Metric x BU Driver Metric c Function Outcome Metric x Function Driver Metric c Function Driver Metric e Metric originally defined at the Corporate level

41 Guiding Principles ... Structured Process
Selected metrics should be embedded in the planning processes and performance reporting (Step 4) Strategic Planning – Selected metrics will be used in the strategic planning process to form the basis for evaluating strategic options Annual Planning – The annual planning process set targets against a larger subset of metrics due to the shorter time horizon Forecasting – The forecasting process will update throughout the year targets for a subset of the metrics used in annual planning Performance Reporting – All metrics will be included in the performance reporting (scorecards and drill-downs) to show actual performance against targets and last year Compensation – Metrics will also play a role in establishing personal targets and compensation

42 Research agenda Importance of Innovation: Executives confirm innovation remains critical Managing Innovation: Companies struggle to manage investments Role of the CFO in encouraging Innovation : CFOs can bring new rigor to the process Performance Measurement and Innovation Metrics : Helps focus on drivers of success Research Agenda Now, on to the study and its findings. In keeping with our speed skating theme, we begin at the ‘starting line’: The first group of slides examines the increasing importance of innovation to the success of technology companies today. [Read quote] Executives confirm that innovation is more intense and critical than ever before. Later we will be examining the how companies are trying to keep pace with the external demands of the market; the internal issues and challenges that they face in managing innovation, and the opportunity that has surfaced for the CFO and Finance organization to help manage the process. But first, let’s examine the increasing importance of innovation to the success of technology companies today. Note: throughout the presentation deck, the executive quotes help to add color to your presentation—so be sure to read some of the quotes on each page—it helps to set the stage Source: Ernst & Young analysis and executive interviews

43 Some Suggestions for Research Agenda
What type of innovation should companies pursue? What kind of innovation is most valuable for a company or industry ? What should be the balance between ST and LT innovation; between opportunity and risk; between in sourced and outsourced innovation What should the Role of the CFO/ Finance be in innovation What innovation measures best relate with share holder value – could be industry specific. Is this a case for some standards similar to financial metrics Compensation for innovation ? How do you compensate for less market facing research

44 Presenter : Dr. Ashish Garg Email : ashish.garg@ey.com
Thank You Contact information Presenter : Dr. Ashish Garg Telephone : (212) Links to the material Ersnt & Young - Balance Point Survey Study -


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