How Much Should You Invest in Innovation?
- Innovation budgets should correlate to revenue growth and ROI. Applying metrics such as Vitality Index and Research Quotient facilitate a predictable model which links investment with generated revenue.
- Budgets vary by industry but more so by type of innovation. The companies with the highest payback allocate more of their budget to transformative ideas.
- The cost to innovate is declining. Prototyping is the most lengthy and costly part of the process. However, tools such as computer simulation, 3D printers, stereolithography, laser sintering, foamware and other malleable products are significantly reducing prototyping time and cost.
Apple invests 5% of its annual revenues in R&D. Facebook invests over 13%, Google over 16% and Amazon now invests more than 28% in R&D. So how much should you invest in innovation?
In this post I'll share a few perspectives, methods and metrics to answer this question.
Align with Growth Goals
Rather than a general investment percentage figure, your budget will align with your growth objective. Bigger growth requires a bigger investment.
I recommend aligning your innovation budget with your revenue targets.
That requires building a model to show the relationship between investment and revenue generated. Most innovation methodologies use metrics to make progress measurable and correlate budget to payback. Key performance indicators that I track with every project include investment allocation, ROI, vitality and Research Quotient (RQ).
Vitality index shows new revenues produced from new products. It's equal to new product sales as a percentage of total sales over a set number of years. I use a three-year horizon for this calculation. Research Quotient (RQ) is equal to the percentage increase in revenue from a 1% increase in R&D. This metric brings a degree of predictability to investment. It also shows the point of diminishing return.
I also calculate the growth-gap before finalizing the budget. This is the additional revenue needed beyond what is forecasted with existing products and markets. The forecasted release of new products can make up the difference to achieve your revenue goals.
Lastly, Investment allocation should show the breakdown among incremental, transformative and disruptive concepts. This is important as each type produces significantly different payback.
Compare to Industry Peers
For each of my client projects, I also like to compare innovation budgets and performance results by industry.
PWC published a report titled, Comparison of Innovation Spending and Revenue. It was based on a survey of one thousand companies and found that the average investment is three to four percent of total revenue. But the figure shifts depending on industry and region. It also shifts based on maturity or where any given company is on their innovation journey.
An IBM benchmarking study revealed a wide disparity among industries.
However, these figures are really understated when you consider the volume of low growth or no growth companies that spend very little on any type of transformation. It doesn't take much more analysis to discover the companies incurring the highest revenue growth make significantly larger investments than their industry peers.
For an additional perspective, it's helpful to separate the spend targeted to existing products compared to new product development. For most mature innovators, this is done with innovation portfolio management in order to reduce risk and make the results more predictable. The chart below shows the allocation of R&D targeted to more transformative ideation.
But here's another interesting perspective. An IDC study found that "Innovation leaders spend 5% of revenue on R&D versus the 7% that laggards spend." This may seem counter-intuitive to new or novice innovators. However, the study went on to share that the leaders allocate less of their budgets toward incremental efforts and more of their budgets toward transformative and disruptive concepts, hence, delivering a better ROI.
More specifically, the leaders spend 29% of their R&D on new concepts, compared to 18% for the laggards. The point here is that it's not just how much you invest but how you invest it.
Many innovators align budgeting with patent acquisitions. They essentially correlate their budget to produce a desired number of patents. This method makes budgeting a predictable exercise and provides an industry comparison point as patents are published in the public domain.
It can make sense for companies that derive licensing, royalty and similar revenue from intellectual property. However, for the rest of the more traditional product and service companies I've found that while patents hold value, they are a lagging performance measure and do not correlate well to revenue growth.
Budgets Define Vested Interests
Effective budgeting is not just about committing an amount of capital but also identifying who shares in the budget contribution. It is common to see sole ownership by R&D or product managers for industrial companies or by marketing for service companies. In manufacturing or consumer goods companies, whoever owns the modeling shop usually owns the budget.
However, multi-disciplinary and cross-functional teams don't work as well when the budget is not also allocated across functions and stakeholders. Allocating the budget across departments or lines of business diversifies ownership and increases vested interests.
Budgets are Going Further
The economics of innovation are becoming much more economical, especially when it comes to prototyping.
Computer simulation can replace manual time for assembly or construction of physical media which significantly reduces cost and cycle time. Malleable modeling platforms such as Ren Share and other foamware enable simplified sculpting, easy modifications, and rapid iterations. 3D printers, stereolithography and laser sintering can produce three dimensional physical objects at a lower cost than model shops and in a fraction of the time.
Tightly coupled software also has a big impact on prototyping speed. Design software can now be integrated to engineering software, which is integrated to manufacturing software, which is integrated to cost accounting and financial software. This creates an end-to-end simulation to production process.
Better and cheaper modeling, simulation and prototyping tools simplify the creation of prototyping media, lower the cost of media production, accelerate iteration rhythm, permit more iterations per cycle and decrease overall prototyping cycle time.
When prototyping media costs are reduced, innovation budgets go further and teams create more iterations and a more refined product in the prototype cycle.