Not enough companies are innovating, even though it’s doubly important that they do so given the current economic climate. Now some companies don’t, and probably won’t ever, get the importance of innovation, and as sad as it is, I get that. A few companies do get the importance of innovation, and are still focussed on innovation. And then there are those companies where the leading thinkers get it, but the management says no because it’s too expensive and too risky, despite the low-risk proposals and high ROI presentations that are put forward by brilliant staff.
Needless to say, this has perplexed me because while I know for a fact that there are always going to be those managers who are just too stupid to get it, I have to assume this is not the case at the average company because most boards don’t put up with idiots for too long, especially when business is going down the tubes. So I did some research, and stumbled upon a great article in last year’s Harvard Business Review that might account for some of the reasons management says no when they should be saying “that’s great … do it now“!
In Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things, the authors highlight three financial analysis tools whose misguided application will cause a CFO to say no to innovation every time, even when the answer should be an exuberant yes. More specifically, the following financial methods tend to lead the CFO, and management, towards the event horizon of the do-nothing black hole where they get sucked in to the forever stagnant singularity from which they’ll never escape.
- Fixed and Sunk Costs
The method of evaluating fixed and sunk costs with respect to future investments confers on unfair advantage to the status quo. - Share Price
The emphasis on earnings per share as the primary driver of the share price to the exclusion of almost everything else diverts resources away from investments whose payoff, no matter how large, lies beyond the immediate horizon. - Discounted Cash Flow (DCF) and Net Present Value (NPV)
The common application of these methods to evaluate investment opportunities causes managers to underestimate the real returns and benefits of investment in innovation.
Of these, the DCF and NPV is probably the deadliest because its often the first calculation done by the CFO, and when your proposal fails this biased sniff-test, your project is stopped cold in its tracks.
So what’s the problem? Why does the DCF, which should be capturing the financial benefits of ROI innovation projects, instead illustrate that they will yield less of a return than the status quo?
The problem, referred to as the DCF trap, is that when most financial managers compare the expected cash flows from an innovation project against the default scenario of doing nothing, they incorrectly assume that the present health of the company will persist indefinitely if the investment is not made. We all know that this is not the case. Pick a vertical … any vertical … the sale of every product declines over time because people always want “new” and “improved”. It’s nothing new. Archaeologists have illustrated that the life-cycle of pretty much every “invention” throughout history followed the battleship curve. This means that, if you do nothing, sales will eventually start to decline.
If, instead of assuming flat line revenues for doing nothing, the financial manager correctly assumed declining revenues starting 6 months to 3 years out (depending on the vertical and product line), they’d quickly see that the loss associated with doing nothing is much greater than the “sunk cost” of a new innovation project, even if the ROI turned out to be less than expected.
Long story short, next time you’re turned down on an innovation request, ask why. When they say it costs too much, or the risk is too high, ask to see the calculations. Review them, find the “trap”, redo them, and try again. You might not succeed (because some managers will never admit their mistake), but if you start educating them, maybe the next project you present will get approved, allowing you to get back on the road to innovation.