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HBR.ORG May 2012 reprinT r1205C Spotlight on innovation For the 21St Century Managing Your Innovation Portfolio people throughout your organization are energetically pursuing the new. But does all that activity add up to a strategy? by Bansi Nagji and Geoff Tuff artwork ricky allman, We Can See You 2010, acrylic on panel, 12" x 16"Spotlight 2  Harvard Business Review May 2012 Spotlight on InnovatIon FoR tHe 21st CentuRy Bansi nagji and geoff tuff are partners at Monitor Group and leaders of the firm’s global innovation practice. Managing Your Innovation Portfolio people throughout your organization are energetically pursuing the new. But does all that activity add up to a strategy? by Bansi Nagji and Geoff TuffPho to gr aP h y: C ou rt es y of t h e ar ti st For arTiCle reprinTs Call 800-988-0886 or 617-783-7500, or visiT hBr.org May 2012 Harvard Business Review 3CopyRIGHt © 2012 HaRvaRd BusIness sCHool puBlIsHInG CoRpoRatIon. all RIGHts ReseRved. ManageMent knowS it and so does Wall Street: The year-to- year viability of a company de- pends on its ability to innovate. Given today’s market expecta- tions, global competitive pres- sures, and the extent and pace of structural change, this is truer than ever. But chief exec- utives struggle to make the case to the Street that their manage- rial actions can be relied on to yield a stream of successful new offerings. Many admit to being unsure and frustrated. Typically they are aware of a tremendous amount of innovation going on inside their enterprises but don’t feel they have a grasp on all the dispersed ini- tiatives. The pursuit of the new feels haphazard and episodic, and they suspect that the returns on the company’s total innovation investment are too low. Making matters worse, executives tend to re- spond with dramatic interventions and vacillating strategies. Take the example of a consumer goods company we know. Attuned to the need to keep its brands fresh in retailers’ and consumers’ minds, it introduced frequent improvements and variations on its core offerings. Most of those earned their keep with respectable uptake by the market and decent margins. Over time, however, it became clear that all this product proliferation, while split- ting the revenue pie into ever-smaller slices, wasn’t actually growing the pie. Eager to achieve a much higher return, management lurched toward a new strategy aimed at breakthrough product develop- ment—at transformational rather than incremental innovations. Unfortunately, this company’s structure and pro- cesses were not set up to execute on that ambition; although it had the requisite capabilities for envi- sioning, developing, and market testing innovations close to its core, it neither recognized nor gained the very different capabilities needed to take a bolder path. Its most inventive ideas ended up being di- luted beyond recognition, killed outright, or crushed under the weight of the enterprise. Before long the company retreated to what it knew best. Once again, little was ventured and little was gained—and the cycle repeated itself. We tell this story because it is typical of compa- nies that have not yet learned to manage innovation strategically. It demonstrates an all-too-common contrast to the steady, above-average returns that can be achieved only through a well-balanced port- folio. The companies we’ve found to have the stron- gest innovation track records can articulate a clear innovation ambition; have struck the right balance of core, adjacent, and transformational initiatives across the enterprise; and have put in place the tools and capabilities to manage those various initiatives as parts of an integrated whole. Rather than hoping that their future will emerge from a collection of ad hoc, stand-alone efforts that compete with one an- other for time, money, attention, and prestige, they manage for “total innovation.” Be Clear about your innovation ambition What does it mean to manage an innovation portfo- lio? First, let’s consider how broad a term “innova- tion” is. Defined as a novel creation that produces value, an innovation can be as slight as a new nail polish color or as vast as the World Wide Web. Most companies invest in initiatives along a broad spec- trum of risk and reward. As in financial investing, their goal should be to construct the portfolio that produces the highest overall return that’s in keeping with their appetite for risk. One tool we’ve developed is the Innovation Am- bition Matrix (see the exhibit at right). Students of management will recognize it as a refinement of a classic diagram devised by the mathematician H. Igor Ansoff to help companies allocate funds among growth initiatives. Ansoff’s matrix clarified the no- tion that tactics should differ according to whether a firm was launching a new product, entering a new market, or both. Our version replaces Ansoff’s binary choices of product and market (old versus new) with a range of values. This acknowledges that the nov- elty of a company’s offerings (on the x axis) and the novelty of its customer markets (on the y axis) are a matter of degree. We have overlaid three levels of distance from the company’s current, bottom-left reality. In the band of activity at the lower left of the ma- trix are core innovation initiatives—efforts to make incremental changes to existing products and incre- mental inroads into new markets. Whether in the form of new packaging (such as Nabisco’s 100- calorie packets of Oreos for on-the-go snackers), slight refor- mulations (as when Dow AgroSciences launched one of its herbicides as a liquid suspension rather than 4  Harvard Business Review May 2012 Spotlight on InnovatIon FoR tHe 21st CentuRy Firms that excel at total innovation management simultaneously invest at three levels of ambition, carefully managing the balance among them. The InnovaTIon ambITIon maTrIx a dry powder), or added service convenience (for example, replacing pallets with shrink-wrapping to reduce shipping charges), such innovations draw on assets the company already has in place. At the opposite corner of the matrix are transfor- mational initiatives, designed to create new offers— if not whole new businesses—to serve new markets and customer needs. These are the innovations that, when successful, make headlines: Think of iTunes, the Tata Nano, and the Starbucks in-store experience. These sorts of innovations, also called breakthrough, disruptive, or game changing, generally require that the company call on unfamiliar assets—for example, building capabilities to gain a deeper understanding of customers, to communicate about products that have no direct antecedents, and to develop markets that aren’t yet mature. In the middle are adjacent innovations, which can share characteristics with core and transforma- tional innovations. An adjacent innovation involves leveraging something the company does well into a new space. Procter & Gamble’s Swiffer is a case in point. It arose from a set of needs P&G knew well and built on customers’ assumption that the proper tool for cleaning floors is a long-handled mop. But it used a novel technology to take the solution to a new customer set and generate new revenue streams. Ad- jacent innovations allow a company to draw on ex- isting capabilities but necessitate putting those capa- bilities to new uses. They require fresh, proprietary insight into customer needs, demand trends, market structure, competitive dynamics, technology trends, and other market variables. The Innovation Ambition Matrix offers no inher- ent prescription. Its power lies in the two exercises it facilitates. First, it gives managers a framework for surveying all the initiatives the business has under way: How many are being pursued in each realm, and how much investment is going to each type of inno- vation? Second, it gives managers a way to discuss the idea in Brief Firms pursue innovation at three levels of ambi- tion: enhancements to core offerings, pursuit of adjacent opportunities, and ventures into trans- formational territory. analysis of innovation invest- ments and returns reveals two striking findings. Firms that outperform their peers tend to allocate their investments in a certain ratio: 70% to safe bets in the core, 20% to less sure things in adjacent spaces, and 10% to high-risk transforma- tional initiatives. as it happens, an inverse ratio applies to returns on innovation. although never the dominant activity, transformational initia- tives are vital to a company’s ongoing health, and firms must recognize that they demand unique management approaches. • talent should include a diverse set of skills and be able to deal with ambiguous data. • teams should be separated from day-to-day operations. • Funding should come from outside the normal budget cycle. • pipeline management should focus on the iterative development of a few promis- ing ideas, not the ruthless filtering of many. • Metrics should recognize nonfinancial achievements in early phases. CR ea te n eW M aR Ke ts , ta RG et n eW C us to M eR n ee ds use eXIstInG pRoduCts and assets add InCReMental pRoduCts and assets develop neW pRoduCts and assets how To wIn w h er e To p la y se Rv e eX Is tI n G M aR Ke ts an d Cu st oM eR s en te R ad ja Ce n t M aR Ke ts , se Rv e ad ja Ce n t Cu st oM eR s TransformaTIonal developing breakthroughs and inventing things for markets that don’t yet exist adjacenT expanding from existing business into “new to the company” business core optimizing existing products for existing customers right overall ambition for the company’s innovation portfolio. For one company—say, a consumer goods producer—succeeding as a great innovator might mean investing in initiatives that tend toward the lower left, such as small extensions to existing prod- uct lines. A high-tech company might move toward the upper right, taking bigger risks on more-auda- cious innovations for the chance of bigger payoffs. Although this may sound obvious, few organizations For arTiCle reprinTs Call 800-988-0886 or 617-783-7500, or visiT hBr.org May 2012 Harvard Business Review 5 think about the best level of innovation to target, and fewer still manage to achieve it. Strike and Maintain the right Balance In contemplating the balance for an innovation portfolio, managers should consider the findings of research we conducted recently. In a study of com- panies in the industrial, technology, and consumer goods sectors, we looked at whether any particular allocation of resources across core, adjacent, and transformational initiatives correlated with signifi- cantly better performance as reflected in share price. Indeed, the data revealed a pattern: Companies that allocated about 70% of their innovation activity to core initiatives, 20% to adjacent ones, and 10% to transformational ones outperformed their peers, typically realizing a P/E premium of 10% to 20% (see the exhibit “Is There a Golden Ratio?”). Google knows this well: Cofounder Larry Page told Fortune magazine that the company strives for a 70-20-10 balance, and he credited the 10% of resources that are dedicated to transformational efforts with all the company’s truly new offerings. Our subsequent con- versations with buy-side analysts revealed that this allocation is attractive to capital markets because of what it implies about the balance between short- term, predictable growth and longer-term bets. A second research finding adds more food for thought. In an ongoing study, we’re focusing on more-direct returns on innovation. Of the bottom- line gains companies enjoy as a result of their in- novation efforts, what proportions are generated by core, adjacent, and transformational initia- tives? We’re finding consistently that the return ratio is roughly the inverse of that ideal allocation described above: Core innovation efforts typically contribute 10% of the long-term, cumulative return on innovation investment; adjacent initiatives con- tribute 20%; and transformational efforts contrib- ute 70% (see the exhibit “How Innovation Pays the Bills”). Together these findings underscore the impor- tance of managing total innovation deliberately and closely. Most companies are heavily oriented toward core innovation—and must continue to be, given the risk involved in adjacent and transformational initia- tives. But if that natural tendency leads to neglect of more-ambitious forms of innovation, the outcome will be a steady decline in business and relevance to customers. Transformational initiatives are the en- gines of blockbuster growth. Let us be clear: We’re not suggesting that a 70- 20-10 breakdown of innovation investment is a magic formula for all companies; it’s simply an av- erage allocation based on a cross-industry and cross- geography analysis. The right balance will vary from company to company according to a number of fac- tors (see the exhibit “Different Ambitions, Different Allocations”). One important factor is industry. The industrial manufacturers we studied have a strong portfolio of core innovations complemented by a few breakouts, and they come closest to the 70-20-10 breakdown. Technology companies spend less time and money on improving core products, because their market is eager for the next hot release. Consumer pack- aged goods manufacturers have little activity at the transformational level, because their main focus is incremental innovation. Of these three sorts of busi- nesses, industrial manufacturers collectively have the highest P/E ratio relative to their peers, perhaps suggesting that they are closest to getting the bal- ance right—for them. A company’s competitive position within its in- dustry also influences the balance. For example, a lagging company might want to pursue more high- risk transformational innovation in the hope of creating a truly disruptive product or service that would dramatically alter its growth curve. A strug- gling Apple made this decision in the late 1990s, ef- fectively betting its business on several bold initia- tives, including the iTunes platform. A company that wants to retain its leadership position or believes the market for its more ambitious innovations has cooled may decide to do the reverse, removing some risk from its portfolio by shifting its emphasis from transformational to core initiatives. A third factor is a company’s stage of develop- ment. Early-stage enterprises, especially those funded by venture capital, must make a big splash. They may feel that a disproportionate investment in transformational innovation is warranted, both to attract media attention, investors, and custom- ers, and because they don’t yet have much of a core business to build on. As they mature and develop a stable customer base, and as protecting and growing the core becomes more important, they may shift their emphasis toward that of a more established company. The point is that a management team should ar- rive at a ratio that it believes will deliver better ROI in the form of revenue growth and market capitaliza- 70% Core 10% tranSForMational 20% adjaCent Is There a golden raTIo? 10% Core 70% tranSForMational 20% adjaCent how InnovaTIon pays The bIlls analysis reveals that the allocation of resources shown below correlates with meaningfully higher share price performance. For most companies, this breakdown is a good start- ing point for discussion. among high performers that invest in all three levels of innovation, we find the following distribution of total returns. as it happens, this ratio is the inverse of the resource allocation ratio we discovered in high- performing companies. 6  Harvard Business Review May 2012 Spotlight on InnovatIon FoR tHe 21st CentuRy tion, should discover how far its current allocation is from that ideal, and should come up with a plan to close the gap. organize and Manage the total innovation System Targeting a healthy balance of core, adjacent, and transformational innovation is a vital step toward managing a total innovation portfolio, but it imme- diately raises an issue: To realize the promise of that balance, a company must be able to execute at all three levels of ambition. Unfortunately, the mana- gerial toolbox required to keep innovation on track varies greatly according to the type of innovation in question. Few companies are good at all three. Companies typically struggle the most with transformational innovation. A study by the Corpo- rate Strategy Board shows that mature companies attempting to enter new businesses fail as often as 99% of the time. This reflects the hard truth that to achieve transformation—to do different things—an organization usually has to do things differently. It needs different people, different motivational factors, and different support systems. The ones that get it right (GE and IBM are notable examples) have thought carefully about five key areas of man- agement that serve the three levels of innovation ambition. Talent. The skills needed for core and adjacent innovations are quite different from those needed for transformational innovations. In the first two realms, analytical skills are vital, because such ini- tiatives call for market and customer data to be inter- preted and translated into specific offering enhance- ments. Procter & Gamble, for example, deploys a cadre of 70 senior employees around the world to help identify promising adjacencies. These “tech- nology entrepreneurs,” as the company calls them, are responsible for researching a variety of sources, including scientific journals and patent databases, and for physically observing activities in specific markets in order to find new ideas that can build on P&G’s core businesses. The company credits its tech- nology entrepreneurs with uncovering more than 10,000 potential offerings for review. Transformational innovation efforts, by con- trast, typically employ a discovery and concept- development process to uncover and analyze the social needs driving business changes (what’s desir- able from a customer perspective), the underlying market trends (what kinds of offers might be viable), and ongoing technological developments (what is feasible to produce and sell). These activities require skills found among designers, cultural anthropolo- gists, scenario planners, and analysts who are com- fortable with ambiguous data. Thus, when Samsung different ambitions, different allocations on average, high-performing firms direct 70% of their innovation resources to enhancements of core offerings, 20% to adjacent opportunities, and 10% to transformational initiatives. But individual firms may deviate from that ratio for sound strategic reasons. Here are three allocations we have seen that made sense for firms in various circumstances. a MidStage teChnology FirM 45% Core 15% tranSForMational 40% adjaCent a leading ConSuMer goodS CoMpany 80% Core 2% tranSForMational 18% adjaCent a diverSiFied induStrialS CoMpany 70% Core 10% tranSForMational 20% adjaCent For arTiCle reprinTs Call 800-988-0886 or 617-783-7500, or visiT hBr.org May 2012 Harvard Business Review 7 decided to compete on the basis of innovative design, it recognized that it needed new and different skills. The company moved its design center from a small town to Seoul in order to be closer to a valuable pool of young design professionals. It also teamed with a number of outside firms with strong design skills and created an in-house school, led by industrial design experts, to hone the abilities of