Structuring for Innovation – Part II

Editor's Note

Part I discussed the difficulty of assigning tomorrow's job of making the organization into a different organization for a different future through needed innovations to those responsible for doing today's job.

But the question remains as to what must be done to create a successful innovation that could be developed into a major breadwinner?

In Part II we discuss the need for a separate, autonomous structure to house a truly innovative idea that needs to be converted into operational reality.

Introduction

According to Peter Drucker & Ted Levitt: Innovative activities must be organized separately and outside of the ongoing managerial business.

Repeat this five times to yourself. It could save your organization millions/billions of dollars and prevent lost opportunities.

Said Drucker: "Innovative companies realize one cannot simultaneously create the new and take care of what one already has in full operation…

…The maintenance of the present business is far too big a task for the people in it to have much time for creating the new, different business for tomorrow…

…Making tomorrow happen is (also) far too big and difficult task to be diluted with concern for today. Both tasks have to be done. But they are different…"

We cannot emphasize this enough. Successful innovative organizations put the new & different into separate organizational units concerned solely with the creation of the new.

In addition to separate organizational structures, innovation strategy requires different measurements, a different use of budgets and budgetary controls from those appropriate to an ongoing business.

This article discusses both separate organizational structures and some best practices with respect to innovative measurements and budgets. These two topics in reality, cannot be divorced.

Establishing Separate Centers Of Initiative For Creating Innovation – A Brief Example

Many universities and colleges entering the field of granting web-based degrees and certification programs have floundered. Yet some have exceeded beyond expectations.

The savvy schools such as Cornell and Penn State have created completely separate entities to deliver, market, and grow online degree-granting & certification programs.

If this is not done, it is almost guaranteed that "a war of the ancients against the moderns" will erupt and threaten the internal upstart web-based learning organization – and deprive it of the resources needed to innovate successfully.

Indeed, many schools have failed in their attempts to launch successful online degree granting & certification programs because they have not identified what should be done and how to go about doing it – starting with creating a separate organizational structure.

Without doubt, continuing professional education and extended degree-granting education are on a collision course.

Another Example: The Birth Of The Television Industry

Radio Corporation of America (RCA). Founded in 1919 and led by David Sarnoff was a telecommunications and media empire that included both RCA and NBC and, at one point in time, became one of the largest companies in the world.

RCA's extremely profitable radio receiver manufacturing business was a global leader. Several books (and Wikipedia's thumbnail sketch) detail how RCA made television into a commercial success.

According Levitt, “When Vladimir Zworykin, the father of television, demonstrated the first crude and enormously bulky TV system to his top management at RCA, the unimpressed reaction of one highly successful executive was typical: 'Why don't you take this guy off this foolishness and put him and his team on something useful - like cutting costs on radio receivers, for example?”

Enter An Entrepreneurial Leader

It was only when David Sarnoff, RCA's single-minded chief got wind of what the new television venture group was attempting did those involved with the venture receive unqualified backing to move onward and independently with the project.

Sarnoff equivalently made the unit into a separate, autonomous operating unit and divorced it from the ongoing business.

Otherwise, the innovative project would have likely been denied of required resources, leading to inevitable setbacks and delays.

Overspending typical in projects of this kind would have probably led to abandonment. 

Even though Zworykin estimated the venture would cost about $100,000 to bring to market (it eventually cost $50 million), Sarnoff stayed with it because he believed "it was a risk RCA could not afford not to take." 

Our Point?

Typical general managers of an operating division are not like Sarnoff.

At the first sign of trouble, they are more likely to opt for ending a venture which needs more time, more monies, and perhaps a change in marketing strategy (e.g., different distribution channels, pricing changes, a strategic repositioning of the product/service).

In many instances, the organization's compensation system  financially penalizes the operating or managing director for a new venture's losses.

The classic response is to immediately slough off what could be a profitable new venture in the long term because it impacts their short-term profitability which, in turn, impacts their take-home pay.

No one says this. CFOs knowingly or unknowingly allow the general manager to trade off long-term growth for short-term profitability – creating a likely future vulnerability and/or loss of competitive advantage.

The general manager charged with the responsibility of making the new and different happen usually proclaims the need for innovation while simultaneously sending to the scrap heap innovative new projects/ventures that could help defend existing markets and/or help gain market position from dominant competitors strategic market segments.

Innovation Measurements Differ From Measurements For the Ongoing Business

The RCA story also illustrates the need for different measurements and different uses of budgets and budgetary controls from the ongoing business.

To impose on innovating efforts, as is typically done in the majority of organizations, the measurements, and especially the accounting conventions that fit the ongoing business, is according to Drucker:

"A surefire way to cripple the innovative effort… It's like putting a 100 pound pack on a six-year-old going on a hike…"

The most successful innovating businesses (DuPont, HP, 3M, Apple) learned these lessons long ago and made the necessary changes to their measurement and budgeting systems to encourage successful innovation.

Put bluntly: To impose the same measurements that fit the ongoing business is misdirected and ultimately self-defeating.

Important Distinctions

Existing businesses focus on return on invested capital. Sometimes this is called the productivity of capital. 

If the productivity of capital decreases in the existing business, the organization begins to examine what and how it should abandon programs, activities, and even businesses.

Abandonment frees capital (i.e., monies and people) to work on those activities that show promise or higher return on invested capital.

But with respect to innovation, a different scenario emerges.

Drucker often referred to the most successful managerial control system developed in the 1920s by the DuPont Company, which, developed a much- praised return on investment model for all its businesses. 

Said Drucker: "As long as a business, a product line, or a process was in the innovating stage, its capital allocation was not included in the capital base on which the individual DuPont division in charge of the project had to earn a return…

…Nor were the expenses included in its expense budget… Both were kept separate … 

…Only after the new product line had been introduced in the market and had been sold in commercial quantities for two years or more were its measurements and controls merged into the budget of the division responsible for the development …" 

Drucker’s Point

Division managers inevitably resist innovation because they view it as a threat to their earnings record and performance.

It's just human nature. General managers and/or managing directors of a given division are usually rewarded on the basis of short-term profits.

Convenient rationalizations are always given for resisting innovation. But the real reason is, quite typically, innovation projects are risky.

The proven way to prevent this is to creatively imitate the DuPont or like models when engaging in major innovative activities. 

Also, observed Drucker, the DuPont model "makes sure that expenditures on, and investments in, innovative efforts can be tightly controlled… It makes possible to ask at every step, ‘what do we expect at the end, what is the risk factor, that is, the likelihood of non-success.'"

Without doubt, in many instances, entrepreneurial faith is what is required to keep going when a new venture/ project is beset with difficulties.

Yet, sooner or later, the question: "Can we justify continuing this particular innovative effort or not" must be asked and answered. 

No organization wants to fund problems. Funding solutions to recognized problems is a different story.

If changes in strategy and tactics makes economic/marketing sense, then the project in all likelihood will be continued. 

But if doing more of the same is the only path recommended, it's quite possible the venture should be abandoned. 

Summary, Conclusions & Additional Thoughts

To succeed with an innovative venture, the first and most serious questions are always: Is this the right opportunity? Do we have the required people with the appropriate skill sets and knowledge to succeed in the marketplace? 

An important question to ask is whether or not the new venture has the right knowledges(s).

For example, decades ago when banks ventured into the credit card business they thought "credit management" was the essential knowledge required. 

It turned out while credit management was important, direct response marketing skills were also essential to success.

And this was a skill that banks (50 years ago) did not possess or even realize was needed.

After answering the above-mentioned questions, decisions concerning how to organize the innovative effort "as a business" must be addressed. 

A major mistake involves treating the innovative venture the same way as the ongoing business. Budgets for the ongoing business and budgets for innovative efforts should be kept separate. 

Following the DuPont formula, a separate measurement system for innovative efforts makes it possible to assess the three factors that determine the eventual outcome of the venture–namely, the realistic upside to the opportunity being exploited, the risk of failure, and expenditures needed to produce and manage an innovative new business.

One final point. Drucker suggested: "One way to organize innovative units within a large business might well be to group them together into an innovative unit, which reports to one member of top management to who has no other function but to guide, help, advice, review and direct the innovating teams at work."

Further, others have suggested when innovative efforts are  structured as separate units/separate companies, the entrepreneur/ in charge of the units (and key members of the group) should have the equivalent of stock or phantom stock–at some point in the venture.

The parent company has majority control and funds the new venture with the equivalent of equity capital and borrowed monies which will lower the total cost of capital.

In most cases when this is done, it is accompanied with a right to buy out the minority stockholders at some future point (if they want to sell) at some prearranged buyout formula.

A Final Note

In the final analysis, large companies are in an especially strong position to support, create, and commercialize powerful new innovations.

Indeed, it is far more qualified than the small firm.

It has more talent to do the job, more money to support it, greater ability to sustain losses during its early commercial stage, and generally a good reputation with which to give the innovation an appealing public credibility.

It will be a very great loss indeed if new innovative activity and new-business development among large companies become increasingly confined to today's tasks.

There is increasing evidence that it is not entrepreneurial zeal that sustains new business creation in large companies, but fear of antitrust prohibition of acquisitions.

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