From Creativity to Profitability

Published at Innovation Excellence, July 12, 2015 (http://www.innovationexcellence.com/blog/2015/07/12/from-creativity-to-profitability/)   

It sounds intuitive that creativity and innovation are important to company success, but when the corporate world focuses so intensely on the “bottom line”, is there a real impact of creativity on company profitability that would justify a shift of that focus from current year bottom line to innovation?

In his 1954 book, “The Practice of Management”, Peter Drucker stated that “The two most important functions of a business are Innovation and Marketing”. Twelve years before him the Austrian-American economist Joseph Schumpeter defined the phenomena of “creative destruction” in which new companies introduce new and innovative products and services, destroying those who cling to the old ways.

The statement “everybody knows that startup companies are more innovative than established ones” is backed up by research. A lot of research. One of the main sources is Harvard University’s Professor Clayton Christensen who in his 1992 doctoral dissertation, followed by his 1997 best selling book “The Innovator’s Dilemma”, explained that good companies with good managers fail when there is a disruptive change in the environment. They fail not because they were not listening to their customers, but for exactly the opposite reason: they failed because they did listen to their customers and continued with incremental innovation, and as a result missed discontinuous market changes caused by companies that had absolutely no “baggage” or vested interest in current technologies, products, services, and processes.

In 2008, the Boston Consulting Group conducted a survey of 3,000 executives to find that 66% of them considered innovation as one of their top three strategic priorities. In 2012, the UK-based research firm StrategyOne conducted a five-country survey of 5,000 people, in which it discovered that 85% of the US participants believed that creativity is key to driving economic growth. However, the above supports the intuitive feeling that innovation is important, but does not quantify the link between innovation (or creativity) and actual financial results. Top management may think and say that innovation is important, but are they convinced?

Not too many studies were published about the link of creativity to profitability, and for a simple reason: the financial results from increased creativity are a much lagging indicator which is thus hard to measure and correlate. However, few studies were done to provide such link.

Paul Geroski, Steve Machin, and John Van Reenen published the article “The Profitability of Innovating Firms” in the summer 1993 issue of the RAND Journal of Economics, in which they claimed that the profitability of companies has less to do with the amount of resources (specifically, money) spent on Research and Development and more with the level of company-wide innovation. In my own 2008-2010 research of creativity in startup and mature companies I found that there is actually a point of diminishing returns, in which more resources can result in less creativity. James Tobin, author of “To Conquer the Air: the Wright Brothers and the great race for flight” noted that while Samuel Langley received $50,000 in government funds to create the first manned flying machine, the Wright Brothers beat him to it on a mere $1,000 budget.

Innovative companies enjoy higher profits when they introduce new products and services before competition occurs, experience higher market share, and sustain consistently high profits over time because they continue to deliver new products and services ahead of their competitors. Geroski et al. managed to quantify the relationships and found that the market shares of innovative companies were 3 times higher than the average. The average sales of innovators was 6 times higher than the average, and EBIT (Earnings Before Income Taxes) Margins of innovative companies were 10% better than average. Given that this is a lagging indicator, they looked longer into the future and found that over a period of 8 years, the overall profit margins of innovative companies were 3 times higher than the average. Finally, they found (since this was a 20-year study that included several business cycles) that during recession, the innovative companies margins could be 50% better than average, and thus innovative firms are less sensitive to cyclical downturns. But they also made a very strong qualitative observation that “in the area of innovative activities, it may matter more what a firm does than what it produces.” In other words–it is not a single innovative product, service, or process that has such a profound impact on the organization’s performance, but rather the level of innovativeness and creativity maintained by the company over a long period of time.

In a research article published by Peter Roberts in a 1999 issue of the Strategy Management Journal, he stated that “an innovative new product tends to face low competition at the point of introduction and therefore earns relatively high profits. These high profits attract imitators, which increase the level of competition faced by the product as time passes. Finally, this increased competition translates into reduced profits for the firm producing the new product.” In his research he found innovative companies can keep profits high for longer time. If two firms have the same profitability at year 1, by year 5 the non-innovative company will have 75% to 80% less profit than the innovative one. After 19-20 years, the distance will shrink to 35-50%. However, if only highly profitable companies were compared, the difference after 19-20 years is 80%.

The reason for those differences in profitability comes from the product life cycle and profitability associated with it. When a company introduces an innovative product, service, or process not offered by any competitor, they immediately redefine the market, and create the type of “creative destruction” that Schumpeter and Christensen described in their books, and gain a very significant market share as a result of the inability of their competitors to offer anything comparable. Sometimes the newness of those products or services could elevate a company to become a monopoly. This is the time when profits are at their highest. However, at some point competition will emerge from existing or new competitors who find a way to imitate. At that point, the then-new products or services commoditize, price pressure increases, and translates into lower margins and lower profitability. A single-product company will not survive this natural evolution of the product life cycle. However, a company that places innovation as a key strategic imperative, and actually executes on it, will continue to release new products and services, gain the high market share and profitability associated with them over and over again.

The following graph will illustrate the effect that continuous innovation can have on company profits over time.

Hypothetically, the profit margins from a new product in year 1 are 80% due to the radical nature of its value proposition is to the market, drop to 60%, 40%, 25%, and 20% in years 2 through 5, respectively, and remain at 20% thereafter. Over a period of 10 years, a one-product company (the blue graph) will have an average of 32.5% profit.

A company that introduces a new product every year will see profit from several generations of products, and as the following chart will show–over the years new products will contribute more to the overall company profit margin, while older products contribute less. In the following chart, the company decides to drop products that are more than 5 years old.

The following is a comparison of three companies. One is a single-product company (blue), one is a company that releases a new product or service every year (red), and the last is a company that drops a product after 5 years (green).

An innovative company that introduces a radically new product every year (while still supporting previous products) will decline to a sustainable 33% ongoing margin (a 62% better profit than the single-product company). If the innovative company decides to drop its “old” products 5 years after their introduction (and then let the imitators have the market), it will maintain a steady 45% profit margin, (125% better than a single-product company). And if you wonder why I used such a hypothesis–Apple generates more than 60% of its revenue from products that did not exist 4 years ago!

I would like to end with the wise words of Gary Hamel of Strategos, from a 1998 executive briefing at Stanford University, who said “Those who live by the sword…
… are SHOT by those who don’t”

image credit: Ann Flickr