Why is this indicator important?

Companies are spending on average 3.5% of their revenues on research, development and innovation activities. This can go much higher for manufacturing companies (around 7%) or high-tech or pharmaceutical companies (around 15%). While in accounting terms R&D spending is viewed as a sunk cost that has to be written off, companies see R&D as an investment in the future. They are hoping that their innovation pipeline (see previous KPI) is delivering future revenues.

Given the large expenses that companies pump into R&D and innovation, it is only fair to ask whether the investments are generating the expected revenues. Measuring the return on innovation allows companies to compare the investments in new products and services with the profits generated by the new products and services.

According to a Boston Consulting Groups (2010) report, fully 50% of managers are not happy with the return they are getting from their innovation process. Understanding the return on innovation provides companies with an insight into the effectiveness of innovation activities in your organisation.

According to Booz & Company partner Alexander Kandybin, the return on innovation investment (ROI²) methodology also allows companies to compare innovation returns with returns from other types of investment, such as marketing, or returns from small projects versus large projects. It therefore makes comparison across innovation initiatives much easier, and that allows you to manage innovation returns very explicitly.

How do I measure it?

Data collection method

ROI² is calculated by comparing the profits of new product or service sales to the research, development and other direct expenditures.

Formula

Return on innovation investment can be calculated in several ways. The most common and useful way is:

ROI² = [(Net profit from new products and services) – (Innovation costs for these products and services)]/(Innovation costs for these products and services)

ROI² is most commonly used as a retrospective KPI taking into account actual costs versus actual profits. However, by using estimations of future revenues and projected costs, it is possible to estimate future ROI².

Frequency

ROI² can then be measured at the end of an innovation project or as a percentage return over a period of a year (most useful for longer-term projects), thus giving a calculation of how long it will take the organisation to cover its investment and then make a profit from that investment. If the rate of return is 33.3% in one year, it will take three years to recover the complete investment . If ROR is 50%, payback is two years; if 200%, six months.

Source of the data

The data for ROI² can usually be extracted from the accounting data and project data.

Cost/effort in collecting the data

The costs for calculating ROI² are moderate if all the information is readily available. The costs will go up significantly if future ROI² is measured, as this requires estimations (see also previous KPI: innovation pipeline strength).

Target setting/benchmarks

There are no generic benchmarks and targets available for ROI² because of the idiosyncratic nature of innovation projects, which can vary massively in scope and time frames.

Tips/warnings

As with any return on investment KPI, it is worth keeping in mind that the calculation for return on investment, and therefore the definition, can be modified to suit the situation. It all depends on what the organisation (or part thereof) decides to include as returns and costs. The definition of the term in the broadest sense just attempts to measure the profitability of an investment and, as such, there is no one ‘right’ calculation.

Furthermore, care must be taken not to confuse annual and annualised returns. An annual rate of return is a single-period return, while an annualised rate of return is a multi-period, average return.

An annual rate of return is the return on an investment over a one-year period, such as 1 January through 31 December. An annualised rate of return is the return on an investment over a period other than one year (such as a month, or two years), multiplied or divided to give a comparable one-year return. For instance, a one-month ROI of 1% could be stated as an annualised rate of return of 12%. Or a two-year ROI of 10% could be stated as an annualised rate of return of 5%.

References

www.booz.com/global/home/what_we_think/reports_and_white_papers/article/47463070?pg=0

www.booz.com/media/file/ROI2_SMR_2009.pdf

The ROI Institute www.roiinstitute.net

Boston Consulting Group, Innovation 2010 – a return to prominence and the emergence of a new world order, 2010, www.bcg.com/documents/file42620.pdf