How Accountants Kill Innovation

by John Steen

How Accountants Kill InnovationThis isn’t going to be one of those rants against ‘beancounters’. We have actually collected and analyzed data which tells us that traditional accounting and valuation methods will damage innovation performance. To be fair to my accounting colleagues (some of my best friends are accountants) the main conclusion from our study is that we need a different type of accounting to manage the innovation process. In particular it’s the project selection step (or the filtering step in Tim’s aggregate, filter, connect model where planning and valuation methods can make or break innovation.

In the study we surveyed Australian biotech executives on how they used financial criteria to select innovation projects. With responses from about 100 firms, we were able to see that there were two styles of innovation planning.

The traditionalists used best estimates of market size, cash flows and chances of success to arrive at a value of the project. For those of you with a working knowledge of financial management, their style was closely aligned to net present value analysis.

The other group placed less emphasis on prediction and valuations and were prepared to stage investments in the project. As the project showed promise (or not) funding would be increased or discontinued. In finance terms, these were the ‘real options’ managers. Like a stock option, they were prepared to ride the uncertainty by taking an initial stake in the upside but also recognized that options are valuable because they limit how much will be lost if the project doesn’t perform after the early stages of development.

When we compared these financial management orientations to innovation performance (as measured by patents, which is valid in biotech) the first result was unsurprising. Real-options management was positively and significantly correlated with innovation. However, the second result was a bit unexpected.

The traditionalists using mainstream planning approaches (NPV managers) were negatively correlated with innovation performance. In other words, imposing strong traditional financial criteria for project selection made the firm less innovative than firms that had no particular financial criteria for the selection of projects!

I think this leaves us with three takeaways for managing innovation:

  1. Innovation means trying things out and failing. Attempting to provide detailed plans and forecasts regarding what is going to work will mean missed opportunities.
  2. Large firms with traditional planning processes and valuation tools need to create different procedures for managing innovation.
  3. We need to change the way we value innovation projects and include the upside of uncertainty in our assessment. While we focus on the downside risks with innovation projects, how many of us consider that risk has an upside too. Risk reduces the value of businesses in traditional valuation tools.

This research paper was written with Mat Hayward, Andrew Caldwell and Peter Liesch. It is currently under review for a journal.

Abacus picture from Flickr by Obraka under Creative Commons license


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John SteenJohn Steen is a Lecturer in Innovation Management in the University of Queensland Business School. He blogs about innovation at the Innovation Leadership Network.

No comments

  1. As an accountant-turned-entrepreneur, I’m not surprised with your conclusion “imposing strong traditional financial criteria for project selection made the firm less innovative than firms that had no particular financial criteria for the selection of projects”.

    Each company is unique in, for lack of a better description, the “mix of power” that each of its departments/functions has. In some companies, the IT function has the power and can do virtually whatever it wants; in other companies IT has to beg to buy a disk drive.

    Likewise, in some companies the CFO has ultimate power, and “out of the box” ideas – which innovation inevitably falls into – is not part of most accountant’s core beliefs. There are exceptions of course – innovative CFOs – but it is more the exception than the rule. So in companies like this, innovations decisions start at “no”, and have to meet many many hurdles to get to a yes.

    So I think that companies that impose “strong traditional financial criteria” are indicative of companies where the accountants have a disproportionate share of the decision-making power. A company’s executive team should be balanced, with no one function holding too much power, in order to strike the right balance and set the right direction.

  2. I have worked in both environments and think if left exclusively to either end of the decision making spectrum, you either stifle innovation or you get no payback. I think it comes down to pragmatisim around product portfolio management and appetite for risk. Too many products in the incubator may not bring in the cash for payroll and too many products in maturity may lead to business performance and firm value issues. There is no single answer. Well researched markets and good preparation for regular business reviews is one good approach to educating the teams involved in the decision making process.

  3. I’m working a few CFOs right now on this very issue. Private companies have it a tad easier, but not much. We are working on getting the finance office
    1. involved in innovation projects earlier on so they understand the process, impact and strategic fits,
    2. changing both the timeframes for ROI as well as inputs to calculating ROI, including some “softer” ones like learning and reputation,
    3. Looking at alternative means of financing (e.g., grants, etc.)
    4. Looking at non-traditional ways of allocating/re-allocating resources
    5. Demonstrating associated/attributable contributions to other aspects of the business
    6. Rethinking “sunk costs” (hate that term)…hey, they’re sunk! Factor in the cost of missed opportunities, especially over time, because sunk costs doesn’t factor in lost gains by doing something else.

    Just a few thoughts – deb

  4. That’s a really good point about private companies Deb. We’ve doing a fair bit of work with both public sector organisations, and both public and private firms. In some ways the private firm environment is the most unique, I think…

  5. You probably know all the steps necessary in order to obtain a Net Present Value. First process the idea enough to understand, how much it could cost, how and when the idea begins to produce money, calculate your marketing budget, estimate your market/target and forecast your incomings. Definitely not an easy job that has to be done.
    In my experience, doing all that stuff and more, is totally necessary to think and plan in long term. In fact, I definitively recommend it. Because, based your ideas in just a feeling that you can’t account, maybe is not a wise decision for a profitable company.
    In the other hand, you have to know if you are in an innovation project, all the things you did in your estimations, all the things you tried to predict, are going to change in an unpredictable way. If not, or you are a wizard, or you probably are not inventing something new. That represents the risk of innovation.
    At the end, you have to trust in your heart, and use the NPV as a valuable data to take a decision and to test your team. Also, NPV has to be greater than zero if you want your CFO approve the project.

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