FORTUNE’S FORMULA
CFOs are finding new ways to make innovation spending pay off.
By Tony Mcauley

Dyneema is the strongest fiber in the world. Invented in the 1980s by DSM (formerly Dutch State Mines), its original commercial uses were in shipping and the offshore
platform industry. DSM then created new markets for the product as a bullet-stopping fiber for the police and military and, most recently, as Dyneema Purity, the fiber is being used in medicine as an ultra-light, ultra-strong thread to minimize invasiveness in surgery. Most importantly for DSM, Dyneema was a key innovation that helped the €8 bn (US$9.9 bn)company transform itself from a stodgy formerly state-owned coal mining operation into a dynamic publicly listed speciality chemicals powerhouse in the 1990s.

Dyneema has been the best of a string of DSM’s innovation successes, but it might just as easily have gone by the wayside. As Arnold Gratama van Andel, who was promoted this month to CFO of the Dutch company, says: “There is nothing easier than pulling the plug on a research project if it looks like it’s not working out. Dyneema took a long time to be completely successful. Now it contributes materially to revenues.” Yet Dyneema highlights what van Andel says is “one of the most intriguing and difficult questions we face: finding the balance between fostering innovation and having financial controls on the investment. It is not the most natural thing to match.”

DSM is not alone in facing this crucial business challenge. Companies across industries, and of all shapes and sizes, struggle with the question of how much to invest in the pursuit of innovation, as well as how to ensure that this investment is allied with the business goals of the company. Recent studies, such as one undertaken last year in the US by management consultancy Booz Allen Hamilton, have found that merely spending more money on research and development does not guarantee results. As the authors of the study concluded: “There is no discernible relationship between spending levels and most measures of business success.”

But while throwing money at R&D doesn’t necessarily bear fruit, not spending sufficiently on innovation is also certain to bring failure. “The Booz Allen study claimed that there is no correlation between spending and R&D success, but read on and you see that there is,” says Andrew Dearing, secretary general of the Paris-based European Industrial Research Management Association (EIRMA), a not-for-profit research institute funded by European companies. “Companies that spent too little underperformed just as much as companies that overspent on R&D,” he notes.

EIRMA published its own study in December, concluding that the effectiveness of spending on R&D can only be determined by considering its integration into the business as a whole. Management tools, such as balanced scorecards and commonly used metrics such as timely delivery of results and operating within budget, are not sufficient for this purpose, it suggests. The study recommends that each company “establish its own key criteria, reflecting its R&D objectives” and foster a “continuous cycle” of measurement and feedback to make sure that individual projects and the R&D effort as a whole are meeting business objectives. But the key element in the process is that senior management is behind the R&D effort and involved in it at every step along the way.

Hot house

DSM is embarking on just such an approach. In April, the company brought all of its research, development, venturing and related activities “under one roof”, as van Andel says, with the group director of the food business, Rob van Leen, given the board-level position of chief innovation officer.

“Though innovation has been key to the company, we’ve seen that we probably haven’t done enough on innovation because most managers have the tendency to concentrate on improving the products they already have and not enough on lateral thinking about their business from the outside in,” van Andel explains. “We now have four emerging business areas with a structure to foster that outside-in thinking.” At the same time, van Andel says the company has been thinking about the appropriate balance between resources and financial control. In its Vision 2010 program, DSM will add 250 people to the innovation teams in the new division and take spending on research from €290m (US$360m) to approximately €360m (US$447m) by 2010.

“In terms of measuring ROI, the huge problem with these emerging business areas is that you should not be too harsh in the beginning,” he says. “You have to have belief in them, provide some seed money. But the test case is when you have to decide to kill off a project. The lesson is that you have to keep a really good eye on timelines and milestones and you have to be ruthless.” Otherwise, he says there’s a risk that the company ends up with too many projects and spreads its funding too thinly.

The appropriate structure for fostering and controlling innovation differs according to industry and timing, Dearing of EIRMA says. “The pharmaceutical industry has seen an enormous rise in R&D costs over the last ten years – from US$100m per drug to US$800m per drug – mainly because of huge rises in the costs of regulatory approval and making sure that you have drugs that provide a significant step forward,” he explains. For this reason, there has been an industry-wide trend to provide much more centralized control of R&D. At the same time, he says, the information technology industry has moved in the opposite direction, with more dynamic networks.

Outward bound

This has certainly been the case for BT, formerly the UK phone monopoly British Telecom. Mike Carr, BT’s director of research and venturing, explains that the company’s approach to innovation has evolved as the role of technology in the business has changed.

“The market has completely shifted from one of poles and lines and so on, to one in which there are a whole range of applications in information and communications technology,” Carr says. Now, the company can’t simply rely on its own inventions to move forward. “For every problem we have at BT, there are probably several start-up [companies] out there trying to solve it for you. So, we put a lot of effort into this ‘open innovation’ approach, as we call it, working with the best we can find and adding value to that using our own research guys.”

Of the approximately £250m (US$446m) spent annually by BT on research, about 20% is devoted to very early stage projects, such as those done jointly with university labs. In terms of managing the innovation life cycle, BT picks up the projects in its own labs when they are perhaps four or five years from being commercial. As it gets to within one or two years of coming to market, BT then typically partners with outside firms to develop products that it would then buy from those providers.

The objective is to get these outside firms to bear the greatest effort in the R&D process. BT makes some direct investments, but prefers to foster the technology by being a significant customer and getting venture funds to provide the investment for the technology companies, something that is easy for them once BT is providing large orders.

Carr cites 2Wire, a California-based broadband company, as an example. “They’re making WiFi residential home gateway technology. We introduced it into the BT broadband portfolio and now it’s sold in many thousands. We didn’t make an investment but gave a real order. By using the new technology best and first, we get our advantage.”

Paying dividends

How does finance interface with Carr’s research and venturing unit at BT? Himanishu Raja, CFO for BT Wholesale, a division that accounts for about a quarter of the group’s £19 bn (US$34 bn) annual sales, explains that this works at two levels. “Full-time members of my team are matrixed into the R&D units and work alongside them to prioritize the activity. Also, I hold quarterly sessions with the BT board to review our balanced scorecard, R&D performance, and deliverables,” Raja says. In terms of measuring research, “we previously depended on a subjective evaluation of the usefulness of the technology that was generated supporting BT’s future business needs. We’ve had a patent target for several years, which is a good measure of originality of the work we do.” BT also introduced the concept of the “innovation dividend”, which is a measure of three-year business case contributions. Meanwhile, there’s an ROI measure and a 90-day cycle for development activity. “This allows the finance and engineering teams to work together to provide development measures at regular intervals,” he says.

An example of the success of the new approach is BT’s global MPLS network, which allows operators to manage and prioritize data streams with greater sophistication than on traditional data networks, says Raja. “It’s in a leading position as a direct result of our key innovations coming from the R&D departments. BT has the number-one position globally in this business.”

In terms of structure, Raja says, it is absolutely key to get a good balance between the development work that directly impacts the current business, purpose-driven research which focuses on known issues and opportunities, as well as a degree of freedom to allow the research department to be innovative in disruptive areas. “We manage this on a percentage basis, with about 20% of our research activity focused on disruption,” explains Raja. “The key focus for this year is expanding the innovation activities across the whole of the business to align with BT’s key strategic objectives.”

The outward-looking, open innovation approach that BT has taken is based, at least partly, on a recognition that it’s futile in a fast-moving area such as IT to put all of your R&D eggs in one in-house basket.

In the oil business in the 1990s, the same open innovation approach was adopted because the costs of development, even for the largest companies, were prohibitive. The result, according to David Brown, a partner at management consultants Arthur D Little, was that R&D spending as a whole declined and was pushed out to suppliers. (See graphs, below.) But the result was an improvement in effectiveness for the industry as a whole.

“The main issue here has been intelligent partnering,” Brown explains. “Rather than developing all the technology in-house, several of the ‘majors’ (ExxonMobil being an exception) have pushed development work out to suppliers, and suppliers haven’t done as much as majors used to but they’ve been able to get more value from doing less.” Schlumeberger, which has made great strides in deep-water drilling technology, is an example of R&D progress that has benefited the whole industry, Brown says.

Mark Thut, a director at management consultancy PRTM, says that large-cap companies “face a unique R&D challenge: cultivating innovative organic growth, while continuously supporting and renewing the core business. Under this pressure, how do such organizations measure R&D effectiveness? Is there one metric or several?” Thut says that most companies rely too heavily on a single “R&D effectiveness” metric, which is calculated by looking at sales generated by new products. This has its place, but is not a good indictor of overall R&D value as it focuses only on new products and fails to recognize the value of incremental innovations, which can be substantial.

Carr of BT backs up this notion, and points to an incremental innovation that saved the company “hundreds of millions of pounds” – the application of artificial intelligence technology to allow it to predict more accurately how to deploy its 20,000 repair engineers to deal with faulty lines.

Thut of PRTM recommends that companies also look not only at innovation in terms of new products, but also leverage. “For example, (US materials company) 3M complemented its use of a single R&D metric with others including revenue from new platforms, to drive the right behaviors throughout its organization,” he says. Also, productivity is a critical parameter of effectiveness, something which American engineering group AlliedSignal used to good effect in the 1990s.

A tip from DSM’s van Andel, as CFOs become more intimately involved in the innovation process, is not to get blinded by the techies. “When it is scientifically complex, as it is at DSM, it gets complex for finance guys like me, too,” he says. “You should be very aware that the research guys are not trying to overwhelm you with difficult things, so that in the end you say, ‘I give in, I don’t understand it.’ Try to keep it simple and make them keep it simple.”