McKinsey & Company/Aase, Roth, & Swaminathan: Taking the measure of innovation

McKinsey & Company
Strategy and Company Finance
 Article - McKinsey Quarterly - April 2018
Taking the measure of innovation
By Guttorm Aase, Erik Roth, and Sri Swaminathan
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Don’t overlook the insight that two simple metrics can yield about the effectiveness of your R&D spending.

You’ve probably heard the old joke about the two economists who saw $20 on the sidewalk. “Look,” exclaimed the first economist, “a $20 bill!” “It can’t be,” the other economist answered. “If it were a $20 bill, someone would have already picked it up.”

We were reminded of this story when we began to notice a pair of innovation metrics that seemed so intuitive that we assumed they must have been conspicuously applied and rejected before. So far, however, we’ve found no indication of widespread use—and a reasonable amount of evidence suggesting that, at least for most industries, the measurements work.
Video
R&D conversion metrics for innovation performance

We call these indicators R&D conversion metrics: R&D-to-product (RDP) conversion and new-products-to-margin (NPM) conversion. Their core components—gross margin, R&D, and sales from new products—are not new, but combining them can reveal fresh insight on the relative innovation performance of business units, within an organization and relative to external peers (Exhibit 1). The first metric, RDP, is computed by taking the ratio of R&D spend (as a percentage of sales) to sales from new products. This allows organizations to track the efficacy with which R&D dollars translate into new-product sales. The second metric, NPM, takes the ratio of gross margin percentage to sales from new products, which provides an indication of the contribution that new-product sales make to margin uplift.
Exhibit 1
Two metrics combine R&D spending, sales from new products, and gross margin to shed light on relative innovation performance.

Notably, these metrics can be gauged outside in, making them ideal for benchmarking. They also apply on the portfolio level, where the net effect of individual project investments reflects the results as a whole. That broader perspective accords with how senior executives and investors typically consider innovation performance. It’s not the most granular way to consider project value creation, and it doesn’t aspire to be. In seeking the ideal metric, one should not let the perfect be the enemy of the good. When a business can convert a high rate of R&D dollars to new products, and when its new products flow through to higher gross margins, good things will happen.
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As we’d expect, the R&D conversion metrics show that higher spend does not inevitably translate to stronger performance. That should come as no surprise to seasoned executives and analysts. Rather, when we benchmarked companies within select industries, results varied markedly. The R&D conversion metrics also demonstrate—sometimes strikingly—where some organizations are falling short and where opportunities for improvement may be found (Exhibit 2). Not every company that scores strongly on RDP is able to follow through to higher margins, and a company scoring above-median performance on NPM may underperform in RDP.
Exhibit 2
Taken together, the R&D conversion metrics can help identify favorable and unfavorable innovation-performance outliers.

While the R&D conversion metrics are useful, context is essential. Benchmarking must be conducted against comparable firms—pure plays versus pure plays, diversified companies against companies with multiple business lines, and product-to-product comparisons with cycle times that are as close in duration as possible. These metrics also work best in industries where product turnover is higher and the incremental effect of innovation is both more immediate and more critical to the business model. For example, in specialty chemicals and consumer goods, two industries with rapid innovation cycles, the three-year average in gross margins correlates strongly with the five-year average of NPS. In industries with markedly longer cycles, such as pharmaceuticals and agribusiness, the r-squareds are lower.
Eight_essentials_1536x1536_Original The eight essentials of innovation
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But in a real sense, those exceptions help prove the rule: the more that innovation matters with immediacy, the more insight is to be gained by tracking your innovation efforts. In our experience, many companies spend too much time looking inward at measures of activity (for example, number of patents, or progress of ideas through a pipeline), and not enough scrutinizing the returns on innovation. Creating value is the name of the game, and these R&D conversion metrics help you keep score.
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About the author(s)
Guttorm Aase is an associate partner in McKinsey’s New York office, where Sri Swaminathan is a consultant; Erik Roth is a senior partner in the Stamford office.
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