Why account for innovation?

 
Portrait of Luca Pacioli  ,  author of the first known published text on double-entry accounting.

Portrait of Luca Pacioli, author of the first known published text on double-entry accounting.

 

Words by Matt Kerr.

The use of traditional double-entry accounting stretches back to ancient times, so the impulse to associate Innovation Accounting with its traditional ‘bean counting’ namesake is entirely understandable. In the 1300’s the great trading empires of Venice, Florence, and Genoa were using double-entry accounting to keep track of their loaves, fishes, finery and more.

So what does something that once helped Venetian merchants keep track of salted cod imports actually have to do with innovation?

“People are accustomed to thinking of accounting as dry and boring, a necessary evil used primarily to prepare financial reports and survive audits, but that is because accounting is something that has become taken for granted.”

-Eric Reis , The Lean Startup

Putting innovation and accounting together in a corporate environment can often result in innovation being crushed under the weight of unrealistic financial targets. When customer-led product development meets premature revenue targets’ it tends to be the revenue target tank division which wins the battle.

“Our prototype has been testing well with customers”. “Great, let's give it some financial targets and throw it into battle.”    Source

“Our prototype has been testing well with customers”. “Great, let's give it some financial targets and throw it into battle.” Source

If Innovation Accounting isn’t about traditional double-entry accounting and it also isn’t about applying traditional business case metrics to innovation initiatives that can’t yet support them, what actually is it about?

Our friends over at The Corporate Startup have come up with a really useful definition for Innovation Accounting:

“Innovation Accounting is about managing three key activities…:

  • Making investment decisions…

  • Tracking and measuring the success of specific innovation projects…

  • Assessing the impact that innovation is having on the business as a whole…”

Measuring and managing innovation initiatives across these three dimensions allows us to both hold ourselves to account, and to have an ongoing dialogue with our executive sponsors and boards about how our innovation efforts are tracking.

So, how do we go about measuring our innovation efforts across the three key activities?

At IE, we have developed a framework to help our clients navigate the new world of innovation accounting. Our framework breaks innovation metrics into four layers:

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Given our growth focus we think it is important to split traction metrics (backwards-looking) and growth metrics (forward-looking) into their own layers. The distinction is made to help with adopting a Venture Capitalist mindset – evidence of traction will get a VC interested, but the final decision to invest is based on the future growth story. It also helps when managing the transition from achieving traction (product-market fit) to explicitly driving growth as our business model matures and we begin to scale more aggressively.

While we may associate measures and targets with corporate bureaucracy, having complete freedom to innovate inside an organisation often brings its own set of challenges.  At IE, we regularly talk to leaders of Corporate Innovation programs which have been cut short and we find broadly two types of demise – short-lived programs which closed down because they weren’t delivering, and longer programs that survived by changing their reason for existing a number of times before they are eventually closed down.

Programs that aren’t delivering tend to fall into the gap between traditional and Innovation Accounting. Innovation projects shouldn’t be expected to deliver against short-term revenue and profit targets. However, in the absence of these metrics business leaders will often only support ‘trust me, I’m an innovator’ for a finite period of time. The progress layer of our framework helps support a conversation around the level of activity, the learnings that are being uncovered, and the cost/runway remaining. The traction and growth layers extend beyond basic activity to inform an evolving conversation about the realistic growth potential of an initiative.

In the case of both short-lived and constantly morphing innovation initiatives, we believe the core problem can also be traced back to a lack of agreed metrics which can itself stem from the lack of a clear Innovation Thesis.

An Innovation Thesis clearly sets out why the innovation programs exists and how it fits into the future view of the organisation.

“In order to lead innovation successfully, every company needs a clear innovation thesis. Leaders need to take a point of view about where the world is going and how they plan to use innovation to respond. This Innovation Thesis must be aligned with the overall corporate strategy.”

- Tendayi Viki.

Our view at IE is that the best way to align corporate strategy with an Innovation Thesis is through a growth lens. While we should avoid saddling individual innovation initiatives with unrealistic growth targets, we can still frame the growth outcome we are seeking from our overall innovation program.

When we have determined an innovation growth frame, we can then use Innovation Accounting to measure how we are tracking toward the overall growth objective. We refer to this process of setting a holistic growth target and then managing many individual initiatives as ‘innovation portfolio management’. Not only does this help us adjust course over time, it anchors innovation within the corporate strategy and supports alignment around what the program is (or perhaps isn’t) delivering back to the organisation. This is the reason our Portfolio layer looks at metrics such as aggregated market and growth potential. While these metrics are uncertain by nature, they inform the growth frame for the innovation program and support more strategic conversations about innovation.   

If we can create alignment between our corporate strategy, our innovation thesis, and our innovation metrics we will be in a powerful position to avoid being short-lived or existing in a state of constant morphing. While this may sound ambitious for a new discipline like Innovation Accounting, the tools and concepts we need already exist and it is more about how we adapt them to our emerging needs. Knowing what metric to use when is the critical piece – is our Idea Funnel being effective? Are our validation sprints running at an acceptable velocity and quality to test assumptions? Are our projects tapping into addressable markets that create a large enough return to justify an investment to scale? How much should our overall program invest and in what parts of the innovation system to return the ambition of our innovation fund?

Back in their day, those Venetian merchants had to rise to a similar challenge. Faced with the twin disruptive innovations of a monetary economy and the emergence of ‘trade finance’ they adopted double-entry accounting to manage their increasingly complex affairs.

“International change agents” -    Source

“International change agents” - Source

Those merchants with their double-entry accounting and foreign trade were actually the ‘international change agents’ of their day. It turns out that we were never just counting beans, or loaves, or fishes - instead we have been using accounting to help navigate uncertainty for a long time.  Its significance in history should provide solid justification for its use as a tool for navigating modern innovation projects.

Matt Kerr is an innovation consultant at IE. This is our first thought piece on Corporate Innovation. In the coming weeks, we will be publishing articles that delve into the why’s and how’s of what we do. This is Part 1 of our first topic, Innovation Accounting.

PART 2 CAN BE FOUND HERE.