By Elijah Eilert
Traditional accounting methods measure and manage innovation efforts but too often they are one of innovation’s biggest disablers.
Standard business cases and financial modeling for example are not helpful in funding corporate innovation initiatives nore measure progress in a meaningful way.
Perversely, standard accounting methods, metrics and funding mechanisms can work against a company’s goals of future proofing through innovation, by providing false or misleading assessments and predictions. In a world of shrinking corporate lifecycles, it is time to gain control over a system that can more reliably deliver new business models and better measure innovation.
For those who are uncomfortable with this idea, it might be helpful to reflect on the fact that accounting has never been a static discipline. Accounting has always evolved and grown with the new challenges and opportunities that have arisen. It is simply time to extend the accounting toolset once more with innovation accounting.
Let’s consider some historical examples that highlight the issues facing traditional approaches before painting a picture of what the future can look like.
Once upon a time, there was no…
The double entry system of accounting is at least 650 years old and maybe 1,000 years old according to some reports. Accounting is undeniably a very important part of running a successful business, and it has evolved a lot since those early days. Similar to Law, accounting seems to be reactive in nature in that it adapts to changes in the environment only when the problems become too big to ignore.
Let’s have a look at two examples.
The Emergence of CPU
The industrial revolution led to the creation of large factories, where most value creating activities happened in-house, resulting in completely new accounting challenges.
A company producing fabric, for example, did not have a system that helped them figure out the cost of one square meter of the cloth they were producing. Calculating the production Cost Per Unit (CPU) subsequently became critical and remains so today. Further, CPU is essential in assigning a value to the inventory for the balance sheet, as the inventory is not valued by its fair market value but by its cost. Following from that, the calculation of Cost of Goods Sold for the income statement (or the profit and loss statement for Aussies) can be made.
CPU is an indispensable measuring unit today, but we did not always have it!
The Emergence of Management Accounting
The earliest widespread implementation of management accounting is credited to Alfred Sloan, who was the CEO of General Motors (GM) from the 1920s through to the 1950s. Before the introduction of management accounting, GM had problems with managing its various departments and factories, interstate and overseas. The problem was so bad that at the end of a given financial reporting period there were huge unexpected swings in inventory, expenses and revenue that the head office had no direct way of controlling or forecasting. Sloan’s introduction of management accounting allowed these departments and factories to be responsible for their own budgeting and reporting that could be funnelled into the corporation’s accounts.
To us, today, this sounds so obvious it hardly seems worth mentioning. Most of us have worked in a department where invoices come in, they get stamped and approved for payment and the approver adds the account code for the type of expense with a prefix that designates the department. This amount is then shown in the department’s P&L for the corresponding period and the department’s manager is held accountable against their budget. If the P&L shows an amount that is well over the budgeted amount, questions from a manager will undoubtedly follow.
The accounting tools we have today are somewhat sufficient when we have historical data available. That is the problem – when it comes to innovation we have little or no historical data.
Accounting is not the problem, but accounting has problems dealing with innovation projects. Let’s look at two examples.
As outlined in this article Innovation Accounting: The Failure of The Business Case there are three distinct problems with the business case, accuracy, veracity and testability. Therefore, the tool itself poses an issue for innovation.
In the early stages of a risky project, the finance department’s well-intended risk management is to not waste organisational resources. Early-stage innovation projects are risky and management discounts future cash flow accordingly. Whoever pitches knows this and inflates favourable and ignores unfavourable assumptions to “demonstrate” a high Return of Investment (ROI) that would be justifying funding.
This process only increases risk as it nearly forces innovators to tell a good story. It rather hides uncertainty than assists in quantifying, understanding and tackling it. The problem goes well beyond the innovators bias, it is in the methods and tools. This approach gives innovators and organisations little wiggle room for an iterative process to search for Product-Market-Fit. It makes breakthrough innovation that can future proof the company less likely to succeed.
Ineffective Innovation Investments
According to Strategy&, a business unit within PWC, after analysing the 1000 most innovative companies in the world for over 12 years, they found – ‘no statistically significant relationship between R&D spending and sustained financial performance’. There are several reasons for this but what is certain, is that simply spending more while still using a traditional approach for transformational innovation, is likely not to pay off.
Funding decisions are often made on the common belief in fiction, not facts (as these are scarce in new projects). The communication abilities and political talent of individuals are more important than the truth.
A system that does honour managers and teams to clearly state the known unknowns of an emerging business model and a clear way to tackle those, is unlikely to produce a return. The pressure to come up with an effective system for large organisations on the other hand is high. According to an Innosight report, a company in the S&P 500 currently lasts about 21 years there. With the trend continuing, Innosight predicts that about 20% of those companies will have to leave the index within the next 4 years. Something better is clearly needed…
Innovation Accounting – the next Re-evolution
Equal to Sloan’s need for change nearly 100 years ago, managing innovation requires us to calculate, allocate and hold people accountable in new and different ways to those that worked in the past.
When Eric Ries coined the term innovation accounting he was really referring to the way we predict the outcome of a product and measure progress to hold its creators (innovators) accountable. While this is essential for a large organisation that intends to build a flourishing innovation ecosystem, it is still not enough. In order for an organisation to react quickly to a changing environment and to test the maximum number of ideas within their budget, it needs a robust system. All constituent components of that system need to be measured. This is what will likely be called innovation accounting in the future. Innovation metrics that enable us to analyse and assist in decision making across the following areas:
Pirates in Monte Carlo
A great improvement on the way financial modelling is done for uncertain ventures is to combine Pirate Metrics for Startups with a Monte Carlo Simulation. This type of modelling expresses the most likely outcome of a venture as a range, not one number. It has many further advantages, described in detail in the article: Innovation Accounting in Practice
An ecosystem that aims to increase the likelihood of success of innovation efforts also needs to handle their non monetary measures differently. Innovation teams for example can not be measured using ‘on time, on budget’ metrics. If we want to make them effective whilst holding them accountable, robust, fair and intelligent measures such as the following are required:
- Experimentation Velocity / % of teams that run experiments
- Insight Velocity / % of experiments that generate insights
- % of falsified hypothesis (validated/invalidated experiments ratio)
We don’t know exactly what the future system will look like, but we do know the elements it needs to contain to drive competitive advantage.
What we do know is that the world will continue to change and we will need to adapt. Not only the way we work, products, services, value chains, cultures but also accounting will adapt and evolve, especially in an innovation context.
In a world where Corporate Social Governance (CSG) issues loom large on the horizon of most corporate boards, Innovation Accounting holds out hope for effective resource allocation and employee satisfaction. The question remains: how long can corporate innovation resist the pending Re-Evolution?
“To improve entrepreneurial outcomes and hold innovators accountable, we need to focus on the boring stuff: how to measure progress, how to set up milestones, and how to prioritize work. This requires a new kind of accounting designed for startups—and the people who hold them accountable.” – Eric Ries (who first coined the term innovation Accounting)
- Accounting needs innovation
- If your current accounting tools are not effective, pivot the system
- Innovation Accounting provides essential tools to manage corporate innovation