Stop Treating Innovation Like a Cost Centre

Innovation labs have been shut down left, right and centre over the past couple of years. And for one simple reason: Keeping loss-making units alive makes boards look foolish.

It’s not that the economics have suddenly changed. They’ve always looked bad.

Whereas hyping up tech and believing in unicorns was sufficient to overlook the economics in the pre-Covid years, this is no longer the case.

Boards now look at the numbers and conclude that innovation –in its current format– isn’t worth the cost. The return doesn’t appear to justify the investment.

The arguments “but look at WeWork, look at crypto,” don’t wash anymore.

So since the economics of innovation are back in focus, let’s talk about them.

Most analytical minds like to start from the data when tackling problems of economics, but I like to take the intuitive angle first.

It feels odd that when seeking to reinvent the business, and thereby ensure its survival, the ROI of such an activity should be negative. I would imagine that the most negative return would be for the company to go out of business – because it failed to innovate or got outcompeted (two ways of saying the same thing).

If doing something is obviously superior to doing nothing when it comes to innovation, then why don’t the numbers add up?

Well, it’s all about how we run the numbers.

One of the most fundamental errors that companies make is to treat their explorative innovation activities –what should be investments in their future business model– as operating expenses.

(Note that I’m not talking here about incremental innovation, i.e. continuous improvement, but rather more radical explorations of new sources of revenue.)

Once a company is well established, core business activities like sales, marketing, procurement, or recruitment are relatively predictable activities. Next year’s budget will probably be this year’s budget +/- a few percent.

If you have a well-oiled marketing machine and you inject an extra million into advertising, you can be fairly confident that you’ll generate more than an extra million in sales.

But innovation is nothing like this.

Sure, you can create a nice-looking funnel and drive your company’s ideas through it, but if anything the past 10 years have shown that this approach doesn’t lead to breakthrough ventures.

Company boards who expect innovation to deliver nice predictable results can expect to experience a very predictable emotion: disappointment.

Innovation (real innovation) shouldn’t be confined to linear expectations. Rather, as we’ll see today, it should be seen as a way to create strategic assets that provide optionality.

Think of optionality as a form of flexibility. It’s about building the power to adapt and pursue opportunities as they arise, on your terms.

My hope is to convince you that the true ROI of innovation is in offering your business the flexibility to pursue new opportunities as they arise, in non-linear fashion.

And this flexibility, this power to choose –particularly when structured into a portfolio– deserves to be seen as an asset, not as an operating expense.

The problem with treating innovation as an operating expense

Innovation usually gets treated by businesses as if it were a predictable expense, squeezed into rigid frameworks designed for marketing, recruitment, sales, etc. all with clearly defined metrics.?

The expectation is that innovation, too, must deliver tangible, quantifiable outcomes within a set timeframe. But this fails to recognise that innovation —especially disruptive innovation— doesn’t behave the way you might want it to (like a conventional operating cost).

Incremental innovation —small, continuous improvements to existing products, services, processes— admittedly does fit much better into linear, funnel-like frameworks.

However, if we’re aspiring to more disruptive innovations, the type which redefine business models or industries, well they’re far more complex and unpredictable.

Take the automotive industry. Volkswagen was fairly slow to embrace electric vehicles, focusing on incremental improvements to petrol and diesel engines while Tesla disrupted the market with a bold bet on EVs.

Similarly, General Motors’ Innovation Group were also more focused on incremental advancements over anything too radical that might imperil sales of SUVs and pickups. A commitment to disruptive ventures, like their BrightDrop electric delivery vehicle division, did come later, but only after competitors had already gained significant traction.

Retail provides another cautionary tale. Toys R Us thrived for years by focusing on incremental improvements — better stores and loyalty programs. Meanwhile Amazon was betting on revolutionising retail through e-commerce.

Toys R Us failed to see the disruptive potential of online shopping, so was left unable to adapt, ultimately leading to its collapse.

Long-term, explorative innovation isn’t just a cost to be managed.

Disruptive innovation doesn’t follow predictable paths. It demands experimentation and flexibility, which are stifled by rigid expectations of immediate ROI.

So companies need to treat innovation as a strategic asset that creates options for the future, not another fixed expense tied to short-term results.

Shifting towards an Asset and Optionality mindset

The alternative to the expense mindset is to view innovation as a strategic asset — one that creates optionality for future growth.

Optionality, as many of us understand from the world of finance, refers to the flexibility to pursue certain opportunities without any obligation to do so.

Disruptive innovation thrives in this mindset, because it allows companies to experiment and explore paths that probably won’t deliver immediate returns but hold the potential for exponential, transformative impact.

When we look at the dominance of Silicon Valley firms today, it wasn’t just down to their ability to create superior products. In addition, they developed a habit of creating optionality for themselves – with relatively small upfront investments.

Tesla are masters of optionality in action. While traditional automakers as we saw were focused on incremental upgrades to combustion engines, Tesla invested heavily in EVs and autonomous driving technologies.

This was by no means a straightforward bet. Tesla brushed with bankruptcy.

It was an exploration of multiple futures – some, all, or none of which may have been destined to come true.

Autonomous driving, for instance, would enable entirely new business models. (Imagine self-driving taxi fleets or transportation-as-a-service.)

None of these possibilities are guaranteed outcomes, but they reflect Tesla’s ability to position themselve strategically to capitalise on whichever vision of the future materialises. Certainly their competitors have already been left in the dust, as the Stockmarket is increasingly convinced that Tesla has invested in all the right assets to dominate the future of the car industry.

Tesla’s success didn’t come from certainty. It came from the flexibility to explore multiple futures, while their competitors were waiting for guarantees.

Thinking back to a different approach Apple took, when they launched their App Store, we see another case of optionality driving long-term value.

Because when the iPhone launched, the App Store wasn’t just a convenient feature, nor just a cheaper alternative to developing apps in-house; it was an open invitation for developers to innovate and make money themselves.

By enabling third parties to create and monetise apps, Apple created an ecosystem of complementary products that boosted the value of its devices. This decision was inherently risky— there was no guarantee that third-party developers would embrace the platform; it could have flopped spectacularly.

But having such an App Store up and running gave Apple the flexibility to promote certain types of apps (or not), to develop new apps of their own (or not) and to introduce novel forms of pricing.

And the optionality created by this ecosystem continues to fuel Apple’s dominance in mobile technology.

Netflix made a big decision to invest heavily in original programming, but it wasn’t just about competing with traditional studios—it was about creating control over its content throughput.

By owning its own shows and films, Netflix insulated itself from the volatility of licensing agreements, whereby studios could suddenly pull content to favour their own streaming platforms (as Disney and Warner Bros. later did).

This ownership gave Netflix the flexibility to shape its brand identity and respond to viewer preferences on its own terms.

Also, now that it owns a diverse library of original programming catering to audiences across genres and geographies, Netflix has created an agile content model that can adapt to emerging trends or and capture opportunities faster than rivals.

For instance, when global expansion became a priority, Netflix invested in region-specific originals like Sacred Games in India and Money Heist in Spain, which became global hits.

These bets reflected Netflix’s ability to pivot its creative focus based on the demands of specific markets – a great example of how owning strategic content (assets!) allowed it to benefit from a rapidly changing entertainment industry.

Some might call Netflix antifragile.

To succeed beyond the short-term, our companies need to build a culture that embraces experimentation and seeks to benefit from uncertainty (not insulate themselves from it).?

Investments in disruptive innovation rarely pay off immediately, and there are no guarantees.?

However, companies that view innovation as a portfolio of options —each with the potential to reshape the business— are far better equipped to benefit from rapid and sudden changes in their industry.

Conclusion

Companies that treat innovation as an operating expense will always be disappointed.

Breakthrough ideas can’t be reduced to a neat, linear process. True innovation is about building assets that create flexibility for the future.

Optionality gives your company the freedom to pivot, experiment, seize opportunities that competitors may miss. But it’s not about gambling on one version of the future and hoping it comes true.

Instead, it’s about positioning for a range of possibilities — and acquiring individual options relatively cheaply to build a future-proof portfolio of opportunities.

The challenge to future-focused leaders is to embrace this mindset: to view innovation not as a cost to justify, but as an investment in a portfolio of future options.

Yes, it may mean enduring a little pain today. But in a volatile, uncertain world, it’s the smartest way not just to survive, but to thrive.

Want to know more about surviving, thriving and everything in between?

?? In case you missed it, David Semmens, CFA and I recently launched Season 2 of The Culturedge Podcast .

In our latest episode, we hosted Rebecca Homkes , strategy consultant and author of the groundbreaking book Survive, Reset, Thrive: Leading Breakthrough Growth Strategy in Volatile Times. (We’re not a paid affiliate.)

Rebecca shared with us some of the ways in which she helps leaders stay agile, make confident decisions and thrive in uncertainty.

?? In Season 2 we’ve gone full video (so you can also find us on YouTube) but we’re still on Spotify and other places if you’d like to listen in while you’re on the move.