Definition of innovation accounting
Innovation accounting refers to the rigorous process of defining, empirically measuring and communicating the true progress of innovation – such as customer retention and usage patterns - whether for start-up companies, for new products or business units within established companies.
The terms innovation and accounting are both well defined and understood. However, by combining the two terms together they take on a very different meaning.
When traditional accounting measures are used to measure innovation, it often has the effect of stifling or suffocating the new product or start up company. This is because traditional accounting tends to work best when measuring established products or on-going concerns. By definition, new innovations have a limited operating history and little to no revenue and are burning cash well in excess of revenue. In this context, financial ratio analysis, cash flow analysis and other standard practices shed an unflattering light on the new innovation, especially in comparison to existing products or businesses within established companies.
why innovation accounting is important
It is critical to use the right metrics to understand causes and effects. Using the wrong metrics can be very damaging.
Using market buzz, PR hits and product awards are often very superficial approaches. Despite this, many entrepreneurs tend to refer to the number of retweets and Facebook “likes” as legitimate market validation.
For example, a network security company focused on the number of resellers contractually signed to resell its new product to indicate validation of its product. In reality, this was a “vanity metric” as there was no financial commitment on the part of the resellers.
In another example, a number of early sales were actually false positives because they were sold to users who required many modifications to the original.
There is no one-size-fits-all approach to the key metrics. They must be carefully selected and they evolve as the business matures.
The metrics must go beyond the obvious and prove objectively that the company is moving towards sustainability. Ultimately, the company will, over time, move from validated assumptions to a quantitative financial model.
Examples include metrics that address depth of user engagement.
There is a legitimate reason that the “hockey-stick” curve is largely flat at the beginning of a new product or business cycle. It's not because the founders or team leaders are not working hard, but because uncovering a business model that works starts with lots of things that do not and need to be refined.
innovation accounting at work
In the 1990s IBM had confronted the harsh reality of missing the opportunity to establish early leadership in many new tech markets from network routers to data communications to the internet.
While there were several reasons for this, one important factor is that IBM applied the same rigorous metrics to its new products as it did to its established products, which led them to be discontinued.
When Lou Gerstner joined the company as CEO during IBM’s darkest days, he recognised that this needed to change and he developed the Emerging Business Opportunity Group (EBO), who was charged with identifying new billion dollar businesses for IBM.
One critical change that Mr Gerstner implemented was to alter the way that these new business opportunities were evaluated.
He brought in entrepreneurial executives to lead these new ventures and tasked them with eliminating market ambiguity and increasing strategic clarity.
Ultimately, the IBM EBO approach resulted in a number of new multi-billion dollar businesses and re-energised and re-established IBM as a major player in the IT space.