“It’s an interesting project but do we have a strong enough business case? Let’s run some ROI calculations and see how it stacks up..”
This sort of eminently reasonable comment often sounds the death-knell for many a worthwhile innovation, despite the best intentions of all involved. Let’s have a closer look at why this is the case, why it’s a problem, and what you can do about it.
The siren song of ROI: why is it so compelling?
Every organization has a limited set of resources, and so it is only natural and prudent to seek a good return on any investment that you make. The heart of the issue is how we define what a “good” return on investment (ROI) actually is.
Commonly ROI is measured using well-established financial tools by looking at the present-value of the expected returns and comparing them to the costs.
However, this approach makes a number of critical assumptions:
- We can accurately predict the costs that will be incurred
- We can accurately predict revenue, asset sales, and other such returns
- We can accurately predict the timing of all costs and returns
- We understand our alternative opportunities and can apply an appropriate interest rate to discount future costs & returns back into what they are worth today.
In the case of a well-established business considering projects that it understands well from past experiences, these assumptions often hold true. There’ll still be some surprises but the actual ROI probably won’t differ too much from what is expected.
In such circumstances, using ROI assessments to choose which projects to fund and which to avoid is highly effective, which is why ROI has become a widely used approach.
Innovation killer: when is ROI the wrong tool?
The danger of having an effective and proven tool is that we tend to apply it to every situation, regardless of suitability. As a result, ROI is often applied where the underlying assumptions are clearly invalid, such as in entrepreneurial activities & innovative projects where costs, returns, timing and alternatives cannot be predicted with any meaningful level of accuracy.
(Note: another scenario where discounted cash flow and ROI analyses tend to give faulty outcomes is when failing to act has serious consequences – i.e. where “do nothing” is equivalent to “get left behind” – because the core business is declining or is vulnerable to erosion by competitors. For more on this, I strongly recommend reading Christensen, Kaufman & Shih’s HBR article “Innovation killers: How financial tools destroy your capacity to do new things“. )
Think of a project with potentially very high returns but also considerable uncertainty. Maybe you’re introducing a new product, expanding into an unfamiliar region, investing in a new technology, significantly changing your value proposition, or setting up a new distribution channel. You have good reasons for thinking that the return is worth the risk, but the outcome is far from guaranteed and the past is not a good predictor of the future.
When this sort of project comes up against the ROI hurdle, it struggles to win support because the future returns are uncertain, they probably won’t contribute to the next budget year, and there is a lack of robust “evidence” from past experience. So despite all its promise, the innovative project ends up being inherently hard for people to justify on traditional ROI metrics.
“Established enterprises struggle whenever they are required to reallocate resources away from established lines of business in order to fund the growth of new lines of business. The period of greatest pain is when the new business is big enough to demand a material amount of resource but not yet big enough to create a material return.” – Geoffrey Moore
As a result, innovative projects consistently lose out to incremental improvements and scaling opportunities. The traditional ROI approach has a bias towards lower but more certain outcomes, and – over time – this kills the capacity of an organization to innovate and achieve above-market growth, despite the best intentions of all involved.
A better way to assess & manage innovative projects
When the future is uncertain, it makes good sense to focus on learning. No amount of planning & analysis can make up for a genuine lack of information & insight. So rather than building precise-looking spreadsheets that ultimately disappoint, why not focus instead on identifying and testing (in the real world) the key assumptions that will make or break your project.
As the saying goes, it’s better to be roughly right than precisely wrong.
One of my favourite approaches for managing investments in uncertain environments is Discovery Driven Growth (DDG), a powerful framework by Rita McGrath and Ian MacMillan. They suggest shifting from the conventional management focus of “making your numbers & hitting projections” to instead emphasize “learning as much as you can for the least possible cost”.
By focusing on key assumptions and reducing the cost of failure (rather than the frequency), you can systematically shrink uncertainty and limit your risk to the funds needed to reach the next learning milestone. All going well, you’ll eventually know enough to invest confidently to scale up the project. On the other hand, if key assumptions turn out to be false and the opportunity is flawed, you can simply disengage from the project, capture & share the insights for future use, pat everyone on the back, and redeploy people to the next opportunity.
Here are a few practical suggestions for helping your organization pursue innovative projects:
- Frame the challenge: what growth is big enough to matter? Where is your strategic focus?
- Set up small, focused projects, with funding contingent on validating key assumptions.
- Reward the right behaviours: learning at least cost, adapting based on insights, etc.
- Eliminate fear: growth initiatives should be career-enhancing, even if discontinued.
- Create time to think about opportunities, free from the pressures of business-as-usual
- …and of course, don’t apply conventional ROI tools to projects with high uncertainty!
- Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things – a great HBR article from 2008 by Clayton Christensen, Stephen Kaufman, and Willy Shih that explores in depth how three specific issues (NPV/DCF analysis; how fixed & sunk costs are handled; and a focus on earnings per share) conspire to derail successful innovation.
- Learning to Escape the ROI Trap – A very practical perspective with examples from Chuck Hollis, chief strategist at VMWare and previously at EMC for many years. He argues that “because we don’t teach people how to evaluate imprecise opportunities, they fall back on tools that expect precision. And we end up with poor outcomes because we chose the wrong tools.” Chuck provides useful tips about reframing ROI in terms of the “risk of ignoring”.
- Discovery Driven Growth – a powerful approach from Rita McGrath & Ian McMillan based on the idea that capitalizing on uncertain opportunities requires a different mindset than pursuing business-as-usual growth in your core business. Some of the concepts here – e.g. investing small amounts of money to get useful information and make ‘roughly right’ decisions – have been widely embraced in the lean startup movement but are still not nearly common enough in more established businesses seeking innovation.
- Escape Velocity – a fascinating book by Geoffrey Moore about how to escape the gravitational pull of business as usual and invest in breakthrough innovation.
How does your organization support & fund innovative growth projects? What advice would you offer people with innovative projects that are stumbling at the ROI hurdle due to uncertainty?