MEASUREMENTS AND INCENTIVES THAT SUPPORT INNOVATION

MEASUREMENTS AND INCENTIVES THAT SUPPORT INNOVATION
ABSTRACT
This paper focuses on the practical elements and tools that will make innovation work. If we want to encourage behaviour, in general, we must communicate our expectations very explicitly to everyone involved, attach metrics to them, measure the achievements, and make sure there are incentives for those who outperform. Designing measurements and incentives for innovation could be very complicated and challenging task and may include many elements for consideration; this practical aspect of "making innovation work" is broadly discussed in this paper.
CHAPTER ONE: MEASURING INNOVATION
"What gets measured gets done" declare Davila, Epstein, & Shelton (2006, p.145). Economists use financial measures for evaluating companies and initiatives rate of success; these measures are based on Generally Accepted Accounting Principles (GAAP), and recently non-GAAP financial measures were developed, resulting from Sarbanes-Oxley Act, SOX (http://www.sarbanes-oxley.com/). Industrial engineers use another set of metrics for measuring efficiency of workers, based on the ratio of amount of work done to the amount of expected work in normal conditions. "The traditional financial performance measures worked well in the industrial era, but they are out of step with the skills and competencies companies are trying to master today," advocated Kaplan and Norton (1992, p.71). They developed the Balanced Scorecard concept, which "translates an organizations mission and strategy into a comprehensive set of performance measures that provides the framework for a strategic measurement and a measurement system." (Kaplan & Norton, 1996, p.2) The balanced scorecard also complements the McKinsey 7-S model (which describes the seven factors critical for effective strategy execution, in article by Waterman, Peters, and Phillips, 1980), argues Kaplan (2005) in a recent article. How could and should we measure innovation? Financial and engineering measures are not sufficient for measuring strategic initiatives; the balanced scorecard principles, with their broader view, should be utilised and applied, instead.
"Measurement systems are managerial facilitators" (Davila et al., 2006, p.146), and they fill three generic roles: (a) plan, define, and communicate strategy, clearly and explicitly through the measurement system, (b) monitor and track the execution of innovation efforts, identify deviations from it, and evaluate performance, and (c) learn and identify new opportunities (learning organisation is discussed later in this paper).
Before jumping to the practical elements of the balanced scorecard that apply to measuring innovation, there is a need to link and refer the measurement system to the business model foundation. "The richer our understanding of the innovation process, the better our business model will be and the derived measurement system will provide a more informed management of innovation." (Davila et al., 2006, p.149) The business model of innovation, which can be applied to any level within an organisation, describes the relationships behind an innovation model; these are defined by inputs (the resources devoted for innovation), processes (measuring the current activities), outputs (the results of innovation efforts, aftermath measures), and outcomes (measuring the value creation by the innovation efforts). The balanced scorecard approach arranges them into four perspectives of measurement: the financial perspective, the customer perspective, the learning and growth perspective, and the internal business processes perspective – each of which is aligned to the vision and strategy (The Balanced Scorecard Institute, http://www.balancedscorecard.org/basics/bsc1.html). Following the development of the business model for innovation, and based on it, the measurement system is developed. Measurement system is innovation-specific and describes explicitly the elements of the business model in concrete terms (e.g., employee resources and external consultants).
"Designing and Implementing Innovation Measurement System" is discussed by Davila et al. (2006, pp.157-173); I have chosen to depict this complicated system, by using the hierarchical tree model:
Innovation Measurement Systems
• Measures for ideation
o Culture
o Exposure to innovation stimuli
? Pear assists
? Pear groups
? Federal groups
o Understanding of innovation strategy
o Management infrastructure for ideation
? Talent
? Money
? Knowledge
? Management systems
? Communication
• Measuring the innovation portfolio
o Time to value
o Risk
o Value
o Type of innovation
o Implementation stage
• Measuring execution and outcomes of innovation
o The ability to provide visibility into all innovation efforts
o Informative picture of the innovation status of the organisation
o Capacity utilisation: resourcing different types of projects
o Product platform effectiveness and efficiency (= derivative development cost or time / platform development cost or time)
• Measuring sustainable value creation
o Return on Investment, ROI = (sales – costs) / investment
o Residual Income = (sales – costs) – (cost of capital * investment)
Measuring innovation is a complicated and challenging task; its complication was illustrated above, in the elements of the innovation measurement system. Many organisations decide to avoid dealing with such a complicated, difficult to implement and challenging measurement system. Kuczmarski (2001), a Chicago-based consultant specialising in new product and service innovation, writes that "Measuring innovation can seem complicated, and many companies have helped make it that way, but it neednt be." (p.34) He identifies "five fatal flaws of innovation metric systems", and suggests ways to avoid them: (1) too many metrics (trying to do too much too quickly or not letting go of existing measures when they no longer are relevant); the antidote - institute sound planning and review processes, (2) too focused on outcome ("project mentality"); innovation initiatives should result in several new things, but more important, they should create new product platforms and big ideas that generate different lines and generations of new products and extensions, (3) too infrequent (the R&D people tend to use the companys annual planning and quarterly update cycles as the default tracking mechanism… from P&L to P&L); establish cross functional teams to develop innovation initiatives, (4) too focused on cutting costs; focus on customer needs and product quality - economies will generally follow, and (5) too focused on the past (despite all the talk about learning organizations, reporting mechanisms might be used for punitive purposes); emphasize the predictive dimension for leadership incentives.
Another generic barrier to effective performance measurement is the data collection and reporting; it is expected to be time consuming, sometimes to a significant extent, and it is the management task to keep these resources in the right balance. Data collection and reporting process should be as simple and easy as possible, while not compromising on the frequency of reporting. These three aspects of reporting (i.e., what granularity of data to record, the process and tools for reporting, and the frequency of reporting) are critical for every measurement system, and to a greater extent for a large, complicated innovation measurement system.
Very often we see on the wall at the reception area a framed colourful mission statement; this is a short statement that points to the most important two-or-three topics of the organisations strategy. The same rule should apply to innovation measurement system; the framed, very visible statement should include "a small number of straightforward, effective measurements to guide and drive successful innovation" (Davila et al., 2006, p.177).
Kaplan and Nortons (2001) book analyses a decade-long study of about 200 companies that have implemented the balanced scorecard; twenty of which have been selected and their case studies show that those organisations "have [indeed] used the scorecard to create new performance management framework that puts strategy in the center of key management processes and systems" (cover page).
CHAPTER TWO: PERFORMANCE EVALUATION AND INCENTIVES FOR INNOVATION
During the 1960s and early 1970s measurement methods were implemented by production engineers, aimed at increasing work efficiency and calculating employees incentive payment. Those measurement and incentives methods were (and in many cases, still are) related to "production" and had the "project mentality"; the focus was on outputs – quantity, cost, quality, and time. Innovation is very different (from production) in its characteristics, and as discussed in the previous chapter, it requires a more complicated set of measurements; and the same applies to performance evaluation and incentives. I have chosen to organise this chapter around the three levels of business activities (i.e., production, incremental innovation, and radical/ semi-radical innovation) and to discuss performance evaluation and incentives for each type. I believe that this design better addresses the managements viewpoint and concerns.
Production and very-short-term projects are characterised by completion of their tasks within a calendar month, so money-based incentives are processed in the following payroll, based on performance evaluation and calculation. Performance appraisal and review, according to Levinson (1970), is aimed at emphasising clarification of job requirements and performance expectations. Challenging the "management by objectives" concept (e.g., Tosi, Rizzo, & Carroll, 1970) that had recently emerged, the author argued that it "fail to take into account the deeper emotional components of motivation. Self-motivation occurs when individual needs and organizational requirements converge." (reprinted, 2003, p.107) More comprehensive was Levinsons (1976) view: "Most performance systems in most companies focus on results of behaviour. In reality people are judged just as much on how they get things gone…. A performance-appraisal system… [needs the establishment of] job descriptions that are behaviour as well as results oriented." (p.30) Production management is not in the mandate of this paper though, yet this paragraph is aimed at shedding some light on the origin of performance evaluation and incentives.
Before discussing performance evaluation and incentives for incremental innovations and for radical/ semi radical innovation, I would like to expand the topic of employee motivation, and its four elements. Motivation, what it is made of, and its interrelation with productivity and performance, have been discussed and empirically studied during the last decades, by management advocates and psychology researchers (e.g., Levinson, 1970). There are four elements of motivation: economic incentives, recognition, vision, and passion – which I ordered from the very primitive element to the highest level of personal motivation. (a) Economic incentives were thought to be effective for line-employees, who dont carry any managerial or supervisor tasks; with the evolution of the economic incentives, which include different stock options, this is not true any more, and economic incentives play as motivators for all sectors of employees, researchers and management. Economic incentives are based on pre-determined formulae that enable calculating performance and money-based incentives. (b) Recognition is a reward that occurs after the completion of the project. Recognition can take the form of money (e.g., special bonus or salary increase) or other forms of rewarding (e.g., tickets for dinner/ show/ vacation, announcement, or job promotion). "Larger companies tend to rely on cash bonuses to a larger extent compared to a start-up that relies on stock based rewords." (Davila, et al., 185) (c) Higher on the motivation ladder is the vision; the example-based leadership and the strong interest that top management show in the project. Motivation-by-vision works well, for example, in election campaigns, during which a candidate is able to motivate many people to work hard for her success. (d) At the top of the motivation ladder I see the personal passion; innovation team members need to be passionate about what they do, regardless of the rewards they may or may not receive. Line-employees are not expected to be passionate about their tasks; they can do it well even without a strong vision. Payment incentives are the best motivator for their efforts to achieve high efficiency and expected outcomes. In some cases, recognition can also work for them, in particular for skilled line-employees who look forward to supervisory position promotion. Incremental innovation staff, however, should be motivated by recognition to a great extent, if the initiative is to take off (and within the time and budget limits). Visionary leadership will also help to motivate incremental innovation staff, although it will be necessary for more radical innovation. The more radical the innovation, the more passionate the staff must be about it, so to be able to carry on for a long time, facing failures and disappointments, many ups and downs, until they see any results of their efforts. In the rest of the chapter Ill discuss the topics of performance evaluation and incentives for incremental innovations and for radical/ semi-radical innovations.
Incremental innovation and middle-term projects normally take longer than a month to complete, but are expected to be completed within the calendar year, and in many cases (depending on the innovation magnitude), within the calendar financial quarter, based on budgeting and financial reporting constraints. Their performance evaluation also takes some time to calculate. The smaller-in-scale the incremental innovation, the more specific the goals for performance evaluation are articulated; these goals are quantified, with a clear time-horizon; they are success-driven (meeting criteria) and loss-avoidance-driven (e.g., projects budget) goals – there might be, however, a trade-off between them; the targets should be demanding but feasible – they need to be challenging enough, but not beyond achievement, otherwise people would be de-motivated, either ignore it or over-invest trying to reach it (at the expense of other goals, more qualitative in nature). Whereas in production, each line-employees performance is evaluated, and incentives are paid individually, in R&D-related work, where the teamwork is a key component for success, performance evaluation and incentives are also team-based. An incremental innovation project is done by a team, small to mid-size team. To motivate teamwork and collaboration, performance criteria are also based on the innovations goals, and these objective evaluations will result in equal incentives for each team-member. Team-members have different roles, resulting in unequal workload, and this is a known problem, normal, and expected; moreover, not all team-members have the same level of motivation and passion, and few may be "free-riders" and receive incentives they do not deserve; to avoid, or at least minimise that de-motivating phenomenon, a subjective performance evaluation is done for each team-member – this could be done either by the team manager or by peers or a combination of both. Using subjective performance evaluation as complementary to the objective ones, have other advantages, too: (a) information not foreseen before the project started, (b) tasks that are difficult to quantify, and need qualified subjective evaluation, (c) uncontrollable events, and (d) weighing measures according to their importance to the innovation effort. Nevertheless, for subjective evaluation to be effective, the evaluating person should be competent, trustworthy, and committed.
Semi-radical and radical innovations are characterised as multi-annual programs that can take from two to five years (and in some cases up to ten years) to materialise; innovation ideas might even be killed before they reach the commercialisation stage. As discussed in the previous chapter, innovation measurement system is as complicated as the innovation size is; the more radical the innovation, the more complicated the measurement system, and so, too, the evaluation and incentives methods. The more radical the innovation, the less specific and more broadly the goals are articulated; for a large radical innovation that goal takes the form of vision and mission statements; radical and semi-radical innovation goals are not quantified, but have qualitative criteria, because the inherent uncertainty; goals for radical innovations should be stretch goals – that ordinary people consider not feasible and beyond their reach; goals for radical innovations are usually success-driven and rarely loss-avoidance-driven – based on the broad definition and great extent of uncertainty. Performance evaluation and incentives for any multi-annual large project is challenging and problematic; the longer the project and larger in scope and size, the more challenges it poses on incentive plans. Innovation projects, less result-oriented and lacking the "project mentality", pose even more challenges. Longer projects mean working years before seeing its fruits (if it is not dropped before completion); to be able to motivate projects members and compensate them for their efforts, interim milestones should be defined (e.g., year-end milestones), and even for a radical innovation that could be done (e.g., breaking it to ideation phase, design phase, prototyping, alpha and beta versions). Yet, because not each milestone creates outputs, the focus in semi radical and radical innovations should be on measuring input- and process-based performance, rather than outputs. Large projects that involve many teams from different business units, pose another dimension of challenge to the measurement and incentives system; in this case not only a team and team-members should be evaluated (as described for incremental innovation teams), but also there are higher levels in the projects hierarchy. There are interdependencies between a projects teams, departments, units, and individuals, and the performance of each one is also dependent, to a great extent on others work. There should be a combination of objective and subjective performance evaluation, for each level of the projects hierarchy, and for each team and individual involved – with an emphasis on more subjective evaluation criteria and less objective ones. The right balance should be maintained between avoiding "dislocation" (e.g., when an individual is rewarded for firms annual profits, to which her contribution and influence is very marginal) and creating a culture of internal competition (at the expense of the much needed collaboration, in particular for semi radical and radical innovation); too much relying on "relative performance evaluation", can also result in fierce competition and be destructive to the overall innovation efforts. For multi annual projects, and innovation projects in particular, financial incentives should be in the form of future options (i.e., stock options), rather than immediate money; that will send a clear message to project members that the more profitable the firm (following the successful radical innovation), the higher their incentives. This also works better in small technology-based companies (e.g., dot-com) where the risk and also the potential of the venture are great.
"Money doesnt necessarily stop people from being creative, but in many situations it doesnt help", believes Amabile (1998). "When reward systems fail, dont blame the program – look at the premise behind it" argues Kohn (1993) who is highly critical to incentive plans and their negative effects. For new product development, research shows an invert u-shape relationship between percentage of compensation and performance, with the optimum performance at around 15% incentive pay, and decreasing steadily thereafter (Davila et al., 2006, p.204). Incentives not only are helpless to innovation projects, but also can have strong negative effects on semi radical and radical innovations and underline intrinsic motivation. Also, add Davila et al., "risk taking behaviour is necessary for successful innovation, but it can be killed if failure is punished either economically or socially". (p.205) To conclude this chapter, I would like to cite Kohn (1993), with his strong opposition to over emphasised incentive plans:
According to numerous studies, rewards typically undermine the very processes they are intended to enhance…. [they] do not alter the attitudes that underlie behaviors. They do not create an enduring commitment to any value or action, rather, incentives merely - and temporarily - change what people do…. people who expect to receive a reward for completing a task do not perform as well as those who expect no reward at all. The number one casualty of rewards is creativity. (p.54)
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