How much does your company need to invest in innovation? It seems like a simple enough question, but answering it with a degree of rigor often highlights a gap that’s bigger than you think between your future financial targets and your current investments in growth.
Identifying this so-called “growth gap” is critical, because the bigger the gap, the more a company needs to look beyond its current offerings, markets, and business models to find growth opportunities.
The exercise required to calculate your growth gap sounds commonsensical:
- Start by setting the growth target you wish to achieve some years in the future. (That could be any number of metrics — revenues, profits, total return to shareholders, or some combination — but for purposes of this discussion we’ll focus on revenues).
- Calculate how much revenue your current business will generate by that time from its current offerings and improvements to them.
- Calculate the revenue your investments in on-going new growth businesses are expected to generate by that time.
- Add up the figures from lines two and three, and compare with the figures from line one.
- The difference is your growth gap.
In reality, though, each step is fraught with psychological difficulties and organizational complications, making the process as much an exercise in rooting out unspoken assumptions as a mathematical exercise.
Setting the growth target. Let’s start with the question of what year you should be targeting. To get everyone to agree on a realistic goal, we suggest picking a year far enough in the future that people feel safe discussing what needs to happen by that time but not so far away that uncertainty about technological or market developments would render a discussion meaningless. That might be three to five years in a relatively fast-moving business like media, but 20 years for aircraft or jet engines.
There are two ways to set revenue targets. One is to mathematically derive the growth expectations baked into your stock price and set the target to reach those expectations (if you’re only concerned with maintaining share price) or to exceed them (if you want to see a stock price rise). The other, if you separate success from the share price, is simply to assert a memorable number, such as doubling revenues over a five-year period.
The biggest obstacle here isn’t calculating an accurate number; it’s reaching a consensus of what the ballpark figure should be. Our work with dozens of companies teaches us that individuals on the leadership team often have very different targets in mind. So it’s wise to start the exercise by asking all team members to write down their views of your firm’s revenue target. If your team is like most, you’ll find estimates vary by surprisingly large amounts.
Ideally, before moving on to step number two, you should hash out some agreement on what the target should be. Perhaps the estimates were close enough that you can agree to pick one as a starting point. If not, though, leave this question unresolved for the moment. Once you’ve gauged the potential of your current investments in the next two steps, you will likely have a more realistic picture of what your target can be and can revisit this.
Calculating organic growth. With a target in hand (if possible), your next step is developing your best estimate of how much potential exists within your current products and services. Your team should start by systematically considering the feasibility of all the traditional sources of organic growth: Can you grow revenues by penetrating new geographic markets? By reaching new customers in current markets? By stealing share from current competitors? Can you improve profits by streamlining costs? Or by making process improvements?
That’s straightforward enough. However, the exercise becomes anything but simple when you begin to consider competitive threats that might decrease future revenues. Most companies do a fairly good job of monitoring their direct competitors but don’t make the considerably greater effort to factor in viable threats from substitutes and existing or yet-to-be-born disruptors. To do that requires a careful scan of the classic early-warning signs of disruptive change that may herald tougher times ahead. To assess such risks to your business, consider the following six questions:
- Is customer loyalty decreasing? This often signifies that a company has overshot the market by introducing improvements that customers increasingly consider irrelevant and will not pay for.
- Are venture capitalists making significant and lasting investments in your industry? While start-ups fail all the time, long-term investments create conditions that support the creation of viable disruptive entrants. So following the money is one good way to identify possibly potent threats.
- Are entrants winning at the low-end or fringes of your market with offerings that look inferior to your best customers? Disruptors typically start in somewhat innocent fashion away from your mainstream customers. But any company in or near your market that’s making the complicated simple or the expensive affordable should be watched carefully.
- Is at least one of your competitors following a different business model that looks financially unattractive to market leaders? Business models that can prosper at structurally lower price points are the engines that power true market disruption.
- Is revenue slowing for market leaders even as profit margins increase, as they exit the low end of the market and/or cut costs?
- Are customers making meaningful shifts in habits and preferences that could cement a disruptor’s advantage?
It’s also worth assessing external variables that serve as early signs of longer-term change. For example, a company that sells housing components like kitchen counters and piping should look at the rate of new home construction or mortgage activity, while automotive companies should look at the percentage of young adults forgoing driver’s licenses. This is the classic domain of strategic planning, and if your company has dedicated strategic planners, don’t hesitate to borrow liberally from their work.
Tallying new growth investments. After calculating your organic growth (and realistically adjusting for future competitive risks), next carefully document current investments in what we call “new growth,” – that is, efforts to reach new customer segments or new markets, often through new business models. That’s a matter of developing a comprehensive list of all your new growth efforts that identifies each idea, its financial potential, and the required investment to realize that potential.
In our experience, few companies track those projects comprehensively, so even just identifying them can be an eye-opening experience.
A couple of years ago, for instance, when an apparel company mapped out what it thought was its new growth efforts, it found to its chagrin that a number of projects existed on paper, but that they were zero staffed – that is, no one was actually working on them. What’s more, the overwhelming majority of those so-called “new growth” efforts involved minor changes to existing products in existing markets. Only one out of about 30 different projects was clearly an effort to bring a new offering to a new market.
Once you have an accurate list in hand, estimate its risk-adjusted value by multiplying the financial potential of each investment with its probability of success.
Once again this sounds straightforward. But companies tend to be wildly optimistic about the returns promised by their current investments in growth. Psychologists have identified a phenomenon called the “planning fallacy,” whereby most humans tend to underestimate the time and cost involved in completing any project, even if they are experts in their field. The problem is even worse for new growth efforts, which involve so many new variables. A new growth effort might, for instance, involve targeting a new customer set, working on an unproven technology, interacting with new partners, and trying out a new revenue model. If the probability that each of those four areas work out as planned is, individually, 80%, the overall chances of success are just 40%.
You can bring rigor to the exercise in some surprisingly simple ways. You can, for instance, look back at growth initiatives from your past. How many of them delivered as much as predicted? You can also use publicly available industry benchmarks. Or just use the data from the venture capital industry showing show that roughly 75% of ideas fail to return capital to investors.
Once you’ve done the hard work of agreeing on the growth target and taken a clear-eyed view of the growth potential of your current offerings and a comprehensive look at the potential in your new growth initiatives, you can calculate the gap between where you want to go, and what you’re currently doing.
As leaders see their risks to current operations increase and expected returns from planned investments decrease, it’s likely they’ll face larger growth gaps than they had expected. But this is not causing for alarm. If calculating a growth gap is approached honestly and openly, it can galvanize the need for change and ensure ongoing attention to the long term. An accurately calculated growth gap will not only enable you to make more accurate investments in future growth but may also highlight the need to make strategic acquisitions buy further time or perhaps (softly) communicate revised growth targets to Wall Street analysts.
The overall goal here is insight, not precision, so our final piece of advice is not to spend much time on this effort. In many cases, a month is more than long enough to get a useful answer that can inform all your important activities related to creating a robust strategy for innovation and growth.
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