As the operating environment for most businesses gets more competitive, innovation becomes imperative. Innovation has continued to distinguish market leaders from followers. However, despite the glaring benefits of innovation, most organizations do not invest enough in Research and Development (R&D) that leads to innovations. This is because they struggle to find the right balance between the chance of innovation with promising returns, and the risk of losing the R&D investment.
Innovation is birthed through Applied Research (application of research to address specific business challenges) and Product Development (identification of the target market for the output(s) from applied research). Generally, innovation is categorized by its intensity (drastic and Incremental Innovation) and result (Product and Process Innovation).
Drastic innovation changes the market demand and supply function, while Incremental Innovation shifts the market demand and supply function. Product innovation is an improvement on an existing product, while process innovation is a novel/more efficient way of producing an existing product.
For instance, Innoson Motors may commence production of electric cars (Drastic Innovation) with cheaper technology as compared to Tesla (Process Innovation), and more durable batteries as compared to all available batteries in the market (Product and Incremental Innovation).
The incentive to innovate (invest in R&D) for each organization differs and depends on six (6) factors which are discussed below
1. The intensity of industry competition: The higher the competition within the industry, the greater the need to innovate. Therefore, products with close market substitutes have a higher innovation need than those without close substitutes. For example, companies involved in the production of toothpaste needs to innovate faster than companies producing brake pads.
2. The size of the market: The bigger the market size in terms of potential earnings, the higher the need for innovation due to high incentives for new market entrants. For example, there is more incentive for pharmaceutical companies to innovate than there is for printing companies.
3. Probability of R&D succeeding: Investment in R&D and its likelihood of success are positively related – the higher the likelihood of success, the higher the incentive to invest in R&D. Due to the nature of R&D, it might not be possible to predict the likelihood of success accurately. Therefore, several companies have decided to collaborate with others in their industry to invest in R&D. This approach solves three major problems; it reduces the cost of R&D for each company, spreads the risk of failure, thereby increasing the likelihood of success, and reduces the competition within the industry.
4. The degree of heterogeneity in terms of willingness and ability of consumers to pay: The wider the price range for a product, the higher the incentive to innovate and vice versa. For instance, a Rolls Royce Sweptail car costs $13 million (N4.7 billion) while a Dacia Sandero car costs $6,995 (N2.5 million). The high degree of heterogeneity in the automobile industry in terms of consumer’s willingness and ability to pay for cars provides a high incentive for companies to be innovative. This is not the case for the FMCG industry.
5. Government regulation: Government regulation and investment in R&D are inversely/negatively related – the higher the degree of government regulation, the lower the incentive to innovate. Therefore, state-owned enterprises and businesses in industries with high government regulation (like the oil & gas industry in Nigeria) are less likely to innovate.
6. The company’s position in the industry: The strategic positioning of a business within an industry significantly impacts its investment in R&D, and thus its propensity to innovate. For a monopolist in any given market structure, there is less incentive to innovate due to a higher level of pre-innovation profits (The Replacement Effect). However, for a new entrant or an existing business in a competitive industry, there is a higher incentive to innovate to maintain or improve its market share (The Efficiency Effect). To summarize, the threat of entry determines the relative relevance of the Replacement or Efficiency Effects. The higher the probability of entry, the more the relevance of the Efficiency Effect, and the lower the probability of entry, the more the relevance of the Replacement Effect.
Generally, the strategic value of innovation for any business is determined by:
- How much the Post-Innovation Profit exceeds the Pre-Innovation Profit of the business
- The probability of its investment in R&D succeeding, and
- The likelihood the business maintaining monopoly or market position; the case for sleeping patents.
Written by:
Victor Mba
Senior Consultant
