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Monday, December 3, 2007

The Tradeoff Between Growth and Innovation Part 2

By Manuel Bueno

Siemens IndiaThis post is the continuation of my previous one last Monday. Just as it was posted, Robert Katz sent me an email with the following question:

"That BOP firms, to be competitive, don't have to be innovative in the same way that Western firms do makes sense. But what about Western firms looking to enter BOP markets? Do they need to invest in R&D to create the sorts of incremental "piggybacking" innovations you describe? Or do they need to invest more in the anthropology/observation to unearth the "obvious" innovations??
As I was writing my reply I noticed that I could have been more specific and less fuzzy about some concepts in the previous post. I also noticed that there was plenty of scope for further analysis ? and further questions.

The mentioned tradeoff between growth and innovation at the BOP was with local big firms in mind and elaborated on innovation in broad terms as an "unusual combination of technologies and other components that generates value for the consumer." By doing that, I lumped together two basic types of innovations: product level innovations and operational innovations.


This is an important distinction because product level innovations (like the torch light mobile example I gave before) happen mostly thanks to consumer knowledge insights. Operational innovations happen in well-run competitive firms (for example, improved Human Resources, budgeting procedures and so on).

Operational innovations relate to the piggybacking idea ("India?s national output could be 4.8 times bigger if only that lagging group of companies were to absorb the existing industry knowledge"). Product innovations relate to "architectural innovations." I do not think one can ?piggyback? on consumer knowledge, because it can?t be measured and so no benchmarking is possible.

MNCs excel in operations, but are weak in consumer knowledge. Local companies, on the other hand, know their customers inside-out, but are (often) not well run and lack management skills.

Both kinds of firms will invest in improving their respective weaknesses, be they operations or consumer knowledge. These investments are sometimes done in the form of partnerships.

Any well-run firm will tend to create innovative products for its customers. Firms that are creative enough to successfully generate innovative products will have to develop operationally and come up with suitable management structures to pass as many profits as possible on to the owners.
In the first case one could argue that some well-run firms do not innovate, but in that instance those firms are condemned to the commoditization of their markets and slimmer profits in the long run. In the second case, firms which innovate but do not develop operationally to serve the BOP will tend to be absorbed by better-run firms which will extract more profit out of exactly the same product. For example, cost reduction is a must at the BOP and only well-run firms can pull the trick for long term periods.

Therefore, product innovation (also called architectural innovations) and operational innovations come hand in hand in the long term. These types of innovations are interconnected.

So, let me qualify the conclusions of the previous post:

  • Operationally:
    a) Innovation entails piggybacking, not leapfrogging, so profits are smaller and shorter-lived.
    b) The innovation process is less complex and closer to the market.
  • At the product level:
    a) The final outcomes tend to be easier to copy by competitors because they are simpler and easier to understand (and also due to non-enforced property rights, but that?s another story!). Innovations therefore entail competitive advantages for shorter periods.
    b) The opportunity costs of product innovations are higher because the foregone growth is bigger. Notice that this is not the case for operational innovations, because these are necessary to grow while keeping profitability and cost levels intact.

These conclusions apply to MNCs too. The only difference here is that MNCs might extract more profits from innovations, because they have pockets deep enough to scale up operations in many different countries simultaneously.

While measuring operational innovations is close to impossible, measuring the amount spent by MNCs in product innovation (or R&D) is difficult but possible. Most MNCs have centralized R&D departments so the costs associated with developing a new product can be spread out among different MNC subsidiaries and hence it can be extremely hard to quantify how much of the R&D spending accrues to local subsidiaries. For example, many research labs in India have a world-wide scope, not Indian only. Added to the costs of these research facilities, come the innovation costs that are incurred by the local MNC subsidiaries which I believe shouldn't be that different (in quantity) from local BOP firms.
If we subtract the costs associated with those centralized R&D departments we make calculating the investment on costs easier, but we obtain a distorted result.

My hypothesis is that MNCs spend more than local BOP firms if we take into account these centralized R&Ds. Without them, there might be similar expenditures, but with different destinations, because they have different weaknesses.

These conclusions are only tentative, since I don?t have any study to refer to.

I am attaching a small slide that summarizes most important points (consultants use lots of powerpoint, call it professional deformation).Slide Innovation


















In both cases most innovations will only be evolutionary, rather than radical - which makes sense, because radical or revolutionary (or leapfrogging) innovations are by definition rare and can hence be very profitable? we can?t have a revolution every day!

As a side-note to this and further posts, if any visitor after reading them would like to raise questions, make a comment or challenge them, they are more than welcome to do so publicly through this website or through email. We might well be at a BOP learning stage in which any answer gives rise to many more related questions. And I am also learning. I welcome and appreciate questions that are raised after reading the posts, because they help me re-think conclusions and they offer different points of view that I might have not considered before. By all means, do not keep your opinions to yourself!

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