Tools for Managing Early-Stage Business Model Innovation [Research Technology Management]

Innovation readiness levels provide a key measure of the stress a business-model innovation is likely to inflict on an organization.

OVERVIEW: Standard financial metrics do not provide useful or meaningful evaluations of the potential of early-stage ideas that require business model shifts. Lockheed Martin has developed a two-stage approach that combines a modified riskreturn framework with a new concept, Innovation Readiness Levels (IRLs). Using a structure analogous to technology readiness levels (TRLs), IRLs offer a quantitative assessment of the organization's state of readiness to implement a specific business model and a measure of the amount of stress an idea is likely to create for the organization. This evaluation provides a surrogate metric for both required investment and the risk associated with the investment.

KEYWORDS: Portfolio management , Innovation readiness levels , Business model innovation

As the articles in this special issue illustrate, constructing a portfolio of innovative ideas and projects is always a subtle undertaking. The goals are to ensure that ideas with the highest return are selected for investigation, that the riskreturn profile matches the objectives of the firm, and that the projects address the correct mix of market areas. At the early stages of innovation, when innovative ideas are mostly just kernels of ideas, the first two goals are particularly challenging. Basic feasibility may reasonably be questioned. Even assuming feasibility, there is often dramatic uncertainty around even the most basic of financial parameters, such as sales, price, revenue, income, and required investment. In this context, computing and comparing return on investment for ideas is not a meaningful exercise. While one can expend resources to generate "detailed" estimates, these estimates are highly questionable since uncertainty results from factors that, if they can be resolved at all, would require significant investment to do so.

These challenges are even more acute in the case of business model innovation, which requires a company to reorder its behavior in order to create value in fundamentally new ways. Business model innovation typically involves two components: a strategy or vision for organizing the firm to create value and a set of capabilities the firm must possess in order to execute the strategy (see Johnson, Christensen, and Kagermann 2008 , 52-53). Business model innovation often requires that multiple functions-not just technology and manufacturing-actively participate in their own reinvention. At this point, uncertainties proliferate and traditional financial metrics to assess risk and value become meaningless.

What, then, is a more useful approach? At Lockheed Martin, we have been experimenting with a new approach that has worked reasonably well. This approach combines a modified risk-return framework with a new concept, Innovation Readiness Levels (IRLs). IRLs offer a measure of the amount of stress an idea is likely to inflict on the organization, and is thus a surrogate metric for both required investment and the risk associated with the investment.

At Lockheed Martin, we have been utilizing this approach as part of our Innovate the Future Program, which has solicited and evaluated thousands of ideas from both employees and the general public. As part of the program, trained evaluators perform rapid evaluations of ideas using the IRL approach. The results of that evaluation are provided to the management team, which works with innovation managers to create an investment portfolio matching the company's strategic objectives. The IRL approach has enabled the company to more quickly and effectively evaluate the total risk, not just the technical risk, associated with ideas and has significantly improved the quality of the company's innovation portfolio.

The Risk/Return Framework for Early-Stage Ideas

Evaluating investment opportunities typically involves a series of calculations intended to define the return on investment (ROI) as a function of uncertainty. ROI is computed as the net present value (NPV) of free cash flows (revenues - expenses from the sale of the product) divided by the NPV of the investment required. At the early stages of idea development, uncertainty makes these computations meaningless. First, free cash flow is a difference of two approximately equal yet highly uncertain numbers, and can thus swing positive or negative depending on the assumptions made. Similarly, the ratio of cash flows to investments is the ratio of two numbers that are typically about equal (or more accurately, equal within a factor of ten). Again, variations in the numerator and denominator can lead ROI to fluctuate widely.

Instead of evaluating return on investment, we ask two related questions: First, if all goes well and the idea pans out, is it likely the business venture will be material to the business? Business model innovation is organizationally painful and requires significant senior management attention. It should only be undertaken if the returns would be meaningful to the organization. As a quick estimate, we ask for a back-of-the-envelope calculation of potential income (estimated total sales x estimated sales margin) in a hypothetical future year in which the new business model is fully up and running. We generally expect the estimate to be accurate to within a factor of 3 to 10. While this may seem like an extraordinary level of uncertainty to tolerate, we find it is sufficient to focus innovators' attention on how the idea will generate value and sufficient to focus innovation managers' attention on the most promising ideas. Further, such estimates can be made within ten minutes. Making better estimates is often difficult, even with orders of magnitude more effort.

Purists will also insist that this approach does not address the time value of money. Doesn't it matter whether the income is realized in the third or the fifth year? Absolutely. However, in our experience, the uncertainty due to the timing of cash flows is not the major driver of overall uncertainty and can be safely ignored at the earliest stages of innovation. To be material, the return in a hypothetical future year should be, say, at least 5 percent of the firm's current annual income. At Lockheed Martin, we generate about $4 billion in cash per year. In this context, a material innovation for the corporation is defined as one that holds the potential to generate at least $200 million in income each year or, at typical margins, $2 billion in revenues. An innovative idea that requires reorganization at the corporate level should be of this scale to be considered. An innovation that does not require the corporation to reorganize, but requires reorganization of one of our five business areas should produce, say, one-fifth of that level of income to be considered.

The estimate of income in a hypothetical future year provides a scale for the opportunity represented by the idea; the opportunity must be balanced against the cost of pursuing that opportunity. Measuring the cost of implementation is challenging, if even possible, at early stages. Proxy estimates are needed for the investment that will be required in money, as well as for the risk associated with implementation. Both of these factors increase (become worse) for business models that are different from the firm's current business model. A business model that is significantly different from the current one will typically require more investment, and it will be significantly more risky to pursue.

Thus, a metric that quantifies the difference between the proposed business model and the firm's core business model is one way to assess cost and the risk associated with an idea. Thought of another way, it is useful to evaluate the "stretch" that the organization will have to go through to be successful in the new business model. Innovation Readiness Levels (IRLs) provide such a metric.

Innovation Readiness Levels

Successfully deploying a new business model requires that each function develop the capabilities needed to carry out the envisioned model. The legal department must have an understanding of the relevant law in order to be able to mitigate risk appropriately. Human resources must have appropriate employment agreements, benefit packages, retention programs, training programs, and other systems to hire and support the talent required by the business model. Finance must have appropriate financial controls and risk management processes. Contracts must be able to construct terms and conditions appropriate to the envisioned transaction. Supply-chain managers must have access to and experience with appropriate suppliers, and sales must have developed the channels and sales staffneeded. Executive management must have developed necessary command media, delegated authority effectively, and established appropriate business rhythms.

Evaluating stretch involves characterizing of the degree to which each of the functions is ready to execute the capabilities required by the new business model. This notion suggests an analogy to an existing technical readiness assessment, Technology Readiness Levels (TRLs). Both the Department of Defense and NASA have published TRL standards ( DOD 2011 ; Mankins 1995 ), and TRLs have been widely adopted. They are now a well-understood means to evaluate and communicate the level to which a technical capability has been developed and can be practiced by a company or by an industry. Under the DOD system, for example, TRL 4 indicates that a demonstration of the system or capability has been conducted in a laboratory environment. A system at TRL 4 would have much more risk to retire, and it would cost significantly more to complete development, than a similar system that had undergone initial prototype demonstrations in a working environment (TRL 6) or been tested in the field (TRL 7). The TRL scale can be thought of as logarithmic; taking a system from TRL 4 to 6 may take in the neighborhood of 10 times as much time and resources as taking it from TRL 2 to 4.

Innovation Readiness Levels (IRLs) represent a broadening of the TRL concept, offering a way to assess an organization's capabilities with regard to a particular business model. An IRL could be defined for each capability (such as implementing a training program for a specific job code), but at Lockheed Martin, we've chosen to group capabilities by functional area and then define an IRL for each functional area. For a given business model, there is a Human Resources Readiness Level (HRRL), a Finance Readiness Level (FRL), and so on.

To evaluate the IRL for each function, the capabilities required are evaluated, using the IRL definitions shown in Table 1 to determine to what degree the function has demonstrated the required capabilities. The assembled collection of IRLs can then be plotted on, for example, a radar diagram ( Figure 1 ). In a radar diagram, a small circle at the center would indicate that significant development work is needed. As the idea is matured, the IRLs will increase and the circle will grow, until the business model is fully implemented and the circle fills the diagram.

It is critical to note that IRLs are not intended to measure the ability of the company, or of any function, to innovate. Nor are they intended as a maturity index, a measure of agility, or any other measure of "goodness." Rather, the IRLs are intended to measure the degree to which the company or function has demonstrated the capabilities needed to move from its existing business model to the envisioned new business model.

It is also theoretically possible to define a composite IRL. We have experimented with a number of algorithms to do so, and it remains an open area of research. One method would be to count the number of functions that are not at IRL 9. Since the bulk of investment is spent in the last stage of development, this could be a potential proxy for cost of development. On the other hand, since most risk is retired early in development, the overall minimum IRL might be an acceptable proxy for overall risk. For the rest of our discussion, we will simply take the sum of all the IRL values and scale it to create an overall readiness value-known as the composite IRL index-between 0 and 100.

An Income / IRL Framework

With the composite IRL estimate in hand, an income-stretch framework can be established ( Figure 2 ). Here, ideas are plotted on a graph where income in a hypothetical future year is plotted logarithmically against the composite IRL index. The data points shown here are notional, but typical. Ideas that are in the dotted area are not material to the corporation and should be handed down to the business areas for further evaluation. Ideas in the hashed area should be handed down even further, say, to the business units, or discarded all together. The most attractive ideas are those that fall along the opportunity frontier, as shown. Ideas that fall below this frontier offer less potential income than other available ideas that require the same amount of stretch (that is, have the same composite IRL index). Similarly, ideas to the right of the frontier will be riskier and more difficult to implement than other available ideas that promise comparable returns.

From this plot, ideas can be selected to form a portfolio based on the organization's strategic objectives. The choice of ideas from among those along the opportunity frontier should be made to fit the organization's risk tolerance and agility. An organization that is inflexible and not accommodating to stretch may choose to focus on ideas further to the lefton the curve; one that is in a time of strategic readjustment and looking to embrace bold new ideas may select those to the right on the curve. There is no one right answer for all organizations. However, the income/IRL framework provides a construct around which to begin the discussion and work toward consensus on outcomes.

It should be emphasized that the plotted position of ideas on the chart is suggestive only. We are not plotting internal rate of return (IRR) vs. uncertainty in IRR. An idea that falls immediately below another idea may in fact generate higher IRR. Similarly, an idea that falls immediately to the right may be less risky or difficult to execute. However, the chart is logarithmic, such that ideas that are significantly separated from each other are likely to offer significantly different outcomes. This chart is useful in that it provides a means to quickly and inexpensively sort ideas according to their potential for return and their relative risk and difficulty of implementation. Formal IRR evaluations should be used much later in the development process.

This framework has a number of additional benefits that are worth noting. First, though it may be obvious to practitioners of business model innovation, individuals steeped in a particular business model for years or decades may not appreciate how an idea they are proposing will require change across the corporation. For example, a technologist at Lockheed Martin may perceive an opportunity to develop a rocket-based fuel that could be used for grilling food at home. While he or she may have a detailed understanding of the technical stretch that will be required to develop the product, he or she may not appreciate the degree of stretch that would be required by sales, finance, legal, and other functions. The IRL framework provides a tool to evaluate an idea's impact on the entire corporation, not just on the technical function.

Relatedly, in many organizations, certain functions are more accustomed to managing change than others. Technology functions, for example, are often very agile and able to quickly develop and work with new technical concepts, while other functions may not have devoted resources to developing this agility because it is not required by the business. When this disparity in agility exists, there is a tendency to devote resources to agile functions first. For example, a company might spend significant resources developing technical prototypes before asking whether the product would be legal to sell or whether the needed sales channels could be developed. While the technical, legal, and sales questions will all eventually need to be answered, addressing detailed technical questions before even basic legal or sales challenges are confronted risks having the project "fail expensively." The IRL framework, in particular the radar diagram, highlights which needed functional capabilities are less mature and require investment first. While a detailed discussion of innovation management is beyond the scope of this article, it is generally counterproductive to, for example, move from TRL 5 to 6 before moving from legal readiness level 2 to 3. The IRL framework provides a means to highlight this principle and identify which areas should receive investment first.

Conclusion

Managing early-stage innovation is challenging. Resource allocation decisions must be made based upon scarce and highly uncertain data. A decision to collect more data is in itself a resource allocation decision. Deciding to ask for more information about all ideas is equivalent to deciding to invest in all ideas-a strategy of dubious efficacy. The trick is to ask a very limited set of questions that can be answered easily yet provide insight needed to make further investment decisions.

The IRL is one possible option. Rough estimates of income in a hypothetical future year, which are easily calculated, can serve as surrogate order-of-magnitude estimates for internal rate of return. Similarly, evaluation of the IRLs provides a quick estimate of both the difficulty and expense of implementing a business model, as well as the uncertainty and risk associated with doing so. A plot of income versus composite IRL then provides a means to determine which of the ideas are most attractive and to select a portfolio of ideas according to both the agility and risk tolerance of the organization.

At Lockheed Martin, this approach has been used to good effect. Focusing on potential income moves the conversation away from technical attractiveness or efficacy in favor of business impact. The process of computing the IRLs engenders an evaluation of the entire set of capabilities the firm would need to develop in order to capitalize on an idea. Considering both factors together enables the company to evaluate whether an idea is worth pursuing in light of the organizational cost and management attention that will be required. Using this approach has dramatically improved our ability to focus our corporate attention and ensure the success of a limited set of ideas-ideas that have a realistic chance of materially affecting the business.

Thought of another way, it is useful to evaluate the "stretch" that the organization will have to go through to be successful in the new business model.

The IRL framework provides a tool to evaluate an idea's impact on the entire corporation, not just on the technical function.

References

Johnson , M. W. , Christensen , C. M. , and Kagermann , H. 2008 . Reinventing your business model . Harvard Business Review 86 ( 12 ): 50 - 59 .

Mankins , J. C. 1995 . Technology Readiness Levels: A White Paper. April 6. NASA Advanced Concepts Office, Office of Space Access and Technology .

US DoD . 2011 . Technology Readiness Assessment (TRA) Guidance . April. Publication 2-13-2-14

John D. Evans is co-guest editor of this special issue of RTM. He serves as vice president, international engineering and technology, for Lockheed Martin Corporation. In this capacity, he represents the corporation's 60,000 engineers and technologists in the development and execution of the corporation's international growth strategy. Before Lockheed Martin, he worked as a program manager for the Defense Advanced Research Projects Agency (DARPA), Chief Technical Officer for start-up Microfabrica, a scientist for Becton Dickinson, and an energy consultant for the United States Congress Office of Technology Assessment (OTA). He holds a BA in physics from Carleton College; an MS in civil engineering and a PhD in mechanical engineering from the University of California, Berkeley; and an MBA from Duke University. [email protected]

Ray O. Johnson is the Chief Technology Officer of the Lockheed Martin Corporation. In that role, he guides the corporation's technology vision and provides leadership in the strategic areas of technology, engineering, production and supply-chain operations, and program management. He also leads the Advanced Technology Laboratory and the Center for Innovation, a world-class laboratory for collaborative experimentation and analysis. He often speaks on a variety of topics at global forums, including the World Economic Forum Annual Meetings in Davos-Klosters, Switzerland. He holds a BS in electrical engineering from Oklahoma State University and an MS and a PhD in electrical engineering from the Air Force Institute of Technology. [email protected].

DOI: 10.5437/08956308X5605007