Report 103

Your newsletter on applied creativity, imagination, ideas and innovation in business – delivered to your e-mail box on the first and third Tuesday of every month.

Tuesday, 19 May 2009
Issue 149

Hello and welcome to another issue of Report 103, your fortnightly newsletter on creativity, imagination, ideas and innovation in business.

As always, if you have news about creativity, imagination, ideas, or innovation please feel free to forward it to me for potential inclusion in Report103. Your comments and feedback are also always welcome.

Information on unsubscribing, archives, reprinting articles, etc can be found at the end of this newsletter.

PROSPECT THEORY, RISK AND INNOVATION

Prospect theory was developed by Daniel Kahneman and Amos Tversky in 1979. It describes how people make decisions around economic risk and is particularly interesting as it demonstrates that people often do not interpret risk rationally, at least in economic terms. In particular, prospect theory shows that people are highly risk averse when it comes to potentially increasing their wealth, but risk seeking when dealing with potential economic loss. Moreover, there is a tendency for the average person to look at losses and gains in percentages rather than absolute terms. For example, a consumer will drive across town to save $5 on a $15 dollar appliance; but cannot be bothered to go out of her way to save $5 on a $125 appliance. In both cases, the absolute saving is the same. However, in the first example, it is one third of the cost of the product; whereas in the second example, it is only 4%.

Prospect theory would seem also to be applicable to innovation and, indeed, shows that start-ups are likely to be more risk-seeking, and hence innovative, than established companies. A situation we know is generally the case.

Prospect theory started as a thought experiment which was backed up by substantial testing. It is widely accepted by economists today and even earned Kehneman a nobel prize. Tversky, sadly, died before he could share it.

The Reflection Effect

Kahneman and Tversky found that if a group of people is offered the choice between:

a) A 100% chance of receiving $3000.
b) An 80% chance of receiving $4000, but a 20% chance of receiving nothing.

About 80% of the subjects will choose option (a). In other words, when it comes to making money, the average person prefers a guaranteed gain rather than gamble on the possibility of winning a greater amount of money but with a threat of getting nothing.

However, when given a very similar choice:

c) A 100% chance of losing $3000.
d) An 80% chance of losing $4000, but a 20% chance of losing nothing.

Some 92% of the subjects will choose option (d). In other words, they would rather risk losing more money with a small chance of not losing anything.

From a logical perspective, of course, this does not make sense. Assuming people are using the same internal maths to evaluate the risk in both cases, we should see similar results. But of course humans are not logical. Moreover, most people are extremely poor at evaluating risk and especially threats.

Risk and Innovation

The implementation of a potentially innovative idea in a business inevitably involves risk. Broadly speaking, the more innovative an idea is, the greater the risk. That's because highly innovative ideas are by definition very different to the current situation (be it a product, service or process). Thus its success cannot easily be measured against existing cases. As a result, the more innovative an idea is, the harder it is to determine the result of its implementation. Let's call this Baumgartner's Axiom of Innovative Risk!

An established business in normal times (ie. Not during an economic recession) usually generates a continuous and most likely slowly increasing income. Thus, when faced with diverting resources to implement an innovative idea, the manager is faced with a choice similar to (a) and (b) above. She can either not implement the idea and stay with the effectively guaranteed slowly increasing income (option a) or she can gamble by diverting resources and budget to implement the potentially innovative idea (option b) which offers an indeterminate likelihood of generating significantly more income than in the past and an equally indeterminate possibility of earning no income.

Not surprisingly, most managers opt for option (a). They avoid implementing the innovative idea and avoid its potential risk.

A typical start-up company, on the other hand, begins its existence losing money. Capital is invested in salaries, equipment, raw materials, etc. But from the moment the start-up begins operations, money is disappearing. Usually it takes one or more years before a start-up generates more income than it losses.

Thus a manager deciding whether or not to implement a potentially innovative idea is faced with a choice similar to (c) and (d) above. Not implementing the idea will result in a continued and predictable loss of income (option c). Implementing the idea, which may require additional resources, however, may result in a greater loss – if the idea does not succeed – or a reduced loss or even a profit if it succeeds (option d).

Risk in Start-ups Versus Established Companies

And indeed, start-up companies are almost synonymous with innovation, whereas well established companies are usually perceived as being risk averse and much less innovative. Indeed, in a medium to large established firm, the most effective form of innovation seems to be to buy a smaller, innovative firm!

Of course there are exceptions. Established companies do periodically launch innovative new products and services. They sometimes develop innovative new operational processes. But prospect theory states that a percentage of people will go against the masses and take on risk, in effect gambling that an opportunity will result in increased income.

Innovation in Loss Making Companies

Interestingly, another area where we often see potentially innovative ideas being implemented is in companies facing serious financial problems. Both General Motors and Chrysler, two American car companies, are in serious financial difficulty. In order to avoid bankruptcy, and on orders of the President of the United States, both came up with business plans far more innovative than anything either company has done in recent decades.

This fits within prospect theory. Faced with losing money (in this case everything) or taking risk in order to reduce that loss (ideally to no loss), the average person will take the second option. This is precisely what the managers at the two companies have opted to do.

Enron was a highly innovative company in its final years. It could trace its roots back to 1932 and for much of its history was a nondescript natural gas and electricity supplier. A number of mergers later and the company became Enron, a company which Fortune magazine called America's most innovative every year from 1996 to 2001. And Enron was innovative, both in terms of financial mismanagement as well as in terms of innovative products and services.

And, again, that follows with prospect theory. As Enron's management realised that the company was actually losing vast sums of money (rather than earning cash by the sackful as their financial statements claimed), it makes sense that the managers implemented risky, potentially innovative ideas in hopes of winning a gamble that would take the company from losing lots of money to breaking even or earning an income.

Of course that never happened at Enron. The company went spectacularly bankrupt in late 2001.

Lessons to Be Learned from Prospect Theory

Prospect theory, when applied to innovation, suggests that managers in profitable companies are likely to be risk averse and therefore are psychologically likely to reject potentially innovative ideas, particularly new product and service ideas that offer an opportunity to increase income. However, potentially innovative ideas which reduce loss, are more likely to be implemented. Thus, in an established firm, process efficiency ideas, which reduce costs, are more attractive to the typical human than are product ideas. And this is true in my experience, anyway.

Likewise, loss making companies such as new start-ups or companies facing economic difficulties are more likely to embrace new product and service ideas as they offer the opportunity to reduce loss. However, start-ups with a young not-yet-defined corporate culture would seem more likely to innovate effectively than established companies that are suddenly losing money and need to innovate themselves out of trouble.

Thought Experiment Nothing More

Lastly, I should point out that this article is nothing more than a thought experiment applying Prospect Theory to a small number of innovation cases. It is hardly conclusive. And I would love to hear your thoughts – and will publish here any intriguing feedback (with your permission, of course!).

References

“Prospect Theory”, Wikipedia
http://en.wikipedia.org/wiki/Prospect_theory

“An Introduction to Prospect Theory”, Econoport http://www.econport.org/econport/request?page=man_ru_advanced_prospect

“Kahneman and Tversky's Prospect Theory”, San José State University Economics Department web site
http://www.sjsu.edu/faculty/watkins/prospect.htm

Enron Anatomy of Greed, 2002, Brian Cruver, Arrow Books.

TEAM BUILDING AND GOALS

The Harvard Business School has published a very interesting paper called “Gone Wild: The Systematic Side Effects of Over-Prescribing Goal Setting” (http://www.hbs.edu/research/pdf/09-083.pdf). The paper details the dangers of poorly set goals for teams. A lot of their findings are counter-intuitive. Rather than try and sum up this excellent paper, I would suggest that if you are at all involved in managing teams, especially innovation teams, you really need to read this paper!

DECLINE OF THE BILLABLE HOUR

Last month, Coca-Cola announced that it would not no longer pay its advertising agencies by the hour (as has been the case for decades) and instead would use a “value-based” compensation plan for all its outsourced advertising. The way it works is that Coca-Cola will guarantee to cover each agency's costs – so no one will be out of pocket – and pay a bonus, based on performance, of up to 30%. That bonus will be dependant upon a number of metrics including the change in sales and market-share of the product being advertised as well as the performance of the agency itself.

The company claims that this move is not about cutting costs, rather about maximising creativity and efficiency in their partner advertising agencies. Not surprisingly, some of the ad agencies feel otherwise. The challenge, of course, is how do you evaluate the value an advertising campaign delivers? Moreover, such an approach is likely to encourage agencies to deliver services – such as promotions – that aim at short term results rather than brand development advertising that delivers longer term, more subtle benefits.

Proctor and Gamble, a massive consumer goods manufacturer, has developed their own performance related fee system for a dozen of their brands. If it succeeds, you can be sure that more firms will follow this trend.

Innovation in a Creative Industry

Although the advertising industry is hailed as a creative one, it has not been particularly innovative in recent years. Indeed, the biggest advertising innovations of the past couple of decades have been Internet related. Here, advertisers can pay based upon measurable performance, such as click-throughs or purchases. This allows performance to be tightly measured. Also, Google demonstrated that the most effective web advertising need not be the loudest, most glaring and most intrusive. Indeed, such adverts often put people off. Rather, small but relevant text based advertisements can be highly effective. But these innovations came from specialist Internet firms rather than ad agencies.

Value based compensation to agencies, if based on a fair and well designed system, might prove to be highly innovative. However, such systems should not be designed merely to punish agencies that do not perform well. They should also allow agencies whose work is extremely effective to earn substantial rewards beyond what they might have made in billable hours for the same work. Rewards should also reflect long term results as much as short term results.

Not Just Advertising

It is not only in the world of advertising that the billable hour is being replaced by value based compensation. Other service industries, including law firms and accounting agencies are now offering value based pricing. Not surprisingly, however, it is the clients that are demanding value based pricing. Most service firms prefer billable hours because it makes their cashflow a lot more predictable.

But again, if a fair value based pricing mechanism can be developed, it should and will allow the best firms, in terms of quality of service and innovativeness, to prosper.

And Innovation Consultants

Of course another business service that typically charges by the hour is innovation consulting. If value based pricing becomes the norm in other business services, it is only a matter of time before innovation consultants will need to follow suit. And indeed, if consultants are as innovative as they claim their results to be, they should perhaps be the first not only to embrace value based pricing, but to develop an innovative approach to compensation.

What do you think? I would love to hear your thoughts on value-based compensation for innovation consultants. (I should probably point out here that, contrary to the beliefs of some, I am not an innovation consultant by profession. I oversee my company which developed, still develops and markets Jenni innovation process web application and while I advise many of our clients personally as well as indirectly through business partners, this is not my primary role and moreover, my compensation for such services is usually included in the cost of Jenni rather than in billable hours.)

OBITUARY: ARTHUR VANGUNDY

If you knew Arthur VanGundy (24 May 1946 to 5 May 2009), you knew that he preferred to go by Andy rather than Arthur. And that was but one of the many quirks that defined a man who was one of the pioneers of business creativity writing.

Andy began writing about business creativity and innovation long before it became fashionable. His book, TECHNIQUES OF STRUCTURED PROBLEM SOLVING published in 1981 “is considered by many to be the 'bible' of problem solving techniques. It was the first comprehensive book on techniques and still is used as a resource book by practitioners in marketing research, new product development, Research & Development, training and many other fields. It also has served as the primary reference resource for many idea generation books currently on the market.” (http://www.creativityatwork.com/CWServices/vangundy.htm)

In the intervening years, Andy wrote numerous books on creativity, most recently GETTING TO INNOVATION. And I am honoured to note that this book got its start as an article he contributed to Report 103 for the 18 October 2005 issue. A longer PDF version of the article remains a popular download from the jpb.com web site today. Indeed, we often recommend it to clients as essential reading for learning how to frame innovation challenges for ideas campaigns.

Andy spent most of his professional life at the University of Oklahoma, starting in 1976 as Professor of Human Relations. In 1987 he moved to the Department of Communication as a full professor where he stayed until his retirement in 2008.

Andy was also a friend. We met through a mutual interest in creativity and innovation, corresponding on an off over the past few years. As our friendship grew, topics spanned wine, Europe, ex-wives, irritating bureaucracy and much else. He had a wonderful sense of humour and seeing one of his messages in my e-mail in-box was always a treat.

It saddens me tremendously that I shall never again see one of his e-mails waiting for me in my in-box.

He is survived by two daughters, Sarah and Laura and a granddaughter Chloe, all of whom I know he loved dearly.

References
Sarah VanGundy's obituary of her father: http://www.havenbrookfuneralhome.com/May_09/VanGundy_obi.pdf

Obituary at Creativity At Work
http://www.creativityatwork.com/CWServices/vangundy.htm

THE INNOVATION PROCESS MANAGEMENT WEB APPLICATION: JENNI

If you are developing an innovation process for your company and expect to have 100 or more people participating, then you should take a look at Jenni, an innovation process management web application that can become the backbone of your innovation initiative.

Unlike suggestion schemes and idea management tools, Jenni provides you with a comprehensive process allows you to focus innovative thinking on business needs, provides evaluation tools that enable you to identify the ideas that offer the most value and an open development tool that facilitates the transition from idea to implemented innovation.

Most importantly, Jenni is not a software. Rather it is a comprehensive service that includes a web application together with a dedicated innovation coach charged with supporting you as much or as little as you need.

For more information about Jenni, to arrange a demo or to talk to an expert near you, visit http://www.jpb.com/jenni.

We look forward to helping you manage your innovation process efficiently and effectively.

ARE YOU AN INNOVATION CONSULTANT?

If you are providing innovation services such as consulting, training or coaching and want to add a great idea management software solution to your portfolio of products and services, contact me and let's talk about how Jenni can help your clients innovate better – and help you gain new clients.

You benefit from our generous commission programme, marketing on the popular www.jpb.com web site (over 150,000 page hits/month) and collaborating with a fantastic global team of innovation, marketing and sales experts (http://www.jpb.com/about/index.php). In addition, by packaging your services with Jenni, you can provide your clients with value added innovation services that help them increase profitability.

It's a fantastic win-win-win scenario for your, your client and jpb.com!

LATEST IN BUSINESS INNOVATION

If you want to keep up with the latest news in business innovation, I recommend Chuck Frey's INNOVATIONweek (http://www.innovationtools.com/News/subscribe.asp). It's the only e-newsletter that keeps you up-to-date on all of the latest innovation news, research, trends, case histories of leading companies and more. And it's the perfect complement to Report 103!

Happy thinking!

Jeffrey Baumgartner

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Report 103 is edited by Jeffrey Baumgartner and is published on the first and third Tuesday of every month.

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