Innovation

Innovation accounting: What it is and where to start

By July 24, 2018 No Comments

Few things in this world are considered more boring than accounting; even to my accountant friends.  People who pick up a book about innovation and startups are usually looking for something a little more exciting. Believe me, if it were possible to accomplish the goal of creating an instrument of continuous innovation without accounting reform, I’d be all for it. But, based on my experience, that is impossible.

The truth is, we need to change our accounting systems to truly transform our organisations and our way of working. This new accounting system is called “Innovation Accounting” (IA).

What is innovation accounting and why is it important?

Innovation accounting represents ways to communicate the process and progress of innovation projects through relevant KPIs.

Innovation needs different accounting from other business projects because business, as usual, executes a business plan in a relatively known environment and have KPIs that are developed to measure their performance.

Innovation accounting is a way of evaluating progress when all metrics typically used in an established company (revenue, customers, ROI, market share are effectively zero).” – Eric Ries

Innovation projects, however, are looking for sustainable business models in an unfamiliar environment and are often pushed into using the same KPIs as other business projects. Because of the different natures of the projects, we believe companies should separate those two activities as much as possible and develop a tailored set of KPIs suitable for innovation projects.

Where do I start with innovation accounting?

In his book, The Startup Way, Ries suggests companies create dashboards to display clear and simple metrics which can be used to report progress in financial terms. These dashboards represent different levels of innovation accounting, each increasingly sophisticated as a new venture or innovation project evolves.

LEVEL 1: Customer-focused dashboards

At the beginning of a new venture, teams should create simple dashboards with a few metrics that are both actionable and measurable to help them get going. Examples include:

  • Customer discussions(Number of customers talked to each week)
  • Customer feedback(Number of customers that provide product feedback each week)
  • Conversion rates(Number of customers that try the product)
  • Per Customer Revenue(Amount a customer is willing to pay)

It gives a basic sense of what’s working and what’s not. For example, if customers won’t even try the product, it doesn’t matter what their repeat purchase rate is.

LEVEL 2: Leap of faith assumptions dashboard

As the concept evolves, The team then identifies its “Leap of Faith Assumptions” (LOFAs), which are essentially the most fundamental assumptions that underlie the business opportunity. The goal is to test and validate or invalidate these LOFAs.

At this stage, the team should focus on two categories of metrics namely, Value Hypothesis and Growth Hypothesis Metrics. Examples of these metrics include:

  • Repeat purchase rates
  • Retention rates
  • Willingness to pay a premium price
  • Referral rates
  • Word of mouth referrals
  • Ability to take revenue from one customer and invest it into a new customer acquisition
  • Ability to recruit new customers as a side effect of normal usage

The goal is to identify what needs to be done to achieve the measurable thresholds where each of these variables can grow sustainably on their own. When these thresholds are achieved, it indicates product-market fit has also been achieved and the business is ready to scale.

LEVEL 3: Net present value dashboards

In this dashboard, learning gained from the first two levels of IA is translated into dollars by rerunning the full original business case with each new set of data collected at Levels 1 and 2.

NPV dashboards focus on indicators of business success and real-time data that clearly outline the venture’s progress over time. For example, if a new venture is creating a marketplace business model like Airbnb, or an App store that includes buyers and sellers, a different set of metrics may be needed:

  • Number of buyers and sellers
  • Number of product listings
  • Number of transactions
  • Revenue per transaction

David Binetti explains how innovation accounting can be used for estimating NPVHEs in a 20-minute video:

Example of an innovation accounting dashboard

Let’s look at an experiment run by a team building an ice-cream business.

innovation accounting

Teams choose whatever metrics they want, as long as they are simple and actionable. They don’t even need to relate to each other at the beginning of a project. The idea is simply to start with something manageable, start looking at numbers over time, and have a plan.

Traditional KPI’s even though relevant, simply don’t work for innovation projects. This new approach of evaluating new projects gives executives a way to link long-term growth goals to a system that follows a clear process of funding innovation. We are curious to know how innovation is monitored in your organization, so let us know what challenges you are currently facing and what you think about the three levels discussed.