A majority of innovative ideas make successful companies but only a minority of successful companies remains innovative. Whether we look at the Pharmaceutical industry where industry’s big pharma model is in question because of the dearth of block buster’s from the big pharma companies after billions spent on R&D, the Automotive industry that hasn’t really seen a ‘game changing’ innovation coming from the large OEMs for some time now or any other industry-we find that successful companies at some point after the culmination of their first or second ideas- somehow stop coming out with the silver bullets.
As innovations are results of death matches of various ideas, where the majority of ideas need to die in order for a few of them to get the necessary allocation of firms’ scarce resources by its’ managers- One of the questions to answer would be, ‘ why do managers in successful firm’s fail to allocate resources to ideas that have a better chance of winning in the market?’ What affects the risk-return calculus in their mental models that they increasingly bet on ideas that are not very successful?
One can try to explain using two phenomenon of the real mental calculus at play. Phenomenon long known to us through extensive research in psychology:
For the past 300 years, starting from one of the best written essays on risky choice by Daniel Bernoulli in 1738, we have been assuming that final states of the wealth suffice to define the utility. Bernoulli proposed that the decision rule for choice under risk is to maximise the expected Utility of wealth (the moral expectation). In rational choice theory, we learn to forgo sunk costs and look at ‘expected values’ of our pay offs that are absolute in nature (without reference values). Taking Kahneman’s simple example we could explain for example the nuances of the rational choice theory. Consider two people that get two separate pieces of news from the same stock broker. One is told that his wealth has declined from a 4 Mio $ to 3 Mio $. Second is told that his wealth has increased from 1 Mio $ to 1.1 Mio $. It is quiet intuitive to guess which of these two people would be happier. Notwithstanding of course the rational choice argument that the first person should in fact be happier as in absolute terms he still has a better asset position.
One can go a step ahead with the rational choice argument under risk and build a Utility function, with multiple iterations of returns under risk and the corresponding certainty equivalents i.e. Equivalents of those risky returns under no risk. One sees that the Utility function is quiet steep and signifies our ‘risk averseness’. It tells us that choices under risk might be strikingly different than choices made under normal conditions. We can build a utility curve and can assess the stochastic utilities vis a vis certainty equivalents and hence can ‘normalise’ the asset positions in normal conditions with those under risk. This is exactly what managers do when they calculate the Net present value of projects. Nonetheless it is still a juxtaposition of an absolute value.
We still are far off solving the stock broker paradox explained above. Traditional economic theory has been based on absolutes, yet what we see in real life are decisions based on differentials. At least in the short term, all our decisions are based on some reference value. Kahneman and Tversky conducted many experiments that lead to the formulation of Prospect theory. In their experiments, the choices made by the subjects showed to depend on different attitudes to gains and losses. Preference hence showed to depend on gains and losses with respect to a specific reference point- not as prescribed by the Bernoullian notion. Hence careers of choice under risk are not notions of utility under absolute wealth rather changes in wealth with respect to Prospect theory.
Above is the schematic described by Kahneman and Tversky regarding the Value or Utility changes under Losses and Gains. It has three salient features: (1) it is concave in the domain of gains signifying risk aversion (2) it is convex in the domain of losses signifying risk seeking and (3) the function is sharply kinked at the reference point, and loss averse- sharply for losses than for gains by a factor of about 2-2.5.
Prospect theory provides a strong tool to assess decision making under risk at least in short term as in the short term emotions usually play a role that are triggered by changes in the measures of utility. In the long term however, the rational choice theory provides a good indication as the transient effect of emotions is away and people tend to make more rational choices.
We can infer from prospect theory that managers in successful companies probably are risk averse and therefore are likely to reject innovative but risky ideas with respect to new products or services. However innovative ideas that potentially reduce loss are more likely to be embraced. This might explain why enterprise cost reduction or process efficiency programs gain on an average more traction then enterprise wide innovation programs in enterprises. This also explains why start-ups are so innovative, followed by companies in doldrums that need to place their bets on innovative ideas to survive rather than successful companies.
How can companies make their managers place their bets on potentially risky but successful ideas? They have to reward not just success but also mistakes! Rewarding mistakes to an extent creates a culture where managers are not averse to risk taking. Secondly, they need to be protected from the short sightedness caused due to the financial market pressures. How can they make decisions for the long term of the company if you measure organisation’s success and their success for the short term? As we see from the prospect theory, in the short term managers would be even more risk averse. Also, structures that provide higher degrees of freedom with smaller ‘absolute’ stakes should enable managers to see themselves as guiding small ‘start ups’.
Of course structures only do not suffice- they need to be backed by empowerment by the corporate leadership. Many of the family owned high innovative and successful German companies have been following this model. Empowered and entrusted by the owners for a long term, a large number of operating companies with their ‘Geschäftsführer’ have been the corner stone of intelligent risk taking in the product innovation space, catapulting these companies as innovation champions in their industries .
In their famous 1999 experiment of a one minute basketball film shown to students where they were supposed to count the number of passes between the two teams, Chabris and Simons let a student dressed in a Gorilla costume come, pat their backs, look at them for some time and go back. Majority of Students failed to notice the Gorilla as they were concentrating on the ball passes! In successful companies (also the not so successful ones), the managers are also locked into their inattentional blindness. Their mental models are so skewed towards the operational nooks and corners or locked in the board decided strategic programs- that when a silver bullet gorilla idea stares in their face or pats their backs, majority of them fail to recognise them. They embrace what they see as their ‘actual attention radar’ and just don’t notice these ideas.
Many companies conduct successful fast track programs where new hires are rotated in different departments, locations and markets. This is primarily done to get the new hires a sense of the whole organisation. Exposing managers after a certain tenure to cross-functional task teams, providing deputation to other departments and markets as well as engaging them time to time in collaborative projects with Research Organisations, Universities and other companies is a good way of breaking the inattentional blindness deadlock.
In essence, the core of organisational innovation sits on the tables of these managers who are referees of the idea death matches. Companies that want to be successful need to not just create rules but help create the right mind set and mental models for these managers to make the right ideas win- as often as they can!