Want to Make Money off Your Innovation? Watch the Cash Curve
Reprinted with permission from Knowledge@Wharton.
When senior executives at Motorola remember Iridium, its ill-fated global mobile network, it is likely that they break out in a cold sweat. Conceived as a path-breaking system based on satellite communications, Iridium was once regarded as one of Motorola's most innovative ventures. The company brought together several partners to share the pre-launch cost of $5 billion and launched 66 satellites into low-earth orbit to serve as communications gateways. In the 12 years it took to get the system off the ground, though, rivals launched their own international networks. Despite a marketing push that cost $120 million, Iridium failed to attract a following: It signed up 15,000 customers rather than the 600,000 it had expected. Ultimately, in 1999, Iridium declared bankruptcy and sold its assets to a group of investors for $25 million. The project died a quiet, though expensive, death.
Motorola's experience is hardly unique. As James P. Andrew and Harold L. Sirkin point out in their book, Payback: Reaping the Rewards of Innovation, companies that want to be innovative are often seduced by ideas that seem alluring on the surface but over time turn into cash traps. If a company is lucky, cash traps merely cost money and puncture inflated executive egos. In the worst cases, a cash trap can dig a financial pit that is deep enough to sink the whole company. As Andrew and Sirkin note, the failure of Polavision — Polaroid's foray into instant film-based movies that was undone by the introduction of video — is a case in point. Nor are companies alone in falling prey to the chimerical appeal of seemingly innovative ventures. In a recent podcast, Sirkin described the Concorde — funded by the British and French governments to revolutionize trans-Atlantic air travel — as the "ultimate cash trap" that bled billions before it was shut down.
One of Payback's merits is that its authors — who are consultants with the Boston Consulting Group — are not content to tell tale after horrific tale of supposedly innovative projects that failed. They also offer an analytical framework that lets companies understand how to sort through various innovative ideas and manage them until they generate financial returns. The underlying premise behind Payback is that companies generate lots of good ideas; the problem is that they often throw money at these projects — all in the name of being innovative — without thinking about how they will make money. According to Andrew and Sirkin, the reason to innovate is simple: It is "to generate cash."
To make money from their innovations, companies must manage what the authors call the "cash curve." As they explain, most companies have reams of figures about their innovative projects, but this data is often impossible to use in practice. "While it is important to have detailed financial information about cash flow, net present value and financial outcomes of multiple scenarios, these tools all too frequently don't enable different groups of people within a company to visualize the implications and alternatives that would help them make effective business decisions," the authors say. This is where the cash curve can help. "This is a case where a picture is worth more than a thousand words — it may be worth $100 million or more."
The cash curve is based on four "S factors": Startup costs, or the pre-launch investment; Speed, or the time it takes to get the product to market; Scale, or the time it takes for the product to build a critical volume of customers; and Support costs, or the investment that is needed to keep a new product or service up and running after it has been launched. The cash curve plots cash flow over time as the product goes through successive phases of idea generation, commercialization and realization.
Now consider each of these four factors in some more detail. When the startup or pre-launch costs are very high — or, plainly put, the size of the hole is too deep — it implies that the product will need to achieve enormous success in the marketplace in order to achieve payback. That, fundamentally, was the problem that Motorola ran into with Iridium. Although Motorola limited its own financial risk by involving other partners, the $5 billion startup costs were so high that the project needed a very large number of customers in order to become viable. When those customers failed to sign on, it sank the project.
Paying attention to speed to market is equally critical. The faster a company can get a new product to market, the greater the chances that cash flow will begin quickly and payback will be achieved. But this can be a double-edged sword. If speed comes at the cost of educating customers about the new product, the company may not be able to cash in on its first-mover advantage. Andrew and Sirkin say that this is the problem that has plagued TiVo, which pioneered the digital video recorder (DVR) but has never quite succeeded in explaining to customers what its product does. "Now that the DVR is growing more popular, the electronics giants are introducing their own models, and it looks increasingly unlikely that TiVo will ever achieve payback," the authors say.
Scale, or the time to volume, refers to the time it takes for a product to gain enough acceptance in the marketplace for the company to achieve payback on the startup as well as launch costs. Ideally, say Andrew and Sirkin, this part of the cash curve should be short and steep. They note that Microsoft's commercialization of Xbox video game consoles is a case in point. While the Xbox's early versions trailed far behind Sony's products, Microsoft ramped up quickly to achieve critical mass.
Finally, Andrew and Sirkin explain that companies must decide how long, and to what degree, they should support products once they have achieved scale. For example, when Whirlpool launched its Gladiator line of garage organization systems, the company deliberately priced wall panels low to achieve scale, although by doing so it made hardly any profits on these products. The panels, however, were designed to work with several other components of the Gladiator system, which included racks, shelves, baskets and so on. "Selling the wall units at a very low margin was essentially a post-launch investment designed to increase cash payback for the entire Gladiator product line," the authors say.
Companies that do not plot a cash curve to think through these four phases may end up taking on too much risk. Alternately they may take on too little risk to achieve any real growth. Andrew and Sirkin describe three principal risks that companies face in achieving payback from their innovations. The first is executional, i.e., whether the company can actually make and deliver the new product or service; the second is technical, i.e., whether the product will perform as it should; and the third is market, i.e., will customers accept the new product or service at the price at which it is offered.
Is there a company that has managed all four phases of the cash curve expertly to win big time on an innovative product or service? The answer that Andrew and Sirkin offer will surprise no one: Apple. They describe the company's launch of the iPod as an example of "superb cash curve management." The company kept startup costs low: Over the course of its development, less than 50 people worked on the project team and the authors reckon that the company spent less than $10 million on developing the iPod. Next, it moved the product into the marketplace with tremendous speed — less than a year. It was able to do this by working with a small company, PortalPlayer, which had developed the design.
Apple also went on to build massive scale through aggressive marketing, spending almost $70 million between 2001 and 2003 on ads featuring distinctive silhouettes swinging and swaying to their iPods' music. Sales soared dramatically in response. Finally, the company offered strong post-launch support by introducing new versions such as the Nano. The authors claim that by 2004, the iPod had already achieved payback. As of February 2007, Apple has sold some 90 million iPods since its launch, according to Tim Cook, the company's chief operating officer.
Payback discusses several aspects of innovation, but for people who care about how to manage innovative ideas in fiscally responsible ways, the section on how to use the cash curve is among the most useful. It can potentially help them create new winners — like the iPod — while watching out for projects that might be, like Iridium, just a pricey pie in the sky.