Toward an Innovation Sourcing Strategy

Most executives would agree that continuous innovation is a competitive necessity for their organizations. At the same time, evidence is growing that innovation processes in many industries are not yielding the benefits they should.1 As a result, companies are increasingly looking beyond their boundaries for help with innovation, working with customers, research companies, business partners and universities.2

In a study we conducted, the amount of innovation coming from external sources was estimated to be, on average, 45% of the total for the companies concerned. For some retail companies that figure was as high as 90%, while for discovery-intensive pharmaceutical and chemical organizations it was 30% —still a significant number. Half the executives we interviewed asserted that the percentage of innovation from external sources would grow over the next three years; not one said it would decline. (See “About the Research.”)

The need to innovate with outsiders has led companies to tap various external sources, from user communities to competitors. That explains why Aker Kvaerner, a company that specializes in oil and gas recovery technology, is collaborating with engineering company ABB Ltd. to develop an undersea oil recovery process. Their customers, major oil companies, realized that no company could solve this problem alone, and persuaded them to work together.3

Given the availability of new types of innovation sources, executives are expanding the purposes for which they consider external sources appropriate. In research-intensive companies, the conventional wisdom was that research in the organization’s core area of expertise must stay in-house; outsiders could provide only less important support activities.4 Yet research powerhouses in the pharmaceutical industry are now turning to small biotech firms for their next-generation drug breakthroughs, and chemical companies with strong internal research traditions are lining up contract scientists in Russia and India to strengthen their staffs and stretch their R&D budgets. Businesses are using external sources for all phases of innovation, from discovery and development to commercialization and even product maintenance.

While all of these changes sound good and are benefiting a great many companies, they also add a new layer of complexity to the manager’s tasks.5 And unfortunately, despite the growing acceptance of external innovation, we have found that many companies lack a sourcing strategy to guide them in managing it. They often take an ad hoc approach that produces uneven results, the very problem they are trying to avoid. Instead of dealing with external sources one by one and one at a time, companies should systematically examine and rationalize the increasingly important activity of innovation sourcing.

Managing Innovation Transactionally

An ad hoc approach to external innovation is, to put it another way, a transactional way of dealing with the issue. That is, it means that managers are making decisions without analyzing how a particular external innovation transaction affects other innovations (internal or external) or how it relates to transactions in other phases of the innovation chain. In large companies this can result in duplicated efforts that waste resources, confuse partners and embarrass program managers.

Transactional sourcing leads to a variety of specific problems. For example, it is often done opportunistically — one researcher meets another at a conference and they start a process of collaboration. In such cases, alternatives do not receive adequate attention. Most companies require an analysis of the potential market for the work’s ultimate deliverables, but few demand a careful review of alternative ways to reach the same goals.

An ad hoc approach can also steer external sourcing toward product development but miss opportunities in service development, finance and capital management, and business-model creation. Companies can innovate in just about everything they do, but most concentrate their activities in a small number of areas, most often product innovation. (See “Innovation and Product Myopia.”) Even executives who describe a broader innovation agenda for their businesses frequently focus solely on product innovation when it comes to external sourcing.

Companies following a transactional approach often fail to leverage organizational learning. It takes specialized skills to construct deals that achieve broad company objectives while protecting intellectual assets, but many firms rely on individual program managers to coordinate cross-organizational teams, cultivate effective relationships and keep complex initiatives on track. Such organizations have multiple external relationships but no method for applying the lessons learned from one to the others.

Even worse than missed opportunities to apply learning, ad hoc innovation sourcing may also result in the unintended loss of knowledge. Toyota Motor Corp., by outsourcing the design and manufacture of the electrical systems for its automobiles, surrendered its grasp of the detailed knowledge this painstaking work entailed and the in-depth understanding of the complex interactions within the systems. And an electronics company found that changing its role from that of manufacturer (making products from components) to assembler (putting together products from subcontracted subassemblies) made it uncomfortably reliant on subcontractors for innovation. In changing its business model, the company lost the capability to participate in and monitor critical subassembly-level innovations.

Creating a culture in which external contributions are accepted, let alone welcomed, continues to be problematic in many companies that use an ad hoc approach. Overcoming this problem requires a significant investment of management time and effort. For example, a leading high-tech firm recognizes universities as sources of cutting-edge intelligence and research. But to nurture these strategic relationships and take advantage of their benefits, managers have to spend time with the professors while developing internal relationships to ready their own organization to make use of the ideas. That is, of course, easier said than done in organizations with proud internal research traditions.

Ad hoc initiatives by definition do not have a clear link to an overall innovation agenda and thus may suddenly drop out of the priority queue. When a program slips off the management agenda in one organization, the other is left wondering how to reenergize the stalled initiative and will be wary of partnering with that organization in the future. A company that pulls out of initiatives repeatedly may find that external opportunities are no longer an option.

The transactional approach also makes measurement inherently difficult. Executives can’t easily track the proportion of their innovation that is externally sourced or systematically assess the performance of their suppliers. In our study, about half the executives said they measure their own company’s innovativeness in some way — most often by the percentage of sales resulting from products introduced in the past several years. But such figures do not provide the information executives need to compare internally and externally sourced innovations and to decide whether external sourcing is paying off.

Finally, companies taking a transactional approach do not manage the range of innovation sources well. Most do not have explicit guidelines for establishing when to use external sources in general or when to use each type of source in particular, and they do not tap all the sources at their disposal. Despite the visibility of Linux and open sourcing in computer software, for example, very few firms take advantage of community sourcing (relying for innovation on loosely connected communities of sophisticated users).6 In addition, companies often do not spell out how to interface with or coordinate among different sources and frequently manage externally sourced projects in the same way as they manage internal ones. As a result, projects stumble over differences in culture, pace and expectations.

These problems underscore the need to have an explicit strategy for managing external innovation sourcing. Sophisticated companies have sourcing strategies for production processes, and managers of many functions have well-defined approaches to build-versus-buy questions. Yet only a few leading-edge businesses can be said to have a sourcing strategy for innovation. Even fewer have a holistic way to manage diverse innovation sources to get the most out of the process.

Managing Innovation Holistically

Companies that manage innovation holistically answer three central questions in the context of their competitive positioning, risk tolerance and strategic time horizons:

• What is the organization’s overall innovation strategy, including goals, desirable domains and end products?
• How will inside and outside sources be managed in order to execute the innovation strategy, and what key sourcing principles will guide decisions in this arena?
• How will the organization manage both internal and external sources of innovation to ensure that business goals are achieved?

Organizations that manage innovation holistically also tend to be those that are driven by what we call “big ideas.” Companies use big ideas to open new categories of products and services and create entirely new market spaces and business models. In pharmaceuticals, the ideas might be about disease categories; in retailing, consumer market spaces; in the automobile industry, vehicle categories. Once companies identify these domains, they tap external sources for innovations that fill out the category. The firms in our study used three organizing frames to put external-sourcing decisions in this big-idea context: business models, scenarios and product domains. Here are examples of three companies that are using one of the frames effectively:

Business Models.

Boots Pharmaceutical Inc., a global retailer headquartered in the United Kingdom, develops new business models to drive growth and focus innovation. For example, the company recognized that the U.K. National Health Service was having difficulty responding to patient demands for diagnostic tests. It then devised a new business model to offer convenient testing services in its 1,400 U.K. retail locations. But Boots does not feel it needs to invent the solutions; it turns to outsiders and focuses on commercializing their new technology.7 Venture capital firms give Boots a gateway to new opportunities by having the retailer vet the marketing plans of startups; it thus gets an early jump on promising entrepreneurial ideas.

Scenarios.

For some time, a luxury automobile manufacturer has staged an annual “call for ideas” to improve its cars. Hundreds of ideas pour in each year from customers, engineers, centers of competence in areas like brake systems or engine design, and employees engaged in competitive intelligence. Each idea is summarized in a one-page document that describes anticipated costs and benefits.

Until recently, the company used an analytical process to rank the ideas, but the senior staff had difficulty selecting the best ones from the torrent. They solved the problem by adding a big-idea component to the process. The senior development staff now prepares a small number of functional scenarios (describing what the car would do, not the technology that would make it possible), each one describing a different view of the car of the future. This top-down look enables executives to bundle collections of bottom-up ideas into focused, long-term initiatives with clear market logic. It also opens up white space for external contributions. According to one senior executive, the goal is to have one major breakthrough innovation per year. By using scenarios, the company defines the areas in which it wants innovators to search. Executives believe the process also gives more top-management weight and attention to innovation management.

Product Domains.

Eli Lilly and Co. aims for a fluid approach, using internal and external sources to generate a surfeit of innovation. According to a Lilly executive, it aggregates innovations by therapeutic focus — such as central nervous system, oncology or diabetes. Managers in each organizational area have their own strategies and identify the products they would like to have, developing a priority list that guides both internal efforts and external sourcing. And because Lilly employs standard categories for therapeutic focus that are common throughout the industry, it is easy to communicate priorities and needs to external suppliers of innovation. A company with new compounds in oncology, for example, can easily determine that Lilly is seeking solutions in that area.

Missing from this list of big-idea approaches are two prominent practices: portfolio management and stage-gate processes. Many companies rely on these well-known practices to organize and evaluate innovation projects, which do provide an overall financial and risk-related portrait of the innovations a company has in process.8 Even the best portfolio management process, however, gives no indication of where to look for the next innovation. To be effective, these important practices must be tailored to the nature and context of a company’s innovation agenda.9

Big ideas need outlets in order to develop. A Lilly strategist explained the different ways the company uses external sources: “You cannot do it all yourself. We’ll look at 1,000 to 1,500 opportunities this year to acquire someone else’s intellectual property.”10 At any given time, Lilly is managing more than 140 external partnerships with research firms at various stages of the drug development process. Lilly also turns to individual scientists for help solving hard chemistry problems through a subsidiary, InnoCentive Inc. In addition, Lilly uses venture capital funds to invest in early-stage biotech research.

According to financial analysts, Lilly has the fullest and most productive late-stage pipeline in the industry.11 The company’s holistic approach and use of what we call innovation channels enable Lilly to excel at drug development.

Using Innovation Channels

Although no company in our study used the term channel to describe its innovation sources, the term does in fact explain what sophisticated innovators use to give shape to their external sources as part of a complete sourcing strategy. Just as experienced marketers reach their end customers through specific distribution channels — not via an ad hoc collection of resellers and outlets — companies like Lilly set up innovation-sourcing channels to meet particular business needs. They match specific sets of sources with their innovation needs in order to manage them as a group, through established processes, rather than as separate and independent relationships. In our research, we identified five types of external innovation channels.

Buying Innovation on the Market.

Organizations such as universities and private research labs offer innovation for sale. This type of channel is well established in all the industries we studied. ABB, for example, actively sponsors research at local universities. In another form of the channel, retailers and automotive companies with strong brands and market power shift the onus of product innovation onto suppliers through a process called “strategic procurement.” Suppliers in this situation compete for purchase orders by investing in and offering differentiated products. For example, U.K. retailers Boots and J Sainsbury Plc have not only contracted out their information technology to outsourcers but also the identification of innovative uses of IT in business processes.

Investing in Innovators.

In seeking to benefit from breakthrough innovations, companies take equity positions in organizations focused on small or emerging markets. Electronics companies make heavy use of this channel. For example, Nokia Corp. has shied away from acquisitions, preferring instead to set up venture funds to invest in companies that complement its own product and business development. Some companies invest in innovators as a strategy to skirt their own entrenched business models, corporate inertia or top management resistance to investing in small markets. One technology executive notes that investing in other businesses like this helps to resolve the “innovator’s dilemma,” in which established firms resist innovation that might cannibalize their existing offerings. Through an equity partnership, a company can participate in and nurture an emerging market.

Cosourcing.

As innovation in some arenas becomes more expensive, companies sometimes band together to share the costs. Automotive businesses use cosourcing to address regulatory requirements that affect them all, such as those mandating emissions standards. Much of Nokia’s success with mobile phones stems from innovative cosourcing through wireless industry associations such as the consortia and technology standardization boards for GSM and 3G. One leading high-tech firm locates its own research laboratories inside universities, sponsoring professors who are working in promising areas and sharing in any intellectual property that is produced. Some organizations also form partnerships to bring together the diverse skills and talents a project requires. One ABB partnership, for example, included a technology company, a university group and four of the companies that would ultimately buy the solution. Another type of partnership, the joint venture, is also used as a way of cosourcing innovation.

Community Sourcing.

Over the past decade, companies have begun tapping loosely connected communities of sophisticated users. This approach has been successful in the open-source software industry, for instance. EBay Inc. uses community-based innovation extensively to identify new sales categories and expand the capabilities it offers customers. The company’s executives say that its customers identified and built what is today its largest sales category, automobiles. Other community members built important new auction-management tools that plug into the eBay platform to facilitate such high-ticket auctions. NTT DoCoMo Inc. employs community sourcing to expand the information it distributes over its i-mode mobile data service by allowing any company or individual to set up a Web site that is compatible with i-mode. Nokia relies on community sourcing for the applications software for its Media Terminal, the centerpiece of the company’s wireless home entertainment system.

Resourcing.

Some companies support their research staffs by contracting with outside suppliers for on-demand talent and innovative new tools. DuPont Crop Protection is increasingly looking to companies in India, Russia and China for high-quality researchers whose pay scales are lower than in the United States. By employing such people, DuPont Crop Protection gains flexibility in managing R&D and takes advantage of the increasingly global nature of a high-quality research capability. To improve its product-development productivity, Aventis SA looks outside for cutting-edge technologies — tools that can help build innovative products. It brings these in-house when a clear leader emerges among competing technologies and its value for the internal efforts has been proven.

Each channel has its strengths and weaknesses relative to various innovation objectives. (See “Choosing the Right Channel.”) Community sourcing, for example, has the benefit of low costs because a company typically pays little or nothing for the work of community-based innovators. However, executives often find it more difficult to direct this channel than others. Cosourcing and community sourcing present complex intellectual-property challenges.12 Each channel requires specific internal management capabilities, innovation processes, external relationships, information flows and intellectual property arrangements.

Each type of channel takes a slightly different shape depending on where in the innovation value chain it sits for a given company, from discovery and early development to end-user sales. Two examples that involve buying innovation on the market illustrate the point. London-based Marks & Spencer Plc, unlike most retailers, distinguishes itself through product innovation. It relies on suppliers to invest in products such as men’s wool suits that are machine-washable, and then it buys the products when they are ready for retail sale. An executive responsible for intellectual property comments, “We have unique relationships with a stable, committed supply base. Historically, much of this business has been done on a handshake.”13 A large pharmaceutical company also buys innovation on the market but at a much earlier stage in the innovation chain. It obtains almost all its drug development from small laboratories, buying the rights to intellectual property from small companies and paying them to complete the development process. Its own organization takes over to manufacture, market and distribute the products.

Companies that leverage innovation channels still occasionally do one-off deals, but most of their externally sourced innovation comes through deliberate, consistently available channels. Moreover, they choose channels that match their strategic requirements. Once established, these channels can be used fluidly as needs arise.

Establishing Organizational Processes

After companies develop an overall innovation strategy and an innovation sourcing strategy, their next step is setting up the organizational mechanisms and structures necessary to execute these strategies.

Some companies create a separate unit or group that is responsible for such tasks as establishing new channel sources, evaluating relationships regularly, and measuring the competitive effectiveness of each channel. Procter & Gamble Co., for example, has a business development group responsible for soliciting and managing outside relationships. And in 1998 Nokia established a third division, separate from its two core businesses of mobile phones and networks, which had similar responsibilities as part of its focus on exploring future developments.

Another organizational task involves establishing processes and even document templates that can be pulled off the shelf in order to guide managers in the process of crafting a deal. Los Alamos National Laboratory, which is known for its successes with technology transfer and commercialization, shares staff and facilities with other companies and engages in straight-up licensing, sponsored research and collaborative research. It has a set of processes at the ready to guide each type of relationship.14 GMP Cos. Inc., a pharmaceuticals, diagnostics and medical device business, developed standard operating procedures for handling its agreements with university researchers, including a review by conflict-of-interest and conflict-of-commitment committees.

A particular challenge for companies that manage innovation sources as channels is working across boundaries. To use external sourcing effectively, executives must identify the boundaries and establish processes to bridge them. Some boundaries can be addressed through routine, accepted business practices. For example, most sourcing processes use some kind of contractual negotiation to deal with organizations’ differing goals, agendas and financial interests. Other boundaries, such as those involving culture and work pace, require more high-touch interventions.

Consider how expectations about work process must be managed. The innovation process at companies usually includes three broad categories of activity — discovery, development and commercialization — and each segment involves a very different work process. Successful innovation partnerships bridge “like to like” processes: Researchers in one organization work with researchers in another. For example, ABB manages projects with the academic world through its own closest equivalent, the corporate research center. Its business units manage development projects with smaller companies. And at the corporate level, it establishes and manages larger development opportunities with external partners of its own size. In each case, the innovative activities are comfortably settled within one segment of the innovation chain so that while a project crosses organizational boundaries, the individuals working on it share a common mind-set.

Another issue that needs attention is pace. Small companies are often more agile and decisive than larger ones, and private labs usually work more quickly than those at universities. One large organization has specifically established a small-firm channel to take advantage of the speed differential. Some universities are countering by establishing organizations that sit on the boundary between academia and private industry — for example, MIT’s Industrial Liaison Program — to manage university research with a mentality in which meeting deadlines, making progress reports and achieving commercially valuable outputs are part of the effort.

A company’s sourcing approach must ensure enough information flow (another boundary) to keep innovative activities on track. Executives at Limited Brands Inc., for instance, believe that the subtle nuances of their brands need to be fully understood by outside partners before they can contribute effectively. The company makes many efforts to convey these nuances, but outsiders must also be willing to invest in learning about the company or risk undermining their credibility. Los Alamos National Laboratory improves information flow in strategic partnerships by stationing individuals in the partner organization for two-year stints. Says Donna Smith, division leader for industrial business development, “When problems arise, we use the informal communication channels our person has set up to get us through the rough spots.”

In the global economy, time and space can also be difficult boundaries to manage, despite technological advances. Face-to-face visits, teleconferences, and Web-based collaboration tools can all help, but far-flung relationships need consistent attention to keep communications open. DuPont Crop Protection’s efforts, for example, encompass research alliances in Europe, Russia, India, China and the United States — a daunting managerial challenge.

A final boundary requiring extra attention concerns the specialization of skills. As one executive wryly explains, “The biochemists do not respect the clinicians; the engineers do not want to speak to the scientists.” In addition to these cultural walls, disciplinary specialties also have their own entrenched and incompatible reward systems. Sophisticated companies use individuals with multidisciplinary backgrounds and establish team-based incentives to bond diverse working groups.

GMP Cos. works to help commercialize the patented research done by university scientists, who would often otherwise fail to do so with their inventions. GMP helps both the university and the patent holders align their interests with the goal of achieving commercial success. It establishes a separate legal entity for the venture and shares equity with the university. The patent holder participates on the development team but does not lead it. That keeps critical knowledge close to the project and accords the inventor respect but maintains project leadership with a focused, deadline-driven mind-set. Throughout a well-defined process for turning patents into products, GMP relationship managers shepherd the communication-intensive process.

Measuring the Benefits

Few organizations have anything but anecdotal data about the performance of their innovation partnerships. But those that use innovation channels also tend to be the ones actively tracking measures that capture each innovation channel’s contribution to the organization’s overall innovation goals. Some pharmaceutical companies, for example, compare the profitability of drugs in their portfolio according to whether they were developed internally or with partners, marketed independently or comarketed, and so on. They feed the results into models they use to make future partnering decisions. Certain high-tech firms track sourcing results by comparing time to market for in-house and partnered product development.

Executives readily testify how their organizations have used external sourcing to improve the speed and quality of innovation, their access to disruptive new ideas and their ability to make tough priority decisions. While such benefits are appealing, they are not easily gained. Sourcing innovation externally is riddled with challenges and risks. Developing an innovation sourcing strategy is a critical step toward balancing the risks with the benefits that external sourcing provides.