Financial Tools as innovation killers

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There are smart and hardworking managers in well-run companies who operate well, however, cannot to innovate efficiently. It looks like most companies are not half as innovative as their senior executives want them to be. There might be various reason for this inefficiency and opportunity cost. Among these reason, the following financial tools and measures are contributing factors for lack of innovation in corporations:

Misapplying DCF and NPV- the first misleading financial analysis tool is the method of discounting cash flow to calculate the net present value of an initiative. While the mathematics of discounting is logically impeccable, analysts commonly commit two errors that creat an anti-innovation bias. The first error is to assume that the base case of not investing in the innovation (default scenario of doing nothing) that the present health of the company will persist indefinitely if the investment is not made. In most situations, however, competitors’ sustaining and disruptive investments over time result in deterioration of financial performance. The second set of problems with discounted cash flow calculations relates to errors of estimation. Future cash flows, especially those generated by disruptive investments, are difficult to predict. Therefore, numbers are not the only language into which the value of future investments can be translated. 

Using Fixed and Sunk Costs Unwisely- typical fixed costs include general and administrative costs: salaries and benefits, insurance, taxes, and so on. Sunk costs are those portions of fixed costs that are irrevocably committed, typically including investments in buildings and capital equipment and R&D costs. Managers need to have a good grasp of what needs to be invested for an innovative project and how to utilize the new capability to write off the older technology. There is a suggestion to value the strategy rather than the project. No manager would consciously decide to destroy a company by leveraging the competencies of the past while ignoring those required for the future. Yet this is exactly what many of them do because strategy and finance are treated independently rather being integrated.

Focusing on Earning per Share- a third financial paradigm that leads established companies to under invest in innovation is the emphasis on earning per share as the primary driver of share price and hence of shareholder value creation. Managers are under so much pressure, from various directions, to focus on short-term stock performance that they pay less attention to the company’s long-term health than they might to the point where they are reluctant to invest in innovations that do not pay off immediately.



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