Wednesday, May 30, 2012

Discovery and Planning: The Essential Tension of Innovation

In my previous two posts I wrote about an intersection between the arts and an emergent form of business innovation that is not yet fully defined. In this space a kind of venture model is possible that draws on the strengths of both paradigms, maximizing creative possibilities while minimizing uncertainty and risk. I affectionately and irreverently call it the Cake Machine. Cake being profit, of course.

The process is abstract, combining the best of several powerful frameworks--Stanford's design thinking, emergent strategy and Rita McGrath and Ian MacMillan's discovery driven growth.

First some definitions. 

Discovery: what you practice when you don't have the data to do anything else. The process of going where there isn't a lot of information to guide the way. It is often led by hunches, intuition and incremental discoveries.The process is uncertain or leads to uncertain outcomes.

Planning: the process of making decisions and strategies that yield desired results over time. The process is predictable.

There is an essential tension between these two. Discovery wants to be an open ended process to maximize its ability to explore and make amazing things. Planning wants to reduce uncertainty to measurable risk, producing desired results next month, next quarter, next year.

The process of creating innovative companies and brands is structured as a cycle that utilizes this tension between discovery and planning. To give this rigor and structure, design thinking is formally articulated as a problem solving tool while discovery driven planning is used to model the business and define the design parameters.

This process throws off creative energy by considering design as a critical component of the entire business ecosystem and by defining design parameters using sustainable business models. It is more of an engine than an incubator. The design, discovery and planning processes are in play simultaneously.

Design thinking, emergent strategy and discovery driven growth are generally formulated as linear processes. By reconstructing them into an iterative loop, I create a cycle which holds at its center a fully formed venture whose final form is, at the start, something of a mystery. As we circle the center, considering it from all angles, we continually refine the entire business and design ecosystems using what we find there to define our design parameters.

Design thinking engages in a process that has been organized by the as follows:

1. Empathy
2. Define (focus): create a clearly defined problem statement
3. Ideate (flare): generate as many solutions as possible to the problem as defined above
4. Prototype
5. Test

In this engine, design thinking is used as an essential framework for problem solving once the problems are defined more clearly by the financials. Reverse financials bring problems to light early in the process, generating clear problem statements and then flaring to generate previously unrecognized solutions. This process of focus and flare, using the business financials as a way of setting design focus early in the process, maximizes innovation within the entire business ecosystem, from the design of the user experience through the supply chain to the overall finances of the organization.

Here is a rough step by step pass through the first cycle.
  1. Start with any basic concept for a product or service offering.
  2. Define the basic unit of business and any alternative units. The unit of business must differentiate.
  3. Build a set of reverse financials--an income statement and balance sheet--that makes the venture worthwhile. 
  4. Back out of the financials as many of the assumptions that you can that have to hold true for this venture to succeed.
  5. Rank assumptions by order of importance, with the most critical assumptions, the ones where everything falls apart if you get it wrong, at the top. 
  6. Design tests to discover the accuracy of your assumptions.
By now you have made a circular pass around the loop with basic definitions of everything that has to hold true for your venture to succeed. You have a sketch of your variable and fixed costs in place, a required income, a sense of return on assets which gives you an allowable amount of fixed assets, and a basic model of how your entire supply chain and marketing efforts have to behave for this to work.

With these inputs you go back to your design concept and refine it based on the cost and price information that your financials have modeled. You calculate your break-even point and evaluate your offering in terms of its potential market. Using design thinking you maximize your creative input into the design within the parameters defined by the financials.

How does this work? The process can be adapted to any venture. Here is one example.

Imagine a designer who believes she can build a disruptive product to fill a perceived hole in the market at a price point of $800. The product is disruptive and differentiated because it will bring a level of quality to that price point that currently only exists in products offered by competitors at a much higher price. How will she go forward?

Her business unit is defined as a product purchased by the consumer for $800. We start with the assumptions that to make this worth the effort, the company should generate $1,000,000 in net income with a contribution margin ratio of 45% and a return on assets of 25%. To start, she believes manufacturing can be achieved with fixed costs of $600,000 per year. Now we work the income statement backwards.

Net Income  $1,000,000.00
Taxes (40%)  $666,666.67
Income  $1,666,666.67
Fixed Costs  $600,000.00
Contribution Margin  $2,266,666.67
Variable Costs (55%)  $2,770,370.37
Sales  $5,037,037.04 

At an $800 price point with $600,000 in fixed costs and a contribution margin ratio of 45%, the venture must sell just over $5 million in sales or 6,250 units to make the desired net income. For this to happen, each unit must have $440 or less in direct labor and materials.

Now that we have used the basic financials (backwards) to define our design parameters, we come back to the design to ask the question, what amazing things can be done in this product space for $440 per unit? How can we disrupt and capitalize in this space? Is there an innovation in manufacturing or distribution that would allow us to disrupt the competition? What does our potential market look like? How could we sell 6,250 units a year? We have nothing so far invested in fixed assets, but our basic balance sheet will allow us up to $4,000,000 in property, plant and equipment. Can we come in under this? What is possible for that amount? How much can be outsourced? How can those investments be delayed while we refine the design?

If the initial pass around the loop is successful, then the project enters the next level in the cycle, making more detailed financial documents, more specific designs and prototypes, while testing assumptions and doing everything possible to delay major investments and keep real options open so that you can refine and discover along the way.
So why are discovery based processes and design so critical to this next wave of profitable ventures in the United States? It has to do with an understanding of how money is created by firms. So much press has been focused on the amount of money made by banking and investment firms of late. What is missed in that is just how narrow the margins are in those transactions. Contribution margins for banking firms can run as low as 3%, which means that to make $3 million they have to move $100 million. That is an amount of capital that is unavailable and those are returns that are unreasonable for most business ventures. 

A well designed venture can produce contribution margins of 50% or more. With lean business plans this can be hugely profitable. It outperforms the financial markets by orders of magnitude. In our above example, the company is represented by $4,000,000 in fixed assets and let's give it another $1,000,000 in net working capital. With $5,000,000 tied up in capital, the company spends $440 to receive $800 in income for a contribution of $360 per sale. That is a return of 80% on money invested in direct materials and labor. If this were successfully implemented it would produce $1,000,000 in net income with $5,000,000 in total assets. Of course you can't just wave a magic wand and make that happen. But you can make it happen if you structure it by design. Or at least you can work through potential projects, avoiding the ones that don't make the cake until you find the ones that do.

What cake machine does is structure the modeling of innovative ventures in ways that focus and maximize the creative input to the process while minimizing uncertainty and risk. You want to quickly discover your major problems and hurdles so you can focus your problem solving and design energy on them first, either solving them to overcome barriers to entry or stopping the process before you spend in other areas.

Giving the process rigor and structure provides discipline for the transfer back and forth between discovery and planning. If we imagine it the way the brain works, this activates both sides, giving equal weight to analysis and innovation throughout. This system is like the corpus callosum, connecting both sides of the brain at the center, with directed and disciplined discovery on the creative side and open ended financials and planning on the other.

By iterating in this way an organization can cycle through any number of ideas at a time, learning from each and focusing on the projects that have the most likelihood for success. Most importantly, the design parameters are set up in sync with the operating and financial goals of the enterprise which focuses creative activity in ways that increase the likelihood of success. To succeed, the process needs leaders who can design the entire business models and drive superb design within the financial parameters. It is a rare breed who can do both, but that is where the cake gets made.

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