As we look at grow out of recession, innovation is more important than ever. However, the types of innovation companies pursue need to change. They must start to find novel ways of adding value at low cost, using existing technology in new applications and re-engineering inefficient business models. Managers wanting to learn how to make this change will find that China is a good place to look.

As we try to throw off the toxic effects of the global financial meltdown and the recession that followed, innovation budgets are remaining tight. Leading consultants such as McKinsey and Company and The Boston Consulting Group argue that this is exactly the time to gain competitive advantage, by investing in innovation that will pay off when the economy bounces back and shortsighted rivals find that their pipeline of new offerings has dried up¹. We all know that maintaining innovation spend is the right strategy for the long term. But it is a brave CEO who is willing to increase the budget for innovation while the after-effects of a recession persist, and departments from operations to marketing argue that “essential” investments to maintain today’s business progress can’t go on being postponed.

We believe that the solution to this dilemma lies not in changing the level of spending on innovation, but in re-thinking the kind of innovation to which the spend is directed. Succeeding in a recession demands types of innovation that are different from those that are prized in boom times. Investing for the long-term is admirable, but we also need innovations that appeal to value-conscious customers squeezed by the crunch, that can be brought to fruition with lower investment, and that have faster payback.

The Economist magazine recently dubbed this the new paradigm of “reverse innovation”². Learning to excel at this type of innovation is now an imperative and, based on our research into innovation by Chinese firms, we argue that there is no better place than the Middle Kingdom to look for insights into how innovation can be re-vectored for recessionary times. This may seem paradoxical given that, in the minds of many, China stands for imitation rather than innovation. And it is true that few cutting-edge, break-through technologies have emerged from China in recent decades. But that is exactly the point: faced with scarce resources and a highly competitive market of ruthlessly value-conscious consumers, Chinese firms have, by necessity, become adept at the kinds of innovation well-attuned to the next round of global competition, in which “value-for-money” segments will be key to driving growth.

Broadening your definition of innovation

Much of the publicity around innovation focuses on fundamental breakthroughs and Nobel-prize-winning research. But breakthrough innovation involves activities that are often closer to art than science. This is the realm of discovery, ideas and basic research. The results tend to be random and the payoffs long – hardly the attributes that meet the need to quickly and reliably augment profits in the face of recession.

Of course managers also recognize the value of so called “incremental innovations” – those that involve relatively minor changes in technology and deliver a small increment to customer value, but can pay off if scaled up to sufficient volume (Diet Coke and Gillette’s multi-blade “Fusion” razor are classic examples)³. They are also well aware that more often than not, the lion’s share of the value of new ideas, products, services, and processes is captured by those who find innovative ways to commercialize, standardize, and engineer these inventions for the mass market. But even here we are used to associating innovation with adding value—more functionality, more features, and entirely new products and services—for which we expect customers to pay a price premium. This is clearly something recession-hit consumers are loath to do.

So to thrive in a prolonged, severe recession we have to broaden our definition of innovation beyond one of delivering novelty that sees the customer pay more. In this regard, the three most common types of innovation we observed Chinese firms pursuing are thought provoking. First was cost innovation: reengineering the cost structure in novel ways to offer customers adequate quality and similar or higher value for less cost⁴.  Second was application innovation: finding innovative applications for existing technologies or products. Third was business model innovation: the well-worn idea of changing one of the four core components of the business model (customer value proposition, profit formula, key resources or new processes) but with a twist – adjusting those aspects that can be changed quickly and at minimal cost.

Given their potential benefits in a recessionary environment, it is worth understanding the mindsets and capabilities that each of these three non-mainstream approaches to innovation requires.

1. Cost innovation

The idea of innovation efforts focused primarily on reducing cost while maintaining quality—on producing cheaper products and offering similar functionality at better value for money—seems unorthodox. Some might even regard it as business suicide: Why invest in R&D and innovation to sell tomorrow’s products at lower prices than prevail today? But maybe that is exactly what is required to increase volume and market share in the deepest recession for decades. Even before the slump began, many consumers in 2007 were finding it difficult to meet their aspirations for improved living standards: the median wage rate for workers in the United States, for example, was stuck at the same level in real terms that it was in 1972⁵. Since then the global financial crisis has seen American household wealth drop by 22 percent between 2007 and 2009. Meanwhile, the annual survey of consumer spending by Booz & Company found that two-thirds of Americans are looking to reduce the cost of their regular purchases. To access these potential customers, delivering better value for money is key.

Cost innovation involves creative ways of re-engineering products or processes to eliminate things that don’t add value (or value that consumers are willing to pay for). Take the example of Chinese battery maker, BYD. Seeing that the high cost of lithium ion (Li-Ion) batteries (at the time costing $40 a piece) was preventing their use in mainstream products, they focused their innovation efforts on reducing costs. Their R&D tried to find a way to replace some of the most expensive materials used in Li-Ion rechargeable batteries with cheaper substitutes, without compromising performance. BYD also worked on re-engineering the production process. It figured out how to make batteries at ambient temperature and humidity, avoiding the necessity to construct and maintain expensive “dry rooms” in the plant. These moves resulted in costs falling 45 percent, taking the cost for each battery down to just $12.

These advances resulted in a value-for-money revolution that saw Li-Ion batteries replace their lower-performance nickel cadmium (NiCad) predecessors in volume applications. As BYD hopped from volume segment to segment, costs fell further, allowing it to notch up global battery market shares of 75 percent in cordless phones, 38 percent in toys, 30 percent in power tools, and 28 percent in mobile phones.

Guangzhou Cranes Corporation (GCC) followed a similar path, focusing its innovation this time on eliminating redundancy in its products and removing unnecessary steps from the production process. Prevailing industry practice, for example, was to secure metal joints by welding both sides of adjoining plates. GCC focused its R&D and engineering staff on redesigning the joints so that equivalent strength could be achieved with a single weld, thereby cutting both cost and production time (a critical consideration for buyers often faced with tight construction schedules).

Another example is Chint, a maker of electrical equipment such as transformers and power supply units that recently formed an alliance with General Electric to penetrate the global market. Chint also focused on cost innovation through reengineering its production process. Its first plant was divided into two areas. On one side were four fully automated production lines, brimming with advanced equipment and run by just two operators. Adjacent were manual lines with thousands of workstations, swarming with people. Comparing the lines in the two areas, Chint found that the maintenance costs of the complex, automated equipment alone were four times higher than the entire wage bill for the workers it had replaced! Chint also found that automated lines were actually less efficient for small batch orders, especially when customized features were required.

These insights launched Chint down a path of innovation aimed at developing processes that would enable the flexibility needed to produce high variety at low cost. Recognizing the flexibility, but also the quality exposures associated with using semi-automated lines to cope with high variety, it first began to develop processes that would reliably deliver highly customized products with minimal extra cost. Chint then took the capabilities and systems it had pioneered on the manual lines and started reconfiguring the automated lines originally designed by equipment makers in the United States and Europe. Every automated procedure was broken down and systematically analyzed. Wherever engineers identified a step that could be better performed manually, they parceled it out of the automatic process. This allowed Chint to increase flexibility while saving $600,000 in capital investment for every line. It also substantially reduced waste because, as the production director put it: “Machines require a high level of standardization, but men can adapt. If a component is slightly out of shape, a manual operator can adjust it slightly to put it back in place. But an automated process cannot; instead, it will discard the parts. This actually increases the cost of procurement and the cost of waste also rises.”⁶

This experience led Chint to develop innovations in procurement and materials handling. Today it separates its incoming raw materials into different grades, optimizing their overall utilization by directing low-grade inputs to the semi-automated lines, while using the high-grade ones in its automatic processes. To manage the elaborate balance between manual and automated processes, Chint developed sophisticated systems for coping with poorly educated recruits and high employee turnover, including graphics-based training, knowledge management, and incentive systems to systematically improve efficiency of workers. It also learned how to deploy advanced information technology to closely monitor, analyze, and improve the performance of each worker on a line. Its annual R&D spending is equivalent to 5 percent of sales, almost all of it focused on cost innovation. The results have been impressive: Chint is now world’s fifth-largest manufacturer of electrical products.

2. Application innovation

Application innovation refers to innovation that is new in terms of its application, but not its technology. In other words, it involves creating a new application for an existing product or technology. The classic example is the humble sandwich: neither the bread, nor the meat filling was new. Instead, the great innovation, credited to John Montagu 4^th Earl of Sandwich back in the 18^th century, was in combining the bread and the meat. In many companies, such re-purposing wouldn’t be graced with the term “innovation” at all. But let’s not forget that, because they rely on proven technology, application innovations often require less investment and generate faster payoffs compared with entirely new inventions – very useful characteristics in recessionary times.

Success in application innovation begins with some lateral thinking. When examining the future potential of an existing product or technology, managers often confine their investigation to product line extension or geographic expansion into new markets. But this tendency to compartmentalize phenomena risks overlooking the potential that exists for making connections across different lines and fields of business. By contrast, lateral thinking seemed to come naturally to many of the Chinese companies we studied — perhaps because Chinese philosophy starts from a view of the world as an interconnected whole, focusing more on similarities, connections and relations rather than on differences, division and the idiosyncrasies of its component parts. As a result, application innovation was more common and more highly valued among Chinese corporate innovators.

This kind of thinking was behind the application innovation that has helped Antas Chemical Company in China’s Guangdong province rapidly win share in the market for sealants used in the construction industry. Builders have traditionally used acrylic-acid based products to seal the frames of exterior doors and windows. These products are reliable once dry, but if rain hits the construction site within the first 24 hours after acrylics have been applied their performance is substantially impaired. Using an alternative, high-cost silicone, in critical applications, typically solved this problem.

Antas wasn’t a supplier to the building industry but it was well established in the business of selling the sealants used in shipping containers – a highly demanding environment for waterproofing. Its butane-based sealants not only offered better long-term performance and were waterproof the instant they were applied, but they also had lower production costs. Their innovative idea of reformulating and repackaging the butane-technology sealants for easy use in the construction industry may look obvious, but it only looks so in hindsight. But because the supply chains for these user industries had remained as proverbial silos, no one had seen the potential before Antas made the leap.

Another variation of application innovation is to combine existing — even mature — technologies for a new purpose. Take the example of Broad, a privately owned Chinese innovator in energy-efficient air conditioners based in Changsha, Hunan Province. The company was formed with capital of just $3,000.00 in 1988, but its founder, Zhang Yue, had an innovative idea: Instead of powering an air conditioner with expensive electricity, why not use waste heat or natural gas to generate cool air directly? The technologies for converting heat either wasted by power stations and boilers or produced by combusting natural gas were well established. But no one had applied them to large-scale commercial air conditioning plants of the type used in skyscrapers or airport terminals. Broad’s innovation was to do just that. Over the years of applying existing technology in new ways, it has succeeded in developing air conditioning systems that reduce energy consumption by up to 80 percent compared with conventional systems powered by electricity – with huge savings in both cost and greenhouse gas emissions. Today its products are installed in over 60 countries, including massive installations that cool Bangkok’s airport and the Expo 2010 pavilions in Shanghai. Broad is the number one supplier of this “green” technology to the U.S. and Europe as well as China.

All of these types of application innovation share characteristics that are particularly attractive to companies struggling to finance innovation in the face of slow recovery in the developed economies: they economise on investment, reduce risk and speed up payback by leveraging existing, proven technologies.

3. Business model innovation

Some of the world’s most profitable innovations have stemmed from novel ideas that didn’t involve changes in the underlying technologies, products or services at all. Instead, they involved innovative redesign of the business model, which created value and delivered it to customers. Low-cost airlines such as South West Airlines or Britain’s Easyjet are classic examples. They share the same aircraft technology as the legacy carriers and offer the same fundamental utility – “get from A to B safely and quickly.” But they deploy a business model that breaks all the traditional norms: flying only point-to-point routes rather than through hubs, standardizing fleets, eliminating frills, charging separately for everything from food to baggage, multi-skilled staff that check you in and then become your flight attendants, and so on.

A recent survey suggests that more than 50 percent of executives think this kind of business-model innovation will become an even more important ingredient for success than product or service innovation⁷. But the same study also indicates that no more than 10 percent of the money invested in innovation by global companies is directed at coming up with new business models. Part of the reason for the apparent contradiction seems to be that business-model innovation is viewed as requiring the kind of wholesale organisational transformation that few companies have succeeded in achieving in a hurry. But our research in China reminded us that rather than turning an organisation upside down, fewer simple and well-targeted innovations in the way things are done can actually revolutionise a company’s business model, and with it, profitability.

Take the case of Tencent, the Chinese company that runs the country’s largest social networking and instant messaging service. Over the past decade Tencent built its core business with the simple idea of allowing subscribers to route short messages from their computers directly to the mobile phones of China Mobile’s customers for a fee of 10 Chinese Yuan (around $1.50) per month. The service was immensely popular: Tencent’s customer base grew to almost 500 million active accounts⁸. Then came Tencent’s next business model innovation: it used its links between PC’s and the mobile network to allow its customers to play on-line games for free. By eliminating the need to download the software onto a gaming console, the problem of counterfeiting that had dissuaded many of its U.S. and Japanese rivals from entering the market simply disappeared. And the profit model? Tencent collected revenue from exploding number of gamers by selling them digital add-ons such as virtual weapons and clothing. It now sells virtual extras ranging from digital wallpaper to picture frames to augment all its base services. Tencent’s revenue is growing at 60 percent per annum and its market capitalization now exceeds $37 billion. It is now seeking to extend this business model overseas, initially through a 10 percent stake in one of the Russia’s leading Internet companies, Digital Sky Technologies, that itself holds stakes in both Facebook and Zynsa.

It’s not only in hot digital businesses, however, that a focus on coming up with simple but powerful business-model innovations is transforming profitability. We also observed this phenomenon in the more mundane business of industrial paint. Recall the application innovator, Antas Chemical, which deployed waterproof adhesive technology from shipping containers in the building industry. The paints division of Antas has also been an innovator – this time by introducing a novel business model. When they visited industrial customers, the company’s sales representatives started regularly receiving requests to set up a recycling system to remove the mounting piles of empty cans taking up valuable space at the end of their production lines. The problem was that Antas could not see how to make the recycling of cans pay. Their solution turned out to be even simpler: re-engineer the business model by installing tanks at the customers’ sites, take over the responsibility for their timely cleaning, and re-supply with new colours to satisfy customers’ changing production runs.

Similarly, our crane-maker GCG has established an on-site service capability at major customers to minimise construction stoppages and loading delays. Initially, GCG’s top-flight Finnish partner opposed the idea on the basis that a permanent maintenance presence would never be economic; instead they recommended a focus on making the equipment as reliable as possible. But GCG discovered that even rare machinery failures carried a heavy cost penalty for construction and shipping customers committed to tight deadlines, so buyers were willing to pay a premium for problems to be rectified on the spot. Meanwhile, while re-training technicians to be multi-skilled, GCG was able to reduce the cost of maintaining on-site service. The company believes this new on-site service business model has been a key contributor to its success.

The lesson from these examples is clear: profitable business-model innovation doesn’t always have to lock a company into a long battle of attrition so often associated with root-and-branch organizational change. Instead, trying to pinpoint opportunities for a few critical, but simple innovations in your business model is often the way to increase return on investment and cut the payback period.

A new typology of innovation

Broadening our thinking about what we mean by innovation to include cost innovation, application innovation and business-model innovation suggests the typology depicted in the chart below. Greater focus on the right-hand categories seems warranted as we face the prospect of continued pressure on innovation budgets during a protracted period of only gradual recovery in developed markets.

A Typology of Innovation

This change in mindset is only the first stage in re-thinking innovation for recovery. The next issue is: what capabilities does a company need in order to pursue this broader innovation agenda effectively? Our research with Chinese companies provides four key pointers.

1. Start from the market

When we think about innovation, and certainly about R&D, we naturally gravitate to the quest for technological advances as our starting point. But for the types of innovation that seem most promising during a slow economic recovery, the market – and in particular, an understanding of customer needs and frustrations — is a more promising motivator. Customer needs provide the pull for identifying the existing, though disparate technologies necessary for successful applications innovation. Business-model innovation, meanwhile, is inherently about finding new ways to deliver, and profit from, fundamental customer value. Many cost innovations also arise from finding new ways to leverage cost advantage without compromising the ability to deliver core functionality at a quality that customers deem acceptable. All of these types of innovation, therefore, need to start from the market.

 2. Simplify, don’t complicate

Look behind most R&D activities in Western companies and you will find the implicit assumption that innovation means additional functionality and greater sophistication. Yet many consumers find that they are drowning in features that are never used but which complicate usability for all. Cost innovation, by contrast, generally starts with the opposite perspective: reverse-engineer the product or service to go back to basics and strip out unnecessary complexity. Likewise, many business-model innovations are based on insights about how to deliver customer value more directly, whether by on-site service or cutting out low-value features or inefficient stages in the distribution chain. Application innovation, meanwhile, is often based on finding an alternative technology capable of delivering the same core functionality more efficiently.

Simplification, however, does not necessarily mean sacrificing variety or customisation. As we have seen, companies such as Chint have found ways to re-engineer the production process to increase flexibility in ways that allow it to deliver variety at low cost. In addition to looking for ways to achieve flexible manufacturing at low cost, careful specification of the choices offered to customers is key. The trick is to design a product line that embodies “variations on a theme,” so as to re-use the underlying platform on which varieties are built, and to customise your offering at the latest possible stage in the value chain so as not disrupt the smooth production of the core components.

3. Play the beggar, not the duke

Chief executives we have interviewed often express a frustration that the chorus of R&D staff claiming that they need more resources is beginning to sound like the proverbial broken record. Yet almost all of our examples of unorthodox innovation we described above reflect the old adage that “necessity is the mother of invention.” Cost innovation is fundamentally about delivering more with less. Application innovation often arises from seeking to make the best of existing technologies – opportunities on which those who enjoy the resources necessary to pursue leading edge (or perhaps “bleeding edge”) ideas seldom dwell. Business-model innovation, meanwhile, is generally born from insights on how to serve customer needs more directly and cheaply, rather than by deploying fancy new technologies. The ideas behind all these types of innovation, therefore, are more likely to strike the resource-starved beggar than the well-heeled duke. The failure of companies like Microsoft to keep pace with their competitors in innovations ranging from web browsers to search engines and social networking — despite almost bottomless pockets of cash– should remind us that creativity and resources don’t always go together. One of the lessons from our research in China is that it is time to jettison the idea that innovation can only be achieved by investing buckets of cash.

4. Go for immediate impact

Finally, we often wrongly assume that innovation is about long-term investments and delayed payoffs. In some cases that is undoubtedly true. But in an environment characterized by a slow emergence from recession and a consequent squeeze on budgets for innovation, we need investments that pay off across the spectrum, from immediate return through to long-term payback. One of the great attractions of an increased focus on cost innovation, application innovation and business-model innovation is that they offer an accelerated return on investment – largely because each of these unorthodox approaches to innovation relies on leveraging existing technologies in different ways. The opportunity is clear: Increase your focus on types of innovation that have the inherent potential to deliver benefits in a shorter timescale than traditional R&D projects.

Time for a re-think

In much of the world, including the developed markets of the U.S., Europe and Japan, we are in danger of taking comfort in the misguided notion that somehow the era of plenty combined with rapid growth we enjoyed in the long boom up to 2007 will miraculously re-appear. The need to address massive government deficits and the huge burden of debt, combined with the retirement burden of the baby-boomers, argues that advanced economies fare more likely to face a slow and painful climb back.

As we emerge from the financial crisis the outlook appears to be rosier in emerging economies. Paradoxically, however, it is in places such as China that we might need to look to find the keys to the kinds of innovation that will allow us to thrive and prosper in a protracted, painful recovery. This is because, despite their high growth, local companies in these regions have not had the luxury of pigeonholing innovation into the category of ever-high technology and more sophisticated products and services. Instead they have had to learn to thrive in an environment where demand growth was for “good-enough” products that the mass of low-income consumers could afford, where competition from a surfeit of both domestic players and multinational seeking a share of the expanding market was intense, and where capital and resources were chronically in short supply.

As a result, these companies have re-focused their efforts on building competitive advantage through cost innovation, application innovation and business-model innovation, rather than Nobel-prize winning breakthroughs and traditional R&D.

It is time for a similar re-think of innovation priorities by companies headquartered in the developed world. Only be re-defining the emphasis of our innovation efforts will it be possible to reliably increase return on investment and shorten pay-back cycles beyond the odd block-buster. To achieve this, however, many of the old shibboleths of R&D will need to be abandoned to make room for innovative thinking that unashamedly starts from the market, seeks simplification rather than complexity, approaches resource constraints as a stimulator of creativity, and is focused on the possibilities for immediate pay-back, not only long-term breakthroughs.

1. Richard F. Dobbs, Tomas Karakolev, and Francis Malige, “Learning to Love Recessions”, McKinsey Quarterly, June 2002; and Jim Andrew, Knut Haanæs, David C. Michael, Harold L. Sirkin, Andrew Taylor, “Innovation 2009: Making Hard Decisions in a Downturn” Boston Consulting Group Report, April 13^th 2009.
2. The Economist, “A special report on innovation in emerging markets: New masters of Management”, Supplement, April 15^th, 2010, 1-15.
3. Chandy, Rajesh and Gerard J. Tellis, “Organizing for Radical Product Innovation,” Journal of Marketing Research, 35 (November 1998): 474-487.
4. M Zeng and P.J. Williamson, Dragons at Your Door: How Chinese cost innovation is disrupting global competition (Boston, MA: Harvard Business Press, 2007), 68.
5. Source: US Census Bureau.
6. Source: Author interviews.
7. Johnson, M., C. Christensen, and H. Kagermann, “Reinventing Your Business Model”, Harvard Business Review 86 (November-December 2008): 50-59.
8. The Economist, “Networked Networks”, April 17^th, 2010, Asian Print Edition, 67.