It's not news to anyone that some of Germany's industrial companies are having problems these days. Burdened with excessive costs at home, they are steadily losing share in the global marketplace. But it is not too late for a turnaround. A good number of leading companies are restructuring to achieve a competitive cost base from which they are beginning to expand aggressively in Europe or even worldwide.

Cost-cutting alone will not be enough, however. If German companies want to recapture their lost share of world sales, they must also find new sources of revenue. Geographic expansion will help, but innovation is equally important—especially if the changes needed throughout industry are to be carried out in a socially responsible way. By 2000, for example, restructuring of European telecommunications is likely to have eliminated as many as 75 percent of the 200,000 jobs that existed in the industry in 1990. Without new, innovative businesses, employment in many sectors has nowhere to go but down.

Besides losing its well-trained workforce, a company that neglects new product development is likely also to lose its competitiveness. One leading German electronics manufacturer, for example, drew about 70 percent of its revenues in the late 1970s from products that were clearly superior to those of its competitors. Five years later that share had fallen to 35 percent; 10 years later the company had not a single superior product. Indeed, as much as 30 percent of its revenue came from products that were inferior to those of competitors.

Innovation is no easy business. The development and introduction of new products usually require tremendous investment in R&D and long lead times. Paybacks are still further down the road. And because the innovation cycle is shortening, products are quickly outdated. The mechanical typewriter, for example, had a life cycle of 35 years. Its electric successor lasted 20 years, and the PC word-processing software of today is upgraded almost every six months.

By the time most companies have a new technology well in hand, moreover, they usually find the market saturated with products based on similar technology. At this stage, even heavy R&D expenditure will probably yield only marginal improvements in their own product, and R&D productivity will already be on a downward track.* It is at this point that companies have to leap to a new technology S-curve. They must have the courage to innovate before the market becomes saturated, or an innovator with greater R&D productivity attacks the market with a new product in a new technology. Companies such as Hewlett-Packard are adept at taking such leaps, generating 60 to 70 percent of their revenues from products introduced within the previous year.

Such courage has long been rewarded with higher profits. While average US corporate profits fell by almost 3 percent between 1978 and 1983, particularly innovative companies, such as those belonging to the American Business Conference, raised them by about 20 percent.

Innovation gaps

German companies were once renowned as the best, most prolific innovators, setting world standards. Aniline chemical dyes, electro-engines, the first commercial motor car (Benz-Motorwagen), and X-rays were all German inventions, and Germans led the development of television, rockets, jet-engines, and high-speed trains. Those days are long gone. Though many German companies still acknowledge the importance of innovation, few have moved decisively or rapidly enough to improve their recent track records. McKinsey's best-practice survey of 102 electronics companies worldwide—including 45 European companies, most of which were German—confirms this.* Not only was overall productivity (the value-added per employee) of some German companies in the survey as little as half that of the most successful businesses, but the gap between their relative "innovation productivity" was even wider.

In 1993, for example, product developers at the German firms in our study generated an average $1.3 million each in sales from products introduced in the previous 36 months. The equivalent figure for non-German companies was $3 million, and among the top third in terms of innovation performance the figure was $6.2 million, almost five times the amount German companies were able to achieve. Getting behind the numbers, it appears that only about one-third of this difference was the result of each developer producing fewer products. The main factor was lower revenues per product. German companies have clearly not been as proficient in coming up with world market hits (Exhibit 1).

For the top third of companies in this study, in terms of profitability and increase in sales, innovation was the principal source of growth. From 1991 to 1993, they increased sales by an average 34 percent, while the bottom third saw a decline of 10 percent. The 34 percent growth was achieved despite an 11 percent sales drop for older products in existing geographic markets. New products in existing and new geographic markets more than compensated, generating growth of 37 percent.

Innovative products and processes are also vital to cost competitiveness. McKinsey's experience indicates that about two-thirds of all unit cost reduction can be traced back to it—half of which comes from new technologies and half from optimization of product performance in specific target segments. The remaining third is due to increased efficiency and falling materials prices.

In short, many German electronics companies urgently need to improve the productivity of their innovation efforts. With competitors increasing innovation productivity by as much as 7 to 10 percent a year, the gap will only widen unless drastic measures are taken. The target should be to double the share of sales derived from new products.

The need to innovate is by no means unique to the electronics industry, however. Other, slower-paced sectors face similar challenges. The six obstacles to successful innovation we have identified in the German electronics industry are therefore likely to apply to other types of companies, in Germany and other European countries.

Innovation obstacles

Low will to win. German companies tend to set lower sales targets than the more successful firms in our study—about 8 percent, well below the aspirations of the top innovators, which aim for nearer 15 percent. In addition, they budget a considerably smaller share of their resources to basic research and predevelopment, and do not identify innovation as a high-priority development goal. Neither is becoming a leading innovator as important a sales and marketing objective as it is among the better performing companies.

Less challenging targets. German electronics companies tend to target less challenging, lower-growth markets which yield average annual growth of only 6 percent. Their most innovative competitors tackle markets growing at more than twice this rate. Not surprisingly, the typical life cycle of German products is also longer—60 months compared with a study average of 40 months. This might sound like an advantage, but less pressure from the market to innovate usually results in less innovation.

Too small, too fragmented. On average, leading innovators are about five times bigger than German electronics companies or business units. So, even with relatively high R&D expenditure—13.5 percent of sales compared with an average 3.8 percent among top performers—German producers have difficulty reaching critical mass. They accentuate that disadvantage by fragmenting the resources they do have. While the best manage an average seven projects per $100 million of sales, German companies in our study manage more than 40, and commit less than half the man hours to each project of their more successful counterparts. They dilute their efforts even further by assigning people part-time to several projects, rather than allowing them to concentrate on one.

Poor integration. Our study shows that German electronics companies rely too little on outside information, and that what they do obtain, they analyze less rigorously than the best innovators. Systematic quality measurements such as Taguchi, Quality Function Deployment or Value Analysis are carried out less than half as often in German companies, and the number of reverse engineering projects is also significantly lower. The application of this limited knowledge is then impeded by lack of cooperation. A German project team works less often with other functions such as purchasing, manufacturing, sales and marketing, or accounting than its counterparts elsewhere, depriving them of others' expertise. And though some firms do have job-rotation schemes, they are not as intensive as they should be. German employees spend on average four months in other jobs, gaining only superficial understanding of them. A two-year rotation is common in more innovative companies.

Inflexible. Many German companies still have rigid management processes which make them inflexible. Redesign intervals, for example, are about one-third longer than at more successful competitors, and individual redesigns also take longer. Design specifications are frozen earlier in the product development process.

Underequipped. Though R&D spending by German electronics companies is relatively high, each R&D employee is backed by less investment than his or her counterpart in more successful electronics firms. In 1991, German companies spent about $115,000 per R&D employee on equipment and infrastructure, while the best companies spent more than $175,000. In effect, the most successful concentrate resources on a few, well equipped top performers, while the average German company spreads its investments more thinly among more staff. Market leaders tend to spend a larger amount per employee because they have a different perspective on R&D. They see researchers and developers as special taskforces; too many German companies view them as foot soldiers.

Strategies for change

Innovation is not just a matter of luck. Innovative companies systematically create and commercialize value for the customer. But how?

Focus on customer value, not inventions per se

Though innovation is not just the further development of existing products and services, neither is it pure inventive genius. The prerequisite for success is understanding customer value. Innovative companies stay in constant contact with end users to find out what is or would be valued in a product or service. Manufacturers of electronic measuring instruments, for example, credit insights gained from customers for three out of four of their innovations. In the semiconductor and printed circuit board industry, it is two out of three. But customer contact should not be limited to sales and service personnel, as is often the case. It is vital that product developers also become involved with end users, ideally standing by their side when they are using the product.

To break genuinely new ground in customer value, however, companies must recognize where value takes a quantum leap in the customer's eyes, and be prepared to leap themselves. Small steps will not suffice. The speeding-up of film processing is a good example. Reducing development time to a week and then to three days did not seem to impress customers much. But reducing it to one hour enabled them to shop while waiting for their photographs to be developed. So-called mini-labs offering this service—like those set up by Germany's Agfa, a Bayer subsidiary—have enjoyed enormous success.

Sometimes customer value is not immediately clear. Ten years ago, the large sound-mixing desks used by most recording studios were based on analog technology, the equipment for which was supplied by many small companies and at negligible profitability. In these companies' eyes, emerging digital technology offered no more than their analog equipment in terms of signal-to-noise ratios, background noise, or phasing. Both technologies performed equally well, and the digital variety was significantly more expensive.

But digital technology carried the day—and faster than most expected. It offered the end user new performance features, such as flexible sound configuration and memory, the value of which was not immediately recognized precisely because it was unfamiliar. The memory capability, in particular, led to a jump in productivity at the recording studio. A studio could begin taping a symphony in the morning, record for a rock group in the evening, and continue with the symphony the next day using the same equipment. Both settings of the mixing desk could be stored on diskette for future use.

Because many manufacturers could not afford to switch to digital equipment production, and because it was expected that the new hardware would be standardized (leaving the software to tailor the equipment to different customer needs), the industry rapidly consolidated around a few companies. Profitability subsequently rose to more than 5 percent.

Innovative processes—which too often play second fiddle to product development—also enhance customer value, especially in industries where price is a key purchasing factor. Japanese automobile manufacturers outpaced the productivity of European counterparts by employing new, lean, production process and management techniques that enabled them to lower prices. European automakers have since had to work hard to catch up, and have done so by adapting Japanese methods. It is only recently that productivity among automakers has stabilized at a world standard, defined mainly by Toyota.

Adapt business systems

Even the most brilliant innovation stands no chance in the market unless technologies and business systems fit together. But new technology rarely fits into existing business systems. So when a company embarks on new technology, it might have to change its focus to predevelopment rather than the creation of variants or cost reductions on existing products. Materials management might have to find new suppliers, vertical integration might be reduced, and manufacturing methods might be rethought. Sometimes whole production lines such as forging or metalworking need to close. Sales and marketing must draw up new strategies and develop fresh distribution channels.

A classic case of how a company failed to adapt its business system is EMI's experience with computer tomography technology in the early 1970s. EMI was by no means inexperienced in innovation, having launched many successful new products. It was also strong in electronics, from which it derived about 25 percent of revenues, and had the good fortune to employ Godfrey Hounsfield, the inventor of tomography and later recipient of the Nobel Prize.

But EMI's R&D strength did not pay off. The results of its research, largely mathematical algorithms for the computerized evaluation of X-rays, had been published in scientific journals and were available for anyone to copy and adapt—which is what General Electric did, entering the market with a superior business system. Unlike EMI, GE had developed strong relationships with hospitals, the primary users of the technology, and it had a strong service organization. It was also able to produce at lower cost. Between 1977 and 1979, EMI made cumulative losses on computer tomography equipment of £56 million, and eventually withdrew from the market.

Canon, on the other hand, was more successful with the innovation of a small photocopier. While photocopier manufacturers traditionally competed with each other on copying speed, Canon recognized that copy quality and speed were not particularly important to small businesses, nor in certain circumstances to big businesses that might want to install a number of small copiers around the office. So it decided to make its copier simpler and pass on the saving to the customer.

Canon realigned its whole business system to produce a desktop copier not much larger than the paper it was to copy, that would cost less than $1,000, and be easy to service. Instead of using the usual light receptor mechanism, R&D developed a special photographic drum that could be thrown away after use and was made almost as easily as an aluminum beverage can. Internal design was kept relatively simple to help ensure reliability, standard parts were used, and the copier was put into mass production. It was not leased through the salesforce as larger copiers were, but sold through dealers and large department stores. The effort paid off. More than 10 years later, Canon still leads the small copier market.

Create an innovation-friendly environment

A one-shot success does not make a company innovative. Truly innovative companies are able to sustain a continuous stream of new products. To do this they create an environment in which there is a simple unifying vision, open internal communications, and freedom to experiment.

Having a unifying vision entails defining how to behave to customers and competitors and weaving that vision into a company's fabric. In more than 75 percent of companies belonging to the American Business Conference, for example, employees are required to adhere to a formal code of ethics. Almost 85 percent have a uniform system of values to guide employees in their daily decisions. At many of these companies, even the most junior managers agree on what the three most important values are. At Caterpillar, for example, one is to make sure replacement parts are available anywhere in the world within a fixed time. At McDonald's, a core value is never to let a customer wait in line more than a certain number of minutes.

Open communications between R&D and the rest of the organization stimulate ideas and enhance creativity and know-how. Innovative organizations open up communications in many ways. A common measure is to limit an employee's stay in R&D to 10 years. His or her expertise can then be used downstream while new people with fresh perspectives join R&D. Innovative companies also set up joint R&D/division projects under divisional leadership, or institute a campus where both central and divisional labs can meet for informal discussion and to exchange ideas and information. Other ways to open lines of communication include publishing short project descriptions in quarterly reports, and appointing R&D personnel as operating group representatives to strengthen the relationship between units.

Some German companies are showing their compatriots the way forward. For example, through intense cooperation, German chemicals group BASF was able to adapt the extruder technology used in its plastics division to the manufacture of tablets in its pharmaceuticals division.

Freedom to experiment comes with substantial investment in predevelopment, which in turn helps a company's technological know-how to grow. Innovative companies offer considerable latitude to predevelopers, whose task is to isolate ideas with the greatest market potential. Downstream developers, on the other hand, have to work to precise timetables with clear decision rules, while progress is closely monitored.

At Honda, the difference is clear. In predevelopment and research, a 99 percent error rate is acceptable; in downstream development, even 1 percent is considered too high. For development to run this smoothly, there needs to be a filter at the interface between predevelopment and development to evaluate product concepts against strict criteria before they are allowed to proceed.

Use innovative marketing techniques

When a product fails, it is usually because of poor commercialization rather than technical problems

When a product fails, it is usually because of poor commercialization rather than technical problems. Innovative companies are savvy about timing a product's introduction and choose the right marketing channels. Though a nose for the market may occasionally be a gift, mostly it is learned.

Companies first have to decide how best to develop and introduce their product by weighing the risks of market entry against the potential rewards. If a competitor has already introduced a comparable product and the company has determined the risk is low and the rewards are high, it would be well advised to start a crash development program or to buy the know-how outside to get into the market as soon as possible. IBM chose such a crash development strategy for its first PC, because Apple was already in the market and it was clear the rewards were high. The extra development costs were a relatively minor consideration. If, on the other hand, the risks and rewards are both high, it might be worth spreading the risk through a joint venture, as in the European Airbus consortium. A thorough review of all options is vital to ensure the optimal solution.

Risks that need to be weighed include whether the user will really appre-ciate the product's new features, whether a company can master the new technology, whether competitors will be faster and cheaper, and whether the technology can be introduced with reasonable effort. It would, for example, test even the best company to introduce several unproven technologies simultaneously.

Having decided a strategy for market entry, a company must identify and project costs in detail to determine the ideal entry time. It would be making a Kamikaze-style launch if its variable cost for the new-technology product were comparable to the going market price for the old-technology product. Competitors would probably lower their price to cost or even variable cost to maintain market share. But if the attacking company's new technology enabled it to price its product below the defender's variable cost, the defender would hardly stand a chance. A reasonable window of entry between the two extremes can often be forecast quite accurately.

An innovation needs a different marketing approach from an evolutionary product. For an evolutionary product, often differentiated by its lower price, it is critical to enter the market as quickly as possible, using existing channels to the full and advertising intensively. With innovations, it is important not only to hit the market at the right time, but to rapidly develop new sales channels that will convince customers of the product's value.

Focusing on this aspect helped JVC become the world leader in VHS systems. By giving away its license to build and sell the VHS system, it built a huge network of distributors and dealers, all of which were in effect company allies. Sony, relying on its comparatively sparse sales channels, stood alone in the fray, continuing to hold its license as proprietary. Despite price-cutting by Sony and the generally acknowledged technical superiority of its product, JVC quickly came to dominate the world VHS market.

Sony learned from its mistake. When it introduced the 3.5-inch disk drive it convinced leading PC producers—Hewlett-Packard, NEC, Apple, and IBM—to sign sales and licensing arrangements, thereby setting the standard for the world. The reward was market share of almost half.

Promote entrepreneurship

Most management theorists and practitioners agree that entrepreneurship is a key ingredient of innovation. The question is how to promote it. We have observed two principal methods: by integrating basic work processes and by hand-picking the best employees.

IBM provides a good example of integration. When it developed mainframe computers, each step followed a strict sequence. But in the development of its first PC, the company took an integrated approach. Needing to get into the market quickly to catch up with Apple, it took drastic measures, developing its product concept at the same time as its marketing strategy. It meant that during the project definition phase, IBM was already talking to Sears and Computerland about how to sell the product. It also departed radically from its traditional operating style—and in doing so encouraged entrepreneurship. The project team was given more autonomy in planning and in making and executing decisions, management systems were greatly simplified, and the team was strictly separated from the rest of the company's activities.

It is generally accepted today that much cost-reduction potential can be realized only through an integrated approach such as IBM's. Methods like design-to-cost, which combine production constraints into product design, and supplier partnerships, which draw suppliers more fully into company processes, can give innovations a valuable cost advantage.

Integration enabled Siemens's telephone division to cut its development time by more than a factor of two and increased its productivity fourfold to regain European market leadership. Similarly, Siemens's machine tool controls division is regaining market share against competitors, including the Japanese world market leader.

The Mercedes All Activity Vehicle, a fun car for the US market to be produced at a brand-new US factory, emerged from the integration of internal functions and suppliers into the development and production processes. So did the Smart city car, a joint effort from Swatch and Mercedes. Manufactured in a new factory in France, the Smart has just 14 main modules but will offer a choice of engines.

Integration apart, successful innovation depends on the quality of the people assigned to the task—not the number. Of the 1,350 R&D employees in one German pharmaceutical company, only 12 percent were involved in the development of products or processes. The rest carried out routine tasks. So despite substantial resources, the company was actually doing little to promote innovation.

Often, employees' performance is not monitored carefully enough. In another pharmaceutical company, only 6 of the 165 people working on new products or processes had made more than one significant contribution during their tenure. Fewer people backed by more resources is the formula that has proven successful for pharmaceuticals, electronics, and mechanical engineering companies.

Sometimes just one person may make all the difference. An innovation that becomes a market hit is often the result of a "champion" pushing a project along to a successful conclusion. The success of Mazda's MX-5 Miata roadster was largely due to the head of development and a multicultural design team who convinced the company the car should be designed like an old English roadster, with rear-wheel drive instead of the usual front-wheel drive. The market proved them right. Within two years, the roadster had doubled its sales and become an industry trend-setter. To develop real blockbusters in this way, companies may have to find a handful of entrepreneurs who, like the Steven Spielbergs of the movie world, become the "producers" of innovative projects.

Overall, the selection of employees for project teams must be done with care, using strict criteria. If teams are to be successful, they must be staffed by the "crème de la crème," who should be shielded from other demands. Top management commitment is also indispensable, for if innovation efforts are to succeed, they must stand alongside restructuring and geographic expansion at the top of management's list of priorities.

The challenge facing companies taking the offensive in innovation is greater even than that posed by improving cost structures and productivity. To meet it, they must set ambitious performance goals and realign their businesses to foster innovation by refocusing processes and staffing (Exhibit 2). They must question the location of the R&D team, their infrastructure, and whether innovation partners are needed. After that, and with determination, there is no reason why German companies should not reclaim their position among the world's best innovators.