Innovation has long been considered one of the most important drivers of national economic growth. However national governments have little visibility of this activity as it happens at a firm level.
The ability to measure value created through innovation at a macro-level, would make it possible to assess to contribution of government policy to the stimulation of innovation and the value created by funding and investment.
David Stroll has been considering the latter challenge, he has worked with client companies over the last 20 years to see how it might be possible to bridge the gap between the firm level and the economic level, and to provide a consistent set of metrics that is based on internationally recognised methodologies. Here he explains his methodology.
The challenge for policy makers keen to stimulate innovation
Since 2008 UK productivity growth (known as Total Factor Productivity or TFP) has stalled at 0.7% per year, one third of its pre 2008 level. With the most recent OBR forecasts predicting no improvement over the next five years.
This is a major national problem. A separate OBR report, which looked at the long-term challenges of climate change and an ageing population, concluded that an annual TFP growth rate of 2.5% would be required to prevent the national debt rising to 300% of GDP.
This underscores that TFP growth is the single most important national econometric number, but this number comes with a massive red flag. National governments aren’t responsible for delivering TFP growth, that is the responsibility of the private sector.
Measuring value created by innovation at a firm level
To understand this issue further we need to explore the current set of measurements used by firms and National Statistical Authorities (NSOs).
The three types of measurement are documented below and those highlighted in red are required by economists for national income accounting – but are not provided by firms.
Without this information economists have no visibility of innovation in the pipeline or how productivity can be improved.
1. Financial Measurements: Profit and Loss and Balance Sheet – Statutory Requirement for all firms registered at Companies House.
2. Economic Measurements: Total Factor Productivity (TFP), and TFP growth, Gross Value Added (GVA,) GVA growth, GVA per head, GVA growth, revenue driven EBITDA (earnings before interest, taxes, depreciation, and amortization), productivity driven EBTIDA, Growth Capital Balance sheet and depreciation.
3. Innovation Measurements: Innovation Expenditures, Innovation Headcount, quality adjusted labour input (QALI), Failed Innovations.
Using ‘Production Units’ to identify where productivity can be improved
My research work for the last 20 years has focused on creating ‘’management production functions’’ as a theoretical construct to be used within firms.
The starting point is the ‘‘Production Function’’ which calculates how efficiently ‘Inputs’ (of labour capital and purchases) are converted into ‘outputs’ (at market prices) at firm level.
These data can be aggregated by industry sector, by region or nationally.
To gain this data, I segment the operations of the firm into Production Units, which typically include marketing, sales, product & service development, manufacturing & service delivery. Each production unit reports on its own inputs and outputs, and these are aggregated at a firm level.
By focusing on the Production Unit, rather that the firm, it becomes apparent where productivity growth can be improved.
I have coined the phrase ‘Productivity Growth Accounting (PGA)’ to describe this methodology.
Applying the ‘production function’ to innovation
Innovation does not necessarily show up in the statutory accounts, but I contend that it should be measured by firms as a matter of course. Further, I propose that a firm can achieve this by directly linking innovation to the production units as outlined earlier.
The reason for this is primarily that whilst the production units can do continuous / incremental innovation as part of their managerial remit, they cannot replace themselves. In order to replace an existing production unit with a better one, there must have been innovation to create the alternative.
Not all innovation succeeds which means that not all production units will be replaced.
Where the innovation is successful, the firm will either replace an existing production unit or add a new one.
Either way it will show up in the economic measurements for the production unit.
The additional costs of the innovation will be captured in the capital Inputs section (as depreciation), and the new or increased outputs of the innovation will be captured by the GVA, GVA per head and TFP growth measures.
Alignment with accepted national measures of innovation
The National Statistical Offices (NSOs) are tasked with the collection of innovation measurements as defined by OECD (Oslo Manual 2005) and these surveys are very comprehensive.
The great advantage of following the OECD standard is that it already applies in the most innovative countries and the data is comparable between countries.
In my view Productivity Growth Accounting should be implemented at firm level as the first part of an Innovation Measurement suite of reports.
These metrics would then include, in addition to innovation expenditures, innovation headcount, QALI and Failed Innovations, the potential for data about innovation categories: product, process, market and organisation, and a measure of innovation scale ie. new to the firm, new to the industry and new to the market.
Benefits of value created by innovation visible to policy makers
A major cause of the UK’s low TFP growth rate is the long tail of firms who make little or no contribution to productivity growth. According to ONS data, the bottom half of firms in the national distribution contribute only 9% of UK’s productivity growth.
This implies that innovations adopted in more successful firms with higher GVA per head, are not being adopted by half of private sector firms. This creates an opportunity to improve national productivity by diffusion of best practice.
One way of measuring this, albeit indirectly, is to look at the management practices of the successful firms to understand how their performance corresponds to their adoption of innovation and management best practices.
The proposed concept of ‘Productivity Growth Accounting’ would begin to make these investigations feasible.
It would then be possible to track the number of firms which are climbing the productivity ladder, and to set national targets for increasing this rate supported by seed funding from UKRI.
Given that public sector enterprises also need to raise TFP, diffusion of best practices could be tested one place at a time.
Next steps
David and his colleagues have been working with a case-study for three years now to stress test the concept of using PGA to measure the value created by innovation, the findings will be available towards the middle of 2025.
He is currently writing the requirements document for the next round of software development which will include all the necessary functionality for all firms (not just SMEs) to implement PGA, including the collection of their own innovation activities using the OECD standard.
If this is of interest to you then do register your interest.
