Standard financial modelling tools have their limitations when it comes to assessing the potential for new ventures to add value to a business down the track. Traditionally, tools such as discounted cash flow have been used to model the potential of an investment to produce revenue in the future. But if a business, product or service is so new this calculation is impossible, other tools are required.
Today, many financial professionals are exploring new methods to enable their business to participate in the innovation boom.
John Meacock is the chief strategy officer for Deloitte Australia. He says financial professionals need to look at a wider range of tools available to CFOs as business models and technologies are changing rapidly.
“When planning innovation, there's a heightened call for businesses to look at a wider range of scenarios. There's also a need to look at the way that businesses will be valued in the future, a range of different metrics that need to be understood and modelled," says Meacock.
“Many of those are around customer engagement and business data. It's also important to recognise businesses will earn income in a very different way in the future. Revenue from subscriptions, data and advertising will grow for some companies, which has been the case for new businesses like Google or Facebook. Network effects have changed a lot of way[s] we think about revenue, income and evaluation of businesses," he explains.
Meacock says the most innovative business models explore new metrics — lifetime value of customer and customer acquisition costs, for example — but don't change the business' financial model.
Real options valuation is another tool businesses are using for financial accounting. It's a way of valuing the different opportunities a business has, based on a series of assumptions, and that has to be taken into account when using real options valuations to model potential future income.
“What you're trying to achieve is a more holistic view around the customer metrics that drive the financials, rather than just looking at the financials," he explains.
Indeed, one of the biggest shifts when it comes to new approaches to financial accounting for innovation is businesses looking at the lifetime value of a customer and the cost to acquire the customer.
Says Meacock: “You might work out that it costs the business $4 to acquire a customer through social media and $10 to acquire a customer using above-the-line methods. The idea is to examine the various methods and assess the impact on earnings. It all comes back to working out the metrics that are going to drive growth or income, or risk any [of] these."
Role of the CFO
When it comes to the CFO's role, Meacock says they must be forward looking and understand there's no straight line between income and expenses.
“CFOs must look at value in a very different way, but clearly understand the investment and cash flow impact. Some innovations may never get to monetisation stage, and it really is a balanced consideration of what drives value and taking that forward-looking perspective rather than saying, 'What is the cash flow that's being driven off the back of the business?"
“Eventually you have to get to monetisation if you are innovating, but it's essential to look at a broader range of models and metrics than in the past. Looking at measures like customer engagement allows them to take a much more holistic view of what is going to drive income in the business."
Amantha Imber is a psychologist and founder of innovation consultancy Inventium. She has a similar take on the topic of accounting and innovation as John Meacock.
She says for disruptive innovation, financial modelling is most helpful when teams have run experiments on the proposed idea with actual customers.
“Experimentation allows testing of actual behaviour, as opposed to intentions. It takes out the assumptions that are rife in traditional financial modelling," she says.
In her view, CFOs can play a role to encourage responsible innovation in their organisations.
“CFOs can encourage teams working on innovation to test their ideas with actual customers before seeking out large sums of money for investment. Using a lean start-up approach by setting hypotheses as to why you think your idea will add value to the customer, creating a minimum viable product – a basic version of the idea that allows for learning – and running experiments to prove or disprove your hypotheses allows for much more certainty when it comes to innovation and whether an idea is going to be successful," she adds.
There's no right or wrong approach when it comes to the tools and methods CFOs should use when valuing the potential for a business to derive revenue from a new product or service. The idea is to do as much modelling as possible given the available information and make a judgement whether to go ahead with an initiative based on that.
Key Takeaways on innovation in accounting.
- Finance chiefs can help businesses model various innovative scenarios to drive future revenue and profit
- Businesses need alternative metrics such as cost to acquire a customer to understand the potential for innovations to add value
- Lean start-up methods can allow a business to develop minimum viable products to help determine if it's possible to monetise a product or service