6-09 New and Improved Products
In a capitalist economy, innovation is necessary to survive. A company cannot survive by offering the same products produced the same way forever because some other company will find a way to make a better product, produce it cheaper, or both. This means that for a company to be profitable in the long-run, “New and Improved” products are key.
Two Types of Innovation
As an investor, the two types of innovation you are most concerned with is Process Innovation, and Product Innovation.
Process Innovation
“Process Innovation” is when a company improves their internal efficiency, allowing them to produce the same (or similar) products for cheaper. This is important because it allows the company to reduce its price (and steal customers from the competition), increase its profit margins (because now it costs them less to produce the same thing), or both.
Think of a mining company that produces iron ore. A thousand years ago, it would be a small army of workers with pickaxes chipping away at rock faces and carrying 5 pounds ore back to an ox cart back to a smelter a few miles away. Today, a single person can operate a giant machine that carves out tons of ore a minute out of a mine, dumping it into waiting trucks that can take it to ships ready to sail anywhere in the world – the cost of getting a bar of iron has gone down to practically nothing from what it used to be, and miners are making a bigger profit for it!
Product Innovation
“Product Innovation” is when a company releases a new or improved product for sale. When companies release improved products, their goal is generally to keep customer loyalty by staying one step ahead of the competition (and perhaps convince some new customers to switch by showing they are better than everyone else on the market).
New products are direct attempts to generate more revenue, either by up-selling current customers to buy the new product, or by seeking new customers entirely by producing something that does not yet exist, but customers probably want. Improving an existing product is usually cheaper for research and development than producing something totally new, but the rewards for a game-changing new product can make it worth the investment.
Innovation in Action
To see clear examples of a company utilizing both at the same time, think of McDonalds. McDonalds gets a ton of revenue each year by selling Big Macs, Fries, Chicken Nuggets, and its breakfast sandwiches. Attempting “Product Innovation” with these key sellers could turn off loyal customers, so instead they need to find ways to offer these products at lower cost in order to increase their profits. Instead, they looked towards “Process Innovation” – one of the biggest costs they have in selling these products is labor.
McDonalds Process Innovation
To innovate their processes, McDonalds began installing automated ordering kiosks in their stores, and a mobile app where people can order and pay right from their phones. This meant that they no longer need to have as many cashiers taking orders and processing payments from a line of customers – they can put more people in the back room making food and taking it straight to customers, lowering the total cost.
McDonalds Product Innovation
At the same time, McDonalds has been losing customers due to being perceived as unhealthy and over-processed. While they do not want to modify their “Flagship” food, the rest of their menu is getting a constant update to attract more customers.
Some of these, like the McSpagetti and McPizza, were flops and were discontinued (although you can still get your hands on both at a single location in Orlando, if you want a slice of McDonalds history). Other attempts have been far more successful – the McCafe concept, selling fancier coffees and pastries in addition to their regular coffee and breakfast sandwiches, has proven to be a winner.
What does this mean to investors?
As an investor, you want to find companies set to be profitable in the long-term, which means companies that are able and willing to innovate. This is generally announced prominently with the company’s press releases and investor calls, but for bigger brand names with new product announcements, this is often the focus of business news headlines.
As an investor, you are keeping a watch for two things:
- Is this company sufficiently investing in innovation compared to other companies in their industry?
- And using your judgement, do you think this innovation is in the right direction, or likely to produce a complete flop?
Both of these are judgement calls, but should be near the top of your mind when making a buy or sell decision.