Innovation Accounting: A Game-Changing New Tool for Lean Startups

What is innovation accounting? It’s a systematic set of principles and key performance indicators (KPIs) established to analyze and present data about an organization’s innovation effort.

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To build profitable innovation ecosystems, companies must not exclusively look at traditional accounting methods. Neither should they base their decision-making on intuition. Remember that you need fact-based innovation accounting metrics to make informed investment decisions, especially for startups. This will enable you to manage innovation and measure its impact even without or lacking base data. 

The innovation metrics must reflect the whole innovation process. Rather than solely focusing on the financial outcome. That’s why organizations must have an Innovation accounting system.

One that’s designed to complement the weak points of a financial accounting system. You can do this by merging an innovation thesis and strategic goals. As well as the need to develop a balanced portfolio.

How Innovation Accounting is a Game-Changing Tool for Lean Startup

Startups assess their success by developing a milestone and interacting with clients. This enables them to gauge whether their overall numbers have increased. But that’s a fallacious method of measuring progress.

That’s because there’s no way of telling if the changes in number correspond with the changes you’ve made. And this is where lean startup tools come in: to effectively measure results. It targets leading indicators. It also gives managers a way of linking long-term growth to a system that follows clear progress.

There are three levels of innovation accounting. With each one of them getting more advanced as startups evolve. We discuss them below.

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Level 1: Client-Focused Dashboards

A lot of company innovation teams begin with market forecasts and then work backward. But with lean startup, identifying and testing specific presumptions is more effective. This grouped-up approach enables companies to build new businesses.

It’s recommended that teams begin by creating simple dashboards with a few metrics. The metrics must be actionable and measurable to help the teams to get going.

The objective of level 1 innovation accounting is to create a measurable cadence. This is where real live clients “flow through the experiment factory.”

Level 1 dashboards first focus on what matters when validating a business opportunity. This is done by measuring clients’ input along the way. It’s better compared to just developing a product and unveiling it with a “ta-da” at a big launch event. 

Level 2: Leap of Faith Assumptions

This level begins when a team identifies its leap of faith assumptions (LOFA). LOFA is basically the most foundational assumption that underlies a business opportunity. The objective here is to test and validate or invalidate leap of faith assumptions. 

This gets done through rapid learning activities such as A/B tests. Where a comparison is made between two versions of a product. This is aimed at figuring out which one performs better.

Level 2 innovation accounting is about creating dashboards. These dashboards help with the tracking and measurement of leap of faith assumptions. The metrics that go into the level 2 leap of assumptions dashboards are called input metrics. That’s because they represent important inputs that make a successful business plan.

The dashboards must be simple. But detailed enough to be regarded as powerful by the finance department. It’s recommended that you focus on two categories of innovation in accounting metrics for these dashboards:

• Growth hypothesis
• Value hypotheses metrics

The value hypothesis metrics track and measure certain client behavior. One that indicates the clients’ delight with the product. Such client-behavior includes:

• Retention rates
• Rates of referral
• Repeat rates of buying

Growth hypothesis metrics also track and measure certain client behavior. Only that this focuses on the behavior that will cause the company to acquire more clients. Growth hypothesis metrics focus on what is called the law of sustainable growth. Where you acquire new clients based on the actions of existing clients. Such actions include: 

• Word of mouth referrals
• Capacity to recruit clients as a side effect of normal usage
• Potential to take revenue from one client and invest in the acquisition of a new client

The objective here is to determine what needs to be done to achieve a measurable threshold. Where every variable grows sustainably on its own. The achievement of these thresholds is proof that the product-market fit has also been achieved. Additionally, it proves that the business is ready to scale.

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Level 3: The Net Present Value Dashboards

This level of innovation accounting is the holy grail of valuing business opportunities. The reason is that the approach focuses on quantifying future success. The most traditional NPV models depend on pro-forma forecasts. The pro forma forecasts are based upon a wide range of assumptions around.

• The market size
• The market share
• The cost of goods sold

The dashboards in this level aggregate certain metrics. These metrics are meant to represent crucial drivers of the long-term business models. The metrics in this level can include the same ones as those found in level 2 of innovation accounting. 

The variance in level 3 accounting is that everything rolls up into a real-time view of the financials of the company. The good news is that most companies know how net present value works.

Level 3 dashboards are organized in the same manner. But, there’s a subtle, yet crucial difference between traditional NVP evaluation and the ones in innovation accounting. The NVP dashboards focus on the leading indicators of the success of a business. As well as the real-time data that outlines the venture’s progress. 

An instance is where a new venture goes to market using a freemium business model like dropbox. A set of client-focused metrics can be applied to measure progress. These metrics include: 

• The number of visitors
• The money paid by product users
• The percentage of visitors signing up for free accounts

But if a new venture is developing a marketplace business model like Airbnb, a different set of metrics will be required. These metrics are: 

• The number of transactions
• The revenue per transaction
• The number of product listings
• The number of product buyers and sellers

A lot of corporate ventures and startups update their forecasts and plans periodically. They make use of spreadsheets and powerpoints to pitch their businesses, not to run them. As for NVP dashboards, they allow teams to run and re-run a full business case in real-time. 

Since clients' experiments and A/B tests result in new data, the dashboards give teams the ability to see the implications of the business model. From an innovation portfolio to a management view. NPV dashboards permit investors to do an apples-to-apples comparison.  This gets done between two or more ventures. Including those focused on different markets.

Conclusion

Innovation in accounting is one of the important principles of lean startup. It addresses the fact that startups don’t have real data history. And neither do they have market traction. Innovation accounting is about getting the important metrics that can allow you to track and measure what matters.