The Inter-Relationship between Innovation, Growth & Profitability of Germany's Online-Based SMEs

An Empirical Study


Master's Thesis, 2014

135 Pages, Grade: 1.3


Excerpt

Contents

Abstract.

1. Introduction
1.1 Research Problem
1.2 Research Questions and Objectives.
1.3 Outline of the Thesis

2. Background
2.1 The Internet as a Platform for Business
The Impacts on SMEs
Rough History and some Drawbacks
The Future: The Internet of Things.
Online Based Business and Revenue Models.
2.2 Internet Business in Germany
The Online based Company
Current Situation in Germany.
SMEs in Germany
2.3 Definitions & Dimensions of Innovation in Online based Businesses
What is Innovation?.
Drivers of Innovation
The Innovation Process
Innovation Management for Success
Innovation Types and Classifications

3. Literature Review & Hypotheses Development
3.1 Literature on Innovation Size & Innovation Profitability Relationships
3.2 Literature on Size Profitability Relationship.
3.3 Literature on Innovation Growth & Innovation Profitability Improvement Relationship
3.4 Literature on Growth Change in Profitability Relationship.
3.5 An Overview of Past Literature

4. Analytical Framework & Conceptual Model
4.1 Measurement Model
Innovation
Growth.
Profitability

5. Methodology
5.1 Mixed methods Research.
5.2 Quantitative Research through Online Survey.
Subjects and Participants
Materials and Tools
Design
Procedure
5.3 Qualitative Research
Participants.
Materials.
Design
Procedure

6. Findings
6.1 Survey Data
Graphical Representation of Collected Data
6.2 Summary of Regression Analysis.
Power and Sample Size Analysis.
6.3 Interview Findings
Expert Interviews
Short Interviews

7. Analysis and Discussion
7.1 Theoretical Conclusions
H1: Innovation Size
H2.1: Innovation Profitability
H2.2 Innovation Earnings
H3: Profitability Size
H4: Growth Innovation
H5: Change in Profitability Innovation
H6: Growth Change in Profitability.
7.2 Limitations
7.3 Recommendations for Further Study

8. Conclusion

9. Notes

10. Bibliography.

11. Appendices.
Appendix A
Appendix B
Appendix C
Appendix D
Appendix E.

Tables and Figures

Table 1 B2C Online based Business Models

Table 2 B2B Online based Business Models

Table 3 Other Emerging Online based Business Models

Table 4 Online based Business Revenue Models

Table 5 SME definition of ©IfM Bonn

Table 6 Summary of Literature Review

Table 7 Survey Questions and Corresponding Measurement Variables

Table 8 Variables in the relationships modeled and tested in this study

Table 9 Data Summary for all Relationships

Table 10 Sample Sizes and Detectable Slopes of PR INN Relationship to approximately 80% Power

Table 11 Sample Sizes and Detectable Slopes of GR PR Relationship to approximately 80% Power

Table 12 Summary of Findings

Figure 1 Economic Surplus of Internet Consumerism in Different Countries (Manyika & Roxburgh, 2011, pg 5)

Figure 2 B2C E Commerce Revenues Worldwide from 2012 with Estimates until

Figure 3 Fraction of Companies Generating Sales over the Internet in 2013 in European Countries

Figure 4 Top 10 EU Countries according to E Commerce Fraction of Total Revenues in

Figure 5 E Commerce Revenues in Germany from 1999 to 2013 and the Prognosis for

Figure 6 Main phases of the innovation process (Herzog, 2008, pg 11)

Figure 7 Cooper's stage gate process (Cooper, 2001, pg 130)

Figure 8 Firm Size and Innovative Activities in Low and High Tech Industries. (Audretsch & Acs, 1991)

Figure 9 Conceptual Model of Relationships between Innovation and Firm Performance in an Internet SME

Figure 10 Gretl Built in Function for Regression Slope CI

Figure 11 Summary results for 1000 random samples of the Monte Carlo simulation for PSS analysis

Figure 12 Plot of data for Firm Size Innovation Relationship

Figure 13 Plot of data for Profitability Innovation Relationship

Figure 14 Plot of data for Absolute Earnings Innovation Relationship

Figure 15 Plot of data for Firm Size Profitability Relationship

Figure 16 Plot of data for Innovation Growth Relationship

Figure 17 Plot of data for Innovation Change in Profitability Relationship

Figure 18 Plot of data for Change in Profitability Growth Relationship

Figure 19 Power and effect size for PR INN depending on sample size

Figure 20 Power and effect size for GR PR depending on sample size

Abstract

This research aims to understand how innovation affects and is affected by a firm’s financial performance. It focuses particularly on the Internet industry and collects both quantitative and qualitative data from online based SMEs in Germany. The results reveal that among online businesses, the size of the company in terms of revenue is positively related to the level of innovation, whereas lower profitability and smaller absolute earnings seem to encourage higher levels of innovation. Companies with higher revenues are found to earn generally lower profit margins. It was also found that companies that experienced a reduction in annual revenue have a tendency to increase innovation levels. No significant effects were found between innovation levels and change in profitability. Similarly, no significant effects were found between change in profitability and growth. Among online based SMEs, this study highlights the importance of innovation as an instrument employed by distressed companies to improve their performance. It also shows that there may be a tendency for the companies that are more profitable to focus less on innovation.

Keywords

Innovation, size, profitability, growth, performance, SME, Mittelstand, Internet business, online based business, e commerce, e business

1. Introduction

1.1 Research Problem

In a 2013 ranking of the largest Internet companies worldwide by market capitalization, it is remarkable that in an era where industries and markets are progressively migrating online, only one of the companies, United Internet is birthed in Germany1. Germany, the largest national economy in Europe, the 4th largest world economy by nominal GDP2, and 3rd largest exporter in the world3, seems to be falling behind not only in the domain of online based businesses but also in its innovation ranking, being placed a mere 13th in the Global Innovation Index4, behind other countries far less significant in economic power.

Even then, from a temporal perspective, United Internet is old compared to the average Internet company, having been founded in 1988 in Montabaur in Germany. Focusing on the younger generation of companies in the sector by analyzing the digital startups industry, it is again a disconcerting fact that only one Germany based company, Zalando, takes a spot, albeit at the lower end of the ranking, in the list of the top ten most valuable startups in 20145. In another evaluation by some of the most active investors in the sector, out of the twenty five fastest growing Internet companies in Europe that are nominated, only two are German based, one of which is again Zalando (Informilo, 2013).

The question of whether Germany’s current low innovation rating have anything to do with its inability to produce more successful online based businesses to rival its true peers such as the USA and China, can be only be answered by analyzing in depth the role of innovation in the development of an Internet company in current times. Only then, can one understand the forces behind the relatively low performing albeit growing digital industry in Germany.

Particularly interesting to this topic are small and medium sized online based companies. According to a report by McKinsey in 2011, it was found that small and medium sized enterprises (SME) and startups are the biggest beneficiaries of the widespread use of the Internet. Online, they are able to leverage on the same kind of reach and capabilities that were once only accessible by large companies (Manyika & Roxburgh, 2011). Also, without being burdened by large overheads, bureaucracy and the inertia that are characteristic of large companies, smaller firms enjoy the flexibility and agility to adapt, explore opportunities, and become more competitive in terms of value creation and innovation. These are important traits to have in a rapidly changing environment characteristic of this digitalized era.

Innovation has long been considered to be essential to the success of entrepreneurial ventures and small firms (Fiol 1996). Various research has shown that innovation stimulates a small firm’s growth (e.g., Wolff and Pett 2006; Motwani et al. 1999; Hax and Majluf 1991) and also provides a key source of competitive advantage in the absence of scale economies (Lewis et al. 2002). It is also considered as a critical factor for the long term sustainability of e commerce and e business (Hasan & Harris, 2009).

However, in the face of the intense competition faced by Internet based companies in today’s marketplace for Internet based businesses due to minimal barriers to new entrants and competitors, the first mover advantage is lost relatively quickly (Mellahi & Johnson, 2000; Liang, Czaplewski, Klein & Jiang 2009) and sustainable competitive advantage is almost impossible. Innovation faces constant challenges of imitation and erosion. It has been found that only 4 percent of all new product innovations beat the expected return on investment (Nussbaum, Berner, and Brady 2005). Another study has argued that being first to market leads rather to a long term profit disadvantage due to the high costs involved in innovation which eventually overwhelms sales gains from any pioneering advantages (Boulding & Christen, 2003).

On the other hand, a company that fails to continually invest in innovation places itself at greater risk of having products and services marginalized by technologically superior competitors (Nikolaeva, 2007; Utterback & Abernathy, 1975).

This seemingly no win situation is also elegantly described by Christensen & Raynor in their book The Innovator's Solution, "There is powerful evidence that once a company's core business has matured, the pursuit of new platforms for growth entails daunting risk. Roughly one company in ten is able to sustain the kind of growth that translates into an above average increase in shareholder returns over more than a few years."6 They explain further that the equity markets put a high valuation on the expected rate of growth of a company, effectively pressuring management to have to choose between pursuing growth and face high risks of failure, or not to pursue the kind of growth that is expected by its shareholders and lose much of its market value (Christensen & Raynor, 2003).

The decisions that a manager must face in maintaining sustainable firm growth and value are complex and seemingly contradictory in nature. The rapid changes in technology, market structure, scope and the relative short span of innovation activities in online businesses makes it fertile ground for research. There has not been a better time than now to study the role of innovation in sustaining performance in internet businesses, which are progressively redefining the economy and set to become the future of trade and commerce.

1.2 Research Questions and Objectives

Despite the rapidly growing online based market and rich interest on the topic of innovation, the extent of innovation as a factor for performance in an online based company is still poorly understood, especially in the background of other influencing factors such as company size which directly affects negotiating and lobbying power. Using quantitative and qualitative data, this research aims to improve our understanding about how a firm’s size, profitability, innovation levels, growth and financial performance interrelate, particularly in the context of online based SMEs in Germany. The following questions are fundamental to this research:

- Are larger companies more likely to invest in more innovation activities?
- Are more profitable companies more likely to invest in innovation activities?
- Do higher innovation levels influence firm performance in terms of improved growth and profitability?
- Must a fast growing company be profitable and vice versa?

This paper presents the search for the answer to these questions through the review of available literature and collection of primary data.

The study presents the long term performance that can be expected from an online based company that is actively and continuously innovating. The findings of this study have implications on strategic management decisions with regards to innovation in an online based business. Moreover, it contributes to the literature of strategic management on whether and how the main factors, size, innovation, growth and profitability are interconnected, particularly in the companies operating in a rapidly changing digital environment that is transforming the economy and the global market.

1.3 Outline of the Thesis

The remainder of the paper is organized as follows: the next section gives a basic introduction to the notion of the internet business in the context of SMEs in Germany, innovation, and the role of innovation in the internet business. Section 3 presents past literature surrounding the topic and hypotheses are derived based on the findings uncovered by previous research. Section 4 conceptualizes the effects of innovation on firm performance in the context of an internet company, leading to the development of a conceptual framework and the selected measurement models. Section 5 describes the research design and the sample. The results section highlights managerial implications, and suggestions for further research are stressed in the conclusion.

2. Background

2.1 The Internet as a Platform for Business

The Internet has provided new opportunities for a company’s value propositions that were not possible prior to the widespread use of the Internet. As web technologies develop, online based business models evolve rapidly to maximize the value creation potential characterized by four interdependent dimensions, namely, efficiency, complementarities, lock in, and novelty (Amit & Zott, 2001). Leveraging on the global, high speed network that the Internet provides, online based business models often replicate the functions of global business platforms in the real world, with innovative extensions based on the specific opportunities presented by operating in electronic space.

To demonstrate the impacts of the Internet on consumerism, a study has found that the interactive nature of the Internet and Web offers consumers increased efficiency of online shopping by improving the accessibility of product information, facilitating buyer decision making through the use of product comparison tools, reducing buyer search costs, its 24 hour availability and its accessibility through multiple locations (cf. Alba et al. 1997).. In a study conducted by McKinsey, the economic surplus is captured by consumers from the Internet as a result of the price transparency that onlinesearch tools offer, and that the online prices were on average 10% lower thantheir offline counterparts as confirmed by preliminary studies (Manyika& Roxburgh, 2011). The following figure demonstrates the economic surplus accrued by consumers in different countries from Internet use.

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Figure 1 Economic Surplus of Internet Consumerism in Different Countries (Manyika & Roxburgh, 2011, pg 5)

The Internet is now serving a significant and growing portion of the world’s population. At the IGNITION: Future of Digital conference inNew York iin 2012, it was reported that about one third of the world's population is currently connected to the web and out of these, one third earns about 85% of the world's income (Blodget, 2012). According to McKinsey, the 2 billion people that are now connected to the Internet worldwide are found to generatealmost $8 trillion in e commerce transactions, accounting for 3.4 percent of global economic output. More than half of that economic impact is linked to privateconsumption, primarily through online purchases and advertising. Almost a third is generated by private sector investments in hardware, software and communications equipment (Manyika & Roxburgh, 2011).

Along with the growing consumer audience, the Internet is also now the a main source of income to a growing number of people as it enables new lifestyles that are attractive to the younger generation of professionals who prefer much more flexibility in time and place of work than conventional. In the US, more than 16 million people now work from home with predictions of a 64% increase in the next four years (Aaron, 2014).

The Impacts on SMEs

Although the Internet has radically transformed the business dynamics spanning the entire value chain virtually all sectors and company types, McKinsey reports that SMEs and startups are the biggest beneficiaries of the change brought about by Internet technologies in business. In its survey on SMEs in 12 countries, the companies that were intensively using the Internet demonstrated growth rates that were twice as high those with minimal web presence (Manyika & Roxburgh, 2011).

Rough History and some Drawbacks

Despite the growing importance of the Internet in business and trade, the online business sector has not been without problems and controversy.

Looking back at the dotcom failure in 2000, the overvaluation of online based companies due to overoptimistic speculations where many investors were willing to overlook traditional financial metrics in favor of their confidence on technological advancement caused some companies to fail completely while others lost a large portion of their market capitalization. At the time, it was forecasted that as many as 75% of Internet companies would fail (Green, 2000).

It was found in a study that the successful companies which survived the dotcom failure of 2000 had been able to effectively control technical, operational and behavioral shortcomings and were highly advanced in logistics, customer support, Web design, promotion and Internet security (Razi, Tarn & Siddiqui, 2004). Another article reported that the reason for the failure of the online services to attract business is fear about security and online fraud. Another common mistake among many online service ventures has been the failure to define the target market (Coleman, 2001).

Despite the bleak outlook for Internet businesses in 2000, the sentiment regarding the Internet business industry had remained positive (Green, 2000). In fact, many large successful Internet corporations of today were founded in the years after the dotcom incident; for example, YouTube was founded in 2005 and Facebook in 2006. Also, it has been found that businesses and consumers are increasing their use of e commerce despite admitting to having growing concerns over online security (Goodwin, 2006).

The internet business industry may have experienced some problems in its history and drawbacks, and perhaps only a fraction of internet companies survive in the long run, but evidence shows that e commerce will continue to grow and revolutionize most industries, some more dramatically than others (Kenny, 2013).

The Future: The Internet of Things

The significance of the Internet and its impact on businesses is set to grow even further, driven by a new digital trend; a concept termed the “Internet of Things” (IoT). It refers to the interconnection of uniquely identifiable computing devices, systems, and applications in what is described as machine to machine (M2M) communications with the existing Internet infrastructure (Holler et. al.,2014).7

The estimate for the number of IoT connected devices by 2020 ranges from around 30 billion (ABI Research, 2013; Gartner, 2013) to 100 billion (Sundmaeker, et. al., 2010).

The forecast for just the B2C sector of e commerce, for example, as demonstrated in the following figure, is forecasted to increase steadily and to surpass 2 trillion US Dollars by 2016.

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Note: Numbers shown are in billion US Dollars Source: eMarketer through Statista

Figure 2 B2C E Commerce Revenues Worldwide from 2012 with Estimates until 2017

The Internet is clearly set to continue to become an important source of business.

Online Based Businessand Revenue Models

A firm’s business model is an important base for innovationand a crucial source

of value creation for the firm and its stakeholders (Amit & Zott, 2001). IIn order to develop a background understanding of the fundamental processes of online businesses and how they sustainably work, it is important todiscuss the wide variety of business and revenue models that currently exist.There are many online based business models, and more are being inventedlimited only by the human imagination as digital and web technology rapidly and radically advance. It is important to note that there is no one correct way to categorize these business models, except only by convenience in the application of the classification itself.

Categorization by Business Functions or How Users are Connected Despite the abundance of potential ways to categorize online based business models, Laudon & Traver's approach is to categorize them according to the market focus of the sector in which they are used, namely, B2C, B2B, C2C, etc. (Laudon & Traver, 2009). The following tables summarize the different types of business models according to sector, as categorized by Laudon & Traver.

B2C (business to consumer) business models

Table 1 B2C Online based Business Models

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B2B (business to business) business models

Table 2 B2B Online based Business Models

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Business models in other emerging areas of e commerce

Table 3 Other Emerging Online based Business Models

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Online based Business Revenue Models

A revenue model is the system design by which a business monetizes its services (Popp & Meyer, 2010). In other words, a firm’s revenue model describes how the firm will earn revenue, generate profits, and produce a superior return on invested capital.

Although there are many different online based revenue models that have been developed, most companies rely on one, or some combination, of the following basic revenue models for online based businesses (Laudon & Traver, 2009):

Table 4 Online based Business Revenue Models

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2.2 Internet Business in Germany

The Online based Company

An online based or Internet company (these terminologies will be used interchangeably throughout this paper) in this study refer to companies that conduct business and generate sales primarily over the Internet.

Current Situation in Germany

It is common understanding that there may be more barriers to the growth of Internet companies in Germany than for example in the US, however, many German cities such as Berlin are emerging as hubs for Internet start ups due to the availability and affordability of resources important for Internet businesses such as young professionals, expertise and real estate. (Blau, 2011).

Among the most well known internet businesses that started in Germany, Rocket Internet, which has produced an array of more than 100 aggressively growing internet businesses, are among the most controversial, known for replicating or “cloning” successful businesses and selling the businesses back to the people who originated the idea. In an industry that celebrates innovation, the Samwer brothers, the founders and owners of Rocket Internet and Germany’s first Internet millionaires, are heavily criticized for its strategy and is largely responsible for Germany’s reputation as the “copycat capital of Europe” among startups (Cowan, 2012; Winter, 2012). Despite this, they had a major impact on the entrepreneurial scene in Germany, paving the way for Internet businesses and becoming role models and inspiring many startups in Germany.

Compared to the rest of Europe, Germany is above average but not necessarily at the forefront of exploiting online based technologies in supplementing its trade and economic activities. In an article, it was reported that "Germany has more Web users than either Britain or France; it has one of the best telecommunications infrastructures in the world and is awaiting the drop in Internet toll charges that should follow the recent deregulation of its telephone industry. But industry insiders put Germany anywhere fromeight months to five years behind the United States in E commerce development" (McGrane, 1999). The figure below ranks European countries in terms of the fraction of companies involved in conducting over the Internet in 2013.

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Source: Eurostat through Statista

Figure 3 Fraction of Companies Generating Sales over the Internet in 2013 in European Counttries

The following figure also demonstrates Germany’s lag behind other European countries in terms of the fraction of total revenues that wasgenerated over the Internet in 2013.8

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Source: Eurostat through Statista

Figure 4 Top 10 EU Countries according to E Commerce Fraction of Total Revenues in2013

Nevertheless, the online based industry in Germany is shown to be growing steadily over the last decade. The following figure shows therevenues from e commerce in Germany since 1999 up to 2013 and the forecast for 2014

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Note: Numbers shown are in billion Euros

Source: Handelsverband Deutschland (HDE) through Statista

Figure 5 E Commerce Revenues in Germany from 1999 to 2013 and the Prognosis for 2014

SMEs in Germany

This research will use the SMEs definition by the Institut für Mittelstandsforschung (IfM) Bonn which is designed to include the "Mittelstand", which show typical characteristics closely resembling thoseof SMEs around the world and particularly for its significance and impact on theGerman economy. Table 5 lists the definition of SMEs according to IfM:

Table 5 SME definition of ©IfM Bonn

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(SMEs) together less than 500 less than 50 million €

(* and no small enterprise)

IfM notes “Due to the fact that Germany hosts a relatively large number of larger Mittelstand companies (in the range of 250 500 employees)which possess the typical characteristics, advantages and resource limitationsof family owned enterprises and which are thus markedly different from large (shareholder owned) corporations, IfM Bonn's definition of SMEs is broader than the European one.”9

The Mittelstand is often used to refer to small and medium sized enterprises (SMEs) in Germany and are often characteristically family enterprises (IfM Bonn). Such companies are a very important part of the country's economy (Günterberg 2004, p.5; Durchslag, 2007; Radow & Kirchfeld, 2010; Holz, 2013; Kajeepeta, 2011). According to IfM, in 2011, there are approximately 3.65 million German enterprises classified as SMEs which are reported to have generated 35.9% of the total turnover of German enterprises, make up 18.2% of the total German export turnover and had a share of almost 55% in total net value added in Germany in 2011. German SMEs were also responsible for approximately 59,4% of total employment in Germany.

Economic and business writers have recognized the Mittelstand’s responsibility for Germany's economic growth since the beginning of the 20th century and its contribution to the resilience of the German economy. Many of the Mittelstand companies existing today have survived through even in harshest economic conditions such as war and economic crises (Girotra & Netessine, 2013; Radow & Kirchfeld, 2010) and they usually emerge stronger (Simon, 2009, pg13).10 It is reported that Mittelstand companies had saved 500,000 jobs during the recession of 2009 leveraging on a federal employment plan called “Kuzarbeit”. (Kajeepeta, 2011)

The historically demonstrated success, resilience and regional impact of the German Mittelstand make it a compelling subject for management research.

2.3 Definitions & Dimensions of Innovation in Online based Businesses

What is Innovation?

Innovation is defined as the application of better solutions that meet new or existing market needs, or in other words, finding a new way of doing something.

(Drucker, 1985, 1998; Maranville, 1992; Cetindamar et al., 2009). It is an act that combines creativity, risk taking and entrepreneurship (Gartner, 1988; Larson, 2000; Stevenson et al., 1989). Quoted as "the practical refinement and development of an original invention to a usable technique or product", Maital & Seshadri in their book on innovation management, claim that innovation is successful “when an invention, related to a product, service or process in some part of the organization's value chain, is joined with a business design, which in turn is implemented with discipline and skill through innovation management" (Maital & Seshadri, 2007, 29). Indeed, it is argued that innovation is not just an invention, but instead, an invention that is commercially exploited (Herzog & Leker, 2010, 9; Chesbrough, & Rosenbloom, 2002). In other words,

Innovation = Invention + Commercial Exploitation (Herzog & Leker, 2010, pg 9)

Drivers of Innovation

It is well known and accepted in theory and corporate practice that innovation is crucial for the long term survival and growth of the firm. Sustained competitive advantage necessarily requires sustained innovation (Maital & Seshadri, 2007, 29 30). However, research has shown that first mover advantages are quickly lost (Mellahi & Johnson, 2000; Liang, Czaplewski, Klein & Jiang 2009), and that the innovative company must continuously and constantly evolve and improve to survive in its ever changing market in the long run (Nikolaeva, 2007).

Innovation is also encouraged through regulations and policy measures. It has been said that “virtually all of the economic growth that has occurred since the eighteenth century is ultimately attributable to innovation" (Baumol, 2002) and that “cost reduction is a type of innovation that can have remarkable impact on humanity" (Maital & Seshadri, 2007, 29). In many countries, the economic importance of innovative activities has brought about policies designed to encourage and nurture innovation at both regional and national levels. The UK Office of Science and Innovation recognizes that innovation is "the motor of the modern economy, turning ideas and knowledge into products and services".

Australian government website states that companies that do not invest in innovation “are unlikely to be able to compete if they do not seek innovative solutions to emerging problems." According to Statistics Canada, the successful SMEs are those that are able to gain market share and increasing profitability through innovation.

Entrepreneurship is also a driver for innovation and purchasing power iis driver for the innovating entrepreneur (Drucker, 2007). Entrepreneurs innovate to create a product of economic value out of resources of littleor no value in themselves (Drucker, 2007). It is often said that revolutionary breakthroughs are often found by small firms, whereas larger firms are usuallyresponsible for cumulative incremental improvements. This is demonstrated by the fact that in a fully grown existing enterprise, the entrepreneurs have "completed their job and left for other places where their firm creation activities canbe used" (Baumol, 2002). Larger firms often only to make repetitious managerial decisions and that even the founder will have transformed from entrepreneurto manager (Baumol, 2002).

The Innovation Process

While various models and theories have been developed regarding the process of innovation, the entire innovation process can generally be described in three main phases as shown in Figure 6 below:

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Figure 6 Main phases of the innovation process (Herzog, 2008, pg 11)

The first phase or the front end is aimed at generating, assessing and selecting new ideas. In the second phase, selected ideas are designed, developed, tested and refined. The final stage is the widespread commercial distribution of the development output.

A more developed conceptualization of the innovation process that has gained popular attention by academics and practitioners is the “Stage gate Process” model by Cooper. In this model, the innovation process is broken down into a series of stages or activities each ending with a “gate” or decision point where the path forward to the next stage is decided upon.

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Figure 7 Cooper's stage gate process (Cooper, 2001, pg 130)

Innovation Management for Success

Maital & Seshadri define innovation management as the “process of creating and implementing a business design surrounding a creative idea, with the goal of transforming an invention into an innovation, and ultimately to achieving sustained competitive advantage, leading to growth and profit, in the marketplace." (Maital & Seshadri, 2007, 29)

There exist a great amount of literature and theories regarding innovation management which varies greatly depending on industry, organization type, and management objectives. Several management approaches,such as the Lean Startup, open innovation and Agile, have been developed with the belief that management of new product development activities can increase the predictability of results and therefore, improve the chancesof success.

However, there have been conflicting arguments11 which suggest that one cannot predict the success of new growth businesses and that it is only through repeated attempts that successful new businesses will randomly emerge (Christensen & Raynor, pg 8). The risk management structure of the venture capital industry where each portfolio’s turnover depends on the success of only two out of every ten investments made can be used to demonstrate the risks and how difficult it is to predict the success of new businesses (Christensen & Raynor, pg 8).12

Yet others accept that the success of innovation lies in balancing the certainty (through analytics) and a tolerance for uncertainty which is imperative for true innovation. In the book "Innovation: The Missing Dimension", it is explained that interpretive management styles cultivates creativity and inspiration in the form of open ended conversations among people from different professional and organizational backgrounds with the aim to broaden the range of alternatives from which business choices are made (Lester & Piore, 2006). On the other hand, the analytical management style contributes to the strategy and controls the progress of innovative activities, thereby adding certainty to the process (Lester & Piore, 2006). Therefore, to maximize chances of success in managing innovation, it is critical to balance interpretive management skills with analytical management skills (Lester & Piore, 2006).

Despite this ongoing debate on the predictability of innovation outcomes and various management approaches, it is generally agreed that strong managerial support and resource commitment remain key success factors for innovation (Fujita 1997).

Innovation Types and Classifications

Dualities in Innovation Types

There are many terms that have been used to describe the widespread recognition of innovation types based on impact size. As with most qualitative classifications, innovations are generally described as being one of two extremes, either small impact or large impact. Some popular terms that are used to describe this duality are “radical and incremental”, “exploration and exploitation”, and “disruptive and sustaining”. Despite the differences in terminology, they are mostly the same in meaning and usually apply to the same models.

Exploration is focused on the future with the aim to discover new fields of knowledge and technologies, whereas exploitation of resources is more focused on the short term results of improving existing technology (Herzog, 2008, pg 13).

Radical innovation uses exploration competencies to develop new businesses or product lines. It is based on new ideas, technologies or implicates substantial cost reductions. It usually transforms the economics of a business. On the other hand, incremental innovation employs exploitation competencies to generate improvements in existing products, services or processes (Leifer, 2000).

In the book, The Innovator's Dilemma, two distinct categories were identified sustaining and disruptive. Disruptive innovation is described to be a simpler, more convenient product that sells for less money and appeals to a new or unattractive customer set is commercialized. It has been found in the study that entrants frequently defeat the incumbents, usually large successful companies, with disruptive innovation thereby disrupting them (Christensen & Raynor, 2003, 31 32). Sustaining innovation refers to making improved products that can be sold for more money to attractive customers. It was found that incumbents are likely to be more successful in reinforce their dominance with sustaining innovation (Christensen & Raynor, 2003).

Product/Process Innovation

At the firm level, innovation has conventionally been classified into product/service and process innovation. Product/service innovation refers to changes in the products/services offered to the customers or clients to meet new requirements and needs, and process innovation refers to changes introduced into an organization's operations to produce a product or render a service (Utterback and Abernathy, 1975; Damanpour and Gopalakrishnan, 2001).

Product innovations are primarily market focused in order to strategically differentiate a firm’s product offerings through new products and product improvements. Product innovations provide firms the opportunity for market leadership and sales growth (Utterback and Abernathy 1975; Romano 1990; Iansiti 1995; Zahra and Nielsen 2002; Wolff & Pett, 2006).

Process innovation is often internally focused (Utterback and Abernathy 1975) and encompasses both technological and organizational dimensions (Edquist et al., 2001) to improve operational efficiencies (Mansfield 1979) leading to cost reductions, improvements in quality, shorter cycle times, greater convenience, and higher value to customer (Simon, 2009, 159 163). Process innovation is known to be often underexploited (Maital & Seshadri, 2007, 72) and is claimed to be more important than product innovations in some companies (Simon, 2009, 159 163).

3. Literature Review & Hypotheses Development

Research on the topic of innovation and firm performance are vast, varied, and mostly inconclusive. This section summarizes some of the more compelling literature as the foundation for the hypotheses formulated for this study.

3.1 Literature on Innovation Size & Innovation Profitability Relationships

In a study conducted by Audretsch and Acs (1991), it was found that in a sample of innovative firms, the number of innovations tend to increase with firm size in terms of sales, although in different curves between high tech and low tech industries. See Figure 8 below:

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Figure 8 Firm Size and Innovative Activities in Low and High Tech Industries. (Audretsch & Acs, 1991)

In another study conducted on Australian firms to investigate the determinants of innovation, Rogers (2004), at the beginning of his study hypothesized that firm size influences in the level of innovative activity by stating the following compelling reasons:

“- Large firms have stronger cash flows to fund innovation. Equally, larger firms may have higher assets to use as collateral for loans. In each of these cases the assumption is that external capital markets may be unwilliing to finance innovation (due to high level of risk or inability to understand technical details).
- A larger volume of sales implies that the fixed costs of innovation can be spread over a larger sales base.
- Large firms may have access to a wider range of knowledge and human capital skills than small firms, allowing higher rates of innovation."

Unfortunately, the study was not able to detect any consistent firm size innovation relationship (Rogers, 2004).

Regardless, based on the findings of Audretsch and Acs (1991) and the initial argument of Rogers’ hypothesis (2004) above, it is reasonable to develop the following hypothesis for this study:

H1: Innovation is significantly determined by firm size in terms of sales revenue.

In a study conducted by Audretsch in 1995 on a sample of small firms collected from the U.S. Small Business Administration Data Base and the Business Week Survey, it was concluded that "the availability of funds, as indicated by company profitability, is more conducive to subsequent innovative activity in firms in a high technological opportunity environment than those in a low technological opportunity environment." (Audretsch, 1995)

However, Rogers (2004) confirmed no significant role for past profitability in association with innovation. Additionally, in another study that examines the relationship between innovation capability and firm profitability through a web based survey in Finnish SMEs, it was found that there is only a minor effect of the determinants of innovation capability on firm profitability (Saunila, Ukko, & Rantanen, 2014).

Although doubtful views exist on the matter, with regards to Audretsch’s research conclusion, higher profitability in an online based business (considered as a part of high technological opportunity environment) should stimulate higher innovation levels. Therefore,

H2.1: Innovation is significantly determined by firm profitability.

Note here that profitability is a ratio of returns to the size of revenues. Size of revenues in this study represents the size of the firm. It can be postulated that to have the strong cash flows that is required to fund innovation, the company must not only be large, but also to have absolute earnings that are large enough to invest in its growth value through innovation. By taking the absolute size of earnings as a determinant, it stands not just for size or profitability alone. Instead it ties both factors together, creating an entirely different perspective on the drivers for innovation in a firm. Therefore, it is interesting to study the effect of absolute earnings on innovation levels. Thus, the following hypothesis is defined:

H2.2: Innovation is significantly determined by firm size in terms of absolute earnings.

3.2 Literature on Size Profitability Relationship

Using market share as a proxy for size, one study which conducted a meta analysis on 276 market share profitability findings from forty eight studies, it was found that on average, market share has a positive effect on business profitability. (Szymanski, et. al., 1993) Current news headlines however, provide a contrasting observation. Prominent internet businesses such as Zalando and Amazon, demonstrate rapid growth but have yet to turn profits even after many years in operation (Auer, 2014; Shanley, 2013; Maier, 2013). In these cases, the firms seem to have chosen the unconventional strategy of focusing on extraordinary high growth in a short amount of time while continuing to make losses annually. In fact, any company listed in the database of the Bundesanzeige (The Federal Gazette of Germany) that earns even 1€ in annual profit, using this measure for firm performance, can be said to be more successful than Zalando or Amazon. However, Zalando and Amazon are currently well in operation, sustaining high prominence, valuation, and growth, and end up becoming much more powerful than small conservative companies that are turning profits, but experience much slower growth. With size comes negotiating and lobbying power, with which Zalando reportedly gained an alleged 35 million Euros in subsidies since 2010 (Hielscher, 2014). The main question of interest here is whether it is more effective to retain competitive advantage for online based businesses through sheer size rather than continuously innovating. The large size low profitability tradeoff strategy and whether this is the trend followed by many if not most internet businesses present interesting grounds for study.

Although the industry provides contrasting observations compared to findings of previous research, it is more compelling that:

H3: Profitability is significantly determined by firm size.

3.3 Literature on Innovation Growth & Innovation Profitability Improvement Relationship

Research has shown that innovation stimulates a firm’s growth (e.g., Wolff and Pett 2006; Motwani et al. 1999; Hax and Majluf 1991) as it provides a key source of competitive advantage in the absence of scale economies (Lewis et al. 2002) and therefore, considered as a critical factor for the long term sustainability of e commerce and e business (Hasan & Harris, 2009). In fact, based on numerous case studies and interviews in a study on German SMEs, internationalization and innovation are found to be the primary drivers of growth. (Simon, 2009, 42)

In the case of manufacturing companies, in a study conducted on 600 durable goods firms in 20 countries, R&D intensity was shown to be significantly associated with improvements in market share. In other words, innovation seems to be the driver for firm growth in manufacturing companies regardless of industry and geographical location in this study. (Ettlie, 1998)

In a study on Spanish service industry SMEs using intangible assets (taken to involve goodwill, patents, and other forms of capitalized R&D costs) as proxy for innovation levels, Carmona, Momparler & Gieure (2012) have found that innovative firms generally show higher growth ratios, better economic and better financial performance than non innovative companies. Their research has also indicated however, that the profitability is similar for both innovative and non innovative companies involved in the study, in other words, it is not apparent that profitability improves for the innovative firms as compared to non innovative firms in the study sample.

Consistently, Koellinger (2008), conducted an empirical study on the relationship between the usage of Internet based technologies, different types of innovation, and performance at the firm level, based on a sample of 7302 European enterprises. It was found that innovation is positively associated with turnover and employment growth. However, it was found that innovative activity is not necessarily associated with higher profitability. To be more precise, only product/service innovations are shown to be positively associated with profitability. Process innovations did not demonstrate a significant relationship with profits in this study (Koellinger, 2008).

However, according to Santarelli & Lotti (2008) in their case study concerning the biotechnology industry in Italy, there is some indication of a statistically significant relationship between innovation (measured by patents filed at the European Patent Office (EPO)) and both productivity and profitability improvements. It is also found that new products and product improvement efforts help SMEs generate new customers and enter new markets (Wolff & Pett, 2006).

Additionally, in a study conducted in 1995 on a sample of small firms collected from the U.S. Small Business Administration Database and Business Week Survey, it was concluded that "the availability of funds, as indicated by company profitability, is more conducive to subsequent innovative activity in firms in a high technological opportunity environment than those in a low technological opportunity environment” (Audretsch, 1995). It was also found that “high growth promotes subsequent innovation more in low than in high technological opportunity environments" (Audretsch, 1995).

Based on the inferences on the relationship between innovation and firm growth, past research have generally supported that:

H4: Growth is significantly determined by innovation.

Studies have been inconclusive or have shown contrasting results with regards to the relationship between innovation and change in profitability as shown in the literature presented above. Innovation in the company may affect long term profitability, however, incurs short term reduction in a company's overall profitability due to the investments that it must make to realize these innovations. In order to test this relationship, for the purposes of this study, the following hypothesis is defined:

H5: Change in profitability is significantly determined by innovation.

3.4 Literature on Growth Change in Profitability Relationship

Conceptually, it is reasonable to assume that a company would only have the capacity to grow if its business model was a profitable one to start with. It is largely consistent with the Darwinist theory of "survival of the fittest" in that only those that are most adapted to the environment could survive in a capitalist market. Giant century old corporations could only come to exist by its ability to continuously fulfill existing market needs at a profit. With the condition that the demand exists, the reinvestment of returns or profits to expand and capture the economies of scale can further increase profit margins and therefore create entry barriers to the market. One might assume therefore, that a firm's profitability determines its ability to sustain long term growth. However, previous studies have presented sharply contrasting facts.

One study which tests whether high growth is correlated to firm profitability using data from three separate time periods of 500 firms (from 1992 to 1996; 1993 to 1997; and 1994 to 1998), high growth rates in terms of sales and number of employees was found to be unrelated to profitability (Markman & Gartner, 2002).

Another issue is the fact that growth and change in profitability can be affected by strategic activities other than innovation, such as internationalization activities through exports and foreign direct investment (FDI). Indeed, in a study conducted on a sample of Japanese SMEs found that at the initial stages of FDI, SMEs are found to experience reduced profits but increased growth. On the other hand, through accumulated knowledge and developed capabilities, the firm eventually realizes long term benefits in terms of profitability from the intrinsic value associated with internationalization of the firm (Lu & Beamish, 2006).

[...]

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Details

Title
The Inter-Relationship between Innovation, Growth & Profitability of Germany's Online-Based SMEs
Subtitle
An Empirical Study
College
Berlin School of Economics and Law  (Institute of Management Berlin)
Course
MBA Transatlantic Management - Innovation
Grade
1.3
Author
Year
2014
Pages
135
Catalog Number
V284157
ISBN (eBook)
9783656840305
ISBN (Book)
9783656840312
File size
2405 KB
Language
English
Tags
Innovation, size, profitability, growth, performance, SME, Mittelstand, Internet business, online-based business, e-commerce, e-business
Quote paper
Yi Ling Wong (Author), 2014, The Inter-Relationship between Innovation, Growth & Profitability of Germany's Online-Based SMEs, Munich, GRIN Verlag, https://www.grin.com/document/284157

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