R&D has long been perceived as the holy grail of the pharmaceuticals, diagnostics, and medical devices industries, and rightly so. While improvements in processes such as distribution and customer service can create incremental value for companies, it is the "quantum leap" innovations in products and technologies that yield the huge growth and profitability improvements demanded by shareholders. And while many factors are necessary for success, the companies who best manage their innovation process tend to enjoy differential returns: Pfizer, who has invested heavily in innovation and is renowned to have one of the strongest R&D pipelines in the industry, outperformed the Dow Jones pharmaceuticals index by 48% over the period 1991 to 1997, even before the introduction of Viagra.

But the hurdle is rising for companies seeking to develop new products. Despite the adoption of new techniques like combinatorial chemistry and high through-put screening that have greatly improved the productivity of drug discovery, the average R&D investment required to bring a new drug to market has more than doubled in the past decade, rising from $230MM to $500MM or more. In the medical devices industry, the cost to develop just one product can exceed $100MM. Furthermore, R&D investments are still extremely risky, with only 2-7% of all pharmaceutical innovation projects ever making it to market.

A number of factors are to blame for these spiraling innovation costs. First, the "low hanging fruit" of the health care industry has in many cases been harvested. Advances in treatment and technology have brought under control many of the better understood diseases and conditions, and companies are now focusing on indications that are increasingly complex, some of them targeting even narrower patient populations.

Second, pharmaceutical companies now face even more stringent regulatory requirements for clinical studies and approval of drugs applying novel technologies.

Third, the rise of managed care approaches, combined with the availability of more products for the same indication, has led to heightened emphasis on the economics of new drugs and products, especially in the United States. Regulators and payers alike now assess not only a product's performance, but its impact on overall system costs. Often, significant total therapy cost improvements are required for the product to gain market acceptance, thus creating increased challenges for the R&D organization. This trend is likely to intensify in coming years as managed care gains favor around the globe.

In the midst of these fundamental changes, however, a few companies manage to wring exceptional returns from their innovation dollars, and produce "blockbuster" drugs and products that lead them to market dominance. What distinguishes these companies?

Our experience working with the leaders in the global health care industry has convinced us that being a world-class innovator requires not just great scientists and research facilities. It requires a great process for managing the generation, development, and in some cases, acquisition of ideas. This process must provide a systematic method for evaluating, prioritizing, and investing in the best research projects, and then driving these projects through the development stage to generate profitable products. Critical to the success of this innovation process is a direct link to the corporate and/or business unit strategy of the company. 1

Innovation as Strategy: The Importance of Process

Corporate strategy, innovation strategy, and R&D need to be explicitly connected, and in the best-run organizations they are indeed tightly linked. The enormous sums invested in R&D, the lengthy time- to-market for pharmaceutical, medical devices and diagnostics products, and the high risk of development failure make it critical that innovation strategy, resource allocation, and ultimately, the activities of the R&D department are carried out with the broader corporate strategy in mind.

To illustrate, consider some of the questions managers face as they fashion an effective innovation strategy:

• What are the key medical and pharmacoeconomic challenges of the future?
• In which therapeutic areas does the company hold the greatest pockets of knowledge, competence, and resources, and how can they be leveraged?
• Which clinical indications/physiological pathways and market segments should the company target?
• How do customers define therapeutic/medical value, and what are the key levers and associated profit economics by which we can create a compelling value proposition for them?
• What data should the company generate during development to prove the value proposition?
• What revenue and profit targets need to be achieved?
• What resources are available for reinvestment?

A sound strategy, devised at the highest levels of the organization, will take all of these factors into consideration. Yet the activities that turn strategy into results occur further down in the organization, and when the link between corporate strategy and innovation strategy breaks down, the results are predictable: R&D teams drift into projects that aren't leveraged, while exceptional capabilities within the organization are under-utilized; products are generated that offer no advantages relative to those of competitors, or worse, aren't viewed by customers as providing significant value; key decision-makers lack a clear definition of desirable outcomes, and so misallocate scarce resources. When the link is clearly established, however, the results can be dramatic: an R&D organization leveraging its core competencies to bring to market products that

represent fundamental pharmacoeconomic or medical improvements over existing offerings,

are valued by key customer groups, and

improve the overall strategic positioning of the company.

When all these gears are turning together, the result is higher profits and higher share prices. Profits can then be funneled back into innovation, perpetuating a "virtuous cycle" of value creation. What follows is a framework for systematically managing the assessment, prioritization, and development of research projects. While it is understood that the innovation process must remain linked to a company's overall strategy, this paper focuses only on managing the innovation process, and does not directly discuss the steps needed to develop a long-term corporate strategy.

Managing the Innovation Process

The goal of the innovation framework presented here is to create a structured approach to the innovation process, ensuring that the most promising research projects are invested in and eventually brought to market, and that the innovation strategy is carried out in concert with the broader corporate strategy.

To illustrate, let's use a hypothetical example. Assume that a pharmaceutical company - we'll call it PharmCo - has decided after a strategic review to bolster their presence in cardiology. To do this they are seeking to develop drugs to combat a variety of indications, including, for the sake of argument, hypertension. Working together in an iterative process, the marketing, sales, and R&D departments have established a set of revenue and profit targets and timelines. Now the organization must deliver.

Based on an understanding of the underlying pathology and the regulation of blood pressure, scientists have identified "biological mechanisms" to regulate either cardiac output or peripheral vascular resistance. For decades, drugs such as diuretics or b-Adrenergic antagonists (commonly known as b-Blockers) have been on the market to treat hypertension. Other drugs such as Renin inhibitors that target different sites or work via alternative pharmacological mechanisms are still in clinical development.

Questions surround these different mechanisms: Which will provide the most efficacious treatment for hypertension? What will be the pharmacoeconomic impact of each possible drug? And will any of them fulfill the strategic objectives - such as revenue and profit targets and competitive positioning - that have been laid out for the company?

In the midst of these unknowns, PharmCo must decide upon an innovation strategy. The framework that allows us to prioritize the allocation of our innovation investments is as follows (Figure 1):

Step I: Identify and develop innovation options

Step II: Assess internal capabilities

Step III: Value and prioritize innovation options

Step IV: Implement and manage the innovation strategy

This is a straight-forward approach. Its power derives not from any new analytic tool or valuation technique, but from its insistence that the decision-maker consider innovation investment systematically, in a way that coordinates with the overall strategic direction of the company.

Step I: Identify and Develop Innovation Options

A pharmaceutical "innovation option" is a possible investment in one or a set of treatment mechanisms that together represent a distinct strategy for developing a product to treat a stated indication. In medical devices and diagnostics, an innovation option consists of one or a combination of product prototypes or technologies. To better illustrate both what constitutes an innovation option and to demonstrate how these options fit into the broader context of our framework, let's continue with our PharmCo example.

As mentioned before, a strategic review has established cardiology, and in particular hypertension, as key areas of focus for PharmCo. Revenue and earnings growth targets have been set, and a budget has been allocated for the generation and development of new products. But there are numerous mechanisms for developing a drug to treat hypertension. Which are viable, and how should PharmCo allocate their scarce R&D resources?

We begin by assembling a robust fact-base consisting of three primary elements:

a science and technology review,

a market overview and customer value proposition analysis, and

a competitive analysis.

Once we have assembled our fact base we can develop the different innovation options available to us.

I.1 Science and Technology Review

By surveying our internal scientific knowledge-base and R&D department, talking to outside experts (academics, independent scientists, even competitors), reviewing contemporary literature, and utilizing emerging sources of information (such as Genome projects), we can develop an understanding of all the known mechanisms for fighting hypertension. We must also investigate any drugs that are either on the market or in development, seeking to understand their pharmacological mode of action, stage of development, likelihood of development success, projected time to market, patent status, and availability for licensing. Technologies for generating and screening molecular leads should also be investigated, with the goal of identifying the technology owner, patent status, and availability for licensing if the technology is not available in house.

Output: A list and basic understanding of all possible mechanisms that are available to us for fighting hypertension. A list of technologies that could assist in the identification, testing, and production of different possible molecules (drug candidates).

I.2 Market Overview and Customer Value Proposition Analysis

We have two goals as we conduct the market and customer overview: to refine our estimates of the potential revenues and profits available to us from each of the mechanisms under research, and to clearly identify the key levers necessary to create a superior value proposition for hypertension treatment.

First, we already have an idea from our prior strategic review of the broad demographics and market potential of a new hypertension drug. But the market potential of a drug could differ based on the mechanism from which it derives. For instance, there may be segments of the hypertension population for which a drug based on Renin Inhibition wouldn't be appropriate due to possible drug-drug interactions or dose-limiting side-effects. If this is the case, the potential market size for Renin inhibitors would differ from that of hypertension products utilizing other treatment mechanisms.

Secondly, we must identify the key criteria that will allow us to develop a product with a value proposition superior to anything currently offered or under development by competitors. In order to create a "breakthrough" product, there must be a fundamental improvement over the existing value proposition (e.g., in improved pharmacoeconomics or via causal rather than symptomatic treatment). The degree of the improvement over current offerings will drive the speed and size of market adoption.

For instance, before Viagra, sufferers of impotence had effective but physically uncomfortable therapeutic options available to them. Viagra is efficacious, but more importantly, it represents a huge quality-of-life improvement over existing therapies. The result has been an extremely fast adoption rate, and a blockbuster product for Pfizer.

The key value proposition criteria as judged by customers will, of course, differ based on the indication being treated, the therapeutic alternatives available to physicians/patients, and the offerings of competitors. Customer groups must be segmented to identify the value they would place on improvements along each of the five criteria for evaluating pharmaceutical products: drug safety, drug efficacy, outcomes, cost effectiveness, and patient quality of life. Once the key customer levers have been identified, each drug candidate should be re-visited to see which might offer improvement on the most important of these key criteria.

The key value proposition criteria will also differ based on who the customer or decision-maker is. For instance, in pharmaceuticals the key decision maker might be the physician actually prescribing the drugs, or it could be a pharmaceutical buyer for a managed care organization. Their selection criteria would likely differ. In the case of medical devices and diagnostics, the key decision-maker could be a scientist, physician, or lab technician, each of whom might also have different selection criteria.

Output: For each treatment mechanism, a detailed customer segmentation highlighting key selection criteria and purchase patterns of the decision maker, penetration and sales curve estimates (taking into consideration the current and future products of competitors), and an estimate of the drug's revenue and "profit pool" potential. 3

I.3 Competitive Analysis

Competitors may be - and probably are - working on projects similar to ours. Their current and future product offerings and strategic intentions will impact how we position our product. For instance, in the case of hypertension, there are a number of effective molecules on the market that exhibit the same mode of action and similar pharmacological responses. This may accentuate the imperative of finding a drug that combats hypertension via another mechanism, or that uses an existing mechanism but exhibits distinct pharmacological advantages. Alternately, it may simply place more importance on the marketing and sales organizations to effectively sell our product if it is similar to those currently offered.

Identifying trade-offs like these requires a thorough investigation not only of competitors' current and future product portfolios, but of their overall strategic positioning, including relative market share, sales and marketing capabilities, and relative science capabilities.

is important not to underestimate this last point: smaller competitors who have invested differentially in a specific treatment mechanism may hold a significant advantage in product development for that mechanism over larger competitors who have spread their innovation investments across many mechanisms or scientific areas (assuming comparable quality of scientists and availability of technologies). This is so because although a strong element of serendipity still exists in the innovation process, innovation is not akin to gambling; indeed, over time, differential investment in certain capabilities will yield differential results.

Output: A profile of key competitors, describing their respective share of the market (revenue and profit pools), key strengths and weaknesses, stated strategy, and a thorough listing of relevant products (current and developmental, including developmental stage, development risk and likelihood of reaching the market, patent protection, licensing status, and availability for licensing).

By combining the three building blocks of Step I - science, market, and competition - we are now able to develop a set of innovation options. In our PharmCo example, one innovation option might be to fund research only on Renin inhibition - a fairly risky strategy since there is no guarantee of finding an effective Renin inhibitor drug. A more moderate innovation option would be to invest heavily in research on Renin inhibitors, but to also invest in finding a more pharmacoeconomically advanced drug that relies on a mechanism that is already proven (such as Angiotensin II Antagonists) (Figure 2). This would allow PharmCo to maintain a presence in the hypertension market should Renin inhibitors not bear fruit.

Clearly a whole array of innovation options can be identified for any given indication and for each strategic scenario. As we develop our options, we must remember the main tenets of the innovation framework. First, we are searching for innovation options that will yield breakthrough products and improved value propositions rather than incremental improvements. Secondly, each innovation option should represent a distinct strategy for innovating towards a new product, even if some of the elements are shared across options. And thirdly, innovation options need to be consistent with the strategic objectives laid out for the company.

Once we have defined the appropriate innovation options, we then need to more thoroughly assess them in light of our internal capabilities and resources.

Step II: Assess Internal Capabilities

The focus of Step I is primarily external: How big is the potential market? What are competitors up to? What is the state-of-the-art science for each indication? In Step II we turn our lens inward in order to better understand the requirements for pursuing each innovation option.

Two primary building blocks make up Step II:

capability and technology requirements, and

cost and capacity requirements.