As Chinese businesses face off against multinationals at home and abroad, they know they'll need more than low-cost production to compete. With China's labor cost advantage eroding, domestic executives are waking up to the fact that there's a new requirement for growth: world-class capabilities for innovating. How important is innovation to Chinese executives? Two years ago Bain & Company asked business leaders from around the world if innovation is more important than cost reduction for their long-term success. A full 88 percent of Chinese executives agreed, compared to 75 percent of the executives from the rest of the world. This isn't surprising given the pressures of competing in a rapidly growing—and increasingly crowded-marketplace.

The fact is, innovation is important anywhere. When we talk with international market leaders from a diverse range of industries, they consistently point to innovation as critical to their success. We've found that innovative companies are more likely to outgrow their category. Innovation is a good way to realize price gains. Also, companies that are first to market capture more of the profit pool. Innovation can and should happen at many points throughout the customer experience value chain. In our view, innovations—when done right-appeal to specific customer needs, leverage a distinct corporate capability, and result in something a competitor can't or won't copy.

The route to successful innovation starts with having a clear and specific strategy, which includes setting goals and determining investment priorities. Companies then must build an innovation organization to support the strategy.  This organization should create attractive new offerings by generating a broad and diverse set of ideas. More important, effective innovators convert these ideas into real, profitable business concepts. This is the heart of the innovation process. The last two steps include ensuring you manage your innovation pipeline as a portfolio and align it with your strategy, and that you are able to accelerate your commercial success.

But as businesses around the world realize the importance of innovating and speed up commercialization, the pace of innovation has increased. For their part, Chinese executives are well aware that they're behind their multinational competitors in this race-and that they face a steep innovation learning curve. When Fortune China and Bain & Company recently surveyed more than 600 Chinese executives across a range of industries, we found that nearly 80 percent readily conceded that they are less innovative than multinationals.

Overcoming innovation obstacles

Three major factors are holding them back. Too often, local companies find they need to purchase from foreign companies the kind of leading-edge technology that will help them innovate.  Also, they fail to invest sufficiently in original research and development. Finally, because companies have focused on cost-saving initiatives instead of product development, there's a limited number of domestic patents up for grabs.

The Chinese government is aggressively tackling these shortcomings. In fact, spurring local innovation now is a top priority for policymakers who have recognized that China is fast outgrowing its once-successful strategy of serving as the world's factory. For example, the government's long-term science and technology development plan calls for using tax incentives to boost R&D spending, reducing dependency on foreign technology, and propelling China into the top five nations globally by 2020 in terms of domestic patents and internationally cited research.

Even as the government makes such moves, China already boasts a few innovation pioneers—companies that have relied on innovation to transform themselves into international behemoths. White goods maker Haier heads the pack. The company has used a disciplined strategy and significant R&D investments to grow from a regional operation into China's leading home appliance maker and a world-renowned home appliance brand, with global revenue for 2007 totaling 118 billion RMB. Alibaba.com, credited with almost single-handedly creating China's e-commerce market, is viewed as an innovation legend, achieving more than 70 percent compound annual revenue growth between 2005 and 2007 and scoring the second-largest e-commerce initial public offering in history after the legendary Google.

Both companies demonstrate that China's substantial barriers to innovation can be surmounted—if you have a clear strategy, resources, and tools.

Refining existing products

Innovation comes in many forms. It can be a new business model, a re-invented sales force, or a transformed operating process. Novice Chinese innovators often make a classic mistake—they have a very narrow understanding of what innovation means. In our survey, more than 90 percent of the executives defined it as creating new products—especially technology innovations. That definition is incomplete and misleading. Innovation also includes the process of refining existing products to better meet customer needs, instead of inventing new ones. In essence, not only should companies innovate on the end product or service, but also on the process for  building awareness, how customers purchase the product or service, and how customers use it.

As the Chinese make the transition from domestic to global players, expanding existing products should be their focus, not taking on the difficult task of trying to innovate completely new ones. For one thing, Chinese companies' capabilities and their strategic competitive positions against multinationals are well suited for generating incremental, customer-led innovations. Domestic players have a deep knowledge of the marketplace and strong frontline organizations capable of collecting and digesting customer feedback. This is where many multinationals still are weak. And incremental innovation requires rapid execution and rollout; here, too Chinese companies have an advantage. Such product extensions also support the local Chinese goal of trading up to higher value products—products that help these companies globally compete.

Innovation is a high-risk venture, even for veterans. Our global research has found that only about 40 percent of major R&D projects actually are developed. Of those, only half become products that make it to market. And only about 50 percent of those new products are successful.  That means, on average, global innovators have only a 10 percent rate of success. Given such a low global success rate for new products, it's no surprise that Chinese business leaders find the task of innovation so daunting. Among the more than 600 Chinese executives we surveyed, over 60 percent described innovation as "difficult."

When we asked them to rank their performance against a specific set of criteria, the senior managers came up short in several categories. By their own admission, they lack a clear innovation planning strategy, under estimate required resources and support, fail to generate enough ideas, and have trouble identifying innovations with the best odds of succeeding. In addition, their innovation pipeline bogs down, making it hard to get ideas to market quickly. Finally—and this goes to the heart of many of their difficulties—they say they have trouble infusing their companies with an innovation culture.

Four steps to innovation success

General Electric Chairman and CEO Jeffrey Immelt has said, "The only way you're going to grow and keep your markets growing is through innovation." Given Chinese executives' admitted difficulty in commercializing ideas and delivering financial returns, how can they play catch-up against seasoned foreign competitors .

Above all, Chinese companies should stick with what they know best: their existing products. By creatively tailoring them to appeal to local tastes and customer needs, or expanding a product line to include new variations, domestic players increase the odds of beating their more experienced multinational competitors at the innovation game. From our research and work with clients, we've identified four key steps that help Chinese companies to successfully refine their existing products for global markets.

1) Have a strategy roadmap and set performance targets

Developing an innovation strategy means asking a series of questions. What are our innovation objectives, given strategic requirements and the competitive landscape? What is the right innovation model and areas of focus for our innovation efforts? Is there alignment around the innovation objectives and model throughout the organization? And, where have we experienced innovation successes and failures, and how do we address gaps in problematic areas?

Winning innovators start by defining the strategic role that innovation will play in driving a company's overall growth, setting clear targets for what percentage of revenues should come from newly introduced products-and rewarding executives for meeting those targets. 

Winners create their strategic roadmaps by determining the number and size of projects required to meet their growth objectives. They are realists, tempering those targets by taking into account marketplace constraints. They take a hard look across all their brands and product categories to identify what types of innovations they need to achieve their strategic goals, and how frequently they need to innovate.

Appliance maker Haier made itself a global competitor thanks to a carefully constructed innovation strategy that enabled sustained growth. Founded in 1984, Qingdao-based Haier was a regional business that once teetered on the brink of bankruptcy. The company did more than simply turn itself around. Its executives had big dreams—and a concrete innovation plan for achieving them. Haier's ultimate goal was to enter the global appliance market with three key capabilities in place: the internal ability to design, manufacture, and distribute products. 

To achieve this goal, the company's strategic plan included relying on imported technology innovations to improve local products; developing a cost-effective innovation process while ensuring high quality; and expanding existing products and developing new ones. The ambitiousness of Haier's plan is reflected in its innovation target: two successful intellectual patent applications every work day.

By building this firm innovation foundation, Haier was able to aggressively enter-and win in-the global appliance market,

A snapshot of Haier's history shows patient, but steady progress. In 1993, nine years after its founding, Haier was confident enough to launch a global IPO. Today, it is one of the world's dominant appliance makers, with a presence in over 30 countries and a product line blanketing 96 appliance categories and is held up as a role model for Chinese businesses eager to replicate its success.

In the fast-changing and intensely competitive electronic commerce industry, Alibaba credits innovation planning and team building for its rapid rise from an unknown startup to China's biggest e-commerce company. Not long after Alibaba was launched in 1999 its founders created an innovation roadmap with a clear goal: Always stay one step ahead of competitors.

Alibaba stayed true to this strategy, constantly reviewing ways to improve its e-commerce offering, while competitors diluted their focus by branching out into other areas. Alibaba began with a business-to-business (B2B) platform and gradually innovated new capabilities until the company became a one-stop e-commerce industrial chain service provider. Systematically, Alibaba began offering clients everything from e-payments to a search engine function.

2) Use Innovation as a Hiring Criteria

Chinese companies might have some great ideas, but they often lack the talent to turn them into profitable ventures. A telling statistic: more than half the Chinese companies surveyed said they have less than 25 people dedicated to an innovation team.

This dearth of talent is a major handicap when going up against multinationals like innovation titan Procter & Gamble. P&G invests heavily in a talent pool that feeds its innovation pipeline for consumer products: 8,500 researchers, 27 global technical centers and 40 percent of its R&D work comes from outside the company.

Chinese electronics maker Hisense is all too familiar with the talent shortage. "We lack [a] comprehensive talent base and efficient recruiting process, which are the absolute advantage of full-armed MNCs over us," acknowledges Hisense chairman Zhou Houjian.

How can domestic companies play talent catch-up? They need to create innovation cultures, starting with the hiring process. Because very few individuals possess both creative and analytical talents, companies need to hire a mix of complementary people—quantitative types who excel at setting strategy and managing the pipeline working side-by-side with qualitative types to drive vision and generate ideas. Make innovative thinking a key criterion when recruiting and promoting employees. When hiring, look at more creative industries for talent. Training programs also should be centered around innovation. And avoid relying too heavily on incentives to spur ideas. Employees who are genuinely passionate about their work won't need to be prodded with rewards.

True to its innovation culture, Alibaba has invested heavily in recruiting and training talent. Not only do they search extensively outside the company for promising innovators, they also ensure that existing employees are exposed to new ideas by arranging for overseas education opportunities.

Alibaba's investment has paid off with pioneering e-commerce products like its trading platform, Export to China, which helps foreign traders feed the appetite of China's growing middle-class for imported products. International suppliers, unfamiliar with the Chinese marketplace, can build their storefronts online and have them translated into Chinese, allowing foreigners to reach millions of Chinese quickly and easily.

By thinking creatively and honing in on the needs of customers, Alibaba's revenues have soared, with a compound annual growth rate of over 70 percent between 2005 and 2007.

3) Invest continuously: Put money behind that strategy

No matter how brilliant the innovation strategy or talented the employees, companies won't get far unless they adequately fund their ideas. A failure to invest in innovation pipelines has been a key barrier to growth for Chinese companies. We found that, on average, Chinese firms spend dramatically less on research and development than successful multinational competitors. For example, Microsoft invests approximately 15 percent of its sales in R&D compared to Sina's 8.6 percent. Haier and Alibaba both are exceptions. Appliance maker Haier has developed an extensive international R&D network. Its R&D spending is significantly higher than the market average—$6.7 billion RMB in 2006, equaling 6.2 percent of its sales. The end result: Haier had the capital to set up both a central R&D institute, as well as R&D labs in over 10 countries. Haier can afford to dig deeper in search of groundbreaking innovations. It has established different labs for researching specific technologies. Not surprisingly, by 2006, Haier had applied more then 7000 intellectual patent accumulatively.

Alibaba invests more in R&D than any other player in China's B2B industry-6 percent of its revenue. What's striking is that its innovation spending growth rate of approximately 90 percent per year outpaced its revenue growth of 70 percent between 2005 and 2007. That investment helped quickly build Alibaba into an international technology player with a market value of more than RMB42.1 billion by July 2007.

Eager to replicate such success for themselves, Chinese companies will be investing more in innovation in the years ahead. More than 95 percent of the over 600 Chinese executives in our survey plan to increase their investment in innovation. Among that group, 23 percent will boost innovation investments by more than 100 percent in the next three-to-five years. Nearly half will increase it by 51 percent to 100 percent.

4) Follow a clearly defined innovation process

Winners start by defining what successful innovation means to their businesses. They use key performance indicators to track results against that definition, and continuously improve innovation processes to ensure that they remain ahead of competitors. Innovation leaders are able to turn concepts into profitable products again and again by following a five-step process.

They generate an exhaustive list of ideas. Winning companies look for ideas from multiple sources—consumer insights, technology breakthroughs at research labs and within industries, knowledgeable suppliers, competitors, and a company's own employees. Innovative companies troll for customer opportunities like unrecognized segments with leadership potential. They explore competitive openings like undeveloped adjacencies. They seek innovation in distinctive capabilities that may be underutilized.

They prioritize ideas by setting up a series of "gates" that narrow down the list. Ask a series of questions. Is the idea a big and growing profit pool? Will the company be able to lead in this space? How far is it from the company's core? Will the idea add too much complexity to the business? Cluster the answers into two categories: an idea's relative attractiveness as a growth engine versus the company's actual ability to use it to improve profitability and market position.

They further validate the idea concept. Winners conduct assessments to demonstrate whether the idea can be turned into a viable product. They look at what it would take to develop a prototype, examine how the product—new or expanded—would benefit consumers, what competitors are doing in the same area, and what financial and regulatory approvals would be required. Then they create a detailed economic viability assessment.

They successfully commercialize the idea. The process of converting ideas into viable commercial concepts or innovation is a critically important step that is often overlooked. One way we've described it is that ideas are atoms, then you develop them into molecules, and in the end you have organic life. Innovators use a design, development, and delivery process that is well-thought-out to ensure that the product is targeted at the appropriate consumer segments and has a strong launch plan. Launch management spells out a timeline and who is responsible for what aspects of the rollout. They also have a system in place for quickly responding to feedback from consumers, channels and the company's own front line—and making the necessary improvements.

Both Haier and Alibaba have employed this process to fuel their success. They continuously track changing market needs and innovate based on what customers want. Haier leverages its local R&D labs to create products that best fit each of its markets. Alibaba also focuses on local customer preferences. The company gauges the cost effectiveness of innovations by considering how much customers would be willing to pay. And Haier and Alibaba have flexible business processes, making them nimble competitors that can quickly respond to changing marketplace demands, speeding refined products through the innovation pipeline.

As Chinese companies enter the global arena, they can look to Haier and Alibaba as role models for innovation. CEOs who question the wisdom of investing heavily-both in money and resources—to create a fine-tuned innovation machine should remember this rule of thumb: brands that innovate to the point of having 10 percent of sales come from new products are 60 percent more likely to outpace their competitors. That's a powerful incentive for any company to master the innovation process.

Paul DiPaola is a partner and Jerry Li is a manager in Bain & Company's Shanghai office. Minnie Song, a senior associate consultant in Shanghai, conducted research for this article.