Addressing the negative impacts of complexity not only releases a large amount of “hidden costs” but also helps free up resources, both human and financial, to accelerate innovation. But where and — perhaps more importantly — how can companies begin unraveling the knot of cost and complexity?

Don’t start by looking at your GAAP accounting metrics, says Stephen Wilson, engagement director in Dallas-based George Group Consulting’s Conquering Complexity practice. “Standard accounting … doesn’t give you a sense of where you are creating value in the organization,” says Wilson, co-author of Conquering Complexity in Your Business (McGraw-Hill, 2004).

According to Wilson and other experts, determining the financial impacts of increased complexity related to innovation begins with taking a close look at existing operations to understand the actual cost incurred and value generated at each step in the process — all the way from idea generation through product development, manufacturing, marketing and customer support, among other back-office functions. Such exercises will help in getting an informed grip on the real value generated by a company’s offerings, and where there are hidden complexity costs.

Wilson says such a “value stream” analysis captures the true costs of various process steps that tend to stay hidden or are inaccurately estimated in conventional financial analysis. Most companies do costing studies by classifying the various pieces in their portfolio of offerings by the specific markets in which they operate. A garment manufacturer, for instance, may use a “market-based segmentation” method and allocate costs by product groups such as children’s wear, menswear or women’s clothing. Wilson argues that the “process-based segmentation” his firm espouses “allows for an understanding of how and where products consume costs and time.” That, he says, brings another bonus for companies working on innovations: “It helps you understand where you have an inherent advantage.” Wilson says it is not uncommon for companies to earn four-fifths of their “economic profit” from just a fifth of their total portfolio. (Economic profit is defined as the return on invested capital minus the weighted average cost of capital.)

By employing such advanced analysis tools, companies are also able to accurately identify specific processes that work faster than others, that are inherently superior to competitors’ and which represent a vein of innovation opportunity. “That could be a tremendous lever for competitive advantage,” he says. “If you have low internal cost [in any process or processes], you can build upon it. The more you grow in that area [with new offerings] and the more your competitors try and match you, they will fail because they don’t have that benefit.”

Such analysis will also help management teams train their sights on processes that are driving up costs to either bring improvements there, or to make bigger decisions like whether or not to retain a high-cost product or service in their portfolios. “I might discover that if I migrate customers from Product A to Product B, my overall customer service time will reduce by 30%,” says Wilson. Companies achieve such migration by discontinuing older products and redirecting customers to “new, improved” offerings whose specific processes help with greater profitability compared with those that were pulled out.

The Silo Pattern

Matt Reilly, a senior vice president at George Group, says the reason the impacts of complexity are not often captured is that companies have become siloed, and therefore fail to see the value-stream view. Such disconnects between product development and other arms of a company are probably worse in large companies, mainly because they are also usually more siloed. “If you take a look at a product’s journey through a company’s value streams, what emerges is that costs and profitability look very, very different if you measure the true cost to develop, manufacture and deliver,” he says. He notes that companies typically measure cost to manufacturing based on standard accounting cost.

Reilly visualizes a typical pattern at many companies: “The marketing department drives the business plan, and throws it over the wall to R&D to develop. They then develop a pilot and throw that over the wall to manufacturing, to manufacture full scale. Manufacturing then throws that over the wall to sales, to sell it.” Each silo has its own turf, and tends not to recognize its own impact on the value stream upstream or downstream. So it’s not uncommon to hear a marketing executive describe a certain problem as “an operations issue” or pass the buck to product development.

This silo pattern showed up in one of Reilly’s consulting assignments involving an industrial goods company. Reilly got to the scene as the company grappled with a new product it felt the market needed but was unable to get its execution right. “They designed the product based on what the customers’ end needs were,” he says, “but after R&D developed the product, it was thrown over the wall to manufacturing, which struggled to manufacture full scale, and what emerged was not exactly what the sales people had sold.”

Reilly discovered “a tremendous disconnect” between what was developed as an innovation and what was delivered to the customer. Contrary to expectations of cornering a large market share, he says, the company actually captured “a very low percentage, and the reason was they couldn’t execute on what they had innovated.”

But fixing those problems presented a $50 million profit opportunity, says Reilly, who used the value stream analysis. “We segmented the value streams and helped them to manufacture the new product in a certain way, and the older products in a certain way,” he says. “They were then able to deliver on the innovation, and the company captured not all, but most of that opportunity.”