Financial innovation is often blamed for having landed the global economy in a mess, but it has also been said that innovation will get us out of the present downturn. Still, companies can be forgiven for feeling that spending time and money thinking about the “next big thing” is a frivolous exercise. After all, every dollar counts these days, and CEOs and their executive teams are busy enough just getting their companies through the day-to-day demands of the recession.

It needn’t be that way, according to Christian Terwiesch and Karl Ulrich. As the two Wharton professors of operations and information management point out in their new book, Innovation Tournaments: Creating and Selecting Exceptional Opportunities, if done with greater focus, identifying new opportunities shouldn’t be seen as a luxury, but a necessity. They note that creativity and process-driven rigor can actually go hand in hand when it comes to vetting and managing new ideas. One way to do this, they explain, is by making new ideas compete with one another in numerous rounds of vetting — that is, by running them through “innovation tournaments” — so that the strongest and most promising ideas make it to the final round.

Rich rewards await companies that make the leap. Among the innovative firms that the professors cite is the U.S. pharmaceutical giant Merck, whose cholesterol-reducing drug Zocor, launched in the early 1990s, has delivered gross profits of $10 billion on an investment of around $500 million.

Below, in this edited transcript from a recent interview, Terwiesch and Ulrich discuss how companies can indeed find exceptional opportunities, regardless of the economic climate. Let the games begin.

Knowledge at Wharton: Before we talk about your book, let us begin with a general question about innovation. Companies often equate investment in R&D with the metric that shows how much they value innovation. Is this true? If so, or if not, what really makes a company innovative?

Terwiesch: It is true that a vast majority of companies think this way, yet both on a case-by-case basis as well as on large aggregate financial data, we show that there is no clear systemic relationship between how much you spent on R&D versus how financially successful you will become afterwards. It’s not about how much you spend; it’s how you manage the innovation process.

Ulrich: But R&D spending itself is what people tend to measure with respect to innovation. It’s actually a pretty incomplete measure. We would like to consider innovation as broader than just R&D. Some of what happens in R&D, you wouldn’t really think of necessarily as innovation. So, having said that, it’s the best proxy we have for measuring innovation.

Knowledge at Wharton: Your book is about innovation tournaments. A logical question to start with would be what exactly an innovation tournament is, and how can companies use such tournaments to identify exceptional opportunities?

Ulrich: A tournament is an organizational problem-solving process in which a large number of opportunities are identified and then systematically evaluated and filtered until only a few exceptional ones remain. A tournament, like its counterpart in sports, is one in which you have a large number of candidates who enter a competition, but only very few emerge as truly exceptional. The challenge is how to evaluate the candidates without going out of business, without spending a lot of resources.

Terwiesch: It’s like the TV show, American Idol. You start with many aspiring winners. You have a round of filters. And at the end, depending on whether you like their singing, you have some remarkable personalities left. That’s a powerful metaphor to think about tournaments.

Knowledge at Wharton: You offer some interesting examples in the book of products like Zocor. How have companies used this process in examples like those?

Terwiesch: When we started our collaboration with Merck, we noticed that we were absolutely clueless about all the medical and chemical details that were associated with the products flowing through their [R&D] pipeline. At some point, we made the link to the American Idol metaphor and thought about the system as an overall process and then applied our operations management mindset on how to manage this process to obtain optimal performance.

Ulrich: Everyone uses tournaments in everyday life. They’re used in society. They’re used in organizations. For example, if you’re hiring a chief executive, you’ll use a tournament structure to do that. So while we obviously didn’t invent the idea of the tournament in innovation, what we’ve observed is that there’s almost no science as to how to manage them. Since they are so expensive yet so important, we felt that the time was right to bring some structured thinking to the process of managing a tournament.

Knowledge at Wharton: Your book offers unusual examples about the context in which tournaments are effective. For example, Pixar used it for Cars, one of its blockbuster movies. Could you tell us about that example?

Ulrich: We think of Pixar as the epitome of a creative company. We don’t often think of creative industries as having structured processes. But Pixar embeds an intensively creative micro-level activity within a fairly structured macro-level activity. Every year, Pixar considers about 500 pitches on average for new animated motion pictures. Then, over a series of years, the 500 will be winnowed down to the critical few that Pixar will make into films. Pixar decides which opportunities to pursue based on one-sentence pitches. For Cars, the pitch, if I remember correctly, was: “A hot-shot race car named Lightning McQueen gets waylaid in Radiator Springs, where he finds the meaning of friendship and family.”

Terwiesch: What has interested us in [the film industry] is that the dollars, the big budgets, are spent towards the end of the tournament. Once the movie is actually produced and when the animation is done, that’s when the money is spent and that’s where the senior executives devote their attention. But, the upfront decision process is often very unstructured. Think about innovation like a gold mine. Even if you have the best miners in the world, and they do a good job with their shovels, it’s almost impossible to get gold out of a location where there’s just nothing to be found. Our goal has been to go into this at the front end and apply some structured thinking.

Knowledge at Wharton: What can companies do to stimulate more opportunity generation from its own people?

Ulrich: There’s a great deal of variation in ability among different individuals in an organization. This isn’t a very popular idea in most organizations because we like to think of opportunity identification as an egalitarian, open process. But it is critically important to identify individuals in an organization who are exceptionally good at this — and to make sure that you’re devoting enough resources to them. If you can do that, then you can be substantially more productive in generating both more opportunities and better opportunities.

Terwiesch: You can also leverage new technologies, especially on the web, which is ideal for idea management — going beyond the good old brainstorming meeting where you have people sitting around a flip chart. By using web-based tools — some of which we developed as part of our research for this book — teams are substantially more successful in generating exceptional opportunities.

Knowledge at Wharton: How did the Red Bull energy drink come about? What does that experience teach about identifying innovation opportunities from external sources?

Terwiesch: As important as it is to generate ideas internally, there’s nothing wrong with sourcing them externally, going around the world with open eyes and looking for opportunities that you then translate and apply to other markets. Red Bull, with the super success that it enjoyed initially in Europe and later on in the U.S., was not brewed by some big pharma company or food company; it was a local drink in Asia. The big commercial value was created in the case of Red Bull by identifying or understanding the value of this opportunity and putting it in another context, initially into the German and Austrian markets and then into the whole world.

Ulrich: In fact, it was a drink used by Thai truck drivers originally. On a visit to Thailand, Dietrich Mateschitz, an Austrian entrepreneur, sensed that the formula might appeal to club goers and youth throughout the world.

Knowledge at Wharton: As you tell in your book, he found that the drink was very effective in reducing his own jetlag, which is when he decided that there might be a market for it. It’s a great story. In another vein, what can companies learn from the British Olympics Association about effective screening processes for innovation?

Terwiesch: We use the sports example partly because both of us are passionate athletes and partly because you see countries that are hungry for athletic talent. In their pursuit of Olympic gold, they have created fairly sophisticated systems — very similar to the American Idol contest — in which talent is screened across the country. Thousands of young people are screened for their physical ability, and then limited resources are deployed wisely so that a country only invests in the most talented athletes who have the biggest chance of winning gold. It is similar to the many ideas that are going around in companies.

Knowledge at Wharton: How should companies think about the short-term and long-term profit potential of their innovations?

Terwiesch: The short term is quite easy. We strongly believe in discounted cash flows. The opportunities that we call “horizon one” opportunities have relatively little uncertainty associated with them. If you are launching another flavor of Colgate toothpaste, you pretty much have a good mental model of what your sales are going to be, and so you can rely on standard financial models to deal with this. If you’re thinking about future horizons, with a lot of uncertainty clouding the numbers, we would recommend that instead of just relying on a standard discounted cash flow model, you could think about the uncertainty resolution. What needs to be found out about the future and how this uncertainty can be resolved are two questions that need to be addressed before you start building fancy spreadsheet models.

Ulrich: In fact, we lay out a simple tool, which is just a listing of all the uncertainties that you face in addressing an opportunity. We recommend that you rank the tasks that you can take on based on how efficient they are at resolving that uncertainty. For example, you want to pick the task that’s least expensive and resolves the most uncertainty and do those things first. That’s a discovery-driven approach to mining the innovation opportunity.

Knowledge at Wharton: You say that some innovation tournaments are cascades while others are whirlpools. What do you mean by that and what are the implications?

Ulrich: If we go back to the American Idol example, it is almost a completely pure cascade in the sense that several hundred contestants arrive on day one, they are filtered, and once they’ve been eliminated, they’re gone. Those who are voted out don’t have a chance to proceed. Moreover, no new singers show up in the middle of the competition; if you weren’t there on day one, you aren’t going to be there in round four.

That’s actually a little bit atypical. In a more typical innovation tournament, two things can happen. First, it’s not unusual that an idea or an opportunity that’s killed early on might re-emerge when the world has changed, or when the opportunity has been further developed. Second, it’s also possible that a new opportunity will sprout up in the middle of the process because of something new that’s been learned or as a result of developing some of the other opportunities. That kind of tournament resembles more of a whirlpool — that is, it has more iterations and reflow than a cascade, where everything that starts in the beginning just flows in one direction.

Knowledge at Wharton: How should companies organize themselves for innovation?

Terwiesch: The decision you need to make is how to run your tournament and who is allowed to play in it. It’s maybe helpful to distinguish two things that are happening in the tournament. One is the generation of contestants. The other is the referee or the people who decide who is allowed to go to the next round. Both these decisions can be done in the firm or outside the firm. A firm can rely on its customers, its suppliers or just the general public to generate ideas, or it can generate ideas in internally. Similarly, a company can rely on its marketing and its senior management to judge which ideas are moved forward or it can rely on early customer feedback. It can rely on, especially these days, on media like YouTube. QVC, the television-based shopping channel, is testing out a lot of its products, early on, on cable television. It can rely on the external world to do the filtering. The two key organizational decisions you have to make with respect to idea generation are: Are you doing it internally or externally; and [with regard to] the filtering and selection, are you doing it internally or externally?

Ulrich: Another decision that organizations face in administering innovation tournaments is the extent to which they centralize innovation. In large organizations, you typically have a lot of geographic diversity in the operating units. It’s sometimes nice to do innovation out in the geographically dispersed units, in that those units are very close to their customers and different geographic needs.

On the other hand, there are advantages to doing innovation more centrally in that you can identify common platforms, common processes and efficiently deploy the innovation across the organization. Most large organizations face a tension between wanting to do innovation close to the customer in a very distributed way and wanting to do it very efficiently in a centralized way.

Knowledge at Wharton: Any final words of advice for companies that want to get started on this path of innovation tournaments?

Ulrich: The first bit of advice would be to just get started. One easy way to do that is to hold a one-day tournament. We’ve done a lot of those in both the classroom and with companies. The first step is to establish a charter for the group of people being brought together. Generate some opportunities using brainstorming and other techniques and then have just one or two rounds of runoffs and do some kind of voting to evaluate them. Just that one-day workshop is often enough to energize an organization and to make tournaments a more systematic part of its process.

Terwiesch: We have run tournaments with professional services companies, and we’ve run them with consumer goods companies. We’ve always been amazed, and I think our participants have also been amazed, by how cheap it is to generate a number of really good ideas. At the end of a day-long workshop, we typically have up to a hundred new ideas which, once they are appropriately filtered, lead to a handful of, if not a dozen, potentially exceptional ideas — and all that is possible with the investment of just a single day of work.