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Effect of innovation on performance

2 THEORETICAL BACKGROUND

2.1 I NNOVATION CAPABILITY AS A DRIVER OF SME PERFORMANCE

2.1.2 Effect of innovation on performance

The majority of the previous research on the relationship between innovation and performance agrees that innovation influences performance positively (c.f., Aragón-Correa et al., 2007; García-Morales et al., 2007; Jiménez-Jiménez and Sanz-Valle, 2011; Hashi and Stojcic, 2013). Previously, the majority of studies used R&D expenditure as the principal innovation measure. However, R&D expenditure suffers from several shortcomings when used as an innovation measure. For example, the tendency towards the understatement of R&D in smaller firms limits the applicability of such a measure to capture the state of innovation. This has resulted in a new generation of research that studies the effect of innovation on firm performance by focusing on the complexities of innovation as a process and channels through which the inputs of innovation are transformed into better performance (Hashi and Stojcic, 2013). After all, from the perspective of its management, it is no longer sufficient to treat innovation as a linear process where resources are channeled at one end, from which emerges a new product or process (Adams et al., 2006).

As mentioned, many scholars have studied the relationship between innovation and performance (c.f., Calantone et al., 2002; Cainelli et al., 2004; Aragón-Correa et al., 2007;

Rhee et al., 2010; Jiménez-Jiménez and Sanz-Valle, 2011) and found a positive relationship.

The study by Calantone et al. (2002) reveals that innovation, measured by the rate of adoption of innovations by the firm and as the organization’s willingness to change, is positively related to firm performance. Cainelli et al. (2004) found that innovation can explain a firm’s performance. Firms with a high level of innovation have higher levels of productivity and economic growth than firms with a low level of innovation. The study by Rhee et al. (2010) concluded that innovation has a positive influence on performance. These results show that performance can be derived from the propensity for innovation. Jiménez-Jiménez and Sanz-Valle (2011) also found a positive and significant effect of innovation on performance, covering the number of innovations, the proactive or reactive character of those innovations, and the resources the firm invests in innovation.

Earlier studies have also suggested that innovation is an important determinant of individual performance constructs, such as profitability as well (c.f., Leiponen, 2000). It has been found that there exists a clear difference in profitability between firms with a high level of innovation and firms with a low level of innovation (Cefis and Ciccarelli, 2005). The findings of Pett and Wolff (2011) indicate that innovation is important for the profitability of return on assets. In the study by Subramanian and Nilakanta (1996), return on assets was used to measure profitability. It was found that the adoption of a large number of technical and administrative innovations leads to greater profitability. According to Cho and Pucik (2005), the effect of innovation on profitability is mediated by quality. They also suggest that innovation has a positive effect on profitability, partly because innovation affects quality, which in turn affects profitability.

In addition to overall performance and profitability, the effects of innovation on operational performance have been studied. Innovations themselves have an effect on operational performance with regard to productivity, lead times, quality, and flexibility (Armbruster et al., 2008). According to Hashi and Stojcic (2013), the firm’s productivity increases significantly with output innovations. Innovation capability is also significantly related to volume flexibility, product mix flexibility, unit manufacturing cost, and speed of new product introduction. It is also marginally related to delivery performance (Peng et al., 2008).

When research has concentrated on specific innovation types, process and product innovations are the most common innovation types examined (Gunday et al., 2011). Akgün et al. (2009) concluded that both product and process innovation affect firm performance. The

study done by Ar and Baki (2011) confirmed that product and process innovation led to better performance, when measured by sales, profitability, and market share. The relationship was stronger with product innovation than process innovation.

Historically research on innovation types has followed a technological imperative (Damanpour et al., 2009). However, not only technical innovations but also organizational innovations, defined as the introduction of new organizational methods for business management in the workplace and/or in the relationship between firms and external agents, are essential conditions for improving performance and for increasing the firm’s value (Lloréns Montes et al., 2005; Bowen et al. 2010; Camisón and Villar-López, 2014).

Bowen et al. (2010) examined the relationships between organizational innovation and performance, and suggested that innovation and performance are overall positively correlated.

In addition, Mazzanti et al. (2006) found that a firm’s performance and organizational innovations are strictly and positively related to each other. The study by Camisón and Villar-López (2014) demonstrates that both organizational and technological innovation positively affect performance. Thus, performance can be improved through both technical and administrative innovation, besides other factors (Lloréns Montes et al., 2005). Damanpour et al. (2009) have found that the combinative adoption of innovation types over time affects performance. It means that certain compositions of innovation types over time will lead to distinctive competencies that positively influence performance.

Only a few studies have investigated the relationship between innovation capability and performance in SMEs. It has been stated that SMEs with strong innovation capability will gain competitiveness against competitors, enabling them to achieve superior performance (c.f., Li and Mitchell, 2009; Rosenbusch et al., 2011; Sok et al., 2013). A significant and positive relationship between innovation and performance in SMEs has been discovered (c.f., García-Morales et al., 2007; Sok et al., 2013), and the study by Keskin (2006) demonstrated that innovation, meaning a willingness to try out new ideas, seek out new ways of doing things, being creative in methods of operation, and the rate of product introduction, has a positive effect on performance in SMEs. Rosenbusch et al. (2011) compared the strength of the effect of innovation orientation (meaning the tendency to engage and support innovation) on performance, with the effect of innovation as an outcome (e.g., patents, new products, or services) on performance. They found that SMEs benefit significantly more from innovation orientation than from just focusing on developing new innovation outcomes. Focusing on generating innovations is not enough, but SMEs should also develop, communicate, and embrace innovation orientation. There are both internal effects (e.g., the development of more

ambitious goals, the allocation of resources in areas where they create more value, an inspiring and challenging firm culture, organizational proactivity, risk-taking) and external effects (e.g., a positive perception by market participants leading to higher brand equity, obtaining better collaboration partners, and attracting highly skilled employees) of innovation orientation that benefit SMEs more than the positive effects innovation outcomes (Rosenbusch et al., 2011).