1. © 2008 MIT Sloan CISR, Westerman and Dodge. CISR Research Briefings are published three times per year to update MIT
CISR patrons, sponsors & other supporters on current research projects.
VENDOR INNOVATION
AS A STRATEGIC OPTION1
George Westerman, Research Scientist, MIT Sloan
Center for Information Systems Research
Garrett Dodge, Sloan MBA Class of 2008
Conservative incentives and management processes
in many organizations can quash efforts to innovate.
Attempting to improve a firm’s innovative climate
from within can be a difficult proposition. A lower-
risk option is to bypass internal inertia by using
vendor relationships to jump-start innovation and
culture change.2
This approach can also be useful for
innovative firms that wish to broaden their
innovation portfolios while controlling risk.
Overcoming Innovation Challenges with Vendors
Organizations face three distinct challenges to inno-
vating with vendors (Figure 1).3
Clients and vendors
have skills and challenges that are different but, in
many ways, complementary. Appropriately con-
figured (as shown in the final column of Figure 1), a
vendor innovation program can exploit the comple-
mentarities and manage the tensions.
The concept gap occurs when an organization lacks
process or knowledge required to capture useful
ideas or to shape ideas into concepts that it can
1
Thanks to Michael Lamb, Sandy Simon, Ray Gogel, and
Mike Carlson of Xcel Energy, as well as their Strategic
Advisory Board members and other study participants, for
their willingness to share practices and insights.
2
Our innovation research with more than two dozen firms
identified several different examples of working with
outside partners, ranging from outsourcing specific
innovation projects to building a full “open innovation”
capability. Two firms were using a hybrid approach that
blended client and vendor capabilities without first
requiring significant client investment or culture change.
The approach described here is effective and implement-
able for firms beginning an innovation program and for
others seeking to broaden their innovation portfolios.
3
This framework improves upon an earlier version first
described in the July 2007 MIT Sloan CISR research
briefing “IT-Enabling Innovation at Intel,” by George
Westerman and Martin Curley, Vol. VII, No. 2E.
consider implementing. Clients typically understand
specific problems and opportunities they face, but
their focus on existing work practices can prevent
them from seeing opportunities enabled by new
technologies. Vendors have knowledge of relevant
technology and external practices, but not of specific
client situations. Capturing ideas from many
sources, and then jointly examining them with
vendors, allows a client to better understand its
opportunities for innovation.
The implementation gap arises when an organization
lacks the skills or resources to implement an innova-
tion. Vendors have useful skills and resources, but
only the client has a real “sandbox” in which to devel-
op innovations. In vendor innovation, the client hosts
an innovative project on its site, while the vendor
invests the bulk of the required people, money, and
tools. The client also drives adoption of the innova-
tion, something vendors often find very difficult.
The third challenge is the incentive gap. Innovations
can fail when individuals do not believe the return
will exceed the required investment of time,
treasure, or trauma to make it happen. Even when
top executives express the need to innovate, other
people in the organization may have differing
incentives and tolerances for change. Vendors and
clients differ, with vendors wanting to invest once
and sell to many clients, while clients want unique
innovations. Long-term outsourcing contracts
introduce additional incentive conflicts. Clients often
expect innovations for ‘free,’ while vendors may see
little incentive to invest in innovations that will
increase costs or reduce billings.
Vendor innovation manages incentive tensions by
recognizing that most innovations tend to be copied
relatively quickly. Vendors invest the bulk of
resources in exchange for the right to resell an
innovation to others. The client gets an innovation,
tailored to its environment, for a low price. The
vendor also gains a reference client for the innova-
tion. Agreeing on how intellectual property will be
shared requires a high degree of trust and flexibility.
Below, we describe how one firm, Xcel Energy, has
successfully implemented a vendor innovation model.
Volume VIII Number 1C March 2008
Center for Information Systems Research
Sloan School of Management
Massachusetts Institute of Technology
RESEARCH BRIEFING

2. CISR Research Briefing, Vol. VIII, No. 1C Page 2 March 2008
Vendor Innovation at Xcel Energy
Xcel Energy is a leading natural gas and electricity
provider operating in the western and mid-western
United States. The company boasts over 3.3 million
customers and $9Billion in revenue. For Xcel Energy,
innovation is a new opportunity to improve envi-
ronmental performance, efficiency, reliability, and
customer service in the face of industry deregulation.
As a 130-year-old regulated utility with 9700 em-
ployees, Xcel Energy had a culture that rarely
questioned existing ways of working. Rather than
face the risk and effort of changing the culture head-
on, the firm built a standalone unit within IT to inno-
vate with vendors. This unit, called Utility Innova-
tions (UI), began in January 2004 with five strategic
partners.
UI established specific guidelines for the innovation
process: projects would be funded through co-
investment; the process would be transparent;
expectations would be realistic and acknowledge
risk; Rapid Application Deployment (RAD) tech-
niques would be used; and IP would be owned by
the company that created the initial solution.
UI has a dedicated staff of eight employees and an
annual capital and expense budget, overseen by an
executive director. UI staff play a program man-
agement role: selecting high-potential projects from
proposals submitted by employees or vendors, assist-
ing and monitoring project teams, ensuring business
unit involvement, and promoting the results of the
projects. Projects are resourced largely by vendors,
who invest in return for the ability to re-sell the
innovations. Additionally, UI has become a steward
for innovation within the firm and is charged with
accelerating the adoption of new technologies.
A key component of the firm’s initiative is the Smart
Grid Advisory Board (SGAB), consisting of a small
number of trusted vendor partners. Very senior
executives, including the CAO, CIO, and the firm’s
head of operations, meet periodically with vendor
CEOs and chief engineers to learn about the
company and each other. The SGAB’s executive-
level membership allows partners to make
investment commitments, share future strategies,
and build trust in ways that would not be possible
for lower level managers. For example, as the SGAB
considers the intelligent electrical distribution
network of the future, SGAB members can openly
share product directions and suggest ideas with little
fear that the other members will unfairly take
advantage of the knowledge.
UI has successfully developed several innovations.
One project integrated historical and real-time data to
reduce equipment failures and improve plant perfor-
mance. Another focused on improving generation
efficiency and reducing pollution by using a neural
network and special sensors to reduce buildup of slag
inside coal-fired boilers. UI also built a new system to
improve the way the firm works with housing
developers, speeding the planning process. Currently,
UI is piloting plug-in hybrid vehicles (PHEVs) with
vehicle-to-grid technology that can allow the utility to
use the cars’ energy storage to reduce pollution and
manage load cycles across the grid.
Xcel Energy’s approach manages the concept gap
through its formal process of vetting ideas with
vendors. UI employees and vendor partners discuss
innovation concepts jointly in a manner that is much
more productive than traditional vendor relation-
ships. All of UI’s innovation ideas in 2005 came
from employees. But prior to UI, these ideas had
fallen on deaf ears. By combining employee ideas
and vendor technical knowledge, UI was able to
shape these ideas into practical concepts that could
be prioritized for implementation.
To manage the implementation gap, UI team mem-
bers provide technical and business assistance, while
vendors drive projects. According to one UI employ-
ee, “we provide the sandbox, and they bring the
toys.” After initially struggling to have innovations
adopted, UI is bringing business units into the proc-
ess early. Business leaders select only the opportuni-
ties they find most interesting, and then influence
projects to ensure innovations have a useful form.
Managing the incentive gap required a great deal of
trust and flexibility in vendor relationships. Xcel
Energy started with only five partners, linking them
together in the Strategic Advisory Board. According
to UI Executive Director Michael Lamb, “Forming
the SAB was part science, but also part art; chemistry,
relationships … you just couldn’t use the word trust,
you had to somehow feel it.” The group’s first joint
effort—improving operational process efficiencies
through a set of on-site experiments—showed that all
could work together in a climate of trust. Then each
new success helped strengthen relationships. The
SAB culture is expected to remain even as the
Board’s composition evolves due to changes in
vendor strategy and willingness to commit.4
4
The SAB evolved into the SGAB with a new direction
and new members during the 4th
Quarter of 2007.

3. CISR Research Briefing, Vol. VIII, No. 1C Page 3 March 2008
To address the incentive gap internally, UI is using
its successes to drive culture change across the
whole firm. Innovation centers in Minneapolis and
Denver promote innovation to internal and external
stakeholders. UI staff also organize idea generation
“pipeline” discussions and employee recognition
programs.
Implications for Other Firms
Vendor innovation allowed Xcel Energy to leverage
a $3 million investment in 2006 to more than $20
million worth of projects. Successful innovations
have already begun to improve operational
efficiencies and set the stage for the Smart Grid,
which will be funded in part by partner investments.
Xcel Energy—a regulated utility—has received
numerous awards for innovation, including “Project
of the Year” from Engineering T&D Magazine in
2006, and being named to the CIO 100 in 2007.
Vendor innovation is a useful starting point for firms
whose cultures or processes resist innovation. It
allows a firm to bypass cultural constraints and then
use its successes to change the culture. Especially in
service industries, where innovations diffuse rapidly,
vendor innovation can be a way to gain temporary
advantage while allowing vendors to bear most of
the development cost.
Even innovative firms should examine the role
vendor innovation can play in their innovation port-
folios. For example, using vendor innovation for
non-strategic projects such as employee self-service
or asset tracking can free up a firm’s internal
innovation resources for projects that may generate
more strategic advantage. The approach can broaden
a firm’s innovation capabilities while limiting risk.
Making vendor innovation work requires firms to
manage the three innovation gaps in concert with
their vendors. This takes constant vigilance and
learning to ensure processes operate effectively
across organizational boundaries. Key to the
approach is building a high degree of trust with a
small set of vendors. Without this trust, vendor inno-
vation is just a series of outsourced projects. With
this trust, vendor innovation becomes a sustainable
source of value for clients, vendors, and customers.
Figure 1: Managing the Three Innovation Gaps in Vendor Innovation
• Ideas gathered from multiple
sources
• Joint vetting of ideas
• Trusted relationship enables open
collaboration
• Client has final choice of projects
• May not know
business
challenges
and practices
•May not know
new technologies
or outside practices
•Knowledge
of new
technology
and outside practices
• Knowledge of
business and
industry
challenges
VendorClient Vendor Innovation
CONCEPT GAP
IMPLEMENTATION GAP
INCENTIVE GAP
• Vendor makes higher investment
of money, staff, tools
• Client advises project, tests
prototypes, and drives adoption
• Client manages portfolio
• IP sharing managed proactively
• Small number of partners with
high degree of trust
• Vendor can sell solution
to others
• Client serves as reference in
exchange for customized low-cost
solution
•Lacks real sandbox
•Difficult to drive
adoption
•R&D funding
•Innovation
tools, skills and
culture
•Fewer resources
to invest
•May lack technical
and development skills
•Business/process expertise
•Real business
sandbox
•Can influence
adoption
•Wants standard
solution
•Wants to sell same
solution to others
•Incentive to
innovate to gain
revenue
•Wants faster
sales cycle
•May not want to
share innovations
with others
•Wants innovative
solution at low cost
•Advantage from first
adoption
•Can use vendor
innovation to spur
culture change

4. About the Center for Information Systems Research
CISR MISSION
CISR was founded in 1974 and has a strong track record
of practice based research on the management of infor-
mation technology. As we enter the twenty-first century,
CISR’s mission is to perform practical empirical re-
search on how firms generate business value from IT.
CISR disseminates this research via electronic research
briefings, working papers, research workshops and exec-
utive education. Our research portfolio includes:
Achieving Superior Business Value from IT
—A Single Framework of What Matters
Managing IT for Efficiency and Growth
Benchmarking and Building Risk Management
Capabilities
Business Models
Distributed Collaboration
Building Innovative Capabilities Through IT
Building a Platform for Agility
Enterprise Architecture as Strategy
IT-Enabled Business Change
Maturing and Globalizing IT Governance
Redefining the CIO; Introducing the SEO
Enhancing Engagement
IT Portfolio Investment Benchmarks, IT Savvy
and Links to Firm Performance
Strategic Outsourcing
Since July 2000, CISR has been directed by Peter Weill,
formerly of the Melbourne Business School. Drs. Jeanne
Ross, George Westerman, Nils Fonstad, and Stephanie
Woerner are full time CISR researchers. CISR is co-
located with MIT Sloan’s Center for Digital Business
and Center for Collective Intelligence to facilitate collab-
oration between faculty and researchers.
CISR is funded in part by Research Patrons and Spon-
sors and we gratefully acknowledge the support and con-
tributions of its current Research Patrons and Sponsors.
CONTACT INFORMATION
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Telephone: 617/253-2348
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Nils Fonstad, Research Scientist nilsfonstad@mit.edu
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