To compensate for the sour economy and pullback on consumer spending, many companies are cutting costs like never before. But are they trimming fat or bone?

It may sound counter-intuitive, but a down economy presents an ideal scenario to invest in talent and new products, says Jeff DeGraff, clinical professor of business administration at Ross. He is one of the founders of Ann Arbor-based Innovatrium, a development community that serves as an idea market, research lab, and think tank for innovation projects and practices. In the following Q&A, DeGraff explains why now is the time to pursue new opportunities, not retreat from them.

How should companies balance fiscal responsibility with a need to position themselves for future growth?
DeGraff: There are three key things to remember about innovating in a down economy. First: you grow a business by investing in innovation when costs are low so you can monetize them when prices are high. During these recessionary times most people cut back on expenditures that lead to growth, the very things that are going to pay off in the future. They cut things like marketing, R&D, and hiring the right kind of people. In a down economy, there's an enormous glut of good talent. All of a sudden the favorable rates on advertising are better. You can do more science for less money because of the depressed economy.

What we see from the numbers, though, is quite alarming. There are two major studies done on innovation every year with thousands of C-level leaders. One is done by the Boston Consulting Group and the other is done by IBM. What both studies suggest is that in the United States, senior leaders are cutting back between 10 and 12 percent on expenditures for breakthrough types of innovation. These studies also seem to suggest that in East Asia, it's almost the opposite: They're spending more on big innovation. This is a great concern. At some point, U.S.-based firms are going to come out of the recession. And there will be a shakeout of those who have invested in the last development cycle and those who have cut back. We call these "stall points," times when incumbents lose ground and nascent competitors overtake them. There's data that suggests about half of all the Fortune 500 companies experience these stall points. The data also suggests about 80 percent of those companies that stalled never regained the trajectory of their growth.

That's what's alarming. This is the best time to become more aggressive about innovation and growth. I'm not just talking about gadgets, fashion, or uses of information. I'm talking about marketing, inbound logistics, business models, design factors, and all forms of innovation. Innovation is really the only value proposition with a shelf life. It's like milk. It goes bad over time. Radical innovation doesn't stay radical for very long. So if you go to Best Buy this Christmas and see something very interesting, I guarantee you by next Christmas it's not going to be that interesting. A recession is usually a time for creative destruction. Down economies are notoriously famous for thinning the herd.

The second opportunity in a down economy is that firms in real trouble have a tendency to try more radical forms of innovation -- show stoppers and category killers. When the risk of innovating and the reward of innovating are reversed, as in a recession, people are more likely to take on increased risk to get the multiplier of a breakthrough. I'll give you some very concrete examples. About 10 to 12 years ago, Apple Computer was basically bankrupt. Now it routinely finishes first in these surveys as the most admired, innovative company in the world. How did Apple go from being dead to the top of the heap in about 10 years? Well, in the words of Bob Dylan, "When you ain't got nothing', you got nothin' to lose."

You're going to do the things you need to do because you have little choice. And it wasn't even a computer that brought them back from the edge but rather the iPod, and they didn't even develop it in their R&D center or build it themselves. They took it outside and created it under the radar. Instead of creating another Byzantine innovation process, their CEO surrounded himself with old Apple fellows, people who knew how to navigate the system and connect the dots. That's part of the brilliance of Steve Jobs. Look at IBM in the late '80s or Nintendo in the early 2000s. Nintendo had been usurped by Playstation and Xbox. But just like with a person, when you have a huge crisis, the risk of changing and the reward of changing is reversed. That is, the more radical the innovation the more likely it is born in a time of crisis. That's why alcoholics stop drinking only when they hit the bottom. That's why the financial crisis has absolutely fundamentally changed some consumer spending activities. Necessity is indeed the mother of invention.

The third point is about the connectiveness of innovation. In a down economy companies have a tendency to innovate in a "federation." Capital is scarce and a firm no longer has the wherewithal to do all the investment or own all the intellectual property, so it connects with suppliers, maybe even competitors, or maybe even joins an organization whose job it is to connect the dots. That's one of the things we do here at the Innovatrium. For example, in the past a pharmaceutical company would have a huge R&D lab and do all of the drug discovery work itself. Now, instead of aligning and optimizing everything as it did five years ago, this company is weaving a web of hundreds of tier-one biotech firms, graduate students, and other service providers, and synchronizing their development efforts across this loose confederation. So they own less of the intellectual property but they've spent less to get it in these hard times. It really comes down to that old philosophy of a rising tide lifts all boats.

That makes sense, but it sounds like too few are doing it.
DeGraff: If the numbers from these surveys are accurate, what's scary is that a very large percentage of these firms are losing ground. Here's why that is important. Because innovation is time-bound, you can't say you're not going to invest in it like you're not going to paint your headquarters building this year. Well, the building will just look a little sloppy. But with innovation what you're doing is losing a product, service, or solution cycle. You're losing a whole generation of profits. The reason to innovate is that you're basically trying to create new markets and higher revenue bands, a uniqueness that creates profits.

(Part 2 of 2)