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Innovation orientations and their

effects on business performance:
contrasting small- and
medium-sized service firms
Daniel I. Prajogo1, Christopher M. McDermott2
and Margaret A. McDermott3
1

Department of Management, Monash University, PO Box 197, Caulfield East, Victoria 3145,
Australia. daniel.prajogo@monash.edu
2
Lally School of Management and Technology, Rensselaer Polytechnic Institute, Troy, New York,
USA. mcderc@rpi.edu
3
Lally School of Management and Technology, Rensselaer Polytechnic Institute, Troy, New York,
USA. mcderm3@rpi.edu

This study examines the relative performance of small- versus medium-sized service firms
with respect to innovation orientations and their effect on business performance. We
examine the effect of innovation on business performance between the two groups of firms,
exploring differences in innovation orientation on performance between the groups of
small- and medium-sized firms. We also examine differences within each group, exploring
the extent to which innovation focus differs within each group. The empirical data were
drawn from 180 managers in Australian service small and medium enterprises. The findings
suggest that while there is no difference between small- and medium-sized firms with
respect to their innovation orientations, significant differences exist between the firms size
with respect to the effect of innovation orientations on business performance. Specifically,
exploitation innovation has a stronger effect on business performance among small firms
compared with medium-sized firms, and exploration innovation shows a stronger effect on
business performance among medium-sized firms compared with small firms. Overall, the
findings show important relative differences between innovation orientations and business
performance across different sized firms.

1. Introduction

ervices are increasingly important for economic

development in many countries, and have delivered significant contribution to economic growth and
employment (Johannessen and Olsen, 2010). Data
from World Bank suggest that service sectors contribute 64% of the total gross domestic product
486

among high-income countries (Soubbotina, 2004).

As a result, studies on service management have
also grown in the past two decades, with one of the
primary focuses being the identification of sources of
competitive advantage in service firms. Innovation
has been recognized as one of the key sources of
competitive advantage in service sectors (Berry et al.,
2006; Therrien et al., 2011). Indeed, innovations in
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Innovation orientations and business performance

services have contributed to significant economic
activity and growth (Cainelli et al., 2004). In this
paper, we adopt the conceptualization of service
innovation by Salunkea et al. (2011) as new knowledge or technologies that firms incorporate into their
service offerings, which results in value for customers as well as the firms. While innovation has largely
been studied in the context of large firms, it has often
been neglected in small and medium enterprises
(SMEs) (Laforet, 2009; Li et al., 2011). Existing
research (Low et al., 2007; Madrid-Guijarro et al.,
2009; Clark, 2010) defines firms as SMEs if they
have less than 250 employees (following EU Commission) or 500 employees (following US standard).
While this classification may be useful in that it separates these firms from their larger counterparts, it is
unclear whether one can assume that this classification truly creates a homogeneous group, or whether
significant differences exist between small- and
medium-sized firms (Cagliano et al., 2001; McAdam
et al., 2004). The present research explores this idea.
We explore the extent to which differences in firm
size are associated with different innovation strategies and performance outcomes. In this study, we
examine the following research questions: (1) Do
small service firms exhibit different innovation orientations compared with medium-sized service
firms? (2) Do performance outcomes differ between
small- and mid-sized firms depending on their innovation orientation? (3) Do the results of research
questions 1 and 2 provide a corresponding match
between innovation orientations and their benefits for
both small service firms and medium-sized service
firms?

2. Theoretical background
2.1. Service innovation theory
A review of literature on innovation in services indicates that this area is still underresearched compared
with manufacturing sectors (Menor et al., 2002;
Droege et al., 2009). Agarwal and Selen (2011), for
example, acknowledge the shortcomings of the existing literature on service innovation and point to the
importance of understanding the complex nature of
service innovation as a key element in this shortcoming. A number of factors have contributed to the
difficulties in studying service innovations. First, the
fuzzy nature of service outputs brings difficulties
in identifying and measuring the innovation,
improvement, or change (Gallouj and Weinstein,
1997). One of the primary implications is that service
development requires more complex and challenging
2013 John Wiley & Sons Ltd and RADMA

processes from development stage until commercialization stage (Drner et al., 2011). For example,
due to their fuzzy and flexible nature, new services
cannot be developed through systematic and standardized processes like manufacturing goods. As a
result, they are difficult to be reproduced repeatedly
and consistently. Also, unlike new products, new
services cannot be pretested before being launched to
the market.
Second, there is a prevalent view suggesting that
services are rather uninteresting with respect to innovation, which may have caused them to attract relatively little attention from scholars of innovation
(Tether, 2005). One of the reasons is that due to its
intangibility of service outputs, service innovations
can be invisible and therefore difficult to identify.
Coupling this with the flexible nature of services (as
mentioned earlier), services need to be constantly
adapted to unique and differentiated customer
requirements. As a result, it often becomes difficult to
differentiate between service variations and innovations (Tether, 2005).
Third, as Freel and Robson (2004) show, manufacturing firms benefit more from novel innovation,
while in service firms it is incremental innovation
that brings significant business growth. As a result,
the emphasis of innovation in services tends to be
placed on continuity rather than newness (Voss et al.,
1992). One of the conditions that discourages service
firms from being involved in innovation projects,
especially the radical ones, is that service innovations
are less protected than manufacturing ones (Drner
et al., 2011). For example, services are difficult to be
protected by patent law (Cowell, 1988). One possible
solution for generating service innovations that offer
sustainable competitive advantage is by developing
new services that capture the whole customer experience (i.e. service bundle) which will be difficult to
be imitated by competitors (Crichton and Edgar,
1995). The challenge is that this kind of service often
requires a very complex and huge amount of
resources, which not many service firms can afford.
Finally, the impact of service innovation on business performance is less certain compared with
manufacturing; in other words, it is difficult for services to gain a sustainable competitive advantage from
innovations (De Jong et al., 2003). As Voss et al.
(1992) suggest, service innovations are commonly
implemented but are also more easily imitated compared with manufacturing innovations. Voss et al.
(1992) also suggest that service innovation may take
longer to have impact on business performance
in service firms compared with manufacturing firms.
This could be because, as noted earlier, innovation
in service is more difficult to be perceived by
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Daniel I. Prajogo, Christopher M. McDermott and Margaret A. McDermott

customers. The above arguments, nonetheless, do not
suggest that service firms cannot derive significant
benefits from innovation, but instead that perhaps the
benefits come from certain aspects of innovation that
are different in service than manufacturing (Prajogo,
2006). From this perspective, it can be argued that it
is necessary to capture the distinguishing features,
and perhaps theories of services innovation, compared with those in manufacturing, although this is
not to say that innovation in manufacturing and in
services has to be sharply demarcated.
As mentioned earlier, services increasingly drive
firm value, and innovation has been considered as an
effective way to accelerate growth and profitability
(Moller et al., 2008). A firm that actively introduces
service innovations by consistently augmenting or
renewing the value of its existing offerings can win
more customers and increase revenue (Victorino
et al., 2005). However, the effect of service innovation on business performance is still underresearched
(Aas and Pedersen, 2010). More specifically, there
are few studies that examine the role of service innovation as a source of competitive advantage. As a
result, we are left with numerous questions, one of
which is the different effects of the different characteristics of service innovation on business performance. As we discuss later, the present paper is aimed
at further expanding our understanding of service
innovation by examining the innovation orientations
in small- and medium-sized service firms.

2.2. Exploration and exploitation

innovation
Drawing from the concepts of product innovation
in manufacturing sectors, scholars have proposed
several service innovation typologies (Droege et al.,
2009). One of the key criteria for establishing the
innovation typologies is the degree of radicalness of
innovation. For example, Avlonitis et al. (2001) offer
a typology that classifies service innovation into six
different types: new-to-the-market services, new-tothe-company services, new delivery processes,
service modifications, service line extensions, and
service repositioning. This typology reflects a continuum of the range of innovation, from discontinuous (radical) innovation to continuous (incremental)
innovation (de Brentani, 2001).
Since the work by March (1991), exploratory and
exploitive innovations have received attention and
are considered important to the long-term viability of
organizations. The definitions of both exploration
and exploitation innovations have been found widely
in the literature (March, 1991; He and Wong, 2004;
Jansen et al., 2006). Exploration innovation is often
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R&D Management 43, 5, 2013

associated with more breakthrough or radical departures from existing offerings. It is associated with
new-to-world products or services, creating new
markets, and the identification of needs for emerging
customers and markets. Exploitive innovation is
associated with extensions to existing product and
service lines. Existing knowledge is utilized to
further incrementally improve products/services to
satisfy existing customers in known markets. In our
study, exploitation innovation refers to extensions
and refinements to existing services. Explorative
innovation, on the other hand, relates to the pursuit of
new opportunities in the spirit of invention and
experimentation.

2.3. Innovation and firm size

The question of whether organizational size has an
effect on innovation activities and outcomes has been
the subject of a great deal of controversy and research
(Stock et al., 2002). In his meta-analysis, Damanpour
(1992) found that firm size has a positive relationship
with innovation among manufacturing firms, but not
with service firms. On the one hand, size is considered to be positively related to innovation because
larger firms have the ability to employ larger R&D
staff, which in turn allows firms to generate and accumulate a larger store of technological knowledge and
capabilities. Apart from R&D or other technological
issues, small firms also face a number of impediments for undertaking innovation activities from both
internal (e.g. lack of managerial, financial, and marketing skills) and external (e.g. access to external
funding sources and finding partners) factors (Freel,
2000). On the other hand, there are arguments that
smaller firms have greater advantages in innovation
because they can be more flexible and nimble, and
therefore be better able to adapt quickly, and to
accept and affect change (Bommer and Jalajas,
2002). In summary, size provides both advantages
and disadvantages on innovation activities in organizations (Vossen, 1998). Therefore, research on the
effect of size on innovation is inconclusive, notwithstanding when the type of innovation (i.e. exploration
versus exploitation) is taken into account.

2.3.1. Small- versus medium-sized enterprises

While small- and medium-sized firms are commonly
combined together as a group (labeled as SMEs),
studies have shown that different size classifications
within SMEs reveal differences in a number of
key managerial aspects, including organizational
structure, leadership style, decision-making processes, and various other organizational practices
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Innovation orientations and business performance

(Ghobadian and Gallear, 1997; Husband and Mandal,
1999; Cagliano et al., 2001). Small firms with 20
employees appear to operate in a different way than
firms with 200 people. By extension, one might
wonder if this can also affect innovation orientation,
but only few studies have looked at this area. Our
knowledge on this subject is limited. McAdam et al.
(2004) examine the effects of SME firms size (less
than 250 employees) in relation to innovation with
respect to a number of areas, including leadership,
people management, culture, and organizational
practices. They affirm that although size classifications within SMEs are not the sole differentiating
factor, they do represent one of the key elements they
examine.
In this study, we specifically seek to compare
small firms with medium-sized firms. A number of
studies have segregated small firms from mediumsized firms and have shown that small firms have
certain distinctive behaviors from medium firms.
For example, Rodwell and Shadur (1997) examined
the differences between small- and medium-sized
companies in terms of a range of human resources,
quality, and general management practices. The
study by Culpan (1989) showed that small-sized
firms show less success in export performance than
do medium-sized firms. The study by Brierley
(2000), in particular, showed significant difference
between the perceptions of managers of small
exporting firms as compared with that of the
medium-sized exporting firms regarding the problems encountered in exporting and motivation to
export.

2.3.2. Empirical studies on SMEs and innovation

More specifically, in the context of innovation,
several studies have segregated small to medium
firms. The study by Laforet (2008) on innovation
propensity among British SMEs shows that mediumsized firms demonstrate a stronger prospector strategy, with stronger focus on product innovation, while
small firms are more oriented toward a defender
strategy, with more focus on process innovation. The
findings suggest a significant difference between
small- and medium-sized firms in their innovation
strategy and focus. Similarly, the study by akar and
Ertrk (2010) among 93 SMEs in Turkey shows differences between small firms and medium firms with
respect to the relationship between organizational
culture and innovation capability. Among their findings, they show that collectivism has a positive effect
on innovative capability in small firms, while among
medium firms power distance orientation shows a
positive effect on innovative capability. None of these
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studies, however, have been focused on contrasting

firms innovation orientations, particularly between
exploration and exploitation, between small- and
medium-sized firms.
In sum, while the existing research has explored
and identified different types of innovation, and has
shown that small and medium firms differ from their
larger counterparts in significant and important ways,
there is much we still do not know, especially with
respect to service firms. The vast majority of what we
do know regarding the relationship among innovation orientation, firm size, and performance is based
on studies from manufacturing, as opposed to service
environments. While insight can be gained, it is not
at all clear how transferable the concepts are across
other operational environments. Innovation in services are important (Miles, 2000), but since service
firms are different from manufacturing firms,
research needs to be conducted in order to better
understand these relationships in the context of services (Droege et al., 2009). As we discuss in our
research hypotheses section later, it is unclear if and
how differences in firm size relate to variations in
patterns of innovation, and how these patterns of
innovation affect a firms overall performance. This
gap in the literature is where we focus our research
efforts in this paper.

3. Research hypotheses
This study compares the level of two different strategies of innovation (exploration and exploitation)
and their effect on business performance between
small firms versus medium service firms, examining
the extent to which different types of innovation
impact the link between size and performance among
service firms. As such, the first set of hypotheses
establishes a baseline by examining the extent to
which firms differ in their innovation orientations
based on their size. The intention is not only to
compare small firms innovative orientations with
medium firms innovation strategies, but also to
compare the innovation orientations (i.e. exploration
versus exploitation) within each group of firms. As
van de Vrande et al. (2009) suggest, the extent to
which firms can engage in technology exploitation
and exploration innovation is likely to be contingent
on their size. In the earlier section, several key arguments are presented concerning the effect of firm size
on innovation. While those arguments do not appear
to be conclusive, they are skewed toward a notion
that larger firms would be inclined to venture into
explorative innovation more than smaller firms. This
is not only because they have stronger resources and
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Daniel I. Prajogo, Christopher M. McDermott and Margaret A. McDermott

capabilities to do so, but also because their size
allows them to take risks in handling the potential
failures of exploration innovation. Bringing this
notion in the context of SMEs, the following hypotheses are suggested:
Hypothesis 1: Medium firms exhibit greater exploration innovations than small firms.
Hypothesis 2: Small firms exhibit greater exploitation innovations than medium firms.
Apart from the above between difference, we
will also examine if within each group of firms (i.e.
small and medium) there exists a stronger orientation
of one type of innovation over the other. This is based
on Marchs (1991) argument that it is difficult for
firms to focus on both innovation orientations simultaneously. The aim of this study is to examine if this
supposition holds true with the case of SMEs, and
whether there is a contrast between small- and
medium-sized firms in their innovation orientations.
The literature does not explicitly suggest such a
different behavior. However, one might draw the
implication from the arguments for the between
variations that small firms have stronger inclination
toward exploitation innovation, while medium firms
toward exploration innovation. Specifically, smaller
firms would be more inclined to focus (relatively) on
exploitation rather than exploration innovation due to
limited resources and capabilities in the organizations. On the other hand, larger firms (i.e. mediumsized firms) with more resources and funds would
be more focused on exploration innovation in order
to capitalize on its benefits. Therefore, one might
hypothesize:
Hypothesis 3: Small firms are more focused on
exploitation innovation than exploration innovation.
Hypothesis 4: Medium firms are more focused on
exploration innovation than exploitation innovation.
While the innovation orientation may differ as a
function of firm size (Hypothesis 1), a firms primary
interest has to do with increasing its business performance. Innovation is widely viewed as a driver of
performance (Akamavi, 2005; Corsino and Gabriele,
2010), but it is unclear whether the different types of
innovation are equally valued in improving the performance of firms. The study by Damanpour et al.
(2009) suggests that service firms that engage in different types of innovations could have more positive
outcomes than continually focusing on one type of
innovation. However, it is unclear whether the effect
of different types of innovation on business performance is equal across various firm sizes (Oke et al.,
2007). Radical innovations have a potential for gen490

R&D Management 43, 5, 2013

erating high returns for small firms (Kanter, 1989),

but it is unclear whether small firms have sufficient
resources to pursue them. As noted earlier, Laforet
(2009) found that medium-sized firms demonstrate
stronger focus on product innovation, while small
firms are oriented more toward a defender strategy,
with more focus on process innovation and incremental change. Alternatively, smaller firms may
pursue a strategy focused on incremental, exploitive
innovation simply because they have learned that it is
a more profitable path for them, given their lack of
resources and areas of specialization. It is beyond the
scope of this study to examine the motives behind the
decisions; yet, if one assumes that the firms behave
rationally, one would expect that different sized firms
might pursue specific types of innovation simply
because that type of innovation is more profitable
than the other. This question is examined in the next
four hypotheses first exploring the extent to which
specific types of innovation have stronger effects on
performance across different sized firms (Hypotheses 5 and 6), and then exploring the extent to which
the two different types of innovation provide relative
performance value to firms within each size (Hypotheses 7 and 8). Specifically:
Hypothesis 5: Exploration innovation has a stronger
effect on business performance among medium firms
than among small firms.
Hypothesis 6: Exploitation innovation has a stronger
effect on business performance among small firms
than among medium firms.
Having tested the differences of the impact of
innovation orientations on business performance
between small- and medium-sized firms, it would
then seem logical to test if one innovation orientation
(exploration or exploitation) shows a significantly
stronger effect on business performance within each
group of firms. This test is important because it could
provide for each group of firms the first set of practical guidelines as to whether or not they should
combine both innovation orientations, or simply
focus on one particular innovation orientation, and if
so which one? In this regard, we extend the line of
arguments in the previous hypotheses (Hypotheses 3
and 4), which posit that medium-sized firms are
focused more on exploration innovation, while small
firms are focused more on exploitation innovation.
Implicit in these arguments is that exploration innovation will be more effective in delivering business
performance within medium-sized firms, while
within small firms exploitation innovation will
function as a more effective competitive strategy
to enhance business performance. Accordingly, we
hypothesize:
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Innovation orientations and business performance

Table 1. Industry sectors based on Australian and New Zealand Standard Industrial Classification
Divisions

Small firms

Medium firms

Financial and insurance services

Wholesale and retail trade
Construction
Accommodation and food services
Information media and telecommunications
Professional, scientific, and technical services
Public administration and safety
Education and training
Healthcare and social assistance
Transport, postal, and warehousing
Electricity, gas, water, and waste services
Arts and recreation services
Other services
Total

35
15
10
10
41
24
4
12
10
5
4
7
3
180

19
8
6
6
23
13
2
7
6
3
2
4
1
100

27
5
5
7
30
15
3
6
7
5
3
2
1
116

8
10
5
3
11
9
1
6
3
0
1
5
2
64

Hypothesis 7: Exploitation innovation has a stronger

effect on business performance than exploration
innovation within small firms.
Hypothesis 8: Exploration innovation has a stronger
effect on business performance than exploitation
innovation within medium firms.

4. Method
4.1. Sample and procedures
This study utilized a cross-sectional mail survey of a
sample of Australian service firms, encompassing
various service sectors based on the Australian and
New Zealand Standard Industrial Classification. A
cross-industry sample such as this was chosen to
increase the generalizability of our findings. The distribution of industry sectors of the sample is presented in Table 1.
In administering our survey, we specifically
requested in the cover letter of the survey that the
questionnaire be assigned to personnel who held a
managerial position that relates to strategic and
operational decisions in the firms daily operations.
In total, 1,500 surveys were mailed out, and 180
usable responses were received for an effective
response rate of 12%.
To test for nonresponse bias, we employed wave
analysis technique by comparing the responses of
early and late waves of returned surveys on several
key variables. This technique is based on the assumption that the opinions of late respondents are
representative of the opinions of nonrespondents
2013 John Wiley & Sons Ltd and RADMA

(Rogelberg and Stanton, 2007). Students t-tests

yielded no statistically significant differences
between early-wave and late-wave groups, suggesting that nonresponse bias was not a problem.
The 180 usable responses consisted of 134 respondents (74%) who held senior management position,
including chief executive officers, directors/managing
directors, and general managers. Six respondents
(4%) were the owners of the firms. Nineteen respondents (11%) held managerial position in the middle
level, including business operations, customer services, finance, marketing, and human resources. Five
respondents (3%) were partners or managing partners
of the firm, and the other nine (5%) were categorized
as others, which include research coordinator and
business development coordinator. Seven respondents
did not specify their formal position in the firm.
In our study, SMEs are defined as firms with less
than 250 employees. The cutoff point of 250 is consistent with that adopted by European Commissions,
and has been used widely in a number of other studies
(Cagliano et al., 2001; Mosey et al., 2002; McAdam
et al., 2004). In classifying the sample based on firm
size, we used 50 people as the cutoff point to segregate
small firms (less than 50 employees) from medium
firms (50249 employees), which is consistent with
that adopted by European Commissions. In our
sample, 116 firms were categorized as small-sized
firms, while 64 firms belonged to medium firms.

4.2. Measures
A diverse range of operationalizations have emerged
for the exploration and exploitation concepts. In this
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Daniel I. Prajogo, Christopher M. McDermott and Margaret A. McDermott

study, the measures of exploration and exploitation
innovation strategies were based on the work by
Jansen et al. (2006). Both innovation measures are
based on a 7-point scale that captured the extent to
which firms depart from existing knowledge and
pursue innovations for emerging customers or
markets (exploration), and the extent to which firms
build on existing knowledge and meet the needs of
existing customers (exploitation). Each measure was
gauged using 7-point Likert scale ranging from 1
(strongly disagree), 4 (neutral), to 7 (strongly agree).
The business performance scale was measured
using three items sales, profit, and market share
following previous studies on operation strategies
and performance (Yamin et al., 1997; Ward and
Duray, 2000). Respondents provided their perceived
rating of various performance measures relative to
the firms industry average. The measure was gauged
using 7-point Likert scale ranging from 1 (well
below), 4 (comparable), to 7 (well above). While the
use of a subjective measure for business performance
may be questioned in terms of its validity, past
studies have shown that that this approach has been
shown as being consistent with objective internal performance and even with external secondary data
(Curkovic et al., 2000, p. 395).
In this study, we included two measures of business environment in terms of uncertainty (dynamism)
and hostility (competitiveness) as control variables
for firms performance because both variables have
been shown in the past to be associated with business
performance (see, e.g., Lee and Miller, 1996). The
inclusion of both variables in the analysis is even
more important given that the focus of this study is
on SMEs whose performance could be significantly
influenced by external environmental factors apart
from their competitive strategies (Miller and
Toulouse, 1986; Covin and Slevin, 1989). Both
scales of business environment were adopted from
the study by Jansen et al. (2006).

5. Results
5.1. Scale validity and reliability
The five scales were subjected to validity and reliability tests. Construct validity was tested using principal component analysis (PCA), and the results
supported the validity of these five scales, as indicated by the amount of variance explained which
exceeded 50% and the loading factors of all items
within each scale which exceeded 0.5 (Hair et al.,
2006). Reliability analysis was conducted by calculating the Cronbachs alpha for each scale. The
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R&D Management 43, 5, 2013

results show that the Cronbachs alpha measures for

the five scales surpassed the threshold point of 0.7
(Nunnally, 1978). The complete results of the validity and reliability tests are presented in Table 2.

5.2. Common method variance

Since the data set was drawn from a single respondent in the organization, common method variance
needs to be checked to ensure that the data had no
major problem with response bias. The test for
checking common method variance used in this study
was Harmans single-factor test suggested by
Podsakoff and Organ (1986). This test was run by
loading all 24 items into PCA and examining the
number of factors extracted from these items. The
result indicated that five factors were extracted from
the un-rotated solution. This result was doublechecked by forcing the 24 items into one factor, and
it produced poor result as indicated by only 29%
variance extracted and more than 50% of the items
suffered from poor factor loadings, which fell below
0.5. These results suggest that common method variance was not a significant problem in the data set.

5.3. Composite scores

Once the scale validity and reliability tests were completed, mean scores were calculated from the scales
items to generate the composite scores for the five
constructs that will be used in the regression analysis
(Hair et al., 2006). Furthermore, the normality of the
five composite scores was checked, and the result
indicated no violation, with skewness and kurtosis
values well within the accepted range ( 1 and <7,
respectively) recommended by Curran et al. (1996).
The results of bivariate correlations among the variables used in this study are presented in Table 3.

5.4. Multivariate analysis of variance

(MANOVA)
As a preliminary test, a MANOVA was performed to
check if there are any differences between service
sectors captured in this study (as per Table 1) on the
three key variables tested, namely exploration, exploitation, and business performance. The result of
MANOVA test was not statistically significant
(Pillais trace F = 1.036 at P > 0.05; Wilks lambda
F = 1.03; P > 0.05; Hotellings trace F = 1.022 at
P > 0.05). Given the nonsignificant differences
between service sectors, it is appropriate to pool the
data in the analysis.
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Innovation orientations and business performance

Table 2. Scale validity and reliability
Scales

Items

Factor
loading

Cronbachs
alpha

Uncertainty

Environmental changes in our local market are intense

Our clients regularly ask for new products and services
In our local market, changes are taking place continuously
In a year, our market has changed significantly
In our market, the volumes of products and services to be delivered
change fast and often
Competition in our local market is intense
Our organizational unit has relatively strong competitors
Competition in our local market is extremely high
Price competition is a hallmark of our local market
We frequently refine the provision of existing services
We regularly implement small adaptations to existing services
We introduce the improved version of our existing services in our
local market
We improve our provisions efficiency of services
We increase economies of scales in existing markets
Our company expands services for existing clients
Our company accepts demands that go beyond existing services
We invent new services
We experiment with new services in our local market
We commercialize services that are completely new to our company
We frequently utilize new opportunities in new markets
Our company regularly uses new distribution channels
The sales of this company is . . .
The profitability of this company is . . .
The market share of this company is . . .

0.70
0.67
0.86
0.78
0.81

0.81

0.91
0.86
0.94
0.69
0.84
0.90
0.86

0.86

Hostility

Exploitation
innovation

Exploration
innovation

Business
performance

0.90

0.88
0.67
0.73
0.62
0.89
0.88
0.88
0.83
0.68
0.89
0.86
0.81

0.88

0.82

Table 3. Mean, standard deviation, and bivariate correlations

Firm size
Firm age
Environmental
uncertainty
Environmental hostility
Exploration innovation
Exploitation innovation
Business performance

Mean

SD

V1

V2

V3

V1
V2
V3

3.11
3.28
4.73

1.23
1.72
1.14

1.00
0.19**
0.07

1.00
-0.01

1.00

V4
V5
V6
V7

5.35
4.84
5.30
4.71

1.20
1.27
0.95
1.24

0.08
0.04
0.08
0.22**

0.05
-0.06
-0.13
0.07

0.25**
0.41**
0.29**
-0.03

V4

V5

V6

1.00
-0.14
-0.09
-0.25**

1.00
0.62**
0.19*

1.00
0.22**

*P < 0.05.
**P < 0.01.
SD, standard deviation.

5.5. Planned contrast test

As mentioned earlier, this study aims to examine the
potential contrasting positions between small- and
medium-sized firms with respect to innovation orien 2013 John Wiley & Sons Ltd and RADMA

tations (exploration and exploitation) and their

impacts on business performance. As such, we
examine both between and within variations (or
differences) between the two groups of firms: the
between variations test if there are significant
R&D Management 43, 5, 2013

493

Daniel I. Prajogo, Christopher M. McDermott and Margaret A. McDermott

Table 4. Mean scores for exploration and exploitation innovations

Exploitation innovation
Exploration innovation
D Mean

Small firms (N = 116)

Medium firms (N = 64)

Mean

SD

Mean

SD

D Mean

5.27
4.81
0.46 (P < 0.05)

1.03
1.37

5.35
4.89
0.46 (P < 0.05)

0.81
1.08

0.08 (P > 0.05)

0.08 (P > 0.05)

SD, standard deviation.

differences between small- and medium-sized firms

with respect to the degree of innovation orientations
(Hypotheses 1 and 2) as well as their effect on business performance (Hypotheses 5 and 6); and the
within variations test if there are significant differences between the level of innovation orientation
within small firms and within medium-sized firms
(Hypotheses 3 and 4). In addition, the within variations also test if the two innovation orientations
show a significant difference in their effect on business performance within each group of firms
(Hypotheses 7 and 8).
A planned contrast test was performed to test the
first four hypotheses, and it was conducted through a
series of t-tests. Table 4 presents the means and
standard deviations of both exploration and exploitation innovations in the two groups (small- and
medium-sized firms).
An independent t-test was performed to examine if
there are significant differences on exploration and
exploitation innovation between small- and mediumsized firms. The results in Table 4 (right-hand
column) show no significant differences between the
two groups of firms (D mean = 0.08 at P > 0.05).
Therefore, Hypotheses 1 and 2 are not supported. In
order to examine the difference between exploration
and exploitation innovation within each group of
firms, we performed pair tests in each group. The
results in Table 4 (bottom row) show that the means
of exploitation innovation are significantly higher
than exploration innovation within small firms as
well as within medium-sized firms (D mean = 0.46 at
P < 0.5) in both groups. The results suggest that both
small- and medium-sized firms have a stronger innovation orientation toward exploitation than exploration. Therefore, Hypothesis 3 is supported while
Hypothesis 4 is rejected.

5.6. The effect of innovation orientation

on business performance
In order to examine the difference of the effect of
innovation orientations on business performance
between small- and medium-sized firms, two regres494

R&D Management 43, 5, 2013

Table 5. Multiple regression analysis

Business performance
Small firms Medium firms
Control variables
Firms age
0.12
Environmental uncertainty -0.05
Environmental hostility
-0.19*
Innovation orientation
Exploration
-0.12
Exploitation
0.41**

-0.01
-0.16
-0.23*
0.28*
-0.11

*P < 0.05.
**P < 0.01.

sion models were run for small firms and medium

firms separately between exploration and exploitation as independent variables (IVs) against business
performance as dependent variable (DV) controlled
for firms age, environmental uncertainty, and environmental hostility. The results are presented in
Table 5.
In testing Hypotheses 5 and 6, the effect sizes (b)
of exploration and exploitation on business performance were compared between small firms and
medium firms. The results in Table 5 show that
exploration innovation has a positive effect among
medium firms, but not among small firms (b = 0.28 at
P < 0.01 versus b = -0.12 at P > 0.05, respectively).
On the other hand, exploitation innovation has a
positive effect on business performance among
small firms, but not among medium firms (b = 0.41
at P < 0.05 versus B b = -0.11 at P > 0.05, respectively). In order to test whether the b values between
small firms and medium firms are statistically different, the method by Cohen (1977) was adopted. This
test compares the two unstandardized b coefficients
using a Z-test. The result is compared with the
z-value of 5% significance level (i.e. 1.96). The
results show that the z-value for both exploitation and
exploration are above the cutoff point, demonstrating
that the regression coefficients between small firms
and medium firms are statistically different. Specifi 2013 John Wiley & Sons Ltd and RADMA

Innovation orientations and business performance

cally, the regression coefficients show that exploration innovation has a stronger effect on business
performance among medium firms than small firms,
whereas exploitation innovation has a stronger effect
on business performance among small firms than
medium firms. Therefore, both Hypotheses 5 and 6
are supported, and these findings demonstrate the
contrasting effectiveness of different innovation orientation in delivering business performance between
small- and medium-sized firms.
Finally, Hypotheses 7 and 8 aim to examine if
within each group of firm size exploitation and
exploration innovation have different effects on business performance. The results in Table 5 show that
exploitation innovation has a significantly stronger
effect on business performance than exploration
innovation (b = 0.41 at P < 0.01 versus b = -0.12 at
P > 0.05) within small firms. Exploration innovation,
on the other hand, has a stronger effect on business
performance than exploitation innovation (b = 0.28
at P < 0.05 versus b = -0.11 at P > 0.05) within
medium firms. A stringent test using the method by
Rindskopf (1984) was employed to compare the
weight of b values of exploration and exploitation as
the IVs against business performance as the DV. The
tests compares an unrestricted model where both
IVs entered separately explains more variance when
compared with a more restricted model in which the
IVs are summed together (the latter testing the null
hypothesis of equality). The addition of the two IVs
represents the equality constraint in a linear model.
The difference of the sum of squares (DSS) of residuals between the two regression models is calculated
and divided by the difference of the degrees of
freedom (D df) of the two regression models, in this
case D df = 1 since the number of IVs was reduced
from 2 (exploitation and exploration) to 1 (combined). The result is then tested using a conventional
F-test for statistical significance. The results of the
F-test are significant at P < 0.01 for small firms and
P < 0.05 for medium firms, meaning that that the b
values for exploration and exploitation are statistically different. Therefore, both Hypotheses 7 and 8
are supported.

6. Discussion and implications

This study presents four sets of key findings: First, in
Hypotheses 1 and 2, we find no significant difference
between small firms and medium firms with regard to
both exploration and exploitation innovation orientations. What this suggests is that both small- and
medium-sized firms are just as likely to engage in
both technology exploitation and exploration innova 2013 John Wiley & Sons Ltd and RADMA

tion, and these orientation choices are not contingent

upon their size. Second, with regard to Hypotheses 3
and 4, we find that small firms exhibit more exploitation orientation than exploration innovation;
however, we did not find that medium firms exhibit
an opposite orientation. Indeed, similar to small
firms, medium firms exhibit significantly higher orientations on exploitation than exploration innovation. Overall, concerning the first four hypotheses,
the findings fail to exhibit the contrast between small
and medium firms with respect to innovation orientations. Therefore, innovation orientations seem to be
fairly homogeneous within SMEs regardless of firm
size. This finding is somewhat different from the
study by Laforet (2008) among manufacturing firms,
which shows that medium-sized firms have more
patents and prizes for new products (which could be
associated with exploration innovation) than small
firms. However, this finding also concurs with
Damanpours (1992) study (mentioned earlier),
which showed that the positive relationship between
firm size and types of innovation is mainly applied
among manufacturing firms, but not so among
service firms. Furthermore, the findings of this study
show that not only the two groups of firms show a
nearly similar degree of both innovation orientations,
but they also consistently show a stronger focus on
exploitation innovation than exploration innovation.
While this finding is consistent with the argument
that the lack of radical innovation in services may be
due to the ease of copying services and the difficulty
in winning recognition from customers (Oke, 2007),
it should also be made clear that there are many other
plausible sources of this finding, including lack of
resources (Freel, 2000). Therefore, this study does
not explicitly examine the why of Okes arguments.
The third set of findings (Hypotheses 5 and 6)
shows significant differences on the effect of different innovation strategies on business performance
between small firms and medium firms. Exploitation
innovation shows a stronger effect on business performance among small firms than medium firms. On
the other hand, exploration innovation shows a
stronger effect on business performance among
medium firms than small firms. Finally, the fourth set
of findings (Hypotheses 7 and 8) show significant
differences of the effects of different innovation orientations on business performance within each group
of firms. Exploitation innovation clearly shows a
stronger effect than exploration innovation within
small firms, while exploration innovation has a
stronger effect than exploitation innovation within
medium firms. Overall, the third and fourth findings
clearly exhibit sharp contrasting (juxtaposition)
effects between exploration and exploitation innovaR&D Management 43, 5, 2013

495

Daniel I. Prajogo, Christopher M. McDermott and Margaret A. McDermott

tion on business performance between the two
groups of firms. Exploitation innovation shows a
positive effect on business performance among small
firms, but not among medium firms. On the other
hand, exploration innovation shows a positive effect
on business performance among medium firms, but
not among small firms. These findings concur with
Gunday et al. (2011) study, which shows the different
effects of the different types of innovation on firms
performance.
Several implications can be drawn from these findings. The significant effect of exploitation innovation
on business performance among small firms differs
from the argument that small firms are established to
exploit something new or radical innovations (Simon
et al., 2002). However, this finding concurs with the
study by Oke et al. (2007) among small firms in the
United Kingdom, which showed that the pursuit of
incremental innovation had a stronger relationship
with sales turnover growth compared with radical
innovation. But as noted earlier, this link is far from
conclusive. This finding also concurs with the notion
held by Verhees and Meulenberg (2004) that limited
resources and capabilities prevent small firms from
conducting in-house R&D activities; instead, many
innovations by small firms are based on off-the-shelf
technologies, concepts, and/or resources offered by
supplying industries. Again, however, caution is
needed in this interpretation as there are obviously
other issues potentially at play. Medium firms, on the
other hand, profit more from exploratory innovation
to make clear differentiation against their competitors. Also, perhaps because service innovations can
often be replicated more easily than their manufactured counterparts, small firms may tend to shy away
from investing the time or resources to bring the
more radical innovations forward. Regardless, these
findings are also somewhat different from previous
studies on innovation among larger service firms
which showed that focusing on the improvement of
existing products had a positive effect on financial
performance (Storey and Easingwood, 1998). The
reasoning may be that these relatively larger firms are
in a better position to exploit an unforeseen innovation because they can more easily enter a new market.
Another way to think of this point is that, as mentioned earlier, larger firms will have the resources to
tolerate occasional unsuccessful innovation projects
that are more related to exploratory innovation (de
Brentani, 2001).
This study examines the potential contrast
between small- and medium-sized firms with respect
to innovation orientations and their effect on business
performance. The overall results suggest that while
size does not influence innovation orientations, it
496

R&D Management 43, 5, 2013

does affect the effectiveness of innovation orientation

in delivering business performance. These results
call for serious attention as to how SMEs manage and
direct their innovation strategies. While on the
surface SMEs (regardless the size) appear to be convergent in focusing more on exploitation than exploration, they do not obtain similar benefits in terms of
business performance. As such, our findings indicate
that there is a match between innovation orientations
and their effectiveness for small firms, yet mismatch
occurs between innovation orientations and their
effectiveness for medium-sized firms. Our results
indicate that small firms generally have a good match
in the sense that they are more focused on exploitation than exploration innovation (Hypothesis 3), and
they also see that it is exploitation innovation that
functions as the source of competitive advantage
(Hypothesis 7). Medium firms, on the other hand,
experience a mismatch as they are also more focused
on exploitation innovation as small firms do
(Hypothesis 4) but our results indicate that their
business performance mainly benefited from exploration innovation (Hypothesis 8). To the best of our
knowledge, no previous studies have addressed this
issue; thus, our study contributes to this knowledge
by showing the match and mismatch between innovation orientations and their effectiveness in delivering business performance based on firm size.
From practical perspectives, our results suggest
that, in general, small firms should be focused on
more exploitation innovation, while medium-sized
firms should venture more on exploration innovation.
In this regard, medium-sized firms may review their
innovation orientations that appear to be dominated
by exploitation innovation. Similarly, firms that grow
from small to medium might be best served to
monitor their innovation strategy to assure that it
changes accordingly. As mentioned earlier, innovation orientations that are skewed toward exploitation
are prevalent among SMEs, and this is driven by both
internal (managerial) barriers, such as conservative
leaders and lack of resources, as well as external
(environmental) barriers, including government supports (Freel, 2000; Madrid-Guijarro et al., 2009).
Overcoming these two barriers requires not only
improved managerial skills but also supporting
national innovation system for SMEs (Daz-Puente
et al., 2009). At the same time, however, we do not
wish to overstretch the implications of our findings
by suggesting that small firms should solely focus on
exploitation and medium-sized firms on exploration.
We have three plausible reasons for this. First, we
believe that exploration and exploitation innovations,
while different, are not mutually exclusive to each
other. For example, exploration innovation could
2013 John Wiley & Sons Ltd and RADMA

Innovation orientations and business performance

result from accumulation of exploitation innovation
(Tushman and Anderson, 1986). The study by
Rothaermel and Deeds (2004), on the other hand,
shows that exploration innovation will trigger a series
of exploitation innovations. Second, while small
firms currently benefit from exploitation innovation,
they also may grow in their size and need to gradually shift their focus toward exploration innovation.
Therefore, they should not abandon exploration innovation, although it does not act as the main source of
revenue. Third, for medium firms, while exploitation
innovation appears to be singled out as the source of
competitive advantage in innovation, recent studies
suggest that as firms increase in their size (hence
greater resources), they may have an opportunity to
balance exploration and exploitation innovation and
seize the benefits of their ambidexterity (Gupta et al.,
2006; Uotila et al., 2009; Lavie et al., 2011).

interaction between exploitation and exploration in

the organizations where one type of innovation could
be followed by the other. Third, this study uses perceptual measure, and therefore we suggest that future
studies incorporate objective data in measuring (the
outcome of) innovation orientations and business
performance. Finally, since our study is focused on
innovation orientations and their effect on business
performance, it does not address the determinants
(exogenous factors) of these innovation orientations.
We acknowledge that this is an important area
that deserves serious attention, and we found that
a number of studies have examined the key organizational factors that have an impact on innovation
among SMEs (see, e.g., De Jong and Vermeulen,
2006; McAdam et al., 2010). We suggest that
these studies can be integrated with our study to
identify the different roles of various factors in the
organizations in determining different innovation
orientations.

7. Conclusion and limitations

Taken together, the results of this study provide
insight into the contrasting role of innovation in
medium and small service firms. While both types of
firms enjoy performance benefits as a result of innovation efforts, these benefits do not occur evenly
across both groups of firms or innovation orientations. Specifically, we found that while there is no
difference in the innovation orientation (exploitation
versus exploration) between the two groups of firms,
differences do exist relating to the relationship
between innovation efforts and performance. Small
firms see strong relationship between exploitation
and performance, while for medium firms it is exploration innovation that shows a positive relationship
with business performance. This finding is interesting and deserves further examination in future
research to reproduce these findings, and to explore
the underlying reasons for this phenomenon. As was
noted earlier, there is scant research into this area to
date, and there is much to be gained from a better
understanding of this phenomenon from both a theoretical and practitioner perspective.
As in all research, this piece of empirical work
has its limitations. First, we acknowledge that our
sample, while broad, clearly does not represent all
industries equally. Also, future studies could focus on
certain service sectors as different industries could
differ in their engagement with innovative activity
(Tidd et al., 2005). Second, while we performed
the appropriate tests to make reparations, ideally
research such as this would have multiple respondents, and if possible use longitudinal data. Such data
would allow researchers to examine the dynamic
2013 John Wiley & Sons Ltd and RADMA

Acknowledgement
The authors wish to thank Dr Brian Cooper from
Department of Management, Monash University,
Australia, for the advice on the analytical methods
used in this paper.

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Daniel I. Prajogo is Associate Professor in the

Department of Management, Monash University,
Australia. Since completing his PhD degree from
Monash University in 2003, he has produced over
100 publications in the areas of operations and

500

R&D Management 43, 5, 2013

supply chain management, quality management, and

innovation management.
Christopher M. McDermott is Associate Professor
at Rensselaers Lally School of Management. His
research and teaching focus on innovation, healthcare operations, and product development. He is
author of over 100 research papers and conference
presentations. He has a PhD in Operations Management from the University of North Carolina and a BS
in Engineering from Duke University. Professor
McDermotts worked as an electrical engineer prior
to returning to academia. His work experience
includes Westinghouse Electric Company, as well as
Fairchild Space Company, where he was an on-site
contractor at NASAs Goddard Space Flight Center.
Margaret A. McDermott is on the faculty at Rensselaers Lally School of Management, where she is
the Director of the Undergraduate Program. Professor McDermotts research explores the measurement
of organizational competencies, as well as the strategic implications of decision-making in hospitals,
hospital focus, and their relationship with organizational performance. She has a PhD in Organizational
Studies from the University at Albany and a BS in
Electrical Engineering from Duke University. Professor McDermott has significant industry experience in
technical/business fields, having held positions in
technical marketing with Fairchild Space Company,
as well as several years in product development at
Alcatel Network Systems.

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