Failure to innovate will cost companies more than just revenue. It has the potential of permanently surrendering market share and perception in consumers

The news today is grim on several fronts, as recession fears continue to grip world markets. If plunging markets and an economic slowdown weren’t bad enough, it became official that General Motors is no longer the world’s largest auto manufacturer. While it hasn’t lost the title entirely, its new sales data shows it’s in a dead heat with Toyota. Odds are, as many industry analysts have predicted over the past several years, Toyota will overtake GM and retain the new leadership mantle with ease.

At the same time, Apple’s financial data shows iPod sales slowed. While the company famous for its Mac computers and the iPhone sold more of the personal music players in the last quarter than ever before, the increase in year-over-year sales slow to its lowest point since the gadget was introduced five years ago.

Part of what’s behind the rise—and fall—of these giants is innovation and the failure to keep innovating.

GM built its business on a tried-and-true model of fixed obsolescence. Like most carmakers, GM’s cars and trucks have an average lifespan of about five years (coincidentally, the same time as most car loans). Each year, it releases new models with modified designs, features and performance standards. The idea is to entice people to churn their cars in favor of more stylish vehicles with new, previously unavailable features.

Guess what? We saw the same thing with the iPod. The iPod Apple sold over the holidays is hardly the same as the brick it introduced in 2002. For roughly $200, you could get a new 8 GB iPod Nano with a solid-state hard drive, color screen, video capabilities and a host of new features like games and whiz-bang graphics that were previously unavailable. Sitting alongside the Nano on the store shelf was the “classic” iPod. For just $150 more, you could get 80 GB of memory and video, but it’s also three times the size and has none of the new features.

For the same money as the Nano and $100 less than the iTouch (basically a iPhone sans phone), gadget buyers could get a Microsoft Zune. Larger than a Nano and with a screen even larger than the Classic, Zune outsold iPod for the first time over the holidays. This leap happened because the iPod started pushing market saturation and its competitors finally started offering products that either rival or exceed the iPod’s novelty.

Same thing happened with GM, Ford and Chrysler. They believed consumers would continue to accept multiple brands with lackluster performance and features, and homogenized designs because they owned the market. Their failure to recognize that better quality, performance and features would allow foreign competitors to undermine their market was one of their biggest mistakes.

Despite critics’ praise for the quality and design of GM’s 2008 line, consumers don’t care. The carmakers reputation is so sullied by countless gaffes of the past that it’s difficult to turn around poor perceptions. The primary factor keeping GM in the game is deep discounts and incentives.

Microsoft faced a similar problem in 2001 following a devastating string of malware outbreaks that compromised tens of millions of networks and machines around the world. In response, it launched its Trustworthy Computing Initiative to clean up its source code and improve the security of its products. Six years later, Microsoft’s security has improved—although there are still plenty of problems and vulnerabilities—but it still battles the perception of having poor security.

No one is saying the iPod is dead or dying, but it may have peaked. So it’s no surprise that Apple is pushing into new markets—the iPhone, on-demand video rentals, Apple TV and, surprisingly, personal computers.

GM and other American carmakers are leveraging new technology—voice-activated audio systems, new safety features, alternative fuels—to revive their lines. While some of this is innovative, it’s difficult to predict if it will have an impact on shoring up eroding marketshare.