European Journal of Business and Management ISSN 2222-1905 (Paper) ISSN 2222-2839 (Online) Vol.8, No.29, 2016 113 The Effect of Innovation on Firm Performance and Competitive Advantage Saida Zainurossalamia Djoko Setyadi Syarifah Hudayah Rusmilawati Doctoral Program of Economic and Business Faculty, Mulawarman University, Indonesia Abstact This study aimed to analyze the effect of innovation on Firm Performance mediated by competitive advantage. The sample is Small and Medium Enterprises (SMEs) in Indonesia. Data collection is done by using a mail questionnaire survey, with the number of samples are 164 respondents. The results show that innovation has a positive effect on competitive advantage. An innovation strategy can improve the bargaining position of more companies competing in the market segment of SMEs in Indonesia. This study proves that innovation strategy of SMEs in Indonesia are in the ability to make better products, in the production process by using advances in technology, as well as in the technology development and maintainance. SMEs have different competitions in the excellence of expertise and resources. Further study shows that positional advantage in the market is based on the existence of a superior customer value or achievement of lower relative costs and generate market share and superior performance. Keywords : Competitive Advantage, Firm Performance, Innovation 1. Introduction Innovation arises because of the high competition. In the increasing fierce level of competition and technological advances that can not be dammed, company products will grow to a point, where these products will be difficult to distinguish between one another. Companies are required to excel, one way is to innovate. Innovation will be able to change the organization position in the market. Innovation is one of the most important factors in gaining a competitive advantage in global markets. Innovation is important to create something different with other competitors. Schumpeter (1942) emphasized the importance of innovation. Practitioners and academics have looked towards innovation as a significant managerial issue (Litz and Kleysen, 2001). From a resource-based perspective, firms have incentives to invest significant resources to maintain and build capabilities for innovation. Corporate excellence in every competition is a major concern of management. Innovation can also be used as a strategy to achieve competitive advantage. The main purpose of the product innovation is to meet the market demand so that product innovation can be used as a competitive advantage for the company. Boredom of customers to a product is a thing that must be observed by the company. Customers generally want innovative products in accordance with their wishes.