©2009 Prentice Hall 5-1 MGMT 738 Management of Technology Lecture 9 Selecting Innovation Projects

©2009 Prentice Hall5-1

MGMT 738 Management of Technology

Lecture 9

Selecting Innovation Projects


Learning Objectives

• Identify the different ways that firms manage the uncertainty of innovation

• Describe the different tools for making decisions about innovation• Use the analytical hierarchy process to evaluate innovation

projects• Calculate the internal rate of return, payback period, and net

present value of innovation projects• Conduct a real options analysis of an innovation project• Explain why real options analysis is often better than net present

value calculations for evaluating innovation projects• Use a decision tree to make decisions about innovation projects• Explain why companies need to manage product portfolios

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Overview

• Methods of choosing innovation projects range from informal to highly structured, and from entirely qualitative to strictly quantitative.

• Often firms use a combination of methods to more completely evaluate the potential (and risk) of an innovation project.

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The Development Budget• Most firms face serious constraints in capital

and other resources they can invest in projects.

• Firms thus often use capital rationing: they set a fixed R&D budget and rank order projects to support.R&D budget is often a percentage of previous

year’s sales. Percentage is typically determined through

industry benchmarking, or historical benchmarking of firm’s performance.

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The Development Budget• R&D Intensity varies considerably across and

within industries.Industry R&D as a Percent of Sales

Software & Internet 12.7%

Health 11.2

Computing & Electronics 7.6

Technology 4.3

Aerospace & Defense 4.1

Automotive 4.1

Industrials 2.3

Consumer Products 2.1

Telecom 1.9

Chemicals & Energy 1.5

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The Development Budget

• Top 20 Global R&D Spenders, 2004Company R&D

Expenditures ($billions)

R&D as percent of

sales

Company R&D Expenditures ($billions)

R&D as percent of

sales

Microsoft $7.8 21% GlzxoSmithKline 5.2 14%

Pfizer 7.7 15% Intel 4.8 14%

Ford 7.4 4% Volkswagen 4.7 4%

DaimlerChrysler 7.0 4% Sony 4.7 7%

Toyota 7.0 4% Nokia 4.6 13%

General Motors 6.5 3% Honda 4.4 5%

Siemens 6.2 7% Samsung Electronics

4.3 6%

Matsushita Electric

5.7 7% Novartis 4.2 15%

IBM 5.7 6% Roche Holding 4.1 17%

Johnson & Johnson

5.2 11% Merck 4.0 18%


Managing Uncertainty

• Strategic actions that can be take to manage uncertainty: Seeking high enough returns to justify the cost of

bearing it Minimizing the magnitude of your investments in non

non-salvageable assets by using generic inputs, starting on a small scale, and turning fixed assets in variable ones

Maintaining the flexibility to change strategic direction Reallocating it to those parties more willing, or able, to

bear it


Decision-Making Tools

Qualitative: compare projects on the basis of scales or words

Quantitative: evaluate projects based on the basis of numerical calculations

Comparative: pit projects against each other

Scoring: compare projects against standard scales


Net Present Value

• Many quantitative decision-making tools are based on the analysis of discounted cash flows Net present value calculation: estimates the value

of a project today, given the amount and timing of cash outflows and inflows and the discount rate

Internal rate of return calculation: estimates the rate of return on a project, given the level of expenditure and the timing and amount of cash inflows and outflows

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Quantitative Methods for Choosing Projects

Discounted Cash Flow (DCF)• Net Present Value (NPV): Expected cash

inflows are discounted and compared to outlays.


Present Value of Future Cash Flows


Payback Period

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• Internal Rate of Return (IRR): The discount rate that makes the net present value of investment zero.– Calculators and computers perform by trial and error.– Potential for multiple IRR if cash flows vary


Internal Rate of Return

• The discount rate that yields a net present value of zero

• Provides an indication of how high a financial rate of return a project will generate

• Estimates whether the project provides enough of a premium to justify bearing uncertainty to undertake it


Internal Rate of Return

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Strengths and Weaknesses of DCF Methods:• Strengths

– Provide concrete financial estimates– Explicitly consider timing of investment and time value of

money

• Weaknesses– May be deceptive; only as accurate as original estimates of

cash flows.– May fail to capture strategic importance of project


Real Options

• A tool that can be used to overcome the limitations of discounted cash flow analysis

• Provides the right, but not the obligation to make a future investment by involving: Option price: the cost of developing a new

technology Exercise price: the cost of exploiting the

technology


Advantages of Real Options

• Limit decision making to information known at the stage at which the decision is being made

• Help you to maintain flexibility, and avoid committing valuable resources to infeasible alternatives

• Permit you to postpone decisions until uncertainty is reduced

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Real Options: Applies stock option model to nonfinancial resource investments. E.g.,with respect to R&D:• The cost of the R&D program can be considered the

price of a call option.• The cost of future investment required to capitalize

on the R&D program (such as the cost of commercializing a new technology that is developed) can be considered the exercise price.

• The returns to the R&D investment are analogous to the value of a stock purchased with a call option.


Decision Tree

• A visual representation of decisions and their effects on: Outcomes Costs Risks


A Decision Tree


Real Options Evaluation for a Wireless PDA

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Examples of real call options


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• Options are valuable when there is uncertainty (as in innovation)

• However, real options models have some limitations: Many innovation projects do not conform to the same

capital market assumptions underlying option models.• May not be able to acquire option at small price: may require

full investment before its known whether technology will be successful.

• Value of stock option is independent of call holder’s behavior, but value of R&D investment is shaped by the firm’s capabilities, complementary assets, and strategies.

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Qualitative Methods of Choosing Projects

• Many factors in the choice of development projects are extremely difficult (or misleading) to quantify.

• Almost all firms thus use some qualitative methods. Screening Questions may be used to assess different

dimensions of the project decision including:• Role of customer (market, use, compatibility and ease of use,

distribution and pricing)• Role of capabilities (existing capabilities, competitors’

capabilities, future capabilities)• Project timing and cost


Checklist

• An example of a scoring model

• Projects are evaluated on whether or not they meet specific criteria

• A useful tool whenever the presence or absence of key factors affects a decision to move forward on a project


A Checklist for Selecting Software


Analytical Hierarchy Process

• A decision-making tool in which a problem is broken down into a hierarchy of different criteria and choices

• Involves ranking the importance of each criteria


Analytical Hierarchy Process

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The Aggregate Project Planning Framework• Managers map their R&D projects according to levels of risk, resource

commitment and timing of cash flows

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• Advanced R&D Projects: develop cutting-edge technologies; often no immediate commercial application.

• Breakthrough Projects: incorporate revolutionary new technologies into a commercial application.

• Platform Projects: not revolutionary, but offer fundamental improvements over preceding generations of products.

• Derivative Projects: incremental improvements and variety in design features.

• Derivative projects pay off the quickest, and help service the firm’s short-term cash flow needs. Advanced R&D projects take a long time to pay off (or may not pay off at all), but can position the firm to be a technological leader.

Managers then compare actual balance of projects with desired balance of projects.

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Q-Sort is a simple method for ranking ideas on different dimensions. • Ideas are put on cards.• For each dimension being considered, the cards are

stacked in order of their performance on that dimension.

• Several rounds of sorting and debate are used to achieve consensus about the projects.


Scenario Analysis

• The representation of investments under different assumptions about key factors that influence those investments

• It assists to identify the sources of uncertainty rather than assuming them away

• Can use Monte Carlo simulation to create a probability distribution of outcomes through the use of computer software that experiments with randomly selected values of inputs

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Combining Quantitative and Qualitative Information

• Managers may use multiple methods in combination.• May also use methods that convert qualitative

information into quantitative form (though this has similar risks as discussed with quantitative methods) Conjoint Analysis estimates the relative value individuals

place on attributes of a choice.• Individuals given a card with products (or projects) with different

features and prices.• Individuals rate each in terms of desirability or rank them.• Multiple regression then used to assess the degree to which an

attribute influences rating. These weights quantify the trade-offs involved in providing different features.

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Courtyard by Marriot Marriot used conjoint analysis to help it develop a

midprice hotel line. First used focus groups to identify customer segments

and attributes they cared about in a hotel. Then created potential hotel profiles that varied on

these features and asked participants to rate the profiles.

Regression identified which features were valued most.

Based on the results, Marriott developed Courtyard concept: relatively small hotels with limited amenities, small restaurants and meeting rooms, courtyards, high security, and rates of $40-$60 a night.

Theory In Action

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Combining Quantitative and Qualitative Information

Data Envelopment Analysis (DEA) uses linear programming to combine measures of projects based on different units (e.g., rank vs. dollars) into an efficiency frontier.• Projects can be ranked by assessing their distance

from efficiency frontier. • As with other quantitative methods, DEA results only

as good as the data utilized; managers must be careful in their choice of measures and their accuracy.


Portfolio Management Tools

• Help companies developing multiple products to: coordinate the different parts of the innovation process, set up the right order for those activities, and determine what resources are needed at different points in the process

• Help decision makers to decide the order in which to pursue projects and to allocate resources between them, given resource constraints


Project Maps

• A portfolio selection tool that helps to manage the allocation of resources across platform, derivative, and breakthrough projects

• Links product development efforts to firm strategy

• Helps companies to avoid over commitment to innovation

• Helps sequence product development efforts to utilize resources effectively

• Improves the management of product development personnel

Documents

©2009 Prentice Hall 5-1 MGMT 738 Management of Technology Lecture 9 Selecting Innovation Projects