Management Of
Technology &
Innovation
Abid Nasim
Chapter 4
nnovation Budgets & New
Product Development
Introduction
Developing innovative new products and services is expensive and
time-consuming. It is also extremely risky—most studies have
indicated that the vast majority of development projects fail. Firms
have to make difficult choices about which projects are worth the
investment, and then they have to make sure those projects are
pursued with a rigorous and well-thought-out development
process. In this chapter, we will explore the various methods used
to evaluate and choose innovation projects. The methods range
from informal to highly structured, and from entirely qualitative to
strictly quantitative. We will start by considering the role of capital
rationing in the R&D investment decision, and then we will cover
various methods used to evaluate projects including strictly
quantitative methods, qualitative methods, and approaches that
combine quantitative and qualitative techniques.
The Development Budget
While many project valuation methods seem to assume that all
valuable projects will be funded, most firms face serious
constraints in capital and other resources, forcing them to choose
between multiple valuable projects (or obtain external financing as
discussed in the Theory in Action section). Many firms use a form
of capital rationing in formulating their new product development
plans. Under capital rationing, the firm sets a fixed research and
development budget (often some percentage of the previous
year’s sales), and then uses a rank ordering of possible projects to
determine which will be funded. Firms might establish this budget
on the basis of industry benchmarks or historical benchmarks of
the firm’s own performance. To provide a sense of what firms in
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different industries spend on R&D, Table 213 shows selective
industries with the highest R&D intensity (R&D expenditures as a
percentage of sales), based on North American publicly held firms
in 2011. Some industries (notably drugs, electronic components,
and communication equipment) spend considerably more than
other industries, on average.
Rank Industry 2011 R&D / Sales
1 Pharmaceutical 16%
2 Semi-conductors 12%
3 Communication 11%
4 Industrial Machines 8%
5 Audio & Video 7%
6 Scientific Machines 6%
7 Computers 6%
Table 2 Top R&D Industries
QUANTITATIVE METHODS FOR CHOOSING
PROJECTS
Quantitative methods of analyzing new projects usually entail
converting projects into some estimate of future cash returns from
a project. Quantitative methods enable managers to use rigorous
mathematical and statistical comparisons of projects, though the
quality of the comparison is ultimately a function of the quality of
the original estimates. The accuracy of such estimates can be
questionable—particularly in highly uncertain or rapidly changing
environments. The most commonly used quantitative methods
include discounted cash flow methods and real options.
13
Based on Compustat data for North American publicly held firms.
.
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Discounted Cash Flow Methods14
Many firms use some form of discounted cash flow analysis to
evaluate projects. Discounted cash flows are quantitative methods
for assessing whether the anticipated future benefits are large
enough to justify expenditure, given the risks. Discounted cash flow
methods take into account the payback period, risk, and time value
of money. The two most commonly used forms of discounted cash
flow analysis for evaluating investment decisions are net present
value (NPV) and internal rate of return (IRR). Both methods rely on
the same basic discounted cash flow mechanics, but they look at
the problem from different angles. NPV asks, “Given a particular
level of expenditure, particular level(s) and rate of cash inflows, and
a discount rate, what is this project worth today?” IRR asks instead,
“Given a particular level of expenditure and particular level(s) and
rate of cash inflows, what rate of return does this project yield?”
For either method, managers must use estimates of the size and
timing of expenditures and cash inflows. Both methods enable the
decision maker to incorporate some basic measure of risk. For
example, riskier projects may be examined by using a higher
discount factor in NPV analysis. Managers also often calculate
discounted cashflow measures using best-case and worst-case cash
flow estimates.
Net Present Value (NPV)
To calculate the NPV of a project, managers first estimate the costs
of the project and the cash flows the project will yield (often under
a number of different what if scenarios). Costs and cash flows that
occur in the future must be discounted back to the current period
to account for risk and the time value of money. The present value
of cash inflows can then be compared to the present value of cash
outflows:
NPV = Present value of cash inflow – Present value of cash outflows
If this value is greater than 0, then the project generates wealth,
given the assumptions made in calculating its costs and cash
inflows.
14
The arithmetic of discounted cash flow is based on the assumed opportunity
cost of money known as the Time Value of Money which may be against the
Islamic principle of prohibition of Riba.
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Internal Rate of Return (IRR)
The internal rate of return of a project is the discount rate that
makes the net present value of the investment zero. Managers can
compare this rate of return to their required return to decide if the
investment should be made. Calculating the IRR of a project
typically must be done by trial and error15, substituting
progressively higher interest rates into the NPV equation until the
NPV is driven down to zero. Calculators and computers can perform
this trial and error. This measure should be used cautiously,
however; if cash flows arrive in varying amounts per period, there
can be multiple rates of return, and typical calculators or computer
programs will often simply report the first IRR that is found.
Real Options
When a firm develops new core technologies, it is simultaneously
investing in its own learning and in the development of new
capabilities. Thus, development projects can create valuable future
opportunities for the firm that would otherwise be unavailable.
Even development projects that appear unsuccessful may prove to
be very valuable when they are considered from the perspective of
the options they create for the future of the firm. Some managers
and scholars have begun arguing that new product development
decisions should be evaluated as real options.
To understand real options, it is first useful to consider the financial
model upon which they are based—stock options. A call option on
a stock enables an investor to purchase the right to buy the stock
at a specified price (the exercise price) in the future. If, in the future,
the stock is worth more than the exercise price, the holder of the
option will typically exercise the option by buying the stock. If the
stock is worth more than the exercise price plus the price paid for
the original option, the option holder makes money on the deal. If
the stock is worth less than the exercise price, the option holder
will typically choose not to exercise the option, allowing it to expire.
In this case, the option holder loses the amount of money paid for
the initial option. If, at the time the option is exercised, the stock is
worth more than the exercise price but not more than the exercise
15
This is because when solving for IRR you might get multiple values of interest
rate or the discount rate that satisfy the condition of NPV being zero, but you
have to select the one that makes sense. Usually, you will get a negative IRR
and a positive IRR, and generally the positive IRR will be the correct one.
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price plus the amount paid for the original option, the stockholder
will typically exercise the option. Even though the stockholder loses
money on the deal (some portion of the price paid for the original
option), he or she loses less than if he or she allowed the option to
expire (the entire price paid for the original option).
In real options, the assets underlying the value of the option are
nonfinancial resources. An investor who makes an initial
investment in basic R&D or in breakthrough technologies is, it is
argued, buying a real call option to implement that technology later
should it prove to be valuable.
With respect to research and development:
• 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.
The value of a call stock option is zero as long as the price of the
stock remains less than the exercise price. If the value of the stock
rises above the exercise price, however, the value of the call rises
with the value of the stock, dollar for dollar (thus the value of the
call rises at a 45-degree angle).
Figure 20 Value of a Call Option at Expiration
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Options are valuable when there is uncertainty, and because
technology trajectories are uncertain, an options approach may be
useful. Though there has not yet been much empirical work in the
area, several authors have developed methodologies and
applications of options analysis to valuing technology development
investments. Also, some evidence shows that an options approach
results in better technology investment decisions than a cash flow
analysis approach. Nonetheless, the practitioner must study the
underlying assumptions for both sets of tools and apply the correct
tool in her situation, wisely.
QUALITATIVE METHODS FOR CHOOSING PROJECTS
Most new product development projects require the evaluation of
a significant amount of qualitative information. Many factors in the
choice of development projects are extremely difficult to quantify,
or quantification could lead to misleading results.
Almost all firms utilize some form of qualitative assessment of
potential projects, ranging from informal discussions to highly
structured approaches.
Screening Questions
As a starting point, a management team is likely to discuss the
potential costs and benefits of a project, and the team may create
a list of screening questions that are used to structure this
discussion. These questions might be organized into categories
such as the role of the customer, the role of the firm’s capabilities,
and the project’s timing and cost.
Some examples are provided below:
Role of Customer
Market
• Who are the most likely customers of the new product?
• How big is this market? Are there other likely markets
for the product?
• What type of marketing will be required to create
customer awareness?
Use
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• How will customers use the product?
• What new benefits will the product provide the
customer?
• What other products are customers likely to consider as
substitutes for this product?
Compatibility and Ease of Use
• Will the product be compatible with the customer’s
existing complements?
• Will the product require significant new learning on the
part of the customer?
• How will the customer perceive the product’s ease of
use?
• Will the product require the customer to bear other
costs?
Distribution and Pricing
• Where will the customer buy the product?
• Will the product require installation or assembly?
• How much are customers likely to be willing to pay for
the product?
Role of Capabilities
Existing Capabilities
• Does the new project leverage the firm’s core
competencies or sources of sustainable competitive
advantage?
• Will the project render some of the firm’s existing
competencies obsolete or cannibalize existing
products? If so, does the firm have a transition strategy
to handle possible cash-flow implications?
• Does the firm have the necessary manufacturing
capabilities, and if not, will those capabilities be
developed in-house or acquired externally (e.g.,
outsourcing)?
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• Will the firm need to hire employees with new skills?
Competitors’ Capabilities
• Do one or more competitors have better capabilities for
developing this project?
• If the company does not develop this technology, are
competitors likely to?
• Will the company be able to protect its intellectual
property through patents, copyright,
• trademarks, or trade secrets?
• Should the firm seek to form a collaboration with a
potential competitor?
Future Capabilities
• Will the project help the firm build new capabilities that
will allow it to achieve its
• strategic intent?
• What other products/markets will the new capabilities
enable the firm to develop?
• Is this project a platform that will lead to a family of new
products?
Project Timing and Cost
Timing
• How long will the project take to complete?
• Is the firm likely to be first to market? Is pioneering the
technology a desirable strategy?
• Is the market ready for the product? (For example, are
enabling and complementary technologies well
developed? Will customers perceive the value of the
technology?)
• If the firm misses its target deadlines, what impact will
this have on the potential value of the project?
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• Are there already appropriate suppliers and distribution
channels?
Cost Factors
• How much will the project cost? What is the potential
variability in these costs?
• What will the manufacturing costs be? At what rate are
these costs expected to
• decline with experience?
• Will the firm need to bear other costs related to
customer adoption (e.g., production of complements,
installation, technical support, etc.)?
After creating a list of questions, managers can use the questions
to structure debate about a project, or they can create a scoring
mechanism (such as a scaled response to each question such as
“Project fits closely with existing competencies” to “Project fits
poorly with existing competencies”) that can then be weighted
according to importance and used in subsequent analysis.
While screening questions such as the one above do not always
provide concrete answers about whether or not to fund a project,
they enable a firm to consider a wider range of issues that may be
important in the firm’s development decisions. Consider Boeing’s
development of the Sonic Cruiser, a supersonic jet that was
designed by Boeing, but never made it off the drawing board.
Boeing continued designing the aircraft even after it became clear
that the jet would not be profitable because Boeing considered the
project necessary for preserving the company’s development
capabilities. As noted by Walt Gillette, Boeing’s development
program manager, "If the company doesn’t create a new airplane
every 12 to 15 years, the needed skills and experience will be gone.
Too many of the people who created the last new airplane will have
retired or moved on to other companies, and their skills and
experience will not have been passed on to the next generation of
Boeing employees." Thus, Boeing’s development of the Sonic
Cruiser is expected to be valuable to the firm even if the only return
from the project is the enhancement of the firm’s development
capabilities. Such value would be difficult to assess via quantitative
methods, but is revealed clearly by qualitative analysis.
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