Financial aspects of innovation #3
Monitoring an innovation portfolio from a financial perspective
Very often, innovation portfolios are looked at only through the innovation content ‘lens’. Is attention being given to the right technologies, to the right markets, etcetera? Financially, projects are assessed on an individual basis: “Are we willing to spend X on this project?”
Only rarely the financial portfolio ‘lens’ is being used. Are enough projects being started, is the right amount of money being spent at the right moment in the innovation funnel? Not from innovation content perspective, but purely from a financial portfolio perspective, the best management of investments and risk.
I would like to demonstrate the power of this approach through a simple model. It is loosely based on risk-adjusted NPV. What is the value of a project taking into account the innovation and development risks? The model needs a few parameters:
- Assuming the organization has a stage-gated model for innovation. How many stages has it? In how many stages (with decision making in-between) is a product developed. Let’s assume 4 stages after idea generation.
- How many of the ideas will make it into actual product-launch? Or what is the chance of a project passing a gate decision? To make it easy, let’s say 50% at each of the 5 gates. That means for every successful launch, you originally have started with 32 ideas.
So if you want to launch 1 product with an NPV at launch of €1,000, the risk-adjusted NPV (NPVra) of 1 project after ideation is €62.50. A first useful finding: do not overvalue ‘young’ innovations! A second one is the number of innovation projects. To launch 1 new product every period, your pipeline will be 63 projects.
To complete the model, a few more parameters are needed:
- After each successful stage, the NPVra will increase, because the risk has decreased. How much should you be willing to invest in a project to realize that NPVra increase? Based on the parameters chosen, I would recommend something like 1%, 2.5%, 5%, 7.5% and 10%.
That may not sound much, but be aware that you have to fund a whole portfolio. And that the NPVra will go up. So the budget for an idea is €0.63, and for pushing a project through stage 4 is €50.
If you do all the numbers, this should come out
This means that for 1 launch per period, with an NPV of €1,000 at launch, you should reckon with an innovation budget of €270, and an idea development budget of €20. Are enough projects being started? Is the right amount of money being spent at the right moment in the innovation funnel? Perhaps the financial portfolio approach can substantially increase the output, financially and otherwise, of your innovation funnel.
I hope that this little series of financial viewpoints on innovation has been helpful in drawing in your financial people, or if you are in finance yourself, you have gotten a better feel for the financial aspects of innovation. If I have been unclear, which is very well possible, please do not hesitate to contact me. In any case, have fun innovating!
Three financial aspects of innovation
- Given the forecasted business case of 1 innovation, what R&D budget is still worthwhile?
- Be aware of the financial impact of slow project execution, your NPV just melts away!
- Monitoring an innovation portfolio from a financial perspective
Jeroen de Kempenaer
Value propositions, business modeling, business cases, road mapping, portfolio management
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This article was originally published on LinkedIn.