Economic Justification and Innovation

1
Chapter 6

• Economic Justification and Innovation

2
Introduction

• Are the traditional finance based methods of
  evaluating proposed investments adequate for
  making important decisions about new technology?
• Discounted cash flow (DC F)
• Net Present Value (NPV)
• Return on Investment (ROI)

3
How do we account For New Technology?

• General managers with manufacturing experience
  are more likely to mount aggressive technology
  strategies.
• Also they are more likely to emphasize direct
  labor savings from technology investments in
  operations.
• Divisional managers deemphasize direct labor
  savings and concentrate on investments in
  training and making organizational changes needed
  to capture the benefit of new processing
  technologies.

4
How do we account For New Technology?

• Companies typically hedge against the risk of
  using new technology.
• Typically they include double-digit rates for
  their DCF analysis.
• This leads to incremental rather than
  revolutionary projects.
• Only easily by savings are often included.

5
RD Investment

• Two characteristics of the RD process make
  application of investment analysis to innovation
  creation unique.
• Risk
• Time
• RD investments are generally thought of as
  portfolios of projects in low, medium and
  high-risk ventures.

6
Developing an Effective RD Portfolio Strategy

• According to Matheson and Menke
• Focus on decision quality.
• Start with evaluating quantifiable
  characteristics.
• Defect Rates
• Useful Life
• Customer Satisfaction
• Recommend a 6 Step Process
• identify the appropriate frame, unique context
  and decision elements
• generate creative, achievable alternatives
• develop meaningful, reliable information
• establish clear values and trade-offs
• apply logically correct reasoning
• build a commitment to action

7
Matheson and Menke Portfolio Grid
High
Bread and Butter
Pearl
Technical Difficulty
Probability of Technical Success
White Elephant
Oyster
Low
High
Low
Commercial Potential
Maintain Competitiveness
Gain Strategic Advantage
8
Matheson and Menke Portfolio Grid

• Bread and Butter -- high technical success, but
  relatively low commercial success.
• Oysters -- long shots, but would potentially big
  payoff.
• Pearls -- a few projects with both high technical
  and commercial success probability.
• White elephants -- project that should be shelled
  for later or discontinued.

9
Typical Patterns of Justification

• Payback and ROI (return on investment) are the
  most popular techniques.
• Net present value (NPV) and internal rate of
  return (IRR) are next.
• More sophisticated techniques like risk analysis
  and weighted scoring models are rare.

10
Justification In Practice

• Formal models can be quite helpful in allowing
  people to stay focused on top priority issues.
• There is a tendency not to document all potential
  benefits.
• Some analysts will conduct sensitivity analysis
  for robustness.

11
Good Projections

• Have five common characteristics.
• 1. The product of a sincere attempt to capture
  many aspects of the problem.
• 2. Documented with the best information
  available.
• 3. Use a time horizon consistent with the
  culture the organization.
• 4. Simple enough to be understood by everyone.
• 5. Consider more than one scenario for the
  future and do not underestimate competitors.

12
Balanced Scorecard

• Measures four balanced perspectives.
• 1. Customer views
• 2. Imperatives for excellence.
• 3. Prospects for improvement and value creation.
• 4. How companies look to shareholders.