Expected Profitability

Two figures are calculated to estimate how much money the firm can expect to earn from a particular new product project, NPV and ROI.

NPV (Net Present Value) is a traditional method for quantifying the financial attractiveness of a project. NPV, also called discounted cash flow (DCF), represents the amount in today's dollars (present value) by which all income projected from the project exceeds all costs. NPV attempts to answer the question, "What is the equivalent lump-sum worth of this project?" First, the PV (Present Value) is computed for a project by discounting estimated future incremental cash inflows and outflows. This is the future stream of earnings from the product, discounted to the present. The length of the future time frame is determined by the product life cycle. The discount rate is chosen to represent a required rate of return for the capital invested. This discount rate is often based on the company's weighted average cost of capital (WACC), the average return on a portfolio of all the firm's securities (equity and debt). It is also necessary to estimate the life-cycle of the product. To derive NPV from Present Value, development (pre-commercialization) and launch (market introduction) project costs are deducted.

The higher the NPV of a project, the more attractive it is. Any project with a positive NPV should be viewed as a good investment. Only projects with a positive NPV should be chosen, except when the firm is willing to take a loss on the project to learn about a new technology or market. Because resources for new product development are limited, a firm may not be able to pursue all NPV-positive projects. However, if it has a surplus of NPV positive projects, it should seek additional resources to pursue all these projects.

To correct NPV for the uncertainty of the future cash flows, a risk-adjusted NPV is also calculated. Risk is the converse of the probability of technical and launch success. It refers to how likely it is that the expectations as entered into the initial NPV calculations will be met. Even though the NPV discounts for the time-value of money, it does not take into account the probability of success (technical and commercial). The lower the probability of success (the higher the risk), the higher the uncertainty of the future income streams. Risk reflects the degree of uncertainty that the technical and commercial expectations will be met. These risk estimates are then applied to discount the expected return of the product.

ROI (Return on Investment) is the ratio of project income to project cost. Given that the firm does not have sufficient resources to pursue all NPV-positive projects, it may prioritize those with the highest return on invested resources. Comparison of the ROI of different projects helps determine which projects provide the best return for scarce resources. It uses the same PV calculations as NPV, but instead divides PV by development and launch project costs. Likewise, the tool calculates a risk-adjusted ROI.

Tips

• Analyze the effects of different scenarios on the product's NPV and ROI. Change the price, costs, market size, length of product life cycle, etc. to see how these changes affect expected profitability.
• Use both NPV and ROI profitability calculations. NPV and ROI give different perspectives on the profitability of a project. For example, a project could have an NPV of $40 million and require $10 million to develop and launch the product. Another project could have an NPV of $20 million, but require only $2 million in costs. Even though the former project has a higher NPV ($40 million versus $20 million), the latter one has the highest return on resources invested (1000% versus 400%).

Technical and Market Risk

Risk reflects how likely it is that the product will be technically and commercially successful. The probability of technical success refers to how likely it is that the product will meet technical specifications and will be manufacturable. The probability of launch success refers to how it is the company will be able to launch the product into the market and achieve adoption by customers. Risk is the converse of the probability of technical and launch success. For instance, 75% technical risk means that the product has one chance in four of being successfully produced at scale and to technical specifications.

Technical and Market Resources

The development and launch of some new products lead firms to build new resources that enable them to enter new markets and technologies. Without building new resources, firms become stagnant and miss avenues for growth.

The resource building scoring is based on the notion that firms develop new resources in the process of developing new products. It assesses to what extent new expertise, skills, or assets will be built as a result of pursuing that particular new product. If these resources are successfully built, they will open opportunities for growth and renewal for the firm. However, the more new resources are needed, the lower the probability of technical and/or commercial success.

The model contains scales to assess both market-related resource building and technological resource building, two distinct types necessary for a successful new product.

Bubble Diagrams

The bubble diagrams provide displays of all projects currently underway on a single map. They integrate values from the financial calculations and scoring models. The tool produces two types of graphs: diagrams depicting risk/return and diagrams depicting profitability/growth.

Risk/return bubble diagrams: These bubble diagrams address the balance between risk and return. The x and y axes represent market risk and technical risk respectively, and the size of the circles denotes the returns in terms of NPV and ROI. Projects further from the origin have higher risk, and should compensate for this by higher potential returns. In other words, projects with small bubbles in the upper right quadrants are unattractive. On the other hand, project with big bubbles in the lower left quadrant provide a very attractive risk-return trade-off. A balanced portfolio has some projects in each of the quadrants.

Profitability/growth diagrams: These bubble diagrams address the balance between projects that build on the existing resources and competences of the firm versus those that require new ones. They help to distinguish which projects are positioning the firm for growth versus current viability. The x and y axes represent market resource-building and technical resource-building respectively, and the size of the circles denotes competitive advantage and NPV. Three regions can be distinguished on this map: the incremental zone, the leveraging zone, and the death zone. The lower left quadrant contains incremental projects which build on existing resources, but don't take the company into new directions. These projects should have fairly high NPV and competitive advantage. The midrange (from 25% to 50%) contains projects that leverage existing technical and/or market-related resources, using them as a stepping-stone for developing new ones. These take the firm in new directions, in a feasible way. Small NPV or moderate competitive advantage can be acceptable if the company wants to test the waters in a new market or new technology. The top right quadrant is a death zone because it contains projects that take the firm too far off base. These projects present too high a challenge, risk, and cost; even with high NPV these projects should be avoided. A balanced portfolio has projects spread over the incremental and the leveraging zones.

Tips

• Develop contingencies by varying assumptions, and examine their impact on the attractiveness of decision options.
• Promote active discussions among decision-makers that enhance a critical stance towards available evidence and assumptions. Completing the models in a group provides an opportunity for healthy discussion and debate.
• Avoid wishful thinking by formulation of best, worst, and likely scenarios. You can enter the same project with these different scenarios separately in the tool, perhaps using suffixes (such as bs, ws, and ls for best, worst, and likely scenario).
• Avoid the sunk cost fallacy. It is very difficult to cut projects off once the company has already started investing in them; they take on a life of their own. The tool purposely asks for remaining costs, not expenditures already made. Monies and effort already spent on the project are sunk costs and hence not relevant to the decision.
• Hold a portfolio review on a regular basis, at least quarterly. The list of active new product projects should be updated and revised, and projections altered as new information is obtained and projects mature. Input data should be revised on a regular basis as cost, competitive conditions, and forecasts change.
• Involve various people from inside (or even outside) your organization in developing the estimates. Recruit people with particular expertise on the technology and the market, involve all project team members, as well as those who will make resource allocation and go/no go decisions.
• The data used for these calculations are often incomplete and uncertain. One way to address this issue is to assume various values for the forecasted variables, incorporate various contingencies for possible future events, and assess the sensitivity of the value of each project under these various conditions. Difficulty in estimating these values should not be an excuse not to ask for them. The purpose is to make reasonable estimates based on the best available data.
• Use a Delphi approach. In this approach each member of the group rates each project privately and independently, the ratings are tallied by a facilitator and anonymously shared with the group. The participants then debate their interpretations and assumptions with each other. Next, group members again rate each project in a second round, followed by another discussion period. Ultimately, final ratings are submitted to the decision-makers.