Use of project milestones
Delayed Stage kills
Cost versus budget
Efficiency of internal technical processes
Use of cross functional teams
For overall process effectiveness see Value Creation metrics
How to select successful R&D projects based upon R&D Financial Regimes
The management funding decisions for R&D are usually guided by one or another of two prevailing viewpoints:
1. R&D As a Necessary Cost of Business – In effect, R&D is supported as an overhead expense. This is most clearly appropriate for early-stage or exploratory research efforts and for developing or maintaining technical expertise in areas judged to be essential to future competitive advantage. However, in practice there are real limits in the amount of funding which senior management feels comfortable in treating this way. See Stage 1.
2. R&D As an Investment – Underlying the treatment of R&D programs as business investments is the basic notion that scarce investment funds should be allocated to alternative company opportunities according to consistent and explicit financial criteria, whether these lie in more traditional investment domains (e.g., capital budgeting for production or distribution facilities) or in R&D. This rationale is clearly most appropriate for those technical development and engineering programs with sufficiently well-understood market and financial implications to permit meaningful quantification and analysis of important decision parameters. An example of these is when projects are in Stages III and IV.
The underlying problem faced by many research directors in the discussion of the overall research program portfolio is that with only two available funding models, all R&D which falls outside the limits management feels comfortable in treating as a necessary cost of business must be justified on the basis of ROI or similar capital budget analysis. This often requires the “force fit” of investment models to R&D situations, in which uncertainty is often directly equated with risk, and future possibilities are significantly discounted.
Putting R&D into Strategic Perspective
An essential step in dealing with the overuse of such investment criteria is to recognize that technical programs are aimed at a wide range of strategic objectives.
Most of the technical work within large corporations is clearly directed toward a well-understood business investment. The technical activity involved is usually development and engineering, and the technical community is usually comfortable with the notion that the financial approach most often suited to its evaluation is an ROI or another capital budgeting framework. At the other end of the spectrum, much of the exploratory or fundamental/basic work in industry is clearly aimed toward knowledge building. For this work, where the business impact is often poorly defined and wide ranging, the more appropriate financial approach is that of considering R&D as a cost of doing business.
However, an important segment of the technical activity, often covering applied research, exploratory development, and sometimes feasibility demonstration, is concerned with the transition between these two broad strategic objectives. The concern is with reducing technical uncertainties and building a strong technical position, to the point where the corporation feels confident it can turn its technical strength into a profitable investment.
It is here where most difficulty is experienced with the two prevailing funding models. On one hand, the expenditures are often too large for management to feel comfortable treating them as an overhead or cost of doing business. On the other hand, the potential impact of the programs is often still sufficiently uncertain as to preclude meaningful ROI measurements.
An important first step in dealing with R&D for strategic positioning is to recognize that these expenditures are not so much directed toward an investment as they are toward the creation of an option. By this it is meant that the corporation is committing relatively modest R&D expenditures now to provide the opportunity to make a profitable investment at some later date.
The second step is to recognize that at least one class of options has been analyzed in some detail, that is, stock options, and that there are parallels with R&D options which suggest important insights that overcome some of the difficulties caused by the force fit of ROI. The concept of treating R&D as an investment option has been in the literature for some time, however, it is just recently that the concept is now being accepted more generally and the literature is expanding.
R&D As a Strategic Option
R&D programs directed toward strategic positioning are in many ways parallel to the American call option which will permit the owner to purchase stock at a specified price (exercise price) at any time prior to an agreed-upon expiration date. The value of a stock option varies with stock price. In establishing the parallel between the R&D option and the stock option:
(a) The price of the call option is analogous to the cost of the R&D program.
(b) The exercise price is analogous to the cost of the future investment needed by the company to capitalize on the R&D program (Potential Value at some future time T) when the investment is made.
(c) The value of the stock for the call option is analogous in the R&D case to the returns the company will receive from the investment (Potential Value of expected returns at a time.
The value of a stock option has been developed formally as a function of most of the parameters involved in the options transactions. From the perspective of the industrial research community, there are two significant observations.
1. The value of an option varies in ways that are counterintuitive. That is, the value of the option moves in the opposite direction to the value of an investment with respect to volatility (uncertainty) and time. These findings apply generally to options as the relationships arise primarily as a result of limited downside risk, and are not overly sensitive to the specific assumptions of the stock options model.
2. The intuitive viewpoint often taken by the research director when justifying technical programs directed to strategic positioning, logic that often seems counterintuitive to the financial community, more closely parallels the relationships developed from the analysis of options than from the rules for business investment and ROI.
Downside Risk – The downside risk for an investment, whether in the stock market or directly in the business, is that the complete investment may be lost. By contrast, the downside risk for a stock option is that the option will not be exercised. The loss is thus limited to the price of the option, whatever the value of the stock.
The equivalent situation of an R&D option occurs when the corporation, for whatever reason, does not make the follow-up investment necessary to capitalize on the R&D program (exercise the R&D option). The equivalent loss is the cost of the R&D program, which in general will be a much smaller than the follow-up investment. In practice, this represents the maximum possible loss, as the results of the R&D program, if not used directly; often provide significant insights into subsequent investments.
Volatility – As volatility or general uncertainty associated with an investment increases, the value of the investment will be discounted as a result of risk aversion. Often no business investment will be made if the level of uncertainty falls above the range with which management feels comfortable.
Volatility has the reverse impact for a call option, as the downside risk is limited to the cost of the option. If the volatility of the stock price is zero, the option is worthless; increased volatility in the stock price increases the chance that it may exceed the exercise price before expiration (without increasing the downside risk).
The R&D option parallels the call option in that R&D programs which address high-impact opportunities, with a modest or low probability of success, do not imply higher risk. This distinction between options and investments is very important for R&D.
Since the downside risk is limited in this way (i.e., the distribution of possible returns truncated below zero), the upside or high potential benefits, albeit uncertain, are not offset by possible losses and are thus important elements in the selection of alternative programs. If viewed from this options perspective, the priority of earlier phase, far-reaching and more basic R&D is often improved over that produced by ROI analysis.
Time – In the investment model, the value of returns is discounted as a direct result of the time value of money. For the call option, time has the reverse effect. Increasing the time for which the option may be exercised increases the probability that stock price may exceed the exercise price during that period, and thus increases the value of the option.
The parallel situation for the R&D option is that R&D programs which offer the corporation flexibility in the timing of the subsequent investment or financial commitment, and particularly those providing the opportunity to make a series of investments over a period of time (even though the outcome of any single one may be uncertain), should be preferred to those projecting a short-range limited window of application.