New product development (NPD) projects are built with inherent risk. We don’t know if the markets will support the idea once it is commercialized. We don’t know if we can design the technology to work in a new application. We don’t know if competitors might flood the product category with similar products and services, devaluing our offering. Yet no company can ignore innovation without falling behind in the marketplace.
Within new product development, we deploy many tools to help mitigate the inherent risk of creating new technologies for new markets. Some of these tools include the structured NPD process (or staged and gated decisions), portfolio management and customer insights (market research). Savvy project managers will also utilize financial risk management tools to ensure success of the business over the long-term regardless of the success or failure of a single new product launch.
Financial Risk Management
One of the reasons that large companies tend toward incremental innovation over more radical developments is financial caution. While big bets can yield big rewards, established firms often prefer lower risk rewards – the kind you can “bank on”. While this can hamper radical innovation, it is understandable that large corporations are conservative in their portfolios to minimize financial risk.
Some tools used in financial risk management are:
- Contingency analysis,
- Minimum acceptable return,
- Joint ventures, and
Let’s examine each of these in more detail and investigate how they apply to new product development.
A contingency in financial risk management is a special fund set aside to cover the associated costs should a risk event occur. Companies will use a contingency when the risk is perceived to be low in impact but may cause a risk to financial health if it is ignored. Normally, projects will consider only single contingencies, meaning that only a single risk event could occur. Multiple contingencies would involve a series of failures with the risk building from each subsequent event.
Innovation projects utilize contingency analysis with the structured NPD process as indicated. Each stage of work is approved within boundaries and cost constraints. Decisions are made at gate reviews to either continue or halt a program. The size of investment and level of risk are small during the early stages of idea generation and technical proof-of-principle. As more data and information is gathered on the markets, technologies, and product categories, the investment is gradually increased. However, risk should not be increased substantially from stage to stage since the NPD work will validate consumer interest in the new product or service.
Managers should be prepared for NPD project contingency by earmarking a special fund for innovation risk. A percentage of each project’s budget for the next stage may also be set aside as a contingency. For instance, if Stage 2 of Project XYZ is estimated to cost $100,000, management may set aside a $20,000 contingency (20%).
Minimum Acceptable Return
Most companies expect a certain return on investment (ROI). While this is a typical point of contention between those promoting incremental improvements and radical innovations, it is a common practice in industry to specify a minimum ROI or to set a “hurdle rate”. The hurdle rate is used as one method by portfolio managers to screen less attractive innovation projects from those that will benefit the business to a greater degree or in the shorter term. Moreover, the hurdle rate is formally known as a “minimum acceptable return”. As an example, firms may specify that projects have a minimum acceptable return of 20% over a two-year period after product launch in order to be funded for development.
One way in which firms will manage project risk is by increasing the minimum acceptable return or hurdle rate. The idea is that by requiring a higher rate of return, successful projects will fund those that are less successful. Additionally, higher risk projects will have to demonstrate higher returns.
While this is a common practice in established firms, it is often difficult for disruptive innovations to demonstrate high returns over a short time frame, especially during the early idea stage. It is also possible for new products to require a longer time period for customers to adopt the established products. We will leave this dilemma to discuss in another blog post at the Idea Incubator. For now, suffice it to say, that many firms will attempt to manage financial risk by increasing the minimum acceptable return on projects.
Another way in which firms can manage risk is through a joint venture. Joint ventures combine the knowledge, skills, and capital of two companies. In some cases, both parties bring shared knowledge to the new organization. In other cases, one party brings technical know-how while the other provides investment expertise.
Joint ventures help to minimize financial risk for a firm by sharing costs (and profits) with another party. By sharing expenses, the consequences of a risk event are limited to a pre-determined level (e.g. the investment into the joint venture by the parent company).
Firms should be aware, however, of restrictions on intellectual property that result from joint venture partnerships. New products may be launched from the joint venture but not shared with the parent company in some situations. Additionally, the time to manage a joint venture may be significant with hidden costs for such management.
Like a joint venture, outsourcing can minimize financial risk by giving certain aspects of a business to a company that specializes in those areas. Common ways to minimize risk in a firm by outsourcing include HR, IT, and marketing functions. For instance, many small- to medium-sized businesses outsource the payroll, hiring, and onboarding functions of HR since many of these activities are heavy on paperwork that must meet a variety of tangled legal requirements.
Companies active in innovation should be aware of various outsourcing opportunities that many minimize development risk. A targeted market research study often can be outsourced at a lower cost than conducting the study in-house. In addition, market research firms specialize in gathering customer insights and can obtain data quickly from pre-established forums, groups, and potential customers.
Outsourcing can also be an effective way to reduce development risk by finding companies that already manufacture standard parts or materials. NPD teams may find efficiencies by outsourcing as well as minimizing financial risk. Management should consider the time to monitor performance of outsourced activities but it is generally an effective way to minimize risk from certain arenas.
Minimizing Financial Risk in Innovation
New product development involves risk. Innovation systems and processes can help to minimize risk. In addition, financial risk can be managed through a variety of tools, including:
- Contingency analysis,
- Minimum acceptable return (hurdle rate),
- Joint ventures, and/or
NPD teams should consider the pros and cons of each method as the firm seeks to minimize financial risk. Especially important elements to consider are the degree of innovativeness sought, intellectual property rights, and effectiveness of the risk management methodology.
To learn more, please register for a new product development or engineering management workshop. Note that over the next several months, we will be migrating our training business to www.simple-pdh.com while maintaining the consulting business here at www.globalnpsolutions.com. If you have any questions, please feel free to contact us at 281-280-8717 or firstname.lastname@example.org.
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