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RESEARCH
The Vanishing $7 Billion:
An Options Approach to Corporate R&D
2002 Philadelphia 100 Find High Growth in Downturn
Research
The Vanishing $7 Billion: An Options Approach
to Corporate R&D
New research co-authored by Professor Ian MacMillan presents a framework for managing corporate R&D investments.
New technologies pose a dilemma for entrepreneurs and established firms: if companies fail to invest in the "new, new thing," they could be left behind. But if they sink too much into an uncertain technology, staggering losses are possible. The solution is to make small investments that create options for a stronger commitment in the future.
"There is a tendency for companies to treat all initiatives in the same way," said Ian Macmillan, research director of the Wharton School's Sol C. Snider Entrepreneurial Research Center, in an interview with Get It Started!
MacMillan and research partner, Columbia University Professor Rita Gunther McGrath recently pursued this topic in an article, "Crafting R&D Project Portfolios," published in Research Technology Management. "Depending on the kind of uncertainty, you need to manage opportunities differently. In positions of high certainty, you can come up with a clear net present value (NPV). In highly uncertainty situations, what tends to happen is that your NPV is going to be either very low or negative. You actually should be talking about creating an option for some kind of future opportunity. If you don't place the bet, you can't be in the horse race. As market and technical uncertainties in the world increase, companies, whether they like it or not, have to manage these options."
Different Options for Different Purposes
Macmillan and McGrath point out that options serve different strategic purposes depending on the level of technological and market uncertainty:
- Positioning
options: These
options are designed to preserve a company's future right to compete
in a highly uncertain technological arena. These are most appropriate
when the trajectory of development of technology is uncertain or where
there are several different competing technologies that could satisfy
a high-potential market but no clear winner among them. The development
of wireless telephony in the United States presented companies with
the challenge of competing standards, and uncertainty about whether
these standards would converge. Given this uncertainty, companies could
make small investments to position themselves to take advantage of the
emergence of a single standard or the continuation of a multi-standard
world.
- Scouting
options: In
environments of high market uncertainty, these options are designed
to learn about customer needs and market conditions in relation to a
particular technology base. Companies learn how future markets will
be segmented and the best applications for the technology for these
emerging segments. "The way you manage in high market uncertainty
is to try to find out if there is a market there," Macmillan said.
Without careful scouting, companies sometimes make expensive mistakes
in launching new products and services that are ultimately rejected
by the market. For example, Iridium LLC of Arlington, Va invested $7
billion to create a telecommunications service that let people use a
portable phone around the globe. The problem? Iridium's system didn't
allow for phone use indoors.
- Steppingstone
options: These
options provide a technological path forward for an organization's long-run
technology strategy while containing cost and risk as new knowledge
is created. Companies make small exploratory forays into less challenging
market niches, gaining the experience with the technology and its applications
to serve as stepping stones into more attractive and more challenging
market arenas. Unlike scouting options, which focus on technology that
is developed or fairly certain to be developed, steppingstone options
are used when there is both high technological and market uncertainty.
For example, Sanyo Corporation began exploring applications of solar
cells in small niches such as light cells for wristwatches and calculators.
It generated modest cash flow and experience with the technology that
allowed it to improve the cell construction and conversion efficiency.
It then used this experience to take the technology into more resource-intensive
and uncertain markets such as solar panels for factory heating.
Where there is fairly high certainty about a technology and its potential markets, options are often unnecessary. In this case, companies might move directly to an enhancement of the existing business, such as Gillette's next generation of razors or Intel's next Pentium chip, or a platform launch such as Boeing's investment in the introduction of the 777 line of aircraft.
Developing a Balanced Portfolio
Even if managers recognize the importance of developing strategic options in theory, when it comes time to allocate dollars, these options often lose out to more certain, short-term investments in the current business. If managers can invest a dollar into enhancing a business with a fairly certain return or put the same dollar into an experiment with a high likelihood of failure, the money will often flow into the sure thing. This can help the bottom line today but sacrifice the company's long-term prospects.
By throwing everything into one bucket, managers are forced to make apples-and-oranges comparisons between options and investments in businesses with higher levels of certainty. "Competition between the different kinds of opportunities tends to drive out the long-term opportunities," Macmillan said. "A short-term investment in scaling up equipment tends to drive out an investment in building a new market in China. But if you don't invest in options, in the long run you will die."
Macmillan and McGrath recommend creating a balanced portfolio of investments, and setting up separate buckets of resources for options and for enhancements to established businesses and technology. This way the options for the future compete against other similar options. "You make a strategic decision as to what percentage of resources to invest in tomorrow and what percentage to invest in today," Macmillan said. "Then tomorrows compete with the best of tomorrows, and todays compete with the best of todays. Once you've decided that a certain percentage of resources should go into scouting options, new scouting options compete only with other scouting options for resources."
The portion of resources allocated to different types of options, enhancements and platform launches depends on the level of technological and market uncertainty. The greater the certainty, the smaller the pool of resources for options. If there is high market uncertainty, companies might devote more resources to scouting options, for example. If there is high technological uncertainty, they might put more into positioning options. If there is both market and technological uncertainty, steppingstone options might get more attention.
When companies sit down and look at the whole portfolio of potential investments, and the resources (particularly human resources) needed to pursue them, much is revealed. When Macmillan and McGrath applied the framework at a medical devices manufacturer and discovered that the company didn't have enough scientific and engineering man-hours on staff to pursue its current platform launches and do justice to its portfolio of options. By looking at the bigger picture, the company was able to put several major product launches on hold and devote more energy to its options. In the end, the firm created a portfolio that included one steppingstone project, the nine most important platform launches, eight enhancement launches, six positioning options and seven low-budget scouting options.
Missed Options
Given the power of real options, why do many managers still rely so heavily on traditional calculations such as NPV? One reason is that managers sometimes see "options" as a justification for bad projects, eroding the rigor of decision making. "Senior managers are concerned that if they do this ‘options thing,' every harebrained idea will be characterized an option," Macmillan said. But companies can bring rigorous thinking and discipline to the process, even without the complex mathematical calculations that are used to formally evaluate options.
Options also run counter to quarterly and annual budgeting. "The world is not so kind as to wait until budgeting time," Macmillan said. "Opportunities don't arrive conveniently, one at a time, for funding."
Finally, you need an organizational culture that accepts failure. "You send someone out to find out if there is a market there," he said. "If a scout comes back to me and says that there is no market there, have they failed? If you are not careful and treat it as a failure, people will not pursue scouting options. The same thing holds with positioning options. If only one of three possible technologies will succeed in the marketplace, by definition two will fail."
The advantage of options is that they allow the firm to "fail fast, fail cheap and start again," in the Silicon Valley mantra, instead of experiencing the crash-and-burn of a major failure. "Big companies spend hundreds of millions of dollars to find out they are wrong," Macmillan said. "I'd rather find out I am wrong more cheaply."
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For
more information see
Ian Macmillan and Rita Gunther McGrath, Crafting
R&D Project Portfolios, Research Technology Management, Washington,
Sept/Oct 2002.
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