World Industrial Reporter

Innovation Delivered Daily

  • Innovation
    • Innovation Article Archive
    • Innovative Companies
    • Innovation Strategies
    • New Equipment Innovations
  • New Products
  • Additive Manufacturing
  • Markets
    • Market Trends
    • Tradeshow Reports
    • White Papers
  • Logistics
  • Newsletters
World Industrial Reporter » Innovation Strategies » Resource Allocation – Decision Criteria for Innovation Projects

Resource Allocation – Decision Criteria for Innovation Projects

September 30, 2013

innovation decisions for resource allocation

Critical questions all small and medium sized businesses ask is whether or not to allocate resources an innovation project, or which projects should be selected over others. Our research shows that minimal or no analysis is used to kick-off or fund product development and innovation projects in small businesses. Often, these projects are funded due to management support, a corporate initiative, or a customer request for a new product or feature, but often the question left unanswered is “will this project create value for the company?”

It is essential for small and medium businesses to identify critical decision criteria to answer that question. A forward-looking methodology that allows better decision-making is essential. The following key decision criteria – Net Present Value (NPV), Internal Rate of return (IRR), and Profitability Index (PI) – used support a this basic and powerful methodology.

Key Concepts

Net Present Value (NPV): The net present value measures the change in value that should result from an investment. This is a forward-looking measure that measures gain from alternative opportunities at similar risk. NPV takes into account the future value of money and the risk of the cash flows.

Internal Rate of Return (IRR): The internal rate of return measures the expected average annual rate of return.

Cost of Capital: Corporate interest rate + estimated inflation + project risk premium

Profitability Index (PI): Is the present value of future cash flows over the initial investment. The profitability index allows firms to rank innovation projects based on the best-combined net present value.

Our team has developed two fictionalized case studies to show how to use these concepts in a simple and efficient way. These cases based on real discussions with customers and recreated data, and present the issues innovation executives face everyday.

Case Study 1 – Technology Licensing

An advanced materials firm is looking to acquire a technology developed by a research institution. The team has completed the required technical and financial due diligence and they are ready to sign a licensing agreement. The cash flows from the commercialization of the technology are expected to be $100,000 per year with an annual decline of 2%. The research institution has valued the technology at $525,000, and is offering the materials firm three options.

  1. Make 3 installment payments. Two $250,000 payments at the time of licensing and in year 4 and a $200,000 payment in year 8.
  2. Make a single payment of $525,000 at the time of licensing.
  3. Make an upfront payment of $300,000 and pay an annual royalty of $50,000, tapered at $5,000 per year.

The table below shows the projected cash flow of the technology, the different payment options, net cash flows and the calculated NPV and IRR of the different options. For this project we have assumed a cost of capital of 10%.

When selecting the ideal licensing option we have to look at different selection criteria. It is clear all options meet the investment criteria, positive NPV and an IRR higher that the cost of capital (10%).

If we use the NPV-IRR methodology, it is clear that Option C created the most value for the firm than the other two options (NPV of $78,000 vs. $57,000 and $46,000). However if risk is not an issue between the choices (the cash inflow for the company is the same in all three options and if the payments have no risk associated to them), we might be tempted to take the option with higher return in this case Option A (IRR of 16.5% vs. 15.2% and 12.0%).

 

Case Study 2 – Project Selection and Budget Allocation

An industrial device firm is looking to select and fund their innovation projects. The firm has $1,000,000 of product development and innovation budget available. The executive team is reviewing the current 7 competing projects that require funding.

Innovation Chart 2

The team is presented with the required initial investments and the expected net present value of each of the projects. Project risk is different for each alternative, only IRR higher that cost of capital is required. The table on the right shows the different project allocation criteria. The management team uses the profitability index (PI) to rank the projects and allocate the available resources.

Based the data offered to the executive team the present value of the projects is calculated (PV=NPV + Initial Investment) providing the value of project inflows. Once the PV of the inflows is calculated we can calculate the profitability index (PI = PV/Initial Investment) of each of the project. Now the projects can be ranked according to their PI.

Innovation chart 3

 

The table below shows that project F has the highest PI, followed by A, E and D, in this case. Furthermore, the cumulative investment is calculated to identify where the $1,000,000 budget limit is.

Conclusions

This is a basic methodology that can be easily implemented at any firm. It can be used in an open innovation environment, where both internal and external projects compete for resources. The methodology provides compelling decision-making criteria to the executive team. More advanced methodologies using options or statistical models can be develop from this basic methodology to further optimize the decision making process.

 

 

For Further Contact

Pedro Guillen

Managing Partner

Technology & Business Innovation

[email protected]

Tel: +1 248.924.5436

 

Share on

Filed Under: Innovation Strategies

Innovation Portfolio Management – Balancing Innovation Risk and Return
Competitive Intelligence – Semantic Analysis
Avatar

About Doug Lee

Doug has over 30 years tracking and reporting on new products and services introduced by industrial companies from around the world.

Follow me
Suppliers

High Accuracy, Non-Contact, Absolute Linear Sensor

Santest Model GY series are high accuracy, non-contact, absolute type linear sensors employing magnetostrictive, Wiedemann effect. An ultra-sonic wave generated by a moving magnet near a magnetostrictive wave-guide on which the sonic wave propagates to the head of the transducer.
View Supplier Email this Supplier

Super High Response Speed Servo Valve

With “Dual Halbach Magnet Array” configuration, which makes the strongest magnetic field more than twice as much as the conventional model. Santest Direct Acting Servo Valve has achieved world-class highest frequency response speed of 800Hz. DA Series also has excellent contamination resistance. Find out more about how this patented servo valve works.
View Supplier Email this Supplier

Precision Micrometer for Large Measuring Ranges

The optoCONTROL 2520-95 precision micrometer is designed for static and dynamic measurement tasks with a large measuring range. It detects geometrical parameters such as diameter, gap, height and position and combines high linearity with high measurement speed.
View Supplier Email this Supplier

Beckhoff will be there: new highlights at the SPS Connect from November 24!

Beckhoff is accompanying the SPS Connect with new technology highlights, AI-based dialog formats, exciting round tables and inspiring presentations. Prebook now and secure free tickets!
View Supplier Email this Supplier

Automatic Spot Finder IR Camera with 80×80 Pixels

An all-rounder imager for numerous industrial applications: From metal processing to plastics, in fire prevention tasks as well as in the automotive sector. The spot finder function allows accurate temperature measurements of moving objects.
View Supplier Email this Supplier

Subscribe

Get the latest WIR reports straight to your inbox.

Free Newsletter Subscription

Find us on the social web.

  • About Us
  • Contact Us
  • Advertise
  • Terms Of Use
  • Privacy Policy
FREE NEWSLETTER SUBSCRIPTION

Get the latest WIR reports straight to your inbox.

  • Innovation Article Archive
  • Innovation Strategies
  • Innovative Companies
  • New Products
  • Additive Manufacturing
  • Market Trends
  • Tradeshow Reports
  • White Papers
  • Logistics
  • Newsletters
  • Fun Stuff
  • Industry Links
Follow us

© 2021 Thomas Publishing Company. All rights reserved.

We use cookies to ensure that we give you the best experience on our website. If you continue to use this site you agree.OkRead more