Written
by Clint Benjamin for the IEEE Engineering Management Society
Calculated
Risk: A Framework for Evaluating Product Development
By Craig R. Davis
EMR Issue:
Volume 31 number 1, First Quarter 2003, pp.
38-44
Reprinted from: MIT Sloan Management Review, Summer Vol. 43
Abstract:
Product development is often viewed as a secondary activity. But failing to attribute strategic importance to product development is sheer folly. It often fails to produce commercially successful products. A tool like NPVR enhances the decision process by addressing critical risk in traditional ROI models. The result is faster development of products and therefore a higher ROI.
Keywords:
Net present value risk-adjusted (NPVR)
Executive
Summary:
The Limitations of
Traditional Financial Models:
Decision-making is obviously a difficult task. Unfortunately, business cases can often describe risks in a way that is designed to coerce rather than inform. Complex models produce outputs that depend on numerous assumptions. As a result, senior executives usually spend little time in the early stage of product development. Risk factors are often presented in narrative form steeped in technical jargon making it difficult for managers who are not experts to make solid judgements. By introducing a framework with a common vocabulary, senior executives can re-engage themselves in the process in a meaningful fashion.
The NPVR framework is designed to bridge this so-called “judgement gap.”
R vs. D- The Difference
Between Uncertainty and Risk:
A frequent error made by decision-makers is confusing the notions of uncertainty and risk. Uncertainty cannot be quantified, while risk is by definition quantifiable and manageable. In research, the challenge is overcoming technology that possibly will not work. In development, the challenge is avoiding products that may not be a success. It is crucial to evaluate research separately from product development to avoid the spurious conclusion that product-development success cannot be effectively managed.
Product-Development
Portfolios:
Product-Development Portfolios are usually divided into four categories as a function of market and product risk. They can be utilized to assess risks that determine the probability for success in each category.
New Ventures:
These are new products that represent the first of their kind. These products represent about 10% of all new products.
New Categories:
These are products that are new to the company. These products include repositioned existing products. They comprise about 27% to 39% of new products.
New Platforms:
These are mostly additions to current product lines, although sometimes the additions can be quite innovative. They represent about 26% of all new product.
New Product:
These are derivative revisions to existing products. For all companies, they represent about 37% of development investment.
Risk Assessment in
Product Portfolios:
The following framework was developed to indicate which are the most prominent risks-market risk, technical risk or user risk. These are not measures of absolute risks, but of risks that are likely to have an impact on future commercial success. They are palpable technical risks in a new venture, yet it is usually the lack of market or lack of user understanding that causes a product to fail. By weighting the subjective assessment of risk for each category, executives and decision-makers can utilize better judgement in selecting proposals for similar investments.
NPVR-A New Model for
Product-Development Evaluation:
The NPVR model relies on using experience and judgment to subjectively assess risk relative to one or more defined situations. NPVR assesses the strength of a business case in six crucial areas of technical, market and user needs risk.
Evaluating Market
Risk:
Market risk is comprised of any element of the value chain required for any new product to reach its potential customers. This includes such factors as distribution channels and customer support.
Each element should be evaluated.
Evaluating Technical
Risk:
Technical risks center on innovation associated with the product as well as the development facilities of the company. Innovation risks must be calculated not only in terms of the technology itself but also how the technology is integrated with the firm’s current product-development process.
Evaluating User Risk:
User risk determines that the company is developing the correct product. User risk assessment centers on the degree to which user interaction with the product are known and the degree to which design and performance output are known.
Calculating NPVR:
NPVR is calculated via the following:
NPVR= aM + bM + cT + dT+ eU+fU
10
X Net Present Value
Where a, b, c, d, e and f are the value chain, market segment, innovation, capabilities, interaction and specification assessments. The values for the risk weighting are M (market) T (technical) and U (user) For further illumination, consult the original article.
Enhancing
Product-Development Success Using NPVR:
The NPVR model gives insight into how additional user research might affect the conditions of success for the proposal. Needless to say, there is no guarantee that the product will succeed if the research is undertaken, but when comparing proposals within a risk category, those with high scores are more likely to succeed than those with low scores.
In closing, for developers, a tool like NPVR gives decision makers another facet in improving the probability that new products will be a commercial success.