It is useful to develop a policy for how funds are allocated to proposed R&D projects. The traditional approach is to require all R&D proposals to pass a minimum return-on-investment hurdle rate. However, when there is limited funding available and too many investments passing the hurdle rate to all be funded, managers tend to pick the most likely projects to succeed. This selection process usually results in the least risky projects being funded, which are typically extensions of existing product lines or other variations on existing products that are will not achieve breakthrough profitability. An alternative that is more likely to achieve a higher return on R&D investment is to apportion investable funds into multiple categories – a large percentage that is only to be used for highly risky projects with associated high returns, and a separate pool of funds specifically designated for lower risk projects with correspondingly lower levels of return. The exact proportions of funding allocated to each category will depend on management’s capacity for risk, as well as the size and number of available projects in each category. This approach allows a company the opportunity to achieve a breakthrough product introduction that it would probably not have funded if a single hurdle rate had been used to evaluate new product proposals.
If this higher-risk approach to allocating funds is used, it is likely that a number of new product projects will be abandoned prior to their release into the market, on the grounds that they will not yield a sufficient return on investment or will not be technologically or commercially feasible. This is not a bad situation, since some projects are bound to fail if a sufficiently high level of project risk is acceptable to management. Conversely, if no projects fail, this is a clear sign that management is not investing in sufficiently risky investments. To measure the level of project failure, calculate R&D waste, which is the amount of unrealized product development spending (e.g., the total expenditure on cancelled projects during the measurement period). Even better, divide the amount of R&D waste by the total R&D expenditure during the period to determine the proportion of expenses incurred on failed projects. Unfortunately, this measure can be easily manipulated by accelerating or withholding the declaration of project termination. Nonetheless, it does give a fair indication of project risk when aggregated over the long term.
Though funding may be allocated into broad investment categories, management must still use a reliable method for determining which projects will receive funding and which will not. The standard approach is to apply a discount rate to all possible projects, and then to select those having the highest net present value (NPV). However, the NPV calculation does not include several key variables found in the expected commercial value (ECV) formula, making the ECV the preferred method. The ECV formula requires one to multiple a prospective project’s net present value by the probability of its commercial success, minus the commercialization cost, and then multiply the result by the probability of technical success, minus the development cost. Thus, the intent of using ECV is to include all major success factors into the decision to accept or reject a new product proposal. The formula is as follows:
(((Project net present value x probability of commercial success) – commercialization cost) x (probability of technical success)) – product development cost
As an example of the use of ECV, the Moravia Corporation collects the following information about a new project for a battery-powered lawn trimmer, where there is some technical risk that a sufficiently powerful battery cannot be developed for the product:
Project net present value |
$4,000,000 |
Probability of commercial success |
90% |
Commercialization cost |
$750,000 |
Probability of technical success |
65% |
Product development cost |
$1,750,000 |
Based on this information, Moravia computes the following ECV for the lawn trimmer project:
((($4,000,000 project net present value x 90% probability of commercial success) – $750,000 commercialization cost) x (65% probability of technical success)) – $1,750,000 product development cost
Expected commercial value = $102,500
Even if some projects are dropped after being run through the preceding valuation analysis, this does not mean that they should be cancelled for good. On the contrary, these projects may become commercially viable over time, depending on changes in price points, costs, market conditions, and technical viability. Consequently, the R&D manager should conduct a periodic review of previously shelved projects to see if any of the factors just noted have changed sufficiently to allow the company to re-introduce a project proposal for development.