Portfolio management is a decision process where a business’s list of active new products and R&D projects is constantly updated, reviewed and revised. In this process, new products are evaluated, selected and prioritised; existing products may be accelerated, killed or de-prioritised. There are tools available to support this process and Clare Farrukh gives an overview.
Portfolio approaches and scoring methods for technology and project prioritisation
The aim of portfolio management is to ensure that a sensible set of innovation projects is supported by the company, for example balancing risk against reward.
Selecting a portfolio is in theory merely a question of optimising profitability within constraints of resources and timing. Well-proven mathematical techniques are available for doing this but, as several authors have observed they are seldom used in practice.
There are two key reasons for this:
- Financial information required for the analysis is often incomplete or unreliable, especially in the early stages.
- The selection process tends to be hidden by the mathematics. Managers cannot readily review or justify the results; nor amend them to take account of factors not explicitly included in the calculations.
In practice there is therefore a preference for more transparent techniques.
Evaluating single projects
Net Present Value (NPV) – portfolio management process must start with an evaluation of the potential worth of each of the projects under consideration. The simplest method is a basic income and expenditure calculation. More realistically a discount factor is applied to the incomes and expenditures taking account of the cost of money to the organisation, to give the Net Present Value (NPV) of the project.
Internal Rate of Return (IRR) – measure of the robustness of the profitability may be obtained by calculating the Break-Even point – the time before the project first achieves an overall profit after initial expenditures – or the Internal Rate of Return (IRR), which is the discount rate that would reduce the NPV to zero. Clearly, a short time to break-even or a large IRR imply robust profitability.
Risk and uncertainty – risk may be included in financial calculations in a number of ways. For a project that is expected to proceed in a single phase without decision points, risk can be included by multiplying the expected income by the probability of success. The costs of the project are unaltered so the result is a reduction in the forecast of net present value, NPV.
New product introductions, however, usually proceed in a number of stages with decision points in between. There may also be branches where the project could take one of several directions, as represented in decision trees. Clearly, the possibility of failure in an early stage reduces not only the probability of the income but also the probability of expenditure in the later phases. If this is included the correct valuation is higher than it would have been if the project had been planned as a single phase. Arguably this is the value of management action at the decision points.
It has been suggested that competing projects should be valued by separately calculating the possible upsides and downsides of each one in relation to a benchmark and weighting them differently according to the organisation’s appetite for risk.
Thus the project value would be: (Upside) – R. (Downside), where R is greater than one if the organisation is risk-averse and less than one if not. This approach appears to have promise for comparing project values more rationally than by using the long-term averages. However, it is not clear how factor R is to be calculated; especially as it must depend on the magnitudes involved (individuals and organisations are usually less willing to gamble for very high stakes than for low ones).
Financial analysis suffers from the fundamental problem that the data required may be unavailable, or of dubious quality, especially in the critical early stages. For this reason many companies prefer to replace, or at least supplement, it with a scoring method. In this projects are assessed and scored according to a range of criteria regarded as predictors of success.
For example scores may be given for unique product features, size of market, the ability to leverage the company’s core competences etc, as well as the planned cost and profit. The criteria may be very broad, reflecting what is known in general about success criteria for new products, or they may be industry- or company-specific. The sum of the scores against all the criteria represents the overall merit, or potential value, of the project. A simple selection of projects can be done by ranking them according to value for money or for effective use of critical resources. See section on designing a scoring tool in Goffin & Mitchell (2017) pp.229-235.
The portfolio must also be balanced in other ways. For example, a spread of projects over time is desirable: no company will want all its projects to come to fruition at the same time, with nothing planned before or after. The portfolio must also reflect the company’s general strategic intent, ensuring that sufficient resources are allocated to strategically important businesses, markets or technologies. This may be achieved by simply allocating a certain proportion of innovation spend (known as ‘strategic buckets’) to particular businesses or types of project.
Alternatively the company may draw up a strategic roadmap stretching several years ahead and use that to ensure that the longer-term orientation of the business is adequately served by the selected projects. The balance of risk and reward across the portfolio must also be considered.
High-risk projects should not necessarily be avoided
If the potential payback is good enough and provided they are accompanied by some low-risk opportunities. The risk-reward profile of a portfolio may be displayed on a two-dimensional diagram with risk and reward (however quantified) as the two axes (see Figure below). Such displays are often called “bubble diagrams”. Managers can use them as an aid to ensure that the portfolio is not inappropriately biased in one direction or the other.
Many authors advocate the use of checklists to ensure that all relevant aspects of value and risk are captured.
Read the full book
Farrukh, CJ and Moultrie, J and Phaal, R and Hunt, F and Mitchell, RF (2007) Risk management in innovation. In: Managing Business Risk- A Practical Guide to Protecting your Business. Kogan Page, London, Great Britain, pp. 231-245.