When times get tough, one of the first things we do is think about what we can do without, like cutting latte consumption from five a week to two. Similarly, companies say no to some things to conserve resources and ensure remaining resources are focused on the right things.
Companies looking to shut down some innovation efforts have to evaluate their portfolio of what's in the process. Prudently pruning this portfolio will help to ensure that resources flow to the right ones. Here's a look at two typical approaches executives often take—and a third that might work better.
Approach 1: First-Year Revenues
Some companies prioritize projects based on their first-year revenues. This helps executives answer the question: "Where are my biggest ideas?" Obviously, first-year revenues are important. But they're not all that matters. A good way to reinforce this notion is to ask a group of executives which of the following innovations they would prefer:
Innovation A came out of the gates like a bullet, racking up first-year sales of more than $200 million. A clear value proposition, clever positioning, and a strong distribution network led to market success.
Innovation B had first-year revenues of a mere $220,000. The innovation had cool technology, but the paying customer and the business model were very unclear.
It's obvious, right? Innovation A is the winning proposition. But let's reveal more information. Innovation A was Vanilla Coke (COKE). It was a line extension that largely cannibalized sales of Coke's other products. Three years after launch, fizzling demand led Coke to pull the product from the market.
Innovation B was Google (GOOG). In Google's early days, it had a technology and not much else. After a couple of iterations, though, it came up with its advertising-based business model, setting the stage for one of the greatest economic success stories of current times.
Vanilla Cokes are great, but Googles are once in a lifetime. And the trick is that many great growth businesses start small and take a few years before they start exponential growth.
Approach 2: Net Present Value
Many companies make portfolio decisions based on the "net present value" (NPV) of individual innovation efforts. That is, they project future cash flows, convert those future cash flows into present-day dollars using some discount rate, and prioritize the projects with the highest NPVs. This approach helps executives answer the question, "Which project is worth the most?"
The math behind NPV calculations is quite sensible. And NPV seems to be an attractive way to compare different types of ideas. But the actual process many companies go through to make the calculations can be problematic.
One problem: Companies' assumptions are flawed when a business is under attack. In reality, a company that doesn't innovate faces declining prospects in its core business. Another problem is that companies often want to make decisions based on "the number," or a precise estimate of a project's financial potential. When companies only consider a single scenario, they almost always feel as if they have to be conservative, leading them to prioritize "sure things" in known markets over risky ventures in new markets.
While that approach might be reasonable when a company is launching a modest line extension into a known market, a new-to-the-world solution could unfold in infinite ways. It might be worth investing in a project that appears to have negative NPV, on average, if a modest investment can highlight whether outsize returns are possible. Further, if you don't invest in the long term, you increase the odds that you will fall behind existing and emerging competitors in the next economic cycle. A company that ranks all of the projects in its innovation portfolio by NPV might unintentionally stop working on projects with the greatest long-term growth potential.
There are other problems. Some companies have well-formulated templates to help simplify NPV calculations. Those templates almost always implicitly assume that an idea conforms to the company's current business model. But if a company is using a new business model, some of the underlying assumptions about capital investment, margin structure, inventory turnover, and so on can be wildly different. A simplifying template can be a straitjacket for teams seeking to introduce new business models.
A Different Approach
It's natural to want to have a simple way to compare multiple projects quickly. But taking an overly simplistic approach can sometimes be wrong. Instead of focusing on a single metric, companies should consider the answers to the following five questions:
1. What is the upside potential?
Of course, you would rather invest in a project that could produce huge returns than one with limited upside potential. Make sure you run multiple scenarios, and consider the "fringe" scenarios carefully. Is there any way a modest investment could identify whether an outlier is possible?
2. How much risk remains?
Any to-be-launched project will have a degree of risk, or uncertainty. Again, you should prefer a project with lower risk to one with more risk.
3. What resources are required to reach the next learning milestone?
Ideally, companies can learn more about the critical risks with modest incremental investment in time and dollars. A project with huge risk but huge potential might be worth keeping alive if you can learn about a critical unknown cheaply and quickly.
4. How well does the idea fit important qualitative criteria?
Making decisions based purely on numbers that are nothing more than educated guesses is silly. Properly applied, qualitative metrics can be a useful way to identify attractive opportunities early.
5. How much does the idea contribute to the overall portfolio's balance?
Modern portfolio theory suggests that reaching the ideal balance between risk and return means investing in diversified assets with different kinds of risks. For innovation efforts, that might mean an approach to reach a new customer segment, or use a new business model, or rely on different technologies. If companies don't consciously seek to diversify their innovation portfolio, they often end up with a narrow focus.
These kinds of questions can help companies identify when it's time to pull the plug on a project. When you can't shake residual risk, when tests grow increasingly expensive and learning increasingly scarce, and when it's getting harder to see the upside potential, it might be time to move on to another project. Making these decisions quickly can help companies maximize the return on their investments in innovation.
Reprinted by permission of Harvard Business Press. Adapted from The Silver Lining: An Innovation Playbook for Uncertain Times by Scott D. Anthony. Copyright 2009 Innosight. All rights reserved. Scott will be introducing more ideas from his book on his Innovation Insights blog at HarvardBusiness.org.