Monday, October 13, 2008

The Option Portfolio for Innovation Projects

In the previous article The Innovation Portfolio we saw how innovation projects can be visualised as a portfolio using different dimensions for their organisation. One good example for such a portfolio can be found in a very interesting article by Ian MacMillan of the University of Pennsylvania and Rita McGrath of Columbia University titled Crafting R&D Project Portfolios. This article can be found in the book Managing Strategic Innovation and Change edited by Michael Tushman and Philip Anderson (which, incidentally, contains many more valuable contributions.)

In the model of MacMillan and McGrath, the axes of the portfolio diagram are defined by two types of uncertainty of success. Market Uncertainty describes the uncertainty of commercial success owing to factors such as demand, competitors' responses or the effects of future laws and regulations. Technical Uncertainty describes the uncertainties with respect to the ability to successfully pursue the project to completion. These uncertainties can be due for example to technical difficulties, availability of resources or size of necessary investments.

Depending on their position in the portfolio, different innovation projects have different meanings for the company.

Projects with both low market uncertainty and low technical uncertainty are incremental innovations, for example improvements to existing products or line extensions. Such projects are technically feasible, and their commerical success is relatively easy to predict.

Projects with a medium level of uncertainty are often so-called platform projects. A platform project will lead in the medium term to a new product based on a new technology, which will serve as a basis for a whole series of subsequent incremental innovations.

Both incremental and platform projects are carried out with the goal of generating revenue; they are intended to produce new products in the short to medium term which protect market share.

By contrast, according to MacMillan and McGrath, innovation projects which have at least one dimension of uncertainty should be treated as options rather than revenue generators. In the stock market, a (call) option is the right to purchase a certain stock at a future date. If the stock goes up, then the right is exercised, if not, then it expires without being exercised. Options are a mechanism for investing a comparatively small amount of money in order to be able to participate in a future development. According to this reasoning, innovation projects with a high degreee of uncertainty should be viewed as options; they are tickets to possible future markets or technologies.

Innovation projects with a high degree of technical uncertainty but only a low or medium degree of market uncertainty are termed positioning options. These projects are carried out when the chances of a given technology achieving full functionality are unclear, or when several technologies are competing for primacy. If the technology concerned works out or comes out on top respectively, then the positioning option facilitates the entry into the market. The goal of a positioning option is therefore to acquire proficiency in a given technology.

Innovation projects with a high degree of market uncertainty but only a low or medium degree of technical uncertainty are called scouting options. These are projects which are feasible, but for which the commercial success is unclear. Scouting options are therefore used to gather information about the market.

Finally, innovation projects with both a high market uncertainty and a high technical uncertainty are called stepping-stone options, because they serve as stepping stones to completely new markets and solutions. They are by nature both positioning options and scouting options.

The importance of each field in the portfolio depends on the type of company and the market it is in. A good innovation strategy recognises the meanings of the various fields and formulates goals for each one to be acheived by innovation management. In a market with fast technological changes, for example, positioning options may play a larger role, while in a trend-oriented consumer market, scouting options will be more important.

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