Quantifying and Forecasting Uncertainty in Innovation Project Management - Dr. Jose A. Briones

Jose A. Briones, Ph.D.SpyroTek Performance Solutions Twitter: @Brioneja

Agenda Problem Definition New Framework for Innovation Management Discovery Driven Planning Reverse Income Statement The “Flaw of Averages” Probabilistic Decision Analysis Case Study: Forecast of iPad Sales www.Brioneja.com Twitter: @Brioneja

Introduction Product innovation has been described as the way out of today‟s difficult business environment. The rate of success of development projects, in particular disruptive innovation projects remains too low. We believe that a reason for the low success rate is the erroneous application of analysis methods designed for incremental innovation like NPV and DCF to projects with high levels of uncertainty www.Brioneja.com Twitter: @Brioneja

Background In this Chapter of the “Beyond Stage Gate” series we will discuss the use of Discovery Driven Planning and Probabilistic Decision Analysis in the management of innovation projects with high levels of uncertainty. Probabilistic Decision Analysis, when combined with the right management processes like Discovery Driven Planning is a very effective approach to evaluate and manage the risk and potential of innovation projects www.Brioneja.com Twitter: @Brioneja

Clayton M. Christensen We keep rediscovering that the root reason for established companies’ failure to innovate is that managers don’t have good tools to help them understand markets, build brands, find customers, select employees, organize teams, and develop strategy”• “Some of the tools typically used for financial analysis, and decision making about investments, distort the value, importance, and likelihood of success of investments in innovation”• “There’s a better way for management teams to grow their companies. But they will need the courage to challenge some of the paradigms of financial analysis and the willingness to develop alternative methodologies” www.Brioneja.com Twitter: @Brioneja

Classical Stage-GateProcess Source: Product Development Institute, Inc.Project is managed in a linear fashion“The Stage-Gate system assumes that the proposed strategy is the rightstrategy, the problem is that except in the case of incrementalinnovations, the right strategy cannot be completely known in advance”– Clayton M. Christensen www.Brioneja.com Twitter: @Brioneja

ChallengeCreate a unified framework for innovation projects/product development that 1. Provides the flexibility needed for innovation to work 2. Still has the metrics needed for proper measurement of progress and resource allocation. www.Brioneja.com Twitter: @Brioneja

A New Innovation Project Categorization Technical Uncertainty High Medium Low Low Medium High Market Uncertainty Source: Product Development Management Association This categorization is based on the most critical variable for new innovation projects: Degree of uncertainty www.Brioneja.com Twitter: @Brioneja

The Spiro-Level™ 3-D Approach to Innovation Resources LaunchQuadrant IV Quadrant I Roadmap/Timeline Level Idea Generation Risk Analysis 3 2 VOC Customer Testing 1 Time Time Technology Supply Chain Assessment Analysis Business Value in Use Case Analysis Regulatory Quadrant III Prototype IP Strategy Quadrant II Development Resources www.Brioneja.com Twitter: @Brioneja

Overall Project Management • Discovery Driven Planning • Knowledge to Assumption ManagementLevel 1 • Product/Technology Roadmaps • Multigenerational Product PlanningLevel 2 • Linear Stage-Gate • Agile/Lean DevelopmentLevel 3 • Rapid Prototyping www.Brioneja.com Twitter: @Brioneja

Financial Analysis • Reverse Income StatementLevel 1 • Real Options • Probabilistic Decision AnalysisLevel 2 • NPVLevel 3 • DCF www.Brioneja.com Twitter: @Brioneja

Discovery Driven Planning(DDP)  Process for management of innovation and development projects with high levels of uncertainty such as disruptive innovations, new product/new market projects or game changers  1995: First Publication by Rita Gunther McGrath and Ian C. MacMillan (1)  2000: Popularity increases with publication of book “The Entrepreneurial Mindset” (2)  2008: Endorsed by Clayton M. Christensen as an alternative to Stage Gate for high uncertainty projects (3)  2009: Publication of book Discovery Driven Growth (4) www.Brioneja.com Twitter: @Brioneja

Description Discovery Driven Planning turns the basic project map on its head  Discovery Driven Planning is a plan to learn, not to show that you had all the answers when you wrote the plan “Learn as you go” DDP uses four basic documents  „Reverse Income Statement‟ models the business economics.  „Pro-Forma Operations Specs‟ defines operations needed to run the business.  „Key Assumptions Checklist‟ identifies the business hurdles and assumptions for the initiative.  „Milestone Planning Chart‟ specifies when the assumption needs to be tested. www.Brioneja.com Twitter: @Brioneja

Reverse Income Statement  Instead of estimating the market demand and calculating the potential revenue/profit, DDP starts by defining the desired financial target that will meet the company‟s targets and strategy  The method then defines the set of assumptions, technical and commercial that MUST be proven true in order for the project to succeed www.Brioneja.com Twitter: @Brioneja

Generic Reverse IncomeStatement Reverse Income Statement Required Profits (MM$/yr) $20 Return On Sales 20% Target Revenue (MM$/yr) $100 Market Share Penetration 30% Market Size (MM$/yr) $333 Unit Price, $ $500 Unit Sales M/yr 200 Production Capacity Per Line, Units/Day 100 Production Lines Needed 6 Capital Cost of a Production Line, MM$ $1 Total Capital Investment Needed, MM$ $6 www.Brioneja.com Twitter: @Brioneja

The Flaw of Averages The Flaw of Averages states that plans based on the assumption that average conditions will occur are usually wrong Can you drown in a river that is on average only three feet deep? www.Brioneja.com Twitter: @Brioneja

Demand Forecast Problem Forecast for annual demand: “Between 150,000 and 250,000 units”  Average 200,000 units.  Plant is sized for average demand estimate  Profit is also calculated using average demand Flaw of averages: Profit WILL be lower than forecasted  No upside to exceeding demand estimate due to plant capacity limitations  Average becomes upper limit www.Brioneja.com Twitter: @Brioneja

Solution: Ranges and Probabilities  Input data and results are expressed as ranges and probabilities  80% Chance of number being between 570 and 689KSource: “The Flaw of Averages” Marketingnpv.com www.Brioneja.com Twitter: @Brioneja

Probabilistic Decision Analysis Model uses @Risk probabilistic decision analysis software  Monte Carlo simulation  Risk and opportunity analysis Designed for complex projects with high levels of uncertainty  Inputs contain high number of variables, either technical or financial with a high degree of uncertainty, assumptions and dependencies ○ New product development assessment ○ Capital spending decisions ○ Value chain analysis ○ Production and sales forecasting analysis Eliminates use of “one at a time” cases  Analyzes thousands of cases simultaneously  Generates a range of outcomes www.Brioneja.com  Outcome charts are analyzed to make decisions on direction Twitter: @Brioneja

Input Ranges Input values are entered in range format – Width and shape of range are critical inputs  Definition of the input ranges is the most critical step  Do not start with the typical value, start with the range, define the shape of the function (10%, 50%, 90% probability). There are multiple choices for the shape of the input range:  Triangular: Most common for initial assumptions  Normal distribution: Used when more accurate input data is available 0.4342 0.6448 5.0% 90.0% 5.0%  PERT: When data is in form of probabilities  Gamma distribution: Good to model pricing distributions in www.Brioneja.com B-B cases 00 05 00 05 00 05 00 05 00 05 .3 .3 .4 .4 .5 .5 .6 .6 .7 .7 Twitter: @Brioneja

Reverse Income Statement Combined with Probabilistic Decision AnalysisReverse Income Statement Min Target Max Required Profits (MM$/yr) $15 $20 $25 Return On Sales 15% 20% 25% Market Share Penetration 25% 30% 35% Unit Price, $ $400 $500 $600 Production Capacity Per Line, Units/Day 75 100 125 Capital Cost of a Production Line, MM$ $0.8 $1.0 $1.4  Define ranges for each input variable www.Brioneja.com Twitter: @Brioneja

Revenue vs. Market Size Target Revenue (MM$/yr) 8.0% $81.00 81.1% $120.00 10.8%  Revenue range is0.030 projected w level of0.0250.020 Target Revenue (MM$/yr) probability Minimum $64.170.015 Maximum $151.41 Mean $101.06 Std Dev $14.690.010 Values 50000.0050.000 Market Size (MM$/yr) $120 $130 $140 $150 $160 $60 $70 $80 $90 $100 $110 $254.36 $436.48 5.0% 90.0% 5.0% 0.008 0.007 0.006 Market Size (MM$/yr) 0.005 Minimum $191.09 0.004 Maximum $553.25 Mean $338.49 0.003 Std Dev $54.93 Values 5000 0.002 0.001 0.000 www.Brioneja.com $400 $450 $500 $550 $600 $150 $200 $250 $300 $350 Twitter: @Brioneja

Unit Sales vs. Capital Unit Sales M/yr 162.5 250.0 10.5% 79.6% 9.9%  Capital investment is0.0140.012 expressed a range vs.0.010 Unit Sales M/yr unit sales0.008 Minimum 114.11 Maximum 338.250.006 Mean 203.46 Std Dev 34.00 Values 50000.0040.0020.000 Total Capital Investment Needed, MM$ 250 300 350 100 150 200 $4.20 $8.00 6.2% 83.8% 9.9% 0.35 0.30 0.25 Tidal Capital Investment Needed, MM$ 0.20 Minimum $2.55 Maximum $12.64 0.15 Mean $6.09 Std Dev $1.40 0.10 Values 5000 0.05 0.00 www.Brioneja.com $10 $12 $14 $2 $4 $6 $8 Twitter: @Brioneja

Capital Investment SensitivityAnalysis Total Capital Investment Needed, MM$ Regression Coefficients Capital Cost of a Production Line, MM$ 0.50 Production Capacity Per Line, Units/Day -0.45 Return On Sales -0.45 Required Profits (MM$/yr) 0.44 Unit Price, $ -0.35 -0.5 -0.4 -0.3 -0.2 -0.1 0.0 0.1 0.2 0.3 0.4 0.5 0.6 Coefficient Value  Sensitivity analysis is a way to focus on the variables that are most important to reduce uncertainty www.Brioneja.com Twitter: @Brioneja

Case Study: iPad™ IncomeProjectionA) Static Analysis iPad 2010 Unit Sales (MM) 7.1 iPad 2011 Unit Sales (MM) 14.4 iPad 2012 Unit Sales (MM) 20.1 Netbook 2010 Unit Sales (MM) 43 Unit Price, $ $650 iPad Cost of Materials, $/unit $264.3  Static analysis iPad Cost of Manufacturing, $/unit $10.5 uses projections iPad Warranty Service, $/unit $20 prior to launch iPad Indirect Expenses 2010 (MM$/yr) $2,100 iPad Indirect Expenses 2011 (MM$/yr) $2,500 iPad Indirect Expenses 2012 (MM$/yr) $2,700 www.Brioneja.com Twitter: @Brioneja

iPad Income Projection: StaticAnalysis www.Brioneja.com Twitter: @Brioneja

B) Probabilistic DecisionAnalysis – iPad IncomeProjection Min Target Max iPad 2010 Unit Sales (MM) 1.3 7.1 12.9 iPad 2011 Unit Sales (MM) 8.6 14.4 55 iPad 2012 Unit Sales (MM) 14.3 20.1 63.3 Netbook 2010 Unit Sales (MM) 36.6 43 58 Unit Price, $ $500 $650 $830 iPad Cost of Materials, $/unit $219.0 $264.3 $335 iPad Cost of Manufacturing, $/unit $9.0 $10.5 $12 iPad Warranty Service, $/unit $15 $20 $25 iPad Indirect Expenses 2010 (MM$/yr) $1,680 $2,100 $2,520 iPad Indirect Expenses 2011 (MM$/yr) $2,000 $2,500 $3,000 iPad Indirect Expenses 2012 (MM$/yr) $2,160 $2,700 $3,240 www.Brioneja.com Twitter: @Brioneja

iPad Market Share Projections iPad Market Share vs. netbooks 2010 iPad Market Share vs. netbooks 2011 9.25% 24.25% 32.0% 80.0% 13.1% 80.8% 6.1% 13.7% 67.5% 18.8%8 2.0 1.87 1.66 1.4 iPad Market Share vs. iPad Market Share vs. netbooks 2010 netbooks 20115 1.2 Minimum 2.83% Minimum 17.3%4 1.0 Maximum 143% Maximum 32.2% Mean 0.8 15.6% Mean 57.3%3 Std Dev 5.46% Std Dev 23.7% Values 0.6 5000 Values 50002 0.41 0.2 0.00 0% 20% 40% 60% 80% 100% 120% 140% 160% 30% 35% 0% 5% 10% 15% 20% 25% iPad Market Share vs. netbooks 2012 41.0% 90.0%1.8 8.3% 68.1% 23.6%  Market share analysis1.6 projects potential level1.41.2 iPad Market Share vs. netbooks 2012 of penetration and1.0 Minimum 27.5%0.8 Maximum Mean 159% 71.7% substitution0.6 Std Dev 25.3% Values 50000.40.20.0 20% 40% 60% 80% 100% 120% 140% 160% www.Brioneja.com Twitter: @Brioneja

iPad Revenue Projections iPad Revenue 2010 (MM$/yr) iPad Revenue 2011 (MM$/yr) $2,400 $6,350 $8,250 $27,500 8.6% 75.2% 16.2% 6.6% 83.9% 9.5% 3.0 7 2.5 6 5 iPad Revenue 2010 iPad Revenue 2011 2.0 Values x 10^-5Values x 10^-4 (MM$/yr) (MM$/yr) Minimum 4 $880.13 Minimum $5,144.81 1.5 Maximum $9,811.24 Maximum $41,875.43 Mean 3 $4,685.46 Mean $17,165.42 1.0 Std Dev $1,637.15 Std Dev $7,070.77 Values 2 5000 Values 5000 0.5 1 0.0 0 $7,000 $8,000 $9,000 $10,000 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 $45,000 $0 $1,000 $2,000 $3,000 $4,000 $5,000 $6,000 iPad Revenue 2012 (MM$/yr) $11,605 $35,590  Upper range of revenue 5.0% 90.0% 5.0% 6 shows dramatic upside 5 iPad Revenue 2012 potential 4Values x 10^-5 (MM$/yr) Minimum $8,217.53  Max revenue value is 3 Maximum $46,917.00 2 Mean Std Dev $21,472.35 $7,522.30 from unit sales analysts 1 Values 5000 estimates 7 months after 0 launch $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 $35,000 $40,000 $45,000 $50,000 www.Brioneja.com Twitter: @Brioneja

iPad Gross Profit Projections iPad Gross Profit, $/unit $252.50 $475.00 7.4% 87.1% 5.5%0.0070.0060.005 iPad Gross Profit, $/unit0.004 Minimum $165.47 Maximum $562.540.003 Mean $356.74 Std Dev $71.92 Values 50000.0020.0010.000 $150 $200 $250 $300 $350 $400 $450 $500 $550 $600 iPad Gross Profit Margin 45.25% 62.82% Gross profit analysis 7 10.0% 85.0% 5.0% can highlight areas of 6 concern 5 iPad Gross Profit Margin 4 Minimum 31.6% Maximum 68.8% 3 Mean 53.6% Std Dev 6.12% Values 5000 2 1 0 www.Brioneja.com 55% 60% 65% 70% 30% 35% 40% 45% 50% Twitter: @Brioneja

iPad Income Projections iPad Income 2010 (MM$/yr) iPad Income 2011 (MM$/yr) $50 $2,000 $2,250 $12,500 38.7% 54.1% 7.2% 12.0% 77.4% 10.6% 4.5 1.2 4.0 1.0 3.5 3.0 iPad Income 2010 (MM$/yr) 0.8 iPad Income 2011 (MM$/yr)Values x 10^-4 Values x 10^-4 2.5 Minimum -$1,869.82 Minimum -$830.65 Maximum0.6 $4,703.02 Maximum $26,029.39 2.0 Mean $431.87 Mean $6,784.18 Std Dev $1,010.77 Std Dev $4,206.06 1.5 0.4 Values 5000 Values 5000 1.0 0.2 0.5 0.0 0.0 -$5,000 $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 -$2,000 -$1,000 $0 $1,000 $2,000 $3,000 $4,000 $5,000 iPad Income 2012 (MM$/yr) $5,000 20.5% 64.4% $13,750 15.1%  Income analysis shows 1.2 1.0 high potential for losses 0.8 iPad Income 2012 (MM$/yr) 1st year, but huge profitValues x 10^-4 Minimum $467.14 0.6 Maximum Mean $27,088.90 $8,893.70 upside for 3rd year Std Dev $4,560.12 0.4 Values 5000 0.2 0.0 $0 $5,000 $10,000 $15,000 $20,000 $25,000 $30,000 www.Brioneja.com Twitter: @Brioneja

iPad 2012 Income Sensitivity Analysis iPad Income 2012 (MM$/yr) $5,000 $15,000 20.5% 68.3% 11.2%1.00.8 iPad Income 2012 (MM$/yr)0.6 Minimum $467.14 Maximum $27,088.90 Mean $8,893.700.4 Std Dev $4,560.12 Values 50000.2 iPad Income 2012 (MM$/yr) Regression Coefficients0.0 $20,000 $25,000 $30,000 $0 $5,000 $10,000 $15,000 iPad 2012 Unit Sales (MM) 0.86 Unit Price, $ 0.48  Sensitivity analysis iPad Cost of Materials, $/unit -0.17 shows where more iPad Indirect Expenses 2012 (MM$/yr) -0.05 market research is iPad Warranty Service, $/unit -0.01 needed to reduce 0.2 0.4 0.6 0.8 1.0 -0.2 0.0 uncertainty Coefficient Value www.Brioneja.com Twitter: @Brioneja

Actual iPad Sales Figures 2010 – 14.8 MM Units  Original industry forecast 7.1 MM Units 2011  Jan-Mar - 4.7 MM Units  Apr-June - 9.3 MM Units  Jul-Sep – 11.1 MM Units ○ Apple sold more iPads than Dell sold in all its PCs together (10.6 million)  Oct-Dec 15.4 MM Units 2011 Sales - 40.5 MM Units  Original industry forecast 14.1 MM Units www.Brioneja.com Twitter: @Brioneja

Use of DDP DDP has been successfully used by oil and pharmaceutical companies to tackle high uncertainty projects More companies are adapting the method, but there is still strong resistance to leave Stage Gate behind.  Stage Gate can be used after the results of DDP have defined the project and reduced the level of uncertainty www.Brioneja.com Twitter: @Brioneja

Summary DDP combined with Probabilistic Decision Analysis provides discipline and framework to the discovery process but at the same time provides the flexibility necessary for the project to change direction or iterate as needed www.Brioneja.com Twitter: @Brioneja

Contact Information Brioneja@SpyroTek.com www.Brioneja.com Twitter: @Brioneja www.Brioneja.com Twitter: @Brioneja

References1. Discovery Driven Planning, 1995, http://hbr.org/1995/07/discovery-driven-planning/ar/12. The Entrepreneurial Mindset, 2000, http://www.amazon.com/Entrepreneurial-Mindset-Continuously-Opportunity- Uncertainty/dp/0875848346/ref=sr_1_1?ie=UTF8&s=books&qid=1274888243&sr=1-13. Innovation Killers, 2008, http://hbr.org/product/innovation-killers-how-financial-tools-destroy-you/an/R0801F-PDF- ENG?Ntt=innoation%2520killers4. Discovery-Driven Growth, 2009, http://www.amazon.com/Discovery-Driven-Growth-Breakthrough-Process- Opportunity/dp/1591396859/ref=sr_1_3?ie=UTF8&s=books&qid=1274887263&sr=8-35. Discovery Driven Planning http://faculty.msb.edu/homak/homahelpsite/webhelp/Discovery_Driven_Planni ng.htm www.Brioneja.com Twitter: @Brioneja

iPad Market Share vs. netbooks 2010 16.5%Backup Data iPad Market Share vs. netbooks 2011 iPad Market Share vs. netbooks 2012 33.5% 46.7% iPad Revenue 2010 (MM$/yr) $4,615 iPad Revenue 2011 (MM$/yr) $9,360 iPad Revenue 2012 (MM$/yr) $13,065 iPad Total Cost, $/unit $294.77 iPad Gross Profit, $/unit $355.23 iPad Gross Profit Margin 54.7% iPad Direct Expenses 2010 (MM$/yr) $2,093 iPad Direct Expenses 2011 (MM$/yr) $4,245 iPad Direct Expenses 2012 (MM$/yr) $5,925 iPad Total Gross Profit 2010 (MM$/yr) $2,522 iPad Total Gross Profit 2011 (MM$/yr) $5,115 iPad Total Gross Profit 2012 (MM$/yr) $7,140 iPad Income 2010 (MM$/yr) $422 iPad Income 2011 (MM$/yr) $2,615 iPad Income 2012 (MM$/yr) $4,440 www.Brioneja.com Twitter: @Brioneja

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Quantifying and Forecasting Uncertainty in Innovation Project Management - Dr. Jose A. Briones

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