While NPVs attached to innovation projects often fall short in capturing the full spectrum of uncertainties, financial modeling as a whole remains an indispensable tool. The key lies in leveraging these models to identify and manage risks effectively.
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We hate most NPVs attached to innovation projects. There, we said it.
In the context of innovation, financial modeling often receives mixed reviews, particularly when it comes to the use of Net Present Value (NPV) calculations. On the one hand, NPV is a widely recognized metric used to evaluate the potential profitability of projects. On the other hand, its application to innovation initiatives often leaves stakeholders feeling uneasy. Why? Because the static NPV attached to innovation projects rarely captures the dynamic and uncertain nature of these endeavors. Yet, paradoxically, financial modeling remains indispensable in innovation work. So, what distinguishes useful financial modeling from its less effective counterparts in the context of innovation?
How NPVs Are Used (or Under-used) Today
NPVs frequently appear in innovation assessments, primarily as a tool to gauge a project's relative attractiveness and as a benchmark to ascertain its viability. Typically, the NPV calculation is reduced to a single slide in a report, presenting a neat, numerical depiction of a project's potential. However, beyond this application, many fail to recognize the value of in-depth financial analysis. This perceived lack of value is primarily due to the uncertainties inherent in forecasting innovation projects. We are all aware that the risk factors and variables involved can skew any conclusions drawn from these models.
The Blind Spot
The inherent flaw in most financial models is their inability to predict the unpredictable. Despite this, the common mantra that "all models are wrong; but some models are useful" is a paradigm that highlights the potential value buried within these models. They may not eliminate uncertainties, but they can illuminate where risks lie. Recognizing and understanding these risks is pivotal, as it informs decision-making in innovation projects.
How Can Uncertain Models Be Hyper-Useful?
Financial models do not predict the future and eliminate risk; rather, they help identify where risks are most pronounced. Each business-building project harbors unique structural characteristics, which in turn dictate its distinct risk profile.
- Some projects demand significant capital investment, while others do not.
- Some necessitate up-front development, whereas others leverage existing products.
- Some projects hinge on achieving high volumes, others rely on high margins.
- Some projects incur high fixed costs, while others incur variable costs.
Understanding the sensitivity of each of these characteristics through financial modeling provides invaluable insights. The tornado chart below provides an example of the sort of insight available from financial sensitivity analysis.
When project teams adopt this approach, they often realize that the’ve been focusing on activities that don’t address critical project risks.
Why is this information so critical?
Because it can be used to direct project activities toward mitigating areas of highest risk. Effective project management involves maximally reducing risk with minimal development efforts, a principle central to stage-gate methodologies. Consequently, financial analysis becomes instrumental in prioritizing which project variables warrant early validation.
For instance, if a financial analysis indicates that volume is a key sensitivity, then validating assumptions related to demand—such as validating target segments and volume per segment—should be prioritized. In this manner, leaders can be confident that projects are being de-risked effectively. When project teams adopt this approach, they often realize that they have been focusing on activities that do not address key project risks. This oversight results in wasted innovation dollars, late-stage failures, and ultimately, lackluster growth portfolios.
Actioning This Insight
To avoid these failures, we propose two crucial adjustments to conventional approaches. First, implement financial sensitivity analysis at the outset of a project's lifecycle and update it at each subsequent stage. This allows teams to stay attuned to evolving risks and adjust their activities accordingly. Second, use the insights gleaned from this analysis to prioritize project activities for the next phase. By aligning project efforts with areas of highest risk, organizations can optimize resource allocation and improve the likelihood of project success.
- Run financial sensitivities to identify highest project risks.
- Prioritize project activities to de-risk the high-risk assumptions.
While NPVs attached to innovation projects often fall short in capturing the full spectrum of uncertainties, financial modeling as a whole remains an indispensable tool. The key lies in leveraging these models to identify and manage risks effectively. By doing so, companies can transform their innovation productivity, reducing wasteful expenditure, avoiding late-stage project failures, and cultivating robust growth portfolios. In a world where innovation is the driving force behind sustained success, refining our approach to financial modeling is not just beneficial—it is essential.
Until next week,
Kendall -
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