[SOUND] Hello. My name is Jan van den Ende. I'm a Professor of Innovation Management at Rotterdam School of Management. Which innovation projects do we undertake as a company? How do we make choices? This video is about portfolio management. Portfolio management is about selecting the right projects for innovation. It will be clear to you that selecting innovation projects is key for the future of companies. An example is Nokia. The company was leading in the development of GSM mobile phones, but it missed the transition to touch-screen smart phones. The performance of the company dropped tremendously and eventually the company was taken over by Microsoft. This example shows that if you select the wrong innovation projects today, this will strongly harm the future of your firm. The selection of innovation projects today determines what products and services you firm will offer to customers in the future. This week I will first give you an overview of how to manage an innovation portfolio. After a short video on portfolio management at Philips Lighting I will focus on the important consideration in portfolio management, intellectual property protection, and I will introduce you to some tools. To create an innovation portfolio firms usually have used a decision process called the innovation funnel. You first generate a large set of project ideas or concepts. In the previous module on creativity, you have learned how to do so. Then a review committee assesses these ideas or concepts and selects the best ones. For each selected idea or concept, you create a project. After some time the committee reviews all projects and makes a further selection based on the outcome of the projects and the market at that moment in time. The review committee may meet several times per year. It's of course best to try to reduce the number of projects as early as possible in the funnel, and to narrow down the funnel early since stopping projects late is costly. We can distinguish between two ways to manage the final process. I call the first one reactive. Many firms apply this process. Firms using reactive process collect ideas and concepts for innovation projects. They define criteria for the selection between the projects. Subsequently, they score the projects on those criteria. They give weights to the different criteria, and they finally select the projects with the highest scores. This process is simple and logical, but it has an important disadvantage. The firm may end up with an unbalanced set of projects. Research has shown that selection of portfolios at this rate leads to over representation of incremental projects. The reason is that, as you will explain later, these projects have a relatively low risk and therefore, score high on financial criteria. You may remember from earlier in this book that firms should also be engaged in radical innovation. The second approach, which I label proactive, solves this problem. In this approach the firm defines a number of so called buckets. We already mentioned this concept previously. You can do so by following a four step process as shown on the slide. Define the budget, define buckets for opportunity areas, define criteria, and classify, and choose projects. First, the company has to define the total budget for innovation. How much do we want to spend? We usually measure it by the so called R and D intensity which is the innovation budget as a percentage of revenues. The R and D intensity depends on the industry, as you can see here at the bottom of the slide. Pharmaceuticals, traditionally, have high levels of R and D intensity, as does the software sector. In the software sector the high levels are mainly due to low costs of operations, which increases the weight of R and D costs in total costs, and consequently, also in total revenues. In services, R and D intensity is usually very low, partly due to the dispersed nature of innovation activities in service companies. Opportunities for innovation is a second factor. If new technologies, markets, or channels create high opportunities for innovation firms will increase their budget. The strategy of the company is a third factor. A highly innovative firm will spend more than a more conservative company. And finally, if firms have high growth targets, they will also spend more on innovation. The second step is to define a number of buckets. Buckets are opportunity areas and time horizons for which you develop innovations. You can see in the following video how the CEO Hans Vestberg of the Swedish telecommunications and IT company, Erickson, defines innovation buckets for his company. As you saw, Vestberg defines three time horizons in which in each of these, a number of programs. We call these programs buckets. In each problem, we will have different projects. Let's have a look at another example, the toy manufacturer, Lego. LEGO defines four different opportunity areas, business, product, communication, and process. Within each area, LEGO defines two sub-areas, business refers to sales channels and business models. The product area is split up into products and the combination of different of products. The consumers, the children get used together. The picture shows that Lego also innovates in customer interaction and production processes. The company has to determine different types of projects in terms of novelty, and to split up each area accordingly. LEGO defines incremental improvement as small changes to existing offerings or processes, new offering as a complete redesign of products or processes, and redefine category as radical new offerings or processes related to a category. After combining this classification with the opportunity areas, LEGO ends up with a set of 24 buckets. This is quite high, usually firms have fewer buckets. The firm allocates a budget to each bucket. The budget of course mainly depend on the importance of the alternative buckets, but also on how expensive innovation projects within the alternative buckets will generally be. The last step is to position the different project ideas or proposals in the right bucket, and to make a selection within each bucket. On the slide, you see how LEGO has done so. When positioning ideas in buckets it may appear that some buckets remain empty, like the top right in this example. This shows the advantage of the bucket approach. You become aware that some areas of opportunity are not covered. The approach challenges you to define projects for those buckets or to invite colleagues to do so. Step three is to craft different selection criteria for each bucket. Possible selection criteria are technical feasibility, market attractiveness, expected commercial value, strategic importance, etc. Also, the possibility to protect intellectual property of innovation, for instance by means of patenting, is often an important consideration. For instance, you may decide not to develop a potential new service if you know it can easily be copied by a competitor, or even less so if the competitor will be able to provide it at a lower cost. For incremental projects the expected commercial value will be very important, where as, for radical innovations, strategical conservations will be key. The expected commercial value are the total revenues minus the cost over a number of years. As I will explain later in buckets for radical projects you may calculate the expected commercial value according to the real options approach while for incremental projects you will apply net present value calculations. All in all this proactive approach may be harder to execute then the reactive process, but it helps you to manage your portfolio in a more balanced way according to your strategic priorities. Let's see how Phillips Lighting manages it's portfolio in the next video. Pay attention to how Philips defines its buckets.
