Operational and Strategic Risk Management
Take calculated risks and invest optimally in your Research and Development (R&D)
An enduringly successful and value-based management distinguishes itself by the high quality of its decisions, and its calculated risk-taking. This requires reliable information and sophisticated tools describing precisely the current situation in a rapidly changing environment, and accurately anticipating future developments. Most importantly, the contribution to research and development cannot be expressed in numbers without an overall risk assessment based on reliable methods.
Measuring Added Value of R&D
There is a broad consensus among industrial enterprises that investing in R&D is necessary to permanently secure business success. But how much should be spent, and on what activity? Expectations regarding investments in R&D are frequently accompanied by strong hopes and high emotions, whilst the risks are subtle and hard to survey. Ex-post analysis often shows that many projects have missed ambitious return-on-investment objectives. Often, not even the cost of capital is covered. This problem can be cured with a risk-adjusted value-based allocation of resources in R&D, which is a process in four consecutive steps.
The basis consists of reliable forecasts and processes (Step I)
Usually, a detailed capital expenditure plan based on methods such as 'discounted cash flow' or 'decision tree analysis' is available. However, the data on which these plans are based is not well investigated, or it is outdated. Consequently, the data cannot be stressed heavily. Besides this, there is often a lack of control. Processes in project management and project controlling are insufficiently defined or implemented. For instance, it is necessary to monitor the milestones with the help of thoroughly defined project phases, to formalize data collections, to define responsibilities across departments.
It is often the case that forecasts lack a common methodology. The assumptions are static, and insufficiently describe the life-cycle of a product, replacement, and margin erosion.
The assessments of individual projects based on a thorough risk analysis (Step II)
The pricing methodology often does not match the complexity of the problem at hand; for example when it comes to an adequate pricing of real options such as increasing capacity or stopping a project. Even when methods from option pricing are employed, some features of the problem may not be addressed properly (for example: several correlated risk factors, compound options, heteroskedasticity, mean reversion, etc.). Also, a valid determination of the parameters is difficult. This way, the real strength of the methodology may become weak.
In order to realize an option premium, the option has to be exercised timely. This has to be supported by data on early indicators from an early warning system. A sound and meaningful risk analysis is often not available at all, or only as a simple sensitivity analysis, although risk represents a figure of significant impact. Experience has proven that market risks are, in general, insufficiently included. The reason for this is usually an unsophisticated understanding of risk (for example Value-at-Risk and Expected Shortfall) and risk methodology.
The thorough identification of risk factors can provide important impulses for controlling a project. When monitoring a project it should become clear that risks decrease as the projects progresses. Successful projects transform capital into knowledge and reliable data, i.e. ignorance and uncertainty are reduced. In financial parlance: You go long an option on innovation (transformation of knowledge and data into cash flows), possessing a value which should be greater than its costs.
Prioritization and Portfolio Selection (Step III)
It is even more demanding to choose the right investment when there is only a limited budget. A prioritization based on expected returns is futile when there are different risks. Nowadays a meaningful risk assessment is indispensable, so that risk is accounted for systematically in every decision. For this purpose, modern approaches such as 'Risk Adjusted Return on Capital (RAROC)' and related concepts are especially well-suited.
On top of this a systematic portfolio selection providing comparability is essential. Primary focus should be put on the timetable of the cash flows resulting from the R&D pipeline (time to market, amortization) which needs to be taken into account for optimizing the entire portfolio. Besides, it is important to realistically model the availability and flexibility of resources.
Implementation (Step IV)
Finally, the R&D portfolio is interlocked with other investments (large marketing project, long-run purchase agreements, fixed asset investments). Thereafter, the key questions of optimal budgeting and portfolio selection can be answered in terms of an integrated value-based resource allocation.
d-fine can help you
We have the entire collection of the necessary methodological instruments at our disposal. Besides these, we possess the professional competence and practical experience of many years to really help you in the selection of your project portfolio and the resulting decisions. This starts with a systematic process of the data ascertainment. The next step is the valuation of individual projects, taking into consideration market and default risks plus a systematic portfolio selection, providing meaningful and comparable numbers. This view, of course, includes the time schedule of the cash-flows resulting from the R&D pipeline.
We not only provide the concepts but also implement them in your company. As a first step, a prototype is implemented as a proof of concept. Later on, the concept should be integrated into your IT systems, since only the implementation of methods and processes in the controlling unit (and their interlocking with value management, risk management, and their respective management information systems) can provide lasting value enhancement and increased quality of decisions.
Our offer
We review your processes and methodology with a quick check on all four steps, or (according to your wishes) also separately, and point out room for possible improvement. It is also possible to set up an individual project, from analysis to implementation, again according to your wishes.
