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At
Any Rate™
by
Bill Harris
Model 6, December 2003
You Need More Than Brilliant Ideas
A few months back, I had one of those fleeting thoughts:
"What the world needs is a large, cheap disk drive with
an Ethernet port for home and small office networks."
A recent e-mail brought news of exactly such a product,
along with a twinge of "Why didn't I do that? I could
be rich and famous now." That's not the first time I've
thought of a new product and done nothing, only to see
it appear on the market some time later. Perhaps you've
had similar experiences.
Of course, there's more to innovation than simply having
a brilliant idea. It costs money to develop and launch
a new product, and a company must have the resources to
carry through. Moreover, a company must recoup its investment
through profits from that product that allow it to grow
the business and develop future generations of new products.
In other words, innovation is both a business and a technical
issue. And the situation is made more challenging by the
long time delays between investing in a new product and
seeing the returns on that investment-which can take months
or even years. It's hard to gauge the effectiveness of
actions when the results are so distant.
Systems dynamics is made for exactly these sorts of issues,
in which there are long time delays between taking action
and seeing the results of those actions and there are
circular feedback loops, such as investment in new product
development that drives future sales and profits, which
in turn enable further new product development. How do
companies manage this process successfully?
Al Bagley, retired group engineering manager of Hewlett-Packard's
Electronic Instruments Group (now part of Agilent Technologies)
and current member of the Board of Trustees for the SETI
Institute, was known for, among other things, the Bagley
Return Factor, a rule of thumb he used to decide whether
a proposed new product should be developed. Although the
rule carries his name, Bagley credits Bill Hewlett with
instigating this measurement and decision approach. Let's
let him tell the story:
In
the early days of HP, Bill Hewlett thought it would be
useful to have a way of quantitatively evaluating possible
development projects. He came up with what he called "Return
Factor," which was the expected operating profit over
the lifetime of a product divided by its total development
cost. This was often used to compare different potential
product ideas with each other before proceeding to development.
After a while we became aware that 5 had been a fairly
good HP return factor, and that particular number became
kind of the first hurdle of acceptability for a project.
We knew that both the numerator and denominator were pretty
rough estimates, but the factor was still useful.
When I served as Group Engineering Manager for the HP
Instrument Divisions . . . I thought it would be useful
to see if the factor had an absolute value that would
relate to a given financial business plan. . . . I guess
I harassed the division engineering managers enough with
the concept that some of them referred to it as the Bagley
Factor. It was still nothing more than Bill's original
factor.*
Calculating the Bagley Return Factor is quite simple,
only requiring two figures: the projected operating profit
(profit before taxes) over the life of the product and
the total product development cost. The ratio of those
two numbers is the Bagley Return Factor. At HP, if the
Return Factor exceeded 5, the product was deemed viable.
While this wasn't the only criterion used to make product
development investment decisions, it conveniently aggregated
the financial return aspect of that decision in a single,
easy-to-understand number.
As Bagley noted, using this Return Factor can help with
strategic product development decisions. Here's an example.
Following Bagley's derivation, assume that product development
projects spend money at a constant rate for A years, and
that the product is then on the market for B years, selling
a constant number of units (or, more specifically, bringing
in a constant revenue) over that time.
If G is equal to one plus the company's growth rate (e.g.,
a 15% growth rate corresponds to G = 1.15), P is operating
profit as a percent of revenue, and R is the percentage
of revenue spent on product development, then equation
1 holds.
With this equation, we can now explore the relationship
between profit, growth, new product development investment,
and product and project lifetimes. For example, if
a company invests 10% of its revenue into product
development, if the typical product development project
lasts 2 years, if products stay on the market an average
of 5 years earning 25% profit before taxes, and if
the company wants to grow at 15% per year, then the
Bagley Return Factor must equal or exceed 4.01.
If the time to develop a product is about equal to its
life, then this formula simplifies to equation 2.
The associated graph, courtesy of Bagley, shows a
company's achievable growth rate as a function of
the percentage invested in product development and
the return factor threshold on new product investment
decisions for a particular product development time,
product life, and projected profit percentage. Thus,
investing 8.5% of revenue in R&D and getting a Bagley
Return Factor of 4.0 would lead to approximately an
11% growth rate; a return factor of 6.0 would lead
to a 25% growth rate. If you're in the product development
business, take a look at your company's figures and
see where you fit.
George Richardson, professor of public administration,
public policy, and information science in the Rockefeller
College of Public Affairs and Policy at the University
at Albany-State University of New York, provides another
take on that decision process. Independently of Al's work,
he wrote a paper giving a systemic, theoretical underpinning
to making such product development investments. To find
out how Bagley's and Richardson's work compares and to
try your hand at managing a product development organization,
download and explore the attached model.
*Correspondence
between Al Bagley and Bill Harris, April 24, 2003.
Acknowledgements
Thanks to Al Bagley, Trustee of the SETI Institute; Karen
Lewis, Agilent Technologies Archivist; and Dr. George
Richardson, Professor of Public Administration, Public
Policy, and Information Science, Rockefeller College of
Public Affairs and Policy, University at Albany-State
University of New York, for their insights.
Using
the Model
To use the model, you'll need to download two files—the
"current model" and the "isee Player"
(the ithink® Runtime for the At Any Rate
model series) that runs the model. Both are located
in the "Get" section toward the top of
the right-hand column. You'll then need to install
the isee Player on your computer. (Once you have
installed the isee Player on your computer, you
no longer have to go through this process unless
the reader is updated.)
1)
Download the "Current Model"
• Click "Current Model."
• Choose "Save this file to a disk"
and click "okay."
• In "Save As," save the ITR file
to your desktop (or to a folder of your choosing).
2)
Download and install the "isee Player"
• Follow the instructions on the isee Systems
site.
After
you install the isee Player, to run the model, you
can go to your desktop and double-click on "model1.itr"
or start the ithink® program and use
the "file open" command to locate and
open the model1.itr file.
You are ready to begin. Feel free to play with the
model. We've put more content in it than we've described
in this column. Try different things. If you've
got an interesting idea, a question, or a comment,
go to our Pegasus
Forum. We'd enjoy hearing from you.
This
learning lab was developed using the ithink®
software, a computer simulation modeling
package developed and distributed by isee Systems.
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