Standard Article

Applying Value of Information and Real Options in R&D and New Product Development

  1. Jeffrey M. Keisler1,
  2. Paul Y. Mang2

Published Online: 14 JAN 2011

DOI: 10.1002/9780470400531.eorms0040

Wiley Encyclopedia of Operations Research and Management Science

Wiley Encyclopedia of Operations Research and Management Science

How to Cite

Keisler, J. M. and Mang, P. Y. 2011. Applying Value of Information and Real Options in R&D and New Product Development. Wiley Encyclopedia of Operations Research and Management Science. .

Author Information

  1. 1

    University of Massachusetts, Department of Management Science and Information Systems, Boston College of Management, Boston, Massachusetts

  2. 2

    McKinsey & Company, Chicago, Illinois

Publication History

  1. Published Online: 14 JAN 2011

Abstract

Real options analysis and value of information are related tools that help in guiding staged action in the face of quantifiable risk and uncertainty. Many types of projects involve early investments in the hopes of receiving later payoffs. Classes of projects such as R&D and new product development have received considerable attention in this regard. This article provides an overview of the concepts and literature of real options analysis and its connection to the value of information and decision analysis, and how these relate to such future growth opportunities.

R&D and new product development functions can utilize real options analysis/value of information by understanding factors that influence the value of such growth opportunities for the firm and the organizational capabilities required to realize those opportunities. We illustrate this with one set of factors and capabilities associated with a standard R&D project.

We define an innovation option as an opportunity for a firm to realize the commercial potential of a new technology by translating it into a novel product or service. During the course of development, information regarding the technical and market feasibility of a project is revealed. The firm can utilize the accumulated information regarding the potential net benefits of a project before committing partially or completely irreversible resources to commercialize the technology. In its most simple form, innovation projects should be viewed as a sequence of two decisions: a decision to gather information regarding the project's prospects (experimentation stage), followed by a decision to commercialize the project (implementation stage).

A basic two-stage model illustrates how a firm can maximize the value of its innovation efforts by investing in projects that match its organizational capabilities. First, we identify characteristics that determine the potential option value of an innovation project. We then turn our attention to the firm's capabilities that permit it to exploit high option value opportunities. We specifically investigate a firm's learning capability and abandonment capability. We find that an appropriate fit between project and the firm's characteristics will permit the firm to effectively appropriate the option value associated with its innovation opportunities. We contend that firms that are endowed with projects that tend to have high potential option value can improve their innovation processes by investing in the firm's capabilities that allow them to exploit their opportunities. On the other hand, firms that are endowed with projects that have low potential option value may be better off shedding potentially expensive, but relatively valueless, capabilities. Firms that recognize real options can analyze them, and then focus their efforts on adding value by managing their capabilities to exploit those options.

Keywords:

  • R&D;
  • new product development;
  • learning capability;
  • abandonment capability