Cost Management: A Strategic Emphasis 5th Edition by David Stout, Edward Blocher, Gary Cokins

Exercise 75

Research Assignment, Strategy Obtain from your library a copy of following article: Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih, “Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things,” Harvard Business Review, January 2008, pp. 98?105. The article focuses on bias against innovation that is attributable to the misuse of certain financial tools. In fact, they conclude (p. 104) that “managers in established corporations use analytical methods that make innovation investments extremely difficult to justify.”

Required After reading the above-referenced article, answer the following questions:

1. According to the authors of the article, how does the use of DCF tools by managers in practice bias against innovation? What solution do the authors propose to counter this problem?

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2. Define the terms fixed costs and sunk costs. According to the authors of this article, what is the bias against innovation that is created by how some decision makers view such costs? What remedies do the authors recommend for dealing with this problem?

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3. The authors suggest that bias in the evaluation of innovation projects is caused, as well, by an overemphasis on (short-term) earnings per share statistics. What is the essence of this argument? What do the authors propose as a recommendation for addressing this problem?

Step 1 of 5

Research Assignment, Strategy (50-60 Minutes)

This assignment pertains to the following article: Clayton M. Christensen, Stephen P. Kaufman, and Willy C. Shih, “Innovation Killers: How Financial Tools Destroy Your Capacity to Do New Things,” Harvard Business Review (January 2008), pp. 98-105. The article focuses on bias against innovation that is attributable to the misuse of certain financial tools. In fact, they conclude (p. 104) that “managers in established corporations use analytical methods that make innovation investments extremely difficult to justify.” The authors point to the following three “misguided applications” of financial tools: (1) discounted cash flow (DCF) and net present value (NPV) to evaluate investment opportunities causes managers to underestimate the real returns and benefits of proceeding with investments in innovation. (2) The way that fixed and sunk costs are considered when evaluating future investments confers an unfair advantage on challengers and shackles incumbent firms that attempt to respond to an attack. (3) The emphasis on earnings per share as the primary driver of share price and hence of shareholder value creation, to the exclusion of almost everything else, diverts resources away from investments whose payoff lies beyond the immediate horizon.

1.  According to the authors of the article, how does the use of DCF tools by managers in practice bias against innovation? What solution do the authors propose to counter this problem?

While not disputing the underlying mathematics of the discounting process that lies at the heart of DCF methods such as NPV, the authors assert two implementation errors on the part of decision-makers:

(1)  The “DCF Trap:” some analysts (erroneously) assume a status quo competitive position in their analysis of an investment project. That is, they extrapolate the current market share and profitability of the company, without recognizing the potential for erosion of both over time as competitors invest. As the authors state, “In most situations, competitors’ sustaining and disruptive investments over time result in price and margin pressure, technology changes, market share losses, sales volume decreases, and a declining stock price.” In short, standing still means you’re falling behind. This underlying error of logic has also been referred to as “Parmenides’ Fallacy.”

The authors suggest, therefore, that a relative analysis be used when evaluating long-term investment projects. That is, in evaluating such projects managers should evaluate a project relative to what would be the expected condition for the firm in the absence of the proposed investment. This is a crucial question. Answering this question entails assessing the projected value of the innovation against a range of scenarios, the most realistic of which is often a deteriorating competitive and financial future.