What's Your Return on Development?
Identifying the Key Levers and Moving the Needle

Mark Davis, Principal, Deloitte Consulting LLP
John La Bouff, Senior Manager, Deloitte Consulting LLP

For the semiconductor industry, the ability to achieve business goals corresponds to constant focus on new products. This is, after all, an industry that has made an art of monetizing the "learning curve." But the relentless pace of product innovation creates enormous pressure to manage the development pipeline with speed and rigor. In the end, the new product portfolio must generate compelling value and continue to fund an increasingly costly development process. Is your company adeptly managing all the moving parts of the development machine, and is it accurately measuring the performance factors needed to achieve financial growth?

As the costs of bringing new products to market continue to grow exponentially, semiconductor companies are finding they need to shift to a new performance curve to innovate, grow, and increase revenue and earnings.

Figure 1. Increasing Costs of Semiconductor Product Development

Source: Synopsys, 2008

Based on Deloitte's work and recent benchmarks, we have identified key drivers and improvement actions that are the primary levers of overall "return on development" (RoD). RoD is a metric that allows companies to track their performance over time and measure it against other companies. Pull these levers correctly for your specific business situation and you stand a greater chance of reaping the rewards of new product development.

Armed with a solid understanding of how to address the components of RoD, these key factors of product development—engineering effectiveness, portfolio optimization and time-to-market—all converge in a stage-gate framework that sustains the focus on project performance, enables informed decision making and drives accountability for delivering "big picture" results.

Product Development and the Importance of Margin Pools

Product development aims to exploit candidate market areas that represent attractive margin pools—areas of customer demand that seem to command a desirable premium over the cost of accessing them.

Margin pools are a function of market size and the gap between the prevailing price and the cost to service the demand. In the semiconductor industry, technology's constant learning curve steadily opens up new margin pools, both by increasing the gap between price and cost, and by introducing new features and capabilities which widen and deepen the market's appetite. Advances in low-power computing and 3-D graphics are a prime example. The smartphone boom accelerated when the power of handheld devices passed a tipping point, expanding into a wider, mainstream audience and exploiting consumer features along with the business capabilities—notably e-mail—of prior generations.

At the same time, the cost of defining, designing and delivering products to tap into those margin pools is increasing. The exponential increase in development cost previously described continues through 40 nanometers and beyond, yet at the same time the unavoidable uncertainty about "if, when and how big" pervades the entire go-to-market process. Ultimately, though, the bets placed in product development must fund the whole enterprise. The overall gross margin pool (money left over after the cost of the goods is accounted for) must pay for the rest of operations, selling and administration, and sustain ongoing development efforts that will produce future generations.

For companies on a steep growth trajectory, this forward investment must reflect future, not current, business magnitude. So the bar is set very high for how big a margin pool is needed to achieve business objectives. Implementing an RoD framework helps a company identify where it is performing well and where it most stands to benefit from "moving the needle."

The Metrics of RoD

RoD is defined as the net present value (NPV) ratio of gross margin produced to the corresponding investment in product development. It is an intuitive, effective and concise yardstick for judging the financial merits (or results) of a development effort.

For example, if your RoD is 3 (3:1), the gross margin "harvest" of your development investment is triple that investment, in present dollar terms.

So the components of RoD are:

• The price-volume curve that the product or service commands in the marketplace (and where your company decides to land on it).
• How much money you are investing to develop the saleable product or service in question.
• The cost of producing and delivering each unit of the product or service.
• The points in time where these monies are moving in and out of the enterprise.
• The company's cost of capital.

Now, how can you improve this metric, despite trends in increasing development costs, product life cycle compression, and more aggressive competition and margin erosion? What are the levers you can pull?

Portfolio and Pricing

Choosing a portfolio of products to develop with the right price, volume and technology is, of course, paramount. The margin pools you select to tap and how well they are chosen is critical. Their interactions with your company's existing product set, their influence on end-to-end development cost, and the degree to which they are accessible or coveted by others can all affect RoD. But the reality is that these also change over time, so your company's ability to track, adapt and reshape its portfolio—especially with respect to products still in the pipeline—is key.

Product Cost

The design locks in 90 percent of product cost, although sourcing and operational wizardry can be tweaked in various places. Establishing design cost targets is the key way of influencing this.

Development Cost

Development cost is always an area of major contention. One key point is that development monies are spent on both the winners and the losers. There is tremendous leverage in selecting the highest probability efforts to work on in the first place—and smartly cutting losses when future prospects start to fade.

The other key area of development cost lies in individual and collective engineering effectiveness. In many companies, hard-to-find engineering talent spends too much time locked in tasks and activities that don't contribute to product development progress, but instead are artifacts of inefficient development processes and organizations.

Time

Time-to-market is not just a competitive question; if your development process takes too long, the revenue dollars that ultimately roll in are nearly worthless compared to the development spend incurred.

Figure 2. Revenue Loss for Being Late to Market

Source: IBS, 2007

Cost of Capital

Take cost of capital as a given. Weighted average cost of capital (WACC) is useful as a tool to take time out of the equation and put today's spend and tomorrow's margin on a level playing field in terms of impact to the company.

Raising the Bar on Product Development Performance

Once a company puts RoD into play and has specific metrics for measuring current performance, it becomes a matter of utilizing effective management techniques, processes and other metrics to jumpstart product development performance. The following includes some of the most effective ways in which leading companies raise the bar to achieve their goals:

Portfolio and Development ROI Metrics

There's inconsistency in how companies approach development financials. The tiered nature of semiconductor development, where individual projects often share "core" intellectual property (IP) and platforms whose development costs are meant to be amortized across multiple end products or families, can be frustratingly ambiguous. This sometimes results in the participants backing off from the controversies that can arise from trying to model and apply tests of financial return. Consequently, many companies are effectively flying blind, with only high-level "rear view mirror" metrics of development results. This can be too little, too late if they happen to get off track.

Leading companies address this challenge by adopting consistent, workable models for financial analysis of multi-tiered development, even if they're not perfect for every use case. The key elements of these models include:

• Thorough capture of development spend at both the individual project and at the platform/core IP levels.
• An allocation mechanism for distributing cross-project spend, such as core IP.
• Consistent models for product cost, including target cost analysis.
• Steadily maintained market and average selling price (ASP) models.
• A development proposal/project ranking based on gross margin or contribution margin metrics.
• A NPV-based "hurdle rate" total return benchmark for company financial performance.

Requirements Management

Requirements management offers two avenues to enhancing RoD. The first is associated with value engineering and design-for-cost disciplines, which force emphasis on feature-cost tradeoffs. It also counters an unfortunate tendency to "load up" product requirements unless they meet stringent criteria.

The second avenue is associated with time. A well-managed requirements process is time-sensitive, and requirements definition is notorious for being one of the most frequently extended stages of product development. Some companies even have "redefinition" as a named stage in their development process. Sure, you can argue that it's a fact of life, but extended development timelines create their own "redefinition" issues as the market passes them by.

The impact of time reduction on development financial performance is twofold. First, it reduces the uncertainty and the likelihood of changes to initial estimates. Second, time compression improves the NPV comparison of margin inflows and development spend.

Lean Engineering and Engineering Efficiency Management

A key driver for many companies is simply how much time each engineer or designer is actually able to devote to core, value-added tasks instead of administration, cross checking, error correction or sorting through disorganized information. Study this data and you will come away surprised by how high a percentage of your development staff time is unavailable for work that actually moves the process forward. By using value stream analysis and other lean techniques, a lot of engineers' non-productive time can be harvested and repurposed.

And let's be clear. Higher effective utilization of key technical resources is not only a cost reduction benefit. Again, it is a key lever for elapsed time. Now, the same staff can execute a given development effort in substantially less time than previously required and slash time-to-market.

Stage-gate Controls and Go/No-go Deployment of Development Resources

Many companies have established functioning stage-gate processes that fairly clearly delineate the progress from requirements to design, first silicon and revenue launch. Yet far fewer incorporate the basic question, "Is it still worth it?"

The criteria that may have launched a development effort are often not revisited for a hard-headed look at whether they still hold water. In the quarters and years that elapse from initial development decisions to later gates, forecast prices may have eroded, estimated product unit costs may have risen, the cost to develop may have overrun and the realistic time-to-market may have elongated. Whether for good reasons or due to imperfect execution, all of these factors can change the original equation of the development effort's fundamental merits. In short, the potential for those hoped-for large returns may have evaporated.

Figure 3. RoD Leverage is Front-loaded in the Development Cycle

Source: Deloitte Consulting LLP

Any high-performing company will charter development projects that, for a variety of reasons, run out of runway before they make it to revenue ship. Here's a simple diagnostic question for your development process: "Do you ever kill projects?" If you can't answer yes, it's possible you are failing to identify and terminate unrewarding development efforts as early as possible in the process. And that means you may also be failing to recoup the available development resources and spend of a lackluster project that could be redeployed to more promising efforts.

Targeting Increased RoD

These are the basics, but implementing improvements that move the RoD needle have to come from all sides:

• Work on the right things. Apply useful financial tests to your portfolio before committing the spend.
• Work effectively. Implement lean-based engineering methods that increase the value-added component of your workforce's time. Stress test requirements to ensure that incremental value mitigates RoD impact.
• Continue to test ongoing projects against criteria for success. Be willing to terminate projects whose value proposition has faded, and re-invest teams' time into higher return efforts.
• Recognize the capital value of time reduction and the true cost of time spent redoing or reworking. Be willing to penalize the business case of laggard projects appropriately.

Figure 4. Accelerating Gross Margin Inflows and Controlling Development Outflow is Key to RoD

Source: Deloitte Consulting LLP

RoD is simple to visualize, but no single improvement lever will consistently send sales soaring. Focus is required on every aspect of the management and operational processes of product development, from critical attention to portfolio-level economics and the minute details of each engineer's work patterns. RoD can provide a valuable collecting point for tying together multiple improvement efforts, all sharing a common objective of making the NPV of gross margin from development substantially exceed the NPV of development cost to meet your profitability and growth objectives.

About the Author

Mark Davis is a principal in Deloitte Consulting LLP's Silicon Valley office and leads the firm's product development practice. He has over 22 years of experience helping companies improve strategic and operational processes around product development and supply chain. You can reach Mark Davis at mardavis@deloitte.com or 408-464-6060.

John La Bouff is a 30-year veteran of the semiconductor industry, and was among the first to develop supply chain practices and systems designed around the fabless model. John is now a senior manager in Deloitte Consulting LLP's Silicon Valley practice, where he focuses on operational performance and product development improvement for semiconductor companies. You can reach John La Bouff at jlabouff@deloitte.com or 650-450-6056.

This article contains general information only and is based on the experiences and research of Deloitte practitioners. Deloitte is not, by means of this article, rendering business, financial, investment, or other professional advice or services. This article is not a substitute for such professional advice or services, nor should it be used as a basis for any decision or action that may affect your business. Before making any decision or taking any action that may affect your business, you should consult a qualified professional advisor. Deloitte, its affiliates and related entities shall not be responsible for any loss sustained by any person who relies on this article.

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