Production, Manufacturing and Logistics
Timing and quality decisions for entrepreneurial product development

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Abstract

An entrepreneur is developing a new product, and each period must decide whether to enter the market or to continue development. We formulate a model of this decision for ventures facing diminishing returns to product quality, and for which funding availability, product development success, and market competition growth are uncertain. We characterize the profit-maximizing time to stop product development and enter the market, and then show how this stopping time is affected by changes in the business environment. By further focussing our modeling assumptions, we are able to translate our time-based criteria into product quality terms; we propose that management set a target quality level that the product must meet in order for the venture to maximize profit. We also demonstrate that management should decrease this target (and hence the quality of the final product) over time, and adjust it to respond to changes in the business context.

Introduction

Consider an entrepreneur with uncertain financing who is developing a new product prior to launching it into the target market. Each period the entrepreneur can choose to either enter the market immediately or to continue product development for another period. The longer product development continues, the higher the product quality and therefore the greater potential profit will be. On the other hand, the longer the delay to enter the market, the more the financing costs will increase and the more the target market will be eroded by competitors. Based on the tradeoff between the advantage of continuing to improve quality versus that of introducing the product to the market before competition arrives, the entrepreneur decides when to terminate product development with the objective of maximizing the success of the business. It is this situation that we will be analyzing herein.

Timing of new product entry, especially as it relates to product success in the marketplace, has captured the attention of many authors. For instance, Zirger and Maidique (1990) empirically support that “… products that are first to the market and experience little competition are more successful.” From a database of 112 new industrial products from 52 French firms, Lilien and Yoon (1990) found that “… if a pioneer's market entry creates a new product class, entry too early may push an underdeveloped product into the marketplace, however if entry is delayed too long, the firm may sacrifice the benefits of being first with a new product or technology.” More recently, Cohen et al. (1996) showed that “… an improvement in the speed of product improvement does not necessarily lead to an earlier time to market, but always leads to enhanced products.” These studies acknowledge the tradeoff between maximizing new product quality and minimizing time to market. This key decision is one faced by more small companies every year, as new ventures are not only used by entrepreneurs with a dream to follow, but also increasingly by larger firms such as Nortel which outsource or spin off their product development so as to focus their efforts on the rest of the value chain (Rubenstein, 1998).

This quality and timing tradeoff is distinct from but has some similarities to that of the technology adoption decision, wherein established companies tradeoff the advantages of being an early adopter of new technology versus those of being a late adopter (see e.g. Loch and Huberman, 1999; Jovanovic and Lach, 1989). Early adopters can capture larger margins and market share, but risk making mistakes as they go (Stinchcombe (1965) introduced the concept of liability of newness to describe the high mortality risk facing new ventures). Late adopters by contrast are able to benefit by learning from others' mistakes, but run the risk of being left behind and shut out of the market.

Existing research in the economic-R&D literature can be categorized into decision-theoretic models and game-theoretic models. In game-theoretic models, several firms compete in the development of a new product; see Reinganum (1989) for a review of this literature. Our work in this paper falls under the category of decision-theoretic models, in which a dynamic R&D investment problem is treated as a single-firm optimization problem. The optimal stream of R&D expenditures is characterized over time and the optimal stopping time of the project is determined. Kamien and Schwartz (1982) and Granot and Zuckerman (1991) give reviews of this literature.

One example from this area is the semi-Markov decision process of Deshmukh and Chikte (1977) which provides dynamic investment strategies for a risky R&D project where the terminal reward of a new product is a function of its relative quality, which can be affected by competition. More recently, Granot and Zuckerman (1991) derived a selection procedure of activities and a stopping time for a development project so as to maximize expected discounted net return. Chi et al. (1997) used an optimal stopping formulation of an investment project that takes an uncertain length of time to develop and can give partial return if not completed. However, none of these studies captures the effect of changing or uncertain funding levels on release time and quality, which we would argue is a major element that distinguishes new start-ups from established companies.

Our work is most closely related to that of Lévesque (2000) who used an approximation of this decision problem with a specific class of revenue functions to conclude that increasing effectiveness of development spending does not necessarily lead to products of higher quality and that more expected funding may lead to products of lower quality. Lévesque utilizes a revenue function that is separable in product quality and competition, with diminishing returns to quality improvement (more specifically, revenue is quadratic in product quality) and constant revenue dissipation due to increases in competition. She approximates the expected incremental revenues from one period to the next and applies a standard dynamic programming result to characterize a simple optimal stopping rule based on a quality threshold. We improve upon this work in three main ways: by making fewer restrictive assumptions about the form of the model; by including several new features present in the business context; and by utilizing an exact analysis rather than an approximation method to derive our results.

In our treatment of product quality as a management decision, our work in some ways complements the stream of work by Ouardighi and Tapiero (1998), Teng and Thompson (1996), and Kouvelis and Mukhopadhyay (1995). Kouvelis and Mukhopadhyay created a control theoretic model with actual product quality q(t) as the decision variable, and incorporated pricing strategy effects on demand and learning curve effects on production as exogenous factors. Their work treated the case of an established firm with a developed product, for which management could adjust the actual quality over the life cycle of the product (from introduction through growth, maturity, and decline). Our work on the other hand focuses on the product development process in a new venture with uncertain funding; so although we both are interested in the management of quality, their work starts at the point in the process where ours ends (i.e. when the product first enters the market).

We begin our discussion by stating our assumptions about the business situation to be modeled; one of the key assumptions is that revenue is a concave function of product quality. We then define our notation and develop expressions for the profitability of market entry at a given point in time for two distinct types of competitive situations, which we refer to as cumulative and one-shot (a third alternative is briefly described in Appendix C). Our formulation takes into consideration the use of both debt and equity financing along with their respective costs, and allows funding availability, product development, and market competition to be random. We describe our analytical results for this general model, which show that there will be a unique optimal time to enter the market in order to maximize expected profit, and which show how this time is influenced by the context of the situation. By further tightening our modeling assumptions, we next recast our analysis in terms of product quality rather than time or profitability; this allows us to define a target quality level that the product must meet in order to maximize profit. We describe how this target quality (and hence the quality of the final product) is affected by the business context. One particularly interesting result is that not only can final quality levels be impaired by inadequate funding, but also by overly generous funding. A numerical example and proofs of our analytical results are contained in Appendix A Numerical example, Appendix B Proofs, respectively.

Section snippets

Background assumptions

An entrepreneur is developing a new product for eventual market release. The amount of funding available for product development in each period is random, and comes from a mixture of debt financing (e.g. bank loans) and equity financing (e.g. shares issued in private placements). Over the time the entrepreneur will tend to issue less new debt (as credit limits are used up) and more new equity (as venture capitalists become interested in the product), but the average total amount (debt + equity)

Cumulative competition

We first consider the situation where competition is cumulative; that is, its level is gradually increasing over time. We begin by defining our notation.

Let Zi be the amount of new funding obtained and spent in period i on product development using funds from a combination of debt and equity financing. The Zi's are i.i.d. random variables which are non-negative, bounded above, and have mean μZ. Let τvi be the amount spent in period i for overhead expenses using funds from the same combination

General analysis

We next propose an optimal decision strategy where the entrepreneur has the choice each period of whether to stop product development and go to market, or continue product development for one more period. The objective is to maximize expected profit. From the standard neo-classical economic literature, profit is maximized when marginal revenues equal marginal costs. The following proposition is a restatement of that condition, obtained by applying a basic dynamic programming result based on

Analysis of target quality

Suppose that in each period development financing is either obtained in a fixed amount φ or else is not obtained at all, and that product improvement (if financing is obtained) in each period is either successful or unsuccessful. This means that Xi and Zi are distributed as Bernouilli (or binary) variables with probabilities of success pX and pZ, respectively. It follows that the product XiZi is then also distributed as a Bernouilli variable with parameter pXpZ.

Mathematically, Bernouilli

Conclusion and discussion

The models that we formulated in the first part of the paper concentrated on optimal timing to maximize the expected profitability of the new product. It included many features inherent in a new venture while making only general assumptions about the specific situation. With this general model we were able to develop some results which cover any venture where there are diminishing returns to product quality, including: (a) the characterization of an optimal stopping time at which to end

Acknowledgements

We would like to thank the editor and anonymous referees for their helpful suggestions and comments. The research on which this article is based was done while the first author was in the Department of Business Administration, Royal Military College of Canada; and while the second author was in the Lally School of Management and Technology, Rensselaer Polytechnic Institute.

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