Optimal project selection and budget allocation for R&D portfolios

We introduce a new formulation of the problem of project selection and budget allocation for R&D portfolios. Due to R&D budget constraints and limited resources, firms are often forced to select a subset of all potential idea/products to carry on the development process. In the formulation presented we make a distinction between budget constraints during the development phase and the commercialization phase by arguing that the latter constraints are not hard constraints. Firms that succeed in developing promising and breakthrough products have little difficulty in securing resources for their commercialization. The portfolio selection at the commercialization phase therefore can appropriately be treated as an instance of selection among a set of financial instruments and the rich theory of financial portfolio formation can be utilized. Optimal selection of projects at the development phase, on the other hand, needs to be performed with the optimal selection at the commercialization phase taken into account. Following this line of argument, we formulate a two stage optimal project selection and budget allocation problem. Properties of the solution and the implications of adopting this formulation are discussed. Project interdependencies at both stages of development and commercialization are considered and illustrated via examples.