Get Smart About Your R&D Spend

Keith Nichols

November 25, 2013

3 Min Read
Get Smart About Your R&D Spend

Few would argue that innovation can fuel business success. Companies that make the investment tend to generate bigger profits than those that don't. But it's also true that spending more on R&D doesn't necessarily make your company more successful. Pouring more money into R&D, however small or large the company may be, doesn't guarantee more profits.

A deeper examination of the relationship between R&D spend and profitability can highlight some important facts. There are a number of cases where a company has invested heavily in R&D but has gained only limited profitability. Other companies in the same industry spend much less and produce profits that are several times bigger. This clearly turns upside down the notion that the more you invest, the more profit you'll make.

So what's going on at these companies to enable them to generate superior results with less investment? The first observation is that some 70% of R&D projects never make it into product development, and of those that do, only 50% ever make profits. The remainder enter the market as weak offerings that don't press the customer buying buttons, or as quite often happens, the investment is used to bolster aging products by giving them a fresh coat of paint in the hopes that it'll extend sales while saving costs.

The result is that about 85% of the R&D spend doesn't generate a profit. In most business circles, a similar return on investment case with such poor returns would be shot down before it even started. Often, company R&D is compared in the form of a league table. How can any conclusions be drawn when there are such large amounts of wasted investment, and it varies from company to company?

Consider Apple and Microsoft in 2010. Both companies were of a similar size and the industries they served substantially overlapped. The one difference that stood out was that Apple invested about 2% of its revenues in R&D compared to Microsoft's 12-13%. One might expect that by investing more, Microsoft would have leveraged greater revenue and profitability in the next couple of years. In fact, the opposite happened. Apple grew 55% between 2010 and 2012, whilst over the same period, Microsoft displayed a modest growth of 7% per annum and received a flood of complaints from angry shareholders who were concerned about the extent of R&D investment with little new to show.

On closer examination, Microsoft had been investing a high percentage of its R&D into simply defending the PC business while the technology marketplace at that time was rapidly shifting to new platforms and opened up new lucrative opportunities, such as mobile devices (smartphones and tablets), cloud-based applications, and data access, and even gaming consoles.

There are several ways of measuring R&D effectiveness. A favored approach is to use a measure referred to as RORC (return on research capital), which can be calculated by dividing the current year gross profit by the previous year R&D spend. Although it makes several important assumptions, it can provide a reasonable indication of a company's year-on-year trend if measured in successive years to drive improvement. Alternatively, it can be used to measure a company's performance against others within the same industry to understand how well its doing and where improvements need to be made. It can start to form the basis for a continuous improvement process for R&D effectiveness. By reviewing performance on each product lifecycle, companies can analyze and inject refinements that will increase learning and create steady commercial progress.

At the end of the day, it's the effectiveness of R&D spend that matters, not how much is spent.

Keith Nichols is a principal analyst at Cambashi.

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