I was reading an article in Business 2.0 about how 3M has reconfigured its R&D process when one particular sentence touting their success hit me:
Product development cycles have shrunk from an average of four years down to two and a half, operating profits are up 23 percent, and R&D spending as a percentage of sales — a key bang-for-your-buck barometer — last year hit an all-time low of 5.7 percent.
Ok – shorter product development cycles; that’s good. Higher operating profits; that is really good. Lower R&D spending as percentage of sales; wait a second – lower? Yes, lower – this is a measure of efficiency (“bang for the buck”).
From a business point of view, this makes some sense. As the old saying goes, I know that half of my advertising [or R&D] budget is wasted, I just don’t know what half. So a company needs to worry about its R&D efficiency.
But from a national competitiveness point of view, this is exactly opposite of what we should be doing. All of the various reports decry our declining R&D budget as a percentage of GDP. In fact, the OECD Science, Technology and Industry (STI) Scoreboard 2005 leads with data on the investments in knowledge as a percent of GDP. So, lower spending is bad – either absolute or relative.
Returning to the business point of view, it is not clear that measuring R&D as a percentage of sale is a good metric for a company as well. It takes the view that R&D is a cost/expense rather than an investment and it is too easy to game the number by lowering R&D expenditures. Investopedia has the following advice on “Buying Into R&D”:
Financial expert/writer, Kenneth Fisher, touts the price-to-research ratio (PRR), which is the market value of the company divided by its research-and-development expenditure over the last twelve months. Fisher suggests buying companies with PRRs between five and 10 and avoiding companies with PRRs greater than 15. By looking for low PRRs, investors should be able to spot companies that are redirecting current profits into R&D, thereby better ensuring long-term future returns.
Technology investment guru Michael Murphy offers the price/growth flow model. Price/growth flow attempts to identify companies that are producing solid current earnings while simultaneously investing a lot of money into R&D. To calculate the growth flow, simply take the R&D of the last 12 months and divide it by the shares outstanding to get R&D per share. Add this to the company’s EPS and divide by the share price.
Measuring R&D Effectiveness Is Key
Unfortunately, while the Fisher and Murphy models both do a great job of helping investors identify companies that are committed to R&D, neither indicates whether R&D spending has the desired effect – the successful creation of profitable products. When evaluating R&D, investors should determine not only how much is invested but how well the R&D investment is working for the company.
Companies often cite patent output as a tangible R&D success measure. The argument goes that the more patents filed, the more productive the R&D department. But, in reality, the ratio of patents per R&D dollar tends to represent the activity of a company’s lawyers and administrators more than its engineers and product developers. Besides, there is no guarantee that a patent will ever turn into a marketable product.
One way, however, to perceive the proficiency of R&D is to calculate the percentage of sales that come from products introduced over a period of time, say the preceding three years. For the calculation, investors need annual sales information for specific new products. If lucky enough to get that kind of data from company reports, investors can do the calculation this way:
New product sales (previous three years) / Total sales (previous three years)
The resulting percentage gives investors a sense of R&D success as well as R&D output and offers a useful metric for comparing R&D performance with peer companies.
Investors should also pay attention to R&D expenditure/sales. According to Michael Murphy, good growth-flow companies spend at least 7% of their sales revenue on R&D. On the other hand, what is deemed a healthy R&D/sales ratio depends on the industry and the company’s stage of development.
Pharmaceuticals, software, and hardware companies, for instance, tend to spend a lot on R&D while consumer product companies typically spend proportionately less. In 2003, Johnson & Johnson, for example, reported spending about 10 cents per sales dollar on R&D, but drug company Pfizer spent 15% of expected sales on R&D; software giant Microsoft spent 16%; and network-equipment maker Cisco Systems spent 18%. For smaller, early-stage software and biotech companies the number can easily stretch as high as 80%.
Yet, the story gets even more complicated in that recent research shows that R&D spending does not deliver profits:
Companies which invest heavily in research and development may be wasting their money. According to a new study, there is no direct relationship between R&D investment and significant measures of corporate performance such as growth, profitability, and shareholder return.
But despite the absence of a clear return on investment, the pace of corporate R&D spending is accelerating, suggesting that many executives continue to believe that enhanced innovation is required to fuel their future growth.
According to consultants Booz Allen Hamilton, who analyzed the world’s top 1,000 corporate research and development spenders, innovation spending is still a growth business. This 2004 Global Innovation 1,000 spent $384 billion on R&D in 2004, representing 6.5 per cent annual growth since 1999.
And the pace is accelerating. Measured from 2002, the annual growth rate jumps to 11.0 per cent.
While the top 1,000 corporate R&D spenders invested $384 billion in 2004, the second 1,000 spent only $26 billion – only an additional 6.8 per cent beyond the top 1,000 spenders.
Yet as the study also points out, being large is an advantage when it comes to R&D. Larger organisations are able to spend a smaller proportion of revenue on R&D than smaller one with no discernable impact on performance.
But while spending more doesn’t necessarily help, spending too little will hurt. Companies in the bottom 10 per cent of R&D spending as a percentage of sales under-perform competitors on gross margins, gross profit, operating profit, and total shareholder returns.
However, companies in the top 10 per cent showed no consistent performance differences compared to companies that spend less on R&D.
And, as Ben McClure writes in the Motley Fool – Ruminations on R&D
Great companies invest in innovation. Those that roll the dice on research and development (R&D) programs tend to generate bigger profits than those that don’t. But take note, Fools: The world of R&D is full of questionable spending, unqualified results, and payoffs that can be hard to measure. Factoring R&D into stock evaluations and analysis is not a simple affair.
The dilemma for those of us looking for good metrics of the I-Cubed Economy is clear. Right now we have a black-box approach: money goes in and patents come out. We need better measures of the process, including a measure of efficiency – not all R&D spending is productive. Yet that productivity is hard to grasp and we don’t want to reward the view that cutting R&D is a good thing.
One of the measures propose in the Investopedia article — the ratio of new products sales to total — is an excellent measure. It is also a variation that is used in OECD surveys of innovation (as codified in the Oslo Manual: Guidelines for Collecting and Interpreting Innovation Data, 3rd Edition).
Unfortunately, the US does not conduct such an innovation study. We should (as I’ve said before). We need real metrics of innovation — not the ones left over from the industrial era.
PS – the Business 2.0 article has other interesting insight about how 3M moved its research away from “mini-alignments with old markets” and tied it basic nanotech research to marketable products. Interestingly, nothing in the article about the “lead user” theory that Eric von Hippel developed through his study of 3M. I wonder how that fits with the problem of aligning R&D with old markets?