How much does R & D matter?

A headline in the Wall Street Journal a few weeks ago caught our eye: "In R & D, Brains Beat Spending In Boosting Profit" (October 11, 2005). Intrigued by this notion of technical meritocracy, we read the article and the study by the consulting firm Booz Allen Hamilton Inc. (www.boozallen.com), "The Booz Allen Hamilton Global Innovation 1000: Money Isn't Everything," on which it was based. It turns out that the field of R & D is yet another arena where nothing is resolved by throwing money at a problem.

In the study, Booz Allen identified the top 1,000 public companies in the world according to their R & D spending as reported in 2004 financial statements. This Global Innovation 1000 was then analyzed for statistically-significant relationships between their R & D spending levels and business performance, as evidenced by sales growth, gross profit, operating profit, enterprise profit, market capitalization, and total shareholder return. The big news is that there was almost a complete lack of any relationship--the results showed that R & D spending had little or no impact on these indicators of business success. The only measure that showed a strong relationship was gross margin--a higher ratio of R & D-to-sales was associated with a higher gross margin. This suggests that R & D succeeds in making products and services that incur lower costs, or with better features that can command a premium price, but that these advantages are obscured by the rest of the process, i.e., once selling, general and administrative (SG & A) expenses are added in, the performance improvement from R & D can no longer be observed. Clearly, there is a need to raise the effectiveness of innovation processes if companies want to get more benefit out of this investment.

Taking a closer look at our area of interest, the automotive industry accounted for 18% of the total R & D spend represented by the Global Innovation 1000, making auto the third-largest-spending industry out of the ten broad sectors in the study, after Computing & Electronics (1), and Health (2). The Top 20 Global R & D Spenders list includes Ford (3), DaimlerChrysler (4), Toyota (5), General Motors (6), Volkswagen (13), and Honda (16). These six companies alone made 53% of the total automotive R & D investment by companies in Booz Allen's top 1000. The average figure for R & D as a percentage of sales by individual automotive companies was 4.1%, very close to the overall study average of 4.2%.

We checked on a set of automotive suppliers to see what happened when we removed the automakers from the mix. The chart shows data on 60% of the public companies that appear on Automotive News magazine's Top 150 suppliers list. The average rate of R & D investment for this group is 3.7% of sales. Since the size of the companies represented by the data points declines as you move from left to right, you might expect to see some pattern, but this set, like Booz Allen's Global Innovation 1000, demonstrates that companies make unique decisions in determining their appropriate R & D spending level.

One reason for this is that, despite the progress the industry has made toward a common understanding of operational excellence, there are still no norms to help with the question of the "right" amount for an R & D budget. While spending more does not reliably generate a return, there is such a thing as spending too little. Companies at the low end of the scale in the Booz Allen analysis did worse on the margin and profit metrics than either those in the top 10% or the middle 80%. Therefore, you have the opportunity to be wrong in two completely different ways, by investing more than you need to, or not enough.

The solution to the issue of how much it is worthwhile to spend lies in paying attention to increasing the productivity or "yield" of the innovation investment. As the Booz Allen study says, "It's the process, not the pocketbook." The results of their study support strengthening what IRN has previously described as five basic "innovation disciplines" that characterize successful practitioners: (1) aligning innovation with your company strategy; (2) creating disciplined innovation processes; (3) creating an innovation culture; (4) creating infrastructures to support innovation; (5) measuring the innovation results. As companies focus more deliberately on improving the effectiveness of their innovation processes, in the same way that they would tackle a corresponding manufacturing improvement project, they will move toward maximizing the return on whatever they do invest. Just as in lean manufacturing, the objective of eliminating waste, and an emphasis on 'time' as a dimension of world-class performance, will enable R & D to contribute more directly and more quickly to the bottom line.

By Melissa Anderson, Vice President, IRN, Inc. [e-mail]