Strategic accounting for R&D.

Each business has its own distinctive accounting profile, but if we don't know the profile of our business, we can not really know our business. Unfortunately, the accounting methods we use today were developed about 500 years ago for manufacturing, and are now woefully inadequate not only for the effective management of manufacturing, but also for services, which have ballooned to about 77 percent of the U.S. GDP (1).

The accounting profile of the business described here does not consider the technology involved, or whether it is a manufacturing or service business, but rather it quantifies the relative contribution of each cost, volume and price factor to the profit margin of the business, using a discounted cash flow return on investment as the yardstick, in effect, this allows comparing apples with oranges for best investments. But each kind of business has its own specific profile, in which different lectors are the most important in determining best operation.

Since 1920, manufacturing accounting has been somewhat improved through the use of "activity-based" and "economic chain" accounting modifications. However, these still do not measure a number of critical factors, which are increasingly essential for assessing the commercial potential of a new technical discovery, or for its downstream incremental improvement and management in a hyper-competitive global marketplace. For instance:

* They do not provide quantitative measurements of the potential profitability of a new innovation, or of a further-improved, already existing, commercial operation.

* They do not quantify the specific contribution to cash flows of each cost, pricing, or volume-throughput factor, of which a detailed knowledge is required both for R&D and for continuous incremental improvements.

* They do not integrate the interactive effects that changes in these variables have on each other and that can allow simulation of alternative options for improvement and strategies of operation.

This author, when vice president of technology for Occidental Petroleum, funded the development of a computer-programmed sensitivity analysis, which reads out a quantitative analysis of the relative importance of each cost, volume and pricing factor, together with both annual and five-year cumulative cash flow projections for any given operation (2). These are graphically displayed with variations of 30 percent or more, for each factor, as a function of profitability. A discounted cash flow return on investment (DCF-ROI) is used as the "yardstick" of profitability.

This type of measurement automatically adjusts for inflation, and also permits simulating the interaction of the infinite number of variations for fine-tuning cost, volume and pricing factors leading to the achievement of optimum performance. The discounted cash flow return on investment that results is a direct measure of profitability and of intrinsic business value as well, since it can automatically adjust the computation for inflation to account for differences in exchange rates, and for alternative risk-free investments such as U.S. Treasury bonds.

The Sensitivity Analysis

This analysis enters all the projected or actual detailed cost-factor, sales volume and pricing decisions, for a given operation into a template (below) over a five-year projected period of operation. The program then prints out cash flows for each year, with both an annual and cumulative DCF-ROI for that set of projections. It also prints out a graph that quantifies the relative importance of each factor, and its contribution to profitability, which can then be selectively modified to simulate maximum profitability.

Each type of business has its own characteristic accounting profile, and a quantitative understanding of that profile is critical both for R&D and for eventual management of the business. Assuming that the initial projections for a given innovation do not show a negative cash flow over a five-year period, then price will always be the most sensitive factor, and any increase will go right to the bottom line.

Volume throughput will be the next most sensitive factor for a business with a positive cash flow, but will have less of an effect on the DCF ROI, because to achieve it, additional operating costs and perhaps capital investments, may be required (Figure 1). The slopes of the lines provide a quantitative measure of the relative contribution that each factor makes to the DCF-ROI. If this return does not meet desired hurdle rates, individual factors can then be modified to generate a "satisfactory" return, followed, of course, by an in-depth analysis of the reality of achieving such modifications, including perhaps, the need to make a further R&D breakthrough in the technology that drives the system. This methodology is as useful for improvement of an existing operation, as it is for assessing a new innovation.

[FIGURE 1 OMITTED]

Commodity Product Example

The bottom portion of Figure 1 illustrates the actual operating profile for an automated aluminum can plant producing 1,000 cans per minute, but operating with a negative 7 percent DCF-ROI. Several strategic options for improvement are theoretically possible and might produce a positive return.

One of these options would be a price increase of 10 percent which would allow breakeven. However, cans are commodity products, which at the time I originated this analysis (1980-82) were in excess supply--Coca Cola, Pepsi and the beer companies would have been unlikely to pay more. Also, energy costs were only 3 percent, and costs of union labor only 4 percent of total costs, so even a 50 percent reduction in these costs would barely result in breakeven.

Doubling production volume from 1,000 to 2,000 cans per minute, at the same price, and with no additional capital investment or other associated costs, would have had a profound effect, but the additional costs mitigated this option. Also, the additional capacity might not be saleable. This left a remaining option to reduce the cost of the aluminum can stock, which involved about 70 percent of total costs.

No further thinning of the aluminum was feasible, but we knew from high school physics that a sphere requires about 30 percent less surface area to hold the same volume of liquid as the conventional can shape. Pilot samples of a spherical cam flattened on the bottom, received a very positive response, but the can business at that time was in trouble, and the deep recession of 1980 82 subsequently saw the demise of the major can companies, with the loss of this initiative. The can plant was shut down.

This is the classic case that exists in most big companies. It is intended to show, first, that a bit of creativity even in a mundane commodity product like cans could make a big difference in competitive advantage, if only the accounting process could first focus the effort where it could be most effective; and second, that in an analysis like this, where no other alternative could resurrect this plant, a potential solution was surprisingly generated.

Blockbuster Products Too

By contrast, the upper part of Figure 1 represents a proprietary "blockbuster" pharmaceutical. The high value-added content of the drug allows it to be sold at a price far above its cost of production, even after absorbing its high cost of development. With no competition, the price and sales volume factors are dominant in this profile, and all of the cost factors are relatively insignificant.

After a number of years, as competitors enter the market with comparable drugs, or when the initial patents expire, the price structure tends to erode and cost factors become more important. However, the model graphically emphasizes the enormous strategic advantage of a highly proprietary, high-value-added product over a commodity product.

The Plastic Bottle

Figure 2 illustrates the profile of a commodity petrochemical product (a plastic bottle), which, if operating at capacity, would then have produced about a 5 percent DCF-ROI. However, in the early 1980s, it was actually operating at about 80 percent of capacity and losing money. The most sensitive of all factors were price, volume and the price of the oil teed stocks, which alone contributed about 80 percent of all costs.

[FIGURE 2 OMITTED]

At that time in the U.S., oil was being lifted at about $10 per barrel, compared with about $4 per barrel in the Middle East. Under these circumstances, no U.S. oil company could be competitive with refineries in the Middle East. The U.S. Department of Commerce, through its Industrial Competitive Assessment Program (3), provided this and similar profiles to U.S. companies. As a result, U.S. plans for new refineries were cancelled, as Middle Eastern companies began to build their own refineries; no additional U.S. refineries have since been built. The Gulf Oil Company even sold its refinery in the Netherlands to Kuwait for $1.00.

Each type of business has its own unique accounting profile, as illustrated by the previous examples, and it is important for a manager to understand the strengths and weaknesses of his operational profile. For example, retail businesses have the profile illustrated in Figure 3. The costs of the materials inventoried usually account for 70 percent to 90 percent of the total cost of operation. These are non-earning assets, and the highest priority strategy must be to reduce these costs.

[FIGURE 3 OMITTED]

About 20 percent of the items in inventory usually generate about 150 percent of the profits, and the bottom 50 percent of inventoried items lose money. However, conventional accounting systems often don't quantify these relationships, or accurately value the business. The opportunity to outsource to low-labor-cost countries, at landed costs in the U.S. that are about 20 percent to 30 percent of the costs of U.S. production, can provide an important competitive advantage. At the same time, just-in-time delivery now possible can substantially reduce costs of inventory as well. This is an essential requirement for global competitiveness.

For example, J.C. Penney used to carry a nine-month inventory of shirts. Now each shirt sold in each of its stores immediately registers in a data base in Hong Kong, and a replacement, made in Taiwan, is shipped to that same store within about ten days, or by air if necessary (4). Low procurement costs and radically reduced inventories have combined to significantly improve the bottom line. Even slow-moving items, when outsourced, can eliminate inventory costs and increase profitability.

Distribution has always been considered to be a support function for manufacturing. However, as most commodity manufacturing now goes off-shore with multiple sources of production, sourcing and localized delivery functions, combined with reduced inventory, have become the dominant factors, as illustrated by the J.C. Penney model. The accounting model must reflect these rather radical changes, which will continually restructure both manufacturing and service businesses.

A potential new product introduction can be subjected to this sort of analysis while still on the drawing board. The sensitivity analysis can then identify up-front the critical cost/volume/price relationships that must be met for commercial profitability, well before development work has begun. Simultaneously, it can identify those cost factors that are most important. The likelihood of its longer-term viability and growth potential can be further enhanced by subjecting it to a Constraint Analysis (5), which can increase its probability of success.

Implementing the Analysis

The first step in using this accounting model for a potential new innovation, or for further improvements in an existing operation, is to determine the sales price and resulting profit margin that would be needed to justify any new or additional investments. The second step would be to fill in the template illustrated in the Table, with actual operating data if available, or simulated data, and run out the resulting cash flow projections to see if they can provide the desired margins. (For a next-generation disruptive technology, the cost/performance margins must be at least 5 times and preferably 10 times greater than the currently-used technology to be replaced).

If the desired margins and cash flow projections are not met by these inputs into the template, then the factors with the steepest slopes (the most sensitive factors) first need to be addressed to see what possible theoretical modifications would be needed to generate the desired margins. If sufficient additional improvements are not deemed feasible, within current technology limits, further efforts should be suspended, pending alternative technical breakthroughs.

The Global Marketplace

Conventional accounting systems are no longer adequate, alone, to meet the requirements for managing either manufacturing or service-type businesses, or for simulating the cost/volume price factors that must be met before making major R&D investments in a new business opportunity. Effective management now requires a detailed quantification of the relative contribution to profitability of each cost factor, and of both volume and pricing decisions. The sensitivity analysis described can provide these inputs and allow simulation of multiple variations and tradeoffs among these factors to achieve optimum results.

Each type of business, as illustrated by its profile, has its special critical factors that need both quantification and continual optimization in order to maintain viability in today's hyper-competitive global marketplace.

References and Notes

(1.) Drucker, Peter F. Managing in the Next Society. Truman Talley Books, N.Y. (2002), pp. 52-53.

(2.) A disc is available from the author at pridco@verizon.net

(3.) U.S. Department of Commerce, International Trade Administration. "Industrial Competitive Assessments."

(4.) Invisible Supplier Keeps Penneys's Shirts All Buttoned Up. The Wall Street Journal, Feb. 10, 2005.

(5.) Merrifield, D. Bruce. Constraint Analysis for Assessment of Business Risks. Int. J. Technology Management, Vol 1, No. 2, (1994), pp. 42-53.

Bruce Merrifield is president and CEO of Pridco Management Co. in Washington, D.C., and professor emeritus of the Wharton School of Business. Formerly, he was vice president of Occidental Petroleum and then the Continental Group. He was president-elect of the Industrial Research Institute when President Reagan appointed him Assistant Secretary of Commerce for Technology and Undersecretary for Economic Affairs. In that position he spearheaded changes in the antitrust, technology transfer and patent laws, and put through the Malcolm Baldrige Quality Award and the National Technology Medal. He also initiated a Small Business Development model for developing countries. He, holds a Ph.D. in physical organic chemistry from the University of Chicago, pridco@verizon.net

Sensitivity Analysis Input Table

 INPUT TABLE

 Firm: XYZ Corporation
 Project Name: Technical Project 1234
Project Description: Hypothetical Project

 Year 1 Year 2 Year 3

Sales Volume-Product 1 1,000 5,000 10,000
Sales Volume-Product 2 500 1,000 2,000
Sales Price-Product 1 $110.00 $105.00 $100.00
Sales Price-Product 2 $150.00 $148.00 $146.00
Direct Labor Costs
 (/unit)
 Product 1 $10.00 $9.00 $8.00
 Product 2 $60.00 $58.00 $56.00
Direct Materials Cost
 (/unit)
 Product 1 $30.00 $28.00 $25.00
 Product 2 $20.00 $20.00 $18.00
Indirect Cost $220,000 $200,000 $240,000
Capital Investment $1,000,000 $500,000 $0
Investment in Operations $50,000 $10,000 $0
Income Tax Credits $10,000 $10,000 $5,000
Assumptions:
 Income Tax Rate 30%
 Depreciation Life 5
 (years)
 CASH FLOW TABLE

* Revenue
 Product 1 $110,000 $525,000 $1,000,000
 Product 2 $75,000 $148,000 $292,000
TOTAL REVENUE $185,000 $673,000 $1,292,000
* Direct Cost--Labor
 Product 1 $10,000 $545,000 $80,000
 Product 2 $30,000 $58,000 $112,000
 Total Direct Labor Costs $40,000 $103,000 $192,000
* Direct Cost--Materials
 Product 1 $30,000 $140,000 $250,000
 Product 2 $10,000 $20,000 $36,000
* Total Direct Material $40,000 $160,000 $286,000
 Costs
 Total Direct Costs $80,000 $263,000 $478,000
 Depreciation $200,000 $300,000 $300,000
 Total Indirect Costs $400,000 $520,000 $540,000
TOTAL COSTS $480,000 $783,000 $1,018,000
INCOME BEFORE INCOME TAX ($295,000) ($110,000) ($274,000)
 Income Tax Credit 0 0 1
 (1 = Yes)
INCOME TAX (BEFORE CREDIT) $50 SO $82,200
 Tax Credit Factor 0 0 1
INCOME TAX (WITH TAX $0 $0 $77,200
 CREDIT)
AFTER-TAX INCOME ($295,000) ($110,000) $196,800
NET CASH FLOW ($1,145,000) ($320,000) $496,800
 Cumulative Cash Flow ($1,145,000) ($1,465,000) $968,200
INTERNAL RATE OF RETURN 42.24%

 INPUT TABLE

 Firm: XYZ Corporation
 Project Name: Technical Project 1234
Project Description: Hypothetical Project

 Year 4 Year 5

Sales Volume-Product 1 30,000 50,000
Sales Volume-Product 2 3,000 5,000
Sales Price-Product 1 $95.00 $90.00
Sales Price-Product 2 $142.00 $140.00
Direct Labor Costs
 (/unit)
 Product 1 $57.00 $6.00
 Product 2 $54.00 $52.00
Direct Materials Cost
 (/unit)
 Product 1 $20.00 $18.00
 Product 2 $17.00 $15.00
Indirect Cost $250,000 $250,000
Capital Investment $0 $0
Investment in Operations $0 $0
Income Tax Credits $0 $0
Assumptions:
 Income Tax Rate
 Depreciation Life
 (years)
 CASH FLOW TABLE

* Revenue
 Product 1 $2,850,000 $4,500,000
 Product 2 $426,000 $700,000
TOTAL REVENUE $3,276,000 $5,200,000
* Direct Cost--Labor
 Product 1 $210,000 $300,000
 Product 2 $162,000 $260,000
 Total Direct Labor Costs $372,000 $560,000
* Direct Cost--Materials
 Product 1 $600,000 $900,000
 Product 2 $51,000 $75,000
* Total Direct Material $651,000 $975,000
 Costs
 Total Direct Costs $1,023,000 $1,535,000
 Depreciation $300,000 $300,000
 Total Indirect Costs $550,000 $550,000
TOTAL COSTS $1,573,000 $2,085,000
INCOME BEFORE INCOME TAX ($1,703,000) ($3,115,000)
 Income Tax Credit 1 1
 (1 = Yes)
INCOME TAX (BEFORE CREDIT) $510,900 $934,500
 Tax Credit Factor 1 1
INCOME TAX (WITH TAX $510,000 $934,500
 CREDIT)
AFTER-TAX INCOME $1,192,100 $2,180,500
NET CASH FLOW $1,492,100 $2,480,500
 Cumulative Cash Flow $523,900 $3,004,400
INTERNAL RATE OF RETURN

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Author:	Merrifield, D. Bruce
Publication:	Research-Technology Management
Geographic Code:	1USA
Date:	Jan 1, 2006
Words:	2946
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