Examining the ROI of R&D

Until lately, research and development expenditures at big companies were one of few areas where CEOs didn’t get too particular about return on investment. They treated bench scientists like quarks who behave differently if merely observed. They wanted to avoid killing the goose laying the golden eggs by overly measuring either the eggs, or the goose. Corporate leaders were wary of crimping innovation with inadequate insulation of R&D outlays. And who could understand what all of those scientists and engineers were up to anyway?

But that is changing in the aftermath of the Great Recession due to the spread of “open innovation” models across big business and with the intensification of global competition in technology-oriented industries ranging from semiconductors to pharmaceuticals. CEOs, CFOs and CTOs now are pressing hard to create the same kinds of windows and levers on R&D disbursements and returns as they long have enjoyed on, say, advertising budgets and audience measurements, or paper-clip procurement and back-office productivity.

“It used to be sufficient to have a leap-of-faith mindset when you were making R&D investments,” said Ananth Krishnan, chief technology officer of Tata Consultancy Services, the Mumbai-based computer-services arm of India’s Tata industrial conglomerate. “You know, ‘If you invest in R&D, then good will follow—or at least good enough.’ But we can’t do that anymore. It’s not sufficient just to be innovative. We need metrics for effectiveness.”

Even leaders in the pharmaceutical industry, a bastion of long-term perspective on R&D expenditures, are beginning to embrace a new approach. “Shareholders are not prepared to see more money invested in R&D without tangible success,” Andrew Witty, CEO of Glaxo-SmithKline, wrote recently. He is making the London-based drug giant a global leader in ensuring financial accountability for the company’s R&D outlays.

Several factors are forcing the change. The recession was the single biggest catalyst. “R&D expenditures became seen as something that companies would have to focus on, maybe for the very first time,” said Marty Grueber, research leader for Battelle Institute, a Columbus-based not-for-profit concern that tracks R&D activity around the globe. “Research managers were asked hard questions they never heard before, such as, ‘Can you measure ROI on a corporate investment basis?’”

Also, in a world where open innovation is becoming the rule, R&D investments become more difficult to track and evaluate as companies invite in more ideas and products from outside. A supplier innovation might show up as a cost of goods sold. A corporate contribution to a university that, in exchange, nets a valuable research insight might be registered under general expenses. Licensing proceeds disbursed to other companies might only manifest themselves as legal bills.

“The traditional accounting measure of R&D only tracks internal spending,” said Henry Chesbrough, executive director of the Center for Open Innovation at the University of California-Berkeley. “In a world of [open] innovation, it’s increasingly inadequate as a measure of innovation ability.”

Stiffening global competition is another reason for sharper attention to what companies are actually getting for their R&D dollars, as players in China, India and elsewhere challenge the traditional hegemony of European, American and Japanese giants in one research-heavy industry after another. R&D hubs in emerging markets also are picking up more and more work from companies in developed countries: About 11 percent of companies based in North America now spend more than a quarter of their R&D budgets in emerging markets, and more than 23 percent expect to have surpassed that mark within five years, according to research by Ernst & Young.

Another factor in the urgency is that success in technology-based markets requires CEOs to make more, bigger and quicker decisions on R&D propositions than ever before. “Making the right bets, and picking the right hedges, is much more important because fast-changing consumer markets now are driving so much of [electronics] technology, compared with a decade ago when more research was going into a build-out of the business-to-business infrastructure,” said John Ciacchella, principal of Deloitte Consulting, in San Jose, Calif.

Better measurement in such an environment is crucial because “how well you run your R&D innovation and processes is a much bigger differentiator of your performance against the competition than whether you’ve got a bigger piggybank,” said Barry Jaruzelski, lead partner in the global innovation practice of consulting firm Booz & Company. Key to success in this arena, he said, is a transparency of information about the prospects for returns from each project—and discipline in deciding what projects to kill or to keep funding.

It’s especially crucial when you’re switching to a smaller piggybank. Nokia, for instance, is expected to have to cut its R&D costs by one-third because its bloated budget hasn’t kept it from badly losing market share to smartphone innovators that are much more efficient with their R&D, including Apple and Google.

Nevertheless, it remains a challenge to come up with numbers that can tell CEOs things that will meaningfully inform their decisions about R&D going forward. “It is by nature a bit chaotic, because you’re embarking on that journey, and you have an end in mind—but no one has ever been there before,” said Aftab Jamil, national leader of the technology and life-sciences practice for BDO USA, a management-consulting firm in San Jose, Calif. “And so many of the things that you get out of R&D and that need to be counted are intangibles, such as winning new customers, getting deeper penetration in a market, coming up with the next generation of a product—and even all-new products.”

“It used to be sufficient to have a leap-of-faith mindset when you were making R&D investments.”

Shopworn and relatively crude measurements of ROI from R&D outlays still guide too many corporations in their decision-making. Customary tools include R&D expenditures as a percent of revenues, also known as “intensity,” and stacking research outlays against numbers such as R&D headcount, or against the number of new-product releases.

“The problem is, those numbers don’t say anything about how useful the R&D is,” said Scott Harper, owner of Business Advancement Inc., a Glen Rock, New Jersey-based consulting firm, and formerly an R&D leader in the drug industry. “Am I getting new products out of that? Is it serving my objectives?” Moreover, said Battelle’s Grueber, as sales fell or leveled off during the recent global economic swoon, merely measuring R&D as a percentage of the revenue number lost meaning as a guide for the future.

Yet, the importance of improving gauges of R&D success is growing exponentially. So, more companies are trying other methods.

Hewlett-Packard, for example, has spent $16 billion on R&D since fiscal 2006, as it has successfully extended its mastery of the mid-range desktop-printer business to strong positions as well in the low-end inkjet -printer market, in both printing from the web instead of from PCs, and in consumer use of photo kiosks at Wal-Mart and other retailers.

One important reason for its string of recent wins is that, in each case, the Palo Alto, Calif.-based company underwent a thorough “investigation phase” aimed at nearly ensuring Hewlett-Packard would “pick the right kind of product that will be a big breakthrough in 24 months from today,” explained Vyomesh Joshi, head of the company’s digital printing and imaging business.

Just as important has been H-P’s switch to measuring ROI on R&D expenditures as a percentage of gross margin instead of as a percentage of sales. “At the end of the day, innovation should drive gross margin, and if you can’t drive gross margin, it won’t succeed,” Joshi said. “A commodity business can drive revenues but maybe not profits. But if you can generate gross margin, you know your innovation is working.”

Tata measures returns on its R&D investments differently, depending upon which of three distinct types of initiatives is involved. There is a “deliberative innovation stream,” mainly consisting of incremental efforts to improve existing lines of business; for those, Tata uses a “scorecard” of several relatively traditional return metrics such as profitability improvements generated by the innovation over the next six months or year.

The second innovation stream involves what Tata calls “platforms,” which are stretch ideas that are potentially larger in scope, usually fall in between the company’s existing operations, and will require two or three years to reach fruition. The business unit that picks up the innovation for a pilot program will apply its own yardsticks to returns from the development, including measures of customer satisfaction or process improvements.

Tata’s third innovation stream consists of even more speculative advances from R&D teams, significant enough that they someday could become completely new businesses for the company. “We try to keep return measures as light as possible for this stream—but we take a harder look at them overall,” said Krishnan. “So we’re looking to give them what they need to be successful. Or we’re asking, ‘When should they be shut down?’”

GlaxoSmithKline’s Witty has been in the drug-industry vanguard in reacting to the strains being put on R&D by the demands of a much tougher new marketplace. Brand success in pharmaceuticals is being increasingly challenged by generic drugs, the consolidation of purchasing power in the hands of central governments and managed-care organizations, and more demanding regulatory regimes throughout the western world. The industry hasn’t done itself any favors, either, as its success rate in bringing new medicines to market over the last few years is only about half what it was previously, according to a new study by the Biotechnology Industry Organization.

“How well you run R&D is a much bigger differentiator of your performance against the competition than whether you’ve got a bigger piggybank.”

So, Witty is forcing underlings to make harsher, quicker choices as to which drugs get further development funds. He has reduced the headcount in the company’s pharmaceutical R&D by 25 percent since 2006. And talk about a gambit that demands attention to returns from drug development: Witty has changed the company’s incentive program so that the bonuses even of clinical-development executives—who traditionally were well insulated from a drug’s commercial fate—now are tied to whether a drug appears for sale and how it performs.

“This has been a real eye-opener for the whole industry,” said Sarah Rickwood, a senior director of IMS Health, a pharma-industry consulting firm in Norwalk, Conn. “And now other big drug companies are following.”

In general, CEOs and consultants in every technology business are scrambling for better metrics on returns from R&D. As they streamline processes, for example, more companies are interested in employing measurements such as new-product-development lead time as a way of gauging the progress of their R&D efforts.

“We’re finding that companies want to shift away from a pure ROI number to something that at least blends ROI with process-centered measures,” said Ron Wince, president and CEO of Guidon Performance Solutions, a Mesa, Ariz.-based management-consulting firm. Professor Chesbrough added that “measuring the time it takes is important because time will influence the ‘I’ part of ROI. With investment time more limited, you have to move faster.”

Another increasingly popular approach is to use a so-called “freshness index,” which measures the percentage of sales or profits over a given number of years that are represented by new products and services.

At Deloitte’s urging, some companies also are implementing “return on development,” a measure of gross margins realized from a particular R&D output against the costs of the investment in that initiative. This template keys on three criteria: the manufactured cost of the product that has been developed and has emerged into the marketplace, without SG&A considerations; overall investment in the development of it; and pricing that has been achieved for the product. “So if you set up a budget to develop this thing at ‘X’ dollars, did you hold to that? “ Ciacchella said. “And did those three criteria give you the kind of margin you were expecting?”

And Booz promotes the idea of measuring returns on “innovation investment,” which means “viewing R&D as a series of investments in a portfolio instead of just a line item on an annual budget review,” said the firm’s Jaruzelski. “You need to look at the total planned investments in every product, not just R&D, and manage the projects as multi-year investments. And if you optimize that portfolio, you’ll get better returns.”

Of course, as CEOs tighten their grip on R&D outlays, they still must be careful not to squeeze too tightly. “If you put too many metrics around the process, you are undoubtedly going to stifle the creative nature of what may take place,” BDO’s Jamil said. “All of these approaches require flexibility.”

Yet as the global economic recovery continues to grow, expect CEOs to keep a better finger on the pulse of R&D returns from now on. “They’re going to keep a very close eye on it,” said Battelle’s Grueber. “They know that, no matter what, it will be a healthy exercise for the company.”

Key Takeaways

1. The new era of R&D favors companies with tight discipline, streamlined processes and an opportunistic mindset.
2. Measurement of returns should stretch beyond traditional percent-of-sales numbers into other metrics.
3. If the pharmaceutical industry can overhaul R&D, significant improvement is possible in any business.

Apple’s Innovation Edge

 

Apple employees celebrating the iPad 2 launch.

Apple Computer has become “the poster child” for R&D envy by CEOs, said Barry Jaruzelski, lead of the innovation practice at consulting firm Booz & Co. That’s because, since Steve Jobs’ return to the top of the company in 1996, Apple’s R&D efforts have turned out one blockbuster product or feature after another, including the iPod, the iPhone and the iPad. As a result, Apple was rated the most innovative company in a recent Booz survey of “innovation executives,” beating out every other high-tech giant as well as highly regarded General Electric and Toyota.

Yet Apple spends relatively little to obtain stellar returns from its newproduct investments. In terms of R&D “intensity” (spending as a percent of sales), Apple ranked ninth among Booz’s top 10 innovative companies, with a 2009 figure of just 3.1 percent; only Procter & Gamble succeeded with a lower figure.

The combination of unparalleled success and minimal R&D investment has many CEOs in awe of Apple. “They spend half as much as the average computer or electronics company on R&D as a percent of sales,” sums up Jaruzelski. “But they run extremely good processes that are disciplined; they have good talent; they rely a lot on third parties and they focus their efforts on where they can meet unmet needs.”