R&D Spending Level: What Is the Right Amount?
You don’t have to be a brain surgeon to know that R&D is something that every business needs.
Yet, like a recurring nightmare, determining how much to spend on R&D and product development each year is an issue that keeps management up at night.
It is a tricky question.
The right amount is “more than you think.”
One of the biggest challenges for R&D departments has been figuring out how to measure ROI. Projects are funded, development starts, products are launched, and commercialization ensues. It can take years for data to accumulate which will prove how much of a success your spending was. Some companies have tens to hundreds of projects going on at the same time, while others only have one or two. The issue remains. You might get results, but the result-spending relationship is not always as immediate or understandable as you’d like, and so many executives modulate R&D to balance swings in other parts of the business.
Since the 1970s, academics and practitioners have experimented with various formulas and approaches to measure R&D results. You can run quick numbers on a single product’s sales, but for larger pools of products or the whole company, it’s a different story. What entails success? Is success measured by revenues? Profits? Units sold? Market share? Technology leverage? Customer satisfaction? Something else? There will likely never be a perfect solution, but we need something better than what we currently have.
If you’re in charge of your company’s R&D, then you’ve come to the right place. In this post, we’ll go over some of the biggest issues faced when determining how much to spend on R&D. What are the common pitfalls? How do I avoid them? What are the alternatives? And finally, I’ll give you some suggestions to help you determine how much to spend.
Research and Development is an important function of any successful company’s strategy. For a product-based company, R&D is the engine that drives innovation and ultimately revenue growth. But determining how much to spend on R&D can be difficult and sometimes very arbitrary.
The first thing to understand is that there is no magic formula that will allow you to determine exactly how much to spend on R&D. There are several different methods to determine the right amount, and they all have their own shortcomings and advantages.
Percentage of Revenues
The first method is to base it on a percentage of revenue. Some companies are comfortable spending 2% of revenues on R&D, while others are more comfortable spending 5%. This method is easy to calculate and implement, but it relies on assumptions that may or may not be true.
A company’s revenue is not a direct indication of its ability to innovate. It is possible for a small company with a simple business model to generate higher revenues than a large company with a complex business model. A company may choose to spend a larger percentage of its revenue on R&D because it is a young company that needs to grow, or it might spend more because it is an established company that has little revenue growth.
Percentage of Profits
The second method is to base it on a percentage of profits. This method is more difficult to implement but is more intuitive and meaningful. Some companies are comfortable with spending 20% of their profits on R&D, while others are more comfortable with spending 10%. The biggest challenge with this method is to determine what portion of profits are attributed to R&D. If a company is profitable, but all of its profits are coming from one product, then it may be hard to justify a high R&D spend.
Total Factor Productivity
The third method is using a formula called Total Factor Productivity (“TFP”). This method was developed by economists to determine how much of a company’s revenue is coming from innovation. But it doesn’t uniquely isolate R&D’s contributions.
Another popular method is to use the number of granted Patents as a measure of innovativeness. This is a popular metric used by many analysts, but it has many limitations. First, patents are granted for many different reasons. Some companies patent for defensive reasons, while others patent to prevent copying. Some companies patent for every little improvement, while others patent only the most significant innovations. Patents are really reserved for larger corporations with a lot of budget availability because practically speaking, the more R&D spending that goes to patent expenses, the fewer funds that are available to develop new innovations, or to launch them.
Many companies look at the spending levels of their competitors to determine their own spending. Some companies want to spend more than competitors, some the same, and some just slightly less. Spending more might be viewed by the markets and investor community as a greater commitment to innovation. Spending less might be viewed as being a more efficient and productive innovator. This approach relies on perceptions of innovation and not the results of innovation.
And then finally, we have the Vitality Index, originally created by 3M in 1988, which measures the percentage of company revenues that come from new products. Some companies have found that an increase in R&D spending increases their Vitality Index. Analysts and the investor community are starting to see a correlation between R&D spending and long-term stock performance.
There are innumerable techniques and data points company leaders use to determine and satiate themselves that they are making the “right” spending allocation for R&D. There is no right or wrong amount of spending for R&D, as long as companies are achieving their strategic and operational objectives.
The key is to be strategic and thoughtful about what you’re spending on R&D, and how the results of that spending will impact your business. In today’s globalized world, it’s imperative for company leaders to be thoughtful about the investments they make in their business, including R&D.
Companies that do so will be prepared for the future, while companies that don’t will likely be stuck in the past.