Keith Nichols at industry technology analyst Cambashi dives into the whys and wherefores of extracting value from investments in innovation.
Conventional wisdom has it that innovation fuels business success and it is true that companies actively investing in R&D often generate bigger profits than those that don’t.
However, simply pouring more money into new ideas does not necessarily guarantee bigger profits.
Annual reports yield a crop of cases where companies have spent significantly on R&D but show only limited gains in profitability. Other companies in the same industries manage to produce greater profits from much smaller investments, turning on its head the idea that the more you invest, the more profitable you will become.
So how do these companies do more with less?
Let’s go back to 2010 and consider Apple and Microsoft, similar in size at that time and serving substantially overlapping industries. The striking difference was that Apple invested around 2% of its revenues in R&D compared to Microsoft’s 12 to 13%.
One might expect that Microsoft would have leveraged this spend to achieve increased revenue and profitability over the following couple of years. This did not happen. Instead, Apple revenues grew by 55% between 2010 and 2012, while over the same period Microsoft grew by a modest 7% per annum. In so doing, they ended up on the receiving end of a flood of complaints from angry shareholders who were concerned about the extent of R&D investment with little new to show for it.
Further investigation showed that Microsoft had been directing much of its R&D at simply defending its existing PC business. At the same time, the technology marketplace was rapidly shifting to new platforms that opened up lucrative opportunities like mobile devices (smart phones and tablets), cloud-based applications and data access and gaming consoles.
Microsoft was so heavily occupied in propping up its existing products that it missed out on these new opportunities.
There are further clues.
Typically, 70% of R&D projects consume investment but never make it into product development. Of those that do, only 50% are profitable. The other 50% don’t press that many customer buying buttons and end up consuming high sales effort for little return.
Many companies believe that they can slap a new coat of paint on an ageing product to give it a face lift and re-generate sales.
They do this to avoid high investment that is normally associated with new product development. Unfortunately a product is unlikely to sell if it is not sufficiently innovative, no matter how many times it is superficially updated.
All of these factors can result in around 85% of R&D spend being unprofitable. In many business circles, a proposed project with this level of return on investment would not get off the ground.
Companies are often compared to one another in terms of how well they fare with regards to effective R&D spend. Given that this measure includes varying amounts of wasted investment, it is not possible to draw any meaningful conclusions without understanding the effectiveness of the spend.
There are several ways of measuring R&D effectiveness.
One approach favoured by industries is to use the measure RORC (return on research capital) which is calculated by dividing the current year gross profit by the previous year R&D expenditure. If measured in successive years, RORC can provide a reasonable representation of a company’s progress even though some assumptions have to be made.
Alternatively, it can be used to compare one company against others in the same industry sector in order to rate its own performance and understand where improvements need to be made. Such a comparison can form the basis for a continuous improvement process for its R&D operation.
By regularly reviewing product life-cycle performance, companies can learn from analysing problems, improve processes, continually inject refinements and create steady commercial progress.
Ultimately, the reason companies innovate is to make significantly more money from launching products than the investment it takes to develop them. Only if they manage to achieve this often elusive goal can they congratulate themselves on having used their R&D spend to the best commercial effect.
The Manufacturer is hosting two events in London on October 16 to assist companies to innovate and increase exports.
Export Connect is the launch event in The Manufacturer magazine’s Accelerated Growth Series, new for 2013. – See more at: www.themanufacturer.com/eventsite/export2013/
The Innovation in Manufacturing conference is part of The Manufacturer’s Future Factory series and will provide delegates with the knowledge and expertise they need to nurture innovation in the workplace and find more efficient ways of developing new, more sophisticated products. – See more at: www.themanufacturer.com/eventsite/innovation2013/