strategy+business is published by PwC Strategy& Inc.
 
or, sign in with:
strategy and business
Published: June 1, 2004

 
 

The World’s Most Exciting Accountant

For the past decade or so, people in this industry have seen research labs atrophy, funding for new initiatives decrease, and a general spirit of financial hunkering-down. The number of patents awarded annually to chemical companies decreased during the 1990s — from 2,942 in 1989 to 2,722 in 1998. At the same time, according to Professor Lev, the chemical industry’s investment in basic long-term research eroded, with funds moving to short-term research de-signed to tweak features of current technology. Indeed, during the 10 years between 1989 and 1998, according to Professor Lev’s figures, R&D spending by major chemical companies remained basically flat (at $3.25 billion), while R&D spending by major pharmaceutical companies increased, on average, by 22 percent per year.

Looking more closely, Professor Lev and his colleagues found that the R&D investment drove profitability — not the other way around. Analyzing changes in R&D investment against changes in operating income over the two decades from 1980 through 1999, they found that a dollar spent on research in the chemical industry yielded, on average, a rate of return of 26.6 percent, or 17 percent after taxes. To be sure, it typically takes seven years to realize the return, but the amount is enough to compensate for the risk that research will not pan out.

Moreover, companies in any industry that emphasize basic research — the kind in which researchers follow their own noses — appear to enjoy higher returns. In other words, having a relatively unfettered basic R&D function is a surefire way to prevent commoditization, as long as you can capitalize on the results. Unfortunately, this causal link between research expense and financial return does not appear on any spreadsheet in most companies. Today’s prevailing corporate preference for applied over basic research may itself be an artifact not of research priorities, but of accounting rules.

In 2001, Baruch Lev presented his data on R&D rates of return to the DuPont board. On the spot, they extended the session by an extra four hours. “These are important issues,” he says one of the board members told him. “But [advocates of long-term research] usually come to us with fiction. You came with numbers.” The following year, DuPont’s new CEO, Charles O. (Chad) Holliday, set in motion a plan to revive the Ex Station and revitalize long-term research; Forbes published a detailed report of the plans in March 2003. But then in December, DuPont announced an aggressive move to trim $900 million in costs, with no mention of long-term research at all.

It’s hard to judge a company from such scattered details, and that’s precisely Professor Lev’s point. Without clearly reported, relatively standard data about a company’s spending on research and development (or training, or supply chain management), we are blind about its true prospects. In such a situation, companies that want to gain the trust of investors must therefore promise to cut costs instead of pursuing a strategy that would serve everyone — employees, managers, customers, investors, and society — better in the long run.

By contrast, Professor Lev’s research shows that companies that voluntarily document and disclose this kind of information unilaterally tend to see profits rise and, especially, the volatility of their stock price decrease. Surprises, whether good or bad, startle and upset investors. Disclosure is an important way to diminish surprises. His primary examples in this argument are pharmaceutical companies, which have gotten used to disclosing information on research as part of their Food and Drug Administration approval processes — and which, according to Professor Lev, have seen their stock prices rise routinely after disclosures.

Even with evidence of the value in more detailed and transparent accounting, it’s hard to get managers to collect and document the data needed to measure the value of intangibles. At one major multinational pharmaceutical company, Professor Lev tried to get performance and productivity results for people who had gone through a popular training program. The head of the training program blocked the study, apparently for fear of finding out that it wasn’t actually making a difference.

 
 
 
Follow Us 
Facebook Twitter LinkedIn Google Plus YouTube RSS strategy+business Digital and Mobile products App Store

 

 
Close