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 / Winter 2005 / Issue 41(originally published by Booz & Company)


Money Isn’t Everything

Money Doesn’t Buy Results
So what does this huge investment yield the Global Innovation 1000? Although there are individual success stories, we could find few statistical relationships between R&D spend and business results. There is no discernible relationship between spending levels and most measures of business success.

For our analysis we used the R&D-to-sales ratio — the percentage of an organization’s revenue that it spends on R&D — as the primary metric for spending. Although this measure has its limitations, it is commonly used and thus familiar and publicly available. It also enables comparisons that reveal the relative importance of innovation in different industry sectors (for example, pharmaceutical companies spend more per dollar of revenue on R&D than utilities do). This measure also eliminates any bias related to company size. For example, Intel (#12) spends 80 times as much as Cymer (#766), but both have an R&D-to-sales ratio of 14 percent; Ford (#3) spends 130 times as much as Nissin Kogyo (#790), but both have an R&D-to-sales ratio of 4.3 percent. Finally, the R&D-to-sales ratio can be indexed across industries to enable meaningful analysis of the Global Innovation 1000 as a whole.

Contrary to conventional assumptions, R&D spending levels within the Global Innovation 1000 had no apparent impact on sales growth, gross profit, operating profit, enterprise profit, market capitalization, or total shareholder return. Whether we looked at R&D as a leading or a lagging indicator, whether we looked at absolute dollar amounts or growth trends for the performance measures, and no matter what the time horizon for the analysis, the story was the same. (See Exhibit 1.)

This scatter plot shows no correlation between our primary metric for R&D spending by the Global Innovation 1000 — the indexed R&D-to-sales ratio for 1999 (the x-axis), and sales growth during the following five years, from 1999 to 2004 (the y-axis). In 495 such analyses, similarly uncorrelated results for profitability growth, enterprise profitability (gross, operating, and net), market capitalization growth, and total shareholder return demonstrated that R&D spending has little or no impact on these indicators of success.

This is big news. It suggests that strategies that focus primarily on increasing the cash input to an innovation “black box” — a process presumed to transform R&D spending into results without anyone fully understanding how — are more likely than not to fail to deliver the desired performance.

It comes as no surprise, however, to our Booz Allen colleague Dr. Allan O. Steinhardt, a former chief scientist of the Defense Advanced Research Projects Agency, the R&D arm of the U.S. Department of Defense. He comments: “It’s absolutely a myth that money alone will solve vexing technical problems. Rather, reckless funding largesse is actually a barrier to transformative innovation as it turns scientists into constituents with an incentive to maintain the status quo. Reasonable constraints are a spur to progress. Entitlement programs for scientists and engineers are a drag.”

Better Mousetraps
We found only one strong performance correlation. Higher R&D-to-sales ratios were associated with higher gross margins: the percentage of revenue left over after subtracting the costs of materials, labor, manufacturing, and direct shipping, and after paying other expenses incurred in making the products or services sold.

This link between R&D spending and higher gross margins was evident in aggregate, where the median gross margins of the top 500 companies based on indexed R&D-to-sales ratios were 40 percent higher than those for the bottom 500. Out of 10 industries we assessed, while the amount of the performance boost varied from industry to industry, none showed a different pattern. (See Exhibit 2.)

Gross margin percentage is an indicator of “better mousetraps”: product differentiation, low manufacturing cost, or both. Across the 2004 Global Innovation 1000, it was the only consistent financial benefit of a higher-than-median R&D-to-sales ratio. As shown here, higher-than-median spenders (the light bars) have a higher gross margin percentage than lower spenders (the dark bars).
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  1. Joris Beerens, Thomas Goldbrunner, Richard Hauser, and Georg List, “Mastering the Innovation Challenge: Results of the Booz Allen Hamilton European Innovation Survey,” a Booz Allen Hamilton white paper, This 2005 study pinpoints both the ambitious innovation targets that European innovators have set — and their concerns that their organizations may not be up to the challenge.
  2. Henry William Chesbrough, Open Innovation: The New Imperative for Creating and Profiting from Technology (Harvard Business School Press, 2003): Harvard’s Professor Chesbrough proposes collaborative, transparent innovation practices that deliver improved performance by opening the corporation to outside thinking from vendors, academics, and investors.
  3. Peter Coy with Ben Elgin, Amy Barrett, and Gail Edmondson, “The Search for Tomorrow,” Business Week, October 11, 2004: A new index that examines corporate R&D and capital spending and ranks all U.S. companies in the S&P 500 plus 700 non-U.S. companies on the basis of their R&D and capital investment spending. Click here.
  4. Alexander Kandybin and Martin Kihn, “Raising Your Return on Innovation Investment,” s+b, Summer 2004: Introduces the concept of the innovation effectiveness curve. Click here.
  5. Robert W. Lane, speech given at Northwestern University’s Kellogg School of Management, April 23, 2003: Describes how Deere aligned its innovation strategy with customer priorities. A transcript is available. Transcript available here.
  6. Erick Schonfeld, “Outsourcing Innovation,” Business 2.0 Web site, May 30, 2003: Contains the Larry Huston quote and a description of P&G’s approach. Click here.
  7. Special Report: R&D ’04, MIT Technology Review, December 1, 2004: Ranks the top 150 R&D spenders in 2003 based on an innovation index that takes into account total spend, spending growth, and R&D-to-sales ratio. Click here.
  8. The 2004 R&D Scoreboard: The Top 700 U.K. and 700 International Companies by R&D Investment, Parts I and II, U.K. Department of Trade and Industry: This study provides detailed demographics and claims a link between R&D and sales performance that our study did not detect. Click here.
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