VideoWhen companies fully implement a stage-review process, "you can begin to change the role of finance," says McGrath, who advocates an aggressive "yes-no" decision process rather than the "yes-no-hold-recycle" recommended in traditional stage-gate models. "If there's no formal process, how can finance get involved?" he adds.
A more organized, efficient, and measurable process need not stifle creativity, says Kosa. "If you're a team leader and working to transition an idea, the lack of discipline is very frustrating, so the more-senior people welcomed the idea. The priority setting is better, and we're trying to capture ideas more formally."
R&D Portfolio Theory
Ultimately, companies wishing to instill more discipline in the R&D process are out to rationalize their product portfolios. But in helping rationalize portfolios, financial models that favor relatively easy projects and certain returns can misdirect resources. In going for the "low-hanging fruit" in product development, spending is spread too thin to create a breakout project, says Edgett. "Everybody is saying we have too many balls in the air for the amount of people and money we have available," he says. "Executives say, 'I know I can kill half of my proj-ects without affecting the long-term viability of the company. The problem is, I don't know which half to kill.'"
To help figure that out, new-product portfolio management should target three main goals, says Edgett: efficient resource allocation (including long-term profitability of the portfolio), a balance between a stress on time- to-market and risk of development, and strong links among the product pipeline mix, spending, and strategy.
As for the method of pursuing those goals, Edgett warns against using any that calculates expected returns in isolation. For that reason, he says, a financial model should calculate uncertainty. Edgett proposes one model in the form of an expected commercial value (ECV) formula, which factors in the probability of both technical and commercial success, unlike standard net present value (NPV) calculations. ECV essentially starts with the NPV, multiplies it by the probability of commercial success minus the commercialization cost, and then multiplies that number by the probability of technical success minus the development cost.
Some consultants also bridle at return-on- capital formulas for R&D, saying a single hurdle rate may be self-defeating. "That's a totally erroneous concept when it comes to product development," says McGrath. He suggests a different allocation model: invest a third of R&D in "something that will change the future" of a company's business, another third in products that will have a 200 percent return, and a final third in products that have a more modest return, say, 30 percent. "You need to set the bar a lot higher, and you need to have the discipline not to invest in a single hurdle rate," he says.
Roche Molecular Biochemicals, for instance, allocates 65 percent of R&D to "next generation," breakthrough-type products.
Yet traditional finance thinking has its place, says McGrath. He recalls how an engineer once told his company's product- approval committee that he had found a solution for a low-margin development problem. The engineer suggested buying a key component in bulk--a non-cancelable, high-volume agreement that would have produced a much lower cost. But the CFO, sitting on the committee, pointed out what might have appeared to many in finance as an obvious risk. That is, if the project were scotched (as it ultimately was), the company would be stuck with a lot of useless components. Without a formal process and a role for finance in the decision-making, McGrath explains, a CFO "wouldn't see that issue until the purchase order was being signed."
With more riding on R&D, fewer companies can afford to be blindsided in this fashion. Says Kodak's Greene: "For the $850 million we spend, there needs to be a disciplined process to make sure we're spending money in the right places." -- George Donnelly
THE R&D GAP
A recent survey concluded that the stocks of companies whose R&D spending growth exceeds their earnings growth are undervalued by investors. Assuming the markets are efficient, those companies should outperform others whose growth in spending is lower or no greater than their earnings growth, according to the survey's authors, Baruch Lev of New York University, Bharat Sarath of Baruch College, and Theodore Sougiannis of the University of Illinois. Based on their findings, companies in the top 25 percent of those whose spending growth over the past five years outpaced their earnings momentum for the same five years can expect their shares to rise by roughly 6 percentage points more than average over the next three years.
The table below lists those companies whose market value exceeds $10 billion and whose growth in R&D spending outpaced their earnings growth by the widest margin as of 1995. -- Ronald Fink
Cisco Systems 1,954%
Microsoft 265%
American Home Products 215%
Nynex 158%
Kellogg 108%
CPC International 77%
Kimberly Clark 39%
Eli Lilly 36%
Bristol Myers Squibb 21%
AT&T 19%
Baxter International 19%
Sources: Baruch Lev (New York University), Bharat Sarath (Baruch College), and Theodore Sougiannis (University of Illinois)
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