Capital Markets

What Money Can’t Buy

R&D pays off, to a certain point.
Oliver JonesDecember 28, 2006

Research & development (R&D) has long been a thorny issue for CFOs, who are frequently tasked with controlling costs and delivering growth at the same time. Booz Allen Hamilton’s second annual global innovation study may comfort CFOs who face resistance to cost cutting on the grounds that such trimming will jeopardize future growth. The study, “Smart spenders—the Global Innovation 1000”, found that “money simply can’t buy effective innovation.”

R&D spending as a percentage of sales has decreased steadily since 2001 for the 1,000 largest corporate R&D spenders in the world, with the median ratio declining from 4.09% to 3.84% last year. The US$407 bn the top 1,000 spent on R&D last year accounts for 85% of global corporate R&D spending, with the next thousand spending only US$25 bn. Of this US$407 bn, over a quarter (26%) is spent by firms in the computing and electronics sectors.

As William Dong, an executive director of UBS in Taiwan, notes: “There has been an increase in capex discipline since the bubble years, with more caution being exercised.” Before the tech bubble burst, huge revenue growth was being projected, and the only way to fulfill these expectations was to spend on R&D. Now, according to Dong, “the CFO has more say in making sure that there is IRR.”

Over the period, the average size of companies in this group has increased from US$8.1 bn to US$10.5 bn in sales, with larger companies generally spending a smaller share of sales on R&D. Nevertheless, 94 of the top 1,000 consistently outperformed their peers over the five-year period on seven measures while spending less on R&D as a percentage of sales than the median for their industry. The measures considered were growth in sales, gross profit, operating income, market capitalization, gross and operating margins, and total shareholder returns. A third of these 94 “high-leverage innovators” were based in Asia (16 in Japan, ten in Taiwan, five in South Korea, and one each in Hong Kong and India), a little over a half (48) were in North America with 13 headquartered in the rest of the world, including only ten firms based in Europe.

One factor keeping the cost of R&D down is its relocation to lower cost countries. The report also cites a recent Booz Allen/INSEAD study which found that “more than 75% of the new R&D centers that businesses plan to open during the next three years are to be located in China or India.” Certainly, there has been a flood of newspaper reports in recent weeks about firms setting up R&D facilities in China, such as Novartis’s plan to build a US$100m laboratory in Shanghai next year. Such facilities have had mixed results to date and some early entrants have scaled down their efforts.

According to Dong, when it comes to the Taiwanese tech sector, China-based R&D activities are still in more labor-intensive activities rather than design and innovation. Following electronics and computing, the next biggest R&D spenders are health (22%) and auto (17%). In all three of these sectors, a large amount of labor-intensive double and triple checking test results is involved in the R&D process.

The Booz Allen report found that the “high-value innovators” have strong capabilities in each stage of the innovation value chain, which it terms as the ideation process (basic research and conception), project selection (the decision to invest), product development, and commercialization, but a distinctive competitive advantage in at least one element. Certainly, CFOs have a key role to play in project selection. And as consumers in China and India become more important customers, these countries will play more and more of a role in the commercialization of new products.

Indeed, the cost of bringing products to market is key. While the 94 “high-value innovators” identified in the report performed better on seven measures at the same time as spending less on R&D as a percentage of sales, it is more broadly the case that above median R&D-to-sales ratios are positively correlated with higher gross profit margins. But these fatter margins are then eroded by higher marketing, sales, operational, and administrative costs. CFOs have a key role in ensuring that the benefits of R&D spending translate to higher net margins.