This article discusses how little large materials companies actually spend on disruptive innovations
Based on a recent report by Accenture, global high tech companies spent over $204 billion on R&D in 2016. On average chemical company spends roughly 3% of sales on R&D. 3M is an outlier with the CTO Ashish Khandpur planning to expand R&D spending to about 6 percent of revenue by 2017. That equates to about $160 million in additional spend for disruptive innovations. For the past 12 years, however, Strategy& has tracked the most innovative 1000 companies and found no correlation between R&D spend and revenue growth.
At face value, Accentures’ report is a troubling insight. Many of these large corporations boast billions of dollars a year in R&D investment. Does this mean that these companies are simply pissing money down the drain?
Innovators and academics say no. Some argue that measure of R&D spend is the wrong metric. Some suggest using R&D productivity as an R&D efficiency metric. Others look at number of patents filings as a metric, which is a poor indicator of shareholder value creation because patent litigation only adds to the company expenses. Some simply argue that a company needs to make long-term technology investment and therefore R&D spend is a necessary cost.
Reality is that any good manager would kill a program that didn’t produce a reasonable ROI. Any way you slice it, company leadership should compare R&D spend relative to revenue growth (input money versus output money) and manage to maximize that success metric. People can argue a ways to quantify R&D efficiency, but it needs to show some method of value generation.
In this article I will make the case that companies improperly invest in disruptive innovations and therefore fail to capitalize on innovation. While management gaps stem from a combination of inadequate funding, unclear goals, and lack of (or use of incorrect) success metrics, this article will focus on misappropriation of R&D funding.
Lets start with dissecting the R&D budget of major materials providers. A recent report by Harvard Business Review broke up the R&D budget into four major categories; daily operations, incremental improvements, sustaining innovation, and disruptive innovation. The chart below describes the focus of each category.
Surprisingly, the study found that 85% of R&D spend is focus on daily operations. Only 5% is spent on identified “disruptive innovations.” So, the R&D budget really looks like this:
Very quickly, a $1 billion dollar R&D budget is reduced to $50M that is focused on “long-term innovation.” For the top materials providers, the disruptive innovation budget rangers between 0.1% and 0.3% of revenue. A far cry from the 3% to 6% of revenue they claim. Now consider that the $50M is split between 10 to 30 projects. 3M boasts that they have over 30 in-house projects at various stages of development. That means you have resources, overhead costs, equipment upkeep, and consumables all split over a $1 – $5 millions dollar annual budget. From the financial model I built in an earlier post, we know that a $2M annual budget barely supports 3 people with a small-scale operation. Based on my experience, funding a project with less than $2M per year is an under-funded project. We also know that scale-up and operation growth for a successful project will require to $10 – $100M in continued investment before an innovation is producing at scale. This means that most R&D budgets don’t have the long-term capital available to support commercialization.
Looking at the top 18 chemical manufacturers’ R&D budget, and making an assumption around how many projects they are supporting, we can estimate the number of projects at risk of being underfunded. Based on this rough analysis, 50% of projects (colored red in the chart below) are at risk of being underfund.
So Few Dollars
Lets take a minute to talk about why disruptive innovation investment receives so little funding. The focus of any public or private company is to maximize shareholder value. The easiest metric that drives stock price is earnings per share (EPS). Senior leadership in any organization is incentivized by increasing EPS year over year and quarter-by-quarter. EPS is calculated at Net Income minus dividends divided by number of shares outstanding. Now, R&D costs are realized as an expense on the income statement. It is not considered an investment or somehow amortized on the balance sheet. Because R&D expense reduces net income, they want to minimize R&D expense. As an extreme example, if 3M eliminated their entire R&D budget, the company EPS would increase by roughly 25%. That is a huge increase that would drive immediate gains!
Now, if they only invest in on-going business activities, they risk being disrupted and actually would decrease near term shareholder confidence. I like to call this the today-tomorrow paradigm. So, they put a little bit towards disruptive innovation, but only just enough.
Based on the analysis above, however, I argue that they aren’t properly funding projects. Dispersing so few dollars over too many projects removes the opportunity for any one innovation to succeed and impact company revenue. This only feeds waste. I see how keeping the R&D expense to a minimum is necessary, but nothing is worst than an underfunded startup.
Under funding a project or over-diluting resources is the same thing as wasting money. Focus drives success. No wonder there isn’t any correlation between R&D budget and revenue growth. I am not saying we need to increase R&D budgets, instead, I am saying we need to better allocate the R&D budgets. Better allocation would be both decreasing percent spend on daily operations, and decreasing the number of disruptive innovation projects. Combined this will provide adequate funding to innovations, increasing likelihood of impacting company revenue and shareholder equity.
That’s all for now! Thanks for reading!
Thoughts on this article? Please post comments and questions below!