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How to Measure the Effectiveness of R&D Based Innovation
Posted on October 28th, 2016 by Stephen Toton in Chemical R&D
Like it or not, we work in an environment where corporate shareholders, board of directors and the C-suite want to see a return on their investment in R&D-based innovation. This has become a significant challenge for technology and marketing executives to answer. In fact, many CTOs claim it’s impossible to measure. We all know that innovation by its own nature has many unknowns and risks, and that forecasting results with precision is not an exact science. Look to examples of breakthrough innovation through the last 100 years that came from inventors who were left to their own devices to innovate without the corporate pressures for financial measurement to prove that point.
But without measuring the effectiveness of R&D-based innovation in your corporation, you run the risk of creating an environment of mistrust with the C-suite and business executives. This leads to stove-piped R&D investment with incremental innovation, yielding little or no growth. The days of large R&D investments without strong business cases and progress metrics are gone. The C-suite is willing to have a balanced innovation portfolio, but wants to see a good financial return.
Most Common R&D Innovation Metrics Today
- R&D % of sales
- Revenue from new products over the last X years
- # of patents filed or granted
- # of new products commercialized
- Total R&D headcount
These are the metrics most cited in corporate annual reports. The problem with these metrics is they’re ether a poor indicator of actual revenue growth or earnings, retrospective in nature, difficult to calculate ROI and can drive the wrong behavior internally. In some cases, they even lack internal standards on how to calculate them. Not to mention, these metrics are so high level that internal R&D organizations can do little to affect a positive change.
What Do We Expect From Innovation Metrics?
- Indication of both retrospective and prospective performance
- Show a balanced investment portfolio linked to the business strategy
- Realistic forecast of revenue that is risk adjusted
- Identify gaps and poor performance to take corrective action
- Relative investment comparable to the competition in similar industries
We should look at R&D innovation investments like we look at our own individual mutual fund or stock portfolio. Depending on our risk profile, we’ll have a variety of investments with different levels of risk. The problem is with R&D innovation investment, we complicate how we communicate investment levels and potential returns. We get caught up in the science and technology and forget who our stakeholders are. They need a language that everyone can understand.
For this reason I believe you need to segment your R&D Innovation investment into four categories.
- Discovery and Early Stage Development
- Top Growth Projects
- Product Extensions
- Maintain and Support
Discovery & Early Stage Development
This is R&D investment that’s exploring new science or technology where the risk level is very high. It’s done in the early stages of development. The purpose is to yield new product concepts that are candidates for growth projects. The investment in this part of the portfolio is low. A best practice is to have this activity paired with early marketing research or business development to develop a solid business case and value proposition.
In my experience, the only financial metric that’s credible is the amount of investment. Although a financial model should be created to evaluate the investment and return, the assumptions will have many unknowns. In fact, any revenue projections should be discounted to <10%. You can certainly use milestones to measure progress, but I would stay away from forecasting revenue until an official project is formed and in Stage 2.
What’s more important is to see the amount of investment in this category, relative to the other categories and each business unit or market segment. It’s important to see the alignment with the business strategy. For example, if a business says it’s a growth-through-innovation business but lacks investment in this category, I would challenge the 5-year revenue forecast.
Top Growth Projects
This is R&D investment focused either on transformative or highly differentiated innovation with the purpose of creating top line growth revenue. I mean revenue that is over and above any replacement or cannibalization. Typically these products are patentable inventions or valuable trade secrets that move the business in new markets, or introduce new technology in existing markets. Relative to a five-step Stage Gate process, these are projects that start at Stage 2 and go through Stage 5.
I strongly recommend these projects be evaluated on a standard financial model created with the cooperation of your finance function, where assumptions are consistent with corporate guidelines. How many times have we seen financial models that have unreasonable “hockey stick” revenue forecasts with missing investments in marketing or capital for manufacturing facilities? Key assumptions are critical in evaluating these projects.
Metrics should be top line growth revenue forecast and actuals after commercialization. However, revenue forecast should be risk adjusted depending on the Stage Gate. For example, Stage 2 could be 20% of revenue forecast. Stage 5 should be 100%. The idea is to assemble a risk adjusted forecast of your Top Growth Projects and track the progress. I recommend updating financial model and revenue forecasts on a quarterly basis. Remember you’re looking at the overall portfolio forecast and actual performance. You’ll see some changes every quarter. But this will give you an early indicator of gaps and / or the need to take corrective action.
A best practice, would be to set strict financial hurdle rates to enter into this category (e.g. a business could use a hurdle rate of $50MM of top line revenue and / or $50 MM NPV).
The Top Growth project portfolio will help you have a realistic discussion with your business leaders and C-suite on what is expected for future growth from you innovation portfolio. Trust me, this dialogue can be a real eye-opener when business strategies don’t line up with the forecast and the R&D investment.
These are smaller, medium-risk projects that are used to maintain competitive position. They’ll include enhancements or applications of current products using current technology. Usually new patents and trade secrets are minimal. In aggregate, products and applications in this category produce significant revenue, but usually aren’t creating top line revenue growth. However, there are exceptions such as growth in a new region or market.
My experience is that investment in this category is not well prioritized. Because the results are short term, R&D gets incentivized by business executives to implement when, in reality, the revenue that is produced is not growing the top line.
The metrics in this category should be revenue, gross margin and % investment relative to Categories 1 & 2. If a business has a majority of its investment in Categories 3 & 4, I would question their ability to grow.
Maintain & Support
These are the small, low-risk projects to support business operations such as sales, service and manufacturing. They could also include regulatory support. It’s difficult to measure any financial contribution, but recognize it’s critical to maintain the business. Relative to Categories 2 & 3, this should be a low % investment.
You can certainly modify these categories to fit your business, but start the process now. In today’s environment you need to develop a financial language about your R&D investment that business executives and the C-suite will understand. Trust needs to start with an honest dialogue on what is possible. Don’t make investment in R&D-based innovation a mystery.
All opinions shared in this post are the author’s own.
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