TVP – Metric 2 Financial Return

Resource Type
Tool
Authors
Alan Fusfeld, Innovation Research Interchange
Topics
Innovation Metrics, Stage-Gate, Tools and Techniques
Associated Event
Publication

1. Metric Definition

A group of measures of the financial return of R&D or the innovation process, including the New Sales Ratio (the percent of current sales originating from new products), Cost Savings Ratio (the percent reduction in cost of goods or cost of operations that have originated from technology changes), R&D Yield (the annual combined financial benefit that is derived from new sales and process cost savings), and R&D Return (R&D Yield divided by the annual investment in R&D).

a. New Sales Ratio

The percent of current sales originating from new products. There are two sub-definitions that are required: “What is a new product?” and, “How old is new”?
The most frequently used and simplest definition of a new product is any new stock keeping unit (SKU) inventory code that has required R&D support to implement. This avoids counting new SKUs which are only packaging changes or other modifications made easily by marketing or manufacturing. The definition of when a new product is old differs for each business and technology.  In rapidly changing and evolving fields, such as electronic chips and software, new might only be one year, but certainly not more than three. Three years is more likely the norm for businesses that are a mix of fashion and formulation, such as cosmetics & toiletries. For more intense capital and industrial products, three to seven is a more likely range.
In practice, changes in the New Sales Ration may be more important information than the level of New Sales Ratio at any point in time.   By being consistent in how the ratio is calculated, it can help gauge the effects of changes in R&D processes and methods.   If consistency in how the ratio is calculated can not reach consensus across business units, the ratio is still useful as long as it is strictly consistent and explained per business unit.    Also, in practice, a method for calculating the New Sales Ratio that can be taken directly from accounting numbers that are already generated is strongly preferable to any method requiring special calculations or manual adjustments, if only to assure consistency in making comparisons and understanding the impact of changes in R&D processes and methods.

b. Cost Savings Ratio

Percent of reduction in cost of goods or cost of operations (including depreciation charges) that are realized in a year to year comparison that have originated from new technology changes. Again, sub-definitions must be resolved, as required for the new sales ratio. In other words, what is being attributed to R&D and how long is new?

Since SKUs are not used to catalogue changes made in operations an alternative may need to be found that will work for each firm. A simple solution can often be created based on the capital approval process. Most companies require a specific approval for all individual capital projects. These can be coded and tracked for R&D involvement and for realized cost savings. However, it is recognized that the accounting involved in examining cost savings impact may be more difficult than that for new sales. It is therefore a more common metric only in those cases which are more significantly impacted by cost savings than by new product sales. Since new technology for operations or manufacturing has a different, useful life than a new product per se, it must be tracked for a different length of time that is industry specific. In some cases, it may be linked to the product life and in other cases, it may go on much longer. In any case, it is not likely that “new” will reach beyond seven to ten years.  It is very important to agree on what “new” is and measure it consistently.
Many organizations using “Six Sigma” or other corporate-wide process improvement approaches create cost savings that the corporation will publish in an annual report or otherwise publicly claim.  In those organizations it is usually sufficient to agree that the cost savings generated in whole or in part with R&D involvement are credited, again in whole or in part, to the R&D function.

c. R&D Yield

The contribution of R&D to current financial performance. It is a metric that is composed of definitions from New Sales Ratio and Cost Savings Ratio, plus an evaluation of gross profit from the new sales.
It is the annual combined financial benefit that is derived from the annual gross profit of new products and the annual cost savings of new processes.  This is the current contribution that the company receives that is associated with its past stream of R&D investments, i.e. the part of the “bottom line” that is relatively “new” and derived from R&D.

d. R&D Return

The relative ROI measure that relates to R&D.  It is composed of the R&D Yield divided by the annual investment in R&D.  Hopefully, this is a large number that is proportional to the risks and variances that are part of R&D.   It is important to include not only R&D return from product sales but also the R&D return from internal process improvements to the degree that the R&D organization is involved – refer back to Cost Savings Ratio for more on determining that internal return.   Again, it is also important to be consistent over time.  At the VP or C-level, it may be that consensus can be reached to combine product sales and internal improvement returns, or it can be agreed to record and report those as separate numbers.  One advantage to the R&D executives that arises from reporting the internal and external returns separately is that the balance of R&D’s contribution between internal and external impact can be tracked.  That tracking can provide support for discussion and adjustment of the emphasis given to planning internal versus external projects in the R&D organization’s portfolio of corporate projects.

2. Advantages and Limitations

The advantages of these financial metrics are that they relate directly to the financial benefits of the company. They are quantitative and comparable to metrics that can be used in different parts of the same firm or between firms. They capture the degree to which R&D is truly making a financial contribution to the value of the enterprise. They answer the question: “What has R&D done for the business lately?” However, they only represent the tip of a process that takes place over a number of years and that involves other functions besides R&D. This means that the numbers reflected by these metrics are associated with activities that are in the past. These metrics are lagging indicators. They are a nice track record, but they may not accurately reflect a current level of effectiveness.

3. How to Use the Metric

The metrics should be tracked at least once a year. Because of measurement and definition problems, a baseline of two years or more of historical data is needed before accurate judgments can be made about trends and ratio efficiencies.  The numbers potentially could be continuously tracked if the process to generate the numbers can be automated somehow.  There are more than a few organizations capable of and performing such automated tracking.
The metrics should be examined carefully for consistency with business strategies and the results required vs. the investments in R&D.  In situations where the metrics, requirements and available resources are not in balance there will be difficulty in executing the overall business and technology strategies.  One or the other must be shifted, and variations in how R&D is conducted need to be examined.
If the financial return metrics are being maintained or going up, the corporation likely has the raw material to extend a technology-based or innovation-based growth program.  In this case, the investors have the possibility of an extended stream of positive returns from the accumulation of financial pay-offs from technology-based innovations.  Additionally, the R&D unit enjoys the likelihood of consistent funding to reinvest in various aspects of technology application for the near-term and base-building for the future.

The key words here are likely or possible. Positive financial returns are a necessary but not sufficient condition for growth.  It is also only a measure at one point in time, whether it is looking to the past or to the future.  Any downward movements will predict the difficulties the business will have in achieving solid gains against the competition. These indicators are crucial to assessing the total returns from R&D investments, whether enough is being spent on R&D, and what is the likely future value of the company from a technology perspective.

4. Options and Variations

There is always something new and innovative that is contributing to revenue or profit. These financial return metrics are intended to capture the new portion of changes that are related to R&D. They require definitions of what is to be considered new and for how long.  These elements can then be tracked separately or together, in ratio or absolute form, by themselves as benefits or as an investment return vs. R&D.  The options and variations fall into place based on each company’s views of these items.  Again, it is very important to be consistent in order to use these measures for strategic planning, external reporting, and performance assessment.

The most common variations are based on the length of time that is “new” and on the decision to include or exclude some product or activity.   The most frequent categories are three years, five years; and seven years and the most consistently included products are those requiring some input or effort from the R&D organization.  Another variation is to use these same metrics in a prospective, future mode.

5. Champions and Contacts

6. References

Shapiro, A.R. 2005. Measuring Innovation: Beyond Revenue from New Products. Research-Technology Management, 48 (6), pp.42-51.
Whitely, R., Parish, T., Dressler, R., and Nicholson, G. 1997, Evaluating R&D Performance Using the New Sales Ratio. Research-Technology Management, 41(5), pp. 20-22.