TVP - How to Select Successful Projects Financial Regimes

How to select successful R&D projects

R&D Financial Regimes (1)

The management funding decisions for R&D are usually guided by one or another of two prevailing viewpoints:

1. R&D As a Necessary Cost of Business - In effect, R&D is supported as an overhead expense. This is most clearly appropriate for early-stage or exploratory research efforts and for developing or maintaining technical expertise in areas judged to be essential to future competitive advantage. However, in practice there are real limits in the amount of funding which senior management feels comfortable in treating this way. See Stage 1.

2. R&D As an Investment - Underlying the treatment of R&D programs as business investments is the basic notion that scarce investment funds should be allocated to alternative company opportunities according to consistent and explicit financial criteria, whether these lie in more traditional investment domains (e.g., capital budgeting for production or distribution facilities) or in R&D. This rationale is clearly most appropriate for those technical development and engineering programs with sufficiently well-understood market and financial implications to permit meaningful quantification and analysis of important decision parameters. An example of these is when projects are in Stages III and IV.

The underlying problem faced by many research directors in the discussion of the overall research program portfolio is that with only two available funding models, all R&D which falls outside the limits management feels comfortable in treating as a necessary cost of business must be justified on the basis of ROI or similar capital budget analysis. This often requires the "force fit" of investment models to R&D situations, in which uncertainty is often directly equated with risk, and future possibilities are significantly discounted.

Putting R&D into Strategic Perspective

An essential step in dealing with the overuse of such investment criteria is to recognize that technical programs are aimed at a wide range of strategic objectives.

Most of the technical work within large corporations is clearly directed toward a well-understood business investment. The technical activity involved is usually development and engineering, and the technical community is usually comfortable with the notion that the financial approach most often suited to its evaluation is an ROI or another capital budgeting framework. At the other end of the spectrum, much of the exploratory or fundamental/basic work in industry is clearly aimed toward knowledge building. For this work, where the business impact is often poorly defined and wide ranging, the more appropriate financial approach is that of considering R&D as a cost of doing business.

However, an important segment of the technical activity, often covering applied research, exploratory development, and sometimes feasibility demonstration, is concerned with the transition between these two broad strategic objectives. The concern is with reducing technical uncertainties and building a strong technical position, to the point where the corporation feels confident it can turn its technical strength into a profitable investment.

It is here where most difficulty is experienced with the two prevailing funding models. On one hand, the expenditures are often too large for management to feel comfortable treating them as an overhead or cost of doing business. On the other hand, the potential impact of the programs is often still sufficiently uncertain as to preclude meaningful ROI measurements.

An important first step in dealing with R&D for strategic positioning is to recognize that these expenditures are not so much directed toward an investment as they are toward the creation of an option. By this it is meant that the corporation is committing relatively modest R&D expenditures now to provide the opportunity to make a profitable investment at some later date.

The second step is to recognize that at least one class of options has been analyzed in some detail, that is, stock options, and that there are parallels with R&D options which suggest important insights that overcome some of the difficulties caused by the force fit of ROI. The concept of treating R&D as an investment option has been in the literature for some time(1, 2), however, it is just recently that the concept is now being accepted more generally and the literature is expanding (3, 4).