Financial aspects of innovation #1

Given the forecasted business case of one innovation, what R&D budget is still worthwhile?

In this series of three financial perspectives on innovation, this first article is on the acceptable size of R&D budget for one innovation. That is: if all goes well with the project, how much money should you be willing to spend on R&D? Please note that I assume some kind of stage-gated approach. Budget is made available per stage, certainly not in one go. The second caveat is that this is management accounting. It helps to make managerial choices. It is not financial accounting, which you should anyhow never, ever use for managerial decision making.

First, we need a simple general business model of the organization.

  1. For its products, how much is generally the percentage of Cost Of Goods Sold (COGS) in the sales price? Let’s assume 50% is COGS. The rest is spent on marketing, sales, logistics, management and all other things.
  2. The second element in the business model is the number of years payback that is acceptable, do you want to recoup the R&D cost in 1 year or 10? Let’s assume 5 years.
  3. The third is the percentage you can charge to COGS for this payback. Can it be 1% or 50% of the cost of goods? Let’s assume 10%.
  4. The final element is the split between R&D cost. For simplicity sake, I have chosen 50%.

Just these four elements are enough to do a reasonable estimate of ‘allowable’ research cost. So we have 50% COGS, 5 years payback, 10% payback percentage, and 50:50 split between R and D. If you do your sums, you will see that an innovation project that will generate €100 new sales turnover/annum, cannot support more than €12.5 research cost. Or as innovative optimist: “This project will generate €100 new turnover, we should be willing to spend up to €12.5 in research!”

I hope this will have two effects. Firstly, that CFOs (and innovators) use this as an early warning on potential problems looming. Secondly, that CFOs will make other MT members aware of the need to spend real money to generate real new turnover.

Next article will deal with the cost of slow innovation. How even small delays will rapidly eat into your NPV.

PS For those who got stuck on the financials, just ping me and I will send you the spreadsheet.

Three financial aspects of innovation
  1. Given the forecasted business case of 1 innovation, what R&D budget is still worthwhile?
  2. Be aware of the financial impact of slow project execution, your NPV just melts away!
  3. Monitoring an innovation portfolio from a financial perspective

jeroen de kempenaer philips innovation services

Jeroen de Kempenaer
Value propositions, business modeling, business cases, road mapping, portfolio management

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This article was originally published on LinkedIn.