In the last article, we discussed how businesses decide how much to invest in R&D. We looked at the different factors that go into making this decision, such as the company’s overall budget, the expected return on investment, the competition benchmarking and the risks involved.
If you missed last week’s article, here is the link to it.
In today’s article will do our best to answer a few of the most frequently asked questions on this topic.
FAQ 1: What should be a recommended level of R&D funding?
There is no definite answer to this question because many factors influence it.
We should consider factors like,
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The risk in development as the success is not a certainty.
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Company’s objective behind the strategic positioning of its product or service lifecycle.
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Market risk, the R&D project may be a success, but market success is another story.
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Technological status of the industry; the technology may still present some uncertainty.
Here is some guidance to support R&D resources allocation decisions
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Talking about separating projects by risk level. Here we classify the projects in categories of risk. For example, high risk, medium risk, and low risk and define how much is allocated to each of the categories.
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Estimating the expected value of the project. This method requires estimating the net present value (NPV) of the project, estimating the market success in terms of probability, and estimating the costs of development plus the cost of commercialization. Finally, the expected value of the project would be the net present value multiplied by the probability of success minus the costs. This approach has a lot of assumptions to make.
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Aggregating the budget by the nature of the project. In this method, we categorize the projects by their nature. For example, new products, existing products, processes. Each category of projects will have a projected budget. Here we are having monetary bases. And this table here shows a percentage of R&D totals for each program. In this case, the company is reducing the investments in new products.
FAQ 2 : What are the common issues we should take care of when budgeting R&D
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Time horizon R&D projects are long term. So, we can consider classifying the projects by their time horizons.
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Intellectual property We should check for the legal aspects of the research. This is both our company’s protection or potential risks of violating other companies’ legal protection.
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Ongoing projects. Check for the project’s potential sunk costs. A sunk cost is a non-recoverable cost, so it should not be considered in the analysis of selecting projects. Projects with high sunk costs may need to be dropped.
R&D projects are prone to failure. The failure rate is an indicator that FP&A professionals should monitor. We can check the historical failure rate. One suggested metric related to failure rate is the failure margin. This is total expenditures in unsuccessful projects divided by the total R&D budget. If this is increasing. We should be prudent and re-evaluate.