Intangible assets are derived from a number of areas, including research and development (R&D) effort grouped as “intangible asset generated from internal process”.
In general, intangible assets are extremely difficult to quantify, but have a strong perceived value in the marketplace, sometimes to such an extent that the market value of a company is primarily driven by its intangible assets. We all, accountants very well know how difficult measurement of intangible asset can be.
Though it is not possible to precisely quantify the impact of reasearch and development (R&D) intangible assets, it is even more dangerous to ignore them, since so much of a company’s value is derived from them. Thus this post describes the measurement techniques available for research development intangible assets. Enjoy!
It is difficult to ascertain the most appropriate level of research and development (R&D) expenditure that a company should incur to maximize the value of its intangible assets that are founded upon R&D. This level varies by industry, since some commoditized areas, such as cement manufacturing, require little R&D, whereas the pharmaceuticals industry requires a massive ongoing R&D investment. Given the disparity by industry, a common measurement approach is to simply compare a company’s total R&D expense as a percentage of revenues to the same metric for other companies within the same industry. Though this approach shows expenditures relative to a peer group, it does nothing to show if a company is spending those funds wisely in the pursuit of new products.
“Time to Market” Metrics in R&D Area
“Time to market” is probably the single most commonly measured performance metric in the R&D area. A rapid product rollout strongly equates to a product’s competitive positioning, so it makes sense to measure this factor for all new products. However, because some product lines take more time than others to bring to market, a company with multiple product lines should aggregate this measurement by product line to determine performance levels. For example, it may take only a month to introduce a new line of fashion apparel, but several years to introduce a watch that may also be considered a fashion statement.
It is also possible to measure the ability of a company’s R&D process to complete new product development. This is a particularly important area if the R&D department suffers from bottlenecks in its development process that prevent the company from bringing new products to market in a timely manner. In many industries, being first to market can result in an unassailable competitive position that brings a very high return on investment— thus, shaving a few months off the development cycle is key to corporate profitability.
Words of Caution
Time to market is so important that many companies will spend considerable additional funds to compress the rollout time by even a few weeks. However, it is important to differentiate between the incurrence of one-time rollout costs and a long-term increase in a product’s direct costs. Being first to market with an unprofitable product will only allow a company to lose more money than the competition. Thus, an important ancillary metric is to compare a product’s targeted direct cost to its actual direct cost at a number of stages in the development process, to ensure that targeted gross margin levels will be met.
Below exhibit shows how this measurement process works—the current cost of the product is calculated at various stages in the development process and measured as a percentage of the final target cost. If the product does not meet a milestone standard, the product is scrapped before it is launched, on the presumption that the final target cost will never be attained. This approach is highly effective for the timely elimination of product concepts before additional development costs are incurred to bring them to market.
Target Costing Measurement Flow
In the above exhibit, the current cost of the product is less than the allowable percentage of the final target cost as the product proceeds through the development process, until it reaches the quality assurance review stage. At that point, the allowable percentage of the target cost is 120 percent, but the design team has only been able to reduce costs to 124 percent of the target.
Accordingly, the project is stopped at that point, on the assumption that the final target cost will never be reached, resulting in substandard gross margins. Rather than just using metrics to determine the value of the R&D process, consider becoming more actively involved in improving the process itself by using throughput analysis to determine the presence and severity of development bottlenecks. This allows a company to increase the speed with which new products are developed.
An example is shown in the next exhibit, where the demand for development time is listed down the left side of the exhibit next to each step in a hypothetical development process, while the available resources are shown on the right side.
Identification of Product Development Bottleneck
By comparing the resource’s supply and demand at each development step, it is easy to determine where additional resources are needed. In the example, the bottleneck operation is the quality assurance review, for which there are only half of the required number of hours available. As a result, new-product projects will back up in front of this operation. Possible solutions are to outsource some of the quality assurance work or to add staff to this work area.
“Time to Profit” Metric In R&D Area
The concepts of time to market and throughput analysis can be combined into a measurement called “time-to-profit“. This is the total time period from the initial incurrence of development costs until the point when gross margins from sales of that product have paid back all incurred costs. This is essentially a risk measure, for it tells management the total period of time during which corporate funds will be at risk before being paid back by a new product.
Time-to-profit metric is likely to be similar for products within the same product line, since they are probably constructed on the same underlying product platform, use similar technology, and have price points resulting in similar profits.
Time-to-profit can be managed by accelerating the development process with throughput analysis, as well as by using target costing to ensure that the required gross margin is achieved.
Lie Dharma Corporation has developed a new lawn mower that uses a rotary engine, the LDP-One. Dharma expects to incur expenses of $1,800,000 over 10 months to develop the LDP-One, and is now selling 1,000 units per month at a gross margin of $120 each. Dharma calculates its time-to-profit by first calculating the total gross margin per month of $120,000 (1,000 units/month × $120/each) and then dividing this into the total development expense of $1,800,000 to arrive at a total time-to-profit of 25 months ($1,800,000/$120,000/month, plus 10 months of initial development time). However, as the development process proceeds, the cost accounting manager informs Dharma’s management that the targeted gross margin will not be achieved; instead, only a $100 gross margin will be earned on each unit sold. This will result in a total gross margin of $100,000 per month and a time-to-profit of 28 months ($1,800,000/$100,000/month, plus 10 months of initial development time).
Tracking the Revenue [Profitability] of Newly Released Product
Financial performance measurements for R&D use several approaches to track the revenue or profitability of newly released products. The various measurements are:
- Revenue from products released within the past years. This is a useful device for determining the general revenue level gained from the corporate investment in R&D, and can be subdivided to show revenue from entirely new products, breakthrough products, and minor brand extensions, in order to see where the development effort has had the most success.
- Profits from products released within the past years. This measurement should accompany the preceding revenue metric. The primary difficulty with matching revenue with profits is that the revenues are caused by products for which expenses were largely incurred in previous years, while the expense being reported may not exactly correspond to the same time period.
- New product revenues as a percent of total sales. This excellent measurement focuses attention on a company’s ability to replenish its product funnel with revenue from new products, and is a fundamental metric used by the strategic planning groups of many organizations. It usually divides revenue from products launched within the past three years by total sales during that period. The main difficulty with this measurement is that it reveals nothing about the composition of new product revenues; are they from minor updates of existing products or from major new products?
- Revenue per R&D professional. This is designed to give management a general idea of the productivity of the R&D staff as it relates to the revenue of new products developed by them. This metric has several flaws. First, it will be several years before a sufficient level of revenue has built up from new-product sales to make the R&D staff look remotely efficient. Second, the measure may mask a decline in new product releases if revenue from older products are still being included in the measurement. Third, the measurement can be manipulated by assigning some work to suppliers, thereby reducing the headcount figure used in the denominator. If this measure is to be used, then at least limit the number of years of revenue to be used in the numerator in order to lend some currency to the calculation; for example, only allow revenue for the past three years.
- Profit per R&D professional. This measure is intended to determine the profitability of the R&D function, but suffers from the same problems just noted for the “revenue per R&D professional” measurement. Also, profitability can be defined in a number of ways, such as gross margin or operating margin—it depends on how much overhead is assigned to the products being included in the measurement. Despite the obvious measurement problems, this measurement is useful for gaining some idea of the general profitability of the R&D function and of the best level of staffing needed to maximize profitability.
- Vintage year revenue. This is the revenues generated over time from a specific year of R&D expenditures. Though an interesting concept, it ignores the duration of product development projects, which may extend over many years. Consequently, is it reasonable to assign new product revenue to a specific “vintage year” of expenses (probably the year in which the new product was released) when related expenditures may have covered several additional years as well? Alternatively, this measurement may work if R&D projects are of such short duration that they can reasonably be assigned to a single year.
Of these measurements, revenue and profits from products released within the past three years should certainly form the core of any measurement system, since they reveal the effectiveness of the R&D department in creating marketable new products.