The Financial Frame for R&D Management
The third facet of a research manager's job is the economic one, and it is the facet most research managers arrive without. Here is the frame a 1984 practitioner source builds on it — including the half of its own toolkit that was never supplied.
The third facet of the job
R3 opens by dividing a professional manager's job into three facets, and states that the third is the one industrial research managers are largely novices at — except, as it puts it, for the limited few who have studied business administration.
The three facets, as the source gives them
Manager of people
The leadership, organisation and motivation work. R3 does not develop it; it is named to be set aside.
Interface
To the other functions in the firm, and representation of the firm in the technological and scientific community at large. Also named and set aside.
Economic, entrepreneurial and financial
The subject of the paper. This is where R&D meets the firm's capital allocation, and where a research manager who cannot speak the language loses arguments they should win.
The consequence R3 draws is uncomfortable and worth stating plainly. The research manager who cannot express projects in the discounted-cash-flow language of the financial reviewer will lose the competition for the firm's scarce capital, regardless of the intrinsic merit of the projects.
Accounting and economics answer different questions about the same project
This is the premise everything else in R3 rests on, and it is routinely misread as a complaint about accountants. It is not. The two disciplines are asking different questions, and both answers are correct.
The accounting question
- Question: how must this outlay be reported in the period in which it occurs?
- Answer: as an expense. The accounting profession requires that expenditures for R&D normally be written off in the time period in which they are incurred.
- This is a rule, not a judgement. It is not open to the research manager to argue with it.
- Consequence: R&D lands in the period's costs, reducing reported profit for that period.
The economic question
- Question: is this a wise use of the firm's money, given what it might return and when?
- Answer: assess it as an investment — an outlay of cash today for a prospective return in a risky, uncertain future.
- This is a decision-making viewpoint governed by financial-management precepts, not by reporting rules.
- Consequence: R&D is compared with every other investment the firm could make with the same money.
R3 then places R&D in a class. Some items are really investments but receive accounting treatment as expenses, and it names three alongside research: advertising, market development and organisational development. Against these sit the capital-accounted alternatives that compete for the same money — fixed assets such as plant and equipment, real estate and other tangibles.
TWO CLASSES OF CLAIM ON THE SAME POOL OF MONEY
| Class | Members named by the source | Accounting treatment | What it does to the case |
|---|---|---|---|
| Expensed investments | R&D, advertising, market development, organisational development | Written off in the period incurred | The full cost hits current profit; the return is invisible in this period's accounts, so the case has to be made economically or not at all |
| Capital-accounted alternatives | Fixed assets (plant and equipment), real estate, other tangibles | Capitalised and depreciated | The outlay is spread; established hurdle rates and appraisal procedures already exist and are already understood upstairs |
Classes and members as named in R3, a 1984 practitioner review. The fourth column draws out the implication the paper argues from.
The frame you are competing inside
R3 sets out the financial manager's world in a handful of statements, and the research manager needs all of them because they define the contest.
- Financial management has two tasks: invest wisely, and raise money economically.
- The investment criterion is that the excess of profits over expenditures be maximised, with both values discounted to the present.
- Good management requires the operating and financing tasks of the firm to be considered separately — although a relationship between them exists. R&D sits on the operating side while competing for financing.
- The financial manager's task obliges them to manage a portfolio. Investing in innovation is only one of several alternative ways to use money to make a profit.
- The competition runs case by case, with all competing proposals matched against innovation proposals at the time of decision making.
Eight groups of tools, four of them here
R3 organises its toolkit into eight groups, split between project tools and budget tools. It is the first of two articles condensed from a longer book treatment, and the budget half was published separately. Of the four project groups, two are treated in depth elsewhere in this library: the selection methods on Financial Techniques for R&D Project Selection, and the probabilistic treatment on the risk page. A separate, later decision-analysis toolkit covering some of the same ground sits on R&D Project Evaluation Tools.
THE EIGHT-GROUP TOOL TAXONOMY
| Half | Group | Covered here? | Where it is treated |
|---|---|---|---|
| Project tools | Project and product life cycles and costs | Yes | This page, below |
| Project tools | Project selection and evaluation methods | Yes | The five objective techniques, on the selection page |
| Project tools | Probabilistic treatment of risk and uncertainty | Yes | The risk and uncertainty page |
| Project tools | Project measurement and control | Yes | The risk and uncertainty page |
| Budget tools | Four further groups | No | Deferred by the source to a companion article that was not supplied |
Sizing the budget is a two-sided problem
The question R3 poses — how much should a line of business or a company invest in R&D — is given an answer with two failure directions and no number between them.
The two-sided rule
Notice how the second arm depends on the first section of this page. The penalty for overinvestment is an artefact of expensing, not an economic verdict on the projects. That does not make it survivable — reported profit is real to the people who read it — but it does mean the two arms of the rule are not symmetrical, and a manager arguing the case should say so.
The R&D time cycle, and where cost accumulates
R3 draws the R&D time cycle as six phases with two curves superimposed: cumulative project costs and manpower, and the relative costs and manpower of the tasks themselves. The caption carries a scale caveat — the cumulative curves are not to the same scale, and represent total buildup over the life of the project.
- Exploration and pioneering
- Business analysis
- Product development
- Process and manufacturing development
- Alpha testing
- Beta testing
The two testing phases, defined by the source
- Alpha testing
- Testing done in the R&D department to verify compliance with performance specifications.
- Beta testing
- Testing done by selected customers in their own facilities, to verify that functionality suits the intended application.
Two properties of the phase model matter more than the phase names. First, at each phase costs mount on a cumulative basis. Second, at each phase there is a mortality of new product ideas — and the mortality runs through two distinct screens in a fixed order.
THE TWO KILL SCREENS, IN ORDER
| Screen | Question | What survives |
|---|---|---|
| First | Is it technically feasible? | Ideas that can be made to work |
| Second | Of those, is it commercially feasible? | Ideas that can be made to work and are worth making |
The order is the source's. A commercially attractive idea that is not technically feasible never reaches the second screen; a technically feasible idea can still fail the second.
Put the two properties together and the arithmetic of late killing follows. The cost of terminating a project in a late phase is not the cost of that phase — it is everything accumulated up to it. That is the same argument the acceleration literature makes from the other direction, on Why Costs Increase When Projects Accelerate.
The two forces pulling on an R&D department
R3 identifies two governing forces, and they pull on different axes. Neither is internal to R&D.
Force 1 — product management
- Generally considered a marketing function.
- The product life cycle acts as a clock that regulates new product initiation.
- To sustain growth, a replacement or extended product must be available before the first product commences its decline.
- Product management therefore specifies what, when and how much.
Force 2 — the state of the art
- In advanced technology and applied research.
- Too little innovation may lead to uncompetitive products.
- Too much may lead to missing the appropriate market window for the product.
- The trade-off between advanced technology and applied research on one side, and product and process development on the other, is driven by the broad time dimension.
The second force has the same two-sided shape as the budget rule, which is not a coincidence: both are statements that R&D has an optimum rather than a direction. More technology is not a better answer if it arrives after the window closes.
Three generalisations from putting the two cycles together
R3 combines the R&D time cycle with the product life cycle and draws three generalisations. Taken together they are an argument about screening capacity, not about thrift.
The three generalisations
If the combined cycle is worth doing, it must be done correctly
There is no viable half version. If the price of doing the combined R&D and product cycle right is too high for the potential reward, the source's instruction is to exit immediately rather than to proceed at reduced quality.
Costs increase exponentially in the early part of a project
The consequence R3 draws is not simply that bad projects waste money. It is that staying with losers too long absorbs much of the effort that could be devoted to screening potential winners. The cost of a bad project is framed as an opportunity cost in screening capacity.
Technological discontinuities carry survival-or-ruin risk
The kinds of risks management must take with technological discontinuities are often the difference between survival and ruin. The paper concedes the resemblance to gambling: it is the outlay today of hard-earned cash in expectation of success in a far-from-certain future.
Run, not walk, to the nearest exit.
The second generalisation is the one to carry into practice. It reframes early termination as a resource-release mechanism rather than as an admission, and it is the financial argument sitting underneath the screening logic on Making Better Project Termination Decisions and the estimation machinery on Risk and Uncertainty in R&D Financial Analysis.
What to carry forward
- Accounting and economics answer different questions about the same project. The accounting answer is fixed by rule; the economic answer is the one you are being asked to argue.
- R&D belongs to a class of expensed investments — with advertising, market development and organisational development — competing for the same money as capitalised assets that already have hurdle rates and appraisal machinery.
- The competition is case by case at the moment of decision, and it turns partly on external conditions. A rejection is not necessarily a verdict on the project.
- Four of the eight tool groups are here. The four budget tool groups were deferred to a companion article that was not supplied, and nothing on these pages substitutes for them.
- Budget sizing has two failure directions and no number between them, and the overinvestment arm is an artefact of the accounting treatment rather than an economic verdict.
- Costs accumulate across six phases and ideas die at two screens, technical then commercial. The cost of a late kill is everything before it, which is why early screening capacity is the scarce resource.
Frequently asked questions
Is the source arguing that R&D should be capitalised rather than expensed?
No. It accepts the accounting requirement that R&D expenditures normally be written off in the period incurred, and treats that as fixed. Its argument is that the accounting treatment answers a reporting question and cannot answer the investment question, so a second frame is needed alongside it rather than instead of it.
What are the four budget tool groups?
The supplied material does not name them. R3 states that four further groups deal with R&D budgets and defers them to a companion article that was not supplied to this library. Anyone needing budget-setting methods has to source them elsewhere and should not attribute them here.
How much should we spend on R&D?
The source gives a two-sided rule and no number. Too little consigns the business to the low-margin commodity segment of its industry; too much penalises current profits because of the accounting treatment. It prescribes no percentage of sales and no benchmark, and any ratio you adopt is your assumption rather than the source's.
What is the difference between alpha and beta testing here?
Alpha testing is done in the R&D department to verify compliance with performance specifications. Beta testing is done by selected customers in their own facilities to verify that functionality suits the intended application. The distinction is location and question, not sequence position alone.
Why does the source say too much innovation is a problem?
Because the state of the art is a two-sided force. Too little innovation may lead to uncompetitive products; too much may lead to missing the appropriate market window. The trade-off between advanced research and product or process development is described as driven by the broad time dimension, so it is a timing argument rather than a quality argument.
Is a 1984 financial frame still usable?
The frame is. Treating R&D as an investment, discounting, and competing case by case against other uses of capital are not period-specific. What is period-specific is the paper's commentary on computing convenience, on how research managers were trained, and on prevailing practice, and those parts should be read at their date.
References and source attribution
- R3 - viewing R&D projects financially. Practitioner review and tutorial article in a journal for research management, March-April 1984; 6 printed pages; the first of two articles condensed from a longer book treatment, covering four of eight tool groups. Includes original empirical material from one division's project portfolio, treated on the selection page rather than here.
- The companion article on R&D budgets, covering the remaining four tool groups, is referred to by R3 but was not supplied to this library. It is recorded here as a gap and is not summarised or reconstructed.
- Eleven copyrighted journal articles on R&D project management, supplied as a reading set for a literature review and profiled for this library. Front matter, abstracts, framework sections, tables and figures were read; article bodies were not reproduced, and all content here is paraphrase.
- Supplied teaching source for this library (research methods and research process materials). Used here for page conventions and voice only; it does not treat R&D project management.
Suggested questions for Ask KEVOS
- Rewrite my R&D business case in the language a financial reviewer already uses.
- Which of our current spending lines are expensed investments in the sense used here?
- Map our development process onto the six phases and show me where cost accumulates.
- How do I argue for R&D spending when the accounting treatment penalises current profit?
- What should I say when a good project is rejected for reasons that are not about the project?
- Help me set up the two kill screens as explicit gates rather than implicit judgements.