Academic journal article Research-Technology Management

Linking R&D Spending to Revenue Growth: Potential Outcomes of Alternative R&D Budget Plans Can Be Simulated with a Model That Links Growth Rate, R&D Intensity, and Shapes of the Revenue and Investment Streams

Academic journal article Research-Technology Management

Linking R&D Spending to Revenue Growth: Potential Outcomes of Alternative R&D Budget Plans Can Be Simulated with a Model That Links Growth Rate, R&D Intensity, and Shapes of the Revenue and Investment Streams

Article excerpt

Marvin Patterson has presented an analytic model that postulates a causal linkage between a firm's R&D investment and its revenue, and gives a formula that links the annual revenue growth rate to the R&D intensity (1). The key assumption is that the R&D investment creates products, which in turn generate a "wave" of revenue after launch, cresting after a few years, and then declining. The lifetime revenue of these products is assumed to be proportional to the R&D investment in that year. The proportionality factor is called the "new product revenue gain."

This article has two objectives. One is to extend the model by relaxing Patterson's simplifying assumption that the R&D investment associated with products launched in a particular year occurs solely in that year. In practice, several years are required for product development. One would like to understand how product development schedule affects the revenue growth rate.

The second objective is to present a time-dependent version of the extended model to illustrate how hypothetical "what if" scenarios can be simulated. This can be useful as a tool to help senior management understand possible ramifications of their R&D decisions. I do not defend the key assumption that R&D investment drives revenue, and acknowledge that there are many other important factors. Nevertheless, such a model provides a means for quantitatively projecting revenue, given a specific R&D investment profile and product development schedule. The simulations presume that certain model parameters will have values in the future similar to those in the recent past.

Extending the Model

Patterson postulated that the lifetime revenue [W.sub.i] for products launched in a particular vintage year is proportional to the annual R&D investment [E.sub.i]. He called the constant of proportionality the "new product revenue gain," G. He also made a simplifying assumption that the R&D investment for the products launched in the "vintage" year is concentrated solely in that year.

Patterson proceeded by decomposing the revenue [R.sub.i] in a particular "vintage" year (for example, the year 2000) into contributions from revenue waves [W.sub.i] from products launched in earlier years, as shown by Eq. 1 (see "Model Formulation," next page). He characterized the shape of a typical revenue wave by a set of fractions [[alpha].sub.k] that describe the percentage of the lifetime revenue collected k years after product launch. They can be extracted from the firm's historical revenue records by product.

To extend the model, the annual R&D budget is also decomposed, this time into investments for products currently under development that will be launched in the vintage year and future years. Year over year, the annual R&D budget can be thought of as a series of product acquisition spending "waves," or PAS waves, each targeted at specified launch years. Thus, the annual R&D budget can be decomposed (see Eq. 2, "Model Formulation"). In this case, the shape of a typical PAS wave is characterized by a set of fractions [[beta].sub.k] that describe the percentage of the PAS occurring k years before launch. The shape of a typical PAS wave can be determined from the firm's investment records by product.

For the extended model, the lifetime revenue [W.sub.i] of products launched in a particular year is assumed to be proportional to the lifetime product acquisition spending, [P.sub.i], that created those products. This differs from Patterson's assumption, where the lifetime revenue is proportional to the annual R&D budget. I call the constant of proportionality the "corporate gain", [OMEGA], and explain in a moment how it is related to G.

A general time-dependent model was constructed using Eqs. 1 and 2 restated recursively for every vintage year, together with a spreadsheet to keep track of revenue and R&D spending elements by year. …

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