It is known that software R&D expenditure positively impacts the gross operating margins or the market-to-book values of a company. However the correlation is not strong. Is it because maintenance, sustainment as well as innovation are lumped together as R&D, yet the return is not equal throughout the software product life-cycle. This articles shows that there may be far less of the high-returning innovation development than management believes. In fact innovation is being starved out by the need to maintain and sustain the existing software product portfolio.
R&D = Innovation + Maintenance + Sustainment
It is generally agreed that R&D expenditure positively impacts gross operating margins or the market-to-book values of a company, but how strong a correlation is hotly debated. What is more difficult is the measure of R&D expenditure productivity, or return on investment. For example, if the majority of R&D expenditure is going into existing product maintenance then it is unlikely to offer the same ROI as investing into new innovations.
In their study Booz Allen Hamilton presents their results exploring the smart spenders of R&D. They question the degree of correlation between R&D and company financial performance: “There are no significant statistical relationships between R&D spending and the primary measures of financial or corporate success: sales and earnings growth, gross and operating profitability, market capitalization growth, and total shareholder returns. Gross profits as a percentage of sales is the single performance variable with a statistical relationship to R&D spending.”
However Booz Allen Hamilton assumes that R&D is limited to ideation, project selection, product development and commercialization, as illustrated below.
In practice we know that the R&D expense continues throughout the innovated product life-cycle to include sustainment and maintenance, where
- Sustainment is the addition of new features to an existing product to maintain or gain market share
- Maintenance is to ensure quality and hence customer loyalty.
As important as sustainment and maintenance are, R&D investment into these later phases of a product’s lifecycle is never likely to offer the same returns as investment in innovation, the more disruptive the better.
Maintenance and Sustainment is an inevitable consequence of Innovation
To truly evaluate the return-on-investment of R&D expenditure we need to distinguish between the R&D investments at different phases of the product life cycle as they surely offer different ROI.
So what is the typical distribution of expenditure for software products? A simple model, verified by actual observations, reveals some surprises.
- Sustainment (adding new features) cost is 8-15% per annum of the original development cost and accumulated sustainment investment to date in any supported code. This 8-15% creates additional code that needs to be sustained and maintained in the future. For example if the original development was $100,000, budget $8,000-$15,000 per annum to add new features requested by customers in order to sustain a competitive product. Note that this would lead to a doubling of the code base over the typical 7-year life-cycle of a product.
- Maintenance (providing bug fixes) cost is 8-15% per annum of development investment to date in any maintained product code. For example if the original development was $100,000, budget $8,000-$15,000 per annum for maintenance in the first year but expect that to grow as sustainment investment increases the code base to be maintained.
So lets us apply this model to a start-up company that has decided to invest $150,000 per annum to create their new product. For the first few years this model works well as the sustainment and maintenance costs are relatively minor. However after a few years the sustainment and maintenance costs are starving out continued innovation until in Year 7 when there is scarcely any innovative development at all. Does this look familiar to you?
No wonder the ROI of R&D does not correlate well; it depends where a company is within this cycle. Code created for the initial release (innovation code) allows one to capture new markets or market share, which is surely more valuable than code added to supply additional features (sustainment code) to ensure that customers are satisfied, and that the product retains a competitive position, which is more valuable than code added to fix problems (maintenance code) to ensure quality and hence customer loyalty. Unfortunately the high-performing innovation investment reduces to less than 12% of R&D total. Over the life-cycle of a product, accumulated sustainment and maintenance can be 180-600% of the original innovation investment.
One could argue that a company which had a successful innovation would be growing, so its R&D budget would be growing proportionately. However, even if we modify our investment strategy and decide to maintain the innovation investment at a constant level, innovation as a percent of R&D would be reduced to 35% by Year 7 as shown below:
How to solve the Innovation Dilemma
Starvation of innovation is caused by the need to sustain and maintain existing code. Therefore, aside from making the innovation investment more productive, the following are suggested strategies: Deprecate old products as soon as possible
Old products do not freely sit on the shelf. They are like volcanoes that have not erupted for some time. Are they extinct? It could be less profitable for that old product to be sold since that will then perpetuate the sustainment and maintenance. However many careers may be wedded to these old products so they become very difficult to kill.
Minimize the code investment in the original product (Lean!)
If you own a larger house, then sustainment and maintenance inevitably costs more. Code is no different. Thus any opportunities to downsize that code yet still meet the functional requirements will reduce the long term sustainment and maintenance costs, releasing more R&D spend for future innovations.
- Code that is created quickly and efficiently allows the product to be released to the market earlier, ensuring an increased internal rate of return or net present value of the investment.
- Code that adds functionality to solve customer problems is likely to be more valuable than core component code that could be purchased from OEMs.
Capitalize code investment
This will probably make accountants pay attention, but expensing code as it is created disguises the fact that it really behaves like a capital investment; it will need sustainment and maintenance investment over the years to retain its value.
 Hall, Bronwyn, Jacques Mairesse & Pierre Mohnen, 2010, Measuring the Returns to R&D, in: Hall, B. and Rosenberg, N, Handbook of the Economics of Innovation, Elsevier, Amsterdam, pp. 1034-1076
 Booz-Allen-Hamilton. (2006), Smart Spenders: The Global Innovation 1000
 The Innovator’s Dilemma. Clayton M. Christensen Cambridge, Massachusetts: Harvard Business School Press, 1997