Financial Techniques for R&D Project Selection
Sales-to-development ratio, cash flow payback, net present value, benefit-to-cost ratio and internal rate of return — plus the one place the 1984 source has hard data, and why it recommends the tool that is not the theoretically correct one.
What the objective techniques are buying you
R3 states the strategic objective before any method: the most critical strategic issue facing research directors and general managers is maximising the profit contribution the firm makes over time from its decision to invest in R&D. Selection techniques serve that, and are not ends in themselves.
The frame these techniques sit inside — R&D as investment, competing case by case against every other use of the firm's money — is set out on The Financial Frame for R&D Management. Note that this page is about choosing between projects, not about how large the R&D budget should be; the source treats those as separate questions and gives the sizing question a two-sided rule with no number in it.
The consistency argument follows. R3 holds that it is particularly important to structure objective assessments in the manner natural for the financial reviewer, because financial hurdles have long since been established for capital appropriations. Using different figures and methods for R&D tends not to put the potentially high returns of new product development in a proper reference frame against capital appropriations for extending capacity on current products.
The five techniques: inputs and arithmetic
THE FIVE OBJECTIVE ASSESSMENT TECHNIQUES
| Technique | Inputs it needs | The arithmetic | Role the source gives it |
|---|---|---|---|
| Sales-to-development ratio | Forecast sales over a defined early window; development cost | Sales divided by development cost. Sales stand in for earnings | A convenient early screening technique |
| Cash flow payback | Investment outlay; the stream of future earnings; a start point for the clock | The time required to recover an investment out of future earnings | A simple time-to-recovery test |
| Net present value | All cash flows, in and out, across the project life; the company's hurdle rate | The algebraic sum of all cash flows discounted at the hurdle rate | A theoretically accurate means of screening projects |
| Benefit-to-cost ratio | Money value of the project's returns; the project's cost; an agreed hurdle rate for discounting | Returns divided by cost, with the time value of money factored in by discounting | An appraisal ratio developed largely in the governmental sector |
| Internal rate of return | The full cash flow — investment cost and future income — over time | The discount rate at which the total cash flow discounts to a present value of zero; equivalently, the rate at which the present value of the investment outflow equals the present value of future profit inflows | The common yardstick, and the source's recommendation |
Definitions as given in R3 (1984). The pill in the last column marks whether the source treats the technique as a rough screen or as a full quantitative appraisal.
What each technique does that the table cannot show
Sales-to-development ratio
The technique uses sales as a proxy for earnings. R3 justifies the substitution on the ground that, on average, the rate of earnings to sales in most businesses tends toward a traditional level — so a sales figure carries information about earnings without requiring the earnings forecast to be built. That justification is also the technique's boundary: it holds only where the earnings-to-sales relationship in your business is near that traditional level.
Cash flow payback
Payback is the least sophisticated technique here and the one R3 partially defends. It attacks not the mathematics but how the number is read. A payback figure invites a fixed-threshold verdict, and the threshold is usually somebody's habit rather than an analysis of the product and the served market.
Net present value
R3 calls net present value theoretically accurate and notes it is often adopted in capital and value analysis procedures. Its decision rule is simple: accept projects whose net present value is positive. The difficulty is not the rule but what happens when you cannot accept everything positive. A later paper attacks the same method from the opposite side, arguing it systematically undervalues R&D by ignoring the option to abandon — see Real Options Valuation of R&D Projects.
Benefit-to-cost ratio
The ratio of the money value of a project's returns to its cost, developed largely in the governmental sector. R3's substantive point is a condition rather than a criticism: proper use requires factoring in the time value of money, usually done by discounting to an agreed hurdle rate. An undiscounted benefit-to-cost ratio is a different and weaker instrument than it appears.
Internal rate of return
R3 offers internal rate of return as the good tool among the objective methods, and the reasons it gives are all about fit rather than accuracy: it is already used in many companies' capital expenditure control procedures, so it serves as a common yardstick for judging the other methods; it is easy to use with computer technology; and it facilitates communication with financially oriented managers. The paper states no weakness for it — which is itself worth noticing, given how carefully it lists weaknesses for the other four.
Where each one misleads
FAILURE CONDITIONS, AS STATED BY THE SOURCE
| Technique | The condition | What goes wrong |
|---|---|---|
| Sales-to-development ratio | The number leaves the R&D department | It does not communicate to financial directors in their own language. It is an internal screen that cannot carry a capital argument |
| Cash flow payback | The product has a long life after recovery | The technique ignores the product life after the payback period, which in some businesses can be substantial |
| Cash flow payback | Market introduction is traditionally slow, as in a conservative industry | The technique ignores market introduction characteristics, and penalises a project for the pace of its sector |
| Cash flow payback | A fixed year-count threshold is applied | The figure is interpreted subjectively — two years is too long for payback — in spite of the fact that, given the product and served-market characteristics, the project may be very valuable |
| Net present value | Capital is rationed and projects must be ranked | There is no good method for ranking under rationing. A large project may have a large net present value and still not be as good for the company as the sum of a larger number of smaller projects, each with individually smaller positive net present values |
| Benefit-to-cost ratio | The time value of money is not factored in | The ratio is computed on undiscounted quantities and stops being comparable with the discounted methods |
| Internal rate of return | No weakness stated by the source | R3 lists strengths only. Treat the absence as a gap in the paper rather than as evidence that none exists |
The equivalence at the cutoff, and one printed inconsistency
R3 offers an equivalence that ties three of the five techniques together near the hurdle. It is presented as a moment of reflection rather than as a derivation, and it is the reason the paper treats the choice among those three as a communication question rather than a correctness question.
The one piece of hard data in the paper
R3 is a review article, but it carries original empirical material from one division's project portfolio. A division that had been evaluating on the sales-to-development ratio recalculated all of that year's projects on internal rate of return, and a second comparison was run against payback. Both produced fitted relationships.
The result R3 draws is more interesting than the coefficients. The two methods selected the same projects and questioned the acceptability of the remainder, and the calculations were not onerous. What improved on moving to internal rate of return was the research director's communications with financial and general management — not the decision.
Choosing the hurdle, and the risk ladder
A technique is only as good as the rate you test it against. R3's criterion is the company's weighted cost of capital, which it says matches other financial assessment criteria once the relative risk of R&D projects is considered — with a premium applied over that cost of capital to account for the degree of risk.
- Government securities — the baseline
- Continuation of existing products — more risky
- R&D projects — higher technical and commercial risk again
That ladder is the argument for the premium. R3's working definition of the thing being measured is narrow and worth quoting in your own words: risk is the amount by which the anticipated profit is likely to vary based on the changing conditions of the economic cycle, and it establishes an objective frame of reference for prospective financial hurdles. The fuller treatment of what risk is, how it differs from uncertainty, and what machinery each calls for is on Risk and Uncertainty in R&D Financial Analysis.
Rules to work by
Selection rules stated by the source
Before you take a selection number upstairs
- The technique is one the capital appropriation process already recognises
- The basis is stated — pre-tax and pre-interest, or otherwise, and consistently across the projects being compared
- The clock start for any payback figure is stated, and is the same for every project in the comparison
- The hurdle rate is the company's, not the department's, with any risk premium shown separately
- Any ranking rule used under rationing is labelled as your choice, because the source does not supply one
- No coefficient borrowed from a published study is presented as a constant for your business
All five techniques consume a forecast. Where the forecast itself has to be built, the decision-analysis toolkit on R&D Project Evaluation Tools sits upstream of everything on this page.
What to carry forward
- The five techniques are not five accuracies of the same measurement. They need different inputs and fail under different conditions, and the failure conditions are the useful part.
- Internal rate of return is recommended for fit, not for accuracy: it is what the capital appropriation process already speaks, and it lets the R&D case be compared with the alternatives on the reviewer's own terms.
- Net present value is the theoretically accurate method and is the one with no ranking rule under capital rationing, which is the condition R&D managers work in.
- The sales-to-development ratio is a screen for internal use. It is not the number you take to a financial director.
- Payback fails mostly through interpretation, not arithmetic. A fixed year-count threshold ignores product life after recovery and the introduction pace of the industry.
- The two regressions are one division's findings for one year. Use the method they demonstrate; do not import the coefficients.
- In that division, the crude screen and the sophisticated method chose the same projects. The gain from rigour was in communication.
Frequently asked questions
Why recommend internal rate of return over net present value if net present value is more accurate?
Because the recommendation is about fit with the firm's existing machinery. Internal rate of return is already used in many companies' capital expenditure control procedures, so it acts as a common yardstick and lets the R&D case be judged alongside the alternatives. The source also notes net present value has no good ranking method under capital rationing, which is the usual R&D condition.
Can I use the regression coefficients from the paper as a shortcut?
No. Both relationships come from a single division's projects in a single year, and the paper makes no generalisation claim for them. What transfers is the exercise: recalculate your own portfolio on two techniques and see whether they agree. What does not transfer is any coefficient.
How should I rank projects when I cannot fund everything?
The source tells you what not to do — do not rank by net present value, because a single large project can have a large net present value and still be worse for the company than several smaller ones with individually smaller positive values. It does not supply a replacement rule. Whatever ranking you adopt is your own choice and should be labelled that way.
Is the benefit-to-cost equivalence in the paper correct as printed?
Partly. A benefit-to-cost ratio of one does correspond to a net present value of zero. The printed statement that it also corresponds to an internal rate of return of zero does not hold under the standard definitions — a zero net present value implies an internal rate of return equal to the discount rate used. The conclusion the source draws from it still stands, but check the arithmetic before repeating the claim.
What discount rate should R&D projects be tested against?
The source's criterion is the company's weighted cost of capital, considered against the relative risk of R&D projects, with a premium applied over it for the degree of risk. It gives no premium size. It also gives a risk ordering to reason from: government securities, then continuation of existing products, then R&D projects.
Does using a better technique produce better decisions?
Not necessarily, on this paper's own evidence. In the division it reports, the crude sales-to-development screen and internal rate of return selected the same projects and questioned the same remainder. What changed was the research director's ability to communicate with financial and general management, which is a real gain but a different one from decision quality.
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. The five objective assessment techniques and their stated strengths and weaknesses are drawn from its project selection and evaluation section.
- Empirical material within R3: two fitted relationships between internal rate of return and, respectively, the sales-to-development ratio and years payback, computed from one division's project portfolio for a single year. Reported here as findings of that study only; the article makes no generalisation claim for the coefficients.
- 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
- Run my project through all five techniques and show me where the rankings disagree.
- What hurdle rate should I use, and how should I present the risk premium separately?
- Explain why my payback figure and my internal rate of return tell different stories.
- Help me build a ranking rule for a capital-rationed portfolio, and label it as my assumption.
- Rewrite my sales-to-development screening output into a form a financial director will accept.
- Which of the five failure conditions on this page applies to the project I am about to submit?