It is not an unusual situation: the Sales Director of a medium-size, high tech company is eulogising to the CEO about a market opportunity the director believes he has spotted. All it will take is for R&D to develop the appropriate product.

Always keen to be supportive, the CEO tells his chief salesman that he should make an estimate of the total revenue for the new product over its lifetime, and check the likely development cost with the Technical Director.

Two days later the Sales Director is back with the figures and is even more enthusiastic. He tells his boss that the figures are looking good with the estimates showing that the margin earned on the new product will breakeven against the R&D cost in just two years, and it will then continue to earn at the same rate in the remaining three years of the product’s life.

Does it meet Revenue Replacement Rule?

The CEO frowns and breaks the bad news: ” I’m sorry but it doesn’t meet the Revenue Replacement Rule.”

“I’ve never heard of that,” the crestfallen Sales Director replies. ” What is this rule and why doesn’t my product meet it?”

To answer the Sales Director’s question, we can start by considering the hypothetical company for which he works.

Calculating Revenue Replacement

It has been running successfully for 15 years, has an annual turnover of $100m and spends 5% of that revenue on its R&D. It operates in a competitive market with an average lifetime of each of its products of 5 years. On average, the company’s products earn a gross margin of 50%. The $5m it spends on development of all the new products it launches are funded from its own financial resources – there are no additional external funds available.

The cost of the R&D is written off to the P&L in the year the cost is incurred and there are no complicating tax or grant considerations. Because the lifetime of the products is relatively short we know that the revenue from older products will gradually fade away and the revenue ‘top -line’ will therefore need to be replenished with new or updated products.

We can go a bit further with this line of thought however, because it is clear that if the company decided to cut back or, even more drastically, cease, spending on the development of new products then the company’s revenue would fairly rapidly start to decline. (Although of course in the short term the lowering of the R&D spend would have a very positive effect on bottom line profit!)

In other words we can say that one of the roles of the R&D investment -perhaps the vital role – is that it generates new product revenue which replaces the turnover lost from the declining sales of older products.

Now let’s come back to our hypothetical company spending $5m of its annual revenue of $100m on R&D. If, for the moment, we say that our modest objective is simply to maintain the top line revenue at this same level going forward, then it is evident that the $5m of R&D spend must yield $100m of future revenue.

Or more generally if the percentage of revenue expressed as a ratio is d then the average revenue yield, y, must be 1/d if the company is to maintain its revenue. So in our hypothetical company where the R&D ratio is 0.05 the revenue yield ratio therefore has to be 20. This is the Revenue Replacement Rule or RRR.

What are the implications of the Revenue Replacement Rule for management teams making decisions on the viability of a development project?

Firstly, although the argument has been developed using the gross total of the R&D spend in one year relative to the gross total of the resulting revenue, in practice the rule can be applied to the development cost of each individual development project and the associated lifetime revenue from the resulting product.

Secondly, the rule is best used as a rule of thumb which can act as starting point for the project evaluation. In most cases it is likely that the objective will be for projects to attain sales considerably higher than specified by the RRR yield so that future revenue growth is built into the company business plan. But of course there will be projects which ultimately do not result in viable products where the yield is therefore zero. These unsuccessful products have therefore have to be added into the average yield return required by the rule.

The RRR also expects that the gross margin achieved on the new project is the same as the older, replaced products, and if that is not the case than due allowance must be made.

Finally, in most cases the RRR represents a much tougher target than most standard return on investment analyses and that may make it harder to justify a project authorisation.

We can now answer the Sale Director’s question. We know that the margin earned over the first two years is equal to the development cost, d. Extrapolating this over the full five year product life, means the total gross margin earned will be 2.5 d. At 50% margin this is equivalent to top line revenue of 5d – i.e. a revenue yield of five times the R&D cost.

But the RRR tells us that in fact the yield needs to be 20 times the R&D cost – and that only achieves no top line growth.

So the Sales Director simply doesn’t have enough anticipated sales to justify the development.

Blog provided by John Shave, Cambridge Pixel