How Automakers Can Get More from Every R&D Dollar with RQ Theory

As governments worldwide set targets for reducing transportation's carbon footprint, automakers are racing to capitalize on that future. Beyond just electric vehicles, the automotive industry anticipates new consumer demands, including connectivity, software, and improved safety. To deliver such innovations, automakers must make their research and development more efficient.  

In 2022, global R&D spending in the automotive sector reached €145 billion. Automakers in the EU had the largest share of R&D spending, at €61 billion. In comparison, the US automotive industry spent €26 billion, less than Japan. So, what is the most efficient approach to set your company’s R&D budget? A widely used financial metric to evaluate R&D spending as a ratio to revenue. But, this approach can be unwieldy due to the lag in years between R&D investments and the final product. Secondly, a company with bold ambitions to pivot its products and services may want to veer from the 70-20-10 rule and invest much more into transformational R&D (Netflix and Meta are two such examples.) Companies that neglect R&D may compromise their future relevance and competitive advantage. This blog explores approaches to effective R&D budgeting by applying Anne Marie Knott's 'Research Quotient' (RQ) theory, which aligns R&D budgets with their marginal returns. Spending billions of dollars does not directly lead to outcomes, firms need to have the intelligence to use the dollars spent wisely, that is what the RQ expresses. Spending billions of dollars does not directly lead to outcomes; firms should understand RQ to use their budgets wisely.

Understanding the 'Research Quotient' framework for R&D budgets

In 2008, business professor Anne Marie Knott published a paper introducing ‘Research Quotient’ as a reliable measure of a company's ability to generate revenue from its R&D investment. RQ is calculated with the formula Y = KαLβRγ, where Y = output, K = capital, L = labor, and R = R&D. In 2021, Professor Knott won the Olin Award for the practical application of RQ as a method to predict a firm’s current and future value. RQ is mapped to a scale with 100 as the mean, similar to IQ. A company with an RQ score above 130 is therefore considered exceptionally “smart” in terms of R&D productivity.  The Wharton School ranked the top US companies according to RQ and compared industry averages, showing that Petroleum Refining scores 108 while Rubber & Plastics scores 97 on average. If you have the expertise within your company to do multilevel modeling, you can estimate your own RQ. Start by collecting eight years of the company’s financial data, then perform regression analysis according to the steps outlined in chapter 10 of Knott’s book How Innovation Really Works.

RQ provides a universal theory to optimize research and development: companies should base their R&D budget on marginal returns. According to Knott’s research, if the 20 top companies increased their 2010 R&D investment using the RQ method, they would’ve seen a collective increase in market capitalization of $1 trillion. She has calculated that 63% of companies overspend and 33% underspend on R&D, leaving an average of $182 million of foregone profits on the table each year.

Sixteen years later, the RQ measure is still not widely applied. Knott sees companies relying on R&D measures that do not correlate with market value, flying blind because they lack good metrics. Executives often lack the initiative and access to data needed for optimal R&D decision-making. Increased R&D spending isn’t necessarily the solution. It turns out that many firms would actually do better by downsizing R&D if it optimizes RQ, thereby leading to more valuable innovation. Firms overspending could benefit from reprioritizing resources, while those underspending may sabotage future growth.

Three steps for effective R&D budgeting

1. Benchmark R&D spending using RQ

For companies unsure of what to spend on R&D, the first step is understanding where you stand relative to the competition. Use Knott’s equation to calculate your company’s current RQ, then compare it to past RQ and RQ across business units. Once you know where best practice lies within the company, you can learn from it and gradually spread those practices to test their efficacy.

To benchmark your company’s RQ against industry peers, you can manually calculate the RQ of publicly traded competitors from their annual ​​financial reports. Alternatively, the Wharton Research Data Services database provides pre-calculated RQ scores for firms conducting R&D.

If your RQ score is lower than the benchmark, that means there’s room for improvement in your company’s R&D practices. Simply spending more in R&D won’t give you an advantage over competitors, because your RQ score indicates that your returns from that investment will be comparatively less.  To improve your company’s RQ, Knott recommends adopting practices already in effect at high RQ organizations. Or, if you’ve identified a high-performing particular business unit in your own company, ask them about their practices, and implement it in the wider organization.

According to Knott, companies can improve their market value by rightsizing their R&D and then improving their RQ score. It’s possible to optimize R&D spending to achieve your company’s strategic growth ambitions, by applying the equations in the Determining Optimal R&D chapter of Knott’s book. If your company has set a goal to grow profits to a specific target amount, the equations will tell you what the R&D budget should be to achieve that.

Knott has used this RQ method to highlight to companies that some departments are more productive than others and that their overall R&D investment is six times lower than what it should be. So, use the RQ framework to benchmark your company’s R&D intensity, identify internal inefficiencies, and see whether the level of investment matches your strategic growth ambition.

2. Allocate resources through strategic portfolio management

Many companies struggle with sensible resource allocation across their portfolio of R&D initiatives. The consequences are duplicated efforts and survival of “zombie” or “pet” projects. This is a suboptimal usage of R&D resources, but internal politics and loss aversion often make it difficult for leaders to take decisive action. Cutting such projects is especially relevant if you’ve applied Knott’s RQ calculations and realized that the company’s R&D budget is more than the optimal amount.  Ensure you cut investments in the right locations,  informed by past RQ performance and alignment with your company’s strategic ambitions.

The cure is a thorough clean-up of the R&D portfolio using transparent metrics to cut or prioritize initiatives. One of our clients saved €800,000 within a month simply by analyzing all their R&D projects for overlaps and synergies, then consolidating initiatives. Automotive firms can follow our guide to optimizing R&D resources and use ITONICS Portfolio to create a transparent overview of R&D initiatives across departments. Our software enables you to easily map out and compare initiatives in an R&D portfolio.  Implementing an interconnected Innovation OS in your company makes it easier to get a comprehensive view and reallocate resources from low-impact projects to high-value R&D initiatives.

3. Get insight and buy-in through cross-departmental collaboration

A manager will face fierce resistance if they try to clean up the company’s R&D portfolio on their own. Their decisions may be prone to individual bias and skewed priorities. It’s much better to tap into collective intelligence and make decisions as a cross-departmental team. Establishing a single source of truth for innovation in your company will enhance internal visibility with real-time reporting. This empowers the team to visualize R&D projects, comment on next steps, and work together to push progress to the next phase.  Making RQ scores visible helps shift decision-making away from biased opinions to being data-driven, and creates transparency about productivity across departments.

The ITONICS Lists tool provides R&D managers with a straightforward overview of their portfolio. It eliminates the need to switch between clunky spreadsheets, and pulls information from elements in the ITONICS Innovation OS, including trends, technologies, opportunities, risks, and more.  You can use it as an interactive dashboard for your R&D portfolio by highlighting the status of KPIs with customizable stacked bar charts, donut charts, and conditional color formatting. You can add a column to indicate the RQ score of particular departments.

By aggregating the budget information and KPIs of your R&D investments on one dashboard, you can make it easily accessible to decision-makers in your organization. The ideal is to revisit RQ assessments periodically to ensure that R&D budgets adapt to internal and external dynamics. Do these assessments collaboratively, getting input from relevant departments such as engineering, manufacturing, finance, R&D, and marketing. That way, you can break through information silos, tap into departmental experts, and steer progress together.

Optimize R&D and innovate faster

Automotive firms should assess their R&D projects’ strategic fit and potential returns, or else they might be leaving money on the table with suboptimal budgets. Applying Knott’s Research Quotient theory, benchmarking against competitors, and doing collaborative assessments of your R&D portfolio, are all good ways to optimize the company’s innovation initiatives. We know that innovation managers often have to juggle multiple research projects, each with unique market pressures, financial risks, and resource requirements, so we’ve designed the ITONICS Innovation OS as an end-to-end solution. To see how our software can help you manage less and innovate faster, book a demo with our experts.