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BUSN20019 Study Of The Impacts Of R&D On Financial Performance

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Question:

What is the impact of research and development on the financial performanceof the companies in Australia?

 

Answer:

Introduction

Project Background

Average returns that companies receive for an organization post development has been mostly positive. Companies that have internal departments for handling their R&D activities have several benefits like assistance in new product development, reduction of production costs, and bringing innovation in the organization.

R&D can help companies increase their capabilities and enhance their knowledge. This has become somewhat essential in today’s scenario considering the levels of rising competition in every business field. However, R&D can be very expensive to an organization which is why exploring the actual impact of the R&D on the financial performance of an organization is important and companies are concerned about exploring the same. If R&D is helping a company grow financially is what many are trying to speculate.

Thus, in this research, R&D efforts of organizations would be analyzed with respect to the organizational economic performance to understand if they have any positive impact and in case they have then what been the most appropriate settings and the environment in which a company has to operate.

 

Aims & Objectives

The aim of this research is to explore the impacts of research and development activities on the financial performance of an organization. To achieve this aim, the following objectives would be fulfilled with Australia considered as the primary focus of the study:

  • What R&D activities do Australian companies execute?
  • How does R&D affect the financial position of an organization?
  • What impacts does R&D make on the financial status of the companies in Australia?

Literature Review

R&D involves innovation which needs the learning of culture, society, and best utilization of resources with the acquired Knowledge too be able to benefit an organization. R&D cost is also called advancement cost as R&D investments are incurred in the expansion of knowledge which helps companies to develop which is crucial for a business.

Formal Research & Development contribute to the knowledge base of an organization. Researches have been done on structure-conduct-performance (S-C-P) that explains the impacts of tax incentives on research and development. As per the studied literature on the subject, tax gains can give positive social gains. Schumpeter argues that larger organizations have greater market power and thus are more efficient despite the fact that they may lose on welfare. Innovation also increases with an increase in the size of the organization. This could be because larger organization economies of scale, can distribute fixed costs over high sales volumes, can spread risks arising from R&D activities, and have access to financial capital.

A number of different theories are available that explain the social interaction in a society in the times of industrial advances. Some of these theories can be useful in understanding the impacts of R&D on the organization as it would also be affected by the social environment in which it is operating. One such theory is the punctuated equilibrium framework which explores the evolution of policies. As per this theory, political processes are mostly characterized by incremental developments and stability but there can also be cases of large-scale departures. When applying this framework to the case of an organisation, it can be said that an organization would keep stable as long as it is following standard procedures for operations but with the addition of R&D, the company can experience departures from a normal performance which can be on either side that is positive or negative. As per this framework, a company cannot expect to have any significant changes in performance unless some changes have been made in policies that can influence major diversions. R&D efforts would make significant political modifications that can influence advances in an organization (Sabatier, Bryan D. Jones, Baumgartner, & True, 2006).

Another theory may be relevant to discuss here as it explains the cost of financing for an organisation. Pecking Order theory model posits that the cost of financing can increase asymmetrically with information. Companies can choose from different sources of finance based on whatever is available easily. The theory can explain the capital structure in an organization that is used to support R&D functions. Based on the capital structure of the organisation, the influences of the efforts on the financial performance of the organisation can also be understood. There are some key characteristics of the capital structure of an organisation and these include profitability, growth, tax, asset structure, size, and dividends. As per the pecking order theory, the first option that a company would take to finance R&D would be an internal source of finance but in the case, it gets exhausted, the company would, be looking for equity from the market (Liesz, 2001). There exists a negative relationship between the debts taken from the market and the profitability of the company and companies those are more profitable are also seen to have more retained earnings that can be used for R&D. However, despite the retained earnings, if the company solely relies on the internal finance, it can be detrimental to the growth of the firm as it would put certain limitations on the capacities of expansion on an organisation.  Thus, additional external funds may get utilized to support a growth. Choice of a firm between the debt and the equity as an external source of funding would also have varied consequences on the growth of the organization. Further in case of debt, Agency costs of a secured debt would always remain lower than the cost of unsecured debts. Lastly, the size of the firm would have impacts on the choice of the source of funds (Adair & Adskou, 2014). As per the pecking order theory, it is the information asymmetry that causes impacts on the cost of financing and large companies can influence these asymmetries in the market so that they have higher chances of getting funds from the market. IN smaller organisations, companies are more concerned with symmetries and stability and thus, would rely more on the internal funds to have more control which puts a limitation on their growth as they do not utilize external funds that may be needed for a long-term growth. Moreover, profitability constraints also make it difficult for smaller organisations to get finance from external sources. Thus, from this theory, it can be concluded that large organizations always have more benefit in terms of securing finance as compared to the smaller funds and thus, would have more positive growth which indirectly suggests higher returns from R&D as compared to smaller organizations (Chen & Chen, 2009).

 

R&D and Financial Performance

As per European commission, only a third of total investment done by companies is on the Research and Development. This makes a significant investment for any organization. Thus, smaller organizations have resistance to adopting it as a major part of their business. Thus, size and power clearly affect R&D such that the probability of good investments done on R&D is higher for companies that have a higher size of operations.

In high-tech industries, R&D is a common way of growth. There may not be a direct linear relationship between R&D and returns but successful R&D can improve the performance of an organization in the long run while its failure can add the sunk costs. A failure in marketing or in producing patent for an innovation can cue such risks. High tech products that command premium price need to maintain high competitiveness which demands significant efforts to be put on research and development. However, it may not always reciprocate with commercial success and there can be uncertainties. There can be problems and failures that would fail to justify the cost in R&D especially in the case of new product launches. However, the accumulated experience from consistent R&D efforts does have positive impacts on the future growth of an organization. Profitability- of a company is increased in the long run as the company develops the capability to quick innovation. In any case, a time lag exists between R&D and company performance which can be up to 10 years of deterrent returns.

R&D in Australia

During the 1990s, the yearly investments done on R&D was $6 billion and the support was provided by the government. Despite this support and investments, the companies still stayed behind most OECD countries in business and Australia was ranking on 17th in R&D work out of 24 countries. There were few large corporates that invested in R&D such as telecommunication company Telstra Corporation Ltd which invested $218 million, Broken Hill Proprietary Company which was a real estate firm that invested $208 million in R&D, and Ericsson Australia Pty which spent $98 million. By 1996, the situation was little improved and more companies started to invest in R&D such as the pharma company CSL Limited that spent $26 million. However, this investment was a 10th of what top companies would invest (Bosworth & Rogers, 1998).

It was found that there are already many studies conducted on the R&D concept and financial performance of the organization. However, there is no single research paper that reflects upon complete view of the situation and would explain how R&D investments can affect the performance of an origination., However, with the collective view obtained, the researcher can explain the same which is done in the current research.

 

Methods

Choice of research methods is influenced by the nature of knowledge and the assumptions in which a researcher believes. There are some major research paradigms that can be explored to identify the right research methods to be used for the current research. These include positivism, constructivism and pragmatism (Atkinson & Delamont, 2010). Based on which of these worldviews does the researcher related most with, methods of data collection and analysis can be determined as well as the research design can be formulated. Positivist believe in the existence of a single truth that can be explained with data collection. Collectivist do not believe in single reality but in the construction of the same by different perspectives. Pragmatists do not believe in a single method and thus, make use of whatever approaches can deliver results (Bhattacharya, 2017). In the current research, there are pieces of evidence existing that can be used for explaining the impacts of R&D investments on company performance and thus, the research believes in the positivist view and decided to collect data for empirical pieces of evidence (Creswell & Poth, 2016). The researcher discovered that there were many studied already done previously and they have the data available on the interpretations that could be used for the current research. With the lack of any literature that gives a comprehensive view of the impacts of R&D costs on the company performance, the researcher took the opportunity to collect secondary data from journal papers with researches conducted on the subject and would, critically analyze the findings from them to present interpretations collectively in the current research (Hsu, Chen, Chen, & Wang, 2013).

Findings & Analysis

Thus, to study the impact of the performance of R&D activities on organizations financial status, data may be collected from the large organization. The market value of the companies investing in R&D can reflect upon the performance of companies. Several empirical kinds of research have already been conducted to determine the market size of companies investing in R&D. The following table summarises the findings from some of these researches.

Research Details

Findings

Sample: 157 US firms

Observations: 1000

Year: 1981

Positive relationship was found between firm value and level of R&D

Sample: 390 US firms

Year: 1977

R&D has positive impact on relative excess value but a negative interaction effect of R&D- concentration ratio was discovered

Sample: 94 US firms

Years: 169-77

Strong relationship found between R&D expenditure and firms market value

Sample: 2480 US companies

Years: 1973-91

R&D was found to have higher rates of returns as compared to advertising but the rates have dropped over years

Sample: 180 UK companies

Years: 1984-1992

R&D was found to be performing better than patents for companies

Sample: 432 US firms

Years: 1973-79

Companies with high R&D activity in the industry tend to gain more but companies with low R&D activities operating in an industry with competition having high R&D have low returns.

As suggested in the findings from the above literatures, it can be said that some industries have organizations focusing on R&D and if an organization is operating in such industries then lack of R&D can lead to lower returns.

The table above shows the comparison between the data from ABS (Australian Bureau of Statistics) and IBIS on R&D for different industries. It suggests that industries that have higher investments in R&D in Australia include manufacturing followed by mining and retail (Schostak,  2006).

A study was conducted on impact of R&D spending and the economic performance of organizations in Australia using measures of sales growth and EBITDA. There were some interesting findings obtained from the research. It was found that the returns from R&D increase with increasing expenditures on R&D (Bowen, 2009). At an optimal R&D level, companies can gain maximum returns which was found to be 4% for the sample explored in the research. However, once this optimal ratio is reached, the marginal utility of R&D will start to drop such that any additional R&D would only have a negative impact on the economic performance of an organization. This negative relationship was also found between R&D and economic performance of organizations that have low investments done on their R&D activities. This supports the findings from literatures discussed earlier. Thus, it can be said that for a company to take the benefit from the R&D, they need to have sufficient investments happening in the space (FREDRIKSSON & WIKBERG, 2015).

A study was conducted on Chemring Group Plc of Australia in which R&D costs were collected for the organization and they were compared with the financial statements for the assessment of their impacts on the economic performance of the organization. The research found reduction in return ratios like Return on capital employed (ROCE) and Return on equity (ROE) post R&D investments. The financial statements however could not truly reflect upon the capabilities of R&D as it cannot record the future benefits that R&D activities may bring to the organization. However, the research does implicate that R&D results are not visible in short-term and thus, need a company to have a long-term orientation to encash benefits (Zakari & Saidu, 2017).

In another study, a sample of 145 manufacturing organizations was taken to identify variables that affect financial performance of an organization in Australia. For the assessment of the financial performance, factors like capital structure, operating efficiency, firm size, and liquidity were explored.  A positive relationship was found between R&D and financial performance as R&D increases the competitive advantage for an organization through knowledge generation and innovation. This finding is aligned with the punctuated equilibrium framework of R&D. Firm size was found to be associated with the profitability of the firm. A negative correlation was found between degree of the financial leverage and profitability of the firm. This finding is aligned with Pecking Order Theory.

In another study conducted on 588 high-tech   firms that are high on R&D investments between 2000 and 2011 included manufacturers of electronics, computers, semiconductors, display panels, telecommunication and information technology. The data was collected on performance parameters like return, net sale, patent, size, Rd ratio, and more. It was found that R&D expenses do not influence investor sentiments significantly in terms of their expectations from the stock performance. However, the net sales do rise with significant investments done in R&D.  A deferral duration exists in which the R&D investments provided only deterred benefits and it would take a few years to create an actual impact on the firm which is positive for growth and performance. After two lags, R&D expenses would begin to influence the earnings of the organization (Hsu, Chen, Chen, & Wang, 2013).

 

Discussions

Some major findings from the studied researches have been obtained. One, the R&D does not give returns in short-term but work for future developments. Companies that have lower investments done on R&D as compared to competition would show low rate of returns from their R&D activities. A company or an industry would have a certain optimum level of R&D investment at which the company could have maximum returns. The returns from R&D are related to the size of the firm such that larger the organization, higher are the returns. The higher returns from larger firms are mainly due to the benefits of size such as economies of scales, larger volumes of sales and more capital for investments. Findings obtained from the previous researches revealed the same patterns appearing in Australian companies. The researches also revealed that that R&D does not show a direct impact on the performance of the organization but only after a minimum 2 lag periods, the performance stats to improve which can be typically a period of up to 10 years (Brown, 2010).

Conclusions

The aim of the research was to explore how performance of the organization is affected by the R&D investments in the firm. For this a secondary research was conducted in which the data was collected from previous study to collate the inferences into a single place so that appropriate understanding can be obtained on the influence of R&D investments on the company performance. There were some significant findings obtained from the research. It was found that R&D does not give direct returns in short run buy after a significant time lag, it begins to show impacts on the performance of the organization which can be positive and most optimum at certain level. It was also found that the larger companies show higher capabilities of gaining funds and utilizing them for growth and thus, are seen to experience more returns from R&D as compared to smaller firms. Industries with high R&D work such as high technology need companies to have significant investments in R&D as any less investment than competition would not give them sufficient returns.

 

References

Adair, P., & Adskou, M. (2014). Trade-off-theory vs. pecking order theory and the determinants of corporate leverage: Evidence from a panel data analysis upon French SMEs (2002–2010). Cogent Economics and Finance.

Atkinson, P., & Delamont, S. (2010). SAGE Qualitative Research Methods. SAGE.

Bhattacharya, K. (2017). Fundamentals of Qualitative Research: A Practical Guide. Taylor & Francis.

Brown, A., 2010. Qualitative method and compromise in applied social research. Qualitative Research, 10(2), pp.229-248.

Bowen, G., 2009. Document Analysis as a Qualitative Research Method. Qualitative Research Journal, 9(2), pp.27-40.

Bosworth, D., & Rogers, M. (1998). Research and Development, Intangible Assets and the Performance of Large Australian Companies. Manchester School of Management.

Chen, L.-J., & Chen, S.-Y. (2009). How the Pecking-Order Theory Explain Capital Structure. Chang Jung Christian University.

Creswell, J. W., & Poth, C. N. (2016). Qualitative Inquiry and Research Design: Choosing Among Five Approaches. SAGE.

FREDRIKSSON, N., & WIKBERG, J. (2015). The Relationship Between R&D Spending and Firm Economic Performance. CHALMERS UNIVERSITY OF TECHNOLOGY.

Hsu, F.-J., Chen, M.-Y., Chen, Y.-C., & Wang, W.-C. (2013). An Empirical Study on the Relationship between R&D and Financial Performance. Journal of Applied Finance & Banking, 107-119.

Liesz, T. J. (2001). WHY PECKING ORDER THEORY SHOULD BE INCLUDED IN INTRODUCTORY FINANCE COURSES. Mesa State College.

Sabatier, P., Bryan D. Jones, Baumgartner, F. R., & True, J. L. (2006). Punctuated-Equilibrium Theory : Explaining Stability and Change in Public Policymaking. UNC.

Schostak, J., 2006. Interviewing and representation in qualitative research. 4th ed. Maidenhead, England: Open University Press, pp.12-14. 

Zakari, M., & Saidu, S. (2017). The Impact of Accounting Treatment of Research and Development Costs: Evidence from Chemring Group Plc. International Journal of Accounting, Finance and Risk Management, 92-97.

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