When a large pharmaceutical firm recently faced a revenue gap due to one of its compounds coming off patent and new ones a few years away, it faced a key question about target R&D margins: how much will the research and development budget be cut to keep the EBITDA margin in line with historical norms? This is classic short-term thinking—maintaining margins by cutting investment in the future.
As we noted in a recent blog post, companies, executives, and especially the financial press tend to fixate on short-term returns. This often leads them to underinvest in innovation, assets, and capabilities they need to meet strategic goals. Take the case of a consumer goods company whose strategic plan called for its Asia–Pacific region to deliver a significant increase in revenue within five years. However, its operating plan didn’t include a rapid build-up of the regional salesforce to support that goal because that would have slightly diluted operating margins.
The data is clear: successful companies invest in innovation and capabilities. If we take investment in R&D as a metric for a relatively long-term orientation, we see that companies with high R&D investments deliver more shareholder value, as measured by higher TSR (Exhibit 1). Such investments not only fuel corporate prosperity but are major drivers of economic growth, spurring innovation and leading to economic progress through efficiency improvements and higher output.
Likewise, companies that make capital investments to secure future growth deliver higher returns and more benefits for the broader economy (Exhibit 2). When executed with prudence, such investments can allow firms to gain a competitive edge and increase their efficiency while capitalizing on growth opportunities. Over time, this can bring higher productivity growth and is vital for developing infrastructure assets and technologies that stimulate economic development.
We don’t mean to suggest that companies should spend recklessly on R&D or assets. However, cutting investment when it’s necessary to secure your future is a mistake. The pharma company mentioned above chose to accept a few years of margin dilution (and analyst noise) and is now stable and growing. The consumer company, on the other hand, did not raise its investment in Asia–Pacific’s sales organization and kept its margins up but at the cost of missing its strategic target.
Tim Koller is a partner in McKinsey’s Denver office, Marc Goedhart is a senior knowledge expert in the Amsterdam office, Rosen Kotsev is a director of client capabilities in the Waltham office, and Pedro Catarino is a capabilities and insights analyst in the Lisbon office.