Hi there. Now, we're going through more details on R&D budgeting. In the last video, we said that R&D funding is a relevant topic. We seek to answer a key question. Where does the funding come from? Well, R&D budgets funding assumptions may be analyzed by different approaches. Let's talk about some of them. First, managers may define the part of the company's cash flow will be used to fund R&D projects. For example, they determined that 3% of the revenue will go to R&D. You may also apply the percentage approach to other items such as current last year revenue, the profits, investment in capital assets, cash flow, expected sales. Second, benchmarking. Depending on the business, there might be an average level of investment in R&D. And companies managers could think about adopting the same level to be competitive in the face of benchmarket companies. Third, managers may consider applying the same level that the company has been investing in R&D from a historical perspective. The decision on which of the approaches you're going to use is part of the budgeting process. Eventually, you may need to address it. Now, If we have a definition on R&D funding then the company has a baseline for the budget, and this baseline allows managers to analyze how to allocate the R&D budget. However, this is not a simple matter. A criteria for resources allocation decisions should be available. Talk to people who might have more information about the criteria. Anyway, here are some alternatives to support R&D resources allocation decision. Separating project by risk level, estimating the expected value of the project, aggregating the budget by the nature of the project. Talking about separating project by risk level. This alternative is a simple straight method. You classify the projects in categories of risk. For example, three types; high risk, medium risk, and low risk. And define how much is allocate to each of the categories, as simple as that. Of course, to do it you would need to have the total budget for R&D. Alternatively, if you don't have the total budget, you can still apply the method by using percentage for each category. Estimating the expected value of the project. This method is based on a calculation which is applied like this. Estimating the net present value of the project, estimating the market success in terms of probability, estimating the costs of development plus the cost of commercialization. Finally, the expected value of the project would be the net present value multiplied by the probability of success minus the costs. I know this approach has a lot of assumptions to make. Anyway, this is R&D budget, so we are talking about the long term. And in the long term, unfortunately, what we have the most are uncertainties. Aggregating the budget by the nature of the project. In this method we classify the projects by their nature. For example, new products, existing products, processes. Look at this example here. Each category of projects, let's call it program, has a projected budget. Here we having monetary bases. And this table here shows a percentage of R&D totals for each program. In this case, the company is reducing the investments in new products. Now, talking about common the issues that we should take care when budgeting R&D. Time horizon. R&D projects are for the long term. Consider classifying the projects by their time horizons. Intellectual property, check for the legal aspects of the research. Be it because the companys' protection or because of potential risks of violating other companies legal protection. Ongoing projects. Check for the project's potential sunk costs. Sometimes people tend to overlook them. Projects with high sunk costs may need to be dropped. A sunk cost is a non-recoverable cost, so it should not be considered in the analysis of selecting projects. R&D projects are prone to failure. The failure rate is an indicator that budget analysts should monitor. Check for the historical failure rate. One suggested metric to failure rate margin could be, the total expenditures in unsuccessful projects divided by the total R&D expenditures. If this indicator is increasing. Managers should take care and evaluate the results. Well, in this video we discussed the major issues about R&D budget. The next session is about how to structure the R&D budget. Please follow the steps of the course. Read the materials, and take the assignments. Stay tuned. See you.
