The mutual relationship between profitability and R&D expenses has been studied by many researchers, yet extant research has not considered the effect of economic cycles on this relationship. Specifically, it is not known from prior literature if all economic cycles have the same effect on the relationship between profitability and R&D expenses. In this study, this important relationship is investigated during two consecutive economic cycles in the USA. During economic cycles, demand may shrink with a disproportionately large shrinkage in profitability followed by demand growth with a disproportionately large growth in profits. What is the effect of this fluctuation in profits on R&D investment? This question is not addressed by previous research. This study attempts to fill this void. One reason for the void in the literature may be the challenge of devising an appropriate investigative method. We chose the method of comparing two economic cycles. Our goal here is to see if the reciprocal relationships between performance and R&D are different in consecutive economic cycles. In other words, we explore whether each economic cycle has the same effect on these variables. If they do, policy initiatives during economic cycles could be standardised across cycles. If the effect of each cycle is different on the variables of interest, then policies must be customised for each economic cycle. There appears to be no history of investigations into the relationship between performance and R&D investments specifically during economic cycles. This study of the performance-R&D link limited to economic cycles is important because demand rises and falls (or vice versa) during an economic cycle with vastly exaggerated impact on profitability. Previous studies of the performance-R&D link have paid little attention to this dynamic in an economic cycle.
We use the economic cycles of 1986–1992 and 1997–2003 to examine the longitudinal reciprocal relationship between R&D investments and firm performance as measured by return on sales (ROS). The two economic cycles include a growth phase followed by an economic downturn. This gives us the opportunity for examining the relationship between R&D intensity (R&D investment per unit sales revenue) and ROS (gross profit per unit sales revenue) during changing economic conditions. The results of this study suggest that 1997–2003 is clearly different from the earlier cycle in terms of R&D intensity and ROS. Our findings suggest that companies must face each downturn with an open mind and adopt appropriate strategies for the downturn without necessarily using a strategy that worked well the last time. One commonly known strategic reaction to the downturn is to cut R&D spending; this may be a questionable strategy. In addition, downturns cause retrenchment of labour that leads to higher unemployment rates. All these variables are eyed by public policy makers because they cause both short- and long-term economic and social stress. With regards to the reduction in R&D spending during downturns, incentives are common to encourage corporate R&D spending. Given the finding that each economic cycle could be different public policy makers, who could influence R&D spending in companies, may wish to understand the nature of each economic cycle and its effect on selected industries or all industries before enacting new policies. A policy that was successful in one economic cycle may not work in the next cycle and vice versa.
The model used in this study confirms a reciprocal relationship between ROS and R&D intensity. This finding creates a dilemma for the top management during the years (in a declining economy) of declining or negative ROS; should a firm reduce R&D intensity in such years? The answer to this question is unlikely to be an easy one because the reduction in R&D intensity, according to this study, would reduce future ROS. However, the pressure to cut R&D intensity during the years of declining or negative ROS could be very strong due to the lack of funds and a prevalent mood to cut ‘cost’. In the recent cycle (1997-2003), we found that ROS is beefed up by R&D intensity and, in turn, R&D intensity causes ROS to increase. How could we explain the ‘R&D propelled cycle?’ History and common knowledge tell us that, in US history prior to 1997, we never saw a rush of technologies coming to the market in a very short period of time. During the recent cycle, product life cycles had shrunk to less than a year in some industries such as the electronics and computer industries. Further, during the 1997–2003 cycle, there was a convergence of the growth of the internet, a computer hardware and software explosion and the start of dot.com businesses and related high-tech industries. In this technology-intensive economic growth it is conceivable that more and more R&D was essential for the development of these industries and their growth. We conclude that, although we compared the recent cycle to only one other cycle, it is unlikely that we will find an R&D propelled economic cycle similar to the most recent one in the years before 1986. We think that the future may see the intensification of the R&D propelled cycles, at least in some industries.
This study shows that R&D spending fluctuates with economic ups and downs and that profitability and R&D are reciprocally tied to each other. Given this finding, R&D spending strategy would be myopic if tied to annual cash flows, which have ups and downs matching an economic cycle. Therefore, for a robust R&D policy in innovation-dependent firms, a long-term R&D spending policy that overrides the ups and downs of the annual cash flows is more appropriate. Thus, an R&D spending strategy ought to cover a long period that spans upturns and downtowns in the economy; for example a ten year horizon. A strategy of uniform spending through the ups and downs of the economic cycle would build resources during the upturn for use in R&D during the downturn.
Source: Nair, A., Jones-Farmer, A. and Swamidass, P. 2010. Modeling the reciprocal and longitudinal effect of Return on Sales and R&D intensity during economic cycles: 1997-2003 emerges as an R&D-propelled cycle. International Journal of Technology Management, Issue on Technology Policy vs. Industrial Policy: A Comparison of Overlapping and Competing Approaches to R&D), 49(1/2/3), 2-24.