Here is an excerpt from an article written by Guttorm Aase, Erik Roth, and Sri Swaminathan for Harvard Business Review and the HBR Blog Network. To read the complete article, check out the wealth of free resources, obtain subscription information, and receive HBR email alerts, please click here.

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Don’t overlook the insight that two simple metrics can yield about the effectiveness of your R&D spending.

You’ve probably heard the old joke about the two economists who saw   $20 on the sidewalk. “Look,” exclaimed the first economist, “a $20 bill!” “It can’t be,” the other economist answered. “If it were a $20 bill, someone would have already picked it up.”

We were reminded of this story when we began to notice a pair of
innovation metrics that seemed so intuitive that we assumed they must
have been conspicuously applied and rejected before. So far, however,
we’ve found no indication of widespread use—and a reasonable amount of
evidence suggesting that, at least for most industries, the measurements
work.

We call these indicators R&D conversion metrics: R&D-to-product
(RDP) conversion and new-products-to-margin (NPM) conversion. Their core
components—gross margin, R&D, and sales from new products—are not
new, but combining them can reveal fresh insight on the relative
innovation performance of business units, within an organization and
relative to external peers (Exhibit 1). The first metric, RDP, is
computed by taking the ratio of R&D spend (as a percentage of sales)
to sales from new products. This allows organizations to track the
efficacy with which R&D dollars translate into new-product sales.
The second metric, NPM, takes the ratio of gross margin percentage to
sales from new products, which provides an indication of the
contribution that new-product sales make to margin uplift.

Notably, these metrics can be gauged outside in, making them ideal for
benchmarking. They also apply on the portfolio level, where the net
effect of individual project investments reflects the results as a
whole. That broader perspective accords with how senior executives and
investors typically consider innovation performance. It’s not the most
granular way to consider project value creation, and it doesn’t aspire
to be. In seeking the ideal metric, one should not let the perfect be
the enemy of the good. When a business can convert a high rate of
R&D dollars to new products, and when its new products flow through
to higher gross margins, good things will happen.

As we’d expect, the R&D conversion metrics show that higher spend
does not inevitably translate to stronger performance. That should come
as no surprise to seasoned executives and analysts. Rather, when we
benchmarked companies within select industries, results varied markedly.
The R&D conversion metrics also demonstrate—sometimes
strikingly—where some organizations are falling short and where
opportunities for improvement may be found (Exhibit 2). Not every
company that scores strongly on RDP is able to follow through to higher
margins, and a company scoring above-median performance on NPM may
underperform in RDP.

While the R&D conversion metrics are useful, context is essential.
Benchmarking must be conducted against comparable firms—pure plays
versus pure plays, diversified companies against companies with multiple
business lines, and product-to-product comparisons with cycle times
that are as close in duration as possible. These metrics also work best
in industries where product turnover is higher and the incremental
effect of innovation is both more immediate and more critical to the
business model. For example, in specialty chemicals and consumer goods,
two industries with rapid innovation cycles, the three-year average in
gross margins correlates strongly with the five-year average of
new-product sales. In industries with markedly longer cycles, such as
pharmaceuticals and agribusiness, the r-squareds are lower.

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Here is a direct link to the complete article.

Guttorm Aase is an associate partner in McKinsey’s New York office, where Sri Swaminathan is a consultant; Erik Roth is a senior partner in the Stamford office.