Every public company in the technology industry measures innovation spending the same way. R&D as a percentage of revenue.
Why? Because Wall Street tracks it. Boards benchmark it. CEOs get fired over it.
And it tells you almost nothing about whether the spending is working.
Bill Hewlett and Dave Packard knew that. From the very beginning, they measured something different. Something the rest of the industry has been ignoring for seventy years. And the proof was sitting in a paper that Chuck House pulled out and sent to me after a conversation at a Computer History Museum board meeting.
By the end of this episode, you'll know what that metric is, why it works, and why the one everyone else uses makes it nearly impossible to tell whether your innovation investment is building the future or just burning cash.
Here's how I found it.
The Question That Wouldn't Let Go
In the last episode, I talked about the argument with Mark Hurd. The question was over whether HP should cut R&D as a percentage of revenue to match Acer. I knew Mark was fundamentally wrong. But I couldn't prove it. The only metric on the table was R&D as a percentage of revenue. That was what Wall Street expected. It's what shareholders expected. It's what the board expected.
But I couldn't argue against it, because I didn't have the data.
I needed a better metric. So I decided to go back to the beginning. HP's complete financial records dating back to the 1940s. Division by division. R&D project by R&D project. The actual operating data. I got access to all of it. The HP archive team gave me direct access to Bill and Dave's original notebooks.
Now, data alone wasn't enough. It was mountains and mountains of data, and you're trying to extract the signal. What is the trigger in that data?
The conversation that cracked it open happened outside HP.
The Man with the Medal of Defiance
I was at a Computer History Museum board meeting, standing next to Chuck House, and I shared with him the struggle I was having.
A little context on Chuck. He spent twenty-nine years at HP. He was the Corporate Engineering Director and he helped launch dozens of products. He's also the recipient, from David Packard himself, of the Medal of Defiance.
The Medal of Defiance was given to him because David had told him at one point to kill a product line. Chuck went around that decision, put the product into the catalog, shipped it, and it turned into a phenomenal success. When David gave Chuck the medal, the citation was something along the lines of: "for going above and beyond the stupidity of management and doing what was right."
Chuck and Raymond Price co-authored a book called The HP Phenomenon, published by Stanford Press. It's the deep dive into the history of the innovation culture inside HP, all of the metrics used back in the Bill and Dave days that put in place the structure that allowed HP to be successful.
By the time I'm at HP, Chuck had long since moved on. He was running Media X at Stanford, the university's research program on innovation, media, and technology. But we both served on the Computer History Museum board.
At that board meeting, I shared the argument I'd had with Mark and the search for a better metric. I had a strong feeling there was something around gross margin. That R&D investment impacted gross margin. But a feeling isn't an argument. I needed data. I needed to correlate R&D spend to margin, and that's extraordinarily hard to do when you've got all these different product lines and divisions.
Chuck got this little smile on his face and said, "I need to send you something."
The Paper and the Whiteboard
What he sent me was a paper. A journal paper he and a few of his colleagues had written decades before. And it laid out the connection between research investment and margin performance. The correlation I suspected but couldn't prove was right there on the page.
I read it that night. The next morning I emailed Chuck, and I was just really excited. What they'd written decades ago matched what I was finding in the data.
That email exchange turned into an invitation. I asked Chuck to come to HP Labs. We met in a conference room in Building 3, the main building for HP Labs at the time. And I'll tell you, I look back on this and it makes me smile a little, because this conference room was just down the hall from Bill and Dave's offices. HP preserved those offices exactly as Bill and Dave left them. You can walk in there today, see their desks, see their offices, just as they were on their last day. There's something about being that close to where it all started that makes the history feel less like history and more like unfinished business.
Chuck walked up to the whiteboard and drew two things.
On the left side: R&D as a percentage of revenue. The metric every company reports. The metric Mark used to argue HP was overspending. Chuck's point was simple. That metric tells you how much you're spending. That's it. Nothing about whether your products are any good. Nothing about whether customers value what you built. It's an input metric pretending to be an output metric.
Two ways to improve the ratio: spend less on research, or sell more of what you've already got. Neither of those is innovation. You can manipulate R&D as a percentage of revenue by cutting your R&D spend, or you can cut prices to drive top-line revenue. But neither has any connection to measuring whether your innovation is actually working.
On the right side, he drew gross margin. The distance between the cost to make something and what the customer pays for it. Chuck said: that gap is a direct measure of differentiation. Solve a problem nobody else can solve, and customers will pay for that difference. Margin expands. Build a product that looks like everyone else's, and customers have no reason to pay more. They'll shop you. Margin compresses.
Then he drew the line connecting both sides. Research investment flows in. If the research produces differentiated products, gross margin expands. That expanded margin funds the next round of research. A virtuous cycle.
But only if you're watching margin. The moment you manage to the spending ratio instead, the cycle breaks. The boardroom conversation stops being about whether research is producing differentiation. It becomes about whether the spending number looks right compared to some peer.
That's what happened with Mark. HP's PC group margins were compressing toward commodity levels. The response, driven by that revenue-ratio metric, was to cut research spending to match the compression. Exactly backwards. Compressing margins are the alarm bell. Fix the research pipeline. Fix your innovation. Not just more innovation, but good innovation. Don't defund it.
Bill and Dave's First Product, and What It Actually Proved
Standing at that whiteboard, I could see it running through HP's entire history.
The HP 200A audio oscillator. 1939. HP's first commercial product. Competitors were selling oscillators for over $200. Bill and Dave were selling theirs for $89.40.
Now that's not because they undercut the market. What Bill figured out as part of his master's degree project at Stanford was that by using a light bulb inside the circuit as a self-regulating component, you could smooth the output in a way competitors couldn't match. Technically superior instrument. Radically cheaper to build. Walt Disney bought eight of them for Fantasia.
The founders tracked the gap. Cost versus what customers pay. Not total revenue. That gap is gross margin. And that gap funded everything that came after. A lower-priced product, a higher-quality product, and the margin it generated is what drove HP's ability to continue to reinvest.
David Packard codified it. He described what he called the six-to-one ratio. Products at HP were considered genuinely successful only when the profit from a product over time was six times the cost of developing it. If it was lower than that, it wasn't generating enough. And this is also how Bill and Dave decided which product lines to kill off. The ratio determined where research dollars were earning their return and where they weren't.
The products that crushed that ratio weren't the ones with the biggest R&D budgets or the most engineers. They were the ones earning the highest return on the research dollar, because customers paid a premium for what the research produced.
And here's what this enabled: self-financing. No debt. No banks. No Wall Street ninety-day pressure. That was back before HP was even public. It was the freedom to invest in research on a ten-year horizon, and that's only possible with healthy margins.
At HP's margins, spending landed at about eight to ten percent of revenue.
Why Eight to Ten Percent Is Not a Contradiction
Now you might hear "eight to ten percent of revenue" and think I'm contradicting myself. I just spent ten minutes telling you that R&D as a percentage of revenue is a useless metric.
Here's the difference.
Bill and Dave didn't start with the percentage and work backwards. They started with margin. They funded the research that kept margins healthy, and the spending that produced happened to land at eight to ten percent. The percentage was a byproduct, not a target. The moment you flip that and make the percentage the goal, you've lost the plot.
That's the distinction the entire industry missed.
Chuck drew all of this in about twenty minutes on a whiteboard. Decades of institutional knowledge, distilled into one diagram. And the thing that hit me hardest wasn't the analysis. It was the realization that HP had already figured this out. The knowledge was in a paper that had been sitting around for decades. The company had just forgotten.
What was old had become what was new. HP didn't need a breakthrough. It just needed to remember.
Confirming the Pattern: Art Fong and John Young
After the session with Chuck, I reached out to two other people who'd been there in the early days.
Art Fong. I've talked about Art many times on this show, and there's an interview with him in the archive. He was the sixth R&D engineer Bill Hewlett ever hired. At one point in the 1960s, twenty-seven percent of HP's total revenue came from Art Fong's innovations and projects.
And John Young. John was the first CEO after the founders stepped back, after Bill and Dave retired. He took HP from $1.3 billion in revenue to $16 billion.
I had the same discussion with both of them about R&D as a percentage of revenue, about margin. And they both confirmed it. They shared their own stories about margin priority, the six-to-one ratio, and their direct conversations with Bill and Dave. That series of conversations with Chuck, Art, and John, capturing all of that history, really drove me to refine the thinking on the R&D-to-margin connection.
So what did I do next? I back-cast against the entire HP history. Division by division. Is it predictive? Can you use a metric to actually predict? That's what turned an insight into something defensible in a boardroom.
But here's the thing. This isn't just an HP problem. Most companies never had the margin insight. They started with R&D as a percentage of revenue because that's what Wall Street asks for, and they've never questioned it.
Margin would have caught it. Margin starts telling you the truth years before the revenue line does. By the time you see revenue take a dip, the damage is done. That is the result of decisions made three, five, ten years prior. Margin compression is the early warning. Differentiation is fading. Research is not producing what it needs to produce.
Half the Answer, and a New Problem
Walking out of HP Labs that day, I thought I'd found the answer.
Track margin, not spending. Watch the output, not the input.
It took me another year to realize I'd only found half of it.
When I started tracing where HP's R&D dollars were actually going, division by division, I found a problem hiding inside two letters.
R and D.
We say it like it's one thing. It's how we report it in financial filings. It's how Wall Street looks at it. It's how the press views it. But it's not one thing. Research and development are two completely different activities, with completely different time horizons, different risk profiles, and different impacts on the business. The moment you combine them into a single line item, you can move money from one to the other, and nobody outside the building can tell.
That's what we're going to get into in the next episode. The split nobody sees.
Here's a question for you. If you've found a way to connect R&D spending to actual business outcomes in your company, how do you do it? What metric are you using with your leadership to make the difference? Drop it in the comments. I read every one of them, and the best answers end up shaping future episodes.
If this episode changed how you think about innovation investment, hit subscribe so you don't miss the next one. And share this with someone in your company who's fighting this fight right now. They'll thank you for it.
Two ways to keep going between episodes. Studio Notes comes out every Monday. That's where I take apart a real company's innovation decisions using public data. This week I dig into PayPal's innovation health. You want to check that out. Studio Sessions, what you're watching right now, drops every Wednesday. This is where the decisions happened. The real rooms, the real calls, what went right and what went wrong.
Show notes and the full analysis are at philmckinney.com.
The idea was never the hard part. It never is. The call is.
