The Allocation Decision on Research and Advertising Spending by Small and Large Firms - an Illustration of Four Industries
Posted: 25 Nov 1996
Date Written: July 1996
Many studies investigate the relationship between firm size and spending on research and development (R&D) and advertising and promotion (A&P) activities. Such relationship may yield insights into the effect of firm size on the effect (the marginal benefit) of the spending and thus facilitate managers of different firms in making optimal investment decisions. Studies have shown that R&D and A&P have long-term effects on firms' profitability; however, they are expensed a incurred as required by generally accepted accounting principles (GAAP). This expense treatment could lead managers to budget spending for R&D and A&P activities based on their relation to sales; accordingly, an intensity measure t relates the expense to sales has been a popular surrogate for researching discretionary spending behavior.This paper discusses the inappropriateness of using the intensity measure to investigate the relationship between firm size and spending effectiveness on R&D or A&P when both activities are important. We propose a decomposition model of the intensity measure, which includes a variable that indicates the all decision on either the R&D or the A&P spending given the total budgeted discretionary spending. This allocation variable reveals the relative marginal b of R&D and A&P activities. Using four industries (two R&D- intensive, two A&P-intensive) to illustrate the model, we find that the intensity measures are often inconsistent in assessing the firm size effect on the spending across industries however, the allocation variable reveals consistent economic relationships between firm size and spending effectiveness. The model and the results described in this paper enlarge the avenue in researching firms' spending on multiplediscretionary activities.
JEL Classification: G31, M49
Suggested Citation: Suggested Citation