Is R&D Really The Secret Sauce?

Should ExxonMobil [XOM] increase its R&D spending from $1 billion to an “optimal level” of $135 billion, a mere increase of 13,500 percent? Is General Motors [GM] as effective at R&D as Apple [AAPL]? Should Johnson & Johnson [JNJ] cut back on R&D spending? These are some of the unusual conclusions that come out of the article by Anne Marie Knott in April issue of Harvard Business Review, The Trillion-Dollar R&D Fix. It offers us a formula for determining the right level of firm spending on R&D. Given the conclusions from using the formula, one is tempted to wonder whether something is amiss.

Does R&D spending correlate with results?

The article begins from the well-known premise that R&D spending doesn’t correlate with market value or growth. It quotes Booz & Company’s annual innovation reports, “Spending more on R&D won’t drive results. The most crucial factors are strategic alignment and a culture that supports innovation.” The trouble, according to the HBR article is that it’s “hard to measure culture or alignment, let alone link them to profitability or market value.”

But wait a moment! Hold everything! According to the HBR article, it turns out that spending more on R&D will generally drive results. Apparently, there is a magic measure that does correlate with profitability and market value. The article calls it "RQ".

According to the article, 19 out of the 20 largest public companies should massively increase their spending on R&D. If the 20 companies followed the article’s advice, it would increase their market capitalization by a tidy $1 trillion.

The magic measure of R&D spending: RQ

RQ is the firm-specific output elasticity of R&D spending. In effect, RQ is the percentage increase in output from one percent increase in R&D spending.

RQ is scaled like the human IQ scale where the mean is 100 and a standard deviation is 15. The analogy is to individual human IQ. Individuals with higher IQ solve more problems per unit of input. Firms with higher RQ get more return from their R&D spending.

The article argues that RQ is the most intuitive measure you can construct for R&D effectiveness: it’s also universal, uniform and reliable.

According to the article, it solves the up-front problem of setting R&D budgets. Increasing R&D spending by 10% (or reducing it for the very few over-spenders) would lead to a $1 trillion increased market cap just for the top 20 firms. It would also enable medium term benefits with better R&D allocation and increased profits and market value. RQ would also solve the back-end problem of evaluating the effectiveness of R&D, by enabling firms to keep what’s effective and drop what isn’t.

Funny numbers

Sounds logical, but using the formula leads to some odd conclusions.

Exxon Mobil (RQ108) with a current R&D spend of $1 billion has an “optimal R&D spend” of a whopping $135 billion, an increase of 13,500 percent.
General Motors and Apple have the same RQ (105)
Hewlett Packard (RQ=114) is a lot more effective at R&D spending than Apple.
Procter & Gamble (RQ=101) and IBM (RQ=100) are just average in terms of R&D effectiveness spending.
A company well-known for its innovativeness, Johnson & Johnson (RQ101), is the one company of the largest 20 firms which is singled out for spending too much on innovation. It spends $6.8 billion on R&D revenues of $62 billion, whereas it’s optimal R&D spend is $5.4 billion.

What’s going on here? The truth is that, the article notes at the outset, firms need innovation, not necessarily R&D. Innovation involves a lot more than R&D spending.

Innovation, not just R&D

Let’s back up and consider the article’s conceptual framework that leads to these odd conclusions.

In the 20^th Century management, the production function was separate from the R&D function. The function of R&D was to develop new activities to be introduced over time into the production function. The main job of management was to drive the variability and costs out of the production function. The managers gave instructions to workers, because they knew best. The goal of the firm was to make money for the company, i.e. maximizing shareholder returns. Cost-cutting provided a sure and immediate boost to the bottom line, whereas innovation provided an uncertain and usually delayed return. Since R&D is expensed rather than capitalized, cuts in R&D spending yield immediate increases in profit. So firms systematically under-emphasized innovation. In the 20^th Century, this didn’t matter very much. Big firms were in charge of the marketplace and could do very nicely, cruising along, largely doing more of the same.

In the 21^st Century, everything is different. That’s because, first, the barriers to entry have broken down. This includes distribution monopolies, customer ignorance and proprietary technology. The big oligopolies are no longer in charge. The life expectancy of the Fortune 500 is in sharp decline. Second, value is generated by the workers who have become knowledge workers and who often know more than the managers about what works and what doesn’t. The role of managers becomes enabling rather than controlling the workers. Third the locus of value creation has shifted closer to the customer. And fourth, knowledge diffuses rapidly. As John Hagel, John Seely Brown and Lang Davison point out in The Power of Pull (2010), mastering knowledge flows is at least as important as funding in-house R&D.

As a result, innovation has become central to everything. In today’s world, as Gary Hamel has written, “We owe our existence to innovation. We owe our prosperity to innovation… We owe our happiness to innovation… We owe our future to innovation… Innovation isn’t a fad—it’s the real deal, the only deal. Our future no less than our past depends on innovation.”

In effect, management has become the art and science of generating continuous supply of additional value and delivering it sooner so as to delight customers. In a phrase: continuous innovation. The idea of looking at R&D as a separate function from production is obsolete. R&D is merely one input into innovation. R&D spending in particular is a poor measure or determinant of the innovation on which the future of the firm rests.

Firms do need more innovation

It’s true that more innovation is needed from today’s big firms, as one can see from the horrible multi-decade decline in the return on assets and invested capital as shown in the Shift Index.

Money vs mindsets

Merely throwing more money at R&D departments doesn’t necessarily create innovation. Companies with a culture based on making money principally by cost cutting are unlikely to use the money effectively for innovation that will generate organic growth.

Apple [AAPL] may not have a large R&D budget but it is hugely innovative, focusing on delighting the customer in everything it does.

Given the innovation-hostile culture of hierarchical bureaucracy, it’s quite possible that the level of spending in these companies is already close to optimal for that culture.

The right response to a lack of innovation is not to throw more money at R&D. The first step is to change the innovation-hostile culture. The firm's top management needs to lead a shift in mindset so that innovation is front and center of everything that the company.

Failure to spend enough on innovation is a result of a culture focused on maximizing shareholder value—the dumbest idea in the world—not the cause.

The culture shift to continuous innovation

Rescuing firms from their innovation-hostile habits won’t be easy. For most organizations, it will take a phase change to the Creative Economy. It will mean rethinking the very basis of the corporation and the way business is conducted, as well as the values of an entire society.

“We must shift the focus of companies back to the customer and away from shareholder value,” says Roger Martin in Fixing the Game (2011)

It also means specific management changes, starting from the goal of the firm becomes that of innovating so as to add value for the customer. A radically different kind of management needs to be in place, with a different role for the managers, a different way of coordinating work, a different set of values and a different way of communicating. This is not rocket science. It’s called radical management.

Throwing more money at R&D might help firms to thrive in the 20^th Century. It's not the recipe for success in the 21^st.

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