RESEARCH AND DEVELOPMENT

Research and development (R & D) is a process intended to create new or improved technology that can provide a competitive advantage at the business, industry, or national level. While the rewards can be very high, the process of technological innovation (of which R & D is the first phase) is complex and risky. The majority of R & D projects fail to provide the expected financial results, and the successful projects (25 to 50 percent) must also pay for the projects that are unsuccessful or terminated early by management. In addition, the originator of R & D cannot appropriate all the benefits of its innovations and must share them with customers, the public, and even competitors. For these reasons, a company's R & D efforts must be carefully organized, controlled, evaluated, and managed.

OBJECTIVES AND TYPES OF R & D

The objective of academic and institutional R & D is to obtain new knowledge, which may or may not be applied to practical uses. In contrast, the objective of industrial R & D is to obtain new knowledge, applicable to the company's business needs, that eventually will result in new or improved products, processes, systems, or services that can increase the company's sales and profits.

The National Science Foundation (NSF) defines three types of R & D: basic research, applied research, and development. Basic research has as its objectives a fuller knowledge or understanding of the subject under study, rather than a practical application thereof. As applied to the industrial sector, basic research is defined as research that advances scientific knowledge but does not have specific commercial objectives, although such investigation may be in the fields of present or potential interest to the company.

Applied research is directed towards gaining knowledge or understanding necessary for determining the means by which a recognized and specific need may be met. In industry, applied research includes investigations directed to the discovery of new knowledge having specific commercial objectives with respect to products, processes, or services. Development is the systematic utilization of the knowledge or understanding gained from research toward the production of useful materials, devices, systems, or methods, including design and development of prototypes and processes.

At this point, it is important to differentiate development from engineering, which can be defined as utilization of state-of-the-art knowledge for the design and production of marketable goods and services. In other words, research creates knowledge and development designs, and builds prototypes and proves their feasibility. Engineering then converts these prototypes into products or services that can be offered to the marketplace or into processes that can be used to produce commercial products and services.

R & D AND TECHNOLOGY ACQUISITION

In many cases, technology required for industrial purposes is available in the marketplace, usually for a price. Before embarking on the lengthy and risky process of performing its own R & D, a company should perform a "make or buy" analysis and decide whether or not the new R & D project is strategically and economically justified. The following influencing factors should be considered: proprietariness, timing, risk, and cost.

PROPRIETARINESS If a technology can be safeguarded as proprietary—and protected by patents, trade secrets, nondisclosure agreements, etc.—the technology becomes exclusive property of the company and its value is much higher. In fact, a valid patent grants a company a temporary monopoly for 17 years to use the technology as it sees fit, usually to maximize sales and profits. In this case, a high-level of R & D effort is justified for a relatively long period (up to 10 years) with an acceptable risk of failure.

On the contrary, if the technology cannot be protected, as is the case with certain software programs, expensive in-house R & D is not justified since the software may be copied by a competitor or "stolen" by a disloyal employee. In this case, the secret of commercial success is staying ahead of competition by developing continuously improved software packages, supported by a strong marketing effort.

TIMING If the market growth rate is slow or moderate, in-house or contracted R & D may be the best means to obtain the technology. On the other hand, if the market is growing very fast and competitors are rushing in, the "window of opportunity" may close before the technology has been developed by the new entrant. In this case, it is better to acquire the technology and related know-how, in order to enter the market before it is too late.

RISK Inherently, technology development is always riskier than technology acquisition because the technical success of R & D cannot be guaranteed. There is always the risk that the planned performance specifications will not be met, that the time to project completion will be stretched out, and that the R & D and manufacturing costs will be higher than forecasted. On the other hand, acquiring technology entails a much lower risk, since the product, process, or service can be seen and tested before the contract is signed.

Regardless of whether the technology is acquired or developed, there is always the risk that it will soon become obsolete and be displaced by a superior technology. This risk cannot be entirely removed, but it can be considerably reduced by careful technology forecasting and planning. If market growth is slow, and no winner has emerged among the various competing technologies, it may be wiser to monitor these technologies through "technology gatekeepers" and be ready to jump in as the winner emerges.

COST For a successful product line with relatively long life, acquisition of technology is more costly, but less risky, than technology development. Normally, royalties are paid in the form of a relatively low initial payment as "earnest money," and as periodic payments tied to sales. These payments continue throughout the period of validity of the license agreement. Since these royalties may amount to 2 to 5 percent of sales, this creates an undue burden of continuing higher cost to the licensee, everything else being equal.

On the other hand, R & D requires a high front-end investment and therefore a longer period of negative cash flow. There are also intangible costs involved in acquiring technology—the license agreements may have restrictive geographic or application clauses, and other businesses may have access to the same technology and compete with lower prices or stronger marketing. Finally, the licensee is dependent upon the licensor for technological advances, or even for keeping up to date, and this may be dangerous.

MOVING AHEAD WITH R & D

Once the decision has been made to perform R & D, the company should decide where and how such R & D should be carried out. There are various possibilities: in-house R & D in the company laboratories, externally contracted R & D, and joint R & D. In-house R & D commands a strategic advantage, since the company is the sole owner of the technology and can protect it from unauthorized uses. In addition, since R & D is basically a learning process, the company can develop a group of experienced scientists and engineers that can be employed in developing more advanced products and processes and in transferring the results of their R & D to operations and to customers. However, since R & D personnel do not like to work alone and are stimulated by peers, the laboratory should have a critical mass in the core technologies and support services; this critical mass may exceed the company resources.

External R & D is usually contracted out to specialized nonprofit research institutions or to universities. The advantages are that these institutions may already have experienced personnel in the disciplines to be researched, as well as the necessary laboratory and test equipment. This will save money and especially time with respect to in-house R & D. The disadvantages are that the company will not benefit from the learning experience, and may become overly dependent on the contractor. Also, the technology transfer may be difficult, and there is always the possibility of leaks to competitors. In the case of universities, costs are usually lower, and there is the additional benefit of identifying graduate students who may be hired later and researchers who may be employed as consultants when needed.

Joint R & D became popular in the United States after antitrust laws were relaxed and tax incentives were offered to R & D consortia. In a consortium, several companies with congruent interests join together to perform R & D, either in a separate organization or in a university. The advantages are lower costs, since each company does not have to invest in similar equipment; a critical mass of researchers; and inter-change of information among the sponsors. The disadvantages are that all the sponsors have access to the same R & D results. However, because of antitrust considerations, the R & D performed must be precompetitive, and each participant in the joint R & D must apply separately the information obtained to its products, processes, and services.

R & D PROJECT SELECTION, MANAGEMENT, AND TERMINATION

Industrial R & D is generally performed according to projects (i.e., separate work activities) with specific technical and business goals, assigned personnel, and time and money budgets. These projects can either originate "top down" (for instance, from a management decision to develop a new product) or "bottom up" (from an idea originated by an individual researcher). The size of a project may vary from a part-time effort of one researcher for a few months with a budget of thousands of dollars, to major five- or ten-year projects with large, multidisciplinary teams of researchers and budgets of millions of dollars. Therefore, project selection and evaluation is one of the more critical and difficult subjects of R & D management. Of equal importance, although less emphasized in practice, is the subject of project termination, particularly in the case of unsuccessful or marginal projects.

SELECTION OF R & D PROJECTS Normally, a company or a laboratory will have requests for a higher number of projects than can be effectively implemented. Therefore, R & D managers are faced with the problem of allocating scarce resources of personnel, equipment, laboratory space, and funds to a broad spectrum of competing projects. Since the decision to start on an R & D project is both a technical and a business decision, R & D managers should select projects on the basis of the following objectives, in order of importance:

1. Maximize the long-term return on investment;
2. Make optimum use of the available human and physical resources;
3. Maintain a balanced R & D portfolio and control risk;
4. Foster a favorable climate for creativity and innovation.

Project selection is usually done once a year, by listing all ongoing projects and the proposals for new projects, evaluating and comparing all these projects according to quantitative and qualitative criteria, and prioritizing the projects in "totem pole" order. The funds requested by all the projects are compared with the laboratory budget for the following year and the project list is cut off at the budgeted amount. Projects above the line are funded, those below the line delayed to the following year or tabled indefinitely. Some experienced R & D managers do not allocate all the budgeted funds, but keep a small percentage on reserve to take care of new projects that may be proposed during the year, after the laboratory official budget has been approved.

EVALUATION OF R & D PROJECTS Since R & D projects are subject to the risk of failure, the expected value of a project can be evaluated according to the following statistical formula:

EV=P×pt×pc×pf

where P is the payoff if the project is successful; that is, the stream of net income accruing to the company over the life of the new product (or process, or service) resulting from the project. The payoff P is then multiplied by the probability of success, which is the product of three separate probabilities:

1. pt is the probability of technical success, i.e., that the new product or process will meet the technical and functional specifications
2. pc is the probability of commercial success, i.e., that the new product will be accepted by the marketplace and will achieve the forecasted market share
3. pf is the probability of financial success, i.e., that the new product will achieve the forecasted financial goals, in terms of profits, return on investment, and cash flow.

Consequently, project evaluation must be performed along two separate dimensions: technical evaluation, to establish the probability of technical success; and business evaluation, to establish the payoff and the probabilities of commercial and financial success. Once the expected value of a project has been determined, it should be divided by the forecasted cost C of the project, in order to obtain a benefit/cost ratio R of the form R EV/C. Obviously the higher this ratio, the more desirable the project.

For more advanced and longer term projects, leading to major (rather than incremental) innovation, it may be difficult to establish reliable values of P, C, pt, pc, and pf. In this case, a relative comparison of projects is made based on their respective technical quality and potential business value. Technical quality is evaluated by analyzing and rating the clarity of the project goals; the extent of the technical, institutional, and market penetration obstacles that must be over-come; the adequacy of the skills and facilities available in the laboratory for carrying out the work; and how easily can the project results be transferred to an operation. Potential business value of a project is defined in terms of the market share of an existing market that can be captured by the new product; or by the size of a new market that can be developed by the new product; or by the value of new technology that can be sold by the company or transferred to its customers.

After the first tentative list of projects has been established in order of priority, it is "matched" with the existing laboratory human and physical resources to make sure that these resources are well utilized. In fact, creative human resources are the laboratory's most valuable asset, and these should not be wasted by asking researchers to do work outside their disciplines and interests. Also, it is difficult to change in a short time the "mix" of available disciplines and equipment, and to hire and fire researchers. Thus, a shift towards new disciplines should be done gradually, avoiding the underutilization or overloading of the existing resources.

Once the tentative list of prospects has been modified according to the above, the entire project portfolio of the R & D laboratory should be balanced, in order to control risk, according to three types of probabilities listed above. Technical risk is controlled in two ways:1) by having a spectrum of projects ranging from low to medium-high technical risk; 2) by avoiding "bunching" too many projects in the same technology, particularly if the technology could be replaced by a superior technology during the expected lifetime of the new product.

Commercial risk can be controlled by not having "too many eggs in one basket," that is, by targeting different market segments (government, capital equipment, consumer, industrial, international, etc.) and attacking different competitors, since directly targeting a major competitor may trigger a dangerous counter offensive and a price war. Financial risk is controlled by having a majority of small- and medium-size projects (in terms of R & D expense), a few large projects, and no projects that, in case of failure, could bankrupt the company. Financial risk, in terms of cash flow, is also controlled by having a spectrum (in time-to-payoff) of more short- and medium-term projects than long-term projects. This type of spectrum is also psychologically important to maintain the credibility of the R & D laboratory in the face of upper-level executives who keep asking "What have you done for me lately?"

By definition, R & D is a risky activity, and there are no "zero risk" R & D projects, since these would then be engineering projects. While the majority of the projects in an R & D portfolio should be categorized as low-risk, some medium-risk projects are justified, and even a few high-risk projects, provided their expected value is high.

Finally, project evaluation and selection should be made objectively, in order to develop and maintain a favorable climate for creativity and innovation. Researchers will be naturally disappointed when their projects are not approved. Some may even suspect that other projects were preferred for subjective reasons, such as the "halo" effect (the past track record and prestige of other, more senior, researchers), the reluctance of management to terminate less deserving projects, and especially political influences to select "pet" projects of executives. If there is a feeling that project selection is not done objectively, many researchers, particularly the junior ones, will lose their enthusiasm and renounce proposing new projects of a high potential value for the company. Eventually, if this situation persists, the laboratory will lose its creativity and concentrate on routine low-risk (but also low-payoff) or "political" projects, and it will have difficulty in keeping and attracting the best researchers. Therefore, it is desirable that the project evaluation and selection criteria be properly explained and that all researchers be asked to participate in the evaluation process. Also, the finalized project portfolio should be presented to, and discussed with, all the researchers.

MANAGEMENT OF R & D PROJECTS The management of R & D projects follows basically the principles and methods of project management. There is, however, one significant caveat in relation to normal engineering projects: R & D projects are risky, and it is difficult to develop an accurate budget, in terms of technical milestones, costs, and time to completion of the various tasks. Therefore, R & D budgets should be considered initially as tentative, and should be gradually refined as more information becomes available as a result of preliminary work and the learning process. Historically, many R & D projects have exceeded, sometimes with disastrous consequences, the forecasted and budgeted times to completion and funds to be expended. In the case of R & D, measuring technical progress and completion of milestones is generally more important than measuring expenditures over time.

TERMINATION OF R & D PROJECTS Termination of projects is a difficult subject because of the political repercussions on the laboratory. Theoretically, a project should be discontinued for one of the following three reasons:

1. There is a change in the environment—for instance, new government regulations, new competitive offerings, or price declines—that make the new product less attractive to the company;
2. Unforseen technical obstacles are encountered and the laboratory does not have the resources to overcome them; or
3. The project falls hopelessly behind schedule and corrective actions are not forthcoming.

Due to organizational inertia, and the fear of antagonizing senior researchers or executives with pet projects, there is often the tendency to let a project continue, hoping for a miraculous breakthrough that seldom happens.

In theory, an optimal number of projects should be initiated and this number should be gradually reduced over time to make room for more deserving projects. Also, the monthly cost of a project is much lower in the early stages than in the later stages, when more personnel and equipment have been committed. Thus, from a financial risk management viewpoint, it is better to waste money on several promising young projects than on a few maturing "dogs" with low payoff and high expense. In practice, in many laboratories it is difficult to start a new project because all the resources have already been committed and just as difficult to terminate a project, for the reasons given above. Thus, an able and astute R&D manager should continuously evaluate his/her project portfolio in relation to changes in company strategy, should continuously and objectively monitor the progress of each R&D project, and should not hesitate to terminate projects that have lost their value to the company in terms of payoff and probability of success.

TAX ADVANTAGES FOR R & D

Since 1981, American companies engaging in R & D have been entitled to a federal tax credit equal to 20 percent of R & D expenditures over a base amount. The base amount is determined by the company's R & D spending patterns in prior years. This tax credit can be claimed every year, and there is no upper dollar limit. As Daniel Kadlec explained in Fortune, "The R & D tax credit is designed to spur innovation by reimbursing companies for some of the costs of engineering better mousetraps."

Some taxpayers resent subsidizing corporate R & D expenditures. After all, corporations that introduce successful new products based on R & D stand to reap huge financial rewards once their products reach the marketplace. Opponents of the tax credit argue that companies thus have ample incentives to fund their own R & D. "Yet there is a limit to how much money private industry is willing to gamble on products that may or may not pan out," Kadlec noted. "If a government kickback for research increases the amount of research being done, then it has value to the economy and society in ways that are hard to measure."

Supporters of the tax credit—which costs the federal government $2.2 billion per year—claim that it pays for itself by creating jobs and stimulating innovation and productivity. They also argue that it adds tangible net worth to small businesses engaged in developing new products and technologies, which makes them more attractive to investors and supports their growth. The R & D tax credit is scheduled to expire in 2004, but it seems likely to be made permanent by Congress before that time.

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