This article, the first in the our guide on R&D, delves deeper into the question of why R&D is so important for companies despite a lack of evidence of its value and the difficulties in measuring the potential impact of R&D activities. This content will help firms improve their R&D function by looking at leading tech innovators and their practices.
The State of Modern R&D
“The enterprise that does not innovate ages and declines. And in a period of rapid change such as the present, the decline will be fast.” Peter Drucker, Legendary business author and management consultant
The appetite for R&D investment is on the rise spurred by technology advancements such as artificial intelligence, AR and VR, robotics, and 3D printing. All of these technologies and more are paving the way for new products that are changing the way we live and work.
This appetite is reflected by huge R&D corporate budgets. Specialist R&D tax advisers Swanson Reed reported that, in 2015, business R&D spending reached $356 billion in the United States, an increase from the previous year of close to 5 percent. Swanson Reed also reported that companies are also investing more of their own funds in R&D, particularly manufacturing companies, which accounted for over 60 percent of domestic R&D spending.
This torrent of R&D activity, somewhat based on the belief of many that R&D is the way to market leadership, belies the fact that no scientific correlation has been found between R&D expenditure and company performance.
According to Tendayi Viki, Managing Partner at Benneli Jacobs, a strategy and innovation consultancy firm, the belief that R&D spending is somehow connected to increased innovation, revenue growth and profits is just a presumption.
PwC’s Strategy& has published the top 1,000 most innovative companies in its annual report for the past 12 years or more. Interestingly, each year, the top 10 most innovative companies are rarely the top 10 spenders on R&D.
So, why are companies investing so heavily in a strategy that has no empirical connection to profits?
Fundamentally, companies spend on R&D to stay ahead of the curve. While sales and operations keep companies afloat, R&D is among the tools that companies must leverage to evolve and prepare for the future. Unlike some of the other tools in the growth and innovation arsenal focused on discovering and fast-following opportunities, R&D is a long-term strategy that creates original moats supported by intellectual property and unique efficiencies. While spending on R&D may not bring the instant lucrative breakthrough, it keeps a company on a level playing field with its competitors as technology and industry practices advance (in addition to providing tax benefits.)
How Big Tech Does R&D
While corporations are spending more than ever on R&D, at the same time, R&D productivity on a national level is on the decline. Further, The United States has dropped out of the top 10 in Bloomberg’s Innovation Index.
While R&D is struggling on a macro-level, the leaders in the modern economy — “ Big Tech” (Amazon, Google, Microsoft, Facebook, etc) — all have fruitful R&D programs. In the following section, we dive into examples of Big Tech R&D strategy.
Choosing an R&D strategy requires following a model, preferably one based on quantifiable data. One problem that Knott’s RQ highlights is the difficulty inherent in determining the impact of R&D.
R&D is difficult to benchmark among firms because R&D practices and strategies are unique to individual firms. For example, Amazon’s practice of expensing R&D hides the firm’s economic earnings. According to Valens Research, for Amazon, “GAAP guidelines that require R&D costs to either be expensed or capitalized from acquisitions as in-process, or written off later leads to a low-quality earnings number and an unreliable balance sheet.”
Therefore, comparing the results of R&D across different companies and industries to find patterns, as Knott did, is troublesome. For example, tech companies spend more on R&D than any other companies in the United States (23 percent in 2017, according to PwC). In contrast, consumer packaged goods (CPG) companies are spending a fraction of that (3 percent in 2017, according to PwC), and 60 to 80 percent of their budgets go towards renovation and maintenance of existing products.
Source: PwC Innovation 1000, 2017
Zoom in on tech companies and the picture becomes even murkier. As a percentage of revenue, firms such as Apple spend very little on R&D, 3 percent, while Facebook spends 21 percent, according to Alice Truong, reporter for Quartz.
Source: Truong, 2014
Comparisons of industries and firms are problematic because there are so many variables.
This lack of relationship doesn’t mean R&D shouldn’t be pursued – Amazon, Facebook, Google, and Microsoft all have high (and increasing) R&D expenditures and are also considered some of the most innovative in the world. Although R&D is a highly individualized process and trends cannot be easily measured on a macro-level, we can look to these big tech firms as a valuable source of examples of what good R&D looks like.
R&D Case Studies
Recent headlines exemplify the race to the next breakthrough transformational that is ongoing among the market leaders. For example:
“Google continues its explosive spending on R&D,” Chris O’B
“Amazon Is Spending Insane Amounts of Money on Research So That It Keeps Crushing Rivals,” Lindsay Rittenhouse, The Street
“Apple R&D Spend Exceeds $3 Billion for the First Time, up $410 Million from September,” Mikey Campbell, Appleinsider
“Alibaba is Doubling its R&D Spend to $5 billion — But that’s Less Than a Third of What Amazon Spends,” Rani Molla, Recode
Here’s a closer look at two of the most interesting R&D leaders, Amazon and Google, and their approaches to R&D.
Amazon: R&D as a Culture
Amazon is the third most valuable in the world, and has been has been ramping up R&D spending since its inception. It has surpassed Volkswagen as the world’s highest spender on R&D, and the company is nipping at the heels of Apple and Alphabet in terms of market capitalization
Amazon’s most visible efforts are found in Lab126, an R&D subsidiary based in Sunnyvale, California. This is the branch responsible for all of the hardware products tied to Amazon — the Kindle, Echo, and the [ashamed] Fire Phone. The lab continues to push out devices, launching the Echo Show, Echo Spot, and redesigning the Fire TV and original Echo — all within a matter of months.
According to Dan Gallagher, reporter for The Wall Street Journal, Amazon spent over $5.5 billion in the second quarter of 2017, which was a year-over-year increase of over 40 percent, and the firm shows no signs of slowing its R&D expenditures.
Amazon’s profitability has benefited from its growing cloud business, which has provided some buffer against the R&D spending that does not provide breakthrough products. But Amazon persists in R&D even in markets where it is already beating its rivals.
Amazon’s Echo dominates the voice-activated speaker market yet the company has issued a newer version that is priced 45 percent less than its predecessor, a move expected to increase the market value of Echo five-fold by 2026. And, referring to the Alexa platform, Amazon CEO Jeff Bezos said: “expect us to double down.”
To better understand the origin of Amazon’s R&D strategy, we can look at Bezos’ 2010 Letter to Shareholders. Bezos explains why Amazon aggressively invests in technology, and it goes beyond Lab126:
“All the effort we put into technology might not matter that much if we kept technology off to the side in some sort of R&D department, but we don’t take that approach. Technology infuses all of our teams, all of our processes, our decision-making, and our approach to innovation in each of our businesses. It is deeply integrated into everything we do.” Bezos adds, “these techniques are not idly pursued – they lead directly to free cash flow.”
This quote explains the importance of R&D activities while at the same time highlighting aspects of Amazon’s culture: innovation and growth are built into every segment of the company, not just R&D.
Amazon’s R&D strategy suggests many best practices. Here are two:
- Use technology throughout an organization not just as part of partitioned R&D activities.
- Recognize core competencies and maximize them.
Google X: Searching for Radical Breakthroughs
R&D, rather than siloed off to a separate corporate arm or department with a separate budget, is often tied throughout a company’s operations, as is evident in Bezos’ letter to shareholders. At the same time, R&D can also be responsible for many of these companies most ambitious (and sometimes bizarre) projects that are not part of a firm’s core competencies.
Google has a sandbox meant solely for these types of projects — “X.” X, aptly subtitled, “The Moonshot Factory,” focuses on radical projects that are 10 times better than any existing solution. Why? According to Astro Teller, director of Google X, a 10 times improvement is often easier than a 10 percent improvement.
Teller explains that when looking for a 10 percent improvement, a company is tied to existing technologies and solutions, but when shooting for 10 times, anything goes. Moonshots are at the intersection between a huge problem, a radical solution, and a breakthrough technology.
The most visible effort from Google X is its autonomous car project, spun out as an Alphabet Subsidiary called Waymo. The Waymo moonshot is framed as follows:
Problem: Close to 1.25 million people die on roads every year globally, and 94 percent of those accidents are caused by human error.
Radical Solution: What if cars could drive people safely from point A to point B at the push of a button — without needing a human to take over driving at any time?
Breakthrough Technology: Vehicles could have built-in sensors to detect pedestrians, cyclists, vehicles, road work and more from a distance of up to two football fields away in all directions. Smart software could predict the behavior of objects and road users to help the vehicle navigate the vehicle safely through everyday traffic.
Source: Waymo, 2017
Today, Waymo is the frontrunner in the autonomous car space. Lucinda Shen, reporter for Fortune, writes that analysts from Morgan Stanley have estimated the firm’s value at or near $70 billion dollars. Waymo struck a partnership in 2017 with Lyft, which has the second biggest volume in U.S. ride service. Further, Shen reports that Waymo and Honda are close to finalizing a deal to build automated delivery vehicles, which is a significant commercialization push from a giant that generates around 90 percent of its revenue from advertising. But this success doesn’t come without struggles.
Google X kills projects — a lot of them. For every Waymo or Verily (Google X’s life science spinoff), there are countless projects that don’t make the cut. “We killed over 100 investigations last year alone,” Teller states in a 2017 Ted talk.
The organization moves quickly, fails a lot, and iterates based on feedback. Teller describes the thought process behind the killing of their buoyant cargo ship project:
“However cheap they would be in volume, though, we found out it was likely to cost close to $200 million for the R&D and materials to design and construct the first one. Since X is structured around tight feedback loops of making mistakes, learning, and new designs, $200 million is way too expensive for us to get the first data point on whether we’re on the right track.”
This cost-benefit analysis must run through every decision, from the mundane to the risky. Both organizations, Google and Amazon, exemplify a mastery over the R&D portfolio, allocating resources to both incremental and radical advancements.
Google’s R&D strategy also suggests best practices that the lay company can apply:
- Balance risk and potential breakthrough goals with investor and stakeholder tolerance.
- Develop a cut-throat portfolio selection strategy.
The final article in this series on R&D, “Metrics and Best Practices for R&D Optimization” will summarize how to avoid the pitfalls of R&D expenditure, what metrics to use in portfolio selection and management, and summarizes best practices for portfolio selection.
West Stringfellow spent over 20 years launching products and leading innovation at corporate giants and startups, holding management roles at Target, PayPal, VISA, Rosetta Stone, GraysOnline and Amazon.
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