How-to Benefit from R&D
Small businesses may see as much as a three percent increase in market value for every 10 percent hike in investment in research and development (R&D), according to a March 2009 study sponsored by the U.S. Small Business Administration (SBA). The study found that the relationship between R&D and business growth and innovation can vary according to industry. Industries such as industrial machinery, trucks and tractors, computing equipment, and mechanical goods manufacturing were the most likely to benefit from increased R&D spending.
"The industries that are typically associated with rapid technological improvements benefit from greater R&D expenditures. Industries with more mature activity or that are service-oriented may not reap as much benefit from greater R&D expenditures," say the study's authors, C.J. Isom and David R. Jarczyk, of the Ceteris Inc., an independent economic consulting group.
Many in the public think of R&D as something that only big businesses undertake, plowing billions into huge labs, vast testing fields, wind tunnels, and crash dummies flailing around as autos are crashed into walls. R&D is associated with the pharmaceutical industry, miracle cures, laser eye surgery, and super fast jet travel. To be sure, a vast amount of the money expended on formal research is expended by large corporations -- often on relatively trivial improvements of products already doing quite a good job -- and by government on weapons systems and space exploration. The glory and the power thus displayed before our eyes on television fail to remind us that the crucial research and development on which much else is based has been -- and continues to be -- the work of small businesses and entrepreneurs.
The pages below will outline the role that R&D can play in small business, how to select and terminate R&D projects, and tax advantages of an R&D strategy.
Objectives of R&D in a Small Business
Small businesses are instrumental in fueling the U.S. economy, as they employ half of all private sector employees and generate more than half of the nation's non-farm gross domestic product, according to the SBA. Small firms have also been a harbinger of technological change. They are awarded 13 to 14 more times more patents per employee than large firms, the SBA notes.
Just look behind some of the nation's most profitable industries today and you often find an entrepreneur or a small business. The explosive development of the oil industry was triggered by the invention of an effective kerosene lamp by Michael Dietz in 1859. Dietz ran a small lamp production business. Oil drilling began in earnest to support such lighting applications. An unwanted residue of kerosene refining was -- gasoline, burned off as useless waste -- until the first cars came along. The story of Thomas Edison is worth rereading occasionally to correct ones vision of modern R&D. Chester Carlson, the inventory of xerography, perfected his invention in part-time labors in a makeshift lab while working as a patent attorney. The computer revolution came about because two young men, Steve Wozniak and Steve Jobs, put together a personal computer in a garage and thus triggered the Information Age.
Countless innovations large and small were made by tinkering individuals or small business people trying something new. The fact that many of these entrepreneurial, inventive, innovative, and persistent individuals are the fathers and mothers of great companies -- indeed of whole industries -- that now dominate formal R&D should not obscure their humble beginnings and catch-as-catch-can methods of discovering the new.
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.
Types of R&D
The National Science Foundation (NSF) defines three types of R&D:
Basic Research. 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. 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. 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. Engineering is the application of state-of-the-art knowledge to the design and production of marketable goods. Research creates knowledge, and development designs and builds prototypes and proves their feasibility. Engineering converts these prototypes into products that can be offered to the marketplace or into processes that can be used to produce commercial products and services.
R&D can be conducted in-house, under contract, or jointly with others. In-house R&D commands a strategic advantage: the company is the sole owner of the know-how created and can protect it from unauthorized use. R&D is also basically a learning process; in-house research thus trains the company's own research people who may go on to ever better things.
Selecting R&D Projects
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.
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:
- Maximize the long-term return on investment;
- Make optimum use of the available human and physical resources;
- Maintain a balanced R&D portfolio and control risk;
- 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.
Evaluating 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 a statistical formula. The value is the payoff anticipated—but discounted by probabilities. These are the probability of technical success, the probability of commercial success, and the probability of financial success. Assuming a payoff of $100 million and a fifty-fifty rate of technical success, a commercial success rate of 90 percent, and a financial probability of 80 percent, then the expected value will be $36 million -- 100 discounted by 50, 90, and 80 percent respectively.
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 can be compared with the projected cost of the technical effort. Given a company's usual rate of return on investment, the cost may not be worth the expected value given the risks.
Needless to say, such statistical approaches to evaluation are not silver bullets but as good as the guesses that go into the formula. Businesses use such evaluations, however, when many projects compete for money and some kind of disciplined approach is needed to make choices.
Managing 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.
When to Terminate 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:
- 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;
- Unforeseen technical obstacles are encountered and the laboratory does not have the resources to overcome them; or
- 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 of R&D
In 2008, Congress extended the R&D tax credit for corporations, which allows businesses to deduct R&D expenses from income. The tax credit was initiated in 1981, but expired in 2004 and has had to be renewed every few years. It expired again in 2007, but in October 2008, Congress renewed the tax credit for two years as part of the U.S. mortgage industry bailout. While the tax credit has sometimes come under criticism by those who believe that government subsidies of corporate development are out of place, it's backed by a wide-range of industry groups representing such sectors as technology, manufacturing, chemical, and pharmaceuticals.
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