Internal R&D--vital but only one piece of the innovation puzzle.

In "Why Big Companies Can't Invent," venture capitalist Howard Anderson asserts that in recent years corporate R&D has not worked well, if at all (1). His article cites how companies like IBM, Apple and Xerox have invested in R&D without reaping significant benefits while being outperformed

by competitors with more meager R&D budgets. Factors that have eroded R&D effectiveness in recent years, the article contends, include the inability of firms to nurture and exploit disruptive technologies, the availability of venture capital to fund startups and poor corporate execution, including insufficient corporate incentives.

We certainly agree with the assertion of the value that startups bring to innovation. We even agree that corporate R&D is overdue for revitalization in many firms. However, R&D is still alive and well at big companies, providing value both within the firms conducting the R&D and in society at large. While "Why Big Companies Can't Invent" cites some valid examples of corporate R&D failures, as we discuss below, it overlooks the evidence of recent corporate R&D successes.

So why do some companies succeed where others fail? We believe the answer lies in a firm's ability to establish an integrated innovation strategy for managing multiple sources of innovation (i.e., internal R&D, acquisitions, joint ventures and licensing) as a portfolio of opportunities.

Corporate R&D Successes

Although Anderson cites some valid examples of corporate R&D failures, one would be remiss to overlook the evidence of recent corporate R&D successes. For example, Eli Lilly generates one-third of its $12 billion in annual sales from Zyprexa, a drug for schizophrenia and bipolar disorders, which was developed through internal R&D. Glaxo, now part of GlaxoSmithKline, developed Flonase, a steroid for treating nasal allergies that has captured a 45-percent market share. General Electric developed LightSpeed, a revolutionary imaging technology that accounts for nearly 80 percent of revenues in GE's CT-scanning unit (2).

And although Apple is called out as having a poor R&D record, its iTunes Music Store (Time's Invention of 2003) reportedly sold 1 million music tracks within the first week of product launch, sold 85 million tracks within the first year and currently sells nearly 2.5 million tracks per week as it expands beyond the U.S. market (3). Apple's iTunes is supported by iPod, already a pop culture icon that is boosting Apple's revenues and brand.

Successes such as these will continue to drive corporations to increase their investments in R&D. Granted, industrial R&D investments have experienced a short-term drop, which is to be expected given the recent recession. However, surveys show that leading companies intend to increase R&D spending as the market improves. For example, GE, widely regarded as one of the best-managed companies in the world, committed $2.7 billion to R&D in 2003, representing a steady increase from the previous two years. CEO Jeff Immelt is making R&D his first major initiative after succeeding Jack Welch.

Cisco Systems is another example. Cisco did not invest heavily in internal R&D during its growth phase in the late 1990s. Instead, with its stock-rich positioning in the market, the company grew via acquisitions. However, internal R&D now has become an important part of Cisco's innovation portfolio. Its R&D-to-sales ratio of 18 percent gives Cisco the highest R&D intensity of the top 17 R&D-investing firms in 2002.

Similarly, Oracle and EMC were cited in "Why Big Companies Can't Invent" as examples of young firms, without significant R&D, stealing market share from IBM. In 2002, however, the R&D-to-sales activity for both Oracle and EMC exceeded that of IBM by a factor of two on average (4). In fact, industry continues to supply 63 percent of total U.S. R&D funding (5), outstripping the investments by the U.S. government and institutional venture capital investors in early-stage technologies. Market leaders in many industries outpace their smaller competitors in R&D spending and patents filed.

Researchers have found the return on R&D to exceed return on physical-asset investment, where the latter only matches the cost of capital of a firm (6). A recent study by Eberhart et al also supports that R&D investments have a positive effect on stock price and operating performance over the life of the firm (7). Five firms--ExxonMobil, Ford, General Electric, General Motors, and IBM--have remained in the Fortune 10 rankings since 1965. Of these, IBM and GE have built the largest cumulative U.S. patent portfolios. Ford and GM ranked in the top five in total R&D investment for 2003 (4).

Not every firm must innovate to be successful, and increasing R&D spending is not necessarily a formula for business success; however, many large firms have clearly found investments in internal R&D to yield long-term benefits.

Upon closer examination, even classic examples of what some have termed "failed internal R&D" reveal insights that support the intrinsic value of corporate R&D. Consider the notorious example of Xerox-PARC. As Chesbrough articulates in Open Innovation (8), by 2001 the cumulative market capitalization of the 24 Xerox-PARC spin-off companies (including Adobe Systems and 3Com) exceeded that of Xerox by a factor of two. The issue was not one of value creation by internal R&D but rather one of harnessing that value for the investing firm. This leads us to the next phase of our discussion.

The Need for an Integrated Innovation Strategy

Perhaps more important than the "R&D investment question" for a company is the issue of its integrated innovation strategy. The need to be innovative within a firm is as strong today as ever. Only now the game has changed: classic R&D is just one of the levers within the corporate innovation machine, Innovation mechanisms such as acquisitions, licensing, joint ventures, and corporate venture capital investments also play an increasing role, in concert with R&D, in a company's innovation strategy.

What is the best innovation strategy? What role should corporate R&D play in that strategy? How should R&D evolve, given that it is only one of many pieces in the innovation puzzle? The best strategy will vary across firms and industries. Common threads, however, within corporate innovation strategies include the following.

* Organize for innovation.--Innovation will not flourish within a firm without the correct organizational framework in place. Organizing for innovation involves at least three inter-related facets: incentives, structure and culture. Companies like 3M, and more recently IBM and GE, have empowered business units with autonomy, upside and profit/loss responsibility like start-up firms. Disconnecting innovation efforts from the corporate bureaucracy allows them to flourish and to adopt a more entrepreneurial spirit and reward structure.

* Adopt a portfolio approach and process.--Just as investors manage risk and optimize profits through portfolio diversification, so too must a firm manage its elements of innovation. A portfolio approach should have at least three dimensions: markets, time and source. Markets define the collection of customers (current of future) that you wish to target. Time defines the horizon on which the innovation creation process must be completed. Source is the category of innovation in which resources are invested to add value to the market over the target time horizon. In concert with the portfolio approach should be a process for managing these dimensions to ensure balance and a focus on returning value to shareholders.

* Renovate the ivory tower and encourage collaboration.--Globalization, workforce mobility and the need for interdisciplinary expertise require firms to seek input from outside sources when creating new products and services. In-house researchers must be encouraged to interact with other researchers, customers and cross-discipline experts to fuel applied research as well as spark serendipitous innovations. The "voice of the customer" as well as the voice of many other constituents must be heard for innovations to be useful and effective.

* Strive for revolutionary (not just evolutionary) inventions.--One reason corporate R&D has become less effective in recent years is the incremental nature of most corporate innovations. Most firms have many evolutionary new products that account for only a small fraction of new profits, while more advanced firms have revolutionary new products that account for over half of new profits.

How can revolutionary innovations be encouraged within a firm? While there is no single solution, internal profit-sharing incentives can help in sparking creativity within a firm. An analog is that venture capital markets would not succeed if fund managers invested in medium risk-return ventures. Fund managers must invest in "home run" opportunities in order to have enough successes to cover the costs of the failures.

In The Innovator's Dilemma (9), Christensen highlights the phenomenal value of disruptive technologies and the inherent challenges big companies face in exploiting these opportunities. Fortunately, in The Innovator's Solution (10), he teaches how big companies can leverage these technologies for success rather than being destroyed by them.

* Innovate business models as well as technology.--Innovation must not occur on the technology front alone. New technologies often require creative business models to unlock their value to the firm. The inertia of large firms creates an inherent bias to existing business models.

GE, IBM and Kodak passed on the opportunity to help commercialize xerography, believing that the high capital costs of the new technology could not supplant the lower-cost, lower-quality copiers of the day. Haloid Corporation (now Xerox) flourished by abandoning the standard equipment sales business model and adopting a leasing model (8). Firms should encourage development teams to consider novel ways to unlock the value of innovations through internal brainstorming as well as external market assessments.

* Shift from the closed-innovation to the open-innovation paradigm.--Chesbrough and others have discussed the need for firms to transition from closed innovation (closed firm boundaries with internal R&D only) to open innovation (open firm boundaries where intellectual property flows in and out). Unlike firms that secure IP for defensive purposes only, today's firms must consider IP as currency and not just a fence. Internal R&D must be managed in concert with licensing efforts.

Note that the closed-to-open shift does not diminish the role of internal R&D. R&D is required not only to generate innovations but also to utilize internal knowledge to assess outside technologies as well as provide an ability to develop architectures to integrate the disparate technologies acquired from sources outside of the firm.

Integrated Innovation in Action

We have outlined a few common threads of a successful innovation management strategy. Do signs of these processes exist today? IBM was cited in "Why Big Companies Can't Invent" as an example of how corporate R&D no longer works. However, IBM has shown great signs of market adaptation. In addition to maintaining strong internal R&D, IBM has also become known for its out-licensing and in-licensing activities, a sign of open innovation. IBM has organized for innovation through the creation of Emerging Business Units (EBOs) that provide startup opportunities to creative employees. Sparked by the leadership of Lou Gerstner, the company experienced a paradigm-shifting change that resulted in a far stronger focus on the needs of customers. IBM realized it should shift its innovation focus to upstream parts of customer value chains, i.e., devote more time to systems integration technologies than on fundamental device technologies.

IBM has successfully transitioned from a historical focus on computer hardware such that, today, it spends over 65 percent of its resources on software and systems. IBM has also adopted the First-of-a-Kind (FOAK) customer collaboration program that encourages interaction with customers to develop products and services where no solutions exist today. In this way, IBM continues to focus on and grow its emphasis on the aforementioned elements of innovation strategy (8,11).

GE also is reinventing its internal R&D and innovation practices, spending millions on R&D facilities in India, Malaysia and Germany that embrace globalization (12). CEO Immelt is quoted as saying, "In the global economy there's going to be pricing pressure in every business. The only way you're going to grow and keep your markets growing is through innovation. Innovation is not just a nice-to-do, but also a real priority. Great technology is the only thing that allows you to protect profit margins (13)."

GE has also embraced a more collaborative culture that leverages cross-functional teams to address innovation issues. R&D funding within the company has shifted from 70 percent centralized sources to 70 percent divisional sources, thus providing some "natural selection" as projects are screened for investment. Like IBM, GE is a large company that has a history of success due to its focus on innovation and its willingness to alter its innovation strategy in response to changes in the innovation landscape.

Let us also not forget that the classic S--curve of product development calls for three phases of competition: innovation, differentiation and commoditization. Not every firm will choose to compete using innovation as a prime lever of value. Consider The New York Times article "Distributor vs. the Innovator" (14), where the competition between HP and Dell in the consumer printer market is discussed. HP clearly competes as an innovator while Dell competes on price (and through differentiation in its PC business). "The days of engineering-led technology companies are coming to an end," Michael Dell declared, while HP's Carly Fiorina says "We're the biggest, we're the best, and we're getting better in a growing market."

Clearly, firms will compete using various angles of competitive positioning. We would argue that HP will continue to innovate and hence will continue its success. And Dell will continue to succeed as the "Wal-Mart of electronics" so long as it can find innovative hosts from which it can leverage technology and then compete on price.

Continuing To Be Vital

Although not every firm that is successful is required to innovate profusely, innovation will continue to be a critical part of the capitalist economy. And for now at least, corporate R&D is playing a significant role in this innovation, benefiting all of us who utilize the downstream products based on that innovation. Of course, firms will continue to periodically mismanage R&D, explore other growth strategies and be subject to attack by small firms in niche markets. However, such events do not diminish the importance of corporate R&D, just as the failure of most startups does not diminish the importance of new-venture activity.

References

(1.) Anderson, H. "Why Big Companies Can't Invent." MIT Technology Review, May 2004, pp. 50-59.

(2.) William Howell, Eli Lilly; Edward Philpot, GlaxoSmithKline; Bobby Compton, General Electric; informal phone interviews.

(3.) Arthur, C. "The iPod Generation Rejoice--The Online Music Store is Here." The Independent Sunday, June 13, 2004.

(4.) "Industrial Research Institute's 5th Annual R&D Leaderboard." Research * Technology Management, Nov.-Dec. 2003, pp. 19-23.

(5.) National Science Foundation, Division of Science Resources Statistics, National Patterns of R&D Resources, available on http:// www.nsf.gov/sbe/srs/infbrief/nsf04307/start.htm

(6.) Baruch, L. "Sharpening the Intangibles Edge." Harvard Business Review, June 2004, pp. 109-116.

(7.) Eberhart, A., Maxwell, W. and Siddique, A. "An Examination of Long-Term Abnormal Stock Returns and Operating Performance Following R&D Increases." Journal of Finance, Vol. LIX, No. 2, April 2004, pp. 623-650.

(8.) Chesbrough, H. Open Innovation. Harvard Business School Press, 2003.

(9.) Christensen, C. The Innovator's Dilemma. Harvard Business School Press, 1997.

(10.) Christensen, C. The Innovator's Solution. Harvard Business School Press, 2003.

(11.) McQueeney, D. "IBM's Evolving Research Strategy." Research * Technology Management, July-August 2003, pp. 20-27.

(12.) Edelheit, L. "Perspective on GE Research & Development." Research * Technology Management, January-February 2004, pp. 49-55.

(13.) Blass, E. "GE always has innovation on its mind." USA Today, November 10, 2002.

(14.) Lohr, S. "The Distributor vs. the Innovator." The New York Times, May 24, 2004.

Joseph Holmes is CEO of Acuity Edge, a Sanford, North Carolina-based management consulting firm that provides strategy, innovation management, market research, partnership development, startup coaching, and training services. Clients he has served include Ford, Motorola, NASA, Siemens, Textron, the University of Illinois, and Xerox. He holds B.S. degrees in materials science and engineering, and electrical engineering, as well as an M.S. degree in materials science and engineering from North Carolina State University. He received his M.B.A. from Duke University. jholmes@acuityedge.com; www.acuityedge.com

Jeffrey Glass is the Hogg Family Director of Engineering Management and Entrepreneurship at Duke University, Durham, North Carolina. He is also a tenured professor in Duke's Department of Electrical Engineering and directs the Master of Engineering Management Program. He received his Ph. D. in materials science and engineering from the University of Virginia and his M.B.A. from Duke University. He has published over 120 papers and is a co-inventor on 11 patents. Prior to his current appointment, he was co-director of the Institute for the Integration of Management and Engineering at Case Western Reserve University in Cleveland, Ohio, and vice president of R&D for Kobe Steel USA, Inc. jeff.glass@duke.edu