In April 2018, Ford Motor Co.’s CEO, Jim Hacket, announced plans to reduce spending by $25.5 billion over the next four years, raising concerns among Ford staff about how the pending cuts will impact R&D investments. Soon thereafter, DowDuPont Inc.’s CEO, Ed Breen, announced the elimination of R&D spending on “moonshots” in order to focus on smaller projects that cost less than $30 million to complete and carry a lower risk profile. From one perspective, this is just part of the news cycle, as business decisions to increase, reduce, or cut spending happen every day. But from another perspective, these announcements raise a few questions:
- Is this part of a trend in R&D spending?
- What are some of the factors that affect CEO decision-making?
- What are some consequences of myopic decision-making?
- Can contract R&D help mitigate myopic decision-making?
R&D investment trends:
Public funding of R&D has been decreasing steadily as a fraction of total federal government spending in the United States since the mid-1960s, from less than 11% in 1965 to about 3% in 2017. However, global funding for R&D increased by an estimated $45 billion from 2016 to 2017, and it is projected to rise by around $87 billion in 2018. In spite of this global increase, there are some sectors such as chemicals and advanced materials in which global funding has been decreasing. And in many G7 countries, at least during the period of 2000-2013, private sector investment in R&D as a fraction of GDP decreased or remained relatively flat (for example, in Canada, the amount decreased from 0.79% to 0.54%). So, what are some of the factors that affect CEO decisions with regard to increasing or decreasing R&D investments?
Factors that affect CEO decision-making:
A key factor in decision-making is risk. In a paper titled Risky Business: The Driving Factors of Creative Risk Taking Attitudes in Engineering Design Industry, the authors state:
“Designing breakthrough products comes at a great cost to the design industry due to the risk and uncertainties associated with creative ideas. However, without creative ideas, there is no potential for innovation. As such, companies need to appropriately embrace the risk associated with creative concepts in the fuzzy front end of the design process in order to build their value.”
Consequently, CEO risk tolerance (or lack thereof) is a major factor with regard to R&D investment decisions. However, many CEOs have a tenure of only 3-4 years and thus often face an ethical dilemma: whether to make decisions that increase their personal wealth in the short term or to base their decisions on the long-term health of the corporations they manage. For example, studies have shown that:
- The structure of CEO compensation packages strongly influences decision-making, where “short-termism” often leads to self-interest and myopic managerial behavior with an emphasis on short-term stock prices.
- CEOs with a short career horizon (being close to retirement) are often increasingly risk averse and thus less likely to invest in prospective breakthrough innovations to avoid potential harm to their organization’s short-term financial performance and their own personal reputation.
Consequences of myopic CEO decision-making:
CEO successions often result in cuts to long-term investments, particularly R&D funding, to quickly increase near-term corporate profitability. In addition, the amount of executive vesting equity (equity that can be sold or exercised) in a given quarter is also associated with reductions in R&D and capital investments. This near-term orientation then negatively impacts both the medium-term and long-term performance of the organization.
Contract R&D to the rescue?
Organizations that engage in contract R&D, such as MATRIC, Southwest Research Institute, bb7, and PreScouter, provide a valuable service to clients who seek to leverage internal R&D budgets through short-term investments with external partners that are decoupled from the risks associated with long-term commitments to new capital and human resources. For example, a recent study of European multinational corporations (MNCs) has demonstrated that MNCs that offshore their innovative tasks to foreign R&D entities are more productive than MNCs that only offshore their non-innovative tasks. Similarly, another recent study that looked at 2,421 German firms that are active in R&D has shown how allocating about 10-30% of R&D expenses to external foreign contracts can yield a significant boost to corporate innovation.
Analyze and act:
A myopically operated organization that chooses to reduce its investments in R&D has an opportunity to potentially mitigate the negative consequences of this choice by allocating a significant portion of its remaining R&D budget to contracts with external R&D organizations. And to realize this potential, the organization merely needs to analyze the evidence – and take action.
