The world’s biggest R & D spenders are putting their money on software and service
Did Microsoft Corp. really spend more on R&D last year than any other company in the world? We think so, but we can’t be sure. The reason is that roughly US $1.3 billion of the software giant’s $8 billion R&D outlay was actually paid out as shares of stock to its researchers. At the moment, hardly any company besides Redmond, Wash.-based Microsoft bothers to track stock or stock options as an R&D expense. The few that do account for this expense in widely different ways.
But before the end of this year, all companies listed on U.S. stock markets may have to begin figuring stock outlays into their R&D expenses. That would be the result of a new rule proposed by a private sector organization in Norwalk, Conn., called the Financial Accounting Standards Board, which establishes U.S. accounting standards. If the rule is not outlawed by an act of Congress this fall, the U.S. Securities and Exchange Commission will soon require all publicly traded firms to abide by it.
The looming prospect of this new corporate accounting practice is already buffeting R&D in a way that few other developments have over the past half-century. Day traders, analysts, and policy wonks are all finding it nearly impossible to assess companies’ R&D spending and, by extension, their commitment to competing in dynamic technology markets and to creating entirely new ones.
Disruptive as it is, the stock-accounting trend is just one of several poised to have long-term effects on R&D, according to analysts and executives contacted for IEEE Spectrum’s third annual R&D survey. These insiders also singled out the increasing concentration of R&D resources on software development, systems engineering, and consulting; the shift of basic research from corporate ivory towers such as Xerox Palo Alto Research Center to government-funded university projects; and the globalization of the industrial research enterprise.
In the short term, though, the stock-accounting proposal is keeping executives up at night worrying about how investors will view such transactions once they are made public—as investments in the best minds stock can buy or as a hit to the bottom line.
To see how accounting for these transactions can affect a balance sheet, step into the shoes of a Microsoft shareholder who reads the company’s fourth-quarter fiscal 2004 earnings statement. At first glance, it certainly looks as though Bill Gates and Steve Ballmer have made good on their promise to increase Microsoft’s spending on R&D to unprecedented heights, throwing almost $8 billion at it in 2004, compared with $4.4 billion in 2001, and propelling the company from No. 10 to No. 1 on our list.
But read the fine print: most of that increase is from an obscure change in Microsoft’s accounting practices. Like every other company, Microsoft counts payroll and employee benefits for its researchers and developers as R&D expenses. Unlike many high-tech companies that partially compensate employees with the option to buy company stock during a particular period at a set price, Microsoft last year began paying out actual shares.
Because the shares have a specific value, Microsoft is required by law to count them as a cost of doing business. If those shares weren’t counted, the company would have reported a reduction in this year’s R&D spending of at least $126 million from 2003.
So without that change in accounting, would Microsoft still have ranked above No. 2, Ford Motor Co., on our list? And, more generally, would companies not currently on the list have appeared on it if they had counted stock options granted to researchers? There is simply no way to know.
We might know a lot more next year, however, if the new accounting rule takes effect. The rule’s proponents claim that it will make corporate finances more transparent. Opponents, such as the American Electronics Association, in Washington, D.C.—whose members include Advanced Micro Devices, Broadcom, Intel, and Texas Instruments—say the requirements are difficult to implement and will make it hard to recruit talented engineers; they support legislation pending in Congress that would derail the new standard. But unless the new rule is adopted, comparing one company’s R&D spending with another’s is a difficult, if not spurious, exercise.
Even with all the accounting uncertainty, it is possible to divine some macro trends from the list [see table, "IEEE Spectrum Top 100 R&D Spenders" (PDF)]. Overall, the Top 100 upped their R&D by 2.2 percent to $236 billion despite sluggish sales growth of 0.8 percent. Bucking the trend, technology hardware companies, which account for about 20 percent of the overall R&D spending, reduced expenditures by 4.9 percent in 2003, even though their sales increased by 2.3 percent. The auto industry had relatively flat spending for R&D, with an increase of 3.2 percent. Semiconductor firms increased spending by 5.3 percent, but that was less than half their increased sales, 12.6 percent, which rebounded from a 10 percent slump the year before. The software and services sector increased the most, with an 18.6 percent gain in R&D spending, mostly because of Microsoft’s spending.
Software dominates R&D, and not just in the sense that, for the first time ever, a software company is the world’s top R&D spender. At most companies, software is taking up a bigger chunk of the development budget year after year, and it is at the heart of everything from drug discovery to automobile telematics. In Stockholm, Sweden, for instance, Hakan Djuphammar, vice president of systems management for LM Ericsson, says that over the last 40 years the telecommunications equipment sector has shifted from making hardware for phone networks to developing software. His company today spends about 85 percent of its R&D money on software.
“With the continuing standardization of powerful processors and hardware components, there won’t be any differentiation in hardware 10 years from now,” says Djuphammar, adding that this trend extends through industries like semiconductors, information technology, and consumer electronics. “You’ll buy extremely powerful processor boards off the shelf and the only differentiation will be in software.”
So now corporate labs are filled with programmers and software engineers. Indeed, the romantic image of monomaniacal scientists toiling for years in a company’s central lab to produce the transistor, polyester, and the scanning tunneling microscope no longer holds. The dominant trend in industrial R&D over the last two decades has been to decentralize research and look outside the company for innovations. The result: company labs spread across the globe, populated by researchers who must fill several roles—investigator, inventor, technology scout, and, increasingly, consultant to customers.
The change in how companies and their researchers conduct R&D mirrors shifts in corporate structures and missions. Henry Chesbrough points out in his 2003 book Open Innovation: The New Imperative for Creating and Profiting From Technology that the vertically integrated enterprise exemplified by Xerox Corp.—which made everything from the toner to the lasers used in the copiers it leased and serviced—continues to give way to horizontally integrated companies that combine components produced elsewhere. Instead of using R&D resources to make better, faster, cheaper widgets, companies like Hewlett-Packard, IBM, and Lucent are employing researchers to service customers that need help putting those widgets together into novel systems.
“Just as computer science emerged in the late 1940s, I believe services sciences will emerge as a discipline,” says Paul M. Horn, senior vice president and director of research for IBM Corp., in an interview with Spectrum. Researchers at the forefront of this new discipline bring the rigors of scientific inquiry to bear on how different parts of a business function.
“We’re really defining the periodic table for the underlying elements that make up all businesses,” says Horn, who thinks such research could spark a $500 billion market. “Once you model a company in terms of components, you can surgically reengineer components and change the IT systems that drive them quickly and reliably with a very significant return on investment.”
Bell Labs, which years ago garnered six Nobel Prizes for discoveries ranging from the transistor to cosmic background radiation, is using a similar consulting model to rouse itself from the doldrums. Between 2001 and 2003, parent company Lucent Technologies’ R&D spending dropped 57 percent from $3.5 billion to $1.5 billion, as sales slid 60 percent, from more than $21 billion to $8.5 billion.
Since 2000, the company has cut loose a boatload of researchers, some of whom went with spinoffs Avaya and Agere. According to former insiders, the head count for Bell Labs R&D dropped from about 30 000 employees at its peak in 1997 to 9500 today. Of those, only about 500 are considered basic research staff.
After four straight quarters of profit, the bleeding has been staunched and Bell Labs expects to return to normal recruiting. The company plans to hire at least 40 researchers next year, many of them for the new Bell Labs Research Center in Dublin, Ireland, which will be devoted exclusively to supply-chain-management research. There, scientists and engineers will investigate manufacturing and assembly operations. They’ll also test methods of fine-tuning the software-intensive process by which firms purchase and distribute products and services from suppliers.
Such a lab would seem to demand researchers who can rechannel their thirst for esoteric knowledge, or who have no such inclination in the first place. Not so, says Jeffrey M. Jaffe, president of Bell Labs’ Research and Advanced Technologies division. He maintains that his researchers are just as intellectually stimulated by today’s research agenda as their Nobel Prize-winning colleagues of bygone days and, he hints, more motivated because they see their work solve real-world problems.
“Researchers are curious people,” says Jaffe, who came to Bell Labs after a stint at IBM under research director Horn. "So when they see that our customers are spending less money than before, they want to understand why. They go out and talk to the customers. What are your problems today? Where do you think the future is going?"
While some companies can still pursue fundamental R&D breakthroughs, most are now relying on universities for them. Basic research paid for by the government and performed by academics has been a pillar of U.S. economic policy ever since Vannevar Bush instituted it in 1945. In his report “Science: The Endless Frontier,” Bush, then director of the U.S. Office of Scientific Research and Development, declared that the federal government has a responsibility to fund basic science to maintain competitiveness.
The problem is that government R&D funding isn’t exactly stable, subject as it is to the whims of politicians. Since the late 1960s, overall R&D spending in the United States has shifted from being two-thirds government-funded to being currently two-thirds industry-funded. This trend has had huge consequences both for the firms that depend on university researchers and for the researchers themselves.
“We’ve seen corporate R&D really force the shift to applied R&D,” says Patrick P. Gelsinger, senior vice president and CTO for Intel Corp. “That’s led to a weakening of the basic research engine. For instance, there hasn’t been a lot of new, fundamental work that’s come out relevant to the computing industry for the last couple of years. I think that’s a direct result of this funding situation.”
That situation isn’t likely to change for the better anytime soon, in part because no company wants to pay for research that could enable competitors to beat it at its own game.
“You never know whether basic research will have any payoff, and even if it has a payoff, you have no idea to whom,” notes William J. Baumol, professor of economics at New York University, in New York City, and an expert on the economics of R&D. “That’s why it’s up to governments and universities to carry it out, and that’s the danger that’s involved in government cutbacks.”
There’s no guarantee that government funding for basic research—in the United States, Japan, Europe, or anywhere else—will continue to increase. According to a 19 May 2004 memo from the U.S. Office of Management and Budget, Bush administration budget forecasts indicate that major U.S. government R&D agencies, including the National Science Foundation, the National Institutes of Health, and even the Department of Defense—with its basic and applied research programs—will have their budgets cut in FY 2006, as their funding falls below FY 2004’s levels in real terms.
Not only is money for basic research limited mostly to what governments ante up, but some experts fear that it is increasingly limited to projects that will pay off for the academics and the institutions performing the research. The U.S. Congress’s Bayh-Dole Act of 1980, which is being emulated in Japan and several other countries, allows universities to patent the fruits of government-sponsored research. It has, according to The Economist, resulted in a tenfold increase in university-generated patents, 2200 spinoff companies, 260 000 jobs, and $40 billion annually to the U.S. economy. But by introducing profit motives, some observers fear, Bayh-Dole has polluted the environment of open inquiry that once characterized all academic research.
“Universities have become extraordinarily greedy and aggressive in prosecuting their patents and, in the process, have backed away from their responsibilities as defenders of open science,” says Richard R. Nelson, a professor of international and public affairs and an expert in the economics of technological advances at Columbia University, in New York City. Some academics, too, seem to be more concerned with money than with the quest for knowledge. “When I talk with faculty at the medical school or the engineering school, the notion that there should be some restrictions on their ability to take out patents and license them any way they want to just raises a tremendous storm,” Nelson adds.
The globalization trend over the last decade has changed industrial R&D in two significant ways. As Open Innovation author Chesbrough, of the University of California, Berkeley, argues, industrial researchers have taken on the additional burden of using the Internet to become knowledge brokers within their companies. They are scouts, if you will, on constant lookout for the Next Big Thing to develop internally or to fund with venture capital. And the pool of research talent for hire has expanded significantly.
“Maybe the Internet enabled globalization; maybe Russia, China, and India were rising up and took advantage of the Internet—it’s not really clear,” says Intel’s Gelsinger, who oversees 27 labs worldwide. “But those two coming together has created a global research environment where there is very little unique leadership that you could point to in any one [technical] area that isn’t very closely followed by someone else in another location.”
In India, companies like General Motors, Hewlett-Packard, Microsoft, and even Google have made major investments in both new and established lab facilities. Russia produces thousands of highly qualified mathematicians, scientists, and engineers who are willing to work for a fraction of the salaries of their U.S. and European counterparts.
And with China churning out more than 4000 doctoral engineering graduates (more than Japan) and 200 000 bachelor graduates (more than any other country) every year, the number of people qualified to do research is rising rapidly.
Also, foreign graduate students, who often outnumber natives in the universities of developed countries, are finding greater opportunities back home working for companies looking to gain footholds in new markets and to take advantage of lower labor costs. Recently minted Ph.D.s working in India, China, and Russia earn less than $20 000 a year.
Relatively cheap brain power is probably the biggest reason U.S. and European multinationals look eastward. But tax breaks and other incentives, combined with the promise of greater efficiencies, are also encouraging companies to move their R&D operations physically closer to their manufacturing facilities in countries like India and China. While liquid capital, intellectual and otherwise, is a fact of life in a global free-market economy, corporations tend to downplay the politically volatile outsourcing issue, emphasizing instead that researchers should be close to customers so they can concentrate on the needs of particular markets.
“We built a lab in Bangalore to help us find our next billion customers,” says Richard H. Lampman, senior vice president, research, and director of HP Labs. “We should leverage what we learn there in different countries or different parts of different countries. If researchers are to really make a difference, the primary focus has to be on changing the company’s offerings to meet the needs of new markets.”
About the Author
Ronil Hira is an assistant professor of public policy at the Rochester Institute of Technology in New York (email@example.com). He is also chair of IEEE-USA’s R&D Policy Committee.