CFOs of U.S.-based companies are looking abroad for cost-effective R&D.
Innovation drives growth, and R&D drives innovation, but at a time when executives are looking for the next business revolution to boost revenues, U.S. corporate R&D budgets are under pressure from all sides. Shareholders are scrutinizing spending, the federal government is shifting subsidies, and labor costs for R&D are rising. These forces are reshaping R&D work in the United States and abroad.
U.S. corporate R&D spending rose only 1.9 percent this year, the fourth year out of the past five in which spending has actually decreased in constant dollar terms, according to Battelle, a global science and technology services company. The $190.9 billion budgeted by companies for U.S. R&D in 2005 is 6 percent less than the amount spent in 2000. Federal R&D spending increased 5.6 percent for 2005, but the Bush administration shifted huge portions of the budget to military projects, leaving basic research underfunded. In addition, the number of scientists and engineers that enter the U.S. workforce each year continues to decline, driving up labor costs for R&D talent.
While these unfavorable conditions intensify in the United States, foreign corporations and governments are boosting their R&D budgets, and European and Pacific Rim universities are pumping out scientists and engineers who are capable of performing the most advanced R&D work at one-third to one-fifth of the cost. As U.S.-based CFOs scramble to fund R&D here, they are also increasingly transforming R&D into a global operation. Labor accounts for a hefty 40 percent to 85 percent of R&D costs, so companies are taking a flexible approach to locating the work.
Project Staffing
It is no coincidence that for R&D spending as a percent of revenues, one of the biggest spenders in the United States is SAS Institute Inc., a privately held software company based in Cary, N.C., that escapes shareholder pressures. Every year, SAS pours more than 25 percent of its revenues back into product research and development, compared with 16 percent at Microsoft and 13 percent at Oracle. SAS runs research facilities in the United States, Europe and Asia.
"We look at R&D as an investment that may require five years of work before we see any return," says SAS CFO Kevin Thompson. "Because we are a private company, we can take a much longer-range perspective on our R&D spending. It's hard to do that if Wall Street is looking at your numbers every 90 days. But even at SAS, there is a limit on what any company can spend on R&D."
SAS funds R&D on a project-by-project basis, charging its marketing and finance departments with evaluating each proposal and the resources it requires, including any additional staffing. "Then we determine whether those head counts will be in North America or in Europe, because that's where the expertise lies, or in India or China, where it's cheaper," Thompson says. "We define the optimal way to build the technology and where it would be most cost-effective. We put our R&D in the lowest-cost location where we can find the knowledge that we need. Then the CEO approves total R&D spending based on what we have determined."
In addition to the cost savings achieved by locating work abroad, SAS finds other advantages in pursuing R&D globally. "Putting work overseas also gives us the tremendous advantage of being able to work 24 hours a day," Thompson explains. "While we're sleeping, a new technology developed in the U.S. is being tested in China or India, and we can make adjustments the next day. It's extremely effective. Teams here have had to learn to manage projects remotely, and there is a learning curve, but we've always had R&D workers around the world." SAS doubled its R&D staff in India in 2004.
Building the Pipeline
Although SAS takes a global approach to R&D, it is increasingly concerned about the ability of the U.S. education system to provide adequate numbers of R&D workers. The company funds several educational initiatives to build math and technology literacy in U.S. schools. SAS's concerns are echoed at Siemens Corp., the German global electrical engineering and electronics corporation employing 45,000 R&D professionals worldwide, including 7,000 in the United States. Siemens' executives voice doubts about the competitive standing of the U.S. R&D workforce.
"There is no question there has been a significant decline in the number of American graduates with science or engineering degrees," says Jack Bergen, senior vice president of corporate affairs and marketing at Siemens. "An even greater concern are the results of the recent study that showed that U.S. high school students ranked 23rd in science and 28th in mathematics out of 41 countries, meaning that the pipeline for future scientific talent has also narrowed substantially."
Seventy-five percent of Siemens' sales come from products and services developed in the past five years, and the company relies on R&D for revenue growth. "Strategic innovation management is a top priority at Siemens, and we spend $6 billion annually on research and development," elaborates Klaus Stegemann, senior vice president and CFO of Siemens Corporation in New York City. "We have to ensure that our output is commensurate with our substantial input."
Siemens invests in high school math and science programs in the United States and grants more than $1 million a year in scholarships and awards for high school students. "Clearly it is incumbent upon business leaders in all industries, and the technology sector in particular, to support education," Bergen says. But with China, India, Russia and other lower-cost countries pouring greater resources into science education and government support for R&D, private initiatives are clearly not sufficient to ensure that cost-effective R&D work can be conducted in the United States.
Global Approach
Given SAS's long-established global approach to R&D, "We're not concerned with technology jobs moving out of the U.S. to India or China," Thompson says. "It's the right economic decision in most cases for U.S. corporations to make sure that they are building their products in the most cost-effective way. If they do that, it will create more profitability inside of U.S. companies, which will allow them to invest more in R&D."
Thompson believes that U.S. companies can generate savings by moving R&D overseas to lower-cost jurisdictions and that this trend will continue for some time. However, he points out, "it can't continue forever because we are now seeing cost increases of about 25 percent a year in India, for example, and turnover is high -- much like Silicon Valley at its peak." He adds, "And for any company, there's only so much capital that you can effectively manage across the water." Although the R&D cost differential between the United States and low-cost locations will narrow over time, research conducted by The Boston Consulting Group demonstrates that a substantial differential will continue for decades.
Thompson is not concerned that the growing U.S. backlash against offshoring may lead to legislation that limits the jobs that can be sent out of the country.
"The U.S. business environment is not going to allow limits to be placed on how we run our business," he says. And at SAS, no U.S. R&D workers are laid off when the company moves work overseas. "The employees here are recast in new projects where industry knowledge is important," Thompson reports. "We don't move work overseas simply to save money. We move work so we can handle more areas of technology."
Now that companies such as SAS, Siemens, Microsoft, Hewlett-Packard, General Electric, Motorola, Cisco Systems, Oracle and Intel are already running global R&D operations, the trend toward offshoring is moving into midsize and small U.S.-based companies that can stretch their R&D budgets by relocating work to Central and Eastern Europe and Asia. CFOs at U.S. companies that have not already moved parts of their R&D work abroad can address their own budget shortfalls by shifting the work.