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Introduction

In outsourcing territory, Research & Development (R&D) activity is considered the final frontier. That’s because R&D is seen as the source of innovativeness – the mother of competitiveness, to be protected at any cost. As we all know from our MBA textbooks, core activities should never be outsourced, as this could potentially create a new competitor.

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The Case for R&D Outsourcing

- Dr. Martin Lockstrom

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However, this is in fact a truth with a rider or two. Firstly, the R&D function contains an array of business activities that need to be analyzed separately. Many of these are operational, of low strategic relevance, and could be performed more efficiently by an external service provider in a low-cost offshore destination. Examples of such activities include (but are not limited to) market study, product testing and legal support. In other words, when making outsourcing decisions, one should not only look at business processes at a functional level, but also dig deeper into sub processes and tasks in order to identify opportunities, which can subsequently be clustered and allocated to external providers in order to achieve efficiency and synergies (see Figure 1).

Figure 1. Clustered sub process outsourcing

Secondly, it doesn’t matter where an invention originates (geographically … internally/externally); what matters is who will finally appropriate it. Take for example Skype, founded by a couple of people from Sweden and Denmark, but developed by Estonian programmers. Or the BMW X3 model, which was to a great extent developed by Magna Steyer and produced at its plant in Austria. And at P&G, more than half of their product innovations originate outside the company today.

In sum, the capability to turn inventions into innovations and successfully bring them to the market is far more important than the inventions per se. This is true in most industries where patents provide limited Intellectual Property (IP) protection and can often be circumvented through alternative designs; research says that only the chemicals and pharmaceuticals industries have adequate patent protection. In other industries, patenting is merely a tactic to fend off competitors in the short to medium term.

R&D Outsourcing DriversSo why do companies outsource in the first place? Well, for starters, the basic idea is to get a job done by whoever is best suited to do it. However, as mentioned earlier, first companies need to come to grips with what they really do best and what differentiates them from their competitors, in order to determine which business activities to retain in-house. When executives and senior managers are asked about their companies’ core competencies, surprisingly, few have a clear answer. This phenomenon, combined with the fact that many executives are incentivized to trim their balance sheets can explain the frequent loss of competitiveness through poorly executed outsourcing decisions. As part of the Infosys Building Tomorrow’s Enterprise (BTE) framework, the following themes help uncover those opportunities that need a greater share of R&D outsourcing.

Smarter Organization

Simplicity. Research shows that company size is strongly linked to R&D productivity; the larger the organization, the lower the marginal return on every dollar invested in R&D. In the past, many companies erroneously believed that R&D productivity could be increased by creating economies of scale, but alas it is not so. The specific causes for this are beyond the scope of this article, but nevertheless this is the reason why most disruptive innovations originate from Small and Medium Enterprises (SMEs). And since complexity tends to grow with company size, R&D outsourcing is often an effective means to passing on some of that to an external party.

Adapt. Besides increasing simplicity in R&D (i.e. reducing complexity), R&D outsourcing also increases adaptability since creative thought processes can be handled in a more autonomous, decentralized fashion without being overburdened by overheads and administration. This characteristic is becoming increasingly important with product lifecycles shrinking and short time-to-market becoming critical to competitive advantage. This is especially important in industries such as consumer electronics, where patents offer limited protection and delay means lost revenue that cannot be recouped easily. To cite one example, this is why Apple uses an ecosystem approach, which enables external firms to develop its smartphone apps.

Collaborate and Learn. In today’s fast-paced economy, no single company can alone possess all the knowledge and capabilities required to bring new innovations to the market. In fact, when external competencies complementing the company’s core abilities are combined and integrated in unique ways, they can add significant value. Outsourcing of R&D and joint activities can greatly increase productivity be expanding the flow of knowledge outside the firm’s boundaries. Take for example the frying pan coating Teflon, which was discovered by accident by the company Kinetic Chemicals, a joint venture between DuPont and General Motors.

Emerging Markets

Over time, emerging markets have become extremely important to companies of any size across all industries: Here’s the view on R&D outsourcing to emerging markets from a BTE perspective.

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Growth Momentum. Emerging markets have become more important than ever due to a couple of reasons. Firstly, companies in mature markets are facing the headwinds of slumping consumer demand caused by the recent global financial crisis. This means that Multi National Enterprises (MNEs) have to increasingly seek new revenue opportunities in emerging markets where growth numbers are still relatively healthy. Secondly, this means that companies also have to localize R&D activities in order to better serve local consumers in emerging markets where competition is rapidly gaining pace. For instance, companies like GE and Novartis have located global R&D centers in Shanghai, China, each of which employ more than a thousand people.

Innovation Hubs. Although new market access and cost reduction are two important drivers of R&D outsourcing, another key driver is access to talent. Whereas the interest in pursuing engineering and natural sciences as a career is on the decline in the West, these subjects are a big draw for the youth in emerging markets like India and China.

Making the Outsourcing Decision

The R&D outsourcing decision cannot be finalized overnight. It must consider all the above mentioned important aspects. Above all, it is critical that the outsourcing decision not be driven by personal incentive. What’s more, as mentioned earlier, it is necessary to analyze not only functions and processes, but also sub processes and tasks. The following checklist can add clarity to the R&D outsourcing decision making process. If the answer to any of the questions is “yes”, the corresponding activity must not be outsourced.

Another important decision is whether or not to retain the organizational capability underlying an activity that has been outsourced; in other words, the make-or-buy decision has to be made in conjunction with the outsourcing decision. Retaining in-house capability makes it much easier to reverse an outsourcing decision. In other words, the outsourcing decision is not painted black and white, but rather in grey tones.

Hence, the supply of engineering talent is vastly bigger in emerging economies. For instance, in 2010, China and India produced more than 2.6 million and 1.19 million science, technology, engineering and math graduates respectively. Even though the majority of fresh graduates may not be globally competitive, the numbers are still attractive.

Smart Sourcing. Due to the many institutional voids – weak legal system, poor infrastructure and so on – frequently encountered in emerging markets, it is necessary to have an adequate network of external knowledge partners. The most common way of building strategic ties is by setting up a joint venture (JV) with a local player, who can provide the necessary guidance on navigating the local market, accessing local governments etc. The foreign MNE partner, on the other hand, usually brings in the required management and technological expertise. Even though JVs are declining in popularity in countries like China, they are still a viable approach for overcoming local obstacles in the early stages of market entry.

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Does the activity help to create a differentiated market position (i.e. core activity)?

Core activities are those that make a company unique among its competitors. Keeping these proprietary and protected from competitors enables the company to command premium product/service pricing and in turn, superior profit.

Does the activity utilize or generate strategically important intellectual property?

Intellectual property is the output of core activities. According to the logic in points (1) and (2) above, activities using or generating strategically important IP should be performed in-house.

Is the activity directly supporting a core activity?

Most companies, if at all, usually only pay attention to core activities. However, the outsourcing of complementary activities that support core activities can put the company in an adversarial dependency position with an external service provider and should hence be retained in-house.

Are there less than two capable external service providers available?

In order to avoid adversarial dependency situations, there must be a sufficient number of service providers available in order to obtain competitive pricing and quality of service. For instance, all too cozy supplier relationships at NASA led to spiraling costs and closure of the shuttle program.

Is the internal option better than the service provider’s offer in terms of cost and quality of service?

A competitive offer from the external provider must also be more competitive than the in-house alternative. If not, the outsourcing decision cannot be economically justified.

© 2012 Infosys Limited, Bangalore, India. Infosys believes the information in this publication is accurate as of its publication date; such information is subject to change without notice. Infosys acknowledges the proprietary rights of the trademarks and product names of other companies mentioned in this document.

About Infosys

Infosys partners with global enterprises to drive their innovation-led growth. That's why Forbes ranked Infosys 15 among the top 100 most innovative companies. As a leading provider of next-generation consulting, technology and outsourcing solutions, Infosys helps clients in more than 30 countries realize their goals. Visit www.infosys.com and see how Infosys (NASDAQ: INFY), with its 150,000+ people, is Building Tomorrow's Enterprise® today.

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ConclusionOutsourcing has become commonplace in most companies and virtually every industry. However, many companies are reluctant to outsource R&D activities for the fear of IP loss. This fear is not baseless, as history is replete with cases of IP theft. Nevertheless, in order to identify potential candidates for R&D outsourcing, companies must analyze the R&D function at sub process or task level. Also, they must base their decision on a solid business case, which factors the impact of outsourcing on not just R&D, but also the rest of the organization.

About the Author

Dr. Martin Lockstrom Principal Consultant, Building Tomorrow’s Enterprise, Infosys Labs

Martin is a specialist in Supply Chain and Operations Strategy, Outsourcing/Offshoring and International Management. During a six-year stint in China, he established the research and education activities at the SCM, Sustainability and Automotive academic centers at China Europe International Business School, Shanghai.

He established the first endowed chair for Purchasing and SCM in China at Tongji University, Shanghai, and was also responsible for setting up Supply Chain Management Institute China, an international network of SCM research and education hubs.

Martin co-founded Procuris Solutions, an IT company specializing in SCM-related solutions, offering consulting services to companies like Accenture, Ariba, BMW, Clariant, Dell, Dow, Ernst & Young and Intel, among others.

He has a Ph.D. in Supply Chain Management from European Business School, Germany, a bachelor’s and master’s degree in Industrial Engineering and Management, from Chalmers University of Technology, Sweden. He speaks Swedish, English, German and Chinese, has published over 50 articles and papers and presented at more than 60 conferences.