More Effective Financial Incentives

Over the weekend I had a long discussion with a friend about Occupy Wall Street and what is wrong with our corporations. A few themes emerged that may actually be interesting for R&D management as well. It has been shown that executive remuneration has grown much faster than average worker. It is also felt that the pay is disproportionately large.

A key problem with driving executive performance is the inability to tie pay to performance. Decisions made by executives have impact months (if not years) later. So, rewards based on current stock price do little to guide executive performance. Traditional approach has been to provide stock options that vest over a long period. However, stock options have shown to be ineffective in driving performance. This is mainly because the vesting of options does not have a direct relationship to the decisions made by the manager. Stock price in the future will depend on performance across multiple products. Furthermore, options will vest either with time, no matter what happens in the future.

So, here is a proposal: Why not tie rewards to performance based on actual performance of new products developed by a set of executives? R&D executives are responsible for deciding which products to develop and how. The primary and largest reward could be a fraction of the profits generated by these products when they actually reach the market (True Profit Sharing). Most organizations develop (and maintain) a business case for pursing any new product. Hence the executive reward can be built directly into that business case. Boards of directors can monitor performance using the same business case. This approach ties rewards to actual decisions executives make on new product development.

One concern of this approach might be that True Profit Sharing will generate bonuses over a long time frame. Executives are also responsible for managing R&D execution, operations and guiding sales. So, We need other bonuses that encourage performance for near and mid-term. To do that, we can tie a part of bonuses to operational effectiveness:

Health of R&D pipeline (various metrics can be used) generates annual rewards (bonuses)
Cost and schedule performance of each new product generates near-term rewards
Third party reviews and market reaction when the product is introduced contributes to mid-term rewards

We can construct similar approaches for marketing, sales, manufacturing etc. This model has the advantage that each decision has direct consequences to rewards. Just a thought…

Impact of Open Source on Open Innovation

McKinsey Quarterly talks about the impact of IP (particularly Open Source development) in a somewhat confusingly titled article (Managing the business risks of open innovation):

“… after all, who would give away patents to make more money from innovation? But as open-source innovation, “crowd sourcing,” and engaging with open communities become increasingly prevalent, could IP-free zones appear in the competitive landscape of other industries? “

Open Innovation is not the same thing as Open Source. As we have discussed in the past, Open Innovation implementation is quite challenging. A key risk involves sharing product development plans in details to identify and incorporate innovation into a delivered product. This is hard to do while maintaining IP ownership rights. One approach to overcome these constraints is to work in Open Source or Shared IP environment. The McKinsey article calls this Open Competition (do we really need another buzzword?). They have evaluated various industries for the potential of Open Source development by asking three questions:

1.Do specialized firms offer proprietary solutions within certain layers of my industry’s value chain?
2.Do integrated firms seek to cut development costs in my industry by drawing on open technologies to substitute for these proprietary solutions?
3.Are the underlying technologies complex—consisting of so many bits and pieces that a significant number could inadvertently infringe on proprietary IP held by specialized firms?

Their results are summarized in the following graphic:

The overall message is pretty intuitive. However, my key message for R&D managers remains that open innovation is hard to implement. In a few industries (such as software), it may be possible to ease implementation by using open source.

Can R&D management be strengthened through certification?

The International Journal of Technology, Policy and Management had an interesting article Evaluating R&D management systems: strengths and weaknesses of universities and government-funded research institutes:

This study was conducted to determine relative areas of improvement in R&D management systems for universities and research institutes in the Republic of Korea. The research was motivated partly by recent efforts of the Ministry of Science and Technology (MOST), Republic of Korea to strengthen the management system of R&D accounts in order to promote efficiency and best practices in handling R&D budgeting and account matters.

CMMI has a guide (and certification) for R&D management. I am not sure how widely this certification is adopted. I am also unsure of the value of this certification because of the breadth of processes and tools it covers. The guide covers the entire practice of requirements management (systems engineering) is in three pages. I understand CMMI’s value in a single discipline development environment such as software development. I am unsure of the value of certification for R&D management in physical systems with long development cycles and complex interdependencies.. Korean government clearly so value in the idea:

To this end, MOST introduced a binding certification system that is able to evaluate the ability and skill of government-funded national research institutes and universities under its jurisdiction to manage R&D accounts. The certification system is based on a set of criteria, broken down into 3 categories and 27 subcategories. This study analyses and compares the government-funded research institutes and major universities applying for the certification of R&D accounts, based on all the categories.

The overall conclusion is intuitive: Pure research institutes were better at management processes, while universities tended to capture information better.

This study shows that the research institutes boast comparatively better systems for self-audit, the precontrol of R&D accounts, the R&D management organisation, the perfection of R&D management manuals and the items of trial production cost and travel expenditures. On the other hand, the universities are better organised in such aspects as the computerisation of R&D management and the database maintenance of R&D accounts.

Taking organizational redesigns from plan to practice

A quick post about a McKinsey Quarterly article with lots of interesting benchmarking info (Taking organizational redesigns from plan to practice):

Organizations often redesign themselves to unlock latent value. They typically pay a great deal of attention to the form of the new design, but in our experience, much less to actually making the plan happen—even though only a successfully implemented redesign generates value.

There are many reasons why organizational redesigns are risky (or may fail to generate results). Here is a comprehensive list from the article:

This is explained by the results of the survey (not sure how anyone is able to estimate shareholder value generated by a reorg):

“Though a majority of respondents at publicly traded companies say their redesigns increased shareholder value, only a very small group of respondents—8 percent of those who have been through a redesign—say their efforts added value, were completed on time, and fully met their business objectives.

Here are some key takeaways: 1) Good reorgs take less than six months to implement; 2) they have clearly defined goals and objectives; 3) focus on how the new org would work (not just how it would look); 4) determine how the org cultures, processes, tools, roles and changed; and 5) leadership is fully engaged in change and not fighting it.

A key to success seems to be clear objectives on what the reorg is supposed accomplish (detailed goals about how the org will work, not just how it would look). Here is some data about the importance of defining detailed goals:

Respondents are much likelier to say their organizations set broad goals than detailed ones for their redesigns (Exhibit 1). Notably, this is true even of redesigns that could have had very specific numeric goals.

R&D: USA, Europe and Japan increasingly challenged by emerging countries

This UNESCO report titled Research and development: USA, Europe and Japan increasingly challenged by emerging countries from few months ago has some interesting data:

While the USA, Europe and Japan may still be leading the global research and development (R&D) effort, they are increasingly being challenged by emerging countries, especially China.

I wish the report had a concise definition of what they include in R&D. For example, according to the report, there are 1.1M researchers in China and the number in US is similar. Does that include all product development engineers? If so, the number sounds a bit low (1 in a 1,000 persons in China is an engineer?) . In any case, one of the key reasons for the rise of emerging economies is the Internet:

This transformation is being helped by the extremely rapid development of the Internet, which has become a powerful vector for disseminating knowledge. Throughout the world, the number of connections leaped noticeably from 2002 to 2007. But this advance is even more significant in emerging countries. In 2002, just over 10 out of 100 people, globally, used the Internet. There are over 23 users per 100 today. And this proportion rose from 1.2 to 8 in the same period in Africa, from 2.8 to 16 in the Arab States, and from 8.6 to 28 in Latin America.

In any case, here is a bit of benchmark data about R&D budgets:

Even if it is hard to quantify the effects of the 2008 financial crisis, the Report points out that the global recession could have an impact on R&D budgets, which are often vulnerable to cuts in times of crisis. American firms, which are among the most active in terms of R&D, slashed their budgets by 5 – 25% in 2009. As a result, the USA has been harder hit than Brazil, China and India, which has enabled these countries to catch up faster than they would have without the crisis. Finally the Report stresses the need to intensify scientific cooperation, particularly between countries in the South.

The full report is here.

Why effective R&D management is challenging

A recent article in Tech-On (Mitsubishi Unveils Ultra-high-speed Elevator for Skyscraper) highlights the challenges involved in managing R&D. First one being the number of technologies that need to come together:

To realize the world’s fastest speed of 1,080m per minute, Mitsubishi Electric used new technologies for higher safety, lifting height and comfort as well as for the motor for the winch.

Specifically, the 40+ mph elevator needed new ceramic brakes, new low weight elevator rope, a roller guide with anti-phase vibration, and a new aerodynamics shape to reduce drag. R&D managers have to ensure all required subsystems mature simultaneously for the final product to be delivered. This is an R&D management challenge because most subsystems take years to develop and most organizations have many different products in the R&D pipeline at various stages of maturity. Maintaining visibility across such disparate projects is quite difficult. However, guiding development (through resource investment) so that the technologies mature when needed requires a rare combination of technical and financial knowledge. (See Prof. Teece’s research for some interesting perspectives)

A second major challenge is the number of engineering disciplines that need to be working together to realize the final product. The ceramic brakes alone needed material scientists, thermal engineers, structural engineers and manufacturing engineers. The aerodynamic shape required computational fluid dynamics in addition to overall design among other disciplines. Coordinating all of these skillsets and disciplines, extremely challenging in itself, becomes even more difficult when we consider multiple companies and organizations involved in development.

Another key challenge results from integration required to build a product from subsystems. Most physical systems have complex interactions and interdependencies. For example, the new rollers not only impact the rails/guides, but also brakes, ropes, control systems etc. Hence any changes to the brake design will cascade into changes in all other subsystems. R&D managers need to effectively coordinate and synchronize progress across these development projects.

How leaders kill meaning at work

I have been meaning to summarize the article How leaders kill meaning at work from McKinsey Quarterly:

“In our book and a recent Harvard Business Review article,3 we argue that managers at all levels routinely—and unwittingly—undermine the meaningfulness of work for their direct subordinates through everyday words and actions. These include dismissing the importance of subordinates’ work or ideas, destroying a sense of ownership by switching people off project teams before work is finalized, shifting goals so frequently that people despair that their work will ever see the light of day, and neglecting to keep subordinates up to date on changing priorities for customers.”

But specifically, the article points out the following traps:

1. Mediocrity Signals: Executives encourage mediocre behavior through their actions, while describing greatness in missions statements. For example, some executives talk at length about innovation, but innovation projects never receive investments. In one company the top executive asked to eliminate non-strategic R&D investments. The portfolio manager ranked all the projects and developed a list lowest ranked projects. The executive overruled the entire list without any justification (they were his pet projects).

2. Strategic “Attention Deficit Disorder”: Executives do not allow adequate time to mature strategic initiatives and see their results. I have seen this many times. Most new technology or product development takes time. Executives loose interest and change priorities. This is very demoralizing for R&D teams.

3. Complex bureaucracies lacking accountability: Many times executives set up complex organization structures to satisfy (mainly) executive politics. Other times, there are overlapping roles and responsibilities. In either case, there is lack of accountability for different functions. One part of the organization not working hard impacts morale everywhere.

4. Unactionable strategies and goals: Many times executives set up big goals but most teams do not know what to do to achieve those goals. In one company the executives wrote a strategic plan which said cut costs and improve innovation (literally). They then proceeded to tell everyone to achieve those goals. No one knew what to do!

It is essential for managers to avoid these traps. One key would be to keep employee perspective in mind and provide clarity on how everyone can contribute. Other is to assess if there is a disconnect between the executive team perspective and that of employees at large.

Sony’s Next President Announces Future Plans

A quick note about Sony’s new CEO from Sony’s Next President Announces Future Plans from Tech-On:

First, Hirai pointed out that the current electronics industry is suffering from commoditization and price drops and Sony is no exception. He said that, to survive this severe competition, he will have a strong heart and a sense of responsibility to lead the company and establish a “one-management” system that allows him to quickly make judgments on various issues.”

I guess one management system could be very important in a company as vast as Sony. Otherwise, here are the new CEO’s top priorities:

As important measures that Hirai will take as a CEO, he mentioned (1) reinforcement of Sony’s core business, (2) rebuilding of its TV business, (3) reformation of its business portfolio and (4) acceleration of innovation.

Focus on the core business means become number one in digital imaging and grow in mobile phones. In TV Sony wants to move away from the difficult LCD market (See the Economist for some background) to hopefully higher margin OLED and Crystal LED TV. The thought about OLED is interesting in that Sony just quit consumer OLED TV market (See Engadget). Acceleration of innovation seems to mean focus on medical markets!

We should see how this turns out.

How to Innovate When Platforms Won’t Stop Moving

The article How to Innovate When Platforms Won’t Stop Moving in MIT Sloan Review has several interesting pointers towards R&D management:

Businesses must cultivate agility — the ability to adapt quickly to or even anticipate and lead change. Businesses must develop deep differentiating capabilities that enable them both to separate themselves from competitors and endure disruptions. Companies such as Apple and IBM show how agility and capabilities can enable organizations to shape-shift as industry models rapidly change.”

Prof. Cusumano has four suggestions on how to be more agile (rearranged based on needs for R&D):
1. Emphasis on flexibility: As markets, customer needs and platforms are changing rapidly, we need to change our development approach so products can be successful despite changes. This is hard to do using current processes and tools for R&D management, however, it is good to keep in mind.

The key for many firms is not to always be creating plans and pushing products out to market but to find ways to react very quickly to new information or responses from customers and other partners to what you are doing or intending to do.

2. Capabilities rather than strategy: One approach to flexibility is to develop capabilities that can be reused if market changes. Capabilities are broad tools while products are targeted towards specific needs. My suggestion is for R&D managers to characterize plans and projects as leading towards key capabilities in addition to products that satisfy particular strategies. This way a minor change in processes can help lead us to flexibility.

For example, the future is unpredictable, so strategy needs to change, but companies can still build unique capabilities that provide a stable base for new products and services as well as help them navigate through change.

3. Economies of scope rather than scale: In case flexibility adds costs to development, one way to make the business case for the additional investment is to see that a broad set of capabilities will let companies address more market niches.

Economies of scope are also useful here because customers today often want a variety of new products and features but do not want to pay much money for them. Companies need to go beyond traditional scale economies and find ways to leverage existing knowledge in the form of reusable components and frameworks to produce a variety of products and services as efficiently as possible.

4. Information Pull Rather than push: To understand what capabilities to focus on, companies need better market information.

Managers also need to create mechanisms that “pull” information from the market in something resembling real time, such as customer-driven product development processes or production management systems that allow firms to change their product mix very quickly.

How do we identify what market information to focus on? Look for “megatrends”:

Managers certainly need to ask themselves — and the smartest people they can find around themselves, inside and outside the company — what are the potential megatrends that could disrupt their businesses in the future or make their business models obsolete. In the industries that I study, for example, there have been two such trends emerging over the last several decades: the rising importance of industrywide platforms as opposed to stand-alone products, and the rising importance of services or service-like versions of products.

That brings us to platform-based design (PBD), which underlies points 1 to 3 above. Prof. Cusumano is focusing on computing industry where platforms provide standards (e.g. PC, WCDMA, 802.11) and standard interfaces (e.g. PCI express, USB) that can be used to define flexibility. There are other forms of platform-based design that can be used in industries such as medical devices which do not depend on standardization. I recently presented a paper on this form of PBD. Please email if you would like to find out more.

Finally, this focus on flexibility may require more significant changes than just R&D:

IBM did a number of studies and figured out that it had all these processes that were designed to ensure quality, but they also meant that it was extremely slow to develop anything new. Different markets, like the PC market and then later the Internet market, required much faster decision making. They didn’t require the same kind of quality standards, but different kinds of standards. And so IBM did decentralize its decision making, but without physically breaking up the company. IBM reorganized into a small number of groups that mapped better to how customers needed to integrate the new technologies.

Kodak’s 30-year Slide into Bankruptcy

The article What’s Wrong with This Picture: Kodak’s 30-year Slide into Bankruptcy in Knowledge@Wharton makes some interesting points. Here is my summary. Kodak, once an industry leader and an innovator could not succeed because of the fear of cannibalizing existing film business.

The technology is one of countless innovations that Kodak developed over the years but failed to successfully commercialize, the most famous being the digital camera, invented by Kodak engineer Steven Sasson in 1975. Digital technology has all but done in the iconic filmmaker. Since 2003, Kodak has closed 13 manufacturing plants and 130 processing labs, and reduced its workforce by 47,000. It now employs 17,000 worldwide, down from 63,900 less than a decade ago.

The challenge in innovation is getting it into a product. Most companies either focus on incremental improvement of current products or long-term research.

Innovations that reach a middle ground — such as envisioning new product lines in the next two to five years — are much more elusive and often don’t have a champion pushing for them in the organization.

One of the root causes is that innovation disrupts the business model. Kodak made money on film and gave cameras away. They could not do the same with Digital imaging.

The company didn’t envision making money off cameras themselves, but rather the images it assumed people would store and print. “If you look at R&D, they were superfast. In terms of the business model, they were quite the opposite.

The problem is the the existing business model is the one generating all the profits. It is very difficult to divert those into new competing business models (because most companies I know allocate R&D resources to each product line based on the revenues they generate). Furthermore, many times Wall Street expectations drive businesses away from innovation.

Over the years he watched digital projects lose battles for research dollars. Even though film’s market share was declining, the profit margins were still high and digital seemed an expensive, risky bet.

Furthermore, a successful business model leads companies to try to change the customer needs to fit existing business model instead of trying to change the business model to fit the market needs.

“It succumbed to inside-out thinking,” says Day — that is, trying to push forward with the existing business model instead of focusing on changing consumer needs. Accustomed to the very high film margins, the company tried to protect its existing cash flow rather than look at what the market wanted.

So, one lesson is to periodically ask the question about what is our core competency? What is our businessbeyond our business model – the way in which we are making money right now? Is our competency in customer understanding (e.g. Nordstrom), technological superiority (e.g. Intel) or execution efficiency (e.g. Walmart). Then focus the investment around the competency:

Innovation is “the match between a solution and a need, connected in a novel way,” Terwiesch says. Kodak had a choice in how it pursued innovation: If it focused on the need, it would have to find new ways to take and store photos. If it focused on the solution, it would have to find new markets for its chemical coating technologies. Kodak’s competitor, Tokyo-based Fujifilm, focused on the solution, applying its film-making expertise to LCD flat-panel screens, drugs and cosmetics. “You have to make a decision: What are you as a company? Is it understanding the need or understanding the solution?” Terwiesch asks. “These are simply two very different strategies that require very different capabilities.

Another approach is to spin out companies that focus on new innovation and business model. It is hard to focus on disruptive innovation within an existing business.

He recalls efforts in the 1980s to drive innovation by setting up smaller spin-off companies within Kodak, but “it just didn’t work.” Venture companies in Silicon Valley are “pretty wild,” Larish adds. “In Rochester, people come to work at 8 and go home at 5.”

On the other hand, the same problem makes spinning out businesses also hard. Who is going to decide how much investment should go into which spin off? Does one set up completely separate infrastructure for the spin off or bring it back once it succeeds? How does one measure success of the spin off? Hence, once the spiral of business model driving the business starts, it is difficult to get out of it.

The digital era pushed Kodak into “a position of reacting,” and the company seemed to lose focus. “They had reorganization efforts … [and] brought in CEO after CEO. When you have that much disruption and change,” it becomes difficult to implement a long-term strategy

The final quote is one we should all remember:

“Don’t assume that just because you’re not willing to do it, somebody else won’t.”