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US offshore outsourcing of R&D: Accommodating firm and national competitiveness perspectives

Thomas A Hemphill
Department of Strategic Management and Public Policy, School of Business, George Washington University, Alexandria VA, United States of America

Abstract

In the United States (US), the policy debate surrounding offshore outsourcing of 'white collar' service jobs, many of them high-paying, professional and technical positions, has recently focused on an area having potentially serious consequences for America's long-term national competitiveness: the business strategy of offshoring firm research and development (R&D) activities of critically important industries, such as information technology (IT) and pharmaceuticals.

The author argues that, from a business perspective, an effective R&D offshore outsourcing strategy embraces an 'Open Innovation' approach, which emphasizes a careful balance between retaining core internal R&D capabilities while leveraging formal, collaborative technology relationships that enhance new product development and protect the corresponding intellectual property.

US public policy complements this private sector strategy by establishing a foundation for improving the technological capabilities of the citizenry, restricting technology-sensitive areas from offshore outsourcing due to national security imperatives, and providing tax incentives for domestic R&D investment (and eliminating public financial incentives) for offshore outsourcing.

Keywords

offshore outsourcing, collaborative technology, offshore R&D

Article Text

In the United States (US), the policy debate surrounding offshore outsourcing of 'white collar' service jobs, many of them high-paying, professional and technical positions, has recently focused on an area having potentially serious consequences for America's long-term national competitiveness: the business strategy of offshoring firm research and development (R&D) activities of critically important industries, such as information technology (IT) and pharmaceuticals.

Offshore outsourcing of R&D is a growing strategic phenomenon in the IT industry, with industry leaders such as Intel, Microsoft, Motorola, and Texas Instruments having moved product development centers to China, and Accenture, AMD, Cisco Systems, Google, IBM, and Microsoft outsourcing product development centers to India. Microsoft is reportedly planning to invest an additional $400 million in India and $750 million in China on R&D between 2004 and 2006 (Austin, Hills and Lim 2003) and Accenture and IBM adding 15,000 additional positions in India by the end of 2005 (Travis 2004). Frost & Sullivan, another market consulting group, estimate that the IT R&D outsourcing market in India will increase from the present level of $1.3 billion annually to $9 billion by 2010 (Frost & Sullivan 2004). According to AMR Research, this translates to 800,000 IT-related jobs being offshore outsourced from the US to India by 2008 (Travis 2004).

For the US pharmaceutical industry, offshore outsourcing has become an increasingly utilized R&D strategy over the last few years. In a recent study, private banker UBS Warburg found that of the $30 billion that the US pharmaceutical industry invested in R&D in 2001, around 20 to 25 percent of this was spent on outsourcing; analysts predicted that this outsourced portion of pharmaceutical R&D spend would expand by 1 percent through 2005 (Pharmiweb.com 2004). This pharmaceutical R&D strategy has been embraced by GlaxoSmithKline, which is planning to conduct four clinical trials in India in 2004 (Frost & Sullivan 2004).

But other industry sectors, such as automotive, are also moving R&D offshore. Examples include vehicle systems and glass supplier Visteon which is launching R&D centers in China; and General Motors, choosing India to outsource product development work in the near future (Frost & Sullivan 2004). Furthermore, industrial systems technology leader General Electric already employs 6,000 scientists and engineers in ten foreign countries (Austin, Hills and Lim 2003).

To address the US R&D policy debate concerning sustainable competitiveness for the firm and nation-state, this article will first introduce the managerial motivations for offshoring R&D activities. Second, organizational and environmental factors inhibiting offshoring R&D activities will be identified. Third, the potential consequences of exporting R&D and its impacts on national competitiveness will be briefly discussed. Finally, a business and public policy model - which can influence the development of a consensus R&D offshore outsourcing policy framework accommodating both private and public sector competitiveness concerns - will be presented for private and public sector consideration.

Managerial Motivations to Offshore R&D

The primary driver of US firms' R&D offshore outsourcing is ostensibly cost-savings. The business press points out that IT and telecommunications development work, costing $100 an hour in the US, can be performed for as low as $20 an hour in India or China. However lower costs is only one factor, albeit an important one, in this strategic decision-making process. The primary driver of offshore outsourcing of R&D is the availability of highly-educated intellectual capital. For example, one-third of the 180 computer scientists at the Microsoft Beijing research center have PhDs from US universities and are responsible for developing the 'digital ink' that makes handwriting show up on Microsoft's new tablet PCs (Engardio et al 2003). In the IT field, India has the largest number of Java-certified developers in the world and its scientists and engineers are fluent in English, thereby reducing communication problems found in other countries popular for outsourcing (Frost & Sullivan 2004). Moreover, India offers IT R&D opportunities in an array of computer sub-specialties, including computing architecture, encryption and network security, human computer interface, programming language and software engineering (Offshore Outsourcing World 2004). Similarly, in telecommunications R&D, business support systems, new versions of IPv6, video servers and wireless sensors opportunities are available for offshore outsourcing on the Indian sub-continent.

Foreign companies are also attracted to Asia's academic institutions as a source of intellectual capital, with companies looking to leverage foreign research efforts and facilities. Moreover, firms now have the ability to perform R&D 24 hours a day, seven days a week. For example, programming code is developed in the US during regular work hours, and then follows the time zones to India, on to Europe and back to the US for the beginning of the next 24-hour period (Babcock 2004). The Boston Consulting Group (BCG) reports that its study of offshore outsourcing found that US firms with major operations in low-cost countries (China and India, for example) report faster R&D (Blustein 2004). Furthermore, the BCG study found that mid-level engineers in offshore locales tend to be more motivated than mid-level engineers in the US and Europe.

The ability of these offshore R&D centers to support co-located manufacturing activities that have previously moved offshore contributes to product development efforts - improving product cost, quality, performance and availability. This allows firms to accelerate the availability and acceptance of state-of-the-art technology and products to business and consumer markets in these underdeveloped market areas. Firms who maintain R&D technical centers worldwide contribute to the local economies of those countries, typically by leveraging such centers of R&D to stimulate their own economies. Those R&D centers ultimately become part of those nations' economic development strategies which result in improving consumer income levels that, in turn, allow for the purchase of higher value-add business and consumer products (National Science Board 2002).

In the pharmaceutical sector, Ernst & Young (2004) identifies India as an emerging hub for collaborative and outsourced pharmaceutical R&D. India can combine lower-cost manufacturing with adequate regulatory protection of intellectual property (IP) resulting in a potential 30 to 50 percent cost saving for global companies. A recent phenomenon has Indian companies shifting their strategic models from business-driven research to research-driven business. According to Ernst & Young, Indian companies are adopting a combination of alternative business models to navigate competition and opportunity. These include:

• Focusing on export led growth through subsidiaries or acquisitions in high margin regulated markets
• Bolstering research capabilities
• Partnering across the value chain with multinationals through licensing, collaborative R&D or co-marketing arrangements
• Contract research and manufacturing

Factors Inhibiting Offshoring of R&D

Given the reasons cited above, one would think that it would be a relatively easy decision for management to offshore R&D. But like many so-called obvious decisions, the devil is in the details. For example, when AMR Research concluded that the benefits of offshore outsourcing of R&D are too great to ignore, the market research firm also noted that it will take the implementation of three projects before a firm will benefit from any cost savings (Watkins 2004). Too often, companies do not make the financial investment that is required to make offshore outsourcing cost-effective. For example, the total cost of outsourcing (TCO) in the IT industry includes: expenses involving selecting a vendor (two percent); transitioning work over to the offshore partner (from two to three percent); layoff and retention expenses (ie severance and retention bonuses) (from three to five percent); cultural costs (eg comfort level with speaking up and offering suggestions and high offshore employee turnover rates) (from three to 27 percent); the cost of ramping up (ie How well-defined and accepted are the internal software development and maintenance processes?) (from one to ten percent); and the cost of managing an offshore contract (from six to ten percent) (Overby 2003). In a survey of 101 companies, CIO Magazine calculated (using the above TCO formula) that even in the best-case scenario, a firm which spends $16.2 million on offshore outsourcing contracts will actually spend 15.2 percent more (a TCO of $18.7 million) in a best case scenario - and in a worst case scenario, as much as 57 percent more (a TCO of $25.4 million) (Overby 2003).

Not surprisingly, morale problems can also result from an American workforce of computer programmers, engineers, and scientists who are critical of offshore outsourcing, leading to productivity reductions and legal actions from laid-off workers. On the other hand, offshore outsourcing is vulnerable to high turnover rates, with Indian or Chinese engineers (who operate in a virtual world) developing only superficial loyalties to a team or vendor. This, in turn, creates potential problems relating to sharing company trade secrets with a new employer and competitor, since according to the National Association of Software and Service Companies, annual employee turnover in India can reach as high as 35 percent (Overby 2003). The loss of core proprietary business knowledge and intellectual property, the vital R&D work that ultimately yields the new products capable of rapidly changing software markets, however, is a key consideration when calculating the risk of offshore outsourcing of R&D in the IT industry (China, for example, has virtually no trade secret laws). For many American executives this risk analysis translates into a strategy of carefully offshoring R&D activities that do not compromise the core intellectual property (and competitive advantage) of the company (Riccuiti & Yamamoto 2004). This results in many American companies adopting a business model combining onshore and offshore R&D functions.

In the IT industry, so-called pioneering efforts in software development are usually not appropriate for offshore outsourcing - especially for smaller vendors whose competitive advantage is innovation and rapid delivery to customers (Watkins 2004). Offshore outsourcing inhibits engineering teams from directly and consistently interacting with critical cross-functional teams to ensure direction, control, quality, and the speed of rapid implementation. The cultural, language, and time differences can hinder simple communications, often creating an 'us versus them' mentality and adversely impacting the development process. Furthermore, the absence of interaction with sales and usability functions, or exposure to industry-specific US business requirements, also limits overseas engineers in managing more than a component of a project.

Impacts on US Global Competitiveness

There are two primary negative competitive impacts that can emerge as a result of widespread R&D outsourcing. First, fewer job opportunities and downward pressure on wages will occur as greater numbers of scientific and engineering jobs are shifted to lower cost, overseas locations; consequently, these employment conditions are likely to discourage many of America's best and brightest students from pursuing careers in science and engineering (IEEE-USA 2004). This could eventually weaken US leadership (ie the 'brain trust') in technology and innovation, leading to serious repercussions for both national security and economic competitiveness. Second, an issue that has been referred to earlier is the loss of crucial intellectual property to overseas competitors as a result of unidirectional technology transfer. Inadvertent knowledge transfers, or employees consciously transferring trade secrets to competitors (encouraged because of difficulties in enforcing foreign civil law covering confidentiality clauses in employee contracts), adversely impact US global competitiveness.

But offshore outsourcing of R&D does have potentially positive impacts on US global competitiveness. R&D collaboration involving foreign-based firms is a central part of scientific research and increases in importance as research activities grow in expense and complexity (Austin, Hills and Lim 2003). Outsourcing can be interpreted as a form of collaboration that fosters both domestic and foreign R&D capabilities. Strategic technology alliances (which serve mutual interests) can open doors toward innovation partnerships between US and foreign corporations, governments, and academia. In addition, for US corporations there is a need to build pools of highly skilled scientific and engineering talent to replace the American intellectual capital which will be retiring over the next few years. These firms face the sobering reality that by 2010 there will be 7 million fewer working Americans, ages 25 to 45, then there were in 2000 (Malachuk 2004).

A Proposed Business and Public Policy Model

Offshore outsourcing of R&D, while confronted with many organizational and political challenges, is impossible for American firms to ignore as a source of sustainable competitive advantage. For American companies, capturing the valuable insights generated from global R&D require a well-coordinated business strategy. Henry Chesbrough (2003) proposes an 'Open Innovation' paradigm for managing industrial R&D that

...assumes that firms can and should use external ideas, and internal ideas, and internal and external paths to market, as the firms look to advance their technology. Open Innovation combines internal and external ideas into architectures and systems whose requirements are defined by a business model. The business model utilizes both external and internal ideas to create value, while defining internal mechanisms to claim some portion of that value (Chesbrough 2003, p.xxiv).

Chesbrough (2003) sees internal R&D as critical for managing successful innovation; specifically, its role in defining the architecture to organize the many parts of a new system, albeit one confronted with ambiguities and complexity. This managerial challenge requires the firm to develop systems-level expertise in understanding how technology works, thereby assessing what aspects of a new technology have what consequences for the larger organizational system. Therefore, developing this understanding of the relationships between the parts of the system as a whole is a critical role for a company's innovation system.

For R&D activities, the form of offshore outsourcing that will most benefit American corporations will involve formal, proscribed, long-term collaborations that offer improved trade secret protections. Critical, coordinating information concerning new product development will be handled internally, while component-oriented information will flow into global R&D project efforts. Formulating and implementing this firm R&D business model will require a careful balance between maintaining core internal R&D competitive capabilities (intellectual capital) that can be enhanced through leveraging external R&D collaborations. For example, in the IT industry, offshore software development has in the recent past been focused on mainframe maintenance, Y2K fixes and other general software maintenance work. However, the role for offshore work has now evolved into high-end and complex algorithm-intensive projects in Russia, India, and China. The 'job-shop' mentality of the past will no longer provide mutual firm and country competitive benefits or protections for the proprietary information that is now emerging in offshore R&D centers.

US public policy attempts to limit offshore outsourcing of jobs by the states and the federal government have focused on governmental contracts or restrictions on personal information; private R&D has not been a target of legislative interest (National Conference of State Legislatures 2004). The longer-term federal response to offshore outsourcing of R&D involves the implementation of a US technology competitiveness strategy that:

• Explicitly identifies those areas critical to national security and, through rigorous policy implementation, retains R&D activities domestically
• Improves mathematics, science, and engineering education, including actively encouraging students in the K-12 grades to consider college and university education in these fields and provides attractive financial incentives for American students to pursue graduate education (this is a fertile area for a robust and coordinated national public-private collaborations)
• Eliminate tax and other government incentives that encourage US companies to move highly skilled, technical jobs overseas
• Institute a permanent tax credit for R&D performed in the US
• Increase federal investments emphasizing basic and applied research in the physical sciences and engineering focused on generic and enabling technologies that can be developed into products that are manufactured and services that are provided in the US
• In conclusion, from a business perspective, an effective R&D offshore outsourcing strategy embraces an Open Innovation approach, which emphasizes a careful balance between retaining core internal R&D capabilities while leveraging formal, collaborative technology relationships that enhance new product development and protect the corresponding intellectual property. US public policy complements this private sector strategy by establishing a foundation for improving the technological capabilities of the citizenry, restricting technology-sensitive areas from offshore outsourcing due to national security imperatives, and providing tax incentives for domestic R&D investment (and eliminating public financial incentives) for offshore outsourcing.

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