The R&D Revolution
If you’re looking for the car design of tomorrow, who ya gonna call? A steel mill?
After holding steady through the recession, research and development spending is slowly gathering steam across American business. Among manufacturers and their suppliers, profits from R&D investments are looking brighter, especially when compared to capital investments in plants and equipment.
But today’s industrial R&D is a far cry from a roomful of scientists dreaming up ideas for a company’s marketing department to peddle. “I’ve worked in every aspect of research and development in the industry,” says Blake Zuidema, who joined the steel industry 24 years ago as a research and development engineer. His current job, director of automotive product applications at the world’s largest steelmaker, ArcelorMittal, finds him re-engineering the design of vehicle skeletons to trim weight with his company’s new steel alloys.
Sixty percent of ArcelorMittal’s annual R&D spending of nearly $300 million is targeted at product innovations in collaboration with auto industry customers, Zuidema says.
“In the past we would do experiments in the laboratory, and when we found something that looked attractive we would go out and try to sell it in the market.” Today, the customer is in the driver’s seat at metals producers, he says.
Like ‘Putting a Man on the Moon’
The U.S. mandate for fleet fuel efficiency—54.5 miles per gallon by 2025 for cars and light trucks—has called all R&D hands on deck in the automotive supply chain. It’s technically not rocket science, but “achieving [54.5 mpg] is on par with putting a man on the moon,” Zuidema says.
“All the new power trains in the world aren’t going to get you to 54.5 mpg,” he says. “Light-weighting is a very big part of getting to the requirement. Reverse engineering is about more than just steel properties and gauge reduction. It is also about finding ways to make all parts of the body structure work together synergistically to achieve optimum performance at minimum weight.”
Demand for energy-efficient materials and products is driving innovation among original equipment manufacturers (OEMs) and their suppliers up and down the manufacturing supply chain. At the same time, within OEMs and their suppliers, a second R&D agenda is unfolding.
“We are in the middle of a particularly intense era for process innovation,” says Cliff Waldman, director of economic studies at the Manufacturers Alliance for Productivity and Innovation in Arlington, Virginia. “This is a dramatic and interesting and scary time with respect to new processes and the way the factory floor is changing.”
“Logistics costs, lean inventories and shorter product lives are driving innovation. This is how we level the direct labor cost differential with foreign competition.”
The 3-D Disruption
The looming breakthrough in industrial process invention is additive manufacturing, the scaled-up application of 3-D printing. Instead of cutting and shaping materials to fit a product design (subtractive manufacturing), additive manufacturing applies layers of carbon fibers, plastics, ceramics or metal powders to replicate the design—a potential revolution in manufacturing.
Additive manufacturing may never dominate mass production factory methods, but it’s the leading edge of a broad move toward simpler, smarter manufacturing routines. The logistics of manufacturing—shrinking space and time in the supply chain—underlie much of industrial R&D, says Steve Vanderink, regional manager at Iscar Metals in Arlington, Texas, a unit of Berkshire Hathaway Inc.
“Logistics costs, lean inventories and shorter product lives are driving innovation,” he says. “This is how we level the direct labor cost differential with foreign competition.”
“In the future, there is a need to make manufacturing more mobile and flexible,” says Roger Hart, a 30-year veteran of industrial automation and R&D engineering manager for Siemens Industry Inc., a unit of Germany’s Siemens AG in Lebanon, Ohio. “Companies can move their factories to wherever the manufacturing is needed and move within their factories. Aerospace—Boeing and Airbus—is driving this.”
Additive manufacturing will bring manufacturing jobs to communities that never had a factory, says Jay Rogers, CEO of Local Motors Inc. in Chandler, Arizona.
Working with Cincinnati Incorporated, Siemens and the Oak Ridge National Laboratory, Local Motors manufactured an automobile called Strati inside a booth at last summer’s International Manufacturing Technology Show in Chicago. The primary material used for the frame, body and seats was acrylonitrile butadiene styrene, known as ABS plastic, reinforced with carbon fiber. The process took 44 hours, compared to about 20 hours to assemble a Toyota Camry from its components, but the plant and equipment investment common to traditional manufacturing obviously shrank, Rogers says.
This is a dramatic and interesting and scary time with respect to new processes and the way the factory floor is changing.
“We want people in local areas, with local fuel choices, local materials and other things to be able to express their ideas,” he said. “Having a microfactory in their area allows them to express it the most. Our business has been directed at developing processes and a footprint that would allow that to happen.”
“It’s too soon to understand the ramifications” of additive manufacturing, says ArcelorMittal’s Zuidema. “There’s a very large installed infrastructure for building cars that is very cost-effective, using cost-effective materials and producing vehicles that are quite affordable to the consumer. Redoing the whole infrastructure would take some time, but we are pushing the envelope on these technologies.”
Measuring Industrial Innovation
Manufacturing geeks aren’t the only ones tracking the innovations underway in industrial products and processes. Wall Street is developing new ways to measure R&D inputs and outcomes in search of investment bargains among industrial stocks. Meanwhile, the U.S. government and its European counterparts are building a new statistical base for policymakers that better measures the contribution of innovation to economic growth.
The growth of R&D spending in the U.S. has outpaced economic growth since the 2008-2009 recession, according to the National Science Foundation. For example, R&D spending by business, government and academia climbed 3.8% in 2012, compared to 2.2% growth in GDP. American companies account for 70% of total R&D spending.
Internationally, companies that spend the greatest share of their GDP on R&D include Korea (4.0%), Israel (4.4%), and Japan (3.4%), based on the latest (2011) data from the National Science Foundation. The United States spends at a rate of 2.9% and China 1.8%. Among the states, the top five on business R&D in 2012 (the latest data) were California ($81.7 billion), Massachusetts ($17.5 billion), New Jersey ($15.8 billion), Texas ($15.2 billion) and Michigan ($14.9 billion), according to the National Science Foundation.
Manufacturing industries produce two-thirds of U.S. business R&D. The auto sector is the third-largest R&D spender as a percentage of balance sheet cash among major industry groups, behind semiconductors and biotech, and ahead of software and technology hardware. In 2012-2013, the auto sector recorded the third-fastest growth in R&D spending, behind software and telecommunications, and ahead of health care and computers and electronics.
“During the recession, R&D spending went down very modestly, only a third as much as revenues fell,” says Barry Jaruzelski, a senior partner in Strategy&, a business strategy unit of consulting firm PwC. “They shifted to more incremental, low-risk R&D projects, away from higher-risk efforts. What people are saying now, which I think is an encouraging sign built around confidence, is that going forward they are shifting the mix to higher-risk, long-term investments in research and development.”
The Beer Can on Wheels
It may seem ironic, considering typical business complaints about government regulation, but mature industrial companies seeking to redefine themselves as profitable innovators have embraced the Obama administration’s fuel economy mandates for cars and light trucks, with deadlines set for 2016 and 2025. More than 70% of Americans support requirements for better fuel efficiency in cars and trucks, according to Pew Research.
Automakers are the targets of CAFE (corporate average fuel economy) standards, which the government says will cut gasoline prices by $1 a gallon. The innovations needed to meet the new standards have sent nearly every auto supplier back to the drawing table to make engines and transmissions more efficient; trim vehicle weight and increase aerodynamic performance; reduce tire rolling resistance; boost the role of electric power, fuel cells and natural gas engines; and upgrade vehicle air conditioning systems.
“Sometimes it’s true: Necessity is the mother of invention,” says Jaruzelski.
Nowhere have the CAFE mandates made a greater impact on R&D collaboration than among industrial metals producers and their customers. When Ford Motor Co. ramps up delivery of its aluminum-body F-150 pickup this year, for example, the automaker could take a major step toward meeting its overall fleet fuel efficiency requirement.
Ford says the new body sheds 700 pounds from its best-selling vehicle. To counter possible customer worries about safety and muscularity in what’s been called a beer can on wheels, Ford is advertising its new F-150 aluminum body material as “high-strength, military-grade.”
Alcoa has a major stake in Ford’s F-150 marketing campaign. In the last two years, Alcoa has invested $575 million to expand automotive sheet production in Davenport, Iowa, and Alcoa, Tennessee. Last spring, CEO Klaus Kleinfeld told security analysts that by 2018 he expects to generate $1.3 billion in auto sheet sales—equaling nearly 6% of total 2013 sales. Together with putting more aluminum in commercial airliners and construction materials, Kleinfeld says the goal of Alcoa’s plunge into vehicle bodies is to create an “innovation powerhouse” out of a commodity-based business.
The New Commodity: Robots
The first commercial robotic arm for manufacturing, introduced in 1961 at a General Motors Corp. plant in New Jersey, weighed 4,000 pounds and was used to pick up hot die cast metal parts and drop them into a cooling bin. In 1969, a GM auto assembly line in Lordstown, Ohio, first deployed robots for spot welding. An enduring image of industrial innovation took the stage.
Today, industrial robots come in many sizes and shapes, and perform scores of tasks in manufacturing plants. “Robots have become a commodity product,” says Siemens’ Hart. The march of robots into factories continues, he says, but “due to the numbers being produced and the number of different manufacturers producing them, the costs have been driven down.”
Current research seeks to integrate and enhance robots’ brains so they become a more sophisticated part of the manufacturing process. Separate computerized controls for the robot and the machine tools robots serve—such as lathes, drills and other cutting tools—are being merged into a unified digital process embedded in a single robotic machine tool unit. Combining the robot and the machine tool simplifies performance, reduces costs and enables better verification of product quality, Hart says.
“We’re not there yet. But it’s inevitable. The need for separate digital controllers for robots and machine tools is going to go away,” he says. “There’s going to be collaboration between one of the robot vendors and one of the [machine tool] vendors that breaks the ice. There is a lot of R&D going on. It’s substantial in the dollar value.”
Such process innovation reflects the perennial drive for productivity—improved output at lower cost, Hart says. But a new motivation is asserting itself in manufacturers’ R&D labs. Hart calls it “mobility.”
Handicapping R&D and Its ROI
Although lacking the wow factor of killer apps and breakthrough drugs, retooling mature manufacturers and transforming industrial commodity suppliers into innovation engines is gaining attention as a tonic for sluggish economic growth. Unfortunately, measuring the costs and benefits of R&D is a murky exercise for government policymakers as well as investors.
Jaruzelski’s team at Strategy& has been evaluating R&D spending by major companies for 10 years. Quantifying returns on investment in R&D is the elusive “holy grail,” he says. One thing is apparent, he adds: “It’s not about how much you spend. It’s about what you do with the dollars. There is no significant relationship between how much you spend and how well you perform in terms of revenues, profitability, stock market returns or market capitalization growth.”
Among the big R&D spenders in Jaruzelski’s studies are GM; Germany’s Volkswagen Group and Daimler AG; and Japan’s Toyota Motor Corp. and Honda Motor Co. The 10 “most innovative companies” include 3M, General Electric and electric carmaker Tesla Motors Inc., according to a PwC global survey of R&D managers.
Yet even the “most innovative” companies often fall short of industry averages for R&D effectiveness, says Anne Marie Knott, professor of strategy at Washington University in St. Louis, Missouri. “Surveys are actually the worst way to rank company innovativeness. They are based on stories people happen to remember.” So Knott created a new metric for measuring R&D performance based on seven years of company data.
Highly ranked R&D performers in Knott’s algorithm are oil and gas giants such as Exxon Mobil Corp., Chevron Corp., Royal Dutch Plc. and ConocoPhillips Co. The energy sector has seen large payoffs from innovations in drilling technology. Non-energy companies with high R&D effectiveness scores include solar panel maker First Solar Inc., defense contractor Northrop Grumman Corp. and off-road vehicle maker Polaris Industries Inc., according to Knott.
She says her research is limited by the gaps in data reported by publicly traded companies on innovation spending and results. “We need to start asking firms what goes into their R&D effectiveness and then have the [Securities and Exchange Commission] impose that [as a reporting rule]. If firms know their R&D productivity, they can choose the optimal amount of R&D to maximize their market value.”
“The manufacturing sector does R&D for the rest of the economy.”
An Important Part of the Investment Story
Wall Street and government statisticians say a simple accounting rule change would help illuminate the role of R&D in U.S. economic growth as well as the intrinsic value of particular companies. R&D spending by U.S. corporations is currently reported on quarterly profit-and-loss statements as an expense, along with advertising and general administrative expenses. International accounting standards, on the other hand, treat R&D as a capital asset, putting investment in innovation on par with long-term investments in plants and equipment.
Recording R&D as a long-term asset rather than an immediate expense reveals the recent contrast between stable R&D spending and flagging capital expenditures for plants and equipment, says Ron Graziano, director of accounting and tax at HOLT Analysis, an equity analysis unit of Credit Suisse in Chicago.
Since the recession, “we see capital expenditures struggling,” he says. On the other hand, “R&D is almost as stable as dividends” in terms of how companies deploy their cash, he says. “It’s becoming an important part of a company’s investment story.”
In recent years, HOLT has uncovered a deep bench of manufacturing companies generating above-average cash flow returns on R&D spending. They include aircraft maker Boeing Co.; vehicle makers BMW Group, Ford, GM, Polaris, Volkswagen and Volvo AB; equipment makers Caterpillar Inc. and Cummins Inc.; and industrial suppliers including 3M Co., Acuity Brands Inc., Johnson Controls Inc., Lear Corp., Rolls-Royce Holdings Plc, Schlumberger Ltd. and Wabtec Corp.
“The U.S. seems to be spending a lot more on R&D than Europe,” Graziano says. But, he added, the benefits are best seen as “singles, not home runs.”
Researchers in academia and government are also trying to illuminate how R&D pays off. A system developed by Dale W. Jorgenson, a professor at Harvard University and chairman of the Bureau of Economic Analysis Advisory Committee, and Steve Landefeld, former director of the U.S. Bureau of Economic Analysis, combines traditional measures of labor productivity with other business data. Called multifactor productivity for manufacturing, the system culls data from the Bureau of Labor Statistics, the Bureau of Economic Analysis, the Federal Reserve Board and the Census Bureau. Eventually, the multifactor project designers hope to include data on educational attainment, health and the environment in a composite measure of national productivity. Similar projects are underway in other industrialized nations.
“Manufacturing innovation has a pretty big rate of return for the economy,” says Leo Sveikauskas, an economist at the Bureau of Labor Statistics who helped develop the multifactor system. “R&D pays off pretty well for the firms that undertake it, and it gives benefits to other firms and to consumers. The manufacturing sector does R&D for the rest of the economy.”
Can Government Drive Success?
R&D is risky business. Despite constant hopes for drug breakthroughs, no pharmaceutical company has ever made the annual PwC Top 10 survey of most innovative companies, Jaruzelski says. “A lot of pharma companies pour huge amounts of money in and nothing important comes out.”
What makes a winning innovator? Washington University’s Knott says success breeds success over the long run. “R&D spending will increase with R&D productivity,” she says. Companies with long-tenured CEOs who reject short-term financial obsessions stand a better chance of successful R&D programs, she says. “One thing that seems to matter is consistency.”
Many argue that government must also play a part. “The best thing government can do is create an atmosphere for fundamental research,” says Waldman of the Manufacturers Alliance for Productivity and Innovation. It’s not a matter of boosting commercialization of R&D projects at certain favored companies, he says.
Federal spending on R&D has dropped from nearly 18% of federal discretionary spending in 1965 to about 10% today, according to the American Association for the Advancement of Science. “We need to get our public investment in basic science back to where it was in the 1960s,” Waldman says. “Just invest in scientific advancement, not industry A versus industry B.”
A second role for government is education. “The single thing you want most is to ensure that a pool of scientific talent is available,” says Strategy&’s Jaruzelski. “Science is not innovation. Science is the stuff people pull off the shelf to create innovations.”
Bill Barnhart, a Chicago-based financial writer, was a business editor and columnist for the Chicago Tribune for 30 years. He is the author of MSCI’s 100th anniversary history, “Links in the Long Chain.”