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Outsourced R&D: The threat to American innovation

Companies make headlines when they outsource manufacturing or—as is occurring more frequently—when they bring it back home to the U.S., a practice known as reshoring. What generates far less news is the potential impact on American innovation and productivity when companies outsource something as critical as research and development.

A recent study by the Center for European Economic Research shows that the cost savings that come from outsourcing R&D can easily be overshadowed by the added complexity to manage the process throughout the organization. The report, which used survey data from a wide range of German companies, concluded that outsourcing more than 15 percent to 30 percent of a firm's innovation activities could make it difficult for management to maintain the effectiveness of the organization.

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Of course, the underlying risk that U.S. analysts point to in any discussion of R&D outsourcing is that companies here will do it to a degree that erodes innovation and creativity. But a look at the latest National Science Foundation (NSF) Science and Engineering Indicators shows that the majority of R&D (84.1 percent) by U.S. multinational companies is still done in the U.S. Perhaps the more noteworthy—and more worrisome—in the data from the NSF report is that other countries, especially China, Korea, and Taiwan, are increasing their research investments at a faster rate and are turning out a greater number of scientists and engineers than the United States.

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Companies that choose to outsource R&D do so for a variety of reasons. Some look beyond their home country because they need to speed up the development of a product and can't find enough of the skills domestically. Other companies, such as Deere & Co. and Eastman Chemical, do it to gather local knowledge in a market where they have, or are building, a significant presence. Still others do it primarily for the cost savings.

Beyond zero-sum R&D

R&D outsourcing done correctly is more about collaboration than cost savings, said Stewart Witzeman, director of the Eastman Innovation Center at Eastman Chemical, a company initially started in 1921 to supply raw materials to Eastman Kodak. "No company, no matter how capable and talented its R&D team, can claim to have all the smart people in the world," he said. "It's very important to go where the best capabilities are. If companies are doing it solely for the cost savings, to me that implies a zero-sum game."

In addition to the substantial R&D work Eastman Chemical does in partnership with researchers at North Carolina State University (the Eastman Innovation Center is based on the NC State campus), Witzeman said the company has research centers in China, the Netherlands, England, Germany and Singapore. Witzeman does advise caution in certain instances. "Projects not protected by patents or those involving sensitive trade secrets should not be outsourced," he said. "There are certain core R&D projects that need to be kept in-house, and I believe most companies understand that."

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For instance, Deere, the global farm-equipment manufacturer, would not consider outsourcing the design of the customer experience for any of its products. "That's something we consider really critical and core to our operations," said John Reid, director of product technology and innovation at Deere. But Deere has outsourced the coding of its mobile apps. "We could take the stance that we need to know how to write all the apps ourselves, but that's not what makes the difference to our customers," Reid said. "We leverage others to build our app so that it's supported across all different devices."

"It's a big world out there, and if a company is going to compete in it, then it has to look outside its home market for that talent." -Stewart Witzeman, director of the Eastman Innovation Center at Eastman Chemical

Deborah Wince-Smith, president of the Council on Competitiveness, a nonprofit that promotes the United States' economic competitiveness around the world, said that talk of an "innovation deficit" occurring in the U.S. is not caused by private-sector outsourcing but rather by uncertainty surrounding the level of federal and state funding of R&D. The Budget Control Act of 2011 (BCA) has direct effects on federal government appropriations, and that could impact federal money earmarked for R&D, according to Battelle/R&D Magazine's "2014 Global R&D Funding Forecast."

"Our best-performing companies are global enterprises, and they are rightfully going to access the best talent and target centers of excellence all over the world," she said. Take General Electric's recent decision to build a global research and development center in Brazil to better serve all of Latin America, including customers such as oil-and-gas giant Petrobras. Roughly 40 percent of GE's Latin American revenue last year came from Brazil.

Indeed, as U.S. multinationals see some of their healthiest growth occurring in markets outside North America, their need to outsource R&D to these locales grows, too. Atul Vashistha, chairman and CEO of Neo Group, a global services and sourcing company based in Pleasanton, California, says adapting to these changing circumstances is crucial if these companies want to stay competitive.

"Companies such as GE, Texas Instruments, and Intel recognize that they need to innovate or do product development that's more suited to these markets," he said. What many of them have done is set up innovation and product development centers in India, China and the rest of the Asian market. "What they've come to see is that the incredible talent there may have started off developing products for the Asian market but suddenly these companies recognize that they can service the U.S. and European markets with the same talent," Vashistha explained.

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For example, he said Google recognized 10 years ago that while search engine access in the U.S. was happening on laptops, it was taking place in Asia largely through mobile devices. Google therefore set up their R&D centers in India and China to address this difference. As Internet access on mobile devices increased in the U.S., Vashistha said Google was able to tap into the wealth of experience and talent it had developed in Asia to better serve the U.S. market.

The health and strength of the U.S. economy is closely tied to its investment in R&D. In 2014, U.S. R&D spending is projected to reach $465 billion, or 2.8 percent of GDP, according to the Battelle/R&D Magazine report.

While America still leads the world in R&D investment, countries around the world are working hard to catch up. As Witzeman of Eastman Chemical points out, the U.S. is not the only place where top R&D talent exists. "It's a big world out there," he said, "and if a company is going to compete in it, then it has to look outside its home market for that talent."

—By Susan Caminiti, special to CNBC.com