Organizational RQ

Anne Marie KnottProfessor of Strategy, Washington University

Director, Berkeley Research Group_______________________________________________

April 17, 2012SIKM Leader’s Community Call

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My life before academia

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The innovation engine is broken

Historically R&D viewed as engine of economic growth

Obama in State of the Union address holds it up as solution to growth problem

Valid through the space race No longer seems to be the case

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Axis Title

Impact of R&D on GDP growth

GDP growth

R&D intensity

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No good measures of R&D effectiveness– R&D spending is an input measure (51% of firms using)– Patents neither universal or uniform

• Less than 50% of firms doing R&D patent; universality• 10% of patents comprise 85% of economic value; uniformity

– Neither Patents nor R&D spending is reliable• Anomaly in their relationship to market value• Booz study each year says no correlation with firm growth

Implications– Front-end: Firms use rules of thumb to choose R&D investment levels– Back end: Can’t tell whether given practice helps or hurts capability

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The Problem: Firms and policymakers fly blind

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Front-end: unsure how much to spend

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Majority of firms are spending sub-optimally

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Back end: Unsure what makes them effective

Changes appear random

Increasing IQ

Decreasing IQ

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0 50 100 150 200Firm IQ 1987-1996

Cross Plot of Old IQ versus New IQ

Number of Firms

Mean Change

Statistically Significant

Increasing IQ 178 13.0 70Decreasing IQ 184 -12.5 65

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A real world illustration of both problems

Charles House, a former longtime H.P. engineer …now at Stanford University, openly rejoiced when he heard that Mr. Hurd was leaving. “I think the sexual harassment charge was a total red herring,” Mr. Hurd was systematically destroying what had always made H.P. great. … The research and development budget used to be 9 percent of revenue, … now it was closer to 2 percent.

Is Mr House right: Did Hurd destroy what made HP great? With existing measures, we have no way of knowing!

– Whether R&D capability has deteriorated, or by how much– Whether the correct investment is 9% or 2%

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Solution: Organizational IQ…well now RQ

Derived from firm’s production function

Y = AaBb

Output = Capitala *Laborb

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Organizational RQ extends the PF in two ways

Expand to include R&D:Output = Capitala *Laborb * R&Dg * Spillovers d * Advertisinge

Make all the exponents firm-specific:– Raw RQ is the exponent, g, on R&D

• “firm-specific output elasticity of R&D”• % increase in output from 1% increase in R&D

– Reported RQ rescales g to the human IQ scale (m=100, s=15) Interpretation:

– Analog to individual IQ: • Those with higher IQ solve more problems per unit of input:• time (individuals), money (firms)

– Need to generate AND exploit innovation

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Normally distributed Variation (within industry) > Variation (across industries)

10IQs by Industry

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Distribution of Firm IQ

Some properties of RQ

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Its most important properties

Universal: RQ can be estimated for all firms doing R&D Uniform: An RQ of 100 (or any other number) means

the same thing across all firms regardless of currency Reliable: It “predicts” firm behavior and market value

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The IQ Guessing Game: The Business Week 5

<85 85-95 95-105 105-115 >115

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Distribution of IQ guesses for BW5

Apple Google

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Comparing RQ to other innovation indices

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Forbes 100 vs RQ

Innovation Premium

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Business Week Rank vs RQ

Business Week Innovation Rank 2010

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IQ defines optimal R&D investment

Theory tells us profits should increase by

Both predictions hold in the real world! Firms with Higher RQ tend to spend

more on R&D Market value increases if you

increase

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Optimal R&D and Market Value both increase with RQ

Using RQ immediately: Set R&D budget

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The REAL promise of RQ: firms can change theirs

Firms can change their RQ!– Though currently random

There is no theory to tell us how much this increases growth, but…– Empirics tell us 10% increase in RDg

increased growth rate 3.2% The holy grail: RQ will do for R&D

– What TQM did for manufacturing cost– What hospital report cards do for

morbidity and mortality Firms are real implementors,

….but analysts are fuel!

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RQ Summary

The most intuitive measure you can construct for R&D effectiveness It’s universal, uniform and reliable Application

– Solves the up-front problem of setting R&D budgets:• Immediate benefit: $1 trillion increased market cap just for top 20 firms!• Medium term benefit: Better R&D allocation should increase RQprofits and market value

– Solves back-end problem of knowing effectiveness: • Medium term benefit: Keeping what’s effective (dropping what isn’t) should increase

RQprofits and market value

To learn more:– Harvard Business Review article “The Trillion Dollar R&D Fix” hits online and

newsstands today: http://hbr.org/magazine• Includes online tool to lookup firms’ RQ

– www.amkANALYTICS.com offers firm reports and subscriptions to RQ data– For help implementing RQ:www.brg-expert.com/professionals-anne_marie_knott.html