Research: Don’t Offshore Your R&D

Just because a company can offshore some portion of its operations doesn’t mean it should. The benefits might come in the form of easily recognized savings on the balance sheet, but the costs may accrue over time in the more obscure form of added organizational complexity.

That appears to be the case with the offshoring of research and development, according to a new paper from the Center for European Economic Research. Offshoring some portion of a firm’s innovation may be beneficial, the authors argue, but beyond a certain point it becomes counterproductive.

As global competition has pressured firms to move portions of their businesses overseas, some have gone so far as to offshore research, development, and design. With nations like China ramping up their innovative capacities, why stop at offshoring manufacturing or customer support? This trend has caught the attention not just of the business world, but of the governments of many developed nations, which fear that such a shift would erode their competitiveness.

That concern may be overstated, given the downsides of offshoring innovation that new research reveals.

“It is commonly held that off-shoring requires also organizational restructuring,” the authors write, but there is disagreement about its effects. One side argues that offshoring “increases organizational complexity and hence reduces the organizational ability to adapt to changing environments” while the other suggests that it may unlock new sources of knowledge, or improve performance by focusing employees on smaller chunks of a problem.

So the researchers set out to test these arguments, using survey data from a wide range of German companies. They examined the relationship between offshoring of innovation and “organizational adaptability” – the ability of a firm to change organizational routines and processes in a way to improve the firm’s performance, measured by things like developing new products, reducing costs and reaction times, and improving quality and communication.

After adjusting for several other variables, the result was the inverted U-shaped curve below, suggesting that offshoring innovation can be beneficial, but only up to a point, after which it begins to hinder a firm’s adaptability:

Offshore_Innov365

(The Y-axis is looking at the probability that a company at any given level of offshoring doesn’t score in the lowest category for adaptability. In other words, the odds that it has maintained some bare minimum level of adaptability.)

The findings suggest that the optimal amount of offshoring differs depending on the activity, with much more leeway for shifting product design abroad than for core R&D or downstream activities including “production of new products/services, introduction of new process technology, [and] marketing of new products/services.”

The takeaway, the authors write, is that offshoring too much of a firm’s innovation is likely to be costly:

Our findings hence imply a trade-off between global knowledge sourcing and a firm’s ability to use this knowledge effectively. The empirical results suggest that off-shoring more than 15 to 30% (depending on the type of innovation) of a firm’s innovation activities becomes challenging for maintaining the effectiveness of the organization.

And:

The threshold level is lower for innovation activities that are more closely related to core functions of the firm, i.e. R&D and marketing of innovation. If a substantial part of these activities take place at firm locations abroad, coordination costs increase and organizational changes become more complex.

In practice, most firms in the sample were at or below the optimal threshold for offshoring of innovation. But within the subset that did choose to offshore core R&D, nearly 40% had exceeded the optimal level. Interestingly, smaller firms seemed less adversely affected by the offshoring of innovation, which the authors suggest may be due to greater organizational flexibility.

But for most firms, the paper’s findings are worth bearing in mind. As the authors conclude, “Keeping most R&D activities at the home base is beneficial in a world where innovation cycles become shorter and developing new technologies more challenging.”

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