Podcast: The Productivity of Defense Independent R&D

Jerry McGinn: [00:00:36] Welcome everyone. Good afternoon. My name is Jerry, and again, I’m the executive director of the center for Goodman contracting here in the school of business at George Mason university. And we’re really excited to welcome you to today’s event webinar on research and development, productivity, measuring trends and R and D for the government contracting community.

This is a very fascinating topic, and we’re gonna have a great panel lined up to, to discuss. But I believe you want to introduce the center and the topic. So the center we’ve stood up in a couple of years ago and our focus is on being a nexus for government industry and academia.

To collaborate and dress business policy, regulatory challenges facing you in in that government contracting community. We do this through events like this research and the like and research is a developments, a topic that I worked on in my most recent government job.

And it’s a really difficult topic to to address in the aerospace and defense community, because there are different types of RD. Government funded research development, internal research and development, which is partially reimbursed and as well as internal research and development. And so we’re very excited to have Ann Marie not choose a professor at the Olin school of business in wash U in St.

Louis. She’s also affiliated faculty member in the center. And she’s going to talk about the measure that she’s created to. To measure productivity of R and D. And then we have a government former government perspective and in Kevin Fahey, former us and secondary defense requisition, as well as Byron Callan.

Who’s one of the premier analysts for the A&D market. And this is an issue which I dealt with in government, and we were trying to measure the impact of gov restrict development for government contractors. And it was really hard to get at. And but hopefully Anne Marie and Kevin and Byron bill helped to show the white and, but I’m really pleased to welcome Stephanie.

Halcrow, who’s our new senior fellow in the center. She comes to us from the council armed services committee, where she was the key acquisition staff member, professional staff member for. The chairman and then ranking member max Thornberry did a lot of work in acquisition reform.

And so she’s got to moderate the discussion, so I’m gonna throw it over her. And we look forward to your comments and questions to wrap. So Stephanie, over to you.

Stephanie Halcrow: [00:02:50] Thanks, Gary. I appreciate the introduction. We have three panelists as Jerry introduced and we will give each panelist a few minutes to talk about their perspectives on this topic. And then we will move into some discussion and Q and a from the attendees.

So at this point I’d like to invite Ann Marie, not to begin and talk about the interesting. Research that she has done on how industry can figure out their return on investment for research and development Amarie over to

Anne Marie Knott: [00:03:27] you. Perfect. Stephanie, thank you very much. I’m delighted to be here. This is my natural home. I began my career working Hughes aircraft company doing missile guidance systems. And one of the things that occurred during that career was that we were acquired by general motors and they started changing the way that we were organizing or our R and D and evaluating R and D.

And I said, these changes are going to be catastrophic. And they’re going to permanently degrade our R and D capability. But the problem at the time was I couldn’t get anybody else alarm because there was no good measure of R and D capabilities. So that became my Holy grail.

It turns out I was right to be alarmed.  What was happening to you is, was happening throughout the entire economy. Historically innovation has been the driver of economic growth. That best estimate is that it accounts for about 63% of growth. And historically that’s been true.   To help you understand that what I want to do is I want to plot company’s R and D spending.

So this is their R and D intensity. So R and D divided by sales. And now what I’m going to do is I’m going to plot on top of it, GDP growth. And what you can see is that GDP growth tracks, R and D spending with the lag through the rise through the fall, but it never picks back up again in the eighties when R and D spending picks back up.

 So that broken engines, not a spending problem. What is the problem is to help us understand that what I want to do is I’m going to apply GDP growth again. And I’m now going to plot on top of that company’s R and D productivity using the measure that I developed called art Q And what you can see then is that GDP growth basically tracks R and D productivity.

So that broken engine is a productivity problem. And what I want to do is I want to get companies to restore their RQ so that we can revive economic growth.  To help you understand the measures. As I said, the name is RQ. It’s a short for research lotion. It’s, intendedly the equivalent of individuals IQ.

So companies equivalent of an individual’s IQ, how smart they are. But that’s the intuition. What’s nice about the measure is that it’s actually rooted in economic theories. So it’s based on Paul Romer’s theory, linking R and D to growth for which he won the Nobel prize in 2018. And I’m just going to take you back for some freshman economics.

So what we have on the right-hand side is the production function. This is the foundation of his theory. And if you remember the production function, links companies, inputs to their outputs.  Some of the typical inputs that we look at our capital and labor, and these outputs would be like a hundred widgets, 200 widgets, 300 widgets.

And what the tool helps us do is understand where along any of those curves we want to be. So for example, if you’re on the inner curve, you might have used a lot of capital and very little labor point B or a roughly equal amounts point D  Romer’s insight is that we’re missing a key input knowledge. And the role of knowledge is to make companies more productive with any given level of capital and labor.

So you can see that if you were using the same level of capital and labor that you would have been at point C originally you would have been producing 200 widgets. Now you would be producing 250 widgets.  Where does knowledge come from? Not surprisingly. It comes from R and D and in particularly the amount of new knowledge that you get as a function of how much you’re spending  how much knowledge you had to begin with.

So for example, you can’t do calculus until you understand algebra and the Delta term which is the productivity of your R and D and in generating new knowledge. So what we can do is we can take the original production function and substitute for a, with the actual R and D that produces it. And when you do that it has its own exponent just as all the other inputs do.

Those explanations are called elasticities. So our RQ is actually this gamma term, the exponent on R and D. It has a technical name. It’s the, from specific output elasticity of R and D.   That’s meaningful Mo mainly to economist, but what’s nice is it’s got a practical translation. It’s the percentage increase in output that you expect to get from a 1% increase in R and D.

Now what’s really nice about having a theoretical foundation is that it supports prediction about the impact of R and D.  So for example, if you know your RQ, you can predict the revenues. There, that’s just plugging the R and D into the production function, profit. You will know your profits as well.

That’s just the gross margin times. The revenue subtracting off the R and D optimal R and D looks like a mess. It’s the partial profits with respect to R and D market values. The net present value of profits and growth is just the R and D term in the revenue equation. Now what I’ve done is as a scientist or engineer I tested all of these predictions and using us data 47 years of all us traded firms.

And they hold and there was no other measure for which they do hold. So   my goal is, as I said, to get companies to restore their RQ so we can read by growth. And what I’m learning is that it’s really important to bring together all the constituencies, which is why I’m so excited about today’s meeting.

It does involve investors. It does involve government. It does involve companies and I represent academia. So I think I’m a little bit less important, but I’m really excited to hear what the other panelists have to say

ZOOM0012_Tr3: [00:08:31] today.

Stephanie Halcrow: [00:08:31] And Ray, thanks so much for those comments. At this time I we’ll move to Byron. Callan, who is Gary introduced is that defense sector analyst. And he has some insights on what the current trends are in industry investment in R and D. Right.

  Byron Callan: [00:08:47] Thank you very much for inviting me to share my thoughts today on this event. I really wanted to offer maybe five observations and some questions around this whole question of, of R and D really drilling down on the defense sector.

And again, this is more from a public company standpoint because that’s where the data is that I can analyze. I think as Ann Marie mentioned in her studies too  I think the first question for me. It’s a bit of a measurement issue. If you look at the data that’s actually disclosed by companies and their sec filing, is there their 10 K annual filings they’ll reference company funded R and D, but they obviously are getting much more R and D in their government contracts and iRead.

Isn’t broken out from company funded efforts. and in some instances you feel like a past data. Companies will include bid and proposal expense in that R and D function as well, too. What are you really talking about when you get into the core of R and D if it’s invention or innovation?

So there’s a measurement issue that I think is interesting to grapple with a bit here. The other part is obviously there are other ways to conduct research and development. You see a lot of venture investing recently companies like Lockheed Martin, Northrop Grumman have set up venture investment arms.

Bowling has been doing this as well. Strategic partnering obviously merger and acquisitions, small kind of bolt-on acquisitions that companies pursue for a specific technology can be another way to bring in R and D. And I think Emory probably has some thoughts about how effective or ineffective some of those other strategies may be.

But I grapple with this a little bit because I think more holistically, what are companies investing in their future? It’s a little more complicated from a measurement issue. Just drilling down on the little part of the market that I focus on.  In looking back at trends. Now having said all that  this is the second point.

The large companies have really been remarkably consistent in the percent of sales that they’ve spent on research and development. Again, the line item that gets disclosed in their 10 K filings, I’ve got data back. To 1960 and on Lockheed recognizing that Lockheed is in a very different company in 1960, 70 or 80 than it is today under Lockheed Martin.

But they spent around 2% of research of sales on research and development annually. It was a little bit higher in the mid 1980s. And I should point out this is data that excludes the development money that they spent on the L 10, 11 civil airliner program. You can back that out, but it’s been fairly consistent Northrup or Northrop Grumman, which is the other company.

I’ve got data going back to 1970. Their average was around two and a half percent. That excludes the  tiger shark program. That was a self-funded effort that they undertook that really blew the doors. I think they were up to 12%, one year in R and D as a percent of sales, but  it’s been fairly consistent for the contractors and looking at data over the last couple of years, there’s been a modest uptick for maybe two to two and a half percent but no, one’s really.

Put the pedal to the metal in terms of a major step up in research and development as a percent of sales.  What I observed you typically see smaller companies spend higher amounts of R and D as a percent of sales in the defense sector. This was, there’s a neat little chart in the 20, 20 defense industrial base report that went to Congress.

It showed this  if I look for example, at Harris, prior to the merger, with L3 they were consistently spending about 5% or more of sales on research and development, smaller companies AeroVironment last eight years they’ve been ranging between 10 to 18% mercury systems and other smaller company, 11 to 14%.

Maybe that’s another way to think about this. And I don’t think that’s unique to the defense sector is a lot of the stepped up investment is really taking place to be second and third tier companies.  Thinking about kind of competitiveness and the distinction that research development could make in the relative positioning of some of these contractors.

Again, thinking about time series of data. There’s just not much out there that I can really make good comparisons to. I’ve tried to get a use aircraft R and D spending, but it was a private company. And even in the general motors days, I don’t think when there was a separate tracking stock there was a breakout for what use was spending on research development, but th the whole competition and the industry has changed too, with the consolidation you saw in the 1990s the fact that companies like IBM and Texas instruments, got out and effected the defense business by selling off their defense unit.

So she really frame this as an aggregate look at the sector over time. They’re just limitations on the data.  Having said that, you know what I observe. There are instances, are there really more anecdotes where companies had stepped up research and development to either reposition the company or were instances where you could show that they had a spurt or growth spurt compared to their competitors.

And in no particular order that wants to come to my mind are Martin Marietta in late 1984, 1985 norm Augustine made a point at the time that basically repositioned the company from an aeronautics company to more an electronics based company. There was a chart that I have somewhere on my computer that showed the reaction, the initial reaction, that stock price, when he announced that I think it was down 15%.

But ultimately, he did succeed in repositioning Martin Marietta. From this kind of core aeronautics business into a more diversified electronics business and maybe, like the end of the cold war kind of mess with the data. Cause you really can’t see how that subsequent growth path would have played out relative to some of the other competitors.

More recent examples Raytheon had talked about their investment in gallium nitride, and how that had actually helped them win a number of radar contracts. You could see a little bit of a growth spurt relative to some of their peers. Another example had been Harris and the Falcon radio they.

Really stepped in very nicely. When the jitters program just wasn’t delivering a capability that was needed in Afghanistan and Iraq, they paid for their, at their money and had built a very good solid business from that research and development investment that showed growth higher than certainly their peers were showing.

 Another two points I want to conclude on. I think, the key question here is, so what can change in the 2020s? Are we really going to see stepped up research and development expenditures right now? I’m not seeing it, at least in the data that’s come out in 2020 for the large defense contractors.

 we’re about to launch into another earning season. Lockheed Martin had their conference call earlier this week. They really didn’t talk about anything about stepped up R and D my census. They probably are going to have to do that. They’ve got more competitive pressure from the low side with a whole.

Constellation of smaller kind of venture backed firms, maybe looking to grow in defense. But also the other interesting phenomenon is when you see companies like general motors or Amazon or Microsoft, also starting to look at low entrance points on the defense market. That too is something that I think they’re going to have to be more attentive to.

 And so this, dominant focus on free cashflow generation and operating margins that we see reiterated in these earnings conference calls. That’s sustainable to a point, and then you’re really going to have to, deal with these new competitive forces in the market.

I guess the following, this is more a question than a conclusion. I don’t know what the right level is for DOD and for defense contractors to spend on R and D. My sense is that it’s more but I can’t give you, is it, should they be spending 3% or 4% of R and D? I think that really is just gotta be taken on a case by case basis.

And you also have to be able to make the business case to shareholders that those investments will ultimately lead to new businesses that will generate profits for these contractors. So Stephanie that’s, those are my comments.

Stephanie Halcrow: [00:16:49] Thanks, Brian. Always great to end with the question and we will start with that question when all the panel members start our discussion.

But before we get to that, I’d like to introduce my good friend, Kevin Fahey, who spent the last few years working very closely together. It’s great to see you again. And I look forward to hearing your. Thoughts on how public policy can influence and encourage investments in research and development, Kevin,

Kevin Fahey: [00:17:17] over to you.

Thanks, Stephanie. So let me, I’ll have a little different perspective obviously. And I’m not nearly as smart as the previous two.  At one time in my career, I was a tech director or an R and D center in rice.

And some instances, I had the experience of where do I convince the army to, to invest in R and D my, my R and D center. And the way I measured it, there was various things, right? Where was my customers willing to spend? But the other things I did measure, which I thought was interested in, not, I often measured the skills of the employees I had.

I basically ran a munitions and armaments center. And so I needed, I knew I needed to have so many people to do all the things I needed to do. So sometimes I would invest in R and D to make sure I did enough stuff to have the. The right people for the right jobs into the future.

And then, most of my career was in acquisition, right? So I was a deputy PM. I was a deputy, a program executive officer. I was a program executive officer twice. And as you can imagine in that role my focus was more. On the, where do I invest on technology that’s going to transition right to a program that I’m going to execute.

So my metrics as a government employee and when I was working, my industry partners was less focused on the, the basic research and, the things that may mature 10 years from now, and more is two years from now, I’m going to start a program. What’s the probability that the R and D I’m going to support because a lot of times they would look to us to where should they S they invest to transition to a real program for a capability from that perspective.

So that was more of a our measure at that was in the army. And the department of defense. That is one of their major metrics they use is transitioned to a real program. And then Stephanie uh, so I left the government and I worked for Cypress international for a couple of years. And then they talked me into coming back for a bunch of reasons.

I agreed to come back really, because I do believe it’s critical. We all, I would tell you one of the main reasons I did come back is I believe we all have to figure out how to do a better and quicker job on how do we transition technology to programs to the field quicker. So it’s really about the maturation and it all starts with technology, and so I was working hand in hand with the research and development folks, as you, as anyone that works with department of defense, we had 10 priority areas. I will tell you, you could argue about the split of acquisition technology and logistics into two organization. But I think where it’s very positive is we had a real focus on technology development.

And I will tell you the big part of it was when I work on something like hypersonics, it’s not just the technology is what is the concept of operation on how I’m going to actually use it? I will tell you, it’s more of something I was working that I still struggle with was right.

How do we incentivize industry? From my experience we, in a, it’s a rare occasion, we talk about innovation. I’ve yet to see very many requests for proposals, have a good way that we have an incentive on how you do innovation. And I’ll give you a good example.

We are all believers that we need to transition into this environment of digital engineering. And so how do you incentivize that? How do you measure that? Because, we met as a department defense with a lot of industry. Why did you do the transition? Because as we have a lot of commercial industry that has already transitioned to do a digital engineering and all those kinds of things.

And as it’s an investment in tools and different people and training and all that stuff. So that to me is an R and D investment that we on the government side, we’re trying to figure out. How do we incentivize industry to make that, change? The other thing I would say, be, then, I just started my new job, which was really part of my old job back with Cyprus.

And one of the things that I have seen that I have always believed in, and I know Stephanie and I have had this conversation is the one thing that government really needs to continue to improve. Uh, You see the recent government trend is almost an expectation that industry will invest R and D.

So they’ll mature the technology so that when we do prototyping, it’s ready to quickly transition to the field. The one thing that government has got to continue to improve on is the transparency on, what do they need the clear understanding to industry on what are the capability needs and what is the return on investment?

Because as to a large extent, the industry Invest where they believe that they’re going to get a return on investment. And so part of the struggle and continuous struggle is one is how do we get better transparency that they have, they as a good as understanding as the government of what the needs are.

And then, how do we incentivize that? The other thing I’d point out which was talked about is you do see differences in different parts of the industry, right? There’s part of the depart defense industrial base. That really is 95% delivering to the department of defense. We’re. Almost all the funding for R and D in one way or another comes from the department of defense, but then you see companies and I’ll give you a great example that, commercial aviation is we see a lot of benefit that the department of defense, because the aviation corporation to a large extent spends their R and D to make a commercial airline or a commercial engine, more producible and effective and efficient.

We saw that a big impact on the department of defense when the last, year or so with COVID where there wasn’t. A lot of cash flow from commercial air. So that if there’s not a lot of cashflow, there’s not a lot of available R and D dollars, that there was more of an expectation that we did through.

And Stephanie knows this through the defense production act. In some instances we’re funding some of the R and D investments to continue to get to the next step. But the one thing that I continue to work and I would have continued to work if I was still there is how do we incentivize. Making the transition to things like digital engineering, which is an R and D investment, and then, how are, how can we be more transparent? So we’re industry is not guessing where to do R and D knowing that the government’s expectation has been an expectation that industry invests more R and D and they will, if they knew the probability of return investment, right?

Because as you know, that’s really their measurement is if I’m going to invest, I’d better get in return. So that’s I have.

Stephanie Halcrow: [00:24:03] Thanks, Kevin, appreciate those comments. Barring you, and did your comments by asking, are we investing enough in R and D? But in listening to Anne Marie she said it’s all about productivity. Kevin says it’s all about national security. Anne Marie, can you talk to, how do we maximize productivity in investments in research and development?

 Anne Marie Knott: [00:24:27] If you have the RQ measure, you can actually compute what the optimal R and D is. So spending the right amount is a different question and becoming more productive. What’s happened over time as companies, R and D productivity has declined. They’ve kept the same rules of thumb for how to invest.

So the same percentage of sales and what that means now is that the bulk of companies are overspending

ZOOM0012_Tr3: [00:24:49] on R and D.

 Stephanie Halcrow: [00:24:49] So are you saying that they should invest that money in other places

Anne Marie Knott: [00:24:53] or give it back to shareholders? Yeah. Yeah, no. Cause what’s happened. So yes. Let me be more helpful with that. So when, I mean the optimal investment, what I mean is that any dollar beyond that point any dollar of R and D beyond that point generates less than a dollar of profits.

And so you don’t want to be spending out there. You want, you can be, if you’ve got other things that are more productive, you could invest your money there. If not, you should be sending the money back to shareholders. And that’s one of the principle reasons why we saw this, that we talked about this yesterday, when we had saw stock buybacks rather than an handsome investment in response to the jobs act,

Stephanie Halcrow: [00:25:26] by what is your thoughts on how shareholders view investments in R and D and is there a difference between shareholders of commercial companies and defense only companies?

 Byron Callan: [00:25:38] I th I’m going to answer it a couple of different ways. There, I think there’s a perception that,  boy shareholders just want to see companies use cash to buy back stock or pay dividends.

So they’re the shareholders are going to get the largest of cash flow, free cash flow.  I tell the anecdote, a couple of years ago there was an investor meeting that mercury systems held in New York. And one of the shareholders at the time got up to the back of the room and said, you guys are not spending enough money on R and D given the opportunity set, I’m willing to take the earnings hit that you’ll see in next year or two, if you can create a clear runway to out your growth.

And I just thought that was an interesting anecdote. I don’t know if that’s going to happen with Lockheed Martin or Northrop Grumman, not to pick on those two, but  I’ll come back to. And I do think, when you see instances, let’s take the launch market, for example, where, ULA was probably thought of, us launch is a backwater, not much is going to happen there, Boeing and Lockheed Martin fun.

You’ve got the United launch Alliance fairly stable profits. Elon Musk comes along what space X and basically destroys the profitability of that particular entity. You can walk that right through the the disclosure that that Lockheed Martin has made of their equity. So I think there’s a competitive part to this, that.

As I said I don’t know. I don’t know. I haven’t been able to do a on RQ for some of these companies might. My sense is, and I don’t know if Ann Marie has some thoughts on this. Yeah. If you look at a lot of technology companies, they’re probably spending, 25, 30% of sales on research and development, but recognizing it’s a very different business model in defense.

I’m not sure if 2%, at the reported levels is the right number and the other part to pick up on Kevin’s theme,  digital engineering is gonna be a game changer or a game changer. I think the other part that, there could be some really rude awakenings if contracts are if incumbent positions are lost in major weapons systems, because someone else spent money on digital engineering that your company didn’t then, and that’ll ricochet back through how shareholders look at some of this stuff too.

Stephanie Halcrow: [00:27:46] Emory. Did you have any thoughts on Byron’s comments?

Anne Marie Knott: [00:27:49] . I looked at this yesterday because I knew that a virus and I asked this so it turns out that about 50% of the number of firms that are overspending is increasing independence, but not at the same rate that it’s increasing in the other sectors.

And it turns out that I think it’s about 50% of firms are overspending and 50% of underspending. So on average we’re getting at

Stephanie Halcrow: [00:28:10] about right. Very cool. Is there anything the government can do to increase the bang for the buck in research and development investments?

Anne Marie Knott: [00:28:18] Oh sure.  I would I would love companies to increase their RQ for, that benefits their shareholders, that benefits the government the government bang for their buck, as I said and to me, the two obvious things the government could do would be one when they’re there.

Letting R D contracts use RQ as one of the measures of technical merit. And the other is to consider in the Iran reimbursement program, companies are accused as a wave, a way for establishing the percentage of reimbursement because once company knows that, when once companies know that somebody is using RQ as a means to reward them, then that will give them more of an incentive to improve

Stephanie Halcrow: [00:28:55] their RQ.

Kevin would feel like to jump in from a government perspective on that.

 Kevin Fahey: [00:29:00] Yeah, a few things, I agree. And Marie, and I know the other day we talked about that. The only thing I’m unclear of is math differences, right? So as there’s significant math differences between commercial and government.

The one being, and Stephanie knows this, in a lot of instances, we invest in the R and D and then we, and we reimburse, as allowable costs and the independent R and D and Oh, by the way, is if you’re. Competing for a government contract, we get full disclosure of your cost and pricing, and we almost cap, the most profit you’ll make is 15%.

None of that math happens in commercial market, right? As they invest a lot in R and D because when, if they let the commercial market drive what they’re going to get for their product, and as like the iPhone, I guarantee you is more than 15% profit. So I agree with what Anne Marie said.

There should be better ways to have metrics to do that. I would argue we have to work through how the math is different from a department of defense perspective. I w you know, I think the Anne Marie would agree with that.

Stephanie Halcrow: [00:30:10] You agree with that?

 Let me turn to some of the questions that our attendees have asked. We have one question just very simply, how does a company raise his productivity?

Thanks, John Bailey for that question. How does the company raise its productivity?

 Anne Marie Knott: [00:30:27] So it’s, there’s a lot that’s company specific, right? The easiest thing to do when I work with companies, what I will tell them to do is, at least benchmark where it’s been and where it is now, and see if you were doing something differently in the past, the broad things that make companies more productive.

Across all sectors one the most important finding I have. So let me step back. I had an opportunity. I had a couple of national science foundation grants that allowed me to relate companies are accused to their R and D practices. And so I combined the two to try to understand what drives our queue.

The most important finding I have is that the RQ of outsourced R and D is zero, meaning a dollar of R and D that you outsource is completely unproductive.  That’s very controversial and we can follow up on that. If anybody has a question, but there’s others too, but why don’t I let other people jump in and ask other questions as well?

 Stephanie Halcrow: [00:31:14] And do you have any thoughts on this? I know you’ve looked at different types of achieving R and D, whether it be partnerships or specific ventures.

 Byron Callan: [00:31:23] I don’t have the data that Emory does. I think anecdotally on a lot of this stuff, I just know there, there have been instances a couple of acquisitions that Raytheon had made, for example, that had helped them significantly so on the productivity question, I don’t have a strong view on that.

I think it probably does get back to people that was mentioned, how are you educating your people? What are you training them to do?  . I am intrigued on the the poll question about outsourced R and D. And again, because I just see the  venture activity that’s been going on. I don’t know if that fits in that same area, Marino, Lockheed in their latest reports has realized a $54 million gain.

And you’ve seen a lot of  if outsourced is including kind of the venture activity, there’s really a lot going on there. It’s helped people like L three position on unmanned, autonomous Naval vessels. I think anecdotally on this, and maybe, there, there are always exceptions to big data sets.

So maybe that’s what I’m seeing from my perch is there’s a lot of that going on. And I think particularly as the commercial sector now is really driving a lot of research and development. It becomes more and more. Of an imperative for defense contractors to be able to tap into that.

And it, it may go back to that earlier question there, or observation that you’ve had a real change in this industry over the past generation or two, where a lot of the multi-sector companies aren’t in defense anymore. So Texas instruments, which used to have a defense systems business, they now focus on commercial technology to Kevin’s point, Boeing and Textron.

I think they are doing interesting things in digital engineering that frankly is going to help them.  It’s helped bawling in the military aircraft market. I think it’s gonna be real interesting to see how it helps Textron in the foreign flora programs. The army is pursuing going forward.

.

Anne Marie Knott: [00:33:14] So when I say outsourced R and D, what I mean is this is the money that the company pays for. It’s R and D that the company funds, but pays another organization to do for it, to conduct for it on its own behalf. So that would be just. I would just, that’s distinguished from things like upfront venture activity and acquisitions.

 And in those cases the preliminary evidence is that acquisitions are okay as long as they’re small, relative to the scale of the company, meaning that, this is a nice marriage where the small company gets the benefit of the big company and on the bencher and on the ventures. That’s a great question.

I don’t know the answer to that yet, but the sense is that the corporate venture funds are actually more productive than independent venture funds. Not everybody knows that.  And that’s because they’ve got in-depth expertise companies don’t go in to CVCs for purposes of taking those ventures public.

They do that to scan the environment and to see what they would want to pick up. And yeah, so you should evaluate them separately. But my guess is that companies that have CDCs and manage them effectively actually have higher up.

 Stephanie Halcrow: [00:34:15] Thanks for the addition, Kevin, I’d like to throw a question your way.

There was a GAO report recently that criticized the defense industry investment in R and D. And that it wasn’t aligned to the strategic goals of the department of defense or vice versa. How can the department of defense better align the research and development that is an allowable cost for defense contractors be better aligned with national security goals.

Kevin Fahey: [00:34:48] you know, one of the things is, I’m a believer that the behavior in a lot of instances you see of our industry and the defense is caused by our behavior, right? The actual defense people, they’re government people. If you think about it, is what is the defense industrial base spend their money on is what they’re incentivized to spend their money on. And sometimes it, it used to upset me. Because you would think that they would spend money in areas that are good for everybody. But for the most part, the reason you see you think I told you for the most part, how do we incentivize digital engineering and those kinds of things or innovation, right? We, the government yet haven’t figured out the good ways to say how, you know, as all about, and the government terms is section L says, here’s what you give us in your proposal. And section M says, here’s how we’re going to evaluate it.

We don’t necessarily incentivize innovation. We usually are going for our product. Like DARPA does a good job of incentivizing R and D research. But you fire across the department. In some instances, the reason that industry doesn’t spend their money on it, because that’s not what we incentivize them to spend their money on it.

We tend to incentivize them mostly to spend their money on winning the next project. Not necessarily, quantum stuff, because quantum stuff is 10 years away or whatever it is, it’s not how to how do I win a program tomorrow? And that’s, I would argue in a lot of instances with the establishment that already we are getting better at incentivizing R and D investments in the right areas.

As it was a big leap for the department of Fest, identified 10 priority areas versus spend their money on everything. But a lot of it’s because we have not. It’s not industry’s fault. My opinion. And a lot of is it’s not what we incentivize them to spend it on.

Stephanie Halcrow: [00:36:40] Great. As a follow-up to this conversation, I’d like to bring in a question from our attendees.

And the question from David Peterson is what criteria or goal should emerging small to medium businesses focus on in their Iran or allowable cost R and D program to compete against large businesses. So again, what can small and medium businesses focus their R and D efforts on to better compete with large businesses.

Anybody want to take that?

Anne Marie Knott: [00:37:12] I’ll jump in for the sake of jumping in things that, that uh, large companies aren’t interested in. The opportunity for small companies, I a lot of small companies start because there was an engineer inside a large company working on a project that they fell in love with.

And the large company just said, that’s below our market’s threshold. We’re not going to go after that. And they go off and start a successful company that wants to get a tone that we can grow and grow bigger. I think the flying under the radar scheme will work for a

while.

Kevin Fahey: [00:37:38] No, I would I agree, that’s a, that, that’s a very hard question, but it really is. Finding out where the niche areas are that they, when you asked about productivity, I was going to add right. Is really about the tools and the people. As that’s why I was a little surprised by outsourcing some stuff.

Cause I’ve seen in some instances, if you need 10 people, but you only have seven of the right skills, you may outsource, for those three other skills that you needed to make the team. In some instances it’s finding those, you find a lot of the Sivir stuff. Stephanie tends to be, good in R and D investments in a niche thing that a large business is not really interested in.

You know what I mean?

Stephanie Halcrow: [00:38:18] Thank you. Appreciate that. Again, we’ve got a lot of great questions from our attendees. I have another one here from Steve Grundman. Does the government subsidizing R and D promote or impede our queue. Or would the productivity of defense R and D be better if it was financed only by private investor provided product profits that success we’re not capped at 15%, for example, Anne Marie, do you want to start?

Anne Marie Knott: [00:38:46] I haven’t thought about the 15% part, but on the but on the reimbursement part, I think that I think that we need to do is draw a parallel to the commercial sector. The commercial sector gets its R and D reimbursed because it embeds, it amortizes the R and D costs into the pricing of the products.

And I think that, I think the Iran program is essentially trying to do the same thing for defense contractors when you know their profits are capped.

 Byron Callan: [00:39:12] It would be an interesting issue to explore. I think in greater depth, it really does go back to the incentives. I mentioned Harris earlier in the division where they developed the Falcon radio, they were selling that as a commercial item and they were reporting 25% operating margins. And again, if you look at technology companies in general, they have much higher gross margins than you’d see in a defense defense program.

On the other hand, they also have the opportunity to go out of business in two or three years if they don’t develop the next new replacement product, given the speed at which things are changing. So it’s a trade off, but yeah I would think, and maybe this gets more into a profit policy question, but if you tailor profit policy to where do you want innovation and risk and reward that not might be another tool to add here.

Kevin Fahey: [00:39:58] Yeah, I would just add as Kevin, Stephanie, the typical government answer, it depends. So if there’s a commercial potential application to it if it’s a unique thing and like the, ground-based strategic deterrent, missile, I don’t think you’re going to get anybody do invest billions of dollars.

With the idea that, you know, 10 years or five years from now, I will make a production decision based on, that or, or the next generation fighter, you name it. But in some of our portfolios, I do believe that we got to learn better on how we let the commercial market drive, what we do,

Stephanie Halcrow: [00:40:35] thanks. We have a question that talks about the increasing amount of knowledge that is being gained through R and D. And do we think that has any effect on productivity? So let me read the question for you. What do we think of the view that R and D productivity is naturally secular decreasing?

Because the accumulation of knowledge is making further scientific advances more expensive. Emory.

Anne Marie Knott: [00:41:03] I have a paper on this because that is a prevailing view that look we’ve just ideas are getting harder to find is the title of the paper that was published and it’s, they don’t even test that.

It’s very frustrating for me. And it turns out we did test it and it’s not correct. What is happening is, and the way that, that kind of the clever test that we did was we said, okay, look, if it’s truly the case that we’ve got this secular decline, which had happened is that it’s not the decline isn’t happening just at the mean it’s happening across the entire distribution.

And what we did was we took the maximum RQ company in each year and look to see what was happening to that over time. And that was actually increasing.  Where if we went to narrow or definitions of in industry, we found that this maximum RQ was actually decreasing. So what’s really cool about that is that it says that you do that get the secular decline, just like everybody believes.

But what happens is when that occurs within an industry, you had got enterprising firms who create new new domains. And that those continued to allow us to at least maintain if not increase productivity.

 Stephanie Halcrow: [00:42:10] I just like to thank my my very well-read colleague for posing that question. Jim Hassett. So thanks. I knew so many would be well-versed to speak on that. Byron Kevin, did you have any other thoughts in potentially I know Kevin, we discussed this a couple of days ago. And you mentioned it a little bit in your comments about the type of R and D that that firms are doing.

It’s not all in quantum, some of it’s in process improvement in incorporating robotics. And so is there is there an effort to diversify R and D spending and does that affect productivity at all or improve the results for the department?

 Kevin Fahey: [00:42:50] Yes. And again, it all depends on where you sit and what you’re trying to capture and what the baseline as Emory and Byron mentioned is what is the baseline you go in from?

But in a lot of instances, I believe, when you make an a real change in the something different, like digital engineering you’re going to have to make an investment in the tools. And the people skills, right? What we found in most industry, when we went and found out, how do we follow their commercial lead?

They all had it, change people skills, right? Because the people that were doing it the old way, aren’t the people that are going to do with the new way, unless you train them to do it the the new way. So I do go in and stuff, I think another good example is what and even internal better government after you’ve seen it across the country, is this whole idea of a software factories, right?

Software factories are a productivity thing, where some of it is the, how you set it up, the tools you set up and the environment you give them. Because that’s another thing that we’ve found in R and D and Maryann and buyer might know, is that the environment you put a scientist in matters.

So those are. Kinds of things that I do believe in addition to spending money on what is the maturation of this specific technology is what are the right skills, tools and investment?

Byron Callan: [00:44:05] I just add, I think there is a. It’s an engineering business at the end of the day. And there’s a mission aspect to it. That’s unique maybe compared to other commercial sectors, but this is a sector that still has to compete for talent. And I think having research development that might in theory, be perceived as wasteful iterations on prototypes, things like that, where you’re still pushing ahead knowledge.

 It may not necessarily be appreciated always in Congress, or it may mean the papers every once in a while but I think there’s a goodness or a richness to pushing some of this stuff along that it continues to attract and challenge younger engineers and. I was always intrigued by Dr.

Roper’s idea of a digital century series of aircraft, where you really start doing those iterations that you’re just missing when you do a once in a generation new combat aircraft. So just a thought there, maybe, as much as you try and measure some of these efficiencies in this, maybe there’s some inefficiencies that create efficiencies in of their own.

Stephanie Halcrow: [00:45:07] Thanks Byron. I really appreciate all the panelists joining us today, and we’ve got so many great questions for the attendees. But I just like to wrap up as we get to the top of the hour and ask each panelist to provide some final comments with the thought that, R and D is good for the bottom line.

It’s necessary for national security. What are your hopes to see in the upcoming president budget? The president’s budget in upcoming India legislation and in, in industries move to increase, decrease improve productivity Tivity in their R and D Emory I’ll turn to you first.

 Anne Marie Knott: [00:45:48] uh, I love that question. One of the big misnomers currently is that we have been under investing in research. So there is all this emphasis on providing more money to universities and providing more money to startup firms. Large firms are the bulk of the innovation engine in the country.

They spend 5.7, five times more on R and D in aggregate. And they’re more productive with their R and D. And the big decline in the big decline in federal funding for R and D is in D it’s. It’s not the big decline. It is. All of the decline is in D and if we really want to drive if we really want to drive growth from R and D, then we’ve got to rethink we’ve got to move away from this idea of research as the preeminent focus in China, who we’re all afraid about, afraid of do far more D relative to our, than we do.

ZOOM0012_Tr3: [00:46:38] Thanks Anne Marie. Byron.

 Byron Callan: [00:46:40] It definitely 22 is going to be a stub year, right? It’s really going to be more about FYI twenty-three column and what plays out there. But I suppose for this year my wishlist, I would hope that the appropriators and the authorizers keep some of these development programs, not, six one, six, three, but the six, four, six, five efforts funded and push them ahead.

And I recognize they’re always the threats. To large procurement programs for new development efforts. And, most representatives are going to get the jobs in their district. And these future programs don’t carry that same resonance, but I’m hoping, you pivot to where we want to be, not where we are today.

That some of these development programs in unmanned, autonomous Naval chips, on down the line are Are funded. I would also ask, or I wish  that management’s might talk a little bit more to their shareholders about what they’re doing and how they’re what their narratives and how they’re trying to position and grow their companies and deflect some of the, what are we doing with cashflow questions too?

What are we doing to actually grow our business? Improve productivity back to the earlier question, align with DOD perspectives. I think that’s, that may also kind of push shareholders a little bit more in the right direction too.

Stephanie Halcrow: [00:47:54] Thanks,

Kevin Fahey: [00:47:55] Kevin. So just a few things I agree with as the previous two said one is I would emphasize this stuff.

You understand this. How important the STEM program is, in some instances fall on what Byron said is finding the right people to do the jobs is important. And so I would argue from the congressional perspective to continue to look at it and even expand it as, we were looking at it, for, software development and the things that we know are the cyber, the things are the skills of the future.

That weren’t necessarily the skills that had passed. I ask everybody here is to continue to help each other. And how do we incentivize the right investments and the right behavior when it comes to R and D. And then probably the last year, just because as I spent a lot of time.

It is, I do believe whether it be skills or technologies cyber is a critical thing that we still need a lot of work on. That’s what I say.

Stephanie Halcrow: [00:48:50] Thanks, Kevin, I appreciate you uh, wrapping us up there. Thanks again to all of our panelists for joining us here at George Mason university school of business center for government contracting, such an important discussion on research and development.