MARKET INSIGHTS: Thinking about R&D at photonics companies

Aug. 2, 2012
The critical R&D question for a photonics company is: Are the funds reserved for this really bringing the return that the owners and management expect?

The critical R&D question for a photonics company is: Are the funds reserved for this really bringing the return that the owners and management expect? To answer this question, we must first understand the nature of research and development at photonics companies, what it should be, and what should be avoided.

First, I should define what I mean by R&D, because there is a clear distinction between the concepts of “research” and “development.” With research we commonly refer to the investment an organization makes in developing new technology from which new products or services can be generated. Development has a broader meaning, which may include new product development, improvement of existing products, and/or satisfying specific customer needs.

For many smaller companies, there is no distinction between these two elements, and R&D as shown in financial statements is rarely broken down between them. Although market research is also a category of research, I will emphasize research for the purpose of improving and expanding a company’s product line.

Research usually takes place in large organizations—sponsored by the government and/or academia, or corporate laboratories. Much of this kind of research can be classified as “basic” as compared to “applied” because it cover primarily the development of advanced new technologies, which tend to be very expensive and beyond the means of most photonics companies. In the highly fragmented world of photonics, where companies with less than 100 employees represent 90% of the entire industry, R&D represents a combination of the two concepts, with more emphasis on product development.

No one in business will disagree that investing in new product development is essential for growth, if not survival. Without new products in the pipeline, product lines will become obsolete and market share taken over by competitors.

However, the owners and management of photonics companies face a variety of problems that stress human and financial resources, varying from meeting delivery times and solving last-minute technical issues, to customers who first delay placing new orders then suddenly demand fast delivery of a large order. Facing these kinds of issues, new product development—particularly in smaller companies—frequently receives less attention in a company’s development.

No short-term thinking

Curiously enough, there are also examples of companies purposely lowering their investment in R&D, mainly driven by short-term financial considerations. It is not uncommon for companies facing acute cash shortages to cut back on R&D or for companies that are for sale to reduce R&D to improve their bottom line, which they believe would make them more attractive to potential buyers.

This is short-sighted and unwise as the opposite is often the case. Buyers will clearly see this as a sign of weakness, valuing their target in a direction that is opposite of what the seller hopes to achieve. It also needs to be stated that pumping more capital in R&D is no assurance of better results. Although this may be true in many cases, there is no guarantee. An example is Apple, by market capitalization the world’s most valuable business. Apple invests only a third of what Microsoft invests in R&D, but no one would accuse Apple of not being innovative.

Investing for returns

Investment in R&D by photonics companies runs from 5% to as high as 20% of sales, with 8% to 12% the more common choice. There is no good or bad number; there are enough examples of companies justifiably investing less than 5% at any given time in their development, and spending more than 20% may not represent an unacceptably high number.

With the possible exception of very small businesses, just about all photonics companies generate an annual budget, which usually includes a line entry for R&D. This number is often based on an in-house practice that has been in place for some time. Unfortunately, after setting this number many photonics companies fail to follow up and develop an operating plan on how to invest these funds for maximum yield.

Like any other investment a company makes, it does so with the objective of generating a rate of return that it has committed itself to achieve. R&D is only one element in the process of bringing new or improved products or services to market. The money set aside for R&D should be based on a careful analysis of what is required to sustain and improve the company’s market position. R&D should not be a reserve pot of money that can be used for any need that happens to come along.

A company’s product line usually can be categorized in three stages: 1) mature products, 2) new products that are generally upgraded versions of mature products, and 3) totally new products often serving new markets based on new technology and targeting customers who differ from the company’s traditional customer base. Each stage requires the support of R&D activities to maintain its market share, improve its market share, or acquire share in new markets based on using existing products or developing new ones.

There is no golden rule about how R&D funding should be allocated among these stages as it depends a great deal on a company’s corporate objectives. But I have observed over many years that mature product lines normally get about 20% of available R&D funding, while 50% goes to upgraded products and 30% goes for totally new products.

Quantifying the return on a company’s investment in R&D has proved to be extremely difficult because it is very different from other investments that a photonics company may make such as investing in physical assets or making acquisitions. These are “hard targets,” the return on which can be more easily calculated. Not so with R&D.

The most common method still is based on sales, but even that does not make it easy to define the return on R&D because so many other factors play a role in generating new products. One thing is assured: When a photonics company loses market share on the sale of its product line—be it a mature product or a new product—the cause indeed could be a lack of effective R&D.

Successful photonics R&D—the essentials

1. The team responsible for R&D must be the best the company has to offer in terms of intellectual and creative talent, having intimate knowledge of the company’s technology base and markets served. Without this information, the team will work in a vacuum and cannot be effective. Market research is essential, especially to learn what key customers need in terms of future products and services, and what the competition is doing.

2. The R&D team needs to interact continuously with the staff at sales and manufacturing to ensure that efforts will be guided in the right direction.

3. Sufficient funds must be made available to allow the hiring and functioning of an effective R&D team. Such funds should not be reallocated to other needs to solve short-term problems.

4. Milestones must be set for the three key stages of development: a) concept, b) prototype, and c) final design.

About the Author

Jan Melles | President, Photonics Investments

Jan Melles is the president of Photonics Investments and was the co-founder and later chairman of Melles Griot. He is currently on the board of numerous public and private companies, and invests in and brokers the mergers and acquisitions of photonics companies. 

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