The following note was written by Prof. Henry Chesbrough of Univeristy of California's Haas School of Business. Hank’s new book, Open Innovation, has just been published by Harvard Business School Press.

Investing in innovation is big business -- industrial R&D spending in the US, for example, amounted to more than $189 billion in 2002. 

Innovation may be big business, but it’s being done by smaller companies than in the past.  As recently as 1981, companies with more than 1000 employees accounted for more than 95% of R&D spending.  Today, they account for less than 80% of US R&D.  Large companies of more than 25,000 employees used to provide over 70% of industrial R&D.  Today, they provide about 40% of R&D.

These figures reflect a fundamental shift in the way in which innovation is being conducted in the 21^st century.  The scale of big R&D labs has declined at the same time as the number of innovation efforts at smaller companies has increased. 

The changes in spending and distribution of effort have not yet been accompanied by changes in innovation management. We need a different approach to R&D, an approach that seeks to leverage external technology in internal R&D, and that also allows internally developed innovations to find their best uses, both within and outside of company borders.

There are two new sets of activities that innovation managers must undertake to profit from these changes:

1.      They must actively embrace external ideas in their own innovation process;

2.      They must aggressively promote their own ideas for other companies to use in their own businesses.

In this Update, we’ll discuss each of these. 

Making Money from Others’ Ideas – Eliminating “NIH”

In the golden age of internal R&D, the term “Not Invented Here” (NIH) signified the superiority of internally developed technology, and the uncertain risks of relying on outside suppliers for important parts of your product.  Companies wanted to avoid products and concepts that came from outside the corporate boundaries.  In order to develop and market a complex product effectively, it was best to do it all yourself. 

Companies built deep pools of expertise in a wide variety of areas, and used that internal expertise to develop all the critical elements of their systems.  This is how AT&T built the US phone system.  This is how GM built its cars.  This is how IBM built its mainframe computers.  It is how Xerox built its copiers and printers. 

Today this thinking has become obsolete.  Useful knowledge today is widespread, and exists in companies of all sizes.  Skilled people are more mobile than they used to be, spreading technology and know-how to newer and smaller companies.   

As a result, the NIH thinking of the 1960s and 1970s is widely criticized today, and most executives accept the idea that innovators within the company should be looking for new ideas both inside and outside the company’s borders. 

Once a company accepts the importance of accessing external technology, its own R&D has to evolve, and these changes have yet to occur in most companies.  The focus of internal R&D must change from one of depth within a discipline to one of breadth and integration across disciplines. Whereas old-school research labs developed new technologies from the ground up, open innovation labs need to scan the external environment of universities, startups, competitors and others, to identify promising technology for internal use. 

Internal researchers must develop architectures that integrate these parts into complex systems, and fill in elements of that system that are missing from the external environment.  Automakers, for example, partner with suppliers and research outfits to stay on top of, for example, new transmission and fuel cell technologies. Automakers still do internal R&D, but their in-house teams focus on how to integrate the technologies they see emerging from their supply base. 

It is this expertise in systems integration that will provide the ongoing rationale for internal R&D investment.  It is systems integration skill that enables a company like Toyota – which buys the same parts in a car that are available to any automotive manufacturer – to build better cars from those same parts. 

Making More Money from Your Ideas – Eliminating “NSH”

Leveraging external technologies is only half of the battle to getting more out of your R&D investment.  The other half is to let others utilize your ideas in their businesses as well.  Here, we often encounter the Not Sold Here (NSH) virus, the business counterpart to the NIH virus in product development.  The NSH virus says, “if we’re not selling it in our own sales channels, we won’t let anyone else sell it either”.  Sales and marketing people frequently insist that they must have exclusive use of the technology, and must restrict the technology to their own channels of distribution. 

While it may sound plausible to provide exclusive use of your ideas to your current sales and marketing organization, this is unlikely to give you the most value from your ideas.  If a company makes a component, and then uses it in its own product, it can often improve its costs by allowing other companies to buy that same component for their own use. 

The film animation studio, Pixar, pioneered the use of its RenderMan animation software to make its award-winning animated films.  But Pixar also sells RenderMan to other companies, who use its animation for a variety of computer simulation purposes.  This spreads the component’s fixed costs (here, RenderMan) over increased volumes, and more subtly, forces the product (here, Pixar’s movies) to compete on its own value added, instead of relying upon exclusive access to the component.  If the product can justify its value added, it benefits from lower cost components.  If it cannot, it will not doom the component to the limited business it can realize from exclusively captive supply.

Not All the Smart People Work for You

Not long ago, internal R&D was viewed as a strategic asset and even a barrier to competitive entry in many industries. Research leaders like DuPont, Merck, IBM, GM, GE and AT&T did the most research in their respective industries – and earned the most profits as well.

In today’s world, where knowledge and skill are widely distributed, companies need to base their innovation strategies around a fundamental fact:  not all of the best people in your field work for your company.  Once you grasp this reality, it is much easier to understand why external ideas may help advance your own business, and why your own ideas should be sold to others to advance their business.  No company today has a monopoly on the best technology, nor does any company have an exclusive franchise on the best way to utilize ideas.  Opening your innovation process to include the ideas and businesses of others is the right way to create value in a world full of smart people, when most of those people do not work for you.

Henry Chesbrough (henry@chesbrough.com) is an assistant professor and the Class of 1961 fellow at the Harvard Business School. He is the author of Open Innovation: The New Imperative for Creating and Profiting from Technology (Harvard Business School Press, April, 2003).