Activity Overinvestment - The Case of Research and Development
Overinvestment in R&D can be damaging for firms. This paper warns managers against the factors that may lead them to overinvest their resources in R&D.
To redress a gap in research, this paper proposes that overinvestment in R&D is a problem that requires attention. Overinvestment occurs when the returns from an investment in a particular business activity (such as marketing, operations, or in this case R&D) fail to generate returns that cover the cost of capital committed. Such investments can be classed as sub-optimal since they ultimately destroy value. This issue is certainly important in the current socio-economic environment, where investment in technology receives substantial interest and many of the world most valued companies are tech firms.
Why overinvestment is likely to occur in R&D
The study suggests that the very key features of R&D investments might contribute to the occurrence of overinvestment. These are:
R&D investment is uncertain
Investment in R&D tends to occur under high uncertainty: uncertainty about the competitive landscape, the potential success or failure of the R&D investment, and the timescale for expected returns. With high uncertainty in estimating cash flows, it is quite easy for managers to overestimate the expected returns from a new technology, based upon an optimism bias that might also be strategically driven to provide a more positive picture to potential investors.
The boundaries for R&D investment are ambiguous.
Boundaries for R&D investment are difficult to draw and the emergence of ecosystems of complementary products has escalated the phenomenon. It is broadly recognized that firms need to know more than they make. This has led technology firms to increase their scope substantially in recent years, investing in technologies that are successively more distant from their focal business as they pursue “ecosystem dominance.” But the lack of clear guidance on “where to stop” might lead firms to overreaching and ultimately overinvesting.
R&D investment is subject to feedback latency & R&D lumpiness
Technologies often have long and uncertain developments and during the process, feedback on the efficacy of the investment is limited. Linked to this, we see that often technology development is “lumpy” i.e. – it may need a lump sum of investment simply to create a proof of concept, technology or product before any feedback can be obtained. Thus, research projects can rack up significant investment beyond the optimal level before any feedback is obtained.
R&D investment is generally seen as legitimate
R&D investments are generally deemed as evidence of sound business management and so come with a high level of legitimacy. However, this can lead to a research project being subject to lesser scrutiny and control, and overinvestment may result.
Decisions on how much to invest in a given activity, such as R&D, are important to a firm. Being able to understand the antecedents and implications of activity overinvestment could be helpful to improving resource allocation practices, in addition to being informative about behavioural influences on managerial decision-making.
A better understanding of overinvestment in activities could also aid companies in designing more effective “activity-specific” safeguard mechanisms that could improve resource allocation.
Although this paper’s focus is on R&D, it contributes to an understanding of why overinvestment occurs in the context of individual activities (for example, marketing or manufacturing) in general.
The researchers hope that their findings will encourage further systematic research into other sub-optimal investments.
The accepted version of the paper is available for download at the link below. The final version was published in Journal of Management.