Operations Practice China’s digital R&D imperative Chinese companies are upgrading their R&D capabilities as they strive for technological self-sufficiency. Success depends on getting three things right. by Elia Berteletti, Thierry Chesnais, and Patrick Hui August 2021 © vm/Getty Images The days when cost leadership was the key competitive advantage for China’s industrial players are long gone. Today, the country’s top manufacturers are betting on innovative technologies, smart product design, and the ability to respond at speed to changing customer needs. That pivot required significantly increased R&D investment across all parts of the economy. From 2009 to 2019, gross R&D expenditures in the country rose threefold, to almost $515 billion. Since the turn of the millennium, China has overtaken Germany and Japan to become the world’s second biggest R&D spender, after the United States (Exhibit 1). China’s transition to an innovation-driven economy has strong support from the top. In the 14th Five-Year Plan, published earlier this year, the government has stepped up targets for growth in R&D investment, patent ownership, and value generated by the digital economy. The plan’s target—7 percent annual growth in R&D investment—would set the country on the path to become the world’s largest R&D spender. At the heart of this strategy lies the desire for technological independence. Chinese companies don’t just want to make innovative, distinctive products; they want to build those products without needing to import core technologies from overseas competitors. The country is already reaping significant rewards for its strategy, rising from the 29th position in the Global Innovation Index in 2015 to 14th in 2020, for example, and from fourth to first in the global league table for patent registrations over the same period. It has also become the world’s fifth-largest intellectualproperty (IP) exporter, just behind South Korea (Exhibit 2). Success in R&D depends as much on quality as on quantity, however. To translate effort into results, companies must invest in the right technologies and turn their ideas into products that match customer Exhibit 1 CeCtoxhhpiiinnnecacar’’tsseeaRRds&&etoDbDiyininn7cvvrepeeseastrtsmcmeeeebnnntytta7ss,,ypwweeahhrrici.ccehhnhhtaaavvyeeeggarrro.owwnn 22..66--ffoolldd iinn tteenn yyeeaarrss,, aarree expected China’s R&D expenditure ratio, China’s R&D gross domestic % of GDP spending, $ billion R&D gross domestic spending, $ billion 2.5 800 800 +30% 2.6× 2.0 600 600 US +7% 1.5 per China annum1 400 400 1.0 0.5 0.0 2000 2010 1Based on 14th Five-Year Plan. Source: OECD 200 2019 0 2009 200 Forecast 2025 0 2000 Japan Germany South Korea 2019 2 China’s digital R&D imperative Exhibit 2 CiCinnhhtteeiinnllllaaee,,ccnnttuouoawwall--ttpphhrreeoopwwpeeoorrrrttllydyd’’ttssrraallaaddrreegg..eessttppaatteennttggeenneeraratotor,ri,sisaammajaojrorppaartritcicipipaannttiningglolobbaal l 2019 Patent Cooperation Treaty lings 2019 trade in IP charges by country, $ billion 60,993 56,228 51,691 38,028 18,899 129 Receipts (exports) 7 47 36 8 Payments (imports) 57 34 26 16 10 China US Japan Europe South Korea Source: World Intellective Property Organization; World Bank; McKinsey analysis US China Japan Germany South Korea needs at the right time. That’s a notoriously demanding, high-risk endeavor. We have been watching the evolution of China’s R&D sector closely over the past decade. Our latest major research effort is an in-depth survey of 95 senior R&D executives from some of the country’s most innovative companies (see sidebar, “Our survey”). Conducted in the first quarter of 2021, this research suggests that while R&D leaders are proud of their progress so far, most foresee significant challenges in the years to come. From refinement to innovation In 2015, our colleagues at the McKinsey Global Institute evaluated the innovation performance of Chinese companies. MGI found that they performed well in two of the four basic archetypes of innovation: customer-focused and efficiencydriven innovation. In the other two archetypes— engineering- and science-driven innovation— Chinese companies were still catching up with their global counterparts. The pressure to close that gap has become significantly greater over the ensuing six years. Chinese companies have strong commercial Our survey Our latest snapshot of the state of R&D in China is based on a survey of 95 senior R&D executives working at large and midsize organizations in China. Respondents came from 18 different industries (including telecom equipment, electronics, industrial machinery, and automotive) that depend on a high level of R&D activity. These respondents work for a mix of local companies and the Chinabased business units of multinational corporations. On average, the surveyed companies employ about 2,000 R&D personnel in China, and some two-thirds of the survey respondents had at least ten years’ experience in a variety of technical or managerial R&D roles. We asked the respondents more than 50 questions covering the R&D priorities, capacity, and capabilities of their industries in the Greater China region. China’s digital R&D imperative 3 To translate effort into results, companies must invest in the right technologies and turn their ideas into products that match customer needs at the right time. and political incentives to reduce their reliance on overseas IP for the core technologies in their products. Respondents to our survey said that this pressure, combined with rising competitive intensity, would probably generate further significant increases in R&D investment in the coming years. Some 80 percent told us that they expected R&D expenditures in their industries to increase, and most respondents expect the increase in the R&D intensity of Chinese companies to exceed global industry averages (Exhibit 3). We asked the R&D leaders in our survey to estimate how long it would take for their industries to achieve self-sufficiency in core technologies: the ability to source all necessary IP within China. Just over half of the respondents told us that they were already self-sufficient or expected to become so in the next two years. Sixty-two percent said that China’s product-development capabilities in their industries already matched or defined global best-in-class performance or that they would reach it in the next five years. That is a five percentage-point increase in confidence levels since our 2016 survey (Exhibit 4). Despite this significant progress, many companies must still work to achieve technology leadership in their industries. The biggest barriers, according to our survey respondents, are difficulties in securing sufficient specialist talent and a lack of long-term R&D programs focused on fundamental technologies or innovative new-product categories. We’ll explore the talent issue in more detail in the next part of this article. Chinese companies have plenty of opportunities to scale up their innovation capabilities. A first step will be to allocate more resources to higher-risk, Exhibit 3 RReessppoonnddeennttsseexxppeeccttththeeRR&&DDiinnvveessttmmeennttssoof fccoommppananieisesininCChhininaatotoininccrreeaasese mmoorree rraappiiddllyy tthhaann tthhoossee ooff ccoommppaanniieesseellsseewwhheerere. . Expected change in R&D expenditures over next 1–2 years, % of respondents Global Flat or decrease 35 Increase 1 5% 40 Increase 5.01 10% 19 Increase >10% 6 China 21 44 23 12 100% Source: McKinsey 2021 China Product Development Survey (n = 95) 4 China’s digital R&D imperative Exhibit 4 TsTsuehhfleeff-ircrseeiuessnpptooc,nniweddnoeertnn,ldttwss-ocaalrrarledess-mmcRoloa&rrseeDsooRcppa&ttpiDimmabciisiastltpiiticaciebaasbib.loitouiuettsC.Chhiinnaa’s’saabbiliiltityyttooddeevveeloloppself- Timeline for China to achieve self-su ciency in intellectual property and core technologies,1 % of respondents Already self-su cient 23 Within 2 years 29 Within 2 5 years 34 Within 5 10 years 14 100% Assessment of China’s product-development environment and capabilities, % of respondents 6 Already at par with or better than best 8 global product-development centers 49 54 Likely to catch up in next 5 years 45 38 Improving but likely to lag behind best global centers 2016 2021 Source: McKinsey 2021 China Product Development Survey (n = 95); McKinsey 2016 China Product Development Survey (n = 77) longer-term R&D projects. Respondents to our survey estimate that around 70 percent of Chinese companies’ R&D investment goes to downstream activities: adding features, improving performance, or reducing the cost of components in existing products (Exhibit 5). Respondents told us that their companies are introducing activities and processes to promote innovation. More than 80 percent said they were using techniques such as annual innovation calendars, sessions devoted specifically to generating ideas for innovation, or review boards to assess innovative ideas. But only about 20 percent of the respondents felt these systems were mature and well followed in their organizations. The looming talent gap The single biggest challenge highlighted by respondents was talent. China’s R&D leaders worry that they may not secure sufficient staff with the specialist skills necessary to meet their strategic goals over the next five years. Most respondents believe that engineering salaries in tier-one cities, such as Beijing and Shanghai, are likely to increase at an annual rate of more than 10 percent during that time. Skills associated with high-tech products are expected to see the highest levels of demand. China’s digital R&D imperative 5 Exhibit 5 MaMdreooevrrodeetetetvhhdoaattnneodttdwwtoooow-d-ttnohhswiitrrnrddesssatroomeffaRaRmc&&tDaiDvcihtthiioveouisutr.irsessa.re Allocation of engineering hours across R&D-activity categories, % of hours, averaged across respondents1 Studying new technologies 31 12 New technology studies for products to launch in more than 3 years 19 New technology studies for products to launch within 3 years were rising competition from existing players within their industries, the need to respond more rapidly to changing customer needs through mass customization and faster times to market, and the impact of new connectivity technologies, such as 5G and the Internet of Things (IoT). Interestingly, while competition was the top driver overall, respondents from companies based in China put the challenge of meeting customer needs in the number-two position; respondents from multinational companies that develop products in China reported that new technologies were the second most important priority. 20 Reduce component costs Improving existing products 69 23 Improve e ciency or performance of existing features 25 Develop new features Those concerns were reflected in the respondents’ priorities for improving the R&D function. Speed to market came first, followed by higher new-product quality. Many respondents told us that solving the speed and quality challenges would also help them address other improvement priorities, including lower R&D costs, higher sales, better returns on investment for new-product introductions, and smoother production ramp-ups. Note: Figures do not sum to 100%, because of rounding. 1Respondents were asked to allocate 100 points representing engineering hours across listed activities; responses were then averaged to yield percentages shown. Source: McKinsey 2021 China Product Development Survey (n = 95) These include electrical and electronics engineering, robotics, automation and control systems, artificial intelligence (AI), algorithm development, data mining, and data management. China is investing heavily in education to increase the supply of technology-based skills, but demand is rising steeply on all sides. Survey respondents described difficulties recruiting and retaining people for product-engineering roles in the face of competition from other sectors. Speed is the key We asked respondents to rank the market factors putting their current R&D strategies under the most pressure today. Their top three answers These findings are consistent with our previous analyses of China’s R&D sector. In our 2016 China Product Development Survey, for example, respondents told us that greater technologyrenewal speed and faster design cycles were the two biggest drivers of growth for China as a center for design and engineering activity. The R&D leaders in our latest survey also told us clearly what they must do to meet these challenges. Their top three priorities for the next five years are better-integrated product-development (IPD) processes, agile R&D (especially in software development, but also in hardware), and the digitization of R&D (Exhibit 6). The respondents’ assessments of the maturity of their own organizations across these three dimensions varied significantly. More than 70 percent said they already have robust IPD processes, suggesting that their five-year focus will be continued expansion and refinement. By contrast, fewer than half claimed to have mastered 6 China’s digital R&D imperative Exhibit 6 CmCmhhooiirrnneeeeaassgegeiiclcleeoo,,mmaapnnpaddannmmiieeoossrrweewaddaniinggttiitttthaahelle..irirRR&&DD pprroocceesssseessttoobbeeccoommeebbetettetreirnitnetgergartaetde,d, R&D process-prioritization matrix HIGH 10 Must learn 8 6 Priority,1 average point score 4 2 LOW Do later 0 0 20 A C B E L O D Must improve F JI H GM N K Must have Top priority A Agile R&D (software) B Agile R&D (hardware) C Digital R&D processes D Integrated product development E Lean R&D F Product-cost management G Product–life cycle management H Product management I Product roadmapping J Product quality-by-design managment K R&D documentation management L R&D knowledge-management system M R&D project management N Stage gates O Systems engineering 40 60 80 Maturity,2 average point score 100 HIGH 1Respondents were asked to allocate 100 points across available processes by their priority. 2Respondents were asked to assess maturity of their organizations in each process, choosing among four options converted to points: “not at all,” 0 points; “just starting,” 33 points; “in place but not well followed,” 67 points; and “in place and well followed, 100 points. Source: McKinsey 2021 China Product Development Survey (n = 95) the challenges of agile R&D, and around half said the same for digital processes. This combination of high priority and low maturity means that agile R&D and digital R&D are the critical “must learn” engineering challenges for companies in China over the next five years. Building China’s innovation engine To achieve their ambition of becoming world-leading and largely self-sufficient innovation powerhouses, Chinese companies will need to address the current limitations of their R&D capabilities while they continue to build on their strengths. Three sets of actions deserve particular attention. Segment the R&D function The historical focus on product-refinement activities, such as cutting product costs, means that the center of gravity of many R&D centers in China lies at the downstream end of the R&D process. One way to rebalance is to adopt an approach that many of the world’s most innovative companies use: to prevent urgent downstream projects from draining the resources needed for strategically important upstream work, these businesses split their R&D functions into two parts. In this arrangement, the upstream (or innovation) half of the function focuses on medium- and long-term efforts to address unmet customer needs and to develop the building blocks of new technologies. The downstream China’s digital R&D imperative 7 half continues to focus on excellence in project execution. To steer the upstream innovation function, companies use inputs from two groups within the business. Product management uses customer and market insights to create and manage a detailed product road map supported by structured value propositions for new products and features. The organization’s technical-research unit, meanwhile, creates medium- and long-term technology road maps (aligned with the overall product road map) that allocate resources to the longer-term research efforts needed to deliver the technologies required by the products on the road map. One large carmaker in China, for example, is already using this approach: its customer-experience team conducts frontline consumer research, and the company uses the resulting insights to generate concepts for a product bluebook (or road map). One of the most successful innovations to emerge from this approach was a new type of seat, with extra legroom and easily accessed extra compartments, developed to meet the specific needs of a welldefined demographic segment. Nurture R&D talent Successful upstream R&D depends acutely on talent. Technical-research teams do their best work in an environment that nurtures creativity and gives them freedom to experiment. As companies ramp up their innovation activities, they will want to nurture such an environment, even while ensuring that their research efforts stay aligned with their strategies and road maps. For companies more familiar with tightly controlled, time-critical downstream R&D, this approach may entail a significant cultural shift. Companies can pursue a range of ways to foster an atmosphere of innovation: they can encourage engineers to engage in open-source software-development communities, for example, or organize internal technical-innovation challenges. Exposing staff to new ideas and external expertise is also a powerful motivator, which can be leveraged by inviting industry thought leaders to engage with R&D teams or by encouraging staff to participate in external events, conferences, and fellowships. Companies should also consider redesigning the career paths for specialist technical staff. Such employees may not wish to pursue conventional routes into management roles. Instead, leading companies create senior-expert roles with status equal to that of managers and encourage the most experienced staff members to mentor junior colleagues. Likewise, KPIs and incentive systems designed for downstream R&D processes must be adapted to (or replaced by) approaches that recognize the contribution made by upstream innovation activities. With the right environment, freedom, and management support, upstream R&D teams can have a significant and surprising impact. In 2010, for example, a small team from a multinational semiconductor company with a large R&D workforce in China was encouraged to experiment with an open-source platform used to manage big data. This work optimizing the system eventually led to a strategic shift that helped the company become a leading player in enterprise-scale data analytics. Accelerate the agile and digital R&D transformation In downstream R&D, companies can give teams the tools, capabilities, and processes they need to move faster in an increasingly competitive environment. Responses to the survey suggest in particular that companies can continue to improve their IPD processes while ramping up the implementation of digital R&D use cases and the deployment of agile R&D-development methodologies, both for hardware and software. Success is not guaranteed. Across the world, companies have learned the hard way that digital transformations are difficult. In 2020, we found that 74 percent of companies which started digital 8 China’s digital R&D imperative projects could not move them beyond the initial pilot stage.1 The root causes of such “pilot traps” are complex: companies cite a range of factors, including high up-front costs, unclear value propositions, and a lack of talent, knowledge, or leadership support. Many found that the sheer range of potential use cases and offerings from vendors made it hard to allocate resources, pick appropriate projects, or select technology partners. built an agile function to introduce new products. In parallel, the company supported the new process by making investments—including advancedanalytics tools for its testing department and automated systems to program lab equipment—in several digital R&D use cases. This program helped the company cut time to market for new products by more than 20 percent and reduce productdevelopment cost by more than 15 percent. Getting R&D transformations right in today’s agile, digital world means taking a systematic approach. Successful change requires companies to think beyond technologies and methodologies and to pay equal attention to the needs of the business and the capabilities of the organization. Leaders are proving that such transformations pay off. In response to increasing competitive pressure from smaller, fast-growing rivals, for example, one Chinese tier-one consumer-electronics supplier Our latest research shows that in only five years, China’s R&D sector has made significant progress, becoming larger, more self-reliant, and more competitive. Now the country’s R&D leaders can get ready for the next S-curve in R&D performance: building a new generation of engineering and science-led innovation capabilities to support existing strengths in efficiency, responsiveness, and customer focus. Elia Berteletti is a partner in McKinsey’s Taipei office, and Thierry Chesnais is a partner in the Hong Kong office, where Patrick Hui is a venture leader. The authors wish to thank YiFan Wu and Yuting Yang for their contributions to this article. Designed by McKinsey Global Publishing Copyright © 2021 McKinsey & Company. All rights reserved. 1 Mayank Agrawal, Sumit Dutta, Richard Kelly, and Ingrid Millán, “COVID-19: An inflection point for Industry 4.0,” January 15, 2021, McKinsey.com. China’s digital R&D imperative 9
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