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Olin Lewis Wethington Subject Files
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Collection/Office of Origin: Economic Policy Council
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Wethington, Olin, Files
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2
FEB-11-1991 12:11 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.01
U.S. Department of Commerce
Washington, D.C. 20230
U.S. DEPARTMENT OF COMMERCE
THE ASSISTANT SECRETARY
A
FOR TECHNOLOGY POLICY
TECHNOLOGY ADMINISTRATION
TECHNOLOGY ADMINISTRATION
FACSIMILE TRANSMITTAL SHEET
Number of Pages (including cover sheet): 13
Telephone Number: 202/377-1581
Fax Number: 202/377-4817
Date: 2/11/91
Room: HCHB 4814-C
To: Olin Wethington
Agency/Company:
FAX number: 456-7739
Telephone number:
From:
Deynah L Wince SmiR
Division:
Telephone:
SPECIAL INSTRUCTIONS/MESSAGE:
I have placed a * next to
relevant text for your interest
FEB-11-1991 12:11 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.02
Why us Conversion to metric system is a Key
comperetiveness i ssue.
World trade is increasingly geared towards the metric system of
measurement. Industry in the United States is often at a
competitive disadvantage when dealing in international markets
because its measurement system differs from that used by the rest
of the world, and is sometimes excluded when it is unable to
deliver goods which are built to metric specifications.
FEB-11-1991 12:11 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.03
DEPARTMENT OF COMMERCE
UNITED STATES DEPARTMENT OF COMMERCE
UNITED STATES OF AMERICA
Technology Administration
Washington. D.C. 20230
DRAFT.
Initiative: Voluntary Implementation of the Metric System
Background: The importance of using the metric system in international trade was recently
underscored during the bilateral negotiations between the U.S. and Japan on removing
structural impediments to trade. The Japanese emphasized that the non-metric character
of U.S. goods is a significant impediment to sales in their market. While the importance
of metric usage in our products may vary from case to case, the measurements we use in
making our products undoubtedly influences their acceptability in many markets. The
advice from Japan is not a surprise. Many U.S. companies find that inch-pound standards
are out of favor abroad. As the European Community unifies their industrial standards
under EC-92, their preferences for metric will grow. These metric standards are already
being harmonized informally as the United Kingdom, France, Germany, Japan and other
metric countries exploit new business opportunities in Eastern Europe and the Soviet Union
A little noticed provision of the Omnibus Trade and Competitiveness Act which President
Reagan signed into law on August 23, 1988 dealt with the adverse impact on U.S.
competitiveness of our failure to complete our transition to use of the metric system in trade
and commerce.
This law conveys an important policy statement by the Congress that metric is the preferred
system of measurement for United States trade and commerce. The law also requires
Federal Agencies to lead the process of voluntary change to preferred metric usage through
use of metric in government contracts, grants and other business related activities and in
government publications.
The law authorizes exceptions where metric use is impractical, disruptive or would adversely
impact U.S. businesses. And, of course, our program remains voluntary with private
business and the general public.
One thing we have learned from others is that the metric system really is a better system,
and the transition is really relatively easy. Within this country the entire U.S. auto and farm
equipment industries and their many small business suppliers went metric and achieved
enormous savings and operational benefits. Many of our larger multi-national firms in other
industries have also changed and in most instances the gains in productivity and
competitiveness have been accomplished with little or no adverse impact on small business
suppliers or on workers.
Suggested Language: ( for state of Union) - 02 a speek.
*
An important factor in American competitiveness in international markets is adoption of the
standard of weights and measures used throughout the world - the metric system. Without
exception, all of our major trading partners have adopted this standard. While Europe has
been on the metric standard for centuries, others have adopted it more recently Japan and
India in the '50s, the United Kingdom and the Commonwealth Nations in the '60s and '70s,
and Canada, which began its conversion program when the U.S. did in 1975, largely
completed it in 1985.
FEB-11-1991 12:12 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.04
Voluntary Implementation of the Metric System
State of the Union Initiative
Page 2 of 2
In 1988, President Reagan signed into law the Omnibus Trade and Competitiveness Act, a
provision of which established metric as the nation's preferred system of weights and
measures. This law called upon federal agencies to lead the process of voluntary change by
adopting metric standards in government contracts.
I realize that it is human nature to be concerned about change, no matter how smooth the
process and how great the promised benefits. But if we fail to act now, our international
competitors will gain a tremendous market advantage.
To demonstrate our resolve and strengthen our commitment to this transition, I am calling
upon all federal departments and agencies to expedite their efforts to meet the target dates
set forth in the 1988 Trade Act. And I am charging the Secretary of Commerce with the
I
responsibility for leadership and coordination of these efforts.
However, let there be no misunderstanding about our objective. Although use of the metric
system by the federal government will be beneficial to the government in its own operations,
the most important changes and the greatest benefits of the change will be in American
industry, commerce, education and, ultimately, in economic benefits and improved quality
of life for our citizens today and in future generations.
FEB-11-1991 12:13 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.05
FORM CD-183
U.S. DEPARTMENT OF COMMERCE
(REV. 3.88)
ABSTRACT OF SECRETARIAL CORRESPONDENCE
TO:
X
The Secretary
The Deputy Secretary
Control No:
Date: FEB
DECISION MEMORANDUM
From:
Robert M. White
Under Secretary for Technology suck
Wendell L. Willkie, II
General Counsel
Prepared by:
ASWhelihan TA/MPO/377-3754
MALevitt GC/377-3151
Subject:
METRIC EXECUTIVE ORDER
DRAFT
STATEMENT OF THE ISSUE
# Presidential commitment and assignment of leadership authority through issuance of an
Executive Order on metric conversion is necessary to accelerate that conversion and to implement
the 1988 Trade and Competitiveness Act's (the Trade Act) Metric Usage provisions.
BACKGROUND
#
The Department of Commerce has provided federal support for U.S. voluntary metrication
activities since funding for the U.S. Metric Board ended on September 30, 1982.
* The Trade Act changed our national metric policy from "accommodating the increasing use of
metric" to a declared preference for metric in U.S. trade and commerce. In addition, all Federal
agencies are now directed to implement the new policy through specific metric usage initiatives.
No single agency is specifically assigned an overall leadership or management role.
* The Trade Act's significant amendment of the Metric Conversion Act of 1975 was accomplished
with little fanfare. As a result, the level of awareness in government, industry, professional groups
and the general public remains very low. This low level of awareness and the lack of an
Administration statement on the issue makes it very difficult to develop a broad based voluntary
move to promptly implement the transition to preferred use of metric units.
A
# An Executive Order on metric would deal with an issue worthy of Presidential attention and
would impress on agency heads the commitment of this Administration to achieve preferred metric
usage in United States trade and commerce as called for in the Metric Conversion Act. as amended
by the Trade Act.
PREPARED BY
CLEARED BY
CLEARED BY
CLEARED BY
CLEARED BY
CLEARED BY
CLEARED BY
SURNAME &
ORGANIZATION
(Please type)
R.M.WHITE
W.L. WILLKIE
U/S TECH.
GC
INITIALS AND
Num
DATE
1118
USCOMM-DC 88-070
FEB-11-1991 12:13 FROM UNDER SEC OF TECHNOLOGY
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94567739
P.06
# In October 1988, OMB offered Commerce the opportunity to develop language for
an Executive Order to guide implementation of the Trade Act's Metric Usage
provisions. The requested language was prepared and submitted. OMB later decided
to combine all of the Trade Act implementation guidance in a single Executive Order.
Unfortunately, last minute edits of the metric text and the rush to issue the Order,
which implemented sanctions against Toshiba, resulted in dropping the metric
language from the Order.
* At Congressional oversight hearings on April 24, 1990, A/S Wince-Smith agreed in
principle in response to a question by the Committee Chairman regarding the
desirability of an Executive Order. We subsequently drafted a proposed Executive
Order and circulated it to the Metrication Operating Committee (MOC), the working
arm of the interagency Council on Metric Policy (ICMP), where various agency
suggestions for strengthening the draft were received and subsequently incorporated.
The ICMP met on October 24, reviewed the draft Executive Order, and voted
unanimously to request your endorsement and forwarding of a request for issuance of
an Executive Order to OMB.
RECOMMENDATIONS
1. We recommend that you approve submission of the attached draft Metric Executive
Order to OMB which: assigns the Commerce Department to be "lead Agency" for
coordinating the Federal Government's metric transition, authorizes you to create
necessary interagency and advisory groups to assist you, requires Federal agencies to
submit their metric transition plans to the Department for review, and calls for heads
of departments and agencies to give their full support to metric transition.
DECISION
Approve
Disapprove
Let's Discuss
2. We also recommend that you approve (but not send yet) the attached letter to each
of the ICMP agency heads requesting their strong support for the Order. The letter
also exhorts them to take a personal interest in spurring action in their agencies to
meet the 1992 target for Federal metric usage implementation. We would send this
letter to agency heads at the time OMB releases the draft Executive Order for agency
comment.
DECISION
Approve
Disapprove
Let's Discuss
Attachments
FEB-11-1991 12:14 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.07
DEPARTMENT OF COMMERCY
GENERAL COUNSEL OF THE
UNITED STATES DEPARTMENT OF COMMERCE
UNITED STATES of AMERICA
Washington. D.C 20230
FEB 4 (99)
DRAFT.
MEMORANDUM FOR: ROBERT G. DAMUS
Acting General Counsel
Office of Management and Budget
FROM:
Wendell L. Willkie, II
SUBJECT:
Executive Order on Metric Usage in Federal Government
Programs
World trade is increasingly geared towards the metric system of measurement.
Industry in the United States is often at a competitive disadvantage when dealing in
international markets because its measurement system differs from that used by the
rest of the world, and is sometimes excluded when it is unable to deliver goods which
are built to metric specifications.
The Omnibus Trade and Competitiveness Act of 1988 (P.L. 100-418) (the Trade Act)
amended the Metric Conversion Act of 1975 (P.L. 94-168) (the Metric Act), codified in
15 U.S.C. $ 205, to designate the metric system as the preferred system of weights and
measures for United States trade and commerce. Section 5164(b) of the Trade Act
amends 15 U.S.C. § 205b to require Federal agencies, by a date certain, and to the
extent economically feasible by the end of fiscal year 1992, to use the metric system of
measurement in its procurements, grants and other business-related activities, except to
the extent that such use is impractical or is likely to cause significant inefficiencies or
loss of markets to United States firms. Section 5164(c) further amends 15 U.S.C. $ 205
to require Federal agencies to establish guidelines to carry out the policy of the
amended Metric Act, and to report to the Congress their metric transition
accomplishments and metric implementation plans.
The Trade Act amendments state the need for all agencies of the Federal Government
to assist industry, especially small business, as it voluntarily converts to the metric
system, and to increase understanding of the metric system through educational
information and guidance and in Government publications. The amendments also
note that the metric system can provide substantial advantages to the Federal
Government in its own operations.
The Commerce Department's involvement in metric conversion arose in 1982 when the
United States Metric Board's ("USMB") funding ended. President Reagan, in a letter of
appreciation to the Chairman of the Board, stated that the functions of the USMB for
voluntary metric conversion would be assumed by the Department.
FEB-11-1991 12:14 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.08
In light of the 1988 Trade Act amendments and the Department of Commerce's
assigned role, we have prepared an Executive Order to clarify and outline Executive
Branch policies and responsibilities in implementing the Metric Act as amended. The
Executive Order would (i) charge the Executive Branch with the task of implementing
metric to provide substantial advantages in its own operations; (ii) require the
development by Federal agencies of procedures and techniques to assist industry,
especially small business, as it voluntarily converts; and (iii) assign to the Secretary of
Commerce specific responsibilities and authority to lead implementation of the new
provisions of the Metric Act. The Executive Order addresses coordinating Federal
activities in planning for metric transition; assisting industry in its voluntary transition
to metric; increasing understanding of the metric system through educational
information, guidance and government publications; establishing Federal metric
guidelines; and developing Federal agency metric implementation plans. The
Executive Order would establish the leadership role of the Secretary of Commerce and
the linkage of his responsibilities with the advisory and coordinating role of the
Interagency Council on Metric Policy. An ICMP membership list is attached for your
reference. The ICMP met recently and voted unanimously to request issuance of a
strong metric Executive Order.
I recommend that the Executive Order be cleared for approval by the President. Any
questions regarding the Executive Order can be referred to Lisa Sockett of the General
Counsel's Office at 377-8843.
Attachments
FEB-11-1991 12:15 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.09
MEMBERS OF THE
INTERAGENCY COUNCIL ON METRIC POLICY
1990
Department of Agriculture
General Services Administration
Department of Commerce
Government Printing Office
Department of Defense
Department of Education
Interstate Commerce Commission
Department of Energy
Department of Health and
National Aeronautics and Space
Human Services
Administration
Department of Housing and Urban
National Science Foundation
Development
Nuclear Regulatory Commission
Department of the Interior
Department of Justice
Office of Personnel Management
Department of Labor
Office of Science and Technology
Department of State
Policy
Department of Transportation
Office of the U.S. Trade
Department of the Treasury
Representative
Department of Veterans Affairs
Central Intelligence Agency
Small Agency Council/Smithsonian
Institution
Commodity Futures Trading Commission
Small Business Administration
Consumer Product Safety Commission
Tennessee Valley Authority
Environmental Protection Agency
Export-Import Bank of
U.S. International Trade
the United States
Commission
U.S. Postal Service
Federal Communications Commission
Federal Emergency Management Agency
Federal Maritime Commission
Federal Reserve Board
Federal Trade Commission
FEB-11-1991 12:15 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.10
Executive Order No.
of
/ 1991
Metric Usage in Federal Government Programs
WHEREAS Congress amended the Metric Conversion Act of 1975 (15 U.S.C. $ 205) (P.L.
94-168) (the Metric Act) through Section 5164 of the Omnibus Trade and Competitiveness
Act of 1988 (P.L. 100-418) to designate the metric system of measurement as the preferred
system of weights and measures for United States trade and commerce; and
WHEREAS in such amendments Congress provided for the performance of certain
functions by the Federal Government with respect to metric usage:
NOW, THEREFORE, by virtue of the authority vested in me as President by the
Constitution and laws of the United States of America, including 15 U.S.C. $ 205, it is
hereby ordered as follows:
Section 1. Designation of Lead Agency.
(a) The Department of Commerce is hereby designated and empowered as the lead
agency responsible for coordinating Federal Government metric usage in accordance with
15 U.S.C. § 205b.
(b) The Secretary of Commerce is hereby authorized to take such actions, including the
promulgation of rules and regulations, as may be necessary to carry out the purposes of
this Order.
(c) The Secretary of Commerce is hereby authorized to charter an Interagency Council on
Metric Policy (ICMP), which will assist the Secretary in coordinating Federal Government-
wide implementation of this Order. The Secretary of Commerce may establish such
subcommittees and sub-Chairs within this interagency committee as may be necessary to
carry out the purposes of this Order.
(d) The Secretary of Commerce is authorized to form such advisory committees
representing other interests such as state and local governments and the business
community as may be necessary to ensure the maximum beneficial effects of this Order.
(e) The Secretary of Commerce shall report to me on progress made in implementing this
Order. The Secretary's report shall include an assessment of progress made by the
Federal agencies and of the effect of Federal metric usage on achievement of the National
objective of preferred metric usage in United States trade and commerce, as set forth in
the Metric Act. On October 1, 1992, the Secretary shall prepare recommendations for any
additional measures, including, but not limited to, regulations or legislation, needed to
achieve the full economic benefits of metric usage.
FEB-11-1991 12:16 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.11
Section 2. Department and Agency Responsibilities.
All agencies of the Executive Branch of the United States Government are directed to take
all appropriate measures within their authority to carry out the provisions of this Order.
Consistent with this mission, the head of each Executive department and agency shall:
(1) Use, by September 30, 1992, or by such other date or dates established by the
department or agency in consultation with the Secretary of Commerce, the metric system
of measurement in Federal Government procurements, grants, and other business-related
activities. Other business-related activities include all use of measurement units in
agency mission programs and functions as further defined in Metric Conversion Policy
for Federal Agencies (15 CFR Subpart 19). Metric usage shall not be required to the
extent that such use is impractical or is likely to cause significant inefficiencies or loss of
markets to United States firms. Heads of departments and agencies shall establish an
effective process for a policy-level review of proposed exceptions to metric usage.
Appropriate information about exceptions granted shall be included in the agency annual
report along with recommendations for actions to enable future metric usage.
(2) Seek out ways to increase understanding of the metric system of measurement
through educational information and guidance and in government publications. The
transition to use of metric units in government publications shall be made as publications
are revised on normal schedules or new publications are developed, or as metric
publications are required for support of metric usage pursuant to paragraph (1) above.
(3) Seek the appropriate aid, assistance and cooperation of other affected parties,
including other Federal, state and local agencies and the private sector, in implementing
this Order. Appropriate use shall be made of governmental, trade, professional and
private sector metric coordinating groups to ensure the maximum beneficial effects of this
Order.
(4) Formulate metric transition plans for the department or agency which shall be
approved by the department and agency head and shall be in effect by September 30,
1991. Copies of approved plans shall be forwarded to the Secretary of Commerce. Such
metric transition plans shall specify, among other things:
(A) the total scope of the metric transition task for that department or agency, including
firm dates for all metric accomplishment milestones for the current and subsequent fiscal
years;
(B) the department or agency's plans for specific initiatives to assist industry, especially
small business, as it voluntarily converts to the metric system, and for cooperating with
all affected parties in undertaking the requirements of paragraph (1) of this Section; and
(C) specific steps and associated schedules through which the department or agency will
seek to increase understanding of the metric system through educational information and
guidance and in department or agency publications.
FEB-11-1991 12:17 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.12
(5) Designate a senior level official as the Metric Executive for the department or agency
to assist the head of each Executive department or agency in implementing this Order.
The responsibilities of the Metric Executive shall include, but not be limited to:
(A) acting as the department's or agency's policy level representative on the ICMP and
for liaison with other government agencies and private sector groups;
(B) management oversight of department or agency outreach and response to industry
and agency client inquiries and questions during the transition to metric system usage;
and
(C) management oversight of preparation of the department or agency's metric transition
plans and progress reports, including the Annual Metric Report required by 15 U.S.C.
§ 205j and OMB Circular A-11.
(D) Preparation by June 30, 1992, of an assessment of agency progress and problems
together with recommendations for steps to assure successful implementation of this
Order. The assessment and recommendations shall be approved by the head of the
department or agency and provided to the Secretary of Commerce by June 30, 1992, for
inclusion in his September 30, 1992, report on implementation of this Order.
Section 3. Application of Resources.
The head of each Executive department and agency shall be responsible for implementing
and applying the necessary resources to accomplish the goals set forth in this Executive
Order and the Metric Act.
Section 4. Internal Management Document.
This Order is an internal Executive Branch management document and is not intended to
create any right or benefit, substantive or procedural, enforceable at law by a party
against the United States, its agencies, its officers or any other person.
THE WHITE HOUSE
FEB-11-1991 12:17 FROM UNDER SEC OF TECHNOLOGY
TO
94567739
P.13
Letter addressed to individual heads of departments and agencies:
Dear:
In June 1989 I wrote to the heads of the departments and agencies represented
on the Interagency Council on Metric Policy. In that letter I urged strong support for
metric usage. The agencies are required by the 1988 amendments to the Metric
Conversion Act to complete their transition to the use of the metric system of units. as
set forth in the law, by September 30, 1992. to the extent economically feasible, or by
a date certain.
Last year the General Accounting Office reviewed progress in the transition to
metric usage by Federal agencies, and its report was somewhat critical of the apparent
slow rate of progress in some agencies. A Congressional hearing was held on April 25,
1990, which examined the report and received testimony by several agency officials. At
the hearing, the advisability and beneficial effect of a metric Executive Order was
discussed.
The Interagency Council on Metric Policy (ICMP), chaired by Dr. Robert M. White.
Under Secretary of Commerce for Technology, reviewed a draft Executive Order at its
October meeting and voted unanimously for issuance of such an Order, but with even
more specific and forceful language. The ICMP members believe, and I agree, that the
President's strong policy statement and firm guidance is essential for the Federal
government to implement metric usage by September 1992.
The draft Executive Order, which I have sent to OMB, reflects the ICMP consensus
and carries my unqualified endorsement. I ask that you support issuance of the Order.
I look forward to your continuing efforts to expedite metric transition.
Sincerely,
Robert A. Mosbacher
OLIN
Sibs FCCSOY
THE WHITE HOUSE
WASHINGTON
Date: 10/11/90
TO: Ede Holiday
C
C
FROM:
STEPHEN I. DANZANSKY
Deputy Assistant to the President
and Director of Cabinet Affairs
This Bromley memo may provide some
background and light on the FCCSET
mandate and relationship with the
DPC & EPC.
It may be useful later if we get
into future "turf" battles on
jurisdiction.
C
THE WHITE HOUSE
WASHINGTON
DQB has seen
February 16, 1990
2/17
MEMORANDUM FOR DAVID Q. BATES
FROM:
D. ALLAN BROMLEY Ana
SUBJECT:
FEDERAL COORDINATING COUNCIL FOR SCIENCE,
ENGINEERING AND TECHNOLOGY
Your memorandum of February 5, 1990 concerning the structure and operations of
the Federal Coordinating Council for Science, Engineering and Technology (FCCSET)
is greatly appreciated. Ken Yale's participation in the first FCCSET meeting on
January 24, and his subsequent conversations with Tom Ratchford on a variety of
issues related to FCCSET have also been immensely helpful. Clearly, it will be a
significant challenge to develop and coordinate truly national research programs from
various components in several agencies. However, the success of the FCCSET
Committee on Earth Sciences in the area of global change does, I believe, point the
way for other areas of research and development.
Although the primary responsibility of the FCCSET is to coordinate R&D among the
federal agencies, and the overwhelming fraction of the efforts of its committees will be
directed toward accomplishment of this mainly technical task, the FCCSET should
play a constructive policy role with respect to the Cabinet Councils. Below are some
preliminary thoughts on how this might be structured; I would be pleased to discuss
the issue with you in more detail, at your convenience.
The major policy role of FCCSET would be to provide expertise and analyses to the
DPC, EPC, NSC, as well as the Space and Competitiveness Councils. Typically the
issues would be very broad, with science and technology playing an important but
subsidiary role. In many perhaps most cases, the FCCSET could be tasked by the
appropriate council to provide analysis of a particular issue. In some cases,
alternative options might be analyzed by the appropriate FCCSET committee, in.
response to specific requests by a council. In other cases probably not very many -
a broad issue with mainly scientific and technological content might evolve to the
point of deserving consideration by a council.
What we need are effective ways for the councils to identify policy issues to be sent to
the FCCSET. With some thought and planning, I believe this can be done in an
operationally satisfactory manner.
cc: STENE
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Somewhat easier to conceptualize, is the process by which policy issues might
originate in FCCSET and be fed into the appropriate council. As FCCSET chairman,
and a member of EPC and DPC, it would be my responsibility to propose these
council agenda items.
The above discussion has focussed on what I call science and technology for policy:
i.e., making sure that the best science and technology (from the FCCSET) is made
available in a timely, "user friendly" manner to the policy fora (Cabinet Councils).
An example of this is the input of the FCCSET Committee on Earth Sciences to the
DPC Climate Change Working Group.
In addition to science and technology for policy, there is also a need, in some cases,
to provide policy for science and technology. This class of issues typically is not
important enough - on the national scale - to earn attention from a Cabinet Council,
and could be resolved directly by the FCCSET. An example of this class of issues is
the setting of priority among and within areas of basic research.
I am convinced that FCCSET, properly organized and functioning smoothly, will make
a significant difference in the coordination and priority setting within federal science
and technology programs. This is the primary responsibility of OSTP and of
FCCSET as set forth in our founding legislation. FCCSET can also be a useful
adjunct to the primary policy fora, and we look forward to working with you to see
that this is done in the most effective manner possible.
revised 5/16/90
DRAFT
CHARTER OF THE COMMITTEE ON
TECHNOLOGY AND INDUSTRY
The Committee on Technology and Industry is hereby established by action of the
Federal Coordinating Council for Science, Engineering and Technology (FCCSET).
Purpose
The purpose of the Committee on Technology and Industry is to examine, monitor,
encourage and increase the effectiveness of federal policies, programs and initiatives
to enhance the application of technology by U.S. industry to improve global
competitiveness. Particular attention will be given to encouraging industry leadership
and initiative in meeting our competitive challenges.
Functions
The Committee on Technology and Industry will:
o
improve planning, communication and coordination among federal
agencies which conduct programs affecting the use of technology by
industry.
0
develop criteria for identifying generic, precompetitive enabling
technologies.
0
identify and assess programs which expedite the commercialization of
new technologies by industry in less time and at lower cost, resulting in
world-class products and services. These should include efforts in
concurrent engineering and management, total quality management, and
flexible computer-integrated manufacturing.
o
review options for gaining greater commercial advantage from federal
science and technology investments.
0
review the record of commercialization of technologies resulting from
Federal R&D support, and recommend a policy for future support of
dual use technologies with applications in two or more departments/
agencies.
0
identify and address issues that limit the diffusion and exchange of
technology among universities, federal laboratories, and industry,
including: cooperative R&D efforts, intellectual property rights issues,
freedom of information policies, and conflict of interest regulations.
identify and assess regulatory and legal barriers that limit the
competitiveness of industry, including capital formation, investments in
R&D, antitrust policies, product liability burdens, and procurement
requirements.
improve the coordination of federal technology and industry outreach
programs with state and local initiatives, and examine the effectiveness
of existing mechanisms based largely in the federal laboratories.
0
identify successful examples of federal technology transfer efforts and
private sector R&D advisory mechanisms, and recommend steps to build
upon these successes.
0
review federal agency technology "intelligence" efforts to track foreign
technology advances, and recommend ways to more effectively gather,
process and disseminate such information for use by U.S. industry.
0
address specific technology-industry issues and problems that affect two
or more federal agencies.
Structure
The Chairman of the FCCSET appoints as Chairman of the Committee on Technology
and Industry, the Deputy Secretary of Commerce. The Vice Chairman of the
Committee is the Deputy Administrator of the National Aeronautics and Space
Administration.
Responsibilities of the Chairman
0
hold regular meetings of the Committee (no fewer than three per year)
and approve agendas.
0
submit an annual report to the Chairman of the FCCSET for review by
the full Council.
o
appoint (and as necessary abolish) sub-committees, task forces and
working groups as necessary to achieve the committee's purpose.
0
meet regularly with the chairman of the FCCSET and other committee
chairmen to evaluate progress, discuss policy coordination, receive new
instructions from the FCCSET and report on ongoing activities.
2
The following departments and agencies are represented on this committee, normally
at the Assistant Secretary level or above:
Department of Commerce, Chair
Department of Agriculture
Department of Defense
Department of Education
Department of Labor
Department of Energy
Department of Health and Human Services
Department of Interior
Department of Justice
Department of Transportation
Department of Treasury
Environmental Protection Agency
National Aeronautics and Space Administration
National Science Foundation
U.S. Trade Representative
Central Intelligence Agency
Council on Environmental Quality
Ex-Officio members will be provided by the Office of Management and Budget and
the Office of Science and Technology Policy.
Membership on subcommittees, task forces, and working groups is not restricted to
committee members and is established as the committee chairman may determine
appropriate. The Committee will subsume the previously existing FCCSET Committee
on Materials.
A Terms of Reference (ToR) will be developed and approved by the committee
chairman for all subcommittees, task forces and working groups dealing with
significant and complex questions. The ToR will identify and bound the issues to be
addressed and will specify the desired products and delivery times.
The Committee will work closely with other FCCSET committees and interagency
groups to include the Competitiveness Council headed by the Vice President.
Committee activities will be coordinated by an Executive Secretary, designated by the
committee chairman. Additional staff and funding assistance, consistent with the
functions of this charter, will be the responsibility of the chairman.
In all matters considered by the Committee, a numerical majority may act for the
committee as a whole.
3
Private Sector Interface
The Committee will recommend to the Chairman of the FCCSET the nature of private
sector advice needed to accomplish its mission. The chairman of the FCCSET will
take necessary steps to ensure appropriate interaction between the President's Council
of Advisors on Science and Technology (PCAST) and the Committee. The Committee
may also receive ad hoc advice from various private sector groups as consistent with
the Federal Advisory Committee Act.
Compensation
All members are full-time Federal employees who are allowed reimbursement for
travel expenses by their agencies plus per diem or subsistence while away from their
duty stations and in accordance with standard government travel regulations.
Documentation
Agendas and records of actions of committee meetings are prepared and disseminated
to members by the Executive Secretary. Records of actions are submitted to members
for approval. Complete records of all committee activities including those of task
forces and working groups, are maintained in the office of the chairman. The
Committee prepares a report for the Chairman of the FCCSET not later than 60 days
after the end of each fiscal year. The report contains, as a minimum, the
Committee's functions; a list. of members; a list of subcommittees, task forces and
working groups and their charters; the dates, places and agendas for all meetings;
and a summary of the Committee's activities, accomplishments and recommendations
during the year.
Termination date
Unless renewed by the chairman of FCCSET prior to its expiration, the Committee on
Technology and Industry shall terminate not later than May 31, 1992.
Determination
I hereby determine that the formation of the Committee on Technology and Industry
is in the public interest in connection with the performance of duties imposed on the
Executive Branch by law and that such duties can best be performed through the
advice and counsel of such a group.
Approved:
Chairman FCCSET
Date
4
JUL 6 '90 13:11 FROM SCIENCE COMMITTEE
PAGE. 001
FAXmail FROM:
COMMITTEE ON SCIENCE, SPACE, AND TECHNOLOGY
U.S. House of Representatives
July 6,1990
DATE
TO: Olin Westhington
TO FAX NUMBER: 456-7739
ATTN:
FROM: Chris Wydher
NUMBER OF PAGES SENT: 10
Repl. Legis. Dir.
(Includes Cover Sheet)
House Cmte on Science,
space & Techology
FROM FAX NUMBER: (202) 225-8280
COMMENTS:
file: Am Tech
Preeminame Act
Any problems, call:
225-6684
JUL 6 '90 13:11 FROM SCIENCE COMMITTEE
PAGE. 002
ROBERT S. WALKER
FLOOR STATEMENT FOR H.R. 4329
Mr. Chairman, I join Chairman Roe in supporting the need for a
comprehensive emerging technology commercialization bill.
At full Committee hearings held last year on "Creating the New
Wealth", it was emphasized that technological development is much more
than just an issue of Federal funding. There was a virtually united
plea. by witnesses for antitrust reform and for tax changes to level
the international playing field.
With today's bill, the Science Committee, as the House's
competitiveness advocate, will recommend to the Congress what needs to
be done across the board, not just for one industry or technology and
not just for yesterday or today, but for tomorrow. H.R. 4329,
co-authored by the Chairman and myself, has drawn upon vast
contributions from many Members on both sides of the aisle, especially
Representatives Sherry Boehlert, Don Ritter, Tom Campbell and Jack
Buechner from the Repbulican side. It is, therefore, neither a
Democrat nor Republican proposal, but a consensus Science Committee
initiative. Nevertheless, the Committee's Republicans are flattered
that the Democrat leadership is endorsing our work by adopting it as
their own.
The existing core program authorizations in this bill are aggressive
but responsible. The National Institute of Standards and Technology
(NIST) is increased almost 30% in 1991 to meet President Bush's
request to make up for those new initiatives in areas such as
superconductivity, fiber optics and advanced materials denied by the
JUL 6 '90 13:12 FROM SCIENCE COMMITTEE
PAGE. 003
Appropriations Committee last year. NIST would then be increased
another 15% in 1992, the pace that would be required for doubling the
agency in five years. These levels are consistent with our
Committee's consensus views and estimates the Chairman sent to the
Budget Committee earlier this year.
The newly authorized Advanced Technology Program is a worthwhile
effort to reduce the marginal cost of capital for developing new
technologies by leveraging the majority funding of industry-led joint
ventures. It is a disciplined approach in that it is competitively
awarded, seeks proposals requesting a low percentage of Federal funds,
requires payback from profits, and does not discriminate based on
ownership against companies that are committed to the U.S. market.
But there is one big problem! Although the $100 million level for
this program in 1991 is consistent with the House Science Committee's
bipartisan views and estimates sent to the Budget Committee just a few
months ago, the $250 million 1992 level is veto bait, pure and simple.
In fact, the House's own Budget Resolution only designates $47 million
for this program. This bill suggests increasing that level by over
500% in 1992. That is very questionable in light of the crisis
Federal budget situation the country finds itself in. I will
therefore seek to substitute the Administration-suggested language of
"such sums" for this number on the floor so the President can sign
this bill.
However, as I mentioned earlier, H.R. 4329 is indeed a comprehensive
approach addressing those structural barriers and burdens that so
badly hurt our international competitiveness. One way it does this is
JUL 6 '90 13:12 FROM SCIENCE COMMITTEE
PAGE. 004
by creating a Presidential Commission to make legislative
recommendations to Congress within one year to encourage greater
private capital investment in technological development.
Congressional representation on this Commission is to be offered as an
amendment to the bill later. That is acceptable as long as the
appointees of the executive and legislative branches are equal.
However, if the Commission is stacked in favor of Congressional
domination, it will be fundamentally unacceptable. That would be
another unnecessarily partisan nail in the coffin of this bill.
H.R. 4329 as reported by the Science Committee also included a title
to amend the National Cooperative Research Act to permit joint
production arrangements among nonaffiliated firms. This is becoming
essential for the successful innovation and commercialization of new
technologies due to their staggeringly high front-end capital costs
and associated risk. Since the Science Committee's original
initiative, the House has passed antitrust language based on H.R. 4329
and I understand the Judiciary Committee has agreed to the Science
Committee's full participation in discussions on the issue with the
Senate. In light of this agreement, dropping the antitrust reform
title from H.R. 4329 is acceptable.
Overall the bill as reported by the Science Committee is a very good
one with the exception I have noted. The rule allows us to address
that problem and, hopefully, avoid a veto.
Thank you, Mr. Chairman.
JUL 6 '90 13:14 FROM SCIENCE COMMITTEE
PAGE. 007
WALKER033
AMENDMENT TO H.R. 4329
OFFERED BY MR. WALKER
[The amendment is stated in terms of page and line numbers of
H.R. 5072.]
Page 30, line 18, strike $250,000,000 and insert in
lieu thereof ``such sums as may be necessary -
JUL 6 '90 13:14 FROM SCIENCE COMMITTEE
PAGE. 008
30
1 the general applicability of any high resolution information
2 systems or advanced materials research and development
-
3 program results to other advanced technologies.
4
(e) FEDERAL REGISTER NOTICE.-The Secretary of
5 Commerce shall, within 120 days after the date of appropria-
6 tion of funds pursuant to subsection (f) of this section, publish
7 notice in the Federal Register stating that the Department of
8 Commerce is prepared to accept applications for assistance
9 under section 28 of the Act of March 3, 1901, as amended by
10 this section. Such notice shall include a description of eligibil-
11 ity requirements for assistance under such section 28, and
12 maximum assistance levels expected to be available for such
13 assistance.
14
(f) AUTHORIZATION OF APPROPRIATIONS.-There are
15 authorized to be appropriated to the Secretary of Commerce
16 for carrying out section 28 of the Act of March 3, 1901,
17 $50,000,000 for fiscal year 1990, $100,000,000 for fiscal
"such sums
18 year 1991, and $250,000,000 for fiscal year 1992.
19 TITLE III-AMENDMENTS TO STE-
20
VENSON-WYDLER TECHNOL-
21
OGY INNOVATION ACT OF 1980
22 SEC. 301. FEDERAL LABORATORY CONSORTIUM.
23
Section 11(e)(7) of the Stevenson-Wydler Technology
24 Innovation Act of 1980 (15 U.S.C. 3710(e)(7)) is amended-
HR 5072 IH
JUL 6 '90 13:15 FROM SCIENCE COMMITTEE
PAGE. 009
06/18/90
16:11
002
B
EXECUTIVE OFFICE OF THE PRESIDENT
OFFICE OF MANAGEMENT AND BUDGET
OF
WASHINGTON, D.C. 20500
June 18, 1990
(House Rules)
STATEMENT OF ADMINISTRATION POLICY
(THIS STATEMENT HAS BEEN COORDINATED BY OMB WITH THE CONCERNED AGENCIES.)
H.R. 4329 - American Technology Preeminence Act
(Roe (D) New Jersey and 45 others)
The Administration opposes enactment of H.R. 4329, as reported by
the House Science and Technology Committee on May 10, 1990, and
as ordered reported by the House Judiciary Committee on
June 12, 1990, unless it is amended to;
-- Reduce the appropriations authorizations for the Advanced
Technology Program to levels in the 1991 Budget (i.e.,
from $100,000,000 to $10,000,000) and authorize "such
sums" for FY 1992.
-- Amend the "foreign participation" provisions to ensure
that foreign-owned or -controlled companies established in
the United States will not be discriminated against with
respect to participation in the Advanced Technology
Program. The provisions in H.R. 4329 appear inconsistent
with U.S. obligations under bilateral investment
agreements and other accords. If enacted, they would
seriously compromise our bargaining position in urging
other nations to adopt similar policies of free and open
trade and investment.
-- Delete the provision elevating the Director of the office
of Science and Technology Policy (OSTP) from Executive
Level II to Level I. This provision would be inconsistent
with the current Executive Schedule for the Executive
branch. Also, the President recently elevated the
position of the Director of OSTP to an Assistant to the
President for Science and Technology, making further
action unnecessary.
H.R. 4329 contains miscellaneous objectionable provisions which
impose inappropriate new requirements on Executive Branch
agencies, restrict agency flexibility in managing programs, or
are duplicative of existing programs.
*****
JUL 6 '90 13:15 FROM SCIENCE COMMITTEE
PAGE 010
TALKING POINTS ON ATP AMENDMENT
The new Advanced Technology grant Program, or ATP, was funded for
the first time this year at $10 million.
The President is seeking to continue that program at $10 million in
1991.
The House passed Budget Resolution would increase the President's
request and current funding almost 500% to $47 million.
But this bill would increase that $50 million level another 500% in
1992 to one-quarter of a billion dollars - new money we are not
currently spending and very probably don't have.
Now, Chairman Roe and I have been able to agree that $100 million
is a justifiable level for these new grants and, in fact,
recommended that level to the Budget Committee earlier this year.
But a quarter of a billion dollars of new spending will put
tremendous pressure for cuts in critical existing technological
research in such areas as superconductivity, fiber optics, and
advanced materials at the National Institute of Standards and
Technology. We would be trading off core research for handouts.
The Administration "opposes enactment of H.R. 4329 unless it is
amended to authorize "such sums" for FY 1992" for the ATP. My
amendment does just that - no more. It is not necessarily a
reduction or a cut.
This simply defers without prejudice setting an unrealistic and,
perhaps, irresponsible grant level until we have a better idea what
resources are available for 1992. In light of the crisis Federal
budget situation taxpayers find themselves in, and with the
uncertainty of the Budget Summit outcome, to commit to a level now
is not prudent.
Remember, if more than $250 million is possible in the 1992 budget
process, my amendment would permit a higher level of funding - the
existing language would not.
Therefore, as the Ranking Minority Member on the Science Committee
and an original author of H.R. 4329 with Chairman Roe, I simply
seek a consensus that will avoid a veto of this critical
competitiveness package. It will save the bill!
JUL 6 '90 13:13
FROM SCIENCE COMMITTEE
PAGE. 006
ROBERT S. WALKER
STAFF IN CHARGE:
16TH DISTRICT. PENNSYLVANIA
CONNIE L. THUMMA
CHIEF DEPUTY REPUBLICAN WHIP
WASHINGTON OFFICE
MARC T. PHILLIPS
COMMITTEE:
Congress of the United States
DISTRICT OFFICES
VICE CHAIRMAN
SCIENCE, SPACE. AND TECHNOLOGY
Douse of Representatibes
Mashington, DC 20515
June 20, 1990
Dear Colleague:
Wednesday, July 11,
On Thursday, June 21, the House will consider H.R. 4329, the
American Technology Preeminence Act, under an open rule. Overall the
bill is very good with one exception.
H.R. 4329 authorizes funding for the first time for a limited
program to reduce the marginal cost of capital for developing new
technologies by leveraging the funding of industry-led joint ventures.
It is a disciplined approach in that it is competitively awarded,
seeks proposals requesting a low percentage of Federal funds, requires
payback from profits, and does not discriminate based on ownership
against companies that are committed to the U.S. market.
But there is one big problem! Although the $100 million funding
level for fiscal year 1991 is consistent with the House Science
Committee's bipartisan views and estimates sent to the Budget
Committee just a few months ago, the $250 million 1992 level is veto
bait, pure and simple. In fact, the House-passed Budget Resolution
only provides $47 million for this program. H.R. 4329 suggests
increasing that level by over 500%. In light of the crisis Federal
budget situation, that is very irresponsible.
Since the Administration "opposes enactment of H.R. 4329 unless
it is amended to authorize "such sums" for FY 1992" for this new
grant program, I will offer an amendment on the floor to do just that.
As the Ranking Minority Member on the Science Committee and the
original author of H.R. 4329 with Chairman Roe, I simply seek a
consensus that will gain enactment of this critical competitiveness
package. It will save the bill.
If you have any questions regarding my amendment or H.R. 4329,
please contact Chris Wydler at 5-6684.
Sincerely,
Robert S. Walker
EXECUTIVE OFFICE OF THE PRESIDENT
THE UNITED
OFFICE OF MANAGEMENT AND BUDGET
WASHINGTON, D.C. 20503
June 26, 1990
(House)
STATEMENT OF ADMINISTRATION POLICY
(THIS STATEMENT HAS BEEN COORDINATED BY OMB WITH THE CONCERNED AGENCIES.)
H.R. 4329 - American Technology Preeminence Act
(Roe (D) New Jersey and 45 others)
The Administration opposes enactment of H.R. 4329, as reported by
the House Science and Technology Committee on May 10, 1990, and
as ordered reported by the House Judiciary Committee on
June 12, 1990, unless it is amended to:
-- Reduce the appropriations authorizations for the Advanced
Technology Program to levels in the 1991 Budget (i.e.,
from $100,000,000 to $10,000,000) and authorize "such
sums" for FY 1992.
-- Amend the "foreign participation" provisions to ensure
that foreign-owned or -controlled companies established in
the United States will not be discriminated against with
respect to participation in the Advanced Technology
Program. The provisions in H.R. 4329 appear inconsistent
with U.S. obligations under bilateral investment
agreements and other accords. If enacted, they would
seriously compromise our bargaining position in urging
other nations to adopt similar policies of free and open
trade and investment.
-- Delete the provision elevating the Director of the Office
of Science and Technology Policy (OSTP) from Executive
Level II to Level I. This provision would be inconsistent
with the current Executive Schedule for the Executive
branch. Also, the President recently elevated the
position of the Director of OSTP to an Assistant to the
President for Science and Technology, making further
action unnecessary.
H.R. 4329 contains miscellaneous objectionable provisions which
impose inappropriate new requirements on Executive Branch
agencies, restrict agency flexibility in managing programs, or
are duplicative of existing programs.
*****
2
Not to be Distributed Outside Executive Office of the President)
This Statement of Administration Policy was drafted by the
Legislative Reference Division (Bowers), in consultation with the
Departments of Commerce (Clark), Justice (Filippini), State
(Rappaport), Energy (Hunsieker), Council of Economic Advisors
(Holtz-Eaken), the National Aeronautics and Atmospheric
Administration (Stehmer), the National Science Foundation
(Chester), the Office of Science and Technology Policy (Wells),
the Small Business Administration (Broadbent), the U.S. Trade
Representative (Richards), TCJ (Beebe and Schwartz), and ES
(Noonan and Schwartz).
Time did not permit responses from the following agencies:
Departments of Defense and the Treasury, the General Services
Administration and the Office of Personnel Management.
This position statement addresses the latest printed version of
H.R. 4329, as reported by the House Science Committee on
May 10, 1990, and as reportedly amended on June 12, 1990, by the
House Judiciary Committee. However, we understand that the bill
is still under review by various committees and further
amendments are possible.
OSTP (Wells) does not object to the third bullet above concerning
the Director of OSTP. (Generally, with the exception of certain
Executive Office of the President officials, only Cabinet
officers occupy Level I positions.)
H.R. 4329 would authorize appropriations for and modify Commerce
Department and other technology-related programs as described
below.
Appropriations Authorizations
H.R. 4329 would authorize the core programs of the National
Institute of Standards and Technology at the 1990 appropriated
level ($145,301,000), which is $1 million over the President's
1991 Budget request. This additional $1,000,000 would be used to
fund three earmarkings for programs not requested by the
Administration. For FY 1992, the bill authorizes appropriations
which are $17 million over the level in the 1991 Budget.
Commerce's Technology Administration (TA) would be authorized at
$6 million in 1991 and $7.5 million in 1992, or $1.4 million and
$2.9 million, respectively, over the 1991 President's Budget
level of $4.6 million.
3
The bill would authorize appropriations for the Advanced
Technology Program (ATP) at $50 million in 1990, $100 million in
1991, and $250 million in 1992. The President's 1991 Budget
requests $10 million (equal to the 1990 appropriated level for
this program.) The appropriations authorization levels are
displayed below.
1991 Budget
H.R. 4329
H.R.4329
Request
1991
1992
(in thousands of dollars)
NIST Core Programs*
183,408
184,408
210,000
ATP Program
10,000
100,000
250,000
Other TA
4,583
6,500
9,000
TOTAL
197,991
290,908
469,000
*This includes funding for Manufacturing Technology Centers.
Substantive Provisions
In addition to the objectionable features already described,
H.R. 4329 would:
-- Expand the authority of the ATP to cover additional
technical and service areas. (The ATP, established by the
1988 Trade Act, is designed to foster development of
precompetitive generic technologies which have broad
application across industries.)
-- Require the Secretary of Commerce to give preference, when
selecting among Advanced Technology proposals of
relatively equal merit, to those requiring the lowest
percentage of Federal funds.
-- Require development of a five-year National High
Performance Computing Technology Plan, as contemplated by
the Administration, to develop supercomputer hardware and
software, and establish a network to coordinate related
federally supported research.
-- Establish a number of Presidential commissions and boards,
including: (1) a Presidential commission on reducing
capital costs for emerging technology chaired by the
Director of OSTP; (2) a Presidential commission on
procurement and technology, chaired by the Director of
OSTP, to study how Federal procurement practices could
4
improve U.S. competitiveness; and (3) an OSTP-sponsored
board to foster and monitor the development of U.S.-based
high resolution information systems industries, like
advanced television.
-- Make permanent the current arrangement whereby Federal
agencies involved in R&D contribute a small percentage of
their budgets to support the activities of the Federal
Laboratory Consortium for technology transfer.
-- Authorize matching Federal funds for a two-year pilot
project to assist other countries in the development
industrial standards.
-- Require the Secretary of Commerce to give preference, when
selecting among Advanced Technology proposals of
relatively equal merit, to those requiring the lowest
percentage of Federal funds.
-- Direct the National Science Foundation to enter into a
contract to develop a methodology to establish
international product standards, a clear responsibility of
NIST.
-- Require numerous reports (e.g., require (1) the Director
of OSTP to report annually to Congress on all major
Science and Technology proposals involving more than one
country and costing over $1 billion; (2) the Secretary of
Commerce to report to Congress on the possibility of
establishing a Federal on-line information product
catalog; (3) the biennial national critical technologies
report to include a list of emerging technologies and
potential markets for related products; (4) the Secretary
of Commerce to report on the feasibility of establishing a
privately-funded Quality Institute; (5) the High
Resolution Information Systems Board to report to the
President annually; and (6) the Director of OSTP to report
to Congress on States that historically receive a small
share of the Federal R&D dollars).
-- Require minimum expenditure levels for steel technology
and NIST's Centers for Building Technology and Fire
Research; and bar any merger of the Building Technology
and Fire Research centers.
Legislative Reference Division Draft
6/14/90 -- 11:30 a.m.
101st Congress, 2nd Session
STATEMENT OF ADMINISTRATION POLICY CLEARANCE FORM
Senate Floor Action
Brief Title AMERICAN TECHNOLOGY PREEMINENCE Bill # H.R.4329
House Action
RULES
AcT
PAD CLEARANCE
HOUSE
1) GRADY
date 6,14,90
Dem Steering/George Kundanis/H209 Capitol/F 59483
6,18,90 6
2) HALE
date 6,14,90
*GOP Leader/Bill Pitts/H228 Capitol FAX 51234
3) Howard
/
/
date 6,14,90
*GOP Whip/Len Swinehart/H219 Capitol FAX 55337
/
/
*GOP Whip/Dan Meyer/1620 Longworth/FAX 55646
/
/
Director/Deputy Director Approval
GOP Policy Committee/1622 Longworth/FAX 50809
/
/
DARMAN
GOP Study Committee/433 Cannon/FAX 58705
date 6,14,90
/
Dem Study Group/Martha Newsome/1422 LHOB/FAX 54022
/
/
date
/
/
GOP Cloakroom/Ji Oliver/H223 Capitol/57350
/
*GOP Rules/Bill Crosby/H305 Capitol/FAX 56763
/
/
1
White House Clearance
*GOP Rules/Don Wolfensburger/421 Cannon/57985
/
/
GOP Digest/Anne Topple/502 House Annex 1/FAX 57298
/
/
date
/
/
time
:
AM/PM
SENATE
HILL DISTRIBUTION COMMITTEES
GOP Policy Committee/Judy Meyers/SR347/FAX 41235
/
/
Ranking Member/Staff Director
GOP Whip/Michael Tongour/S235 Capitol/FAX 43913
/
/
SCIENCE SPACE! TECH
date
6,18,90
GOP Leader/Jon Lynn Kerchner/S234 Capitol/FAX 43163
/
/
VP/Bill Gribbin/S212 Capitol/FAX 40291
JUAICIARY
/
/
date 6,18,90
Majority Leader/Martha Pope/S221 Capitol/45556
/
/
date
/
/
Dem Policy/C. Kinney/S-118/FAX .Corbin/FAX 45651
/
/
GOP Cloakroom/John Doney/S226 Capitol/46391
/
/
House Appropriations Distribution
Dem Cloakroom/Bob Bean/S225 Capitol/
/
/
Majority Secretary/Abbey Saffold/S309 Capitol/43735
/
/
Fred Mohrman
date
/
/
Jim Kulikowski
date
1
/
WHITE HOUSE/KOB DISTRIBUTION (15 copies Hs: 14 copies Sen)
date
/
/
WHCOS/John Sununu/lst Floor, West Wing/6797
/
/
date
/
/
WHDCOS/Andrew Card/1st Floor, West Wing/2533
/
/
WH/Ed Rogers/1st Floor, West Wing/6594
/
/
Senate Appropriations Distribution
WH Cabinet Affairs/David Bates/1st FL, WW/2174
/
/
WH LA/Fred McClure/2nd Floor, West Wing/2230
6 / 18 / 90
Jim English
date
/
/
WH LA/Rob Portman/2nd Floor, West Wing/2230
/
/
Keith Kennedy
date
/
/
WH LA HOUSE/1st Floor, East Wing/6620 (5 copies)
/
/
date
/
/
WH LA SENATE/1st Floor, East Wing/7054 (4 copies)
/
/
date
1
/
WH Admin/Jim Cicconi/Ground Floor, West Wing/2702
/
/
WH Dom Policy/Roser Porter/2nd Floor, West Wing/2705
/
/
OFFICE OF
EXECUTIVE OFFICE OF THE PRESIDENT
OFFICE OF MANAGEMENT AND BUDGET
WASHINGTON, D.C. 20503
June 18, 1990
(House Rules)
STATEMENT OF ADMINISTRATION POLICY
(THIS STATEMENT HAS BEEN COORDINATED BY OMB WITH THE CONCERNED AGENCIES.)
H.R. 4329 American Technology Preeminence Act
(Roe (D) New Jersey and 45 others)
The Administration opposes enactment of H.R. 4329, as reported by
the House Science and Technology Committee on May 10, 1990, and
as ordered reported by the House Judiciary Committee on
June 12, 1990, unless it is amended to:
-- Reduce the appropriations authorizations for the Advanced
Technology Program to levels in the 1991 Budget (i.e.,
from $100,000,000 to $10,000,000) and authorize "such
sums" for FY 1992.
-- Amend the "foreign participation" provisions to ensure
that foreign-owned or -controlled companies established in
the United States will not be discriminated against with
respect to participation in the Advanced Technology
Program. The provisions in H.R. 4329 appear inconsistent
with U.S. obligations under bilateral investment
agreements and other accords. If enacted, they would
seriously compromise our bargaining position in urging
other nations to adopt similar policies of free and open
trade and investment.
-- Delete the provision elevating the Director of the Office
of Science and Technology Policy (OSTP) from Executive
Level II to Level I. This provision would be inconsistent
with the current Executive Schedule for the Executive
branch. Also, the President recently elevated the
position of the Director of OSTP to an Assistant to the
President for Science and Technology, making further
action unnecessary.
H.R. 4329 contains miscellaneous objectionable provisions which
impose inappropriate new requirements on Executive Branch
agencies, restrict agency flexibility in managing programs, or
are duplicative of existing programs.
*****
2
Not to be Distributed Outside Executive Office of the President)
This Statement of Administration Policy was drafted by the
Legislative Reference Division (Bowers), in consultation with the
Departments of Commerce (Clark), Justice (Filippini), State
(Rappaport), Energy (Hunsieker), Council of Economic Advisors
(Holtz-Eaken), the National Aeronautics and Atmospheric
Administration (Stehmer), the National Science Foundation
(Chester), the Office of Science and Technology Policy (Wells),
the Small Business Administration (Broadbent), the U.S. Trade
Representative (Richards), TCJ (Beebe and Schwartz), and ES
(Noonan and Schwartz).
Time did not permit responses from the following agencies:
Departments of Defense and the Treasury, the General Services
Administration and the Office of Personnel Management.
This position statement addresses the latest printed version of
H.R. 4329, as reported by the House Science Committee on
May 10, 1990, and as reportedly amended on June 12, 1990, by the
House Judiciary Committee. However, we understand that the bill
is still under review by various committees and further
amendments are possible.
OSTP (Wells) does not object to the third bullet above concerning
the Director of OSTP. (Generally, with the exception of certain
Executive Office of the President officials, only Cabinet
officers occupy Level I positions.)
H.R. 4329 would authorize appropriations for and modify Commerce
Department and other technology-related programs as described
below.
Appropriations Authorizations
H.R. 4329 would authorize the core programs of the National
Institute of Standards and Technology at the 1990 appropriated
level ($145,301,000), which is $1 million over the President's
1991 Budget request. This additional $1,000,000 would be used to
fund three earmarkings for programs not requested by the
Administration. For FY 1992, the bill authorizes appropriations
which are $17 million over the level in the 1991 Budget.
Commerce's Technology Administration (TA) would be authorized at
$6 million in 1991 and $7.5 million in 1991, or $1.4 million and
$2.9 million, respectively, over the 1991 President's Budget
level of $4.6 million.
3
The bill would authorize appropriations for the Advanced
Technology Program (ATP) at $50 million in 1990, $100 million in
1991, and $250 million in 1992. The President's 1991 Budget
requests $10 million (equal to the 1990 appropriated level for
this program.) The appropriations authorization levels are
displayed below.
1991 Budget
H.R. 4329
H.R.4329
Request
1991
1992
(in thousands of dollars)
NIST Core Programs*
183,408
184,408
210,000
ATP Program
10,000
100,000
250,000
Other TA
4,583
6,500
9,000
TOTAL
197,991
290,908
469,000
*This includes funding for Manufacturing Technology Centers.
Substantive Provisions
In addition to the objectionable features already described,
H.R. 4329 would:
-- Expand the authority of the ATP to cover additional
technical and service areas. (The ATP, established by the
1988 Trade Act, is designed to foster development of
precompetitive generic technologies which have broad
application across industries.)
-- Require the Secretary of Commerce to give preference, when
selecting among Advanced Technology proposals of
relatively equal merit, to those requiring the lowest
percentage of Federal funds.
-- Require development of a five-year National High
Performance Computing Technology Plan, as contemplated by
the Administration, to develop supercomputer hardware and
software, and establish a network to coordinate related
federally supported research.
-- Establish a number of Presidential commissions and boards,
including: (1) a Presidential commission on reducing
capital costs for emerging technology chaired by the
Director of OSTP; (2) a Presidential commission on
procurement and technology, chaired by the Director of
OSTP, to study how Federal procurement practices could
4
improve U.S. competitiveness; and (3) an OSTP-sponsored
board to foster and monitor the development of U.S.-based
high resolution information systems industries, like
advanced television.
-- Make permanent the current arrangement whereby Federal
agencies involved in R&D contribute a small percentage of
their budgets to support the activities of the Federal
Laboratory Consortium for technology transfer.
-- Authorize matching Federal funds for a two-year pilot
project to assist other countries in the development
industrial standards.
-- Require the Secretary of Commerce to give preference, when
selecting among Advanced Technology proposals of
relatively equal merit, to those requiring the lowest
percentage of Federal funds.
-- Direct the National Science Foundation to enter into a
contract to develop a methodology to establish
international product standards, a clear responsibility of
NIST.
-- Require numerous reports (e.g., require (1) the Director
of OSTP to report annually to Congress on all major
Science and Technology proposals involving more than one
country and costing over $1 billion; (2) the Secretary of
Commerce to report to Congress on the possibility of
establishing a Federal on-line information product
catalog; (3) the biennial national critical technologies
report to include a list of emerging technologies and
potential markets for related products; (4) the Secretary
of Commerce to report on the feasibility of establishing a
privately-funded Quality Institute; (5) the High
Resolution Information Systems Board to report to the
President annually; and (6) the Director of OSTP to report
to Congress on States that historically receive a small
share of the Federal R&D dollars).
-- Require minimum expenditure levels for steel technology
and NIST's Centers for Building Technology and Fire
Research; and bar any merger of the Building Technology
and Fire Research centers.
Legislative Reference Division Draft
6/14/90 -- 11:30 a.m.
JUL '90 13:13 FROM SCIENCE COMMITTEE
PAGE. 005
TALKING POINTS ON COMMISSION
The bipartisan, consensus bill reported to this floor included a Capital
Costs Commission with 13 members appointed by the President.
The Democrat leadership has suggested that Congress also appoint some
of the Commission's members. No one has any problem with that.
But the specifics of the proposal currently before us would substantially
change the makeup and control of the Committee-reported Commission.
It would provide for 14 Congressional appointees to only 6 Presidential.
In light of the fact that the Executive and Legislative branches of
government are Constitutionally equal, their representation on a
Commission which is to make consensus legislative recommendations
should be equal.
Worse, however, is the fact that of the 14 Congressional appointees, 10
are to be appointed by the majority to only 4 from the minority. That
represents only 28% for Republicans in the House and Senate, even
though they make up 41% and 45% of those bodies, respectively. That
is even a worse ratio than on the House Rules Committee.
This causes one to pause and wonder what the motivation of the
majority is. Why try to stack the Commission with such Congressional
domination unless a pre-determined industrial policy outcome is desired?
As for having equal representation from both branches of government, it
is unrealistic, as we all know, to assume that just because one is
appointed by House or Senate Republicans that they will follow the
Administration line. In fact, often quite the contrary is true. But, in
any case, requiring a two-thirds or three-quarter majority vote on all
legislative recommendations would protect against that unlikely concern.
And since these recommendations are legislative, they will have to be
acted on and disposed of by the Congress. We will get the final say.
What's the point of proposing something if it is not even supported by
the President.
So if the Commission is stacked in favor of Congressional domination it
will be fundamentally unacceptable to this Member and be yet another
objection to the bill by the Administration.
This is an unnecessarily partisan nail in the coffin of this bill and I
therefore offer a substitute (or amendment to the amendment) to allow
each branch to appoint six Commission members with the Democrats
appointing two and Republicans one in each House.
DRAFT: tassey
04-09-90
SCIENCE AND TECHNOLOGY
FOR ECONOMIC GROWTH
Where Do We Stand?
A consensus has been slowly but relentlessly building that the United States faces
major challenges to successfully competing in the rapidly changing global markets of the
1990s. Relative competitive position can only be truly assessed over extended periods of
time. To achieve such an assessment, the Council on Competitiveness uses four
summary indicators of a nation's competitive position: standard of living, trade (share of
world exports), productivity, and investment. Based on these indicators, a comparison
with the other Summit Seven nations shows the United States lagging the average
growth rates for these countries in all four categories over recent 14 and 15 year
periods:
Table 1
U.S. GROWTH SINCE 1972
RELATIVE TO OTHER NATIONS
(an Index value of 100 represents the average growth rate for Summit Seven)
Competitiveness Indicator
U.S. Index
Standard of Living (1972-87)
78.9
Trade (1972-87)
82.6
Productivity (1972-86)
68.7
Investment (1972-86)
96.2
The above set of indicators represents the trend for the entire economy over
several business cycles, implying that the problem is structural rather than cyclical.
Recent data do not indicate that these trends are reversing.
Growth Policy Issues
The process of self-examination and change has been slow because, for several
decades after World War II, the United States was the dominant technology-based
economy. Technology and related market life cycles were relatively long due to a
number of inefficiencies that existed in the R&D, manufacturing, and market
development stages of the typical industrial technology. Without substantial foreign
competition, incentives were insufficient to address these imperfections. This situation
was of little consequence as long as competing industrialized nations did not improve
the efficiency of their own technology delivery systems. However, evidence had
accumulated by the late 1970s that major foreign competitors had materialized and were
catching and even surpassing U.S. firms in a number of important economic sectors such
as semiconductors, machine tools, robots, bioprocessing, optoelectronics, and others.
In response, U.S. growth policy in the early 1980s focused on stimulating
industrial innovation. The United States had been an innovative economy in the past,
and it was natural to assume that "innovativeness" alone would solve what was then
referred to as "the productivity problem". In fact, some progress has been made.
However, these improvements may have to be strengthened in order to achieve a highly
competitive U.S. economy in the 1990s.
The U.S. economy is proceeding as if technology life cycles are still long, when, in
fact, they have shortened dramatically. Government funding and conduct of early-stage
technology research has not been aimed at commercial markets, but rather at public
goals such as national defense. Corporate culture has not adapted to the demands of
global markets for increased quality, productivity, and flexibility. Many of the critical
elements of manufacturing technologies exhibit significant "economies of scope" and are
therefore not being developed by industry. That is, many new technologies have a range
of potential market applications that is greater than the set of markets targeted by the
strategies of most, if not all, potential market participants. These firms therefore tend
to underinvest, especially in the early stages of the technology's development when
uncertainty is high as to the eventual size and nature of individual markets.
Even at the marketing stage, significant underinvestment by industry exists. Many
of the most important technologies for the 1990s, such as communications, distributed
data processing, and factory automation, are systems technologies. Such technologies
require significant infrastructure to assure private investment. This infrastructure is
technologically complex and competitively neutral and will therefore not evolve without
significant cooperation and communication between industry and government.
Both industry and state governments have increased pressures for new measures
that will restore the major ingredients for successful economic performance. Proposed
policy changes fall into two major categories: macroeconomic (policies targeted at the
national economy as a whole: savings and investment, cost of capital, price stability) and
microeconomic (policies targeted at sectors of the economy).
2
Little disagreement exists over the need for macroeconomic policies. Rather, the
debate is over their emphasis and timing. The desired level of interest rates, maximum
rate of inflation, incentives for saving are continuously debated, but the Federal role is
central and accepted. As a nation, we agree that consumption needs to be reduced and
savings increased, that inflation needs to be kept at low levels, and that capital must be
available, cheap, and patient. The debates are over the particular policy mechanisms to
achieve these objectives and the timing of their application.
Microeconomic policies are more controversial. First, they do exist but are
focused in two areas: (1) specific public objectives such as national security, space
exploration, and (2) economic sectors for which the existence of externalities and hence
underinvestment is widely accepted such as in agriculture and health. In the case of
agriculture, the small size of the average business prevents the realization of economies
of both scale and scope in research as well as in the efficient transfer of technology and
the acquisition of market information.
As a result, the Federal Government has traditionally financed and conducted
agricultural R&D and transferred it to farmers through an effective, nationwide
extension service. In the area of health, the Federal Government has provided an
impressive technology infrastructure through the National Institutes of Health (NIH).
This infrastructure significantly accelerated the evolution of U.S. health care generally.
In particular, NIH was the genesis of the U.S. biotechnology industry and is a major
reason for that industry's global superiority today. The Federal Government has also
provided measurement infratechnologies through the National Institute of Standards and
Technology (NIST). These infratechnologies leverage all stages in technology-based
competition.
A recent Department of Commerce analysis of emerging technologies that will be
critical to U.S. competitiveness in the 1990s identified 12 major technological areas with
economic potential similar to biotechnology. However, the investment in infrastructure
for most of these is small and uncoordinated. Much of existing investment is through
agencies with specific missions whose technological requirements have in general grown
increasingly distinct from the needs of commercial markets. In a number of these areas,
the agency missions no longer require state-of-the-art technology. For both reasons,
spinoffs to commercial applications, which were seldom high, are declining further.
These trends led the President in a March, 1990 speech to the American
Electronics Association to state:
"The Administration is committed to working with [industry]
in the critical pre-competitive development stage where the
basic discoveries are converted into generic technologies that
support both our economic competitiveness and our national
security."
In releasing OSTP's FY 1991 budget request, the President's Science Advisor, Dr.
D. Allan Bromley, stated:
3
"The sophistication and capital-intensive nature of modern
technology require new ways of increasing cooperation
between government and industry and of fostering
communication on long-term technology goals. SEMATECH
is an important example of such government-industry
cooperation."
The "Overview" to the Administration's FY 1991 budget pointed out that one of
the two areas in which the Federal Government has traditionally supported R&D is:
"to meet broader national needs (e.g., basic research in all
areas, measurements and standards R&D, health-related
R&D)." This "R&D, for which the Government is not the
principal market, includes both basic research and generic
applied research. Federal investment in such R&D is
warranted to capture the public good benefit."
What Areas of Growth Policy Will Require Particular Attention in the 1990s?
In large, developed economies such as the United States, the appropriate
economic growth strategy requires that a portfolio of a substantial number of emerging
and strategic technologies be under development at any point in time to diversify risk
and broaden the future industrial base. This is a very different concept from the hotly
debated "targeted industry" strategy. In the latter approach, a few technologies or
industries are singled out as priorities and given intensive government support. Such a
strategy is appropriate for a developing country with limited technological resources --
most of which it must import. However, a large, technology-based economy can and
must continually nurture its comparative advantage -- a diversified technological base --
by simultaneously pursuing development of a large number of emerging technologies.
To implement this strategy, industry and government will have to consider the possibility
of cooperatively modifying the following activities that make up the technology-based
economic process.
Research & Development. Many of the emerging and strategic technologies that
will provide a competitive advantage in the 1990s need modest but critical
encouragement from government. Industry and government will have to jointly focus on
early-stage or "pre-competitive" research. Examples are advanced (engineered)
materials, optoelectronics, digital imaging technology (DIT), biotechnology, and factory
automation (specifically, flexible computer-integrated manufacturing or FCIM). Several
of these, such as DIT and FCIM, have a "systems" character, and therefore require
additional infrastructure, particularly standards.
4
One of the considerations may be that industry and government will, in effect,
move the "pre-competitive line" forward to include early-stage generic technology
research in the "underinvestment" category. This adjustment is an incremental change
from the traditional government role of supporting basic research, and it is the same
basic philosophy that has evolved in other industrialized nations over several decades.
Commercialization. Major dysfunctions have occurred in the ability of the U.S.
economy to translate the results of R&D into commercially successful products and
processes. Reasons include out-of-date industry structures (particularly insufficient
vertical integration), poor intrafirm organization (particularly inadequate integration of
R&D, production, and marketing), and unwillingness to assume the risks associated with
new technologies. These elements interact with each other and collectively inhibit rates
of investment in new technology.
Because aggregate productivity growth is driven in the long run primarily by
widespread acquisition and use of technology, the entire process, including
organizational and behavioral factors, by which technology is acquired and utilized must
be examined. Organizational and behavioral factors are important concerns because
many U.S. firms have been unable or unwilling to make fundamental internal changes
and also because firms, industries, and other institutions (i.e., laboratories, universities,
the financial community, etc.) have not been able to effectively interact and cooperate.
The "cultural" adaptations required to implement organizational and behavioral change
will take place more rapidly with appropriate leadership from government that is, with
government acting as a catalyst for change through the educational system and within
the various evolving cooperative arrangements between industry and government.
Contrary to some elements of economic literature, technical knowledge does not
transfer or diffuse without cost. That is, it is not a "free" good once produced. In fact,
considerable effort is often required by individual firms to acquire and internalize
generic technology so that it can be effectively used in subsequent internal applied
R&D. Studies have shown that direct personal contact is the single most effective
means of transferring technical knowledge, but inward-looking corporate culture, the
isolation of many Federal laboratories, etc. have inhibited this mode of information
sharing.
Moreover, creating a viable technology base is one step; effectively and quickly
utilizing it is another. U.S. industry is particularly bad at sharing generic, competitively
neutral information in a timely manner. In fact, defining such information as
competitively neutral has been a major barrier to getting as fast a start in the R&D
stage as do the Japanese when a new development occurs. Systems-type concepts such
as concurrent engineering and total quality management are increasingly important as they
greatly improve the efficiency of both R&D and manufacturing across a wide range of
technologies. Because of the economies of scope in their development and especially in
their diffusion throughout industry, a catalytic role exists for government in facilitating
the evolution and transfer of these concepts.
5
Market Development. European and Asian nations have focused on market share
as the primary strategy objective, believing that all other strategic objectives follow from
this one. In today's highly competitive global economy, market share is determined by
five critical variables: productivity, quality, price, timing, and marketing. Technology is
the main driver of the first three and, surprising to some, is increasingly important for
the last two. Other variables are also important (organizational strategies, human
resources development, supplier relationships, etc.), but they are subservient to the five
primary ones.
Moreover, access to markets and diversification into related markets often
depend on compliance with standards. Because standards can vary depending on the
technical basis selected, disputes arise which slow market penetration of the technology.
Even when such disputes are resolved in the U.S. domestic market, major foreign
markets (Japan and the European Community) increasingly have evolved different
solutions, based on different infratechnologies and hence standards. Such situations
result in barriers to the penetration of foreign markets by U.S. firms. Conversely,
foreign firms can sometimes penetrate the U.S. domestic market while U.S. firms
attempt to develop and agree on the technical basis for acceptance testing and other
infrastructure for reducing transaction costs.
Summarizing Foreign Competitors' Strategies
Many have asked why the Japanese can make commitments to new technologies
when the U.S. cannot. The several reasons are (1) capital is cheaper and more plentiful,
meaning that more projects with longer time horizons are funded; (2) Japanese
understand the importance of economies of scope to a much greater extent than do
Americans (for example, they have successively transferred generic production
technology from semiconductors to optoelectronics to superconductivity); (3) the
Japanese government makes commitments to new infrastructure which has an enormous
motivating effect on private investment decisions (they made an early decision to wire
the country with optical fiber, while the U.S. is still debating the issue).
In the mid-1970s, Japan perceived the inefficiencies in industry and research
structures in the United States and Europe. They first applied this understanding of
underinvestment in early-stage or pre-competitive technology research to semiconductor
technology. In 1976, they launched their now-famous VLSI (very large-scale integration)
semiconductor research consortium. In four years, this cooperative project between
industry and government had caught up with and, to some degree, passed U.S. and
European firms in semiconductor processing technology.
In a second, less-appreciated application of this approach, Japan adapted the
semiconductor processing technology to the important new area of optoelectronics by
establishing in 1979 a similar cooperative research project. Optoelectronics is a critical
technology for communications, data storage and retrieval, and likely data processing
6
(through optical computing). By cooperative planning and research at the generic
technology stage, the Japanese were able to accelerate the optoelectronics technology to
the applied research stage. At this point, the Japanese Government removed itself from
the technology development process (i.e., the pre-competitive line had been crossed).
Individual Japanese companies, having the advantage of an early technological lead now
greatly increased their individual investments in applied optoelectronics R&D. The
result is Japanese dominance in this critical technology.
Over the 1980s, the Japanese have applied this model in one emerging technology
after another. Their "Key Technology" program provides support to a wide range of
technologies through the research consortium mechanism. Support for early-stage
technology research is given to emerging technologies that industry and government have
jointly determined to have significant economic potential. The Japanese Government is
therefore neither focusing on a few "picked" technologies, nor is it making funding
decisions unilaterally.
The European Community is now pursuing the same general strategy through its
EUREKA and ESPRIT programs. Neither Japan nor Europe can be said to be
"targeting" specific technologies with these programs. In fact, the opposite is the case.
They are removing the underinvestment problem in early-stage technology research
across a wide range (i.e., a portfolio) of emerging technologies. The ultimate objective is
to provide their domestic industries with a broad and deep technology base from which
private firms will then make decisions with respect to which specific market applications
to pursue. That is, the subsequent steps in the economic process -- applied R&D,
investment in production facilities, and marketing -- remain the responsibility of the
private sector. Thus, the nature, scope, and magnitude of the resulting markets are still
determined by private-sector investment decisions; but, with the areas of systematic
underinvestment removed, the development and commercialization of a technology can
proceed faster than foreign competition.
In summary, the Japanese, other Asian countries, and now the European
Community have removed market imperfections in the various stages of technology-
based economic activity with the following results:
-
The efficiency of early-stage research is increased so that technology life
cycles are shortened. This creates the critical competitive advantage of
strategic technologies being available earlier which, in turn, enables the
applied R&D that results in commercialization. Foreign government
programs, including laboratory research, government-industry research
consortia, etc., have been able to advance generic technologies to the
applied R&D stage for a range of economically important technologies
such as ceramics, composites, and other materials, biotechnology,
computers, software, electronic components, superconductivity,
optoelectronics, robotics, machine tools, etc. These more rapid advances
give the domestic industry a running start in determining which
applications of the generic technology to pursue, conducting the applied
R&D, and reaching the marketplace ahead of foreign competitors.
7
Commercialization is facilitated by more efficient technology transfer.
Government laboratories, research institutes, transfer centers and extension
services, cooperative programs, trade associations, and other mechanisms
have more rapidly diffused new technologies. Wider use means higher
percentages of a nation's economy will be introducing new products
(innovations) at any point in time -- making a nation's economy as a whole
more competitive.
Market development is accelerated by productivity and quality programs,
and by other infrastructure such as standards. Market share is the single
most important strategy variable for other industrialized nations. These
nations therefore target faster productivity and quality growth strategies
and allocate more resources to standards in order to move quickly beyond
initial commercialization to penetrate global markets and take market
share away from lagging countries.
Where Do We Go In the 1990s?
The United States spends more on R&D than the next four countries combined.
Yet this country continues to be challenged by our major competitors. A major reason
is that U.S. R&D investment is not (1) sufficiently directed at civilian applications, (2)
allocated through the right mechanisms. A consensus view is that Germany and Japan
currently have the most productive and generally successful economies in the world.
The reason for their competitive advantage is indicated in part by Table 2, which shows
that their economies are 45-55 percent more civilian R&D-intensive than is the United
States. Over time, this higher rate of investment in technology with direct commercial
potential has enriched the technology base of both countries and thereby led to
significantly higher rates of new product and process commercialization.
Table 2
NON-DEFENSE R&D
AS % OF GNP
Country
1986
United States
1.8
West Germany
2.6
Japan
2.8
Source: National Science Foundation
8
As a result of policy changes over the past five years, some of the basic
institutional mechanisms are now in place. For example, the 1984 National Cooperative
Act has stimulated approximately 125 research consortia. However, most of these
consortia are quite small in scope with limited research objectives. By far the most
ambitious consortium is SEMATECH, but it must be considered an exception not only
because of its large size but also because of the broad scope of its research objectives
(generic technology research through development) and the fact that it receives
substantial government funding.
The United States will have to respond to global trends in the 1990s, or its
competitive position will continue to be challenged. This response does not require an
industrial policy of "picking winners and losers". Instead, it requires acceptance that
the "pre-competitive" line, which in the past was the completion of basic
research, has moved somewhat forward into the early stages of technology
development -- specifically, generic technology research; the resulting
systematic underinvestment at this early stage in the R&D process requires
an industry-government partnership (as the President's Science Advisor,
Allan Bromley said, "the sophistication and capital-intensive nature of
modern technology require new ways of increasing cooperation between
government and industry and of fostering communication on long-term
technology goals");
more effective support for commercialization is required of the technology
infrastructure; this means increasing the efficiency of technology transfer,
the assignment and protection of intellectual property rights, and the
provision of science, technology, and market information from all over the
world; and
more encouragement is needed from the technology infrastructure for such
corporate strategy and "culture" changes as concurrent engineering, total
quality management, productivity-enhancing tools, and other education-
based techniques as well as for standards that greatly affect the success of
global market-share strategies.
Technology infrastructure has been effectively designed and used in a few
industries such as aerospace, agriculture, and biotechnology. The increasing
technological content of virtually all industries will require technology infrastructure
synthesized from the lessons of these past successes and also from the successes of
foreign competitors.
The implication is that the United States will have to view its technology
infrastructure as a portfolio of technologies. This would ensure a diverse and timely
technology base that will stimulate higher levels of investment by U.S. industry and can
be drawn upon by industry as it develops and markets specific applications.
9
Other categories of market imperfections exist because of cultural and
institutional biases towards information sharing and technology transfer. The Federal
Government will have to act as a facilitator in information flows among U.S. firms.
Such a role will be required not only in the conventional sense of technology transfer
but in the dissemination of holistic organizational methods such total quality
management that embody the systems concepts still foreign to much of U.S. industry.
In conclusion, the increasingly global scope of investments in technology and
capital will drive world economic expansion in the 1990s. However, the distribution of
the benefits of this growth among nations is highly uncertain. The challenge for the
United States is to gain and maintain global market shares that steadily increase the
standard of living.
Although the social and economic structures of the United States are different
from those of other countries, lessons can be learned from the economic success stories
in Japan and Germany. One important conclusion from this discussion is the complexity
of the typical technology-based industry. In particular, the process of developing,
implementing, and utilizing new technologies is a "systems" process that requires many
timely contributions from both industry, academia, and government. Much analysis has
been done of other economic systems as well as of the U.S. economy. The time has
come to effectively use this knowledge to design and implement a combined
macroeconomic and microeconomic strategy that will enable the United States to
maintain a position of world leadership across the range of technologies that will be
driving the world economy in the 1990s.
10
GLOSSARY
competitiveness: the ability to systematically increase the performance, productivity
and quality of products and services, so that the economy grows fast enough to
increase the standard of living at desirable rates.
More specifically, competitiveness at the industry level means increasing the
performance, productivity and quality of the economy's product and service mix in
order to maintain substantial global market shares. Market share is necessary to
generate the cash flow which funds subsequent technology and product life cycles.
Competitiveness at the national level means attaining and maintaining competitiveness
in enough industries to achieve a balanced and diversified growth pattern for the
economy as a whole, so that the national standard of living increases at acceptable
rates over time.
concurrent engineering: the simultaneous design of products and production
processes so that on the one hand the production process is optimized with respect to
the manufacturing requirements of the product and on the other hand the product is
designed to facilitate manufacture. Such "simultaneity" enables, for example, quality-
enhancing attributes to be designed into the product, while the production process is
configured to ensure maximum yield, thereby increasing productivity.
generic technology research: the first stage in technology research; the objective is to
show that the technological concept "works" in a laboratory environment and thus
reduce the typically large technical risks before moving on to the more applied stages
of R&D. The large technical and market risks at this stage provide the rationales for
"risk pooling" through cooperative research.
infratechnology research: the process of creating the basic data, measurement
methods, test methods, and measurement-related concepts which increase the
productivity or efficiency of R&D, production, and marketing.
Such infratechnologies are by nature widely used and thus are largely nonproprietary
from the point of view of individual firms. Their competitive neutrality, use by several
industries, and roles in standards development provide rationales for their provision by
government laboratories.
innovation: the first commercialization or market introduction of a technology.
In the case of a new product technology, an innovation is the first market introduction.
In the case of a process technology, an innovation is the first use to produce products
for sale. Consequently, the term innovation has a narrower meaning than is frequently
believed.
In particular, it has been used to describe market penetration (i.e., diffusion).
Statements such as "innovation determines productivity growth" are misleading. One
firm innovates and may earn substantial profits as a result, but until competing firms
imitate and the user (i.e., demand) side of the market widely adopts the new product
(i.e., technology diffusion occurs), aggregate productivity growth will usually not be
significantly advanced.
pre-competitive technology research: early-stage technology research involving some
degree of cooperation among firms and government that removes sufficient technical
risk to enable individual firms to then make applied R&D and subsequent
commercialization decisions in a timely manner relative to the investment strategies of
foreign competitors. For the majority of technologies, the pre-competitive line is at the
end of the generic technology research stage.
total quality management: the integration of all aspects of the firm's activity, including
R&D, production and marketing, for the purposes of (1) generating and exchanging
information of quality-related attributes of both the firm's products and services, and
(2) designing and implementing firm-wide strategies. Quality objectives and strategies
are viewed not only as a total-firm activity but also includes relationships with suppliers
and customers.
2
THE WHITE HOUSE
WASHINGTON
April 5, 1990
MEMORANDUM FOR OLIN WETHINGTON
FROM:
TODD G. BUCHHOLZ
NB
SUBJECT:
Science and Technology
You asked for information on OSTP and for some issues that could
be raised with Dr. Bromley. In addition, you asked for
information on the Stevenson-Wydler Technology Innovation Act and
the Omnibus Trade and Competitiveness Act of 1988.
OSTP; meeting with Dr. Bromley
Bromley's key person on the EPC working group will be Bill
Phillips, recently confirmed as OSTP's Associate Director for
Industrial Technology. Phillips coordinates the FCCSET committee
on technology and industry.
Ken Yale has requested from OSTP an update on FCCSET's current
activities, which he will immediately forward to us.
Aside from procedural questions on how he expects FCCSET to
coordinate with the EPC working group, you might raise the
following broad policy issues with Bromley in order to generate
discussion:
O
Do U.S. investors undervalue firms that engage in research
and development? If so, is this a cost of capital problem? A
perception problem?
O
Who counts as a U.S. company? The biggest selling car in
the U.S. is the Honda Accord, largely manufactured in the U.S.
Some of Chrysler's biggest sellers are imported, as are many
components of Ford and GM cars. Should this issue affect U.S.
policy on research consortia or federal labs?
O
Does Bromley think the EPC Working Group should attempt to
identify economically strategic technologies (e.g.
semiconductors?) that the U.S. should attempt to promote even if
not always profitable?
o
What kind of strategy could the U.S. develop to tap into
foreign labs or research consortia?
32UOH 3TIHW 3HT
NOTE HEAW
O
The Superconducting Super Collider (budgeted for $318m in
1991) and Space Station Freedom (budgeted for $2.6b in 1991) have
each been criticized in the press for their expense. Does
Bromley have any doubts about the value of these investments?
O
Is the U.S. transportation industry moving as quickly on
magnetic levitation as foreign companies?
O
Recent studies show that the quality of final products are
greatly affected by the manufacturing process, not just by the
design of the final product. Engineers and consultants now
recommend "design for manufacturing," i.e., designing the final
product while simultaneously considering the manufacturing
process (as opposed to designing the final product and then
developing a process for manufacturing it).
Given the administration's aversion to "industrial policy,"
how can the federal government encourage "design for
manufacturing"?
Stevenson-Wydler Technology Innovation Act of 1980
The Act charges the Secretary of Commerce, on a continuing basis,
with a number of responsibilities, including:
O
identifying technological needs, problems, and opportunities
within industrial sectors;
O
assessing whether industries with promising technologies are
receiving enough capital and technical resources to promote
productivity; and
O
encouraging and assisting in creating centers and other
joint initiatives between private business and all levels of
government.
Omnibus Trade and Competitiveness Act of 1988
This Act grants broad powers to the Secretary of Commerce,
(through the Director of the National Institute of Standards and
Technology), to take any action "necessary and appropriate" to
assist industry in developing technology and procedures to
"modernize manufacturing processes, to ensure product
reliability
and cost-effectiveness, and to facilitate the more
rapid commercialization of products based on new scientific
discoveries in fields such as automation, electronics, advanced
materials, biotechnology, and optical technologies."
WASHINGTON INC.?
a
E
WHILE THERE'S STILL NO CLEAR-CUT POLICY, THE FEDERAL GOVERNMENT
IS ACTIVELY FOSTERING TIES BETWEEN SCIENCE AND INDUSTRY
EGINNING IN 1986, A SERIES OF
National labs
In the past, the government has often fo-
B
extraordinary meetings took place at
cused the nation's scientific and engineering
the Commerce Dept. in downtown
have been
talent on specific problems. Federal dollars
Washington. Top executives from more
encouraged
tamed the atom, gave birth to the computer,
than a dozen U.S. semiconductor com-
panies were summoned to hatch an idea
to push their
rocketed man to the moon, and spawned the
most advanced aerospace industry in the world.
that used to be anathema at Com-
patents in the
Moreover, the development of the supercom-
merce-and illegal. The topic: banding together
marketplace
puter, artificial intelligence, and advanced ma-
to meet the onslaught of Japanese competition.
terials were driven by military needs and fund-
"We got the companies together and kicked
ed by the Defense Dept.
them in the shins," recalls D. Bruce Merrifield,
Those programs, however, rightly assumed
then Assistant Secretary of Commerce for Pro-
that the U.S. industrial base was alive and
ductivity, Technology & Innovation.
well. But in the 1980s, as one critical industry
With Commerce taking the lead, the compa-
after another fell to foreign competition, it be-
nies formed Sematech, a consortium designed
came obvious that the industrial base was
to develop advanced chipmaking technology to
boot the U.S. back into the lead in the interna-
cracking. Suddenly, it was painfully clear that
individual companies-even some of the na-
tional semiconductor race. Fueled by $200 mil-
lion from the Pentagon and 14 companies, Se-
tion's mightiest-often could not compete alone
on a global scale.
matech is one of the most visible signs of a
profound change in the way the U.S. supports
While there is still no clear policy, over the
technology: Washington is now actively and di-
past eight years Washington has gradually
PHOTOGRAPH BY ROBERT HOLMGREN
rectly fostering industrial innovation.
mounted a broad effort to emulate the coopera-
tive successes of Japan Inc. Antitrust laws
BUSINESS WEEK
40
INNOVATION 1989
have been relaxed; SO have laws restricting the
spread the gospel to companies that could use
ability of national laboratories, such as Ar-
the technology.
gonne National Laboratory and Oak Ridge, to
Fearing that weak U.S. industries threaten
push their technology into the private sector.
national security, the Pentagon is also adjust-
Already, scores of industrial consortiums
ing its role. The Defense Advanced Research
have been created so companies can conduct
Projects Agency (DARPA) has long funded key
joint research on common problems, from su-
studies in computers, electronics, and advanced
perconductors to machine tools. Now Congress
materials. Now, DARPA is taking a larger, more
may consider relaxing antitrust laws even fur-
public role-funding and overseeing Sematech,
ther so companies can form consortiums that
and awarding grants in HDTV technology. At
would actually manufacture a product-high-
the same time, Defense's Strategic Defense Ini-
definition television (HDTV) sets. Says Represen-
tiative agency has moved quickly to dump seed
tative Harris Fawell (R-Ill.): "Cooperation is
money into new technologies, such as diamond
one of the buzzwords for competitiveness."
films, that have important short-term applica-
Washington has created more than 30 cen-
tions for industry.
ters at universities to marry industry with
One of the most successful government
cutting-edge science. The National Science
programs relies on the traditional mother
Foundation was one of the first to make a
lode of U.S. innovation-entrepreneurial
major push. Under its current director,
ongress may
spirit. Small Business Innovation Re-
former IBM Vice-President Erich Bloch,
across the country since 1985. The idea is
C
search grants, for instance, are awarded
the NSF has set up 18 Engineering Re-
soon relax
by federal agencies to small companies
search Centers on university campuses
with promising ideas. So far, they have
antitrust law
nurtured hundreds of new products.
to use the carrot of government funding
Among them: a high-pressure water jet
(the NSF pays approximately half the costs
for cutting materials, a crib that soothes
of each center) to lure universities into
even more,
colicky babies, and new ceramic materials.
conducting research directly related to the
"The program has been phenomenally
needs of industry.
to let consortiums
successful," says Merrifield, now a con-
Researchers at the national laboratories
sultant at the American Electronics Assn.
are also being turned into front-line
pursue HDTV
It's too soon to say that consortiums
troops in the international economic bat-
are the way to go. Although they have
tle. Far too much of the useful technology
swept the research-and-development land-
they developed for the government was just
scape, most are still very new, and few have
sitting on the shelf, instead of being turned
borne fruit. While consortiums in Japan have
into products by industry. So, Congress stepped
clearly pushed their members to world leader-
in. The Stevenson-Wydler Technology Innova-
ship, a recent Commerce Dept. evaluation of
tion Act of 1980 ordered the labs to pursue
Sematech warned that such ventures may not
applications of their work, while the Federal
work smoothly in other U.S. industries because
Technology Transfer Act of 1986 allowed them
many companies don't want to share research
to collaborate with business.
results. "The jury is still out," says Robert A.
Take Dieter M. Gruen, a materials scientist
Frosch, vice-president for research at General
at Argonne. In 1983, Gruen and two colleagues
Motors Corp.
discovered a process that allows lasers of cer-
Most experts also believe that it's just as
tain wavelengths to slice through materials
important to boost funds for basic research and
without heating them. "It had tremendous im-
for science and engineering education. Over the
fo-
plications," says Gruen. The result: a laser scal-
past decade, the defense-related slice of the
pel for repairing damaged eyes that was intro-
government R&D pie has risen from 50% to
ineering
dollars
duced last year by
more than 70%. But
Summit Technology Inc.
over the same period,
mputer,
the
in Watertown, Mass.
THE SHRINKING SHARE OF CIVILIAN R&D
military spending on ba-
world.
Other government
sic research dropped
labs are tackling prob-
dramatically.
percom-
lems specifically for in-
NONFEDERAL SPENDING
FEDERAL SPENDING
DEFENSE SPENDING
SPACE-RELATED
Many still think the
ma-
dustry. The Commerce
CIVILIAN-RELATED
fund-
government's best role
Dept.'s National Insti-
is that of hands-off gar-
60
ssumed
tute of Standards &
dener, sprinkling grants
and
Technology (the old Na-
on fertile fields and
ndustry
tional Bureau of Stan-
waiting for innovation
dards) is building a pilot
40
it
be-
to spring forth. But the
version of the automat-
more active role has
was
ed factory of the fu-
worked before. And,
that
the
PHOTOGRAPH BY ROBERT HOLMGREN
ture. Earlier this year,
20
with U.S. industry tak-
na-
alone
it formed three centers
ing a drubbing in the
at college campuses, in-
marketplace, similar
the
cluding Rensselaer
moves may yet prove
adually
Polytechnic Institute
0
'80
'81
'82
'83
'84
'85
'86
'87
'88
'89
wise.
oopera-
and the University of
PERCENT
By John Carey in
DATA: NATIONAL SCIENCE FOUNDATION
laws
South Carolina, to
Washington
BUSINESS WEEK
41
INNOVATION 1989
H
MEET D. ALLAN BROMLEY
'MY RESPONSIBILITY
IS SOLID SCIENCE AND TECHNOLOGY INPUT'
N APRIL, YALE UNIVERSITY PHYSICIST
projects. Quite frankly, the luxury of going it
D. Allan Bromley, 63, was named White
alone is perhaps no longer available to us.
House science adviser, a job President
George Bush elevated to Cabinet rank. The
Q. How much should scientists be involved in
founder of the Arthur W. Wright Nuclear
setting such priorities?
Structure Laboratory at Yale, Bromley is
A. We in this country are already unique in the
more highly regarded as a scientist than
degree to which our science policy and budget
were his two predecessors in the adviser's job.
are developed from the bottom up, under pro-
Bromley has also served in a number of sci-
posal pressure, with tremendous input from the
ence-policy posts over the past decade, includ-
scientific community.
ing president of the American Association for
But the decisions on major projects are not
the Advancement of Science and member of the
purely scientific ones. There are political con-
White House Science Council.
siderations and considerations of national secu-
Last month, the new adviser discussed sci-
rity and national prestige. My responsibility
ence and technology issues at his
will be to make sure there is sol-
Yale office with BUSINESS
id science and technology input.
WEEK's Washington science re-
porter, John Carey:
Q. What are the most impor-
tant issues?
Q. Will you have the access to
A. If our economy isn't strong,
the Oval Office that you need to
then we simply aren't going to
be effective?
be able to do all the other good
A. I have been assured by the
things we want to do. That
President that I will have direct
means, first of all, we have to
access. It's absolutely essential
find ways to really develop a
that the science adviser be
partnership between research
viewed as a member of the Presi-
universities, the private sector,
dent's team. That is obviously
and national laboratories. We
something I will not abuse.
also have to focus on improving
the quality of science and mathe-
Q. You face an unusual situa-
matics education, not only in
tion because White House Chief
high school but at the grade-
of Staff John H. Sununu is an
school level as well.
MIT-educated engineer. Will
that present problems?
Q. Why do countries like Japan
A. We both are recognized as
seem better able to compete on
having strong opinions, but I
a global scale?
think that there is mutual re-
A. We have tax laws, antitrust
spect. I think the chemistry will
laws, and a whole body of legis-
be excellent.
lation that was developed purely
with the mindset of a national
Q. There are a number of big
market. We've been slow to rec-
science projects pending. Since
ognize that we are dealing in a
the budget probably won't cover
global market.
them all, how will you decide
which ones to support?
Q. But you don't believe we
A. What we're talking about more than any-
should prevent Japan and other countries
thing else is a question of timing. What people
Bromley is first
from tapping into U.S. science?
have called megaprojects-the superconducting
in the job of
A. No. Science is public knowledge. Anything
supercollider, the human genome map, the
science adviser
you hold close to your chest is priestly lore; it's
space station, the space plane, the compact-
not science. Of course, there's always the ques-
ignition tokamaks-wouldn't have reached this
at Cabinet rank
tion of where the openness of basic sciences
stage if a lot of people weren't actively sup-
ends and where the specific knowhow-the
porting them. What has to be established is the
competitive edge in the technology for the pro-
relative priority.
duction of a product-takes over.
Q.
What about collaborating with other na-
Q. Are you ready for Washington politics?
tions on some of these big-ticket projects?
A. Having survived 30 years on an Ivy League
PHOTOGRAPH BY GALE ZUCKER
A. We do have to address the question of
faculty, I doubt there's much in the way of
whether we treat these as uniquely American
politics that I haven't encountered.
BUSINESS WEEK
44
INNOVATION 1989
THE
POLICY
ELITE
T
he Bush Administration faces big
decisions on big-ticket science
projects: the supercollider, the
I
space plane, the human genome
map, and more. Here are profiles
Emdicot/sacco
of 12 Washington players who will
be putting their spin on policy-
making in science and technology.
DAVID ALLAN bromley
BARBARA A. MIKULSKI
Science Adviser to the President
Chair, Senate appropriations subcommittee
Key Administration adviser
Holds purse strings for research agencies
Born: 5/4/26, Westmeath, Ontario.
Born: 6/20/36, Baltimore.
PhD in physics, University of Roch-
MSW, University of Maryland. Career
ester. Career path: physicist at Univer-
path: Baltimore City Council; U.S.
sity of Rochester, Atomic Energy of
House of Representatives (D-Md.);
Canada Ltd., and Yale; director of the
U.S. Senate in 1986; chair of subcom-
Office of Science & Technology Policy and assistant to
mittee for HUD and independent agencies in 1988. As
the President for Science & Technology in 1989. Also
such, oversees NSF, NASA, and EPA, and funds HUD and
directs the White House Office of Science & Technology
the VA. Believes science and technology are directly
Policy. Earned a reputation as a shrewd politician while
linked to the nation's international competitiveness. Is
serving on the White House Science Council. Faces task
expected to defend appropriations for her agencies ag-
of sorting out priorities in an era of tight budgets; must
gressively. Threatens to oppose funding for science if
deal with chief of staff with strong ideas on technology.
housing funds are inadequate.
ROBERT E. GRADY
ERNEST F. HOLLINGS
Assoc. Dir., Office of Mgmt. & Budget
Chair, Senate Committee on Commerce,
Influences science and technology budget
Science & Transportation
Born: 10/22/57, Livingston, N.J.
Shapes sci/tech agenda in Congress
MBA, Stanford University. Career
Born: 1/1/22, Charleston, S.C.
path: staffer for former Representa-
LL.B., University of South Carolina.
tive Millicent Fenwick (R-N. J.) and for
Career path: Army in World War II;
New Jersey Governor Thomas H.
South Carolina House of Representa-
Kean; speechwriter for Bush; OMB czar for natural re-
tives; U.S. Senate (D-S. C.) in 1966. Chair of the Com-
sources, energy, and science. No science background,
merce, Science & Transportation Committee. Heads ap-
but wrote Bush's first major budget speech, calling for
propriations subcommittees that control Commerce
increases for science. Tells the science community it
Dept. budget. Believes technology is key to a strong
PHOTOGRAPHS BY (TRAXLER. PRESS. ROSENZWEIG) GROUP;
needs to lobby harder for funds, yet has been so optimis-
defense and civilian economy. Spearheaded legislation
tic about science faring well in upcoming budget battles
permitting Commerce to promote technology. Advocates
that some wonder if he grasps the realities of his job.
government funding of technologies such as HDTV.
BUSINESS WEEK
48
INNOVATION 1989
BOB TRAXLER
FRANK PRESS
Chair, House appropriations subcommittee
President, National Academy of Sciences
Holds purse string for basic research
Influences government on science policy
Born: 6/21/31, Kawkawlin, Mich.
Born: 12/4/24, Brooklyn, N.Y.
LL.B., Detroit College of Law. Ca-
PhD in geophysics, Columbia Univer-
reer path: Army; county prosecutor;
sity. Career path: professor of geo-
state representative; U.S. Representa-
physics at Columbia, California Insti-
tive (D-Mich.) in 1974. Chair of the ap-
tute of Technology, and MIT; science
propriations subcommittee over HUD, NSF, NASA, and
adviser to President Carter; president of the National
EPA. Pushed agricultural initiatives in the past. Is not
Academy of Sciences in 1981. Under Press, reports and
expected to push hard in Congress for science funding.
testimony from the Academy's 1,573 elected members
Supports an increase in the NSF budget, but is lukewarm
are increasingly used to direct science policy. Its recom-
toward the space station. Sees little hope of funding all
mendations, however, tend to be conservative. He has
the science and technology efforts that Bush has put in
suggested that scientists should help set priorities in
the proposed Administration budget.
science. Advocates doubling U.S. spending on R&D.
ROBERT A. ROE
JOHN A. YOUNG
Chair, House Committee on Science,
President, Hewlett-Packard Co.
Space & Technology
Emelicott/saccs
Influential industry voice on policy
Influence over science priorities
Born: 4/24/32, Nampa, Idaho.
Born: 2/28/24, Wayne, N.J.
MBA, Stanford University. Career
Washington State University. Career
path: Joined HP in 1958, president in
path: mayor of Wayne, N. J.; New Jer-
1977, CEO in 1978; chair of President's
sey commissioner for conservation and
Commission on Industrial Competitive-
economic development; U.S. Representative (D-N. in
ness in 1983. Founded the privately funded Council on
1969. As chair of the House Committee on Science, Space
Competitiveness, whose positions became the basis for
& Technology, has a visible pulpit. Made a name pushing
Bush's science and technology plank. Has stumped for
water projects and probing the space shuttle accident.
permanent R&D tax credits, for grants or loans for tech-
Fought for the proposed doubling of the NSF budget.
nical professorships, and for doubling the NSF budget.
Plans legislation to help industry hold key markets, such
Lobbied for raising status of Science Adviser to Cabinet
as supercomputers. Could exercise greater influence.
level. A frequent voice at Congressional hearings.
ERICH BLOCH
RALPH E. GOMORY
Director, National Science Foundation
President, Alfred P. Sloan Foundation
Directs the important basic research agency
Respected industry voice on R&D issues
Born: 1/9/25, Sulzburg, West Germany.
Born: 5/7/29, Brooklyn, N.Y.
areer
U.S.
BS in electrical engineering, Universi-
PhD in mathematics, Princeton Uni-
Md.);
ty of Buffalo. Career path: 22 years at
versity. Career path: 20 years at IBM,
IBM-from engineer to vice-president;
director of research in 1970, senior
com-
As
NSF director in 1984. This visible, pow-
vice-president for science and technol-
and
erful, and controversial director persuaded Congress to
ogy in 1986; president of the Sloan Foundation in 1989.
increase the agency's budget to $1.8 billion in fiscal 1989.
Chaired Presidential advisory committee recommending
Is
ag-
PHOTOGRAPHS BY (TRAXLER, PRESS, ROSENZWEIG) STEINKAMP/PICTURE GROUP; (YOUNG) MENUEZ/PICTURE GROUP
Wants further funding boosts this year. Changed NSF's
consortiums develop high-temperature superconductors.
direction by adding technology-and collaborations with
Instrumental in creating the superconductivity consor-
if
industry-to the agency's mission of supporting basic
tium formed recently by MIT, AT&T, and IBM. Believes
scientific research. Respected by the Administration and
product development and manufacturing in industry, not
Congress. Tough and abrasive.
research, is key to competitiveness.
ILLUSTRATION BY JAMES ENDICOTT: PHOTOGRAPHS BY GALE ZUCKER (GRADY)
ROBERT M. WHITE
ROBERT M. ROSENZWEIG
President, Nat. Academy of Engineering
President, Assn. of American Universities
Influences Congress on technology policy
Speaks for universities on science issues
Born: 2/13/23, Boston.
Born: 8/27/31, Detroit.
PhD in meteorology, Massachusetts
PhD in political science, Yale Univer-
II;
Institute of Technology. Career path:
sity. Career path: instructor, dean,
meteorologist at MIT; chief of weather
vice-president at Stanford; AAU presi-
bureau at NOAA; president in 1983 of
dent since 1983. Represents the inter-
the National Academy of Engineering, a 1,300-member
ests of 56 powerful research universities that receive
sister organization of the National Academy of Sciences.
60% of federal research funds for all universities. Is a
Is gradually gaining influence as Congress looks more
strong presence in Washington because of the universi-
to technology and engineering to solve problems of U.S.
ties' clout. Now lobbying Congress for money for bricks
industrial competitiveness. Supports funding more ap-
and mortar. Is concerned that the rapid deterioration of
plied science, warning: "We fiddle while our engineering
university buildings and research facilities is putting the
and technology base burns."
U.S. research enterprise in danger.
BUSINESS WEEK
49
INNOVATION 1989
New fee accountary hower
Additional Discussion and Background Papers on
The "Accounting Problem"
Tip Parker, January 24, 1990
Three terms are key to understanding the literature on
accounting for high-tech and modern manufacturing companies:
1. Financial accounting -- the recording and reporting of the
operations and financial condition of a company to the
general public and investment community. The reports are
approved by Certified Public Accountants (CPAs) in
accordance with standards developed by the Financial
Accounting Standards Board (FASB). Requirements of the
Securities and Exchange Commission and the Internal Revenue
Service are also important.
2.
Management accounting -- the recording, reporting, and
interpretation of information for use by managers within a
company. This information is often proprietary and need not
be comparable from company to company.
3.
Cost accounting -- largely an attempt to meet the management
accounting needs of a company by adapting information
required for financial accounting. Much of the literature
is about where cost accounting has not been a successful
bridge and companies have made serious mistakes as a result.
Nine Papers:
Paper 1: Perhaps the issue is best framed by Akio Morita of Sony
as quoted in "A Japanese View: Why America Has Fallen Behind,"
Fortune, 9/25/89. He says, "Real business entails adding value
to things by adding knowledge to them, but America is steadily
forgetting this. That terrifies me. America no longer makes
things, it only takes pleasure in making profits from moving
money around.' A big part of the problem is that accounting (and
traditional economics for that matter) treats most knowledge as
an intangible of no value.
Paper 2, Morita's point is expanded by Jeffrey Staley in
"Forecast 1990," New Technology Week, 1/8/90. His explanation of
how accounting turns new technology into hidden assets that
companies do not managed well, also applies to knowledge in the
form of product designs, employees upgraded through training, and
manufacturing computer software.
Paper 3. When Mr. Murrin was at Carnegie Mellon, he encouraged
Thomas Johnson and Robert Kaplan to investigate the accounting
problem. Paper 3 is my brief review of the resulting book,
Relevance Lost -- The Rise and Fall of Management Accounting. My
comments are intended to put what Ted Lettes and I have been
trying to do for small companies into the context of Johnson's
and Kaplan's work which has been mostly with large companies.
1
There is a scale factor that makes both the financial and
management accounting tasks for modern small companies different
than those for large companies.
Paper 4. One of the four streams of activity in Ted's Advanced
Manufacturing Program is to hold a series of Roundtables where a
variety of people and interests are brought together to explore a
problem, and if possible, agree to work toward a solution. "FCIM
--- A Watershed Opportunity to Improve Accounting Systems for
Small and Intermediate Size Firms?" was written two years ago for
one of these Roundtables. I include it here for three reasons:
1
It gives examples of how cost accounting, as typically
employed, fails to bridge the gap between financial and
management accounting.
2
It discusses the software "repertoire" of a computer
controlled manufacturing facility as an asset that is
usually overlooked.
3
It suggests that solutions may be found to the management
side of the accounting problem without treading too hard on
FASB standards or current financial accounting.
Paper 5. The tax impact of changing accounting standards is an
important question that almost always comes up. The Dual Path
P & L Statement is a proposal I floated in another paper on the
management accounting problems of small companies. This proposal
for retaining the current financial accounting treatment of
strategic expenditures but reporting them separately from routine
operating expenses on the Profit and Loss Statement would have
minimal impact on FASB standards and not change a company's
income tax situation. If the Dual Path P & L were allowed as an
optional presentation format, a company could use it to explain
what it is doing more clearly to the financial community. The
hope is that the financial community would then distinguish
between strategic expenses intended to yield long term benefits
from run-away current costs and treat the company accordingly.
The risk of this proposal is that unless it is implemented with
care it could allow new opportunities for fraud.
From our standpoint, the proposal is important because it is an
idea that a number of accountants and managers agree could work.
Like the Wright Brothers' first flight, the importance is not in
showing how to do something, but that it can be done. Once the
feasibility is demonstrated, others can add the refinements.
Paper 6. "The Cost Accounting Model: A New Proposal" is a
technical paper written by Dennis Peavey, a Partner of Coopers &
Lybrand. As a result of our 9/26/89 Roundtable, Dennis and
Al King, Managing Director of the National Association of
Accountants agreed to convert it into a White Paper to place the
broad accounting problem on the FASB agenda for the first time.
FASB has looked at individual pieces such as inventories and R&D,
2
but not the cumulative effect of expensing most knowledge-related
expenditures. The proposals in the paper are similar to the
ideas we floated in the "Watershed" paper (#4 above). The
proposals are partially justified by inconsistencies in existing
FASB standards. As shown by the example, rather than being tax
neutral, this proposal could shift income and taxes forward.
Paper 7. The financial accounting issue is primarily important
in relation to U.S. financial markets. The 3/6/89 Dick Davis
Digest, a widely read investment newsletter has two front-page
articles. The first is part of a review of Peter Lynch's book,
One Up On Wall Street. Lynch manages the Fidelity Magellan Fund,
the largest and one of the most successful stock mutual funds.
He says, "Getting the story on a company is a lot easier if you
understand the basic business. That's why I'd rather invest in
panty hose than in communications satellites, or in motel chains
than in fiber optics. The simpler it is, the better I like it.
When somebody says, 'Any idiot could run this joint,' that's a
plus, because sooner or later, any idiot is probably going to be
running it. If it's a choice between owning stock in a fine
company with excellent management in a highly competitive and
complex industry, or a humdrum company with no competition, I'd
take the latter.' This is the view of one of the most
influential investment managers in the country.
A similar story is told in the second article on Caterpillar.
The point is that CAT stock dropped nearly 10% on the day it
announced record sales and earnings, but also said it would
increase its strategic expenditures to stay on a long-term growth
curve. "As is often the case, the institutional herd on Wall
Street has a time horizon substantially shorter than corporate
management's" Financial accounting plays to the herd.
Paper 8. To complete the cycle, "New Faith in Old Money" by
Diana Henriques in the 1/21/90 New York Times tells of a study
showing that some companies which are well managed and kept under
family control have grown 1,400% in the last ten years, while the
S&P 500 grew by 400%. The article closes with, "the family is
the ultimate long-term investor." I think Akio Morita would
agree, in part because the Japanese industrial structure is
modeled after the extended family.
As a confirmation of this point, Motorola received the Baldrige
Quality Award. Two of Motorola executives have told me that they
would not have undertaken the knowledge intensive program that
led to the award had not 12% of the company's stock been under
family control. The risk of hostile take-over from the stock
price decline that could be expected to follow depressed earnings
reports would have been too great.
Paper 9. For those who are really gluttons, the last paper by
Ted and me is scheduled for the August publication in Management
Accounting, the Journal of the National Association of
Accountants.
3
PAPER 1
COMPETITION
A JAPANESE VIEW: WHY AMERICA HAS FALLEN BEHIND
Few Japanese businessmen are as
and devote their efforts to making prod-
how far ahead he looks. One week? 'No,
at home in America as Akio Mor-
ucts that really appeal to Japanese peo-
no.' came the reply. 'Ten minutes.' If
ita. ebullient co-founder of Sony. And
ple and that they will want to buy. We
Americans think only in terms of ten-
few have had as much success. When
should have no compunction about as-
minute action. while we Japanese think
other Japanese TV makers underpriced
serting this, and Japanese politicians
in ten-year terms. America assuredly
U.S. competitors to gain market share,
should confidently insist on it."
faces gradual decline."
Sony charged more-and set new stan-
Morita is disturbed by trends he sees
Morita argues that the U.S., which in-
dards for quality. The Walkman. now
in the U.S. economy. The big problem,
vented the transistor and semiconductor
ten years old, created not only a new
he feels, is that America has opted out of
chip, has forgotten how to innovate:
market, but part of a new way of
"The main reason why Japan's in-
life. Imaginative products, like the
IDWI INSURAN
dustrial might has become so
Mavica filmless camera (see page
strong is not that it borrows basic
43), keep coming.
technologies-though. to be sure,
With Shintaro Ishihara, a se-
many have been brought in from
nior Liberal Democratic Party
abroad-but that it leads the
politician who was a candidate for
world in devising ways of creating
Prime Minister in August. Morita
products derived from those basic
has written The Japan That Can
technologies. America is by no
Say No. The book has created a
means lacking in technology. But
sensation in Japan. partly because
it does lack the creativity to apply
of Ishihara's flamboyant asser-
new technologies commercially.
tions of Japanese dominance that
This. I believe. is America's big-
remind some readers of the coun-
gest problem. On the other hand.
try's prewar militancy. Released
it is Japan's strongest point."
early this year. it has sold 60.000
To buttress his assertion that
copies.
U.S. industry has itself to blame
American readers, though,
for much of the trade deñcit. Mor-
won't get a crack at it soon. Ko-
ita recalls a golf game with an
bunsha. the Tokyo publisher, has
American friend in the New York
talked of an English-language edi-
City suburbs. "As I stood on the
tion but is awaiting a decision by
Morita: Beware the ten-minute money manager.
tee I took out my [U.S. made]
the authors. Insiders say that Mor-
MacGregor driver. My friend.
ita and Ishihara aren't anxious for the
manufacturing: "Real business entails
who likes to tell me that Japan is unfair
book to reach a foreign audience.
adding value to things by adding knowl-
and how appalling that is, pulled out a
In the book, Morita, 68, chides his
edge to them, but America is steadily
[Japanese-made] Yonex. I chided him
countrymen for their penchant for acqui-
forgetting this. That terrifies me. Ameri-
for using these clubs. He replied that his
escence. The Japanese, he says, should
ca no longer makes things, it only takes
Yonex clubs gave him better purchase
start being direct and forceful with their
pleasure in making profits from moving
on the bail. So we set off on our round.
trading partners: "Perhaps as a result of
money around."
safe in the new understanding that using
Confucian influences, we Japanese find
Nor is Morita impressed by predic-
Japanese clubs was a necessary evil.
it very difficult to say a clear 'no' in inter-
tions that the service sector will take
"After the round he invited me back
personal relationships. Large numbers of
manufacturing's place. "There has been
to his home and showed me around
Japanese feel that even if they remain si-
a lot of hot air about America gradually
while his wife prepared an evening
lent, they will be understood."
transforming itself into a post-industrial
meal. In the garage were a snowmobile,
Americans, says Morita from his
society," he writes. "But now the coun-
a motorboat, and a four-wheel-drive ve-
Westernized perspective, have no such
try is facing the question of what hap-
hicle-all Jäpanese. In the house he had
understanding. The result is massive
pens if manufacturing ceases to exist. In
a Sony television and stereo. In fact,
misunderstanding: "One of the reasons
fact, even now America is not producing
there were Japanese products every-
why Japan-U.S. relations have gone
for itself the things that it uses."
where. So I asked him frankly: 'Time
askew is that Japan has not said to the
U.S. managers are often criticized for
and again you have angrily claimed that
Americans what should have been said."
their short-term outlook, supposedly
Japan doesn't buy American products,
What should have been said? "If
forced on them by Wall Street. Morita
but if you yourself use only Japanese-
Americans want to rectify the trade im-
joins the chorus, recalling a chat with a
made things, what do you suggest we
balance, they should pause for reflection
money trader in New York: "I enquired
can buy from you?'
52 FORTUNE SEPTEMBER 25. 1989
PAPER 2
6
Monday, January 8, 1990 NEW TECHNOLOGY WEEK
In the United States, ourac-
company as a whole
FORECAST
counting standards are funda-
Technology asset plans de-
mentally responsible for the fact
scribe product, process, service
that technology assets are not
and infrastructure technologies
shown on the balance sheet. Our
that will be required to successful-
Financial Accounting and Stan-
ly execute strategic plans. They
dards Board (FASB) requires [that]
also describe current technology
R&D and engineering activities be
assets and the pattern of financial
expensed in the current period.
and human resource investments
that will be made to close the gap.
Jeffrey Staley
The FASB concluded that
measurement of future benefits to
3. Establish an identified set of
Surprisingly, some of the most
be derived from these expendi-
technology assets available for
valuable assets possessed by
tures was too uncertain to war-
trade with external organizations.
multinational companies are in-
rant capitalizing them. They ar-
visible to management. The costs
rived at this conclusion despite
Creating the ability to trade
of creating these assets are typi-
their admission that certain
technology assets could uncover
cally expensed every year result-
research and development costs
assets held by others that were
ing in their having absolutely no
do benefit future periods and are
previously unavailable. Many or-
value on the balance sheet. Since
therefore conceptually assets.
ganizations find licensing fees too
they have no accounting value,
While this makes good sense as a
small to justify the time and
they are not included when calcu-
conservative accounting practice
energy required to successfully
lating Return on Assets (ROA).
for reporting to current and poten-
transfer a technology to another
Because they are not counted on
tial holders of debt and equity, it
organization. However, the possi-
ROA, management is not rewar-
makes little sense as an internal
bility of both parties trading tech-
ded for using them efficiently or
management accounting practice.
nologies with low perceived
[is not] penalized for wasting
values in return for technologies
them.
Most corporations devote con-
with high perceived values can
siderable effort to managing tang-
motivate both sides to overcome
These invisible assets are tech-
ible assets like capital equipment
barriers.
nology assets created through
and real estate. Few, however,
An explicit inventory of techno-
internal research, development
focus on aggressive management
logies available for trade under
and engineering efforts or ac-
of intangible intellectual assets
defined circumstances is very
quired through joint de-
like product, process and service
important [because] once negotia-
velopments, licenses or acquisi-
technologies. Global Technology
tion of any specific business deal
tions. Technology assets are not
Asset Management involves find-
begins, it is very difficult for parti-
systematically managed today,
ing creative ways to extract max-
cipants to break away and search
even in multinational companies
imum value from technology as-
for technologies that might be of
considered excellent by other
sets, wherever they may exist be-
interest to the other side.
measures. While this problem is
fore they become obsolete. The
In general, the ability to trade
not new, methodically addressing
five ideas presented below ad-
technology assets for other tech-
it will be much more important in
dress this objective.
nologies, goods, services or
the competitive world of the
money would represent a new de-
1990s.
1. Modify the internal manage-
gree of negotiating freedom in
Manufacturing companies suc-
ment accounting system to show
many corporations.
cessfully commercialize perhaps
capitalized R&D and engineering
30 or 40 percent of the techno-
expenditures by project or pro-
4. Establish a geographically
logy assets they create. If they
duct line and create a reasonable
distributed network of corporate
were measured, the ROAs on
depreciation schedule.
technology explorers.
these assets would likely be very
high. Conversely, the ROAs on
The information and discipline
5. Develop a process for manag-
technology assets they don't or
associated with capitalizing and
ing global supplier technology as-
can't commercialize are typically
depreciating research, de-
sets as extensions of internal
zero.
velopment and engineering in-
technology assets.
vestments that produce techno-
Many companies have been
To those who believe in max-
logy assets could be very positive.
working to create deeper re-
imization of shareholder value,
The potential pain associated with
lationships with a reduced number
this practice is an oversight of
writing off assets that have no
of suppliers. In their efforts to re-
staggering proportions. To those
willing to take a fresh look at this
foreseeable use should motivate
main among the chosen, suppliers
problem, technology assets rep-
managers to more carefully con-
have been working to increase
resent bargaining chips that may
sider investments in technology
their technological capabilities as
play a critical role in creating new
and find creative ways of extract-
well as their ability to deliver qua-
alliances, previously unimagined
ing value from them prior to ob-
lity parts with short lead times.
solescence.
joint development projects or
highly leveraged trades for tech-
2. Create technology asset
Jeffrey L. Stanley is founder and
nology assets that can be applied.
plans for each division and the
president of Hechathorn Technologies
of Cambridge, Mass.
PAPER 3
RELEVANCE LOST
The Rise and Fall of Management Accounting
by H. Thomas Johnson and Robert S. Kaplan
Accounting
The accounting profession has two branches. First, management
accountants do the internal recordkeeping, analysis, and
reporting necessary to run a company. Their work is usually a
company secret. Second financial accountants develop, review,
and approve the reports a company makes to the outside world.
Their work is public and is dominated by standards developed by
the Financial Accounting Standards Board (FASB) and requirements
of agencies such as the Securities and Exchange Commission and
the Internal Revenue Service.
Relevance Lost
The book by Johnson and Kaplan is mainly about management
accounting. The first half shows how management accounting
evolved to control increasingly complex processes and companies.
Starting with early textile mills, the evolution is traced
through steel, railroads, retailing, vertically integrated firms
such as the Du Pont Power Company, and multidivisional
organizations such as General Motors. During each of these
phases, management accounting systems were created to fit the
needs of the companies they served. Managers understood the
basic processes of their companies and demanded information in
physical terms that were specific to the processes. Costs were
important but only in the context of physical operations.
The point of the book is that starting in the mid '20's, there
was a shift in management attention from data about the physical
processes to financial data intended to represent the processes.
A number of reasons are given for the shift including the cost of
data collection (e.g. ton-miles, time, fuel consumption, and
revenue by individual train run) and the increasing diversity of
company products and operations that made it harder to manage a
company in physical terms. Most important, however, wider public
ownership of large corporations required more accurate public
financial statements with particular emphasis on the value of
inventories. The concern was less with the cost of manufacturing
individual items in inventory, than with their aggregate value
to report profits and assets correctly. The cost of running two
types of accounting systems became prohibitive, so financial
accounting overshadowed management accounting.
One effect of the shift has been to ignore the types of cost
information needed to manage a company, and the authors are
concerned about cross-product subsidization. By analogy, four
people go out to lunch--one orders a second drink and the most
expensive entre--then suggests the tab and tip be split equally.
This is what happens when different products that use varying
1
amounts of services (e.g. electricity, floor space, and
purchasing transactions) that are charged to a single overhead
cost pool and apportioned to the products with a single overhead
rate. This can be seriousness when some products are made and
sold at a loss; others overpriced enough to invite competition;
and management does not know the difference.
The authors' main concern, however, is over the belief that has
evolved in this country that a company can be judged and managed
primarily by dollar figures, rather than by understanding what is
happening physically. The financial view dominates the way
accounting staffs are used, and line managers have been denied
what they need to manage. In many cases, they are put in charge
of small cost centers where they have an incentive not to spend
the funds necessary for long term success.
The authors' conclusion is that when U.S. companies competed only
with each other, this was less important than it is today when
foreign competitors are being managed as U.S. companies used to
be prior to 1925. Factors such as total quality control, just in
time delivery, computer integrated manufacturing, short life
cycle/high technology products, and deregulation must all be
considered in physical and operational rather than just dollar
terms, while short term profits are a meaningless distraction.
Modern automated processes can now provide the data needed for
both types of accounting at an acceptable cost.
Comments
1.
Converting the history of management accounting into a
lively, enjoyable, and useful book was a major achievement.
2. The authors concentrated on large companies. Kaplan is
working with Computer Automated Manufacturing--International
(CAM-i) the Texas-based research consortium dedicated to the
management of advanced manufacturing which is mainly serving
large companies.
Our work with small companies, however, has led Ted and me to
conclude there is a scale factor that limits what they can do.
In many cases, the minimum advanced manufacturing module for
small companies is very costly in relation to their capital
structures. Small companies can not collect and evaluate ever
more data as large companies appear to be doing, and should be
offered a management accounting solution of watershed simplicity
if one is possible. (This is one of the things we are working
with the accounting profession to try to create.) Large
companies keep their management accounting data and projections
secret, while small ones often must disclose them to raise
capital. Large companies, which raise capital on the basis of
their total corporate strength, whose cost of capital is related
to their quarterly reports, and which may be subject to hostile
takeovers after depressed earnings statements, are more directly
affected by financial accounting requirements.
2
3.
The authors concentrate on cross-product subsidization,
which occurs more in large companies than small. They discuss
what we call cross-period subsidization but place less importance
on it than we do. Today, unless a small company uses shared
facilities to convert to an advanced manufacturing process, it
must spend large sums of money, some of which are treated as
capital investments. Expenditures for employee training, product
redesign, computer software, and other types of knowledge are
charged to current expense in accordance with financial
accounting standards. Before production begins, these onetime
outlays plus the continuing cost of money to finance them may
equal 80% of the total cost of everything that will be made
during the life of the process. And to make matters worse, if
the new process is bought to respond quickly to unpredictable
markets, there may be only hunches or hopes of what products and
the future utilization will be.
The management accounting challenge has shifted from allocating
operating costs such as direct labor to products as they are
incurred, to apportioning large, one-time expenditures to an
opaque future. There is no accepted basis for making these
apportionments. Returning to the analogy of the four diners, the
problem is as if they ate in a club that one of them had recently
joined, and the member asked to recover a "fair share" of the
initiation fee which vastly exceeded the cost of the meal.
4. In summary, under current management accounting practice,
nobody knows what a product made with advanced manufacturing
really costs. Regardless of what a conventional job cost sheet
says, in some cases it can be shown that the cost of not making
and shipping a part is greater that the cost of making it. In
extreme cases, nobody may know for years after converting to
advanced manufacturing, whether a company is making or losing
money on the conversion. This creates severe problems for:
O
Companies attempting to do business with DoD or any other
government agency on a cost-plus basis,
O
A small company attempting to raise capital to fund its
conversion to advanced manufacturing, and
O
A medium or large, publically-held company trying to provide
for the future without increasing its cost of capital or
inviting a hostile takeover attempt.
A primary measure of U.S. business is profit and profit is what
an accounting system says it is. If what accounting systems tell
about profits from advanced manufacturing is unreliable,
excessively conservative, or outright negative, modernization
will continue to be slow until new accounting techniques,
investment criteria, or both are found.
Tip Parker
1/10/90
3
PAPER 4
FCIM -- A WATERSHEAD OPPORTUNITY TO IMPROVE ACCOUNTING SYSTEMS
FOR SMALL AND INTERMEDIATE SIZE FIRMS?
A Discussion Paper for the March 30, 1988, OPTI Roundtable
T. J. (Tip) Parker
Office of Productivity, Technology, and Innovation
U. S. Department of Commerce
Watershead developments sometimes have a way of turning up
just when they are needed most.
Shortly before jet aircraft engines were introduced, turbo-
compound piston engines and propellers had become marvels of
technology, complexity, and cost. Before the Salk Vaccine became
available, treatment of polio symptoms had become one of the most
expensive medical procedures. Transistors arrived as computers
reached the limits imposed by electron tubes.
Jet engines, the Salk Vaccine, and solid state electronics
were watershead advances. In each case, the process of gradually
refining an older technology by adding more complexity was bodily
shifted to a new plateau of simplicity and economy.
Many writers and several studies suggest that companies
installing Flexible Computer Integrated Manufacturing (FCIM) may
have to add new and perhaps costly features to their accounting
systems to manage the new technology. Before we accept this
conclusion, perhaps we should pause and ask if maybe FCIM brings
a watershead opportunity to shift to new levels of accounting
accuracy, utility, simplicity, and economy, particularly for
small and intermediate size firms.
Traditional cost accounting systems divide a company's
expenditures into many categories. For this discussion, the
three most important ones are:
Capital investments--purchases, usually of tangible assets,
that are intended to be useful for several years.
Direct costs expenditures for material, labor, and other
items that are used directly in manufacturing specific
products.
Indirect costs expenses like heat, light, managers'
salaries, strategic marketing, product development, employee
training and depreciation of the capital investments. These
are combined into cost pools which are then applied to
specific products through an overhead rate as a percentage
of direct costs.
The object of the game is to record or compute the cost of
making each product within the limits of practical accuracy. If
most of the costs are direct, this is easy to do and the
information is very useful.
1
But the accuracy and management value of traditional product
cost information declines as the proportion of indirect costs
increases. When overhead rates reach several hundred to a
thousand percent, minor changes in a direct cost such as labor
can to lead to grossly incorrect indications of total cost.
The normal accounting response to this problem is to obtain
more detailed indirect cost data, create multiple overhead cost
pools and rates, and subdivide direct costs for application of
the new rates. This is what most articles and studies on
accounting for FCIM advocate without mentioning that it may add
more accounting expense to the company's indirect costs while
maybe not adding much utility. It is the accounting equivalent
of adding another ignition system to an aircraft engine because
with twenty-eight cylinders there will almost always be a bad
spark plug.
Comes now FCIM with very high start up and indirect costs,
but direct costs of little more than material. Many writers
indicate that substituting machine time for direct labor will
bring everything to rights. They overlook, however, that labor
costs can be measured accurately, are controllable to some
degree, and may change significantly if the product or the
process is changed. If the product is not made, they may be
avoided entirely.
In contrast, the investment in a machine bought three years
ago cannot be changed regardless of how much or how little it is
used. Different accounting judgements for apportioning the
investment and indirect costs to individual products can alter
the imputed product costs by several hundred percent or more. If
managers treat these apportionments as having the same meaning
and validity as direct costs when making decisions on what or how
to produce, the decisions can be awfully wrong.
Two simple examples can illustrate this point:
1.
It is easy to show how the depreciation rate for a million
dollar piece of equipment can be set anywhere between $10
and $100 an hour by merely making different judgements about
the equipment's useful life and its anticipated rate of use.
2.
Before an FCIM system can produce, its every action must be
planned and put into machine instructions. There is often a
tradeoff between the time a process planner spends
developing the instructions and the efficiency of the
resulting operation. For some time after a company installs
an FCIM system, the equipment is likely to sit idle for
extended periods awaiting instructions, while the process
planners have a backlog. If the accounting system shows a
single dollar amount per hour as the cost of using the
equipment, management may be induced to emphasize efficient
equipment operation and hire more process planners to cut
2
down the backlog. This will increase the company's total
cost. If, on the other hand, the accounting system stresses
best use of whatever is the the critical resource, it might
point to forgoing machine efficiency for a while to increase
sales without increasing direct costs. As the equipment
becomes more fully used, the accounting system might then
advise management on whether to improve operating
efficiencies or get more equipment.
This may be where the watershead comes in. Perhaps the
accounting systems should concentrate on forecasting and
recording costs that are variable within the time covered by a
particular decision to be made. Rather than than trying to
allocate the costs of past decisions to the present question of
whether to accept an order, an accounting system should indicate
what it would actually cost to accept and fill the order (e.g.
material and electricity), as opposed to the cost of money that
will continue to be compounded if the sale is not made. The
direct cost, subtracted from the selling price in relation to the
cost of not receiving the income would be the net benefit of
accepting the order and should be the basis for the decision.
This is called marginal costing. It is what economics text
books say a business should do, but what few accounting texts say
how to do.
This is oversimplified, of course. For one thing, it begs
the question of what price to charge or bid for an order. But
maybe even that is not all bad. Since a virtue of FCIM is its
ability to exploit niche markets, should a company set its prices
on the basis of costs imputed from historical events, or on a
more value-oriented pricing strategy that takes advantage of the
quality, predictability, responsiveness, and other features of
FCIM ?
A frequently unrecognized feature of an FCIM system is its
ability to remember how to make everything that it has ever made.
We are calling the system's memory of what it has done, its
"repertoire." Over time, it can build the repertoire of designs
that cost money to create, but which can be reused or even
licensed to others at little additional cost. Further, each of
the designs in the repertoire has the potential of being modified
to produce similar but slightly different products at a much
lower development cost than completely new designs. A company
with an extensive FCIM repertoire has SO many cost and
responsiveness advantages over firms without similar assets, that
the value of the repertoire may become a major element of the
value of the company.
To enjoy the greatest benefit from this feature, a company
must concentrate on building its repertoire of basic designs and
design elements that can sire whole clans of related products;
obtain orders that add new product families to the clans; and
obtain as many repeat orders for individual products as possible.
3
Most articles on FCIM concentrate on what goes on within the
factory. Taking advantage of the repertoire, however, must also
involve salesmen, product designers, and the process planners who
develop the detailed FCIM instructions. The machines, for all
their accuracy, dependability, and other virtues, will be little
more than organized junk without with the living, growing
repertoire and the keen people who create and use it. In the
last anlysis the ability to exploit niches really will depend
heavily on using these human and programmed technology resources.
Traditional accounting systems would treat the costs of
developing the repertoire as current expenses to be forgotten
soon after they are written off. But should not the accounting
system concentrate on helping to build and maximize the value and
use of the repertoire? Wouldn't a company receive more value
from a system that shows the alternative costs of making a
product using various combinations of new design elements and
elements already in the repertoire than a system which apportions
past costs in great detail but ignores what is truly variable at
the moment? And couldn't an accounting system be designed to
compute sales commissions and other incentive payments on the
basis of the actual profit that individuals help generate?
Accountants will point out that their systems must report
inventories and profits for investors and tax purposes. While
certainly true, one can ask whether these reports could be made
more easily. For example, must depreciation be apportioned to
each product, or can it just be recorded in one bookkeeping entry
each month? If FCIM eliminates the piles of work-in-process
sitting around awaiting their next stage of manufacture, is
detailed WIP inventory accounting still needed? Would it make
sense to shift from emphasizing inventories to maximizing the
value and use of the repertoire?
This paper is really asking about something deeper than
accounting. The questions go to the very core of what a small or
medium size company is trying to do or become. They ask, in
essence, whether the management of a company that intends to use
FCIM to become a strong innovator of new products for new market
niches needs to think about its opportunities and alternatives
in more dynamic and holistic way.
If the answer is yes, the paper then suggests the watershead
opportunity to invert some present accounting practices. It
suggests routinely keeping track of some details that would today
be computed as special studies, while treating many of the costs
that are now apportioned in great detail as gross numbers
4
PAPER 5
The Dual Path P & L Statement
A companies displays its financial condition with its Balance
Sheet and Profit and Loss Statement. The Balance Sheet is a
static snapshot of the company's position as of a point in time,
while the P & L Statement is a summary of operations during a
period of time. Accounting convention requires changes in the
Earned Surplus line of consecutive Balance Sheets to be connected
or explained by the P & L Statement for the interverning period.
This convention was developed when company outlays tended to fall
into the two relatively neat categories of
1
Provision for the future or investment, and
2
Current operations or expense.
In simpler days, investment or provision for the future normally
yielded something tangible and durable like a machine or building
while expensed items were consumed during the period. Over time,
the test for whether to show an expenditure as an operational
expense or an investment has come to be based on the tangible or
durable aspect instead of the reason for making the expenditure
or the duration of its anticipated benefits.
Some expenditures, particularly for research and development or
employee training have long presented an accounting problem. The
objective was clearly provision for the future, but since
knowledge and technical capability are not tangible, there was
usually nothing concrete to call an asset. The problem was
handled two ways. First, in even the most progressive companies,
these expenditures were usually modest in relation to overall
operations and they tended to occur at a relatively constant rate
except during lean years, so they were not much of an issue.
Second, providing for the future was viewed as a continuing
operational requirement for staying in business--thus the problem
was defined away. Over time, the performance of companies with
continuing R&D and training programs tended to be recognized by
the investment community, and they were often accorded higher
price-earnings ratios for their stocks.
Today, many small and medium size companies must develop new
technology or create a manufacturing capability that requires a
surge in outlays for knowledge or technology which accounting
conventions treat as a current expense. These provision-for-the-
future or strategic expenses become merged with routine operating
expenses on the P&L Statement in a single path that leads from
Sales to Changes in Earned Surplus. A bold program for the
future can thus appear as mismanagement. The accounting
convention, intended to provide a conservative view of the
company, when coupled with the normal organization of the P & L
Statement, becomes a perverse measure and an incentive not to
provide for the future.
1
The idea of a Dual Path P & L is an attempt to split the
statement in two, showing one path for routine operating expenses
and a second path for the strategic expenses of providing for the
future. Both paths could appear side-by-side and lead to a
common bottom line. A P & L Statement organized this way would
provide a far more useful display of information without any
changes to actual accounting conventions. While this information
can be provided in text or footnotes, it does not have the effect
that two parallel columns of figures would have. Few investment
analysts, for example, routinely calculate two P/E ratios, one
for current operations and one for the long term as the dual
paths would almost demand.
Managers could be measured by one set of criteria on the
operating side and a different set on the strategic side.
Bonuses, promotions, stock options and retirements could be
designed to take the two paths into account and support both
short term profitability and long term strategic objectives.
The strategic column would include the costs of the repertoire
and a supporting statement could show some multi-year trends.
This path can also include more than expenses. If, for example,
there is a significant inventory reduction and sale of the space
formerly used to store it, these one-time positive cash flows
could be shown in the strategic path rather than as nonrecurring
income in the routine operations path. The future year
reductions in inventory carrying costs and lower space costs
would be shown in the as routine operations.
Over time, the strategic path can lead to an indication of how
well a company manages its technology. There ought to be a
positive correlation between extensive strategic costs and
relatively healthy operations data in the future.
The technique would probably also help guard against unfrieldly
acquisitions by the few who are able to recognize when the value
of a company exceeds its reported value because of its repertoire
and other investments in technology. The technique is not a
general solution to the problems of justifying and measuring
investments in technology, but it may be a step forward that
would not involve difficult changes in accounting principles or
systems.
2
PAPER 6
DRAFT 9/20/89
The Cost Accounting Model: A New Proposal
Much has been written about the shortcomings of the traditional cost
accounting model, including the lack of attention given to internal
and cost controls and the improper matching of revenue and expenses
and their emphasis on conservative inventory valuation at the expense
of management reporting. Suggested solutions to these problems
generally require an additional set of books or other off-line system
to properly analyze and determine real product costs for management
purposes. These suggested solutions, although satisfactory treatments
for the problem, have two side effects. One, they cause additional
and redundant effort and, two, they create inconsistencies between
decisions based on management reporting versus financial reporting and
the evaluations of those decisions.
An alternative to these suggested solutions is for the accounting
profession to adopt new methods of accounting for product costs under
generally accepted accounting principles (GAAP).
A Time To Adopt New Methods of Accounting
The reports of American manufacturing's demise, so prevalent only a
few years ago, have given way to brighter prognoses. Manufacturing is
experiencing a resurgence that cuts across industrial, geographic and
company-sized boundaries. It has survived a stock market crash and
fierce worldwide competition, and many industries are reaching
capacity levels and enjoying increased sales and profits.
-2-
A commonality among companies leading this resurgence is a
significantly changed manufacturing environment, which is presently
characterized by increased automation and computerization, reduced
levels of direct labor and inventory, increased attention to product
and production planning, and shorter product life cycles. Although
manufacturing philosophies such as JIT (just-in-time is a
manufacturing approach designed to minimize inventory levels and
reduce waste time during the manufacturing process through improved
logistics), along with changing technologies, are fueling the
traditional resurgence, this is just the beginning. Over 50 percent
of the manufacturing executives participating in a 1987 Coopers &
Lybrand survey see "very extensive implementation of JIT and CIM
(computer-intergrated manufacturing is the use of computers and
advanced technology to manufacture products) during the next five
years. = (1)
In light of the revolution taking place in our factories, one would
expect to see significant accounting changes under this new
environment. After all, the traditional cost accounting approach was
designed for a prior era of manufacturing when labor was often the
most significant component of product cost and was used as the primary
method of allocating overhead and other indirect costs. Today,
overhead itself is often the most significant product cost and labor
could be characterized as an indirect cost. With labor and overhead
costs moving inversely, it is becoming increasingly difficult to
determine product costs. Labor costs or hours are no longer an
accurate basis to allocate overhead and a convenient substitute is not
appeasement.
-3-
still, cost accounting techniques based on a disappearing
manufacturing environment prevail today. However, these techniques
are no longer appropriate. New generally accepted accounting
principles should be adopted to ensure that the traditional model does
not inappropriately influence cost management decisions and financial
results.
Activity, technology, and life-cycle accounting techniques, discussed
below, have been developed to update the traditional cost accounting
model to adequately reflect today's manufacturing environment.
Activity and technology accounting techniques are interrelated and
generally focus on cost control and the elimination of the overhead
allocation problems, and could be adopted under the traditional model,
although an accounting change under APB No. 20 would most likely
occur. For publicly traded companies, a preferability letter would
also be required. Life-cycle accounting promotes better matching of
revenues and expenses and may require changes in the GAAP model.
These techniques are discussed in more detail below to explain why and
how the traditional cost accounting model should be changed.
Activity Accounting
Activity accounting accumulates product costs and other financial and
operational information based on the activities required to
manufacture the product or achieve a financial or operational goal.
There is a general agreement that allocating overhead to production,
based solely on direct labor, does not adequately reflect the
complexity of today's manufacturing environment. It is not unusual to
-4-
find direct labor hours, once the benchmark for allocating overhead,
to account for only ten percent of total product cost and the trend
continues to decline.
Activity accounting is the first step in solving the overhead
allocation problem. It starts by analyzing a company to determine all
its production and support activities. The activities of a purchasing
department, for example, might include raw materials and spare parts
purchasing, as well as special work related to new products. Next,
all costs are allocated to activities. In our purchasing department
example, it may be determined that 40 percent of the purchasing
department's costs are attributable to each of the two purchasing
activities and 20 percent to the special work.
Next, activity accounting links the activity with the products
manufactured by the use of the factor whose occurrence creates the
costs. This factor is a measure of activity volume which most
directly determines the cost of the activity. To illustrate in our
example, the factors of a purchasing department might be as follows:
Activity
Factor
Raw materials purchasing
Quantity of materials
used in production
Spare parts purchasing
Number of different parts
ordered
Special work
Number of new products
-5-
Finished products are then assigned costs based on the factors
included in their production. Costs of purchasing raw materials
and special work would be allocated based on raw materials used in
production and whether it is a new product. The costs of spare
parts purchasing would first be allocated to machine activities
based on the machines for which the spare parts were ordered.
These activities would then be allocated to products based on a
factor such as machine-hours. The total cost of finished products
would be an accumulation of the activities required to produce the
products.
This method of allocation directly relates product costs to the
resources used to produce them. This is in contrast to the
traditional model which spreads overhead costs between products on
a basis such as direct labor-hours which generally does not
directly relate to the consumption of the individual overhead
items. One company that implemented activity accounting found that
overhead costs applied to their products could be as little as one-
fifth or as much as 20 times the amounts applied under the
traditional model.
Controls are also strengthened under activity accounting since
costs are controlled at the activity level where they are being
incurred. The traditional model emphasizes cost control at the
finished product level once the goods are produced and the costs
have been incurred.
-6-
Activity accounting is acceptable under the traditional GAAP model
but may cause an accounting change under APB No. 20. However, once
a company has better allocated overhead using activity accounting,
the next logical step may be to change the traditional GAAP model
to permit more activities to be allocated to inventory, including
some activities traditionally considered general and administrative
expenses. The activities of accounts payable, payroll, and
personnel are all part of product cost. By selecting the most
reasonable factor as a basis of allocation, the costs of these
activities can be reasonably allocated to production. These
factors might include the number of different raw materials used in
a product, number of employees, number of new hires, or number of
new products. The line between product costs and general expenses
becomes less clear under activity accounting and is an area of the
traditional GAAP model that needs to be revised.
Technology Accounting
Technology accounting embodies the concept that technology costs,
which include plant, equipment and information systems, should be
treated as direct costs, equivalent to direct labor and
material. (2) Today, technology costs, for the most part, are
accounted for by amortization (or depreciation) and included in
indirect overhead.
The problem with this method of accounting is that conventional
amortization methods are time-based, not production-based. A time-
based method equates time with cost and often causes amortization
-7-
of idle machinery to increase overhead costs when there is little
or no production. This encourages constant and ineffective
production to maintain a desired cost per unit. Product costs are
further affected by the inclusion of the time-based amortization in
overhead which must then be allocated to production. By adopting a
direct production-based amortization method, such as units-of-
production, costs are more accurately matched with products
manufactured.
When determining the number of units over which to amortize an
asset, only the planned production of the asset should be
considered. To simply use the asset's total lifetime production
capacity does not solve the problems associated with a time-based
amortization method. Total units used to amortize an asset should
be limited by planned production, product demand, and obsolescence
of the asset's technology or the manufacturing process.
As discussed in activity accounting, the choice of an overhead
allocation method can significantly alter product costing. As
technology costs increase as a percentage of total product costs,
any misallocation will improperly influence management decisions
and possibly the financial results of the company. The GAAP model
should require that direct production-based amortization methods
replace the indirect allocation that results from time-based
methods.
-8-
Life-Cycle Accounting
Life-cycle accounting is defined as "the accumulation of costs for
activities that occur over the entire life cycle of a product, from
inception to abandonment by the manufacturer and the consumer. " (3)
This concept is significantly different from traditional practice.
A primary objective of life-cycle accounting is a better matching
of revenues and expenses. This is achieved by expensing certain
activities based on the total planned number of units to be sold.
Life-cycle accounting also requires separate accounting for the
risk associated with initially deferring the cost of these
activities. Under the traditional GAAP model, this risk is
accounted for by expensing such costs as incurred.
Under life-cycle accounting, all costs that benefit the future and
are pursuant to management's plan are capitalized as incurred.
Requiring costs to be incurred pursuant to a plan before being
deferred is important because this requires expenditures to be tied
to a future product or objective. These costs would include
preproduction costs such as research, development, planning, start-
up, and marketing costs.
Conservatism Distorts the Matching Principle
In the interest of conservatism, the traditional GAAP model
distorts product costs by expensing a major portion of a
product's cost as incurred and before production begins.
Further, many of these product-related costs are expensed below
-9-
the gross margin line and are, therefore, not viewed as product
cost. Many others are included in overhead which is allocated to
current production although this production is neither related to
nor benefits from these expenses.
Accounting for risk by conservatively expensing costs for which a
future benefit is planned also makes it difficult to measure the
success or failure of these expenditures. Significant
investments are made in these activities but the traditional
model does not readily permit the measure of return on those
investments. It also encourages many of these expenditures to be
considered discretionary when success in today's marketplace
requires research, development, and marketing.
Most agree that engineering a product for production is most
efficiently done during its preproduction stage. It is easier
and more efficient to solve problems at that time rather than
after production begins. These preproduction costs directly
impact earnings under the traditional model by encouraging many
products to be prematurely placed into production. Also, by
expensing engineering costs as incurred, the actual cost of a
product is unknown and the product may in fact be selling at a
loss while the company reports a profit.
Traditional accounting theory says that expensing costs as
incurred to account for risk is the correct answer. However,
this theory is not consistently applied. When recovery is
expected, the same theory requires the capitalization of
-10-
goodwill, motion picture production costs, plant additions, and
mineral, oil, and gas rights for which there is a risk that the
full future benefit will not be received. Other areas of
accounting where conservatism does not dominate the matching
principle are:
SFAS 86, Accounting for the Costs of Computer Software To Be
Sold, Leased or Otherwise Marketed, allows costs to be
capitalized once technological feasibility is obtained.
SFAS 68, Research and Development Arrangements, allows
capitalization in certain circumstances of the amount paid for
the results of a known successful project.
SFAS 25, Suspension of Certain Accounting Requirements for oil
and Gas Producing Companies, allows full costing, where many
costs related to unsuccessful efforts are capitalized to be
later matched with revenues generated from operations
generally within the same country.
Program accounting used in the aerospace industry defers
learning curve costs of the first units produced over total
planned production.
Defense contractors capitalize general, administrative,
research and development expenses by inclusion in overhead
pools as recoverable costs.
Completed research and development projects purchased in an
acquisition are capitalized along with the costs of research
and development results that have alternative future uses.
-11-
Risk Accounting
To benefit from improved matching and product costing of life-
cycle accounting, risk can no longer be accounted for by directly
expensing these product costs as incurred. Under life-cycle
accounting all costs that are incurred pursuant to management's
plan and expected to benefit a future period are deferred. A
risk reserve is then established by management to measure the
probability that these deferred product costs will be recovered
through related product sales. The risk reserve should be
charged to income separate from cost of goods sold.
Under this method, additions to the reserve would be charged to
expense and result from the following expenditures based on the
possibility that they will not be realized:
Research and development costs;
Preproduction product costs;
Marketing costs; and
Additional reserves for changes in estimates of prior reserved
amounts.
The reserve would be released as a result of the following
determinations:
Future benefit becoming more probable;
Write-off of deferred expenditure to a realizable amount;
Related products are produced or sold; or
Abandonment of projects.
-12-
Given the numerous reasons why the risk reserve would increase or
decrease, it appears at first it would cause income to fluctuate
unpredictably from period to period. If objective reserves are
established as the risk expenditures are made, subsequent
adjustments should be minimal. Any significant changes should be
related to a specifically identifiable event occurring in a given
year and a change in the reserve would then be expected.
Footnote disclosure of significant changes in the reserve would
give financial statement readers an opportunity to assess the
success or failure of a company's risk expenditures and determine
the return on that investment. Such disclosure is not required
under the traditional model. The traditional model often creates
more unexplained fluctuations in the income statement than the
life-cycle model.
For those who believe risk expenditures should be expensed as
incurred, the life-cycle model still works. If all amounts
previously expended are fully reserved for when incurred,
reported net income would be the same under both models. What
would be gained from life-cycle accounting is more accurate
product costing because the risk would be accounted for
separately from product costs.
An Example of Traditional VS. Proposed Accounting Models
This example demonstrates the significantly different financial
results that occur when technology and life-cycle techniques are
applied as compared to the traditional model. Which model better
reflects the results of operations?
-13-
Assumptions:
Year One - Research and development costs
incurred in search of new products
$ 800
- Given the early stage of
development, a risk reserve is
recorded for all expenditures
Year Two - Marketing study performed for new
product and research and development
completed
400
- Study indicates 3,000 units will be
sold at $15 each and direct
materials and labor will be $5 each
- Marketing plan calls for $4,500 in
expenditures over three years
- Plant, equipment and information
systems purchased with 5,000 unit
capacity and five-year estimated
life
6,000
- No additional risk expenditure
reserve appears necessary based on
marketing study
Year Three Product introduction marketing
2,000
- 500 units produced and sold
2,500
- Due to profitability of new product,
no risk reserve appears necessary
Year Four - 1,500 units produced and sold
7,500
- Routine marketing
1,000
-14-
Year Five - 2,000 units produced and sold,
including 1,000 units more than
management's plan
$10,000
- Marketing related to increased
competition, including $500 more
than management's plan
2,000
Income Statement Under Traditional Accounting Model
YEAR
1
2
3
4
5
Revenues
$7,500
$22,500
$30,000
Costs of Goods Sold:
Direct Costs
2,500
7,500
10,000
Depreciation
$6,000
1,200
1,200
1,200
5 years
Abandoned Plant
2,400
3,700
8,700
13,600
Gross Margin
3,800
13,800
16,400
Research and
Development
$800
$100
Marketing
300
2,000
1,000
2,000
Income (Loss)
($800)
($400)
$1,800
$12,800
$14,400
Gross Margin (%) *
-
-
51%
62%
55%
Income as a
Percent of
Revenues*
-
-
24%
57%
48%
*Fluctuation caused by time-based depreciation method and varied
marketing needs.
-15-
Income Statement Under Proposed Accounting Model
YEAR
1
2
3
4
5
Revenues
$7,500
$22,500
$30,000
Costs of Goods Sold:
Direct Costs
2,500
7,500
10,000
Depreciation
$6,000
3,000 units
1,000
3,000
2,000
Marketing
$4,800
3,000 units
800
2,400
2,100
Deferred Costs
$900
3,000 units
150
450
300
4,450
13,350
14,400
Gross Margin
3,050
1,150
15,600
(Provision for) Benefit
from Risk
Expenditures
($800)
800
Income (Loss)
($800)
$3,850
$ 9,150
$15,600
Gross Margin (%)
-
-
41%
41%
52%
Income as
Percent of
Revenues
-
-
51%*
41%
52%**
*Reflects successful results of risk expenditure.
**Reflects sales in excess of management's plan net of excess
marketing costs.
-16-
A Time for New Proposals
Clearly, there are apparent shortcomings with the traditional cost
accounting model due to the revolution in today's manufacturing
environment. The model was formulated in an era that has all but
vanished. It's time for the accounting profession to adopt new
proposals and make the model a better gauge of manufacturing
realities. New techniques have been proposed that are reflective of
today's manufacturing environment and may better show the results of
management's decisions and better serve users of financial statements.
Perhaps most importantly, these techniques appear to more fairly
present the results of operations.
Dennis E. Peavey, Partner
Coopers & Lybrand
1251 Avenue of the Americas
New York, New York 10020
(212) 536-3286
VOLUME 7 NUMBER 163
MARCH 6, 1989
PAPER 7
DIGEST
INVESTMENT IDEAS FROM THE BEST MINDS ON WALL STREET.
Personal Note:
Spotlight Stock:
PETER LYNCH PART II:
CATERPILLAR: EARTH
THE PERFECT STOCK
MOVER IS "DIRT CHEAP"
Few articles in this publication have generated
J
ames Amold (The Primary Trend, 700 N.
as much positive response as the recent excerpts
Water St., Milwaukee, WI 53202, 24 issues,
from Peter Lynch's upcoming book, One Up On
$180, 2/21/89) remains an adamant bull, despite
Wall Street (Simon & Schuster). Lynch's Magellan
recent market weakness. "The market is certainly
Fund is the top performing mutual fund for the past 10-years,
entitled to a pause and a rest, given the excellent 300-point rally
with a stunning total return of 1,279% for the period. Clearly,
from mid-November to early-February. So far, the pullback has
Lynch's market observations are well worth our attention.
not been much, yet bearish speculators are coming out of the
With this highly-recommended book expected within the next
woodwork, as evidenced by the huge increases in put buying.
month, we thought we would share excerpts from one par-
When speculators in the options market are overwhelmingly
ticularly astute chapter, "The Perfect Stock."
convinced that the market will go down, it is a reasonable
expectation that the next significant market move will be up. We
"Getting the story on a company is a lot easier if you under-
expect the current pause to be well-contained, and limited in
stand the basic business. That's why I'd rather invest in panty
both time and extent. Easy riches will not be garnered by the
hose than in communications satellites, or in motel chains than
frenetic gamblers betting on the downside. The real money will
in fiber optics. The simpler it is, the better I like it. When
be made by patient investors who seek quality and value."
somebody says, 'Any idiot could run this joint,' that's a plus,
Here's the latest featured buy recommendation from Amold:
because sooner or later any idiot probably is going to be
running it. If it's a choice between owning stock in a fine
"Caterpillar (CAT 59 NYSE) is the largest construction
company with excellent management in a highly competitive
machinery maker in the world, with a world-class name. The
and complex industry, or a humdrum company with mediocre
company has two broad product categories: earthmoving and
management in a simpleminded industry with no competition,
I'd take the latter. 'Any idiot can run this business' is one
construction machinery; and gas and diesel engines. During
characteristic of the perfect company, the kind of stock I
1988, sales ($10.4 billion) and earnings set records -- erasing
dream about. You never find the perfect company, but if you
peaks set in 1981. Despite the apparent good news, CAT stock
can imagine it, then you'll know how to recognize favorable
declined some 6 5/8 points or nearly 10% on Jan. 19, the day of
attributes, the most important of which are as follows:
the announcement. As is often the case, the institutional herd
(Cont. on page 2)
on Wall Street has a time horizon substantially shorter than
corporate management's. In this instance, the disappointment
was a realization that CAT will spend 40% more on internal
capital improvements in 1989 than earlier thought, penalizing
STOCKS AND FUNDS IN THIS ISSUE
short-term earnings and the expectations of some investors.
We view the short-term decline in CAT as an excellent buying
Allied-Signal
8
Int'l Paper
7
BankAmerica
Korea Fund
opportunity for several reasons:
4
7
Boeing
8
McCaw Cellular
11
Carmike Cinemas
5
MCI Comm
.5
1) CAT's product lines will benefit from worldwide recovery
Caterpillar
1
Merck
.9
Centel
11
Strong funds
10
trends in capital spending. We expect a lot of dirt to be moved
Chase Manhattan
5
T. Rowe New Horiz.
10
around all over the world, and CAT is in the unique position to
Circuit City
12
United Brands
.4
benefit from that activity particularly in housing, highway
Florida Progress
5
USACafes
9
Franklin Resources
8
Vanguard Index
10
Gemini II Capital
10
Vermont American
.3
General Motors
3
Vitalink
6'
(Cont. on page 8)
Gabelli Equity
10
Waste Management
.9
Page 1
(1) The perfect company has to be engaged in a perfectly
jewelry business. If you're in the jewelry business, you're
simple business, and the perfectly simple business ought to be
competing with other jewelers from across town, across the
perfectly boring. The more boring it is, the better. Processing
state, and even abroad, since vacationers can buy jewelry
paychecks, which is what Automatic Data Processing does, is a
anywhere and bring it home. But if you've got the only gravel
good start. That it has a dull name is even better. Pep Boys:
pit in Brooklyn, you've got a virtual monopoly, plus the added
Manny, Moe, and Jack is the most promising name I've ever
protection of the unpopularity of rock pits.
heard. It's better than dull, it's ridiculous. Who wants to put
money into a company that sounds like the Three Stooges?
(7) I'd rather invest in a company that makes drugs, soft
(2) I get even more excited when a company with a boring
drinks, razor blades, or cigarettes than in a company that
makes toys. In the toy industry somebody can make a wonder-
name also does something boring. Crown, Cork, and Seal
makes cans and bottle caps. What could be duller than that?
ful doll that every child has to have, but the parents only buy
one. Eight months later that product is taken off the shelves to
You won't see an interview with the CEO of Crown, Cork, and
make room for the newest doll the children have to have
Seal in Time magazine alongside an interview with Iacocca, but
manufactured by somebody else. Why take chances on fickle
that's a plus. A company that does boring things is almost as
purchases when there's so much steady business around?
good as a company that has a boring name, and both together
are terrific. If a company with terrific earnings and a strong
(8) There's no better tip-off to the probable success of a
balance sheet also does dull things, it gives you a lot of time to
stock than that people in the company are putting their own
purchase the stock at a discount. When it becomes trendy and
overpriced, you can sell your shares to the trend-followers.
money into it. When insiders are buying like crazy, you can be
certain that, at a minimum, the company will not go bankrupt
in the next six months. Long term, there's another important
(3) Better than boring alone is a stock that's boring and
benefit. When management owns stock, then rewarding the
somehow disgusting at the same time. Something that makes
shareholders becomes a first priority, whereas when manage-
people shrug, or turn away in disgust is perfect. It's hard to
ment simply collects a paycheck, then increasing salaries
think of a more perfect industry than waste management. Now,
becomes a first priority. If the stock price drops after the
if there's anything Wall Street would rather ignore besides toxic
insiders have bought, so that you have a chance to buy it
waste, it's mortality. Service Corp. Int'l does burials. Despite
cheaper than they did, so much the better for you. Buying back
an incredible record, the SCI executives had to go out on
shares is the simplest and best way a company can reward its
cavalcades to beg people to listen to their story. That meant
investors. If a company has faith in its own future, then why
amateurs in the know could buy stock in a proven winner with
shouldn't it invest in itself, just as the shareholders do?
a record of solid growth in earnings, and at much lower prices
than they'd have to pay for a hot stock in a popular industry.
Many people prefer to invest in a high-growth industry, where
The greatest company of all fictitious, of course - would
there's a lot of sound and fury. Not me. I prefer to invest in a
have to be Cajun Cleansers. Cajun Cleansers is engaged in the
low-growth industry like plastic knives and forks, but only if I
boring business of removing mildew stains from furniture, rare
can't find a no-growth industry like funerals. That's where the
books, and draperies that are victims of subtropical humidity.
biggest winners are developed. In a no-growth industry, espe-
It's a recent spinoff from Louisiana BayouFeedback. Its
cially one that's boring and upsets people, there's no problem
corporate headquarters are located in the bayous of Louisiana,
with competition. You don't have to protect your flanks from
and to get there you have to change planes twice, then hire a
potential rivals because nobody else is going to be interested.
pickup truck to take you from the airport. Not one analyst from
New York or Boston ever visited Cajun Cleansers, nor has any
(4) Spinoffs of divisions or parts of companies into
institution bought a solitary share. Mention Cajun Cleansers at
separate, freestanding entities often result in astoundingly
a cocktail party and soon you'll be talking to yourself. It sounds
lucrative investments. Large parent companies do not want to
ridiculous to everyone within earshot. No popular magazines
spin off divisions and then see those spinoffs get into trouble,
except the ones that think Elvis is alive have mentioned Cajun
because that would bring embarrassing publicity that would
or its product patents. The stock opened at $8 in a public
reflect back on the parents. Therefore, spinoffs normally have
offering seven years ago and soon rose to $10. At that price,
strong balance sheets and are well-prepared to succeed as
corporate directors bought as many shares as they could afford.
I hear about Cajun from a distant relative who swears it's the
independents. Spinoffs are often misunderstood and get little
attention from Wall Street - a favorable omen for the stocks.
only way to get mildew off leather jackets left too long in dank
closets. I do some research and discover that Cajun has had a
(5) If you find a stock with little or no institutional owner-
20 percent growth rate in earnings for the past four years, it's
ship, you've found a potential winner. Find a company that no
never had a down quarter, there's no debt on the balance sheet,
analyst has ever visited or that no analyst would admit to know-
and it did well in the last recession. I visit the company and find
ing about, and you've got a double winner. When I talk to a
out that any trained crustacean could oversee the making of the
gel. The day before I decide to buy Cajun Cleansers, noted
company that tells me the last analyst showed up three years
economist Henry Kaufman has predicted that interest rates are
ago, I can hardly contain my enthusiasm.
going up, and then the head of the Federal Reserve slips on the
(6) I always look for niches. The perfect company would
lane at a bowling alley and injures his back, both of which
have to have one. I'd much rather own a local rock pit than a
combine to send the market down 15 percent, and Cajun
Cleansers with it. I get in at $7.50, which is $2.50 less than the
movie company, which has to compete with other movie
companies. Certainly, owning a rock pit is safer than owning a
directors paid. That's the situation at Cajun Cleansers. Don't
pinch me. I'm dreaming."
Page 2
Dick Davis Digest
CATERPILLAR
(CONT. FROM PAGE 1)
FIXED-INCOME DOUBLE PLAY
spending, commercial and industrial construction, and mining
"Franklin Resources (BEN 26 NYSE), with $37 billion of
activities. The firm will also benefit from a resurgence in
assets under management, is one of America's premier
agriculture and in the petroleum industry. Importantly, we
management companies," says The Callard Report (PO Box
also believe that the warming of U.S./Soviet relations, the
3000, Denville, NJ 07834, 24 issues, $450, 2/16/89). "The
industrial expansion of China and other Far East countries,
company has been very versatile through its history, including
and the relaxation of tensions in the Persian Gulf area hold
great success in gold and other precious-metals funds in the
promise for significant sources of future demand. 2) CAT
1970s. Today, the fund is heavily oriented to fixed-income
possesses a significant asset in its worldwide dealer network,
funds. The largest funds, which account for 73% of managed
which will ensure a competitive advantage both in domestic
assets are Franklin's Government Securities, California and
and foreign markets. The lower dollar, plus aggressive cost-
New York tax-free, and federal tax-free funds. The company
cutting, has restored the CAT's position as the industry's low-
has a very strong market franchise. Its funds are well-known
cost producer and price leader. 3) CAT is in the midst of a
and the firm has excellent relations with the brokers and
major cost-reduction and modernization program. Designed
dealers who distribute them. In 1988, BEN was the top selling
to reduce costs by approximately $1.6 billion below levels of
outside fund group for Merrill Lynch. In a climate of declining
the mid-1980s, the cost of the six-year program (1987-1992)
interest rates, the bond holdings of BEN's funds will rise,
will approximate $600 miilion. As costs of this reorganization
carrying fee income up. In addition, a climate of rising stock
wane in 1991, profits should accelerate as the benefits of these
and bond prices will stimulate added investor purchases. Thus,
programs materialize. 4) From the $6.07 earned per share in
there is a double-play benefit for Franklin in a positive invest-
1988, Catepillar has the potential to double earnings per share
ment climate. The company earned $2.51 a share in 1988, up
by 1991-1992, as the benefits of rising demand and cost cutting
15% from 1987. Forecasts call for $2.75-$2.90 a share in 1990.
are realized. In 1989, we expect earnings of $6.50-6.75 per
In 1987, the stock traded in the low 40s. A strong market
share; in 1991-1992, earnings of $10-15 a share are a definite
climate could easily carry BEN to new highs by year-end."
possibility. 5) As investors look to participate in capital goods
and export-related industrial stocks, a 'scarcity value' exists
there are few high quality, large cap issues. Reflecting this,
ALD: UNPOPULAR AND MISUNDERSTOOD
CAT has historically sold at a P/E premium to the general
market. Currently, the P/E is at an approximate 15% discount
"Our favorite rule for investing is 'Buy ignored, misunderstood
relative to the general market. In all, the stock is dirt cheap
stocks when they are cheap relative to sales, book value, cash
selling at the lower end of its historic valuation range for the
flow, earnings, and dividends," says The Value-Income Investor
last 15 to 25 years. We expect Caterpillar to be a big mover
PO Box 2151, Winter Park, FL 32790, 24 issues, $200, 2/17/89).
down the road, and recommend purchase up to a limit of 65."
"One stock that definitely meets this criteria is Allied-Signal
(ALD 35 NYSE). In 1983, Allied, then Allied-Chemical,
acquired Bendix Corp. In 1985, it merged with Signal. In 1986,
DESPITE TRAGEDY, BOEING'S A BUY
Allied spun off 35 subsidiaries, know as The Henley Group.
Criticized in the past for wasteful spending, ALD is attempting
"In light of the recent United Airlines 747 incident, we feel it is
to mend its ways and is now well-positioned in its various
timely to reiterate our buy recommendation on Boeing (BA 61
markets. The company has a strong presence in aerospace,
NYSE)," says Michael Rosen of Drexel Burnham Lambert.
supplying wheels and brakes to Boeing, McDonnell Douglas
"The 747 involved was over 18 years old one of the oldest in
and Airbus. The firm's auto segment is one of the leading
United's fleet. This will likely re-raise the 'aging-of-the-fleet'
suppliers of car and truck braking systems and turbochargers.
issue and increase our conviction of an extended aircraft cycle
The company spent over a billion dollars on research in 1987.
due to replacement aircraft requirements. Despite our
Allied recently received a patent for a new substitute for Freon
projections for a domestic recession in 1990, we do not feel
in auto air conditioners. This environmentally safe product
production rates at Boeing will be negatively impacted, as
could be a significant breakthrough. The firm has also
fleets need to be modernized and foreign demand remains
developed a new material ten times stronger than steel, which
strong. Investors should be reminded that the 1988 Aloha
can be used in bulletproof vests, military helmets, and armored
incident, when part of the top structure came off an aircraft,
cars. Earnings peaked in 1984 at $5 and have since fluctuated
led to a surge in new orders for Boeing. Based on current
around $3 per share. Earnings are estimated in the $3.60 area
production rates, BA already has a 3 1/2 year backlog for 747-
for 1989, up 16% from 1988's $3.10 per share. We believe that
400s. These aircraft are the company's most profitable line.
Allied's highly-publicized past problems are overshadowing
Our earnings estimate for 1989 remains $6.25 a share, with
the company's vast future potential. Further, we note that if
$7.50 expected in 1990. Our 9 to 12 month price target, given
Allied continues to flounder, its strong asset value and low
our outlook for a static overall stock market, is the mid $70s."
valuation make it vulnerable to a takeover. Buy."
Page 8
Dick Davis Digest
PAPER 8
YORK TIMES MONEY SUNDAY, JANUARY 21, 1990
F
15
Wall Street/Diana B. Henriques
New Faith in Old Money
LD money. America has always been
said Dirk Junge, vice chairman of the Pit-
fascinated by family wealth, rooted in
cairn Group and one of the PPG heirs. "When
some corporate bedrock and carefully
The Family Factor
a family firm is good, it is very, very good.
handed down from one generation to the next.
1,400%
But when it is bad, it can be more terrible
Perhaps the volatility of today's market-
than you could ever imagine."
place has heightened the vague sense that
Cumulative return,
Family discord, inept heirs who take on
inherited wealth is somehow more. stable
assuming dividend
more than they can handle and self-indulgent
than the cash flashed around by leveraged
reinvestment, in
1,200
owners who live high at the company expense
millionaires. In any case, men who were
percent.
are just some of the sins that can befall the
branded robber barons by their 19th century
family firm. So the analysts sifted further to
contemporaries are now cited as the heroes
29
1,000
find family firms that displayed the hall-
of a golden age before Wall Street became
Pitcaim
marks of managerial discipline: low debt,
obsessed with quick profits.
Choices
good cash flow, reinvested earnings, thought-
800
ful capital spending and fat profit margins.
The result is a portfolio of 29 stocks in
Nostalgia is notoriously myopic, of course,
which the Pitcairn Group has taken an in-
and the past had its fair share of short-
132
vestment stake. And Pitcairn research shows
sighted entrepreneurs and fast-buck invest-
Family
600
that its choices, based on historic data, have
ors. But some intriguing research by the
Controlled
outpaced both the S.& P. 500 and the larger
Pitcairn Financial Management Group, a
Public
roster of family-controlled firms.
small financial services firm in Jenkintown,
Companies
400
Pa., suggests that there may be more than
just wishful thinking behind the notion that
There are other wrinkles in the group's
family wealth is somehow special. This re-
200
stock selection strategy, too. For example,
search indicates that public companies domi-
the Pitcairns like the Walton family's firm,
nated by a single family may be much better
Wal-Mart, but for a different reason than
long-term investments than the modern cor-
most of its fans. "When you have a family-
poration run by professionals and owned by a
0
controlled company in an industry that is not
host of passive pension funds.
'79'80 '81 '82 '83 '84 '85'86 '87 88 '89
generally family-controlled, the family firm
To be sure, the researchers may have had
has a really tremendous advantage," ex-
Source: Fitcairn Financial Management Group
a slight bias in favor of family firms. Pitcairn
plained D. Mark Cunningham, an assistant
Financial Management Group began life in
vice president. "You can see that difference
The New York Times/Jan. 21, 1990
1923 as the "family office" providing invest-
between Wal-Mart and K-Mart."
ment and tax administration services to the
shares and have managerial control.
A less familiar stock that the Pitcairns
heirs of John Pitcairn, the co-founder of
The resulting roster is an idiosyncratic
have included in their portfolio is Hubbell
Pittsburgh Plate Glass, now PPG Industries.
mix of household names and obscure compa-
Inc., the electronics company that grew up
While the firm is still owned by the family
nies in industries ranging from long-haul
from founder Harvey Hubbell's invention of
and serves a host of Pitcairn offspring,
trucking to pizza retailing to shampoo. The
the pull-chain electric light switch. For al-
stretching to the fifth generation, its officers
Fords, the Belzbergs, the Chandlers and the
most three decades, Hubbell has reported
decided 18 months ago to sell its services to
DuPonts are there. But so are the Carvers
consistently higher operating earnings, said
outsiders, chiefly to other well-endowed fam-
(Bandag Inc.), the Ueltschis (Flight Safety
David Lawson, the portfolio strategist for
ilies, provided they have liquid net worth of
International), the Sobeys (Hannaford Bros.)
Pitcairn. "It has a very, very strong balance
at least $10 million.
and the Kriebels (Loctite Corporation).
sheet, and has been a consistent generator of
The focus on family is more than a market-
excess cash," he said. In a market where
ing gimmick; it is the heart of the Pitcairn
investors are very jittery about the reliabil-
Group's investment strategy. After diversi-
After identifying this set of family firms,
ity of corporate earnings, he added, "this is a
fying out of the family's PPG holdings in the
analysts at the Pitcairn Group compared those
'sleep-well-at-night' kind of stock."
mid-1980's to give the family greater liquid-
companies' performance to the S.& P. 500 over
To keep the Pitcairns sleeping soundly, Mr.
ity, the company decided to put its equity
the past two decades. The results were impres-
Junge said, the investment committee con-
investments to work in the same vineyard
sive: The family firms beat the broader meas-
stantly watches for any sign that the family
where the family's own wealth was cultivat-
ure in both bull markets and slumps. In 1986,
fabric underlying portfolio companies is
ed: family-dominated companies.
for example, the annual return of the family
fraying. "If there is divisiveness or a dissi-
To guide their investment policy, the firm
firms was 27 percent, compared with a 19
dent factor in the family, there can be a very
used the Pitcairn family's connections, schol-
percent gain in the S.& P. 500. And in 1987, when
mixed agenda presented to the company in
ars and lots of old-fashioned research to
the October crash cut the return-on-the S.& P.
terms of its direction and its long-term com-
identify a universe of 132 publicly traded
500 to a scant 3. percent, the family firms'
mitments," he said. That could prompt the
companies where, wealthy family owners
annual return was 11 percent.
Pitcairns to sell. Otherwise, he said, "the
hold at least 10 percent of the outstanding
"But a family stake alone isn't enough,"
family is the ultimate long-term investor.'
PAPER 9
IS ACCOUNTING STANDING IN THE WAY OF
FLEXIBLE COMPUTER INTEGRATED MANUFACTURING? -
A NATIONAL PERSPECTIVE
INTRODUCTION
Current accounting practices are having a negative impact on the
ability of small companies 1) to justify moving to advanced
manufacturing, 2) obtain adequate financing for the move, 3)
operate modern processes effectively, and 4) do business with the
Department of Defense. This serious condition requires national
attention. Accounting practices will have to be modernized to meet
the new realities.
The key elements of competitiveness for manufacturing companies in
many of today's global markets are quality, life cycle cost, just-
in-time delivery, and the ability to rapidly change product.
Flexible Computer Integrated Manufacturing (FCIM) provides the
capability to meet these criteria, if effectively applied in the
context of a company's total business operation. However, current
accounting practices do not recognize these new key elements of
competitiveness; they are considered intangibles and do not
"quantify" easily. Thus, justification of investment in advanced
manufacturing is often a leap of faith. After the fact, on the
basis of reported operating experience, it may be considered a
mistake. These management accountanting limitations provide a
major barrier to FCIM adoption, especially for small firms which
have to rely on conventional financing sources.
FLEXIBLE COMPUTER INTEGRATED MANUFACTURING
There are two striking economic characteristics of a factory that
makes extensive use of current FCIM technology.
Startup Costs -- The first characteristic is the large startup
costs in relation to modest operating costs. This characteristic
applies to the initial facility, each enhancement, and each new
product to be made. In an FCIM environment determining the
manufactured cost of an individual part involves allocating large
one-time costs and overhead, far more than measuring direct costs.
Put another way, the costs of FCIM facilities are driven or caused
by actions taken independently of, and frequently long before, the
decision to produce a particular batch of parts.
In addition to the planned startup costs, there may also be events
1
The views expressed here are solely those of the authors, and
do not represent the views of the Department of Commerce or the
Technology Administration. Pursuant to section 105 of title
17, United States Code, copyright protection is not available
for this work.
that produce unplanned additional startup costs. These events
typically occur when the various components of hardware and
software, obtained from different sources, are brought together to
work as a single system. These events may produce cost overruns,
or, less obvious but equally serious, shortfalls from planned
capabilities where too much was paid for what was obtained.
Retained Knowledge -- The second characteristic stems from the
ability of an FCIM facility to learn how to perform a series of
operations. Because the facility can remember and build a
repertoire of all that it has done, the cost to make a repeat batch
of parts can be far less than the cost of the first batch.
Similarly, developing a new part as an adaptation of a previously
produced part may cost much less than starting from scratch. The
more the facility knows how to produce, the lower the cost of
adding to its repertoire. Most of the repertoire is in computer
software and NC data that can be kept in confidence, duplicated,
shared, or sold. Yet the value of this knowledge base is not
captured in any existing accounting reports.
ECONOMICS OF A FCIM
Each of the following five primary elements of cost of an FCIM
facility are driven or caused by specific decisions, most of which
are made long before any routine production runs:
1. Capital Equipment -- Except for the building, the facility's
largest investment is in the machinery comprising the original
cell. The CAD system hardware is a relatively minor investment.
The equipment will be depreciated on the basis of anticipated
useful life, residual value, number of shifts of use, and expected
use rate per shift. It is easy to show how legitimate but
different choices among these factors could lead to a range of
hourly charges from X dollars to 10x dollars for a particular
machine. Selecting these factors are among the most critical
decisions to be made in justifying and measuring an FCIM facility.
If, for example, the equipment is depreciated on the basis of a one
shift operation, the depreciation charged to its products will be
three times greater than if a three shift operation is planned.
But if machine time is priced on the basis of three shifts and that
level is not reached, the facility will appear to run at a loss
which anticipated. might have been avoided had a lower use factor been
2. System Software -- The computer software necessary to link the
cell machines with the control computer and link the control
computer to the CAD computer is often a mix of purchased software
products and individually tailored programs. This software must
2
be operational before the facility begins production, and if it is
developed entirely on site, its cost could approach the cost of the
equipment. Normal accounțing practice and tax laws call for this
software cost to be treated as an expense as it is developed, even
though it is for use in future periods. Selecting, developing, and
controlling the initial cost of system software is second only to
hardware in its effect on the eventual costs of FCIM products.
3. Product Technology -- Once the equipment and system software
are operational, the cell must be programmed or "taught" how to
make each type of part. Special hardware may be needed and one or
more pilot runs may be necessary to test and improve the process.
In this analysis, we are calling the combination of steps needed
to make a new part or family of parts, "product technology". Each
decision to create new product technology is a cost driver. We
would include the setup for the initial or test batch as part of
the cost of new product technology, as opposed to the costs of
routine setups for subsequent batch runs which are operating costs.
The cost of creating product technology includes the following
three items:
(1) Software and NC Data -- There are several ways to instruct the
cell, ranging from developing the design of a part through the
CAD process to putting a robot in a learn mode and manually
guiding it through its paces while it creates its own code to
repeat what it is being taught. In general, the more this
form of programming can build on programs, codes, and data
part. already in the system, the lower the cost for a new type of
(2) Special Tools, Jigs, and Fixtures -- The efficiency of
repetitive process can often be increased by using hardware,
such as special cutting tools or devices, to hold the work.
Decisions to make and use this hardware are usually a function
of inventiveness, cost of the hardware, and anticipated
savings. With FCIM systems, there may be tradeoffs between
using special hardware or developing software.
(3) Testing and Debugging -- While computers bring new economies
and predictability they also bring new opportunities to make
mistakes. Each time product technology is developed for a new
type of part, it may have to be tested and perhaps modified
before it can be used for production.
4. Operations -- By some estimates, upwards of ninety percent of
the cost of making a part with FCIM may be committed before
production starts. While there is little of the direct labor that
characterized earlier manufacturing, a factory does cost something
to run. Here are four examples of costs which can be measured and
3
may, product. to varying degrees, be attributed directly to the specific
(1) Routine Batch Setup -- Traditional manufacturing attempts to
use long production runs to minimize setup costs. One of the
advantages of FCIM is low setup cost for economical production
of short runs. (An FCIM cell may be less efficient for long
runs than more specialized equipment designed for sustained
performance of a few operations.) It may be possible to
schedule the cell to make sequential batches of similar parts
so that little time is spent shifting from one batch to
another, but some machine time and labor will probably be
needed for most setups. These times and costs are measurable
and may be attributed directly to specific batches,
particularly if they include adding or removing special
hardware. Once the product technology to make a part is
fixed, there are two cost drivers for each batch setup. The
first is the decision to order the batch, and the second is
when it is scheduled in relation to other jobs. Other things
being equal, schedule driven costs may be saved if orders
provide enough lead time to optimize setup activities.
(2) Production -- The direct costs of production are relatively
easy to measure. Material, abrasives, lubricants, and tools
may be consumed directly. If the cell is attended, there is
direct labor. Electricity can be metered, though judgment may
go into setting the rate to charge. These costs are driven
by the quantity, type, and production processes for the parts
rather than the number of batches.
(3) Maintenance -- Maintenance costs can be driven by the passage
of time, operating hours, types of operation, abuse, and
unanticipated failures. Examples of these are:
(a) Routine -- Lubrication, checking and adjusting for wear,
and reviewing computer driven self-diagnostic tests are normal
maintenance procedures that are intended to prevent costly
equipment failure. They can be measured easily, but judgement
is needed in allocating them to individual production runs.
(b) Tool Wear and Replacement -- Cutting tools need to be
sharpened or replaced, and if desired, computer records can
decisions on what types of tools to use and how fast to feed But
trace their use to individual production batches.
them can be important. Both the volume of production and the
choice of process can be cost drivers.
(c) Specific Use Factors -- Some products may require more
of a machine's capabilities or cause more: rapid deterioration
4
than others. A worn machine may be able to hold to wide
tolerances but not meet more demanding requirements. It
appears that Japanese firms run machines below their rated
capacity, to limit wear. Thus, the type of use may drive some
maintenance costs, while actions to avoid wear can lead to
increased production time.
(d) Unusual Events -- Sooner or later, most machines break
down or need unscheduled maintenance. Although normally hard
machine is used.
to predict, these events may be caused by abuse or the way the
(4) Education and Training -- By training, we mean teaching people
how to operate the equipment and software to make products.
By education, we mean helping managers as well as technical
people expand their abilities to think. Running a company
that uses FCIM successfully requires new ways of thinking.
Both education and training can involve initial and continuing
costs, all of which are intended to improve future performance
and are hard to link to specific products.
(5) Other Factory Overhead -- Most of the ongoing operating costs
of the facility will be treated as overhead. These include
space charges, heat, light, fire protection, insurance,
materials handling outside the cell, purchasing, financial
operations, management, and the cost of money. It is
important to understand the significance and causes of these
costs, but they will normally not be driven by decisions to
use the cell itself.
THE FCIM ACCOUNTING PROBLEM
Up to this point, we have alluded to product costs as if they were
readily determinable. Unfortunately, this is not quite so.
The accounting problems of FCIM systems are caused by:
The way standard accounting practice treats some of the large,
early expenditures.
The sales. long delays between the expenditures and the resulting
The way accounting systems treat various types of knowledge.
The difficulty of relating expenditures to specific sales.
The way accounting systems combine current direct costs with
5
apportionments of previous expenditures.
O
The tendency of accounting systems to ignore other critical
information that are not collected in financial terms.
1.
Early Expenditures -- Standard accounting practices requires
a company to record as current expenses, the expenditures it must
make to develop computer software, program FCIM equipment to make
its current products, do strategic market analysis, develop new
products, train its people, and make other provisions for the
future. The effects of this treatment of strategic costs are to:
(a) Reduce reported current profits and report the company as
being in a poorer position than it would have been had it not
provided for the future. This lower reported profit may,
therefore, act as an incentive not to modernize.
(b) Lose track of these early strategic costs when they are
incurred. There is a cross-period subsidization and the true
costs of future production are understated.
2. Long Delays -- Regardless of whether modernization
between outlays and the sales-produced revenue has two effects:
expenditures are treated as investments or expenses, the time lag
(a) The risk of not recovering the expenditures may be large.
(b) The cost of capital during the period of negative cash flow
elements of the cost of modernization.
becomes important to the point of being one of the largest
the research and development necessary to make new products, train
3. Accounting Treatment of Knowledge -- When a company pays for
technology, it is investing in knowledge. Because accountants do
its people, or develop a repertoire of computer-encoded production
knowledge, as an easy way out they assign it a value of zero.
not know how to (accurately or precisely measure the value of
An effect of this is illustrated in spare parts inventories.
Although treated as an asset on a company's books, most companies
strive to reduce parts inventories to minimize risk, reduce
carrying charges, and apply the just-in-time concept. One to
the knowledge of how to produce in an FCIM computer. When this is
reduce these inventories is to simply do away with them and way keep
done, the repertoire becomes in effect an infinite inventory with
no risk or carrying charges on inventory. But on the company's
books, the physical inventory, which was an asset of value, is
replaced with the repertoire which is treated as having no value.
Yet we can envision the time when small companies are bought and
6
sold for the value of their repertoires.
4. Relating Costs to Sales -- In its early days, accounting was
largely a process of relating labor and material costs to
particular jobs and to the sales receipts from those jobs. As
centralized activities such as purchasing and accounting grew, and
more capital equipment was used, these costs were pooled and
charged to production through an overhead rate, usually as a
percentage of direct labor. Today, with FCIM, direct labor costs
have declined almost to the vanishing point and most of the costs
base! are what used to be treated as overhead. Yet there is no labor
5. Mixing Current Direct Costs with Apportionments of Previous
Expenditures -- The typical factory cost accounting system treats
labor, material, and depreciation as similar costs. A ten dollar
hourly use charge based on a schedule to recover the purchase price
of a machine over many months is treated as being equal to ten
dollars worth of material just purchased. For making operating
decisions about how to make a product, the two are not comparable.
The machine was bought and the money is gone. Purchasing material
creates a new out-of-pocket cost, while the real cost of using an
otherwise idle machine may be negligible. The normal accounting
approach overstates the real cost to process something with capital
equipment, and can lead to buying more expensive, pre-processed
material to reduce the use of an already under used machine.
The typical cost accounting system also ignores the interest cost
of unrecovered money used to buy capital equipment. Thus, by
overstating the true cost of processing and understating the
continuing cost of idle capacity, accounting systems can lead to
wrong cost estimates, wrong decisions on what orders to accept, and
mistakes in weighing tradeoffs among processing alternatives.
Accounting experts are currently developing what they call
"activity based accounting" which measures various support costs
like accepting an order, purchasing material, stocking material,
shipping, etc., and traces them directly to decisions such as the
acceptance of an order. This work will help users of FCIM, but
some fundamental problems will still remain. These include:
(a) Only direct costs such as material are proportional to sales.
The startup costs of pre-production years have no relationship
to sales at all. Even though these expenditures for computer
software, employee training, factory rearrangement, etc. are
made to obtain future sales or reduce future costs, they are
treated as expenses when incurred because they do not yield
tangible assets of readily determinable value. Normal
accounting practices does not allow a company to shift its
7
expenses from prior years into current accounts.
(b) A firm can charge depreciation on the basis of use, making it
more parallel to the direct variable costs. This would be
managerially sound, but if this approach is used to calculate
profits while accelerated depreciation is used for tax
purposes, the minimum income tax provision may come into play.
(c) The choice of number of hours of planned use for the system
can be as important as the choice of the depreciation
schedule. Any formula for computing hourly costs or charging
rates has a dollar figure as the numerator and number of hours
over which the dollars are to be spread as the denominator.
(d) Defensible choices for depreciating capital investments can
vary by an order of magnitude, while prior period strategic
costs simply disappear from view. Thus product "cost" is no
longer a function of measurement, and instead has become a
function of company strategy.
(e) While major corporations can use complex accounting systems
such as Activity Based Costing to determine product costs,
there is a scale factor that prevents small companies from
using similar systems.
(f) Finally, the only point at which the one-time strategic costs
and capital investments can be controlled is when the
expenditures are being made. Although these expenditures will
determine the bulk of a company's product costs for years to
come, most accounting systems tend to ignore them and
concentrate on today's routine, repetitive operations that are
of decreasing importance.
6. Other Critical Information -- Advanced manufacturing is
becoming increasingly dependent on quantifiable information other
than dollars. The measures used in statistical process control,
product reliability, and short run setup times are examples of
information that may be more important to factory operations than
typical cost numbers, yet what they measure have a major effect on
bounds. costs. Accounting will have to be extended beyond its traditional
THE IMPORTANCE OF PROPER ACCOUNTING
The importance of the FCIM accounting problem for small businesses
can system. be seen in terms of two of the functions of an accounting
(a) Relate how funds are used to the incomes received to measure
8
changes in inventories and profit or loss. We have shown how
it is impossible to relate much of the outflow of funds
directly to resulting sales. Instead, actions taken to
benefit future operations are treated as current expenses
which detract from profit when they are incurred. For firms
and managers measured on the basis of their quarter-to-quarter
and year-to-year profitability, this can provide a strong
incentive not to undertake FCIM systems.
It may be hard to prevent allowing the initial years that bore the
startup costs from subsidizing future years. As sales and expenses
are reported in normal financial statements, a company might appear
take bff, but on a cumulative cash flow basis, the breakeven point
profitable shortly after its sales of FCIM manufactured products
is probably much later. Because of subsidization by the startup MARGIN
years, a company could be made to run at an indicated profit each
year after startup and never reach the cash flow breakeven point
before the system is scrapped.
(b) 'Help managers make decisions regarding products, prices, and
costs to attain successful operations. So far, we have been
primarily discussing sales and total costs of a company using
an FCIM system, but operating decisions are made for
individual jobs or increments--not the totals. In simpler
times, records for each job would show profit or loss by
customer, job type, or individual job. From this information,
control costs.
sound decisions could be made on what work to seek and how to
A prime advantage of an FCIM system is its ability to produce
short runs of many different parts. But if each run is
sale, how does a company determine what orders to accept and a
what price to charge to yield a desired profit if it can't
determine its cost to make the run? Further, while each
initial run of a product involves preparatory work that need
not be done for subsequent runs, how does a firm estimate the
number of production runs to use as the basis for spreading
the preparatory costs? How does it decide what new products
to make, or choose its mix of new products and repeat runs?
CONTROLLABLE AND CONTINGENT COST DRIVERS
with literature. The idea is to identify the activities that cost money
The term "cost driver" is increasingly popular in cost accounting
greater accuracy and sensitivity to cause and effect. This
paper emphasizes the importance of startup costs to the success of
an FCIM system. Startup cost drivers can be divided into two
9
categories:
(a) Controllable Cost Drivers -- individual activities or
decisions that lead directly to planned expenditures, and
(b) Contingent Cost Drivers -- the interaction, often delayed,
costs. among individual actions or decisions that lead to unexpected
Ordering a piece of equipment is a controllable cost driver, as is
ordering software to use with it. Finding that the equipment and
software are not compatible and the subsequent actions taken to try
drivers. to recover from the unanticipated problem are contingent cost
The concept of "contingent costs" a thought normally restricted
to expenses such as bad debts in most accounting texts--may be
important to establishing FCIM systems. To be successful, these
systems require people and organizations to do things right the
first time, things they may not have done before. A single,
runaway contingent driver can increase the cost of an FCIM system
to the point where it may never be profitable. By the time
already have been done.
accounting reports indicate the problem, most of the damage will
REPLACE
WITH
We are developing an FCIM System Planning Chart to help
INSERT 1
organizations develop their management processes In its present
form, the chart indicates 43 events--from writing the initial
concept paper to completion of the first production batch. The
events are organized by five streams of activity for Marketing,
Product Design, the CAD CAM Design and Instruction System, the FCIM
Equipment, and the Facility. Twenty of the events are identified
directly related to producing a specific product.
as controlla cost drivers, and of the twenty, only 6 are
An additional 5 events, where different lines of activity come
together for testing, are identified as contingent cost drivers.
If work up to these points has been done well, the tests will be
almost cost-free. But if mistakes have been made, these are the
points where problems will be most likely to surface. Because they
are not routine, companies find the costs produced by these
contingent drivers are difficult to predict and control.
Companies might formally budget amounts for each of the contingent
cost drivers they can identify. This would underscore the
them may lead to actions that minimize them.
contingency aspect of the possible costs, and just thinking about
(The FCIM System Planning Chart is too bulky to include with this
10
paper and is subject to frequent revision. Draft copies are
available on request.
PROVIDING FOR THE FUTURE
Some expenditures, particularly for research and development or
employee training have long presented an accounting problem. The
objective was clearly provision for the future, but since knowledge
and capability are not tangible, there was usually no result to
call an asset. The problem was handled two ways. First, in even
the most progressive companies, these expenditures were usually
modest in relation to overall operations and they tended to occur
at a relatively constant rate SO they were not much of an issue.
Second, providing for the future was viewed as a continuing
operational requirement for staying in business- thus the problem
was defined away. Over time, the performance of companies with
continuing R&D and training programs tended to be recognized by the
investment community, and they were often accorded higher price-
earnings ratios for their stocks.
Today, more than ever before, companies must develop new technology
or create manufacturing capabilities that require a surge in
outlays which accounting conventions treat as a current expense.
These provisions-for-the-future expenses become merged with routine
operating expenses on the P&L Statement in a single path that leads
from Sales to Changes in Earned Surplus. A bold program for the
future can thus appear as mismanagement. The accounting
conventions, intended to provide a conservative view of the
company, when coupled with the normal P&L Statement, become a
ADD
perverse measure and an incentive not to modernize.
INSERT 2
CUMULATIVE CASH FLOW ACCOUNTING
Several people are working on an idea based on cumulative cash flow
that may provide small companies with a watershed opportunity to
has become more a function of strategy than measurement, then the
simplify their accounting problem. If, as we believe, accounting
basis for evaluation.
strategic plan or multi-year budget of a company may be the best
Under this notion, only two sets of numbers really matter from an
operating management standpoint--the cumulative outlays and the
cumulative receipts. Concentrating on these two numbers and how
decisions affect them, would show whether a company is doing what
it undertook to do in the same way a lender looks at the company.
To illustrate the idea, when a company decides to convert to FCIM,
it would make a cumulative cash flow projection for several years.
This projection would show the planned cumulative outlays,
11
receipts, interest costs and profit by the end of the projected
period--let's say five years. As the company makes startup
expenditures, it would relate the cumulative outlays, the passage
of time, and what is accomplished to the projection. As production
to the plan.
starts and sales begin, the cash flow effects would to be compared
During any period, if the accomplishments and the net cash flow is
on target, the company would have attained the anticipated goals.
A variance between the anticipated net cash flow position and
accomplishments would be shown as a profit or loss.
These ideas are preliminary. They will not satisfy all
requirements for an accounting system. But they may be useful for
guiding the internal operating decisions of a small company. Their
ideas are presented as an example of the type of accounting
U.S. companies.
innovation that may have to precede successful use of FCIM by small
GOVERNMENT PROCUREMENT
At this point, the implications of the FCIM accounting problems
for Government procurement should be clearer. What sort of
negotiations and subsequent audit can lead to a fair distribution
of costs among products made for the Government and private sector
customers? If it is hard for a company to estimate its costs for
its own purposes, how will it ever be able to reach agreement on
the cost of sales to the Government? We don't have easy answers.
But if industry and government together do nothing, the industrial
hurt. base so necessary for U.S. defense purposes will be irrevocably
This is a National problem, requiring answers from
Government, order. Industry and Accounting--and not necessarily in that
AMK/ET/POLICIES.ECO
12
Editorial Notes on
"Is Accounting Standing in the Way of Flexible Computer
Integrated Manufacturing?"
Minor changes on pages 1, 2, 6, 7, and 9.
Signifncant changes on pages 10 and 11.
Insert 1.
In order to examine this concept, we developed an FCIM
Systems Planning Chart that shows 43 events--from writing
the initial concept paper to completing the first production
batch. The events are organized in five streams of activity
for Marketing, Product Design, CAD/CAM and Process Control
Systems, FCIM Equipment, and the Facility. Twenty of the
events are controllable cost drivers, but of the twenty,
only 6 are directly related to making a specific product.
Insert 2,
An alternative might be a dual path P&L Statement with two
columns, one for routine operating expenses, and one for the
uncapitalized costs of providing for the future or strategic
costs. Both paths would lead to a common bottom line. Over
several years (which could include recaps of past years) the
relationship between the strategic and the routine operating
paths could show how well the company is managed. Two P/E
Ratios could be used by investors, one for the whole company
and one for routine operations. Incentive systems could use
both. With this approach, more accurate information could
be provided with minimal changes to accounting conventions.
REFORMING MANAGEMENT ACCOUNTING
TO SUPPORT TODAY'S TECHNOLOGY
Technical managers are in a unique position to lead in developing management
accounting systems more suited to the needs of modern technology.
Lynn W. Ellis and Robert G. McDonald
Accounting for management should provide a basis for
One source of this problem is the recognized career
making correct decisions not only for the current
path for corporate controllers and treasurers, which has
business but also for building the future value of its
been to work in public accounting and auditing, get the
activities. Much of what has been written recently on the
CPA qualification, and be hired by the firm which had
problems with our present management accounting
been audited. This placing of key management
practices, as applied to modern technology, is a litany of
accounting positions in the hands of those who have a
its many deficiencies (1-5). In proposing reforming
financial reporting orientation readily explains why
management accounting to overcome these cited
management accountants lack a production or internal
inadequacies, we shall summarize, first, the key points of
focus and formulate internal reporting on that financial
criticism; then address the role of research-technology
accounting perspective. As a consequence, managers'
managers in preparing this reform; and, finally, offer four
horizons contract to the short-term cycle of their
specific proposals for a new management accounting
monthly profit and loss statements served up. with the
biases of those who have been trained in the financial
system.
accounting viewpoint.
Critics of current management accounting cite four
distinct categories of shortfalls:
2. Management reports are of little help to operating
managers attempting to reduce-costs and improve
1. The dominance of financial accounting for those
productivity. Accounting reports are too aggregated;
outside the firm over internal management needs.
they are too late by the time all the data are run; they
Financial accounting, sanctioned by the Securities and
use allocation methods that result in cross-subsidies of
Exchange Commission and the Financial Accounting
different products giving incorrect costs; and they are
Standards Board (FASB), is concerned with reports to
prepared under impropèr bases, such as the use of direct
outside creditors and investors and not what is reported
labor to spread unallocated costs as overhead onto
internally to managers. The financial accountant values
products. With the evolution toward high-technology
the inventories of the firm by the "costs attach"
manufacturing operations, the overhead items such as
approach in which the cost of the product will only
industrial engineering and production control have
include the manufacturing costs. Administrative,
increased, while increasing use of capital to replace labor
marketing and R&D charges are considered costs of the
has cut the direct labor content to as little as 5 to 10
period in which they are incurred, and expensed
percent of manufacturing costs. This shift in costs, plus
immediately. The result of these calculations is a value
the spreading of overhead onto product through direct
for the cost of inventory on the balance sheet and a
labor, has contributed to skyrocketing overhead rates
value for the cost of products sold on the income
due to many more dollars of overhead per hour of direct
statement. The latter understates the true product cost
labor.
by not including any of the costs incurred before
When operating managers are presented with these
manufacturing.
apparent high labor costs, one natural tendency is for
Lynn Ellis is professor of management at the University of New
them to try and reduce costs by still further reducing
Haven (Connecticut) and president of Lynn W. Ellis Associates,
direct labor. This wastes much effort, however, because
a consulting firm for telecommunications, technology
attention is directed to the least important cost category
management and strategic planning. He was formerly vice
instead of directing efforts to analysis and control of
president of engineering at Bristol Babcock, Inc. and before
those overhead items which are susceptible to reduction
that director of research at ITT. A Fellow of the Institute of
Electrical and Electronics Engineers and of the American
3. The management accounting system fails to provide
Association for the Advancement of Science, Ellis has a B.S.E.E.
accurate product costs. Accountants only include as a
degree from Cornell, an M.S. degree from Stevens Institute and
a Doctor of Professional Studies in Management degree from
product cost the manufactured cost of direct material,
Pace University. He is the author of The Financial Side of
direct labor and allocated overhead; they leave out the
Industrial Research Management (John Wiley & Sons, 1984).
specific costs attributable to marketing, product
Robert McDonald is chairman and associate professor of
management, administration and planning, R&D, and
accounting at the University of New Haven. Prior to joining the
manufacturing development undertaken prior to
university he was assistant treasurer for Thermo Electric
launching the product into manufacture and sales. Thus.
Company and an internal auditor for Merck & Company. He
in a high-technology environment, product costs are
has an M.B.A. in corporate finance from New York University
and is a certified management accountant, certified internal
understated and this may lead to improper
30
auditor and a chartered financial analyst.
decision-making.
4. The subordination of growth-producing strategic
Growth-enhancing
activities (including R&D) to the bottom line of return
on investment. Since it is past investment. expending
activities such as R&D
funds on growth-producing strategic activities, such as
are treated as expenses to
R&D, tends to produce a lower current return as
measured by the accounting system. However, proper
be minimized rather than
management needs to balance today's return with
as investments in the
tomorrow's, and this means optimizing the net present
value of the combination of present and future streams
future.
of income, considering the time value of money, in order
to maximize the value to shareholders (8,9). A
consequence of this erroneous focus is that
growth-enhancing activities such as R&D, market
now
development and manufacturing development, are
*
treated as expenses to be minimized rather than as
Recem
Why Technical Managers Should Care
investments in the future (7).
There are several reasons why managers of research,
Even though one of accounting's main principles is the
development and technology should be concerned with
matching of revenues to the expenses of those revenues,
the problems thus far outlined. First, they are in the
the current system fosters a bad match. With short
business of addressing the corporation's future through
product life cycles, which are natural in the
the growth of the firm's product and service base. Any
high-technology environment, money spent today on
management accounting system that does not support
design and development of new products will be
this goal is a handicap to proper business management
expensed immediately for "conservative accounting."
(10).
Then, in the future, the product's revenues will be
matched with that period's spending for even more
Second, computers (and particularly personal
distant product innovations. With today's revenues
computers) are now so readily available as to make more
matched to spending for tomorrow's products, and the
practical the use of accurate costing systems focusing on
costs of developing today's revenues matched to
management's goals. With the lower cost of processing
yesterday's revenues, the accounting mismatch is shifted
data on computers, it is no longer necessary to
one whole cycle.
economize by having one system do the accounting
valuation, and have that system suffice for all other
Prior to 1974, companies were at least allowed to
internal management reporting needs. It should be
capitalize R&D expenditures (6). One benefit showed up
remembered that the internal reporting and the
when a research effort came up dry, and the capitalized
information needs of management are in no way bound
amounts were written off. Stock analysts looked for these
by the FASB rules. These rules come into play only when
write-downs as evidence of where the firm sought
the firm reports to outside (and presumably uninformed)
results and where it failed. Normally it would be very
investors and creditors. For inside reporting, a company
difficult for an analyst to be aware of a firm's direction in
can do anything it wants-even reading tea leaves or
the R&D area due to the complexity of the research and
checking zodiac signs! Of course, an accounting system
the firm's efforts to maintain secrecy. With write-downs,
that easily reconciles financial and management
the analyst could gauge where the remaining efforts
accounting would have somewhat greater credibility.
were directed, or how the firm might regroup and
Finally, in the words of a leading critic of present
redouble its efforts. The analyst could also compare
management accounting systems, who has repeatedly
firms' write-downs and estimate future successes. Since
invited engineers to become involved in this area:
current financial accounting no longer allows capitalizing
R&D, the information once contained in these
Management accountants who leave their offices will not
write-downs is now hidden. Conservative accounting has
find it difficult to discover the engineers who are in the
thus generated less disclosure about R & D efforts than
forefront of implementing these changes we need to again
learn from engineers bow to design more effective internal
before.
measurement systems the professional organizations in
the forefront of promoting change in management
Another consequence of this accounting treatment for
accounting systems are basically production and engineering
R&D is the lost opportunity of emphasizing design
organizations. (2, sidebar).
engineering. With shorter life cycles, more savings may
be realized from better design than from efforts to
Research and technology managers should accept this
squeeze out efficiencies from the production line;
challenge and devise reformed rules of measurement
however, no common yardstick exists between these
which will address the shortfalls identified by these
critics.
March-April 1990
two activities in current management accounting
systems. Accounting reports show R&D as a cost of the
period, and not of the product, as a consequence of
financial accounting's treating costs by function
Proposals for Reform
(manufacturing, marketing and administration) and not
by product or product line.
The FASB has a conceptual framework for accounting
theory to ease later rule making which concludes that
for financial accounting, users' (creditors and investors)
Conservative accounting
needs are primary. It would appear time for management
bas thus generated less
accountants, in partnership with their research and
technology managers, to present their own conceptual
disclosure about R&D
framework and declare that for management accounting,
efforts than before.
internal user needs are primary, and that they differ from
outside user needs.
The following four proposals for changes in management
accounting might be the start of such a framework:
1. Extract strategic expenditures from present
manufacturing costs, leaving true operating costs. The
Costs associated with machines, such as depreciation,
present income statement which is split between "costs
interest, taxes, floor space occupancy, and electric
of goods sold" (manufacturing expenses) and general
power, need to be in the machines' overhead rates,
expenses (administration, marketing, and R&D) needs to
rather than in that of the few people left on the factory
be shifted into one which more nearly represents the
floor. Similarly, direct materials, purchased parts, etc.,
line between operating and strategic decisions, as was
generate their own overhead costs in purchasing,
pointed out nearly two decades ago (8). Operating
logistics and storage, which belong in a materials burden
expenses entered as "costs of goods sold" should clearly
or overhead rate. Human labor ovehead would then be
exclude those activities which are aimed at future years
reduced to costs really attracted by people, such as
business. As shown in the Table below, under
fringe benefits, and the building occupancy costs only
manufacturing in the first column, the activities in the
for those areas used by people. In this manner, operating
upper block relate to current operations, while those in
cost reduction efforts can be focused correctly the
the lower block represent expenses being incurred now
cost drivers and not just the direct workers.
for the benefit of future operations. Also in the next
It is even possible that three systems may have to be set
three columns, the expensed activities under financial
up until we learn to integrate them better: One each for
accounting are similarly divided into operating and
process control, inventory valúation and product cost
strategic sectors. The primary effect of such a change
(11). The time frame dictates the response of each
would be to ensure that decisions to reduce operating
system: Process control monitors material and/or labor
costs would be made separately from, and thus not
down to the hour or minute with real time
impact, preparing for tomorrow's products and services.
capability-not summary reports at the end of the week
2. Allocate operating overhead costs to machines and
or month. Inventory valuation can be accomplished on
materials rather than only to direct labor. In automated
existing systems with little change. Product costs should
factories, where machines have replaced human labor,
be long term, in most cases over a one-year horizon, as
the concept of machine labor needs to be introduced.
covered below.
Comparison of Accounting Systems
A Possible New
Financial Accounting
(and Present Management Accounting)
Management
Accounting System
Inventoried
Expensed
Marketing
General &
Manufacturing
R,D & E
& Sales
Administrative
Sales
General
Operating Expense
Fabrication
Engineering
Accounting
for current busi-
Assembly
ness (sub-total of
Production Control
items at left)
Purchasing
Industrial Engineer-
Research
Market Develop-
Strategic Planning
Strategic develop-
Product Develop-
ment
ment expense for
ing
Manufacturing
ment
Product Manage-
future business
Development
ment
(sub-total of cur-
Process Develop-
Advertising
rent projects of
Promotion
items at left)
ment
Employee Training
Inventoried Sub-
R.D & E Sub-total
Marketing Sub-total
G & A Sub-total
Total for reconcilia-
tion of the two
total = "Cost of
systems
Goods Sold."
32
Views from Abroad
3. Separate functional expenses on the current income
statement into a new category of strategic investment
The need to reform management accounting has not
activities, corresponding to those allocatable to true
gone unnoticed outside the U.S. Not surprisingly,
product cost, as shown in the Table Included in the
proposals from other countries differ in substance from
strategic investment activities would be the costs
the suggestions in this article. Japanese management
associated with future products such as R&D; market
accounting is used to play a role in integrating the efforts
of employees with the long-term strategies of
development, product management, and long-term
management (15). An alternative concept put forward in
promotion from marketing; training and organizational
the United Kingdom, is to calculate an annual innovation
development from human resources management; and
expenditure in the form of a value-added statement (16).
value analysis, product start-up, process development,
Neither of these, in our opinion, get to the heart of the
and programming robots from manufacturing (12).
matter in recognizing the investment nature of product
These activities should be budgeted and approved on an
decisions.-L.W.E. and R.G.M.
investment basis, as with capital plant, so that all
investments in the future by a company share a common
accounting yardstick.
Internal reporting can adopt any convention it wishes for
product cost and not be bound by financial accounting's
price too low products with high strategic investments
inventory cost. For management decisions, therefore,
nor price too high long-running products which have
true product cost would equal inventoried product cost
depreciated their shadow investment accounts to zero.
plus an additional cost representing investments made in
the past for the product, which financial accounting has
4. Use option theory as a value of those strategic assets.
A fourth element of such a conceptual framework should
required to be expensed. This approach would try to
calculate "life-cycle" standard costs of a product, to
be a means of policing the values in the shadow
include manufacturing, marketing and R&D (5). Lest this
investment account. While the initial values will be the
seem strange to readers, consider that marketing has for
costs incurred, good practice in managing such an
some time used a standard cost of sales for many
account requires that the value of each project carried
products-it is just labeled a "dealer discount." This
forward annually should be the lesser of cost or current
approach would match costs with the transactions that
market value, as is the practice with inventories of
cause them, and not be content to believe that costs are
goods. Thus, if the market value is lower than costs
spent less writeoffs to date, additional writeoffs would be
affected by volume alone.
required beyond the standard amounts determined in
As a consequence of such a shift in emphasis, efforts to
setting true product costs. This would trigger review by
define an optimum functional budget, such as for the
management, reevaluation of the standard amounts, and
R&D function, would be- replaced by the more correct
thus recalculation of true product costs.
management task of determining an optimum strategic
investment budget. Once this budget was set, balancing
This raises the issue of how to calculate market value,
the company's present and future, it would then be
since there is no free market on which to rely. Clearly,
apportioned among functional project proposals
the benefits of a product or project which is well past its
according to their relative contribution to the firm's net
initial launch or operational date can be reforecast in
present value (NPV), as recommended for R&D return
terms of the NPV of its future streams of income,
(13). Thus, a common measurement would apply for the
thereby providing a comparison with costs being carried
R&D project, cost reduction in the factory, new
forward in the shadow account.
machinery, or opening a branch sales office in a new
Option theory provides an alternative solution to
territory. The management accounting task under such a
valuation early in the product life cycle (14). An option
scheme would become the task of project accounting
gives the investor the right to make a decision in the
against preestimate, a radically different task from the
future. This is the equivalent of doing the R&D in
present focus on accounting by functional department.
anticipation of a later decision on launching the product
As such an accounting system requires a record of past
if the prospective return is right, or cutting losses if it is
project expenditures, some investment portfolio
not. This right has value whenever there is uncertainty,
valuation scheme needs to be devised. While the FASB
such as early in the R&D cycle. Thus, the value of
requires that these strategic investment activities be
initiating R&D is the right it gives to be in a position to
expensed in external reporting, they may be
make the later commitment, with maximum loss limited
"capitalized" for the purposes of internal accounting by
to the negative cash flow of the R&D.
writing them into a shadow investment account for each
The formulas for calculating option value are
product or product line. When the products are sold and
complicated, but have been reduced to tables in finance
revenues recorded, the "standard cost" of each item in
textbooks and programs usable in personal computers.
the shadow account would then be written out of the
These tables and programs depend on two principal
March--April 1990
account and into the true product cost of goods sold.
inputs:
The new management accounting would recognize not
only true product profitability but also the strategic
return from the sum of such products, based on their
The ratio of projected NPV of income streams to
contribution. More important, however, product pricing
product launch costs is one input, with the value of the
would need to recognize true product cost. and neither
option increasing accordingly. This is just the R&D
we are really talking december
today's management accountants and MIS specialists fail
return as recently defined (13). While this needs to be
to perceive the need for the reforms expressed above.
greater than one in investment theory, it may be less
Research and technology managers are now in a unique
than one in option theory in the expectation that
fluctuations in the period before launch might raise it
position to exert leadership in developing the
management accounting systems for future of modern
above one by then
technology.
If the NPV of future income streams at the time of
launch is not above the launch cost, the option will not
be exercised. However, the more this NPV is above the
Acknowledgement
launch cost, the greater is the project's profitability. This
Thanks are due Robert Rainish for his many provocative
input is not linear, but works out to the multiple of the
ideas and critiques during the preparation of this paper.
project's standard deviation (risk) times the square root
of the number of years to the launch decision. Higher
References
risk and longer time to hold off deciding increase the
1. H. Thomas Johnson and Robert S. Kaplan, Relevance Lost:
value of initiating the project.
The Rise and Fall of Management Accounting Boston:
Harvard Business School Press, 1987, reviewed in "Accounting
For example, for a R&D return of 1.4 and a 40 percent
Critic Robert Kaplan," Inc, April, 1988, pp. 55-67.
per year standard deviation, with four years to exercise
2. H. Thomas Johnson and Robert S. Kaplan, "The Rise and Fall
date, the option is worth 43 percent of the launch cost,
of Management Accounting," Management Accounting
setting a market value on the early R&D stages of the
January, 1987, and IEEE Engineering Management Review, 15
(3), Autumn, 1987, pp. 36-44.
project.
3. John Holusha, "Cost Accounting's Blind Spot," New York
With an option, as the time until decision nears zero, the
Times, October 13, 1987.
4. Ford S. Worthy, "Accounting Bores You? Wake Up," Fortune,
ratio of the NPVs dominates the value formula, and thus
October 12, 1987.
carries smoothly into the post product launch
5. Kevin Kelly, "That Old-time Accounting Isn't Good Enough
calculation referred to earlier.
Anymore," sidebar to "How the New Math of Productivity Adds
Up," Business Week, June 6, 1988, pp. 103-113.
6. Maurice S. Newman, "Accounting for Research and
Development," Research-Technology Management,
What Managers Should Do
July-August, 1988, pp. 6-7.
It is clear that many management accountants have
7. Lynn W. Ellis, "Managing Financial Resources,"
Research-Technology Management, July-August, 1988, pp.
hidden behind the facade of the FASB and may continue
21-38.
to do so. The authors believe that as the principal
8. Richard F. Vancil, "Better Management of Corporate
potential beneficiaries of a more appropriate accounting
Development," Harvard Business Review, Sep.-Oct., 1972, pp.
system, research and technology managers should get
9. 115-124. Peter F. Drucker, Managing for Results, New York: Harper
involved and create the needed system for providing the
& Row, 1967.
requisite management information. After all, engineers
10. Lynn W. Ellis, The Financial Side of Industrial Research
are fortunate in that they are not bound by the 500
Management, New York: Wiley, 1984.
years of accounting tradition now codified in the
11. Robert S. Kaplan, "One Cost System Isn't Enough," Harvard
Business Review, Jan.-Feb., 1988, pp. 61-66; "Management
statements of the FASB.
Accounting for Advanced Technological Environments,"
Science, 245 (4920), 25 August 1989, pp. 819-823.
A similar switch of roles took place years ago-when the
12. Lester C. Thurow, "A Weakness in Process Technology,"
management information (MIS) specialists overtook the
Science, 18 December, 1987.
accountants. As computers were introduced for the
13. Richard N. Foster et al, Improving the Return on Research
accounting needs of order processing, payroll and
and Development, New York: Industrial Research Institute,
1984, summarized with the same title in Research Mangement,
inventories, MIS personnel reported to the controller.
Jan.-Feb.. 1985, pp. 12-17 and Mar.-Apr., 1985. pp. 13-22.
While the accountants were satisfied with financial
14. Graham R. Mitchell and William F. Hamilton. "Managing R
accounting rules and obsolete procedures, the new
& D as a Strategic Option," Research-Technology Management,
capabilities of information systems thrust MIS staff from
May-June, 1988, pp. 15-22.
15. Toshiro Hiromoto, "Another Hidden Edge-Japanese
reporting to the controller to equality with the
Management Accounting," Harvard Business Review, 66 (4),
controller, and in some firms superior to the controller.
Jul/Aug. 1988, pp. 22-26.
The controller's data base became a subset of today's
16. David W. Budworth. Rewinding the Mainspring: A
MIS. A similar sequence could happen again in
Discussion Paper on Innovation Expenditure in Company
tomorrow's microcomputer-dominated environment if
Accounts, London: Technical Change Centre, March, 1987.
Research Technology Management
34
THE FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)
AND U.S. COMPETITIVENESS
I. ISSUE
Financial accounting procedures have not kept up with industrial
changes brought about by global competition, new technologies,
emphasis on quality, use of computers in manufacturing, and needs
for higher skilled workers. As a result, investments that firms
must make to be competitive are discouraged because accounting
systems often overstate initial costs and understate future
benefits. This, in conjunction with efficient capital markets
that stress short-term performance, is impeding the modernization
of U.S. industry.
II. DISCUSSION
Profits are the main goal of most U.S. companies, and financial
accounting provides the report card that shows how well they are
doing. Accounting procedures have been developed over many years
to measure profit, preserve assets, protect the interests of
owners and creditors, prevent fraud, provide a basis for
interfirm comparisons by investors, and help managers control
routine operations. Applying these procedures often requires
judgement, so standards have been developed to help accountants
and auditors ensure that a company's financial condition is
reported with completeness, accuracy, and fairness in ways that
will be comparable from company to company over time.
While the standards emphasize stability, many of the businesses
they measure are changing rapidly as product development and
manufacturing operations become knowledge-intensive. In order to
be competitive, emphasis in manufacturing has shifted from using
unskilled labor to make long runs of identical products, to
highly skilled and professional employees who use computers and
other expensive equipment to make new, varied, and rapidly
changing products. This shift, which is required to meet the new
market requirements for quality, just-in-time delivery, and
flexible manufacturing capability, requires companies to spend
large amounts to develop new products and processes long before
production begins but spend relatively little during actual
production.
In the past, long term expenditures usually resulted in tangible
assets like buildings and machinery. Today, in addition to
buying tangible assets, companies must increasingly pay for the
costs of strategic activities such as long term marketing,
research, product development, education and training, computer
programming, and product testing. These activities produce
critical knowledge in the form of know-how, product designs,
computer software and data that controls manufacturing equipment,
and employee skills. This knowledge, critical to survival and
growth, operates as a long term asset (perhaps the most important
1
asset in the firm), but current accounting standards require most
of it to be treated as an intangible with a value of zero, and
its development costs are charged to current expense.
The primary accounting challenge in modern manufacturing and
high-tech firms, should change from measuring operating costs
when they are incurred, to apportioning one-time expenditures for
years after they have been incurred. But accounting standards
inhibit this change. For example, inventories are treated as.
assets, even though companies usually try to minimize them. With
modern manufacturing processes, inventories can be replaced by a
repertoire of computer code that directs machine tools to make
small batches of products and replacement parts as they are
needed for the life of the product. Present accounting standards
require the cost of the computer code to be charged to expense
when the code is created; the code to be assigned a value of zero
because it is an "intangible"; and the asset value of the
inventory to be reduced -- all of which reduce the company's
stated value and profit.
In other words, providing for the future through strategic
activities that are not allowed to be capitalized leads to a
direct reduction of current profits even though they are intended
to result in long term profits. The result is a negative
incentive, or an incentive for managers not to modernize. This
is compounded for publicly traded companies whose stock drops
after reports of lowered earnings, and for small companies that
must borrow for expansion. There is reason to believe that some
companies avoid modernization for fear that current expense
charges and resulting drop in stock value will lead to a hostile
takeover.
Thus the lag between evolving industrial processes and accounting
systems that measure them allows costs and profits to be
seriously understated or overstated for different products and
different periods of time. The report card, based on existing
accounting standards, is no longer reliable, and it is becoming
increasingly difficult to determine whether actions a company
takes to achieve its profit goal are working.
Company managers who are trying to justify modernization programs
or raise financing for them are increasingly aware of parts of
the accounting problem, but few of them have spoken out on the
broader issue of how the accounting lag has combined with the
changing nature of manufacturing, short term investment emphasis,
and high capital costs, to impose a severe handicap on U.S.
companies.
III. COMMERCE DEPARTMENT ACTIONS
Solutions to the accounting problem will not come quickly, but a
start appears to have been made. The Advanced Manufacturing
Program of the Department of Commerce's Technology Administration
recently held a roundtable with representatives from the
2
manufacturing, financing, accounting (including the Financial
Accounting Standards Board) sectors, universities, and several
federal agencies including SBA and DoD to consider the financing
problems of small manufacturing companies seeking modernization.
The FASB representative commented that while specific questions
such as treatment of inventories and R&D had been considered, the
fundamental issue of accommodating basic changes in the nature of
product development and knowledge-intensive manufacturing
processes had not previously been understood or considered. An
outcome of the meeting was an agreement among the accountants to
begin consideration of the broad problem. It must be remembered,
however, that the process of changing accounting standards can
take years.
The Technology Administration could bring together a group of key
managers to explain the problem to Treasury, CEA, and OMB
officials. The group might include about ten people like:
Robert Frosch -- former Administrator of NASA, now General
Motors VP for Research who is investigating the accounting
problem.
Steven Jobs -- who obtained significant financing from Japan
to ensure stability for his new company.
Robert Galvin -- Two of whose officers at Motorola explained
that the company's efforts to win the Baldrige Quality Award
might not have been possible had not a significant block of
its stock been privately held.
In bringing this issue to the attention of the policy level, DOC
could address it with the appropriate Federal agencies while the
Advanced Manufacturing Program continues to encourage private
sector actions by the manufacturing, financing, and academic
communities. The parallel paths could be mutually reinforcing
and expedite the necessary changes.
3
4/10
TECHNICAL COMMENTS* ON THE PAPER,
"COMPETITIVENESS & THE COST OF CAPITAL:
EXECUTIVE SUMMARY"
(Paper prepared for the EPC Working Group
on Competitiveness and the Cost of Capital)
Section II: Defining the Cost of Capital
NEWS ITEM: On March 28, Oracle Systems Corporation, whose
revenues have doubled in 12 of the past 13 years, announced
that its quarterly earnings were a flat 18 cents a share,
instead of the anticipated 23 to 25 cents predicted earlier.
The difference was due to auditors' disallowance of sale-on-
trial contracts which customers might still decline. The
next day, Oracle closed at $17.50, down $7.875 or 31%.
(From a 4/5/90 New York Times article which discusses
business problems that Oracle may or may not have.)
Comment: The paper defines the cost of capital as the return a
corporation has to pay to attract investors. It might
be useful to define investors in terms that support the
concept of competitiveness. Investors, including
managers of large investment funds, can have a variety
of motivations, many of which have nothing to do with
the competitive success of the companies in which they
invest. Those who dumped oracle are an example.
Failure to distinguish between the types of investors
at the outset may limit the value of the paper.
Section III: Why the Cost of Capital is Important to Investment
Comment: It might help to distinguish the business objectives of
different groups of technology company owners or their
representatives. Some "owners" manage funds for others
and are measured on the basis of safety and consistent
earnings. Often, these "owners" even set their target
selling price for a stock when they buy it, and have no
continuing interest in the companies contained in their
portfolios. Expenditures made for long term
competitive benefits, particularly those such as R&D,
process improvement, and worker training which
accounting conventions treat as expense, destroy values
for this class of "owners." Should the study serve to
aid, discourage, or be neutral toward "owners" of this
type of disengaged owner/representative?
*Prepared by the Office of Technology Policy, Technology
Administration, U.S. Department of Commerce.
1
We are testing the idea that investors can be
classified as "conservative" or "productive." On a
typical cash flow chart, the conservative investor
seeks predictable and steady gains from the outset with
no chance for loss of principal. Buyers of Treasury
bills fit this profile. The productive investor, on
the other hand, accepts the fact that the value of the
investment will decline before it produces a revenue
stream which is intended to recover the investment plus
profits. The productive investor, who is needed to
finance new competitive products and new processes,
also recognizes that the entire investment may be lost.
Most investors fall between these two extremes, but it
appears that capital increasingly is being concentrated
toward the conservative end of the spectrum in the
hands of managers of large pension, mutual, and trust
funds. Since the objectives and methods of the two
types of owners are so different, the effects of the
cost of capital probably are also different.
Reducing the cost of capital is not a cure-all for
U.S. competitiveness. For example, sharp reductions in
the cost of capital will not change corporate
management strategies in such key areas as quality,
concurrent engineering or management, or the formation
of long term relationships between suppliers and their
primes (e.g., Xerox and Honda of America).
Section IV: Factors Impacting the Cost of Capital
Comment: It may be useful to compare investment rates with GNP
for the 1980s. For example, the February Business
Conditions Digest shows that commercial and industrial
loans outstanding in 1982 dollars grew about 74% while
GNP in fixed dollars grew only about 30%. A Federal
Reserve Board chart shows a similar pattern for 1953-
77. If other measures also show that investment grew
more than GNP, perhaps there is more of a capital
productivity problem than a cost of capital problem.
One way of looking at interest rates for an industrial
project is that they comprise at least four components:
(a) The price paid for the privilege of using the
money (overcoming the lender's liquidity
preference).
(b) Anticipated loss of the principal's purchasing
power due to inflation.
(c) The risk of loss of the principal or interest.
2
(d) The opportunity to earn significantly more than
the minimum acceptable interest rate.
But for the types of productive investments we are
seeking, with a period of negative cash flow, (c), the
risk of loss, becomes the most important factor. This
varies with each investment. It is outside the range
of macro economic control but is reflected in hurdle-
rate calculations. Since risk normally grows with time
because of unknowns like unanticipated technical
problems, market responses, and competitor actions, the
risk element of the interest rate normally will be
higher for longer range projects. It seems unlikely
that changes in (a), which most observers appear to
advocate, can offset the increases in (b) and (c) to
cause longer range investments.
Conservative capital managers must ignore (d) if
significant risk is indicated by (c) ; and, if they are
obliged to show steady growth, they cannot accept the
time delay. So, while (d) is what drives the truly
productive capital managers, it is of little interest
or incentive value to the conservative ones.
Savings and Macroeconomic policies
Comment: This section opens by saying that savings supplied by
individuals, governments, and businesses determine the
amount of funds which are available for investment. It
may be useful to point out that much U.S. functional
investment is treated as expense. Private autos used
for commuting are consumption while taxis and buses are
investment. Similarly, company expenditures for
knowledge-related activities such as education, worker
training, R&D, and most software are booked as current
expenses although they are made for long-term reasons.
If discrepancies such as these were resolved, the
investment rate and the savings rate might show more
favorably.
Market efficiency
Comment: This section begins by saying, "The extent to which
impediments to capital flows remain between nations and
within a given country determine how efficiently
capital is allocated, which in turn, influences its
cost to specific users." As this paper is directed
toward competitiveness, it may be important to
distinguish between capital market efficiency and
capital use efficiency. The Japanese are widely cited
for both their competitiveness and their low capital
cost. But they created an inefficient capital market
to the degree that they restricted both capital exports
3
and low cost loans for consumption. For years, they
induced capital use efficiency by restricting capital
market efficiency.
There is a serious question of how much new capital
that is raised is used for productive investment.
According to an article in the April 2, 1990 New York
Times business supplement, from 1982 to 1989, new
investments by venture capital companies in buyouts and
acquisitions tripled. As of 1988, only 13% of venture
capital firms' dollar commitments went to startups.
And these are supposed to be the classic productive
capitalists.
It is not clear that new capital such as pension fund
contributions will be channeled into productive
investment as opposed to speculation. It also appears
that much of the pension fund money "invested" in
blocks of S&P 500 stocks did little more than inflate
their market price value while adding few productive
assets.
The Japanese are now having to cope with the effects of
low cost capital in land and stock speculation.
Agency Costs and Costs of Financial Distress
Comment: This may well be where most of the U.S. problem is
located. There seems to be a growing gap between the
"Techies" who need money for new products, processes,
training, etc., and the "Buckies" who control the
money. Although the theory of efficient markets rests
on a presumption of perfect knowledge, most of these
people just don't understand each other, and so far,
the Buckies have done well enough without even trying
to.
One of the elements of an interest rate calculation
discussed above was (c), or the risk of loss of the
principal or interest. There is also a (c') the risk
or cost of the capital manager's inability to
understand and evaluate the factors that cause (c).
This leads to the conclusion that the highest cost of
capital situations probably occur when (c) and (c') are
cumulative. Unfortunately, this is increasingly the
case, with most productive investments now carrying a
significant (c) factor, and capital increasingly being
concentrated in the hands of investment managers who
add the (c') factor. Whether or not one wants to call
this a cost of capital issue, it appears to be a
primary reason why productive investment is lagging.
4
The Japanese keiretsu are ideally suited to handle the
(c) and (c') problem. Members of the same industrial
group can, together, explain to their member megabank
how one company's advanced development program will
help the others, and an assured partial market can be
established even prior to the investment. Given
assurances like this, the project has a lower (c) cost,
and the lender who may be a member bank, customer, or a
supplier, has much less of a (c') problem. This is
where the Japanese can obtain a lower cost of capital.
Section V: Policy Implications
Comment: This section proposes policies that reduce the cost of
capital. As the debate proceeds on this, it would be
useful to distinguish the particular aspects of the
cost of capital affected--liquidity preference cost,
inflation adjustment, project risk, and investors' lack
of knowledge of the risk.
If the (c) and (c') problem is the real capital cost
driver, the actions mentioned above under Section IV
dealing with agency costs may be the most useful part
of the paper. For example, there is some evidence that
family controlled businesses outperform others because
they have more latitude to make long term strategic
investments. The Japanese keiretsu are similar.
Another mechanism to reduce the cost of capital in an
important area would be an investment tax credit for
the purchase/lease of flexible, automated computer
integrated manufacturing equipment, including related
training and software expenses.
5
Analysis of the Research Tax Credit*
Background
Under section 41 of the U.S. Tax Code, a 20 percent tax credit is
available for certain incremental expenditures related to two types
of research activities: (1) qualified research and (2) basic
research. The credit for qualified research activities, which is
the subject of this paper, is calculated based on the increase in a
taxpayer's qualified research expenditures in the current year over
a "base amount" for that year. The credit for basic research is
available to corporations funding certain research activities by
universities and other qualified organizations.
The research credit was enacted originally in 1981 as part of
President Reagan's first tax package. According to the 1981 House
Report 4242, the stated purpose of the credit was "to reverse [a]
decline in research spending by industry" and to "overcome the
reluctance of many ongoing companies to bear the significant costs
of staffing and supplies, and certain equipment expenses such as
computer charges, which must be incurred to initiate or expand
research programs in a trade or business."
Since its enactment, the concept of a research credit has enjoyed
almost universal support by Congress and the Administration, as well
as business. Controversies that have surrounded the credit have
dealt with the question of how to create an efficient mechanism to
encourage businesses to increase their R&D expenditures beyond the
level they would have spent in the absence of a credit, and how to
do this with a minimum revenue loss to the Treasury.
Major changes to the research credit were made by Congress in 1986,
1988, and 1989. The character of these changes clearly reflects the
tension between Congress' desire to ensure a strong R&D incentive
and Congress' need to exercise fiscal restraint. Beginning in 1986
the dollar value of the credit has been significantly reduced by
reducing the rate from 25 to 20 percent, narrowing the definition of
qualifying research activities, and disallowing section 174 research
deductions. On the other hand, the incentive value of the credit
has been increased by reforming the base amount and making the
credit available to new technology ventures. These changes are
detailed below.
*Prepared by the Office of Technology Policy, Technology
Administration, U.S. Department of Commerce, April 6, 1990.
04/06/90
1
Legislative History
The 1981 Act
Credit Rate and Base Period: As enacted in 1981 on a
temporary five-year basis, the rate of the research
credit was 25 percent. This rate applied to the excess
of a taxpayer's qualified research expenditures for the
taxable year over the taxpayer's "base period research
expenses,' i.e., the average amount of such yearly
expenditures in the base period (generally the preceding
three years). At a minimum, the amount of base period
research expenses is treated as equal to 50 percent of a
taxpayer's qualified expenditures for the current year.
The incremental nature of the credit was designed
specifically to limit the credit only to those research
expenditures that would not have been undertaken in the
absence of the credit.
Definition of Qualified Research: Under the 1981 Act,
"qualified research" had the same meaning as the term
"research or experimental" under section 174 (the R&D
deduction), i.e., R&D in the experimental or laboratory
sense. However, certain expenditures such as research
conducted abroad and for the humanities or social
sciences were specifically excluded from eligibility for
the credit.
Limitations on Qualified Research Activity: Only certain
types of expenditures for qualified research activities
could be included in the research credit calculation.
These include in-house expenditures for research supplies
and wages paid to individuals who are supervising,
performing or directly supporting research activities.
In addition, 65 percent of the amount paid or incurred by
a taxpayer for contract research conducted on the
taxpayer's behalf could be included.
Availability: Significantly, the research credit was
made available only for research expenditures paid or
incurred in carrying on a trade or business of the
taxpayer. This meant that the credit was unavailable to
start-up firms, many joint ventures, or existing firms
entering a new line of business. Thus, from its
inception, the research credit encompassed a more limited
array of research activities than those eligible for
current deductibility under section 174.
04/06/90
2
The 1986 Act
Credit Rate Reduction: The Tax Reform Act of 1986
significantly modified several important credit
provisions, the most important of which were reduction of
the rate from 25 to 20 percent and the tightening of the
definition of qualified research. According to
Congressional explanations of the 1986 Tax Reform Act,
the rate reduction was deemed appropriate "in the context
of the base broadening and rate reduction provisions of
the Act, and the continued allowance of full expensing of
research expenditures."
Narrowing the Definition of Qualified Research: Following
several years of debate, Congress, Treasury, and
representatives from industry arrived at a compromise
definition that narrows the definition of "qualified
research" for R&D credit purposes. Proponents of a
narrower definition believed that the 1981 definition had
been applied too broadly, and that taxpayers had claimed
the credit for virtually any expense related to product
development regardless of whether the taxpayer's
activities involved any attributes of technological
innovation. Thus, the new definition is intended to
limit the research credit to research activities
undertaken to discover information that is technological
in nature and reflects a process of experimentation.
Specifically excluded activities include: research
conducted after a business component has been developed
to its functional and economic requirements, and
adaptation of existing business components (e.g.,
modifications for the needs of a particular customer).
While some have argued that the narrower definition
provides little incentive for the final phases of
technology commercialization and the adoption of advanced
manufacturing processes, industry has not advocated
reopening the issue. Considering the fact that both
Treasury and the Congress regard the definition as
settled, proponents of greater tax support for technology
commercialization might have more success in advocating a
separate tax provision (e.g., an investment tax credit
for the purchase of flexible computer automated
manufacturing equipment).
04/06/90
3
The 1988 Act
Deduction Disallowance: A new Code provision enacted by
the Technical and Miscellaneous Revenue Act of 1988
limits the deduction available when a taxpayer claims a
research credit. As enacted by the 1988 Act, section
280C (c) disallows section 174 research deductions for the
portion of a taxpayer's qualified R&D expenses that
equalled 50 percent of the taxpayer's research credit.
According to one estimate this new disallowance reduced
the credit's effective rate from 20 to 16.6 percent.
GAO Report: The 1988 Act also required GAO to report to
Congress on the operation and effectiveness of the
research credit, and to consider alternatives to the
structure of the credit. Issued in September 1989, the
GAO report concludes that the credit "stimulated between
$1 billion and $2.5 billion of additional research
spending between 1991 and 1995 at a cost of $7 billion in
tax revenues." Although the revenue cost was greater than
the additional spending stimulated by the credit, the
report acknowledges that the credit may still be sound
tax policy due to the larger social benefits of increased
R&D activities. The GAO report also noted that the
research credit is difficult for the IRS to administer
and that the incentive value of the credit would be
increased if the moving-average base enacted in 1981 was
replaced with a fixed base indexed to GNP growth or some
other factor.
The 1989 Act:
More Deduction Disallowance: The Revenue Reconciliation
Act of 1989 amended section 280C(c) to further increase
the deduction disallowance to 100 percent of the research
credit, thereby further reducing the credit's effective
rate to 13.2 percent.
The Base Amount: The 1989 Act redefines the "base
amount" used to calculate the proper amount of the
incremental research credit. The three-year moving base
period that had applied since 1981 had been long
criticized as reducing the marginal incentive of the
credit because it so intricately linked current spending
to future base amounts. Thus, while an increase in
research expenditures would result in an increased credit
for that year, it would also result in increased base
period amounts and a tendency towards smaller credits in
04/06/90
4
the following three years.
The provisions adopted in the 1989 Act attempt to enhance
the credit's incentive effect while retaining a structure
designed to limit the credit to those expenditures that
would not have been undertaken in the absence of the
credit.
The new provisions define the base amount in terms of two
different elements: (1) the ratio of each company's
spending on qualified research activities during a five
year period to the company's total gross receipts during
the same period (referred to as the "fixed base
percentage"), and (2) the taxpayer's average annual gross
receipts for the four taxable years preceding the taxable
year for which the credit it claimed.
The fixed base percentage is the percentage that the
taxpayer's qualified research expenditures for the five
taxable years beginning in 1984 through 1988 is to the
taxpayer's total gross receipts for the same period.
(This percentage may not exceed 16 percent and is three
percent for certain categories of start-up companies).
The base amount is determined by multiplying this fixed
base percentage by the taxpayer's average gross receipts
for the four taxable years preceding the taxable year for
which the credit is claimed. Thus, for a company to
receive the credit its research expenditures in given tax
year must exceed a fixed base that is indexed to the
company's average growth in receipts for the four
preceding years. As under previous law, the base amount
used for R&D credit calculation purposes may not be less
than 50 percent of the taxpayer's qualified R&D
expenditures for the year.
Expanded Availability: The 1989 Act expands the
availability of the research credit by modifying the
requirement that expenditures must be incurred "in
carrying on a trade or business" to qualify for the
credit. With respect to in-house research expenditures
of certain start-up ventures, the trade or business
limitation is deemed to be satisfied if the principal
purpose of the taxpayer in making the expenditures is to
use the results of the research in the active conduct of
a future trade or business.
04/06/90
5
Need for Permanence
Lack of permanence is the most common business complaint
concerning the research credit. Re-extended for an additional
three years by the 1986 Act until December 31, 1988, the
credit has been renewed twice more on a one year basis by the
1988 and 1989 Acts. It is now scheduled to expire at the end
of 1990 (although as a practical matter, the credit will be
effective only through September 1990 due to a special
provision that prorates expenditures incurred before January
1, 1991, i.e., allowing only 75 percent of expenditures to
qualify for purposes of computing the credit). Thus, although
taxpayers did not know from year to year whether the research
credit would remain, it was available continuously from the
time of its enactment in 1981 through 1990.
The fact that Congress regarded research credit legislation as
experimental in 1981 was the principal rationale for making it
temporary. However, with the enactment of structural
refinements in subsequent years and the increasing recognition
that the provision's very impermanence may be its greatest
detriment, this rationale has lapsed. Currently, Congress'
desire to reduce revenue losses is the chief roadblock to
permanence as evidenced by the reduction of recent extensions
to only one year.
While it is generally believed that the research credit has
contributed to industrial R&D efforts and the general
prosperity of U.S. business, the start and stop nature of the
credit to date has created a degree of uncertainty that
impairs the ability of firms to make long-range plans.
Complex, sophisticated research programs must necessarily be
planned years in advance. With a constantly expiring credit
provision, however, firms must make such plans completely in
the dark without foreknowledge of the tax consequences.
Proponents of a permanent research credit argue that a stable
tax provision would permit firms to plan and undertake
research activities with a much greater assurance of the tax
consequences. Accordingly, firms could establish and expand
their research facilities and projects without the concerns
brought about by constantly changing tax rules.
Administration Position
The Administration's budget for FY 1991 "proposes to make the
20 percent research tax credit permanent by allowing 100
percent of total research expenses to be used for computation
04/06/90
6
of the credit for all years after December 31, 1989." The
Administration estimates that permanent enactment of the
credit will incur revenue loses of $0.5 billion in 1991, $0.9
billion in 1992, and $1.1 billion in 1993. To assure tax
stability the Administration concurs with industry that the
current research credit should be made permanent and allowed
to operate for a while before considering any further changes
or structural adjustments.
04/06/90
7
DEPAR
MERCE
GENERAL COUNSEL OF THE
UNITED STATES of AMERICA
UNITED STATES, EPARTMENT OF COMMERCE
Washington. D.C. 20200
DEC
4
1989
MEMORANDUM FOR SECRETARY MOSBACHER
DEPUTY SECRETARY MURRIN
WAYNE L. BERMAN
MICHAEL SKARZYNSKI
BRUCE SOLL
FROM:
Wendell L. Willkie, II
72m
General Counsel
SUBJECT: Research and Experimentation (R&E) Tax Credit and
Rule 861 R&E Allocation Rules
Following up on our conversation of this morning, set forth below
is a summary of current law and changes made by the Reconcili-
ation Bill (which has yet to be formally transmitted by the
Congress to the President for his signature) regarding the R&E
tax credit and R&E allocation rules.
I. Research and Experimentation Tax Credit
Current Law.
The current research and experimentation credit expires at the
end of r989. It is available for research expenditures paid or
incurred in carrying on the trade or business of the taxpayer.
The credit is equal to 20 percent of the excess of qualified R&E
expenditures for the current taxable year over the base amount.
The base amount is equal to the average of the previous 3 years'
R&E expenditures. The base is subject to the limitation that it
never be less than 50 percent of qualified expenditures for the
current taxable year.
Any deduction taken against taxable income for research
expenditures must be reduced by 50 percent of the credit taken.
Changes Made by Reconciliation Bill.
The credit was extended for amounts paid or incurred up to
December 31, 1990.
The current 20 person tax credit is retained, but the formula for
computing the base amount has changed. The base amount will now
be computed by multiplying the taxpayer's "fixed-base percentage"
by the average amount of the taxpayer's gross receipts for the
four preceding years. The "fixed-base percentage" for existing
firms is the ratio of total qualified research expenditures to
total gross receipts for the 1984-88 period. Start-up companies
which did not both incur R&E expenses and have gross receipts
during each of at least three years between 1984 and 1988 are
assigned a fixed-base percentage of 3 percent. No taxpayer's
fixed-base percentage can exceed 16 percent.
Any deduction taken against taxable income for research
expenditures must be reduced by 100 percent of the credit taken,
and must be "reasonable under the circumstances."
(The Administration's proposal would have made the tax credit
permanent. It also would have made the base a fixed historical
base equal to the average of the firm's qualified R&E
expenditures for the years 1983 to 1987, indexed to GNP growth.)
II. Section 861 - - Allocation and Apportionment of Research and
Experimental Expenditures Between Foreign and Domestic Income.
Current Law.
Until the recent R&E allocation rules expired on May 1, 1988,
domestic firms were allowed to allocate 64 percent of their
expenses for research performed in the United States to U.S.
source income. The remaining expenses were allocated to foreign
source income on the basis of gross sales or (subject to a
limitation) gross income.
Changes Made by the Reconciliation Bill.
The Reconciliation Bill basically recodified the law as it
existed prior to May 1, 1988. The new provision is effective
only for the taxable year beginning after August 1, 1989 and
before August 2, 1990, and applies only to research expenses paid
or incurred during the first nine months of that period.
(The Administration's proposal would have made the R&E allocation
rules permanent. The Administration also wanted a 67 percent R&E
expense allocation, and no limitation on the use of the gross
income method for foreign source allocation, but is generally
satisfied with the recodification of prior law.)
NOTE: Between May 1, 1988 and the effective date of the new
provision, firms were allocating R&E expenses based on Treasury
regulations promulgated in 1977.
2
DEPARTMENT OF COMMERCE
GENERAL COUNSEL OF THE
UNITED STATES DEPARTMENT OF COMMERCE
UNITED STATES OF AMERICA
Washington, D.C. 20230
DEC
26
MEMORANDUM FOR Wendell L. Willkie, II
FROM:
Michael A. Levitty
Lisa Sockett
SUBJECT:
Examples of Research and Experimentation (R&E)
Tax Credit and Rule 861 R&E Allocation Rules.
This memorandum responds to Deputy Secretary Murrin's request for
examples of the impact of the Omnibus Budget Reconciliation Act
of 1989, Pub. L. No. 101-239, as enacted into law on December 19,
1989, on the above-referenced tax provisions. Set forth below
are some numerical examples and a further discussion of the
changes made by the Reconciliation Act.
I. Research and Experimentation Tax Credit
The way the base period was calculated under the previous R&E tax
credit, an increase in research expenditures in one year resulted
in higher base period amounts (and therefore smaller credits) in
following years unless research expenditures were increased by
ever greater amounts. It also benefitted cost increases due to
inflation rather than real increases in research activity. The
Reconciliation Act ties research expenditures to gross revenues.
This has the advantage of indexing the credit for inflation, and
ameliorating the impact of increasing research expenditures as
long as firms maintain research expenditures commensurate with
their own sales growth.
The following example calculates the R&E tax credit for the
taxable year 1990 under the previous law and under the
Reconciliation Act (which is effective for taxable years
beginning after December 31, 1989) to demonstrate the application
of the new base period formula.
Example
A calendar-year taxpayer, X, is created in 1984. X's qualified
research expenditures for 1984-1990 are as follows:
1984
$ 0
1985
$ 10,000
1986
$ 20,000
1987
$ 30,000
1988
$ 40,000
1989
$ 50,000
1990
$ 60,000
X's gross receipts for 1984 through 1990 are as follows:
1984
$100,000
1985
$125,000
1986
$200,000
1987
$275,000
1988
$300,000
1989
$325,000
1990
$400,000
The amount of X's research credit for 1990 is determined as
follows:
Under previous law - The credit is equal to 20 percent of the
excess of qualified R&E expenditures for the current taxable year
over the base amount. The base amount is equal to the average of
the previous 3 years' R&E expenditures. The base is subject to
the limitation that it never be less than 50 percent of qualified
research expenditures for the current taxable year.
1990 qualified research expenditures
$ 60,000
Less the base amount, which is the larger of:
(1) Average base period research expenses of
previous three years
($50K + $40K + $30K/3)
$ 40,000
(2) Minimum average base period research
expenses (50% of $60,000)
$ 30,000
$ 40,000
Remainder of qualified research expenditures
available for credit
$ 20,000
Research credit (20% of $20,000)
$ 4,000
Under the Reconciliation Act - The base amount is computed by
multiplying the taxpayer's "fixed-base percentage" by the average
amount of the taxpayer's gross receipts for the four preceding
years. The "fixed-base percentage" for existing firms is the
ratio of total qualified research expenditures to total gross
receipts for the 1984-1988 period. No taxpayer's fixed-base
percentage can exceed 16 percent. As under current law, a
taxpayer's base amount may not be less than 50 percent of
qualified expenditures for the current taxable year.
2
1990 qualified research expenditures
$ 60,000
Less the base amount, which is the larger of:
A. (1) Average amount of taxpayer's gross receipts
for four previous years ($325K + $300K + $275K
+ $200K/4)
$275,000
multiplied by the
(2) Fixed-base percentage, which is the smaller of
(a) Total qualified research expenditures for
1984-1988 ($0K + $10K + $20K + $30K + $40K =
$100,000), divided by total gross receipts for
1984-1988 ($100K + $125K + $200K + $275K +
$300K = $1,000,000) = 10 percent
(b) Minimum fixed-base percentage
16 percent
($275,000 X 10%)
$27,500
B. Minimum average base period research expenses
(50% of $60,000)
$30,000
$ 30,000
Remainder of qualified research expenditures
available for credit
$ 30,000
Research credit (20% of $30,000)
$ 6,000
II. Section 861 -- Allocation and Apportionment of R&E Expenses
Under the U.S. Tax Code, each item of income of a multinational
company is assigned either a U.S. source or a foreign source. A
tax credit is available, subject to a limitation, for foreign
taxes paid on foreign source income. The limitation is that the
credit cannot exceed the amount that would be payable if the
taxpayer's U.S. tax rate was applied to the foreign source
income.
In calculating the amount of foreign source income available for
the foreign tax credit, taxpayers are required to apportion
expenses such as R&E expenses between foreign source income and
U.S. source income. Subject to the foreign tax credit
limitation, the lesser the expenses apportioned to foreign
sources, the greater the amount of foreign source income
available for the foreign tax credit, resulting in lower U.S.
taxes.
The Reconciliation Act provides that a taxpayer shall allocate 64
percent of R&E expenses for research conducted in the United
States to U.S. source income, and 64 percent of R&E expenses for
3
research conducted in a foreign country to foreign source income.
The remainder of total R&E expenses can be allocated by either
the gross sales or gross income method. If the gross income
method is chosen, the amount apportioned to foreign source income
can be no less than 30 percent of the amount calculated under the
gross sales method. (There is no restriction on the gross sales
method.)
The following example compares the gross sales method to the
income method under the Reconciliation Act, which recodifies
previous law. In the example, the income method is preferable
for allocating R&E expenses, because less expenses need to be
allocated to foreign sources, thereby leaving a greater amount of
foreign income available for the foreign tax credit.
Example
Company Y has a wholly owned foreign subsidiary. In 1989, Y had
$100 of U.S. research expenses and $100 of foreign research
expenses. 50 percent of Y's gross sales produced U.S. source
income, and 50 percent produced foreign source income. 90
percent of Y's gross income is from U.S. sources, and 10 percent
is from foreign sources.
Allocation of qualified R&E expenses:
U.S.
Foreign
Gross Sales Method
Allocation of R&E expenses for
-- research conducted in
the U.S. ($100 X 64%)
$ 64.00
-- research conducted in
foreign country ($100 X 64%)
$ 64.00
Allocation of Remaining $72 ($200-$128)
based on gross sales
U.S. ($72 X 50%)
$ 36.00
Foreign ($72 X 50%)
$ 36.00
Total Allocations
$100.00
$100.00
4
Gross Income Method
Allocation of qualified R&E expenses:
U.S.
Foreign
Allocation of R&E expenses for
-- research conducted in
the U.S. ($100 X 64%)
$ 64.00
-- research conducted in
foreign country ($100 X 64%)
$ 64.00
Allocation of Remaining $72 ($200-$128) $128)
based on gross income
Foreign -- Larger of
($72 X %10)
$ 7.20
or
30% Gross Sales Limitation,
($36 X 30%)
$10.80
$ 10.80
U.S. ($72 - $10.80)
$ 61.20
Total Allocations
$125.20
$ 74.80
5
TECHNICAL COMMENTS* ON THE PAPER,
"COMPETITIVENESS & THE COST OF CAPITAL:
EXECUTIVE SUMMARY"
(Paper prepared for the EPC Working Group
on Competitiveness and the Cost of Capital)
Section II: Defining the Cost of Capital
NEWS ITEM: On March 28, Oracle Systems Corporation, whose
revenues have doubled in 12 of the past 13 years, announced
that its quarterly earnings were a flat 18 cents a share,
instead of the anticipated 23 to 25 cents predicted earlier.
The difference was due to auditors' disallowance of sale-on-
trial contracts which customers might still decline. The
next day, Oracle closed at $17.50, down $7.875 or 31%.
(From a 4/5/90 New York Times article which discusses
business problems that Oracle may or may not have.)
Comment: The paper defines the cost of capital as the return a
corporation has to pay to attract investors. It might
be useful to define investors in terms that support the
concept of competitiveness. Investors, including
managers of large investment funds, can have a variety
of motivations, many of which have nothing to do with
the competitive success of the companies in which they
invest. Those who dumped oracle are an example.
Failure to distinguish between the types of investors
at the outset may limit the value of the paper.
Section III: Why the Cost of Capital is Important to Investment
Comment: It might help to distinguish the business objectives of
different groups of technology company owners or their
representatives. Some "owners" manage funds for others
and are measured on the basis of safety and consistent
earnings. Often, these "owners" even set their target
selling price for a stock when they buy it, and have no
continuing interest in the companies contained in their
portfolios. Expenditures made for long term
competitive benefits, particularly those such as R&D,
process improvement, and worker training which
accounting conventions treat as expense, destroy values
for this class of "owners." Should the study serve to
aid, discourage, or be neutral toward "owners" of this
type of disengaged owner/representative?
*Prepared by the Office of Technology Policy, Technology
Administration, U.S. Department of Commerce.
1
We are testing the idea that investors can be
classified as "conservative" or "productive." On a
typical cash flow chart, the conservative investor
seeks predictable and steady gains from the outset with
no chance for loss of principal. Buyers of Treasury
bills fit this profile. The productive investor, on
the other hand, accepts the fact that the value of the
investment will decline before it produces a revenue
stream which is intended to recover the investment plus
profits. The productive investor, who is needed to
finance new competitive products and new processes,
also recognizes that the entire investment may be lost.
Most investors fall between these two extremes, but it
appears that capital increasingly is being concentrated
toward the conservative end of the spectrum in the
hands of managers of large pension, mutual, and trust
funds. Since the objectives and methods of the two
types of owners are so different, the effects of the
cost of capital probably are also different.
Reducing the cost of capital is not a cure-all for
U.S. competitiveness. For example, sharp reductions in
the cost of capital will not change corporate
management strategies in such key areas as quality,
concurrent engineering or management, or the formation
of long term relationships between suppliers and their
primes (e.g., Xerox and Honda of America).
Section IV: Factors Impacting the Cost of Capital
Comment: It may be useful to compare investment rates with GNP
for the 1980s. For example, the February Business
Conditions Digest shows that commercial and industrial
loans outstanding in 1982 dollars grew about 74% while
GNP in fixed dollars grew only about 30%. A Federal
Reserve Board chart shows a similar pattern for 1953-
77. If other measures also show that investment grew
more than GNP, perhaps there is more of a capital
productivity problem than a cost of capital problem.
One way of looking at interest rates for an industrial
project is that they comprise at least four components:
(a) The price paid for the privilege of using the
money (overcoming the lender's liquidity
preference).
(b) Anticipated loss of the principal's purchasing
power due to inflation.
(c) The risk of loss of the principal or interest.
2
(d) The opportunity to earn significantly more than
the minimum acceptable interest rate.
But for the types of productive investments we are
seeking, with a period of negative cash flow, (c), the
risk of loss, becomes the most important factor. This
varies with each investment. It is outside the range
of macro economic control but is reflected in hurdle-
rate calculations. Since risk normally grows with time
because of unknowns like unanticipated technical
problems, market responses, and competitor actions, the
risk element of the interest rate normally will be
higher for longer range projects. It seems unlikely
that changes in (a), which most observers appear to
advocate, can offset the increases in (b) and (c) to
cause longer range investments.
Conservative capital managers must ignore (d) if
significant risk is indicated by (c) i and, if they are
obliged to show steady growth, they cannot accept the
time delay. So, while (d) is what drives the truly
productive capital managers, it is of little interest
or incentive value to the conservative ones.
Savings and Macroeconomic policies
Comment: This section opens by saying that savings supplied by
individuals, governments, and businesses determine the
amount of funds which are available for investment. It
may be useful to point out that much U.S. functional
investment is treated as expense. Private autos used
for commuting are consumption while taxis and buses are
investment. Similarly, company expenditures for
knowledge-related activities such as education, worker
training, R&D, and most software are booked as current
expenses although they are made for long-term reasons.
If discrepancies such as these were resolved, the
investment rate and the savings rate might show more
favorably.
Market efficiency
Comment: This section begins by saying, "The extent to which
impediments to capital flows remain between nations and
within a given country determine how efficiently
capital is allocated, which in turn, influences its
cost to specific users." As this paper is directed
toward competitiveness, it may be important to
distinguish between capital market efficiency and
capital use efficiency. The Japanese are widely cited
for both their competitiveness and their low capital
cost. But they created an inefficient capital market
to the degree that they restricted both capital exports
3
and low cost loans for consumption. For years, they
induced capital use efficiency by restricting capital
market efficiency.
There is a serious question of how much new capital
that is raised is used for productive investment.
According to an article in the April 2, 1990 New York
Times business supplement, from 1982 to 1989, new
investments by venture capital companies in buyouts and
acquisitions tripled. As of 1988, only 13% of venture
capital firms' dollar commitments went to startups.
And these are supposed to be the classic productive
capitalists.
It is not clear that new capital such as pension fund
contributions will be channeled into productive
investment as opposed to speculation. It also appears
that much of the pension fund money "invested" in
blocks of S&P 500 stocks did little more than inflate
their market price value while adding few productive
assets.
The Japanese are now having to cope with the effects of
low cost capital in land and stock speculation.
Agency Costs and Costs of Financial Distress
Comment: This may well be where most of the U.S. problem is
located. There seems to be a growing gap between the
"Techies" who need money for new products, processes,
training, etc., and the "Buckies" who control the
money. Although the theory of efficient markets rests
on a presumption of perfect knowledge, most of these
people just don't understand each other, and SO far,
the Buckies have done well enough without even trying
to.
One of the elements of an interest rate calculation
discussed above was (c), or the risk of loss of the
principal or interest. There is also a (c') the risk
or cost of the capital manager's inability to
understand and evaluate the factors that cause (c).
This leads to the conclusion that the highest cost of
capital situations probably occur when (c) and (c') are
cumulative. Unfortunately, this is increasingly the
case, with most productive investments now carrying a
significant (c) factor, and capital increasingly being
concentrated in the hands of investment managers who
add the (c') factor. Whether or not one wants to call
this a cost of capital issue, it appears to be a
primary reason why productive investment is lagging.
4
The Japanese keiretsu are ideally suited to handle the
(c) and (c') problem. Members of the same industrial
group can, together, explain to their member megabank
how one company's advanced development program will
help the others, and an assured partial market can be
established even prior to the investment. Given
assurances like this, the project has a lower (c) cost,
and the lender who may be a member bank, customer, or a
supplier, has much less of a (c') problem. This is
where the Japanese can obtain a lower cost of capital.
Section V: Policy Implications
Comment: This section proposes policies that reduce the cost of
capital. As the debate proceeds on this, it would be
useful to distinguish the particular aspects of the
cost of capital affected--liquidity preference cost,
inflation adjustment, project risk, and investors' lack
of knowledge of the risk.
If the (c) and (c') problem is the real capital cost
driver, the actions mentioned above under Section IV
dealing with agency costs may be the most useful part
of the paper. For example, there is some evidence that
family controlled businesses outperform others because
they have more latitude to make long term strategic
investments. The Japanese keiretsu are similar.
Another mechanism to reduce the cost of capital in an
important area would be an investment tax credit for
the purchase/lease of flexible, automated computer
integrated manufacturing equipment, including related
training and software expenses.
5
THE FINANCIAL ACCOUNTING STANDARDS BOARD (FASB)
AND U.S. COMPETITIVENESS
I. ISSUE
Financial accounting procedures have not kept up with industrial
changes brought about by global competition, new technologies,
emphasis on quality, use of computers in manufacturing, and needs
for higher skilled workers. As a result, investments that firms
must make to be competitive are discouraged because accounting
systems often overstate initial costs and understate future
benefits. This, in conjunction with efficient capital markets
that stress short-term performance, is impeding the modernization
of U.S. industry.
II. DISCUSSION
Profits are the main goal of most U.S. companies, and financial
accounting provides the report card that shows how well they are
doing. Accounting procedures have been developed over many years
to measure profit, preserve assets, protect the interests of
owners and creditors, prevent fraud, provide a basis for
interfirm comparisons by investors, and help managers control
routine operations. Applying these procedures often requires
judgement, so standards have been developed to help accountants
and auditors ensure that a company's financial condition is
reported with completeness, accuracy, and fairness in ways that
will be comparable from company to company over time.
While the standards emphasize stability, many of the businesses
they measure are changing rapidly as product development and
manufacturing operations become knowledge-intensive. In order to
be competitive, emphasis in manufacturing has shifted from using
unskilled labor to make long runs of identical products, to
highly skilled and professional employees who use computers and
other expensive equipment to make new, varied, and rapidly
changing products. This shift, which is required to meet the new
market requirements for quality, just-in-time delivery, and
flexible manufacturing capability, requires companies to spend
large amounts to develop new products and processes long before
production begins but spend relatively little during actual
production.
In the past, long term expenditures usually resulted in tangible
assets like buildings and machinery. Today, in addition to
buying tangible assets, companies must increasingly pay for the
costs of strategic activities such as long term marketing,
research, product development, education and training, computer
programming, and product testing. These activities produce
critical knowledge in the form of know-how, product designs,
computer software and data that controls manufacturing equipment,
and employee skills. This knowledge, critical to survival and
growth, operates as a long term asset (perhaps the most important
1
asset in the firm), but current accounting standards require most
of it to be treated as an intangible with a value of zero, and
its development costs are charged to current expense.
The primary accounting challenge in modern manufacturing and
high-tech firms, should change from measuring operating costs
when they are incurred, to apportioning one-time expenditures for
years after they have been incurred. But accounting standards
inhibit this change. For example, inventories are treated as
assets, even though companies usually try to minimize them. With
modern manufacturing processes, inventories can be replaced by a
repertoire of computer code that directs machine tools to make
small batches of products and replacement parts as they are
needed for the life of the product. Present accounting standards
require the cost of the computer code to be charged to expense
when the code is created; the code to be assigned a value of zero
because it is an "intangible"; and the asset value of the
inventory to be reduced -- all of which reduce the company's
stated value and profit.
In other words, providing for the future through strategic
activities that are not allowed to be capitalized leads to a
direct reduction of current profits even though they are intended
to result in long term profits. The result is a negative
incentive, or an incentive for managers not to modernize. This
is compounded for publicly traded companies whose stock drops
after reports of lowered earnings, and for small companies that
must borrow for expansion. There is reason to believe that some
companies avoid modernization for fear that current expense
charges and resulting drop in stock value will lead to a hostile
takeover.
Thus the lag between evolving industrial processes and accounting
systems that measure them allows costs and profits to be
seriously understated or overstated for different products and
different periods of time. The report card, based on existing
accounting standards, is no longer reliable, and it is becoming
increasingly difficult to determine whether actions a company
takes to achieve its profit goal are working.
Company managers who are trying to justify modernization programs
or raise financing for them are increasingly aware of parts of
the accounting problem, but few of them have spoken out on the
broader issue of how the accounting lag has combined with the
changing nature of manufacturing, short term investment emphasis,
and high capital costs, to impose a severe handicap on U.S.
companies.
III. COMMERCE DEPARTMENT ACTIONS
Solutions to the accounting problem will not come quickly, but a
start appears to have been made. The Advanced Manufacturing
Program of the Department of Commerce's Technology Administration
recently held a roundtable with representatives from the
2
manufacturing, financing, accounting (including the Financial
Accounting Standards Board) sectors, universities, and several
federal agencies including SBA and DoD to consider the financing
problems of small manufacturing companies seeking modernization.
The FASB representative commented that while specific questions
such as treatment of inventories and R&D had been considered, the
fundamental issue of accommodating basic changes in the nature of
product development and knowledge-intensive manufacturing
processes had not previously been understood or considered. An
outcome of the meeting was an agreement among the accountants to
begin consideration of the broad problem. It must be remembered,
however, that the process of changing accounting standards can
take years.
The Technology Administration could bring together a group of key
managers to explain the problem to Treasury, CEA, and OMB
officials. The group might include about ten people like:
Robert Frosch -- former Administrator of NASA, now General
Motors VP for Research who is investigating the accounting
problem.
Steven Jobs -- who obtained significant financing from Japan
to ensure stability for his new company.
Robert Galvin -- Two of whose officers at Motorola explained
that the company's efforts to win the Baldrige Quality Award
might not have been possible had not a significant block of
its stock been privately held.
In bringing this issue to the attention of the policy level, DOC
could address it with the appropriate Federal agencies while the
Advanced Manufacturing Program continues to encourage private
sector actions by the manufacturing, financing, and academic
communities. The parallel paths could be mutually reinforcing
and expedite the necessary changes.
3
REFORMING MANAGEMENT ACCOUNTING
TO SUPPORT TODAY'S TECHNOLOGY
Technical managers are in a unique position to lead in developing management
accounting systems more suited to the needs of modern technology.
Lynn W. Ellis and Robert G. McDonald
Accounting for management should provide a basis for
One source of this problem is the recognized career
making correct decisions not only for the current
path for corporate controllers and treasurers, which has
business but also for building the future value of its
been to work in public accounting and auditing, get the
activities. Much of what has been written recently on the
CPA qualification, and be hired by the firm which had
problems with our present management accounting
been audited. This placing of key management
practices, as applied to modern technology, is a litany of
accounting positions in the hands of those who have a
its many deficiencies (1-5). In proposing reforming
financial reporting orientation readily explains why
management accounting to overcome these cited
management accountants lack a production or internal
inadequacies, we shall summarize, first, the key points of
focus and formulate internal reporting on that financial
criticism; then address the role of research-technology
accounting perspective. As a consequence, managers'
managers in preparing this reform; and, finally, offer four
horizons contract to the short-term cycle of their
specific proposals for a new management accounting
monthly profit and loss statements served up. with the
biases of those who have been trained in the financial
system.
accounting viewpoint.
Critics of current management accounting cite four
distinct categories of shortfalls:
2. Management reports are of little help to operating
managers attempting to reduce-costs and improve
1. The dominance of financial accounting for those
productivity. Accounting reports are too aggregated;
outside the firm over internal management needs.
they are too late by the time all the data are run; they
Financial accounting, sanctioned by the Securities and
use allocation methods that result in cross-subsidies of
Exchange Commission and the Financial Accounting
different products giving incorrect costs; and they are
Standards Board (FASB), is concerned with reports to
prepared under improper bases, such as the use of direct
outside creditors and investors and not what is reported
labor to spread unallocated costs as overhead onto
internally to managers. The financial accountant values
products. With the evolution toward high-technology
the inventories of the firm by the "costs attach"
manufacturing operations, the overhead items such as
approach in which the cost of the product will only
industrial engineering and production control have
include the manufacturing costs. Administrative,
increased, while increasing use of capital to replace labor
marketing and R&D charges are considered costs of the
has cut the direct labor content to as little as 5 to 10
period in which they are incurred, and expensed
percent of manufacturing costs. This shift in costs, plus
immediately. The result of these calculations is a value
the spreading of overhead onto product through direct
for the cost of inventory on the balance sheet and a
labor, has contributed to skyrocketing overhead rates
value for the cost of products sold on the income
due to many more dollars of overhead per hour of direct
statement. The latter understates the true product cost
labor.
by not including any of the costs incurred before
When operating managers are presented with these
manufacturing.
apparent high labor costs, one natural tendency is for
Lynn Ellis is professor of management at the University of New
them to try and reduce costs by still further reducing
Haven (Connecticut) and president of Lynn W. Ellis Associates,
direct labor. This wastes much effort, however, because
a consulting firm for telecommunications, technology
attention is directed to the least important cost category
management and strategic planning. He was formerly vice
instead of directing efforts to analysis and control of
president of engineering at Bristol Babcock, Inc. and before
those overhead items which are susceptible to reduction
that director of research at ITT. A Fellow of the Institute of
Electrical and Electronics Engineers and of the American
3. The management accounting system fails to provide
Association for the Advancement of Science, Ellis has a B.S.E.E.
accurate product costs. Accountants only include as a
degree from Cornell, an M.S. degree from Stevens Institute and
a Doctor of Professional Studies in Management degree from
product cost the manufactured cost of direct material,
Pace University. He is the author of The Financial Side of
direct labor and allocated overhead; they leave out the
Industrial Research Management (John Wiley & Sons, 1984).
specific costs attributable to marketing, product
Robert McDonald is chairman and associate professor of
management, administration and planning, R&D, and
accounting at the University of New Haven. Prior to joining the
manufacturing development undertaken prior to
university he was assistant treasurer for Thermo Electric
launching the product into manufacture and sales. Thus.
Company and an internal auditor for Merck & Company. He
in a high-technology environment, product costs are
has an M.B.A. in corporate finance from New York University
and is a certified management accountant, certified internal
understated and this may lead to improper
auditor and a chartered financial analyst.
decision-making.
30
4. The subordination of growth-producing strategic
activities (including R&D) to the bottom line of return
Growtb-enbancing
on investment. Since it is past investment, expending
activities such as R&D
funds on growth-producing strategic activities, such as
are treated as expenses to
R&D, tends to produce a lower current return as
measured by the accounting system. However, proper
be minimized rather than
management needs to balance today's return with
as investments in the
tomorrow's, and this means optimizing the net present
value of the combination of present and future streams
future.
of income, considering the time value of money, in order
to maximize the value to shareholders (8,9). A
consequence of this erroneous focus is that
growth-enhancing activities such as R&D, market
inv
development and manufacturing development, are
treated as expenses to be minimized rather than as
Recem
Why Technical Managers Should Care
investments in the future (7).
There are several reasons why managers of research,
Even though one of accounting's main principles is the
development and technology should be concerned with
matching of revenues to the expenses of those revenues,
the problems thus far outlined. First, they are in the
the current system fosters a bad match. With short
business of addressing the corporation's future through
product life cycles, which are natural in the
the growth of the firm's product and service base. Any
high-technology environment, money spent today on
management accounting system that does not support
design and development of new products will be
this goal is a handicap to proper business management
expensed immediately for "conservative accounting."
(10).
Then, in the future, the product's revenues will be
Second, computers (and particularly personal
matched with that period's spending for even more
computers) are now so readily available as to make more
distant product innovations. With today's revenues
practical the use of accurate costing systems focusing on
matched to spending for tomorrow's products, and the
management's goals. With the lower cost of processing
costs of developing today's revenues matched to
data on computers, it is no longer necessary to
yesterday's revenues, the accounting mismatch is shifted
economize by having one system do the accounting
one whole cycle.
valuation, and have that system suffice for all other
internal management reporting needs. It should be
Prior to 1974, companies were at least allowed to
remembered that the internal reporting and the
capitalize R&D expenditures (6). One benefit showed up
information needs of management are in no way bound
when a research effort came up dry, and the capitalized
by the FASB rules. These rules come into play only when
amounts were written off. Stock analysts looked for these
the firm reports to outside (and presumably uninformed)
write-downs as evidence of where the firm sought
investors and creditors. For inside reporting, a company
results and where it failed. Normally it would be very
can do anything it wants-even reading tea leaves or
difficult for an analyst to be aware of a firm's direction in
checking zodiac signs! Of course, an accounting system
the R&D area due to the complexity of the research and
that easily reconciles financial and management
the firm's efforts to maintain secrecy. With write-downs,
accounting would have somewhat greater credibility.
the analyst could gauge where the remaining efforts
were directed, or how the firm might regroup and
Finally, in the words of a leading critic of present
redouble its efforts. The analyst could also compare
management accounting systems, who has repeatedly
firms' write-downs and estimate future successes. Since
invited engineers to become involved in this area:
current financial accounting no longer allows capitalizing
R&D, the information once contained in these
Management accountants who leave their offices will not
find it difficult to discover the engineers who are in the
write-downs is now hidden. Conservative accounting has
forefront of implementing these changes
we
need
to
again
thus generated less disclosure about R & D efforts than
learn from engineers bow to design more effective internal
before.
measurement systems the professional organizations in
the forefront of promoting change in management
Another consequence of this accounting treatment for
accounting systems are basically production and engineering
R&D is the lost opportunity of emphasizing design
organizations. (2, sidebar).
engineering. With shorter life cycles, more savings may
be realized from better design than from efforts to
Research and technology managers should accept this
squeeze out efficiencies from the production line;
challenge and devise reformed rules of measurement
however, no common yardstick exists between these
which will address the shortfalls identified by these
critics.
March-April 1990
two activities in current management accounting
systems. Accounting reports show R&D as a cost of the
period, and not of the product, as a consequence of
financial accounting's treating costs by function
Proposals for Reform
(manufacturing, marketing and administration) and not
The FASB has a conceptual framework for accounting
by product or product line.
theory to ease later rule making which concludes that
for financial accounting, users' (creditors and investors)
Conservative accounting
needs are primary. It would appear time for management
accountants, in partnership with their research and
bas thus generated less
technology managers, to present their own conceptual
disclosure about R&D
framework and declare that for management accounting,
internal user needs are primary, and that they differ from
efforts than before.
outside user needs.
The following four proposals for changes in management
accounting might be the start of such a framework:
1. Extract strategic expenditures from present
manufacturing costs, leaving true operating costs. The
Costs associated with machines, such as depreciation,
present income statement which is split between "costs
interest, taxes, floor space occupancy, and electric
of goods sold" (manufacturing expenses) and general
power, need to be in the machines' overhead rates,
expenses (administration, marketing, and R&D) needs to
rather than in that of the few people left on the factory
be shifted into one which more nearly represents the
floor. Similarly, direct materials, purchased parts, etc.,
line between operating and strategic decisions, as was
generate their own overhead costs in purchasing,
pointed out nearly two decades ago (8). Operating
logistics and storage, which belong in a materials burden
expenses entered as "costs of goods sold" should clearly
or overhead rate. Human labor ovehead would then be
exclude those activities which are aimed at future years
reduced to costs really attracted by people, such as
business. As shown in the Table below, under
fringe benefits, and the building occupancy costs only
manufacturing in the first column, the activities in the
for those areas used by people. In this manner, operating
upper block relate to current operations, while those in
cost reduction efforts can be focused correctly on the
the lower block represent expenses being incurred now
cost drivers and not just the direct workers.
for the benefit of future operations. Also in the next
three columns, the expensed activities under financial
It is even possible that three systems may have to be set
accounting are similarly divided into operating and
up until we learn to integrate them better: One each for
strategic sectors. The primary effect of such a change
process control, inventory valúation and product cost
would be to ensure that decisions to reduce operating
(11). The time frame dictates the response of each
costs would be made separately from, and thus not
system: Process control monitors material and/or labor
down to the hour or minute with real time
impact, preparing for tomorrow's products and services.
capability-not summary reports at the end of the week
2. Allocate operating overhead costs to machines and
or month. Inventory valuation can be accomplished on
materials rather than only to direct labor. In automated
existing systems with little change. Product costs should
factories, where machines have replaced human labor,
be long term, in most cases over a one-year horizon, as
the concept of machine labor needs to be introduced.
covered below.
Comparison of Accounting Systems
Financial Accounting
A Possible New
(and Present Management Accounting)
Management
Accounting System
Inventoried
Expensed
Marketing
General &
Manufacturing
R,D & E
& Sales
Administrative
Fabrication
Engineering
Sales
General
Operating Expense
Assembly
Accounting
for current busi-
Production Control
ness (sub-total of
Purchasing
items at left)
Industrial Engineer-
Research
Market Develop-
Strategic Planning
Strategic develop-
ing
Product Develop-
ment
ment expense for
Manufacturing
ment
Product Manage-
future business
Development
ment
(sub-total of cur-
Process Develop-
Advertising
rent projects of
ment
Promotion
items at left)
Employee Training
Inventoried Sub-
R.D & E Sub-total
Marketing Sub-total
G & A Sub-total
Total for reconcilia-
total = "Cost of
tion of the two
Goods Sold."
32
systems
3. Separate functional expenses on the current income
Views from Abroad
statement into a new category of strategic investment
The need to reform management accounting has not
activities, corresponding to those allocatable to true
gone unnoticed outside the U.S. Not surprisingly,
product cost, as shown in the Table. Included in the
proposals from other countries differ in substance from
strategic investment activities would be the costs
the suggestions in this article. Japanese management
associated with future products such as R&D; market
accounting is used to play a role in integrating the efforts
development, product management, and long-term
of employees with the long-term strategies of
promotion from marketing; training and organizational
management (15). An alternative concept put forward in
development from human resources management; and
the United Kingdom, is to calculate an annual innovation
expenditure in the form of a value-added statement (16).
value analysis, product start-up, process development,
Neither of these, in our opinion, get to the heart of the
and programming robots from manufacturing (12).
matter in recognizing the investment nature of product
These activities should be budgeted and approved on an
decisions.-L.W.E. and R.G.M.
investment basis, as with capital plant, so that all
investments in the future by a company share a common
accounting yardstick.
Internal reporting can adopt any convention it wishes for
product cost and not be bound by financial accounting's
price too low products with high strategic investments
inventory cost. For management decisions, therefore,
nor price too high long-running products which have
true product cost would equal inventoried product cost
depreciated their shadow investment accounts to zero.
plus an additional cost representing investments made in
*
the past for the product, which financial accounting has
4. Use option theory as a value of those strategic assets.
required to be expensed. This approach would try to
A fourth element of such a conceptual framework should
calculate "life-cycle" standard costs of a product, to
be a means of policing the values in the shadow
include manufacturing, marketing and R&D (5). Lest this
investment account. While the initial values will be the
seem strange to readers, consider that marketing has for
costs incurred, good practice in managing such an
some time used a standard cost of sales for many
account requires that the value of each project carried
products-it is just labeled a "dealer discount." This
forward annually should be the lesser of cost or current
approach would match costs with the transactions that
market value, as is the practice with inventories of
cause them, and not be content to believe that costs are
goods. Thus, if the market value is lower than costs
affected by volume alone.
spent less writeoffs to date, additional writeoffs would be
required beyond the standard amounts determined in
As a consequence of such a shift in emphasis, efforts to
setting true product costs. This would trigger review by
define an optimum functional budget, such as for the
management, reevaluation of the standard amounts, and
R&D function, would be replaced by the more correct
thus recalculation of true product costs.
management task of determining an optimum strategic
investment budget. Once this budget was set, balancing
This raises the issue of how to calculate market value,
the company's present and future, it would then be
since there is no free market on which to rely. Clearly,
apportioned among functional project proposals
the benefits of a product or project which is well past its
according to their relative contribution to the firm's net
initial launch or operational date can be reforecast in
present value (NPV), as recommended for R&D return
terms of the NPV of its future streams of income,
(13). Thus, a common measurement would apply for the
thereby providing a comparison with costs being carried
R&D project, cost reduction in the factory, new
forward in the shadow account.
machinery, or opening a branch sales office in a new
territory. The management accounting task under such a
Option theory provides an alternative solution to
scheme would become the task of project accounting
valuation early in the product life cycle (14). An option
against preestimate, a radically different task from the
gives the investor the right to make a decision in the
future. This is the equivalent of doing the R&D in
present focus on accounting by functional department.
anticipation of a later decision on launching the product
As such an accounting system requires a record of past
if the prospective return is right, or cutting losses if it is
project expenditures, some investment portfolio
not. This right has value whenever there is uncertainty,
valuation scheme needs to be devised. While the FASB
such as early in the R&D cycle. Thus, the value of
requires that these strategic investment activities be
initiating R&D is the right it gives to be in a position to
expensed in external reporting, they may be
make the later commitment, with maximum loss limited
"capitalized" for the purposes of internal accounting by
to the negative cash flow of the R&D.
writing them into a shadow investment account for each
product or product line. When the products are sold and
The formulas for calculating option value are
revenues recorded, the "standard cost" of each item in
complicated, but have been reduced to tables in finance
the shadow account would then be written out of the
textbooks and programs usable in personal computers.
These tables and programs depend on two principal
March--April 1990
account and into the true product cost of goods sold.
The new management accounting would recognize not
inputs:
only true product profitability but also the strategic
return from the sum of such products, based on their
The ratio of projected NPV of income streams to
contribution. More important, however, product pricing
product launch costs is one input, with the value of the
would need to recognize true product cost, and neither
option increasing accordingly. This is just the R&D
we are really talking decessions
return as recently defined (13). While this needs to be
today's management accountants and MIS specialists fail
greater than one in investment theory, it may be less
to perceive the need for the reforms expressed above.
Research and technology managers are now in a unique
than one in option theory in the expectation that
fluctuations in the period before launch might raise it
position to exert leadership in developing the
management accounting systems for future of modern
above one by then
technology. O
If the NPV of future income streams at the time of
launch is not above the launch cost, the option will not
be exercised. However, the more this NPV is above the
Acknowledgement
launch cost, the greater is the project's profitability. This
Thanks are due Robert Rainish for his many provocative
input is not linear, but works out to the multiple of the
ideas and critiques during the preparation of this paper.
project's standard deviation (risk) times the square root
of the number of years to the launch decision. Higher
References
risk and longer time to hold off deciding increase the
1. H. Thomas Johnson and Robert S. Kaplan, Relevance Lost:
value of initiating the project.
The Rise and Fall of Management Accounting Boston:
Harvard Business School Press, 1987, reviewed in "Accounting
For example, for a R&D return of 1.4 and a 40 percent
Critic Robert Kaplan," Inc., April, 1988, pp. 55-67.
per year standard deviation, with four years to exercise
2. H. Thomas Johnson and Robert S. Kaplan, "The Rise and Fall
date, the option is worth 43 percent of the launch cost,
of Management Accounting," Management Accounting
setting a market value on the early R&D stages of the
January, 1987, and IEEE Engineering Management Review, 15
(3), Autumn, 1987, pp. 36-44.
project.
3. John Holusha, "Cost Accounting's Blind Spot," New York
With an option, as the time until decision nears zero, the
Times, October 13, 1987.
4. Ford S. Worthy, "Accounting Bores You? Wake Up," Fortune,
ratio of the NPVs dominates the value formula, and thus
October 12, 1987.
carries smoothly into the post product launch
5. Kevin Kelly, "That Old-time Accounting Isn't Good Enough
calculation referred to earlier.
Anymore," sidebar to "How the New Math of Productivity Adds
Up," Business Week, June 6, 1988, pp. 103-113.
6. Maurice S. Newman, "Accounting for Research and
Development," Research-Technology Management,
What Managers Should Do
July-August, 1988, pp. 6-7.
It is clear that many management accountants have
7. Lynn W. Ellis, "Managing Financial Resources,"
Research-Technology Management, July-August, 1988, pp.
hidden behind the facade of the FASB and may continue
21-38.
to do so. The authors believe that as the principal
8. Richard F. Vancil, "Better Management of Corporate
potential beneficiaries of a more appropriate accounting
Development," Harvard Business Review, Sep.-Oct., 1972, pp.
system, research and technology managers should get
9. 115-124. Peter F. Drucker, Managing for Results, New York: Harper
involved and create the needed system for providing the
& Row, 1967.
requisite management information. After all, engineers
10. Lynn W. Ellis, The Financial Side of Industrial Research
are fortunate in that they are not bound by the 500
Management, New York: Wiley, 1984.
years of accounting tradition now codified in the
11. Robert S. Kaplan, "One Cost System Isn't Enough," Harvard
Business Review, Jan.-Feb., 1988, pp. 61-66; "Management
statements of the FASB.
Accounting for Advanced Technological Environments,"
Science, 245 (4920), 25 August 1989, pp. 819-823.
A similar switch of roles took place years ago-when the
12. Lester C. Thurow, "A Weakness in Process Technology,"
management information (MIS) specialists overtook the
Science, 18 December, 1987.
accountants. As computers were introduced for the
13. Richard N. Foster et al, Improving the Return on Research
accounting needs of order processing, payroll and
and Development, New York: Industrial Research Institute,
1984, summarized with the same title in Research Mangement,
inventories, MIS personnel reported to the controller.
Jan.-Feb., 1985, pp. 12-17 and Mar.-Apr., 1985, pp. 13-22.
While the accountants were satisfied with financial
14. Graham R. Mitchell and William F. Hamilton, "Managing R
accounting rules and obsolete procedures, the new
& D as a Strategic Option," Research-Technology Management,
capabilities of information systems thrust MIS staff from
May-June, 1988, pp. 15-22.
15. Toshiro Hiromoto, "Another Hidden Edge-Japanese
reporting to the controller to equality with the
Management Accounting," Harvard Business Review, 66 (4),
controller, and in some firms superior to the controller.
Jul./Aug. 1988, pp. 22-26.
The controller's data base became a subset of today's
16. David W. Budworth, Rewinding the Mainspring: A
MIS. A similar sequence could happen again in
Discussion Paper on Innovation Expenditure in Company
tomorrow's microcomputer-dominated environment if
Accounts, London: Technical Change Centre, March, 1987.
Research Technology Management
34
The Federal Technology
Transfer Act of 1986:
The First
2
Years
DEPARTMENT OF COMMERCE
*
*
UNITED AMERICA
STATES OF
Report to the President and the Congress
from the Secretary of Commerce
July 1989
DEPARTMENT OF COMMERCE
THE SECRETARY OF COMMERCE
Washington, D.C. 20230
UNITED STATES of AMERICA
JUL 05 1989
The President
The White House
Washington, D.C. 20500
Dear Mr. President:
It is my honor to transmit to you and to the Congress the
first report on the extent to which federal agencies are using
the authorities vested in them by the Federal Technology Transfer
Act of 1986. This report is required on a biennial basis by
Section 3710 (g) (3) of Title 15, United States Code.
The report comes at a time of challenge to our Nation's
technological leadership. The signs are everywhere. The rate
of increase in research and development in the United States is
declining. Foreign applicants are obtaining increasing
percentages of patents issued in this country. U.S. industry has
become increasingly dependent upon foreign-born scientists and
engineers.
Nevertheless, this Nation is determined to retain its
scientific and technological leadership. Tax and antitrust
policies have been adopted that, as President Reagan's last
Economic Report stated, "have strengthened incentives for the
private sector to put the results of R&D into commercial use."
Congress and the executive branch have protected our Nation's
innovators through strengthened intellectual property laws and
unwavering insistence on international respect for such rights.
Funding for basic research through the National Science
Foundation has been substantially increased.
With so much at stake, a top priority must be to get more
commercial value from our enormous $63 billion annual federal
investment in research and development. It is important that we
continue to invest in generating new knowledge. However, we must
also make sure that the knowledge generated at federal labora-
tories or developed elsewhere with federal support contributes to
long-term U.S. competitiveness in the form of new products, new
processes, new industries, and new jobs.
This report focuses on one of our greatest national
resources - federal laboratories. Much of the work done in
federal laboratories is at the cutting edge of technology. With
proper incentives and management tools, this technology can be
transferred successfully to the private sector for commercial
development. The Federal Technology Transfer Act provided these
incentives and tools.
2
As the report indicates, although many viewed the Act as a
challenge to their long-held views on the proper role of federal
laboratories and scientists, most agencies have eagerly embraced
it and are implementing the law as Congress intended. I believe
that in future years we will look back on this Act as one of the
seminal developments in the history of federal efforts to put
technology to work for the taxpayers who paid for it.
Although the Stevenson-Wydler Technology Innovation Act
calls for a biennial report of somewhat broader content, much of
that ground was covered in the June 1988 report by your Office of
Science and Technology Policy entitled "Progress in Facilitating
Access to Science and Technology, Highlighting Superconductivity." "
I look forward to working with you to ensure that this
Nation maintains its technological Em leadership.
Sincerely,
Robert A. Mosbacher
Enclosure
DEPARTMENT OF COMMERCE
THE SECRETARY OF COMMERCE
UNITED STATES OF AMERICA
Washington, D.C. 20230
JUL 05 1989
Honorable Dan Quayle
President of the Senate
Washington, D.C. 20510
Dear Mr. President:
It is my honor to transmit to the President and the Congress
the first report on the extent to which federal agencies are
using the authorities vested in them by the Federal Technology
Transfer Act of 1986. This report is required on a biennial
basis by Section 3710 (g) (3) of Title 15, United States Code.
As the report indicates, agencies have now completed most of
the internal administrative arrangements necessary for full
implementation of the Act as Congress intended. More than one
hundred cooperative agreements have been concluded and the pace
is clearly accelerating. The incentives to federal scientists
and engineers are working beyond expectations, as demonstrated by
the dramatic increase in the number of reported inventions at
some agencies in just one year.
Some problems remain. The Act does not provide a suitable
basis for commercializing the valuable software that is often
produced at federal laboratories. Laboratory officials tell us
that the private sector remains concerned that valuable informa-
tion generated under these agreements may be inadequately
protected from disclosure to competitors.
Nevertheless, the inescapable conclusion is that the Act is
achieving its intended purpose of linking the research. capabili-
ties of federal laboratories with the research needs of U.S.
business and is fostering a new era of public and private sector
cooperation for the benefit of all Americans.
Sincerely,
Robert A. Mosbacher hug
Enclosure
DEPARTMENT OF COMMERCE
THE SECRETARY OF COMMERCE
UNITED STATES OF AMERICA
Washington, D.C. 20230
JUL 05 1989
Honorable Thomas S. Foley
Speaker of the House of Representatives
Washington, D.C. 20515
Dear Mr. Speaker:
It is my honor to transmit to the President and the Congress
the first report on the extent to which federal agencies are
using the authorities vested in them by the Federal Technology
Transfer Act of 1986. This report is required on a biennial
basis by Section 3710 (g) (3) of Title 15, United States Code.
As the report indicates, agencies have now completed most of
the internal administrative arrangements necessary for full
implementation of the Act as Congress intended. More than one
hundred cooperative agreements have been concluded and the pace
is clearly accelerating. The incentives to federal scientists
and engineers are working beyond expectations, as demonstrated by
the dramatic increase in the number of reported inventions at
some agencies in just one year.
Some problems remain. The Act does not provide a suitable
basis for commercializing the valuable software that is often
produced at federal laboratories. Laboratory officials tell us
that the private sector remains concerned that valuable informa-
tion generated under these agreements may be inadequately
protected from disclosure to competitors.
Nevertheless, the inescapable conclusion is that the Act is
achieving its intended purpose of linking the research capabili-
ties of federal laboratories with the research needs of U.S.
business and is fostering a new era of public and private sector
cooperation for the benefit of all Americans.
Sincerely,
hug
Robert A. Mosbacher
Enclosure
FEDERAL TECHNOLOGY TRANSFER ACT OF 1986:
THE FIRST TWO YEARS
Table of Contents
PAGE
Executive Summary
i
1.
Introduction and Review
1
2.
Technology Management and Principles and the FTTA
3
3.
Relationship of the Laboratory to its Parent
5
4.
Cooperative Agreements Under the Act
7
5.
Impact on Laboratory Personnel
10
6.
International Considerations
13
7.
Statutory and Other Problems
16
8.
Conclusion
19
THE FEDERAL TECHNOLOGY TRANSFER ACT: THE FIRST TWO YEARS
EXECUTIVE SUMMARY
The Federal Technology Transfer Act (FTTA) of 1986 (P.L. 99-502)
was designed to provide a bridge between the superb research
facilities of government-owned, government-operated (GOGO)
laboratories and the research needs of the private sector. At
the time it was pending in Congress, United States citizens were
investing more than $50 billion annually in R&D. Many in
Congress and the Executive branch believed that this investment,
however vital for federal programs, was not returning to the
taxpayers sufficient dividends in terms of new products, new
processes, new jobs, and enhanced international competitiveness.
Reflecting the principle that those who best understand a
technology and its economic potential are the ones who created
it, the FTTA authorized agency heads to delegate to their GOGO
directors the authority to enter into cooperative research and
development agreements (CRADAs) with private firms and other
appropriate parties, to agree in advance on rights the parties
could expect in any inventions made by a federal scientist under
the CRADA, to reward the inventor with at least 15% of any
royalties received by the agency from the invention, and to
review and clarify the missions of their laboratories.
In doing so, the FTTA required a change in prevailing agency
practice and management prerogatives by transferring power from
headquarters to the field. Some were concerned that the Act
could interfere with agency management responsibilities, that it
could divert attention from mission-related research, and that
commercial considerations could discourage the free exchange of
scientific information.
Under these circumstances the Department of Commerce, which plays
a general oversight and coordinating role, was concerned that
the Act would be interpreted in the narrowest possible manner.
Instead, the Department found the following:
O
Most agencies with substantial GOGO activity are relying on
the FTTA and have completed the necessary internal admin-
istrative arrangements for implementing it. Although the
delegations vary in scope, most have attempted to delegate
authority to the smallest unit that can be realistically
called a laboratory. The National Aeronautics and Space
Administration is the one major research agency whose
organic statutes, rather than the FTTA, guide their
technology transfer policy. The Department of Commerce
will continue to monitor the various agency arrangements
to ensure that the principle of decentralization is
preserved.
i
As of the close of FY 1988, agencies had negotiated more
than 100 CRADAs and the pace has accelerated in the
current fiscal year. Several agencies believe that even
though some of this research may have occurred under other
authorities, the FTTA nevertheless provides a much more
useful tool for structuring the collaborative arrangements.
The FTTA has spurred agencies to think creatively in
developing technology transfer initiatives. Examples
include USDA's Peoria Biotechnology Consortium and the
Army's Construction Productivity Advancement Research
(CPAR) Program.
The incentives to federal scientists appear to be working
beyond expectations. Agencies have been generous in using
their royalty-sharing authority, in some cases allowing
inventors to retain as much as 35% of the royalty income.
The number of reported inventions increased by more than
40 percent in some agencies between FY 1987 and FY 1988.
Although CRADAs are too new to have generated royalties, the
pattern of payments to inventors under the Bayh-Dole Act
(P.L. 96-517, as amended), including the Department of
Energy's government-owned, contractor-operated facilities,
suggests that substantial royalties may be generated.
Nevertheless, there are still obstacles to be overcome:
Barriers to commercialization of Federally developed software
are still a problem. Software often has substantial
commercial value which may not be realized because most U.S.
firms will not make the investment necessary to bring it to
the marketplace without adequate proprietary protection.
Agencies repeatedly report that private sector collaborators
worry that proprietary data will be made available to their
competitors through FOIA. Such concerns may have deterred
some firms from seeking to enter into CRADAs.
The private sector does not always use federal facilities
when they might. In order to facilitate identification of
relevant areas of cooperation, agencies must continuously
examine and define their laboratories' missions, as
required by the FTTA, especially in those cases where the
program justification is not clear. Foreign entities, on
the other hand, are adept at identifying valuable research
projects at federal facilities.
In general, agencies heads and laboratory personnel have greeted
the Act with enthusiasm. U.S. firms are becoming increasingly
aware of its relevance to their needs. The FTTA may well be
creating the framework for a new era of scientific cooperation
between the public and private sectors.
ii
THE FEDERAL TECHNOLOGY TRANSFER ACT: THE FIRST TWO YEARS
1.
Introduction and Overview
Enactment of the Federal Technology Transfer Act (FTTA) of 1986
(P.L. 99-502) was largely a response to the increasingly tough
international economic competition facing the United States. By
all accounts, this competition will intensify as more countries,
anxious to promote their economic development, enter the high
technology competition. This is a healthy competition. The
United States, however, will be unable to meet this challenge if
it takes its technological leadership for granted.
Remaining competitive in fields such as superconductivity,
biotechnology, new materials, pharmaceuticals, and other
research-intensive areas could depend in large measure on our
ability to link more closely our unsurpassed public research
institutions with the needs of the private sector. U.S.
industry's cooperation with universities and federal laboratories
will become even more critical in determining whether we will be
able to remain on the cutting edge of technology.
The Federal Government funds a substantial share of the R&D
performed in this country - some 47%, according to the 1989
Economic Report of the President. Thus, a substantial share of
the world's new scientific knowledge is paid for by the U.S.
taxpayer. If this public investment is not translated into new
jobs, products, and processes, we will have lost a significant
opportunity for improving this nation's economic position.
The FTTA was enacted in response to these concerns. This law,
along with former President Reagan's multi-phased program for
improving access to federally funded research contained in
Executive Order No. 12591, charged Federal agencies with linking
their government-owned, government-operated (GOGO) laboratories
to the private sector. This report summarizes how agencies have
prepared to meet these challenges in the more than two years that
have passed since the FTTA became law.
Most federal agencies have now completed, or are close to
completing, the internal administrative arrangements necessary
for managing programs of cooperative research with the private
sector, universities, and state and local governments under the
Act. Many have begun to negotiate agreements and a number of
these have already been put into effect.
In general, agencies have made substantial progress and have
developed firm foundations for successful technology transfer
operations. By necessity, they concentrated first on resolving
sensitive internal questions of control and accountability. Now
they are addressing the practical problems of attracting the
interest of the private sector and designing appealing
arrangements.
1
To help them accomplish this and to ensure that Congress is kept
fully informed on their progress, the FTTA required the Secretary
of Commerce to: (a) report to Congress every two years on how
agencies are using their new authorities, (b) report to Congress
on barriers to the commercialization of computer software and on
the feasibility of maintaining an inventory of federally funded
training software, and (c) provide agencies with model coopera-
tive research and development agreements and other appropriate
technical assistance.
Taking these in order, this report is the first of the biennial
reports required by the FTTA. It is based on information
provided to the Department by agencies represented on the
Interagency Committee for Federal Laboratory Technology Transfer,
a forum established by former Secretary of Commerce Malcolm
Baldrige to provide a continuing high level mechanism for
addressing problems in implementing the Act and developing
solutions. It is also based on follow-up questions and
discussions within the Committee's Executive Working Group, a
forum of senior headquarbters and laboratory personnel which
meets on a regular basis and which has become an important
support network for addressing the practical problems agencies
face in implementing the law and Executive order.
Major agencies providing information included the Departments of
Agriculture (including the Forest Service and the Agricultural
Research Service), Commerce (including the National Institute of
Standards and Technology, the National Oceanic and Atmospheric
Administration, and the National Telecommunications and Informa-
tion Administration), Defense (including the individual military
departments), Energy, Health and Human Services (including the
Public Health Service agencies), Interior, Transportation, and
Veterans Affairs, as well as the Environmental Protection Agency
and the National Aeronautics and Space Administration.
The report on barriers to commercialization of software and on
federal training software was submitted in May, 1988. These
barriers are discussed in this report in Section 9.a.
As to technical assistance, the Department has provided agencies
with draft model agreements and continues to work with them on
technical issues through the Interagency Committee and its
Executive Working Group. This Group has met 13 times. In
addition to the development of model agreements for working with
industry, the Group has addressed model delegations of authori-
ties for federal laboratories, employee conflict of interest
issues, impact of the Freedom of Information Act, access by
foreign companies and scientists to federal laboratories,
protection of intellectual property in international science and
technology agreements, problems in commercializing computer
software, and training laboratory personnel in technology
transfer.
But the real credit goes to the individual agencies. Their
accomplishments have been particularly gratifying, given the many
2
obstacles that had to be overcome before the FTTA could be
successfully implemented. These obstacles must be understood if
progress to date is to be evaluated properly.
First, the FTTA challenged the status quo. As a general
observation, the FTTA forced many agencies to confront and
reassess long-held attitudes with respect to:
O
the role of federal laboratories and scientists in promoting
joint R&D with industry and transferring the results to the
marketplace,
O
the necessary methods and incentives for accomplishing this,
and
O
the relationship between the laboratories and their parent
organizations.
These various factors are discussed more fully in the pages that
follow. Evidence has shown to date that most agencies are taking
advantage of the opportunities the new law afforded them. Agency
personnel at headquarters and in the laboratories are making
sincere efforts to implement the new law as the President and
Congress intended. Many practical problems have been resolved.
In short, federal technology transfer has gotten off to a good
start and can look forward to a very promising future.
2.
Technology Management Principles and the FTTA
The fundamental objective of the FTTA is to promote U.S.
competitiveness by allowing the private sector to pursue original
R&D with our public research institutions, and by adapting the
fruit of that research to the marketplace.
By 1986, Congress began to examine how the U.S. could reap
substantial commercial returns on the $52 billion (now up to
$63 billion) annual federal investment in research and
development. A common complaint heard was that the U.S. wins
Nobel Prizes while other countries walk off with the markets.
The designers of the FTTA responded by building upon certain
fundamental principles:
O
First, the federal government will continue to underwrite
the cost of much important basic research in scientifically
promising areas that takes place in the United States.
Second, transferring this research from the laboratory to
the marketplace is primarily the job of the private sector,
with which the Federal Government should not compete.
Third, the Federal Government can encourage the private
sector to undertake this by judicious reliance on market-
3
oriented incentives and protection of proprietary interests.
These principles were first tested by the Bayh-Dole Act
(P.L. 96-517) upon which the Federal Technology Transfer Act was
modeled. The Bayh-Dole Act generally allowed universities and
small businesses to elect to own inventions made by them with
federal funding and required universities to share royalties with
the inventor. This was accomplished without diverting the
universities from their primary educational missions.
That Act has been very successful in promoting university-
industry cooperation. In its April 1987 report to Congress
(GAO/RCED-87-44), the General Accounting Office found that such
cooperation had increased 74% since passage of the Act.
Certain fundamental factors to the university successes quickly
became evident:
O
First, the translation of technology into commercial
products usually requires the full cooperation and
involvement of the people who created it and who best
understand its potential. Research reports can never hope
to convey all that the researchers have learned and absorbed.
This is especially so in the case of federally-supported
R&D where the resulting technologies tend to be far from
commercialization. As such, supervision from "headquarters"
must be such as to ensure proper accountability, but not so
heavy as to discourage active involvement by laboratory
personnel.
Second, there must be early interaction between the creators
of the technology and those who understand the complexities
of manufacturing and marketing it. Technology developed in
disregard of these practical considerations will often not
benefit the public through practical application.
O
Third, to bring this about there must be powerful incen-
tives for all sides to cooperate. This is especially true
for employees of public sector institutions such as our
universities and federal laboratories where research is
normally undertaken for broad public purposes.
The FTTA responded to these lessons. The new Act authorizes
agency heads to delegate to laboratory directors the authority to
enter into cooperative research and development agreements with
the private sector and other entities, and to agree in advance on
the rights the cooperating parties would have in any resulting
inventions made by a federal employee. The employee was entitled
to a guaranteed share of the royalties received by the government.
The lab itself was also entitled to retain the majority share of
the remaining royalties.
In addition, a mechanism was put in place designed not only to
transfer federally-developed technology to the private sector but
to make private sector scientific talent available to federal
4
researchers as well, thus making the flow of information a two-
way street and increasing the skills and expertise of all
participants.
Thus, the key principles of decentralization of technology
management, federal-private sector interaction, and suitable
incentives were all satisfied in the new statute.
The Act did not specify exactly how it was to be implemented.
Even the FTTA's most enthusiastic supporters knew that it would
take time to change a culture that had existed for so long.
President Reagan ended any lingering debate over how the law
would be applied by issuing Executive Order 12591 on April 10,
1987. The President instructed the agencies to delegate
authorities to their laboratory directors to implement the
Federal Technology Transfer Act.
3.
The Relationship of the Laboratory to its Parent
Decentralization of technology management is a central feature of
the Federal Technology Transfer Act. Consistent with the
principle that those who understand a developing technology best
are those who created it, the Act encourages agency heads to make
appropriate delegations to laboratory directors instead of
retaining such authorities at headquarters, except as necessary
to satisfy legitimate oversight needs.
In providing for a decentralized approach, the FTTA implicitly
reflected a concern of the 1983 Report of the White House Science
Council's Federal Laboratory Review Panel which had deplored the
tendency of some agencies to micromanage their laboratories. The
commission had emphasized that "excessively detailed direction
of laboratory R&D activities from agency headquarters has
seriously impaired R&D performance in some laboratories. "
A review of agency rules implementing the Act reveals that
agencies have displayed considerable sensitivity to the need to
decentralize and to reduce the administrative burden on
individual laboratories. All recognize that the point at which
"the rubber meets the road" - where the heart of an agreement is
developed - is the point at which contact between industry
representatives and federal scientists occurs.
Most have made efforts to delegate authority to enter into
agreements, subject to appropriate higher level review, to the
smallest practical unit that can realistically be called a
laboratory, which is defined in the Act as "a facility or group
of facilities. If But because of differences in agency missions,
structures and traditions, different approaches have been taken
toward decentralization.
For example, within the Department of Commerce, authority has
been delegated to the Director of the National Institute of
Standards and Technology (NIST), formerly the National Bureau of
5
Standards, for all arrangements within the scope of that
organization's program responsibility. The Director has in turn
delegated the authority to the directors of NIST's major
laboratories: the National Engineering Laboratory, the National
Measurement Laboratory, the Institute for Materials Science and
Engineering, and the National Computer Systems Laboratory.
The National Oceanic and Atmospheric Administration, also at
Commerce, has delegated authorities to five laboratories and
three Assistant Administrators for research services.
The Department of Agriculture, on the other hand, has delegated
authority to the Agricultural Research Service which, unlike NIST
or NOAA, has chosen to treat itself as a single laboratory. To
some degree, USDA's decision is rooted in practical
considerations: it has 120 field locations, many of which are
two- and three-scientist operations. USDA's approach is intended
to ensure that these smaller operations receive encouragement and
administrative support.
On the other hand, some of ARS's facilities have over 200
scientists. Accordingly, ARS and other organizations with
similar arrangements must nurture decentralized technology
management by the larger, more capable facilities while
assisting their smaller, less capable components.
The Environmental Protection Agency has defined laboratories
broadly so that it can apply to very small operations and even to
those not normally considered to be laboratories in the layman's
use of that term, such as its Policy Office. EPA's view is that
even its Policy Staff develops computer models and that such
models eventually may have commercial applications.
Given different agency needs and organizational charts, we cannot
conclude that there is one "right" way. In future reports, the
Commerce Department will address how particular delegation modes
are working. Right now it is simply too soon to tell.
Although NASA is using the authorities of the FTTA as the basis for
sharing royalties with its inventors, it has chosen to continue
its centralized technology management system based on the
authorities of the Space Act.
The Space Act, unlike the FTTA, (a) permits the agency to commit
federal funds to cooperative ventures and (b) provides for
greater centralization of authority, which NASA believes is more
appropriate for its needs. NASA also has a long history of
working with the private sector under this law. In future
reports we will compare NASA's record with respect to the number
of cooperative agreements with industry, royalties returned to
the agency, number of inventions reported by its laboratories,
and any other relevant factors, with the records of other
agencies relying on the FTTA.
In the final analysis, however, the success of the FTTA depends
6
less on the degree of freedom that laboratories have to enter
into cooperative arrangements than it does on the respect which
private firms have for the laboratories, their knowledge about
laboratory capabilities, and their perception that these
capabilities are consistent with their own needs.
It is here that the agency headquarters have a major role to
play. The previously cited 1983 White House Science Council's
report in reviewing agency-laboratory relations, complained that
many laboratories had only ill-defined missions or obsolete
missions and that "in most cases, the agencies' oversight means
an excessive amount of reporting and paperwork, but inadequate
scrutiny of the quality and relevance of the laboratories'
activities." The Commission was concerned that a laboratory
would confuse its mission with its preservation.
The FTTA recognized the importance of a clearly stated mission by
(a) requiring each agency to make separate determinations of the
mission or missions of each of its laboratories, and (b) making
technology transfer a laboratory responsibility, to the extent
consistent with its mission responsibility. Some of these
facilities, such as those concerned with national security or
national defense, have missions that are likely to result in
only limited opportunities for pursuing private sector
responsibilities. But for those whose missions are less clear,
the degree or absence of private sector interest may be a useful
indicator as to whether that facility's charter warrants
reexamination.
The Department notes that the establishment of research advisory
committees, such as those of USDA and NIST, could be important
devices for agency use in ensuring that their R&D has practical
applications.
4.
Cooperative Agreements Under the Act
The Department of Commerce estimated that, as of the close of FY
1988, federal agencies had concluded, or were in the final stages
of negotiating, approximately 111 cooperative agreements within
the meaning of the FTTA. Many of these are based on a model
agreement which was developed by Commerce's Office of Federal
Technology Management and modified by individual agencies to meet
their specific needs.
These included agreements involving the Department of Agriculture
(39), the Department of Health and Human Services (29), the
Department of the Air Force (17), the Department of Commerce
(10), the Department of the Army (7), the Department of the
Interior (6), the Department of Veterans Affairs (2) and the
Environmental Protection Agency (1). Agreements in fairly early
stages of negotiation are not reflected in the above figures.
A number of points should be kept in mind in evaluating these
figures. First, the pace is clearly accelerating. NIH, a part
7
of HHS, has informally advised us that it is now processing
approximately 5 proposed R&D agreements each month. As such, the
numbers for FY 1989 should be much higher. NIST, in the
Department of Commerce, has advised us that in the few months
since the close of FY 1988, its agreements have almost tripled
from the 10 noted above to 28.
Second, some agencies do enter into agreements similar to those
described in the FTTA but rely on other authorities. NASA is a
notable case. To the extent that they do so, the figures above
are lower than they might otherwise be.
Third, some agencies perform much of their research through
facilities other than GOGOs, such as DOE's contractor-operated
facilities, and this research has commercial potential in areas
ranging from solar energy to superconductivity. Such activities
in support of technology transfer are not reflected in the above
figures.
Fourth, agency use of the FTTA does not necessarily mean that the
cooperation is "new" - i.e., that it would not have taken place
in its absence. Many agencies have long and rich histories of
cooperation with the private sector, state and local governments,
and academic institutions. The Forest Service's record goes back
to its establishment more than a century ago. NIST representa-
tives have advised us that much of the research covered by its
ten agreements might have occurred anyway, but that the FTTA is
often a better vehicle for establishing these cooperative
relationships.
Fifth, simply counting numbers misses the importance of vital new
relationships formed under the Act such as USDA's Peoria,
Illinois Biotechnology Consortium. This noteworthy project
combines the resources of the USDA's Northern Regional Research
Center, the University of Illinois, six private companies
contributing $1 million each, the State of Illinois (which is
investing $4 million), and the city of Peoria. This type of
highly promising cooperation fulfills the promise of the the
Federal Technology Transfer Act and would be impossible without
its sensitivity to the proprietary interests and motivations of
the private sector.
Other notable examples of initiatives inspired by the FTTA
include the following:
0
In October 1988 HHS held its first NIH and ADAMHA-Industry
Collaboration Forum which was attended by more than 250
representatives of leading pharmaceutical and biotechnology
companies. The forum provided a means by which those
representatives could meet directly with individual NIH
and ADAMHA scientists to discuss potential cooperative
research.
O
The U.S. Army's Electronics Technology and Devices
Laboratory developed a formal, comprehensive, well-focused
8
procedure for implementing the Act which includes
establishment of teams in specific technology areas, careful
definition of objectives and responsibilities of each
player, methods for developing statements of work for the
research project, customization of model agreements and
attendant legal reviews - all of which make it easier to
obtain necessary approvals from higher authority. In short,
ETDL appears to be striving to make the process routine
while treating each agreement as a unique case.
The Environmental Protection Agency has institutionalized
the FTTA by forming an Office of Technology Transfer
and Regulatory Support within its Office of Research
and Development and has also established a Technology
Transfer Advisory Committee to ensure that technology
transfer issues are factored into program planning at
its earliest stages.
The Army's Corps of Engineers, by combining the intellectual
property provisions of the FTTA with certain cost-sharing
authority vested in it by the Water Resources Development
Act of 1988 (P.L. 100-676), has developed a foundation for
its new Construction Productivity Advancement Research
(CPAR) Program. This initiative is designed to improve the
applied research base that is available to the U.S.
construction industry - an industry that has traditionally
invested little in R&D.
The Department of Energy has similarly combined FTTA-type
concepts with other authorities as the basis of its Clean
Coal Technology Project, a joint government-industry effort
to demonstrate a new generation of environmentally clean,
highly efficient coal technologies.
Some tentative conclusions regarding use of the law can be drawn:
First, many agency officials are of the view that the FTTA
is more than "business as usual" and that a good number of
the agreements represent research and cooperation that would
not have otherwise taken place -- illustrated most
dramatically in the Peoria Biotechnology Consortium.
Representatives of the Army, Health and Human Services, and
USDA's Agricultural ResearchService were especially convinced
of this. For future reports, the Department will closely
watch for new relationships with the private sector that are
forming because of the FTTA.
Second, officals of other agencies that believe the research
would have taken place anyway note that the FTTA provides a
better basis for undertaking it than was previously available
to them.
Finally, most personnel believe that the Act has greatly
stimulated agency personnel to think creatively in terms of
technology transfer. That is discussed more fully in the
9
next section.
5.
Impact on Laboratory Personnel
Federal scientists have traditionally had little reason to delay
publication of their research, even though the disclosure of an
invention in a printed publication before a patent application is
filed destroys patentability in those countries that, unlike the
United States, have no grace period that permits patenting within
a specified period following publication. Most nations have no
such provision.
As the White House Science Council reported more than five years
ago - and as the Navy Department's experience confirms - many
federal scientists rightly take great satisfaction from being
able to advance scientific knowledge through publication of
research results. Traditionally many federal scientists have
viewed the private sector as an awkward partner with a different
value system, and have published their findings even when this
would prevent a patent from issuing.
The Federal Technology Transfer Act addressed this problem by
creating important rewards for successful technology transfers
for federal scientists and their laboratories. The FTTA directs
agencies to pay the inventors at least 15% of any royalties their
invention might bring in, and by allows the laboratories to share
in the royalty stream as well. (Although the FTTA also permits
agencies to develop alternative inventor incentive plans, all
agencies have opted for the automatic royalty sharing plan.)
Thus, R&D funding under the FTTA has two vital goals: the
traditional one of advancing scientific knowledge, and an
important new element of seeking commercial applications for
resulting discoveries.
A review of agency experience to date permits certain
observations:
a.
Increase in Number of Reported Inventions
The widespread publication of information about the possibility
of receiving royalties and the growing commitment of agencies to
the principles of technology transfer appears to have contributed
to the remarkable upsurge in the number of reported inventions by
federal scientists during FY 1988, the first full fiscal year
since enactment of the FTTA.
In FY 1987, the Department of Agriculture reported 76 inventions;
in FY 1988 this figure had increased to 139. The Army reported
309 inventions in FY 1987; this figure was up by almost 40% in
FY 1988 to 424. The Navy, where the tendency to publish had been
particularly strong, saw its reported inventions increase by more
than a third - from 336 in FY 1987 to 463 in FY 1988.
10
HHS figures, reported on a calendar basis, reveal that the number
of inventions (133) reported during the first nine months of 1988
approximated the number (132) reported for all of CY 1987, a
figure which itself represented an increase of almost a fourth
over the number (109) reported in CY 1986.
This bodes very well for the impact of the Act. A similar jump in
invention disclosures at the universities was the first sign of
the impact of the Bayh-Dole Act. In 1976 there were about 230
patents issued to universities. By 1986 the number had tripled
to about 700, increasing to 900 in 1987. Particularly striking
is that this sharp increase in university patenting and invention
reporting by federal scientists is occurring at a time when U.S.
patent rates have levelled off or have declined for other
sectors. Discussions with federal officials suggest that this
increase in federal invention activity is likely to have real
commercial significance, rather than leading to "paper" patents.
This is an encouraging sign that U.S. creative activity is alive
and well in our public sector and underscores the wisdom of
President Lincoln's observation as to the importance of adding
"the fuel of interest to the fires of genius."
Today, universities are becoming engines for economic development
because of their successful technology transfers. High tech-
nology centers across the United States are forming around them.
Future reports will closely monitor whether the federal
laboratories are following this heartening example.
b. Diversity of Plans
The agencies have shown remarkable resourcefulness in devising
royalty payment plans to suit their individual needs. Many
recognize that inventions may bring in relatively modest dollar
amounts and, to ensure some meaningful return, allow inventors to
keep higher percentages of the first dollars that come back to
the agency.
The military services, for example, will allow their inventors to
keep 20% or the first $1000, whichever is greater. Within HHS,
the National Institutes of Health, the Centers for Disease
Control, and the Alcohol, Drug Abuse and Mental Health
Administration allow their inventors to keep 25% of the first
$50,000 in royalties, 20% of the next $50,000 and 15% of any
additional royalties.
The Food and Drug Administration, also within HHS, takes the
opposite approach. Greater percentages of the first dollars are
retained by the agency. The FDA allows its inventors to keep 15%
until program costs are recovered and 35% of any additional
royalties. EPA allows its inventors to keep a flat 35% of all
royalties.
Congress evidently recognized that agencies would take different
approaches and encouraged experimentation. It directed the
Comptroller General to report to it on the efficacy of different
11
plans in 1991, thus giving agencies a chance to experiment and to
alter their programs, if appropriate.
Accordingly, the Commerce Department will withhold further
comment at this time except (a) to note that such differences do
exist, (b) to express the hope that GAO's report will also
discuss the experiences of agencies, such as NASA, which prefer
to rely on authorities other than the FTTA, and (c) to assure the
Congress that the Commerce Department will also monitor these
various plans.
C. Royalties to Date
Although interest is high and implementation plans are in effect,
the agreements under the FTTA are too new to have generated any
significant royalty income.
However, data from the Department of Energy and the National
Technical Information Service provide some useful insights.
In 1980 Congress enacted legislation which, as discussed earlier,
allowed certain federal contractors to own and license inventions
made with federal funding. This law applied to many of DOE's
contractor-operated facilities. The remaining DOE contractor-
operated facilities received ownership on a case-by-case basis
under other authority. All of these facilities, however,
established royalty sharing programs with their employed
inventors.
In 1981, DOE's contractor-operated laboratories received $14,000
in royalties. In FY 1985, these royalties had increased to
$144,000 and in FY 1987 they stood at $297,000. For FY 1988 the
figure reached $584,000.
Preliminary data from the National Technical Information Service
(NTIS) suggest the same trend is beginning for federally-owned
and -operated laboratories. NTIS, even prior to enactment of the
FTTA, licensed federally owned patents for royalties or other
consideration under the provisions of Section 207 of Title 35.
It also paid inventors a share of resulting royalties, but its
authority to do so was uncertain. The FTTA made it clear that
inventors were entitled to a share of royalties under either a
cooperative R&D agreement or the Government's "207" program.
For FY 1985, NTIS collected $1.5 million in royalties in
connection with 146 federally owned inventions and paid out
approximately $69,000 to inventors. For FY 1988, by which time
federal scientists became more aware of the possibility that they
could profit from their inventions and legal confusion had been
resolved, royalty payments had increased almost fourfold to
$5.6 million, the number of inventions increased by almost 40% to
201, and awards to inventors amounted to $356,200.
These results have been achieved in a manner consistent with the
objective of preserving the free flow of information. As noted
12
earlier, we have already seen a dramatic increase in the number
of reported inventions at universities without any corresponding
decrease in the number of scholarly publications. At most,
there has been short-term publication delay to afford the
laboratory an opportunity to decide if a patent should be sought.
Indeed, universities are generally seeing an increase in both
patenting and publishing rates, including a striking increase in
co-authored university-industry publications in the decade
following enactment of Bayh-Dole.
In short, if the experience of the universities and NTIS is any
guide, a fair program of royalty sharing, when coupled with
support and encouragement by laboratory managers and the parent
agencies, should yield steady progress.
6.
International Considerations
The ultimate aim of all federal technology transfer initiatives
is, as indicated in Section 2, to promote the ability of U.S.
firms to compete in world markets. U.S. taxpayers contribute
more than $63 billion each year to federal R&D initiatives. To
the extent that this investment can yield new products, new
processes, new industries and new jobs, those taxpayers ought to
be the principal beneficiaries.
In the Bayh-Dole Act, Congress prohibited not-for-profit
contractors electing to take title to federally financed
inventions from giving exclusive licenses to firms that did not
agree to manufacture the invention in this country - except to
the extent that domestic manufacture was impractical or efforts
to find licensees that would agree to such terms proved
unsuccessful.
During the 1980's, as concern about U.S. competitiveness began to
mount, this emphasis on domestic manufacture as a means of
protecting the taxpayers' investment was seen as insufficient.
Focus shifted from the relatively narrow issue of where a
particular invention might be used or manufactured to the broader
question of whether the taxpayer-financed technology on which the
products of tomorrow might be based was being given away without
receiving an adequate quid pro quo, particularly as other nations
demonstrated an adroitness at turning basic research into
products for the marketplace.
It has long been evident that our foreign competitors routinely
scour our public R&D institutions looking for technology leads.
Historically the United States has been by far the leader in
conducting - but not necessarily commercializing - basic
research. Countries such as Japan are redoubling their efforts
to close the basic research gap.
Thus, the drafters of the Federal Technology Transfer Act were
concerned that the advantages of entering into cooperative
research arrangements with federal laboratories not be extended
13
to participants from foreign countries that deny U.S. entities
the right to enter into similar ventures. The Act required
laboratory directors to consider such practices when deciding
which proposals to pursue.
Since then there have been a number of other instances in which
Congress and the Executive branch have expressed their
determination that the United States receive an appropriate quid
pro quo before making its technology available to foreign
entities whose governments fail to protect our interests or
discriminate against us.
In Executive Order No. 12591, President Reagan expanded upon that
principle by requiring laboratory directors to consider also the
extent to which the relevant foreign government protects
intellectual property. Subsequently, in the Omnibus Trade and
Competitiveness Act of 1988, Congress required that federally
supported international science and technology agreements be
negotiated so as to ensure: 1. that the United States enjoys
similar access to the research facilities of the other countries
as we grant here (i.e., the agreement should ensure "symmetrical
access") ; and 2. that the other country provides proper
protection for intellectual property. It also required that
proposed science and technology agreements be reviewed for their
consistency with the principles of the Bayh-Dole Act and the
Federal Technology Transfer Act.
In short, the requirements of the FTTA should not be viewed in
isolation but as part of broader, evolving policies aimed at
encouraging agencies to exercise greater discretion with respect
to, and control over, commercially valuable, federally financed
technology.
In consultation with the various agencies, an informal system has
been devised whereby laboratories will simply notify the
Department of Commerce when they have identified a party
proposing an agreement as being foreign controlled and the
Department will consult with the United States Trade
Representative. The laboratories then will be advised as to
whether the home country's protection of intellectual property is
adequate and whether there is any evidence that it denies U.S.
firms the right to enter into similar agreements or otherwise
precludes their access to its research facilities.
It should be noted, however, that Congress has not provided
agencies with much guidance for determining what is meant by
"foreign controlled." However, Congress recently defined the
concept in the "Buy American Act of 1988" (see Title VII of P.L.
100-418) and the Department and USTR are considering the extent
to which these standards can be adapted for use by agencies in
implementing the FTTA.
The Department of Commerce published a request in the Federal
Register in April 1988 for information from the public concerning
denial of access to foreign research facilities. It followed up
14
with press releases, letters to private firms and calls to trade
associations to urge them to bring the request to the attention
of their members. To date, the Department has received some
information as to potential problems but no specific,
identifiable cases of governmentally-imposed barriers to U.S.
participation in foreign R&D programs.
This response is not surprising given that the concept of
conducting R&D with foreign research institutions is generally
new to American industry. U.S. firms, until recently, have shown
only limited interest in working with federal facilities, much
less with those operated by foreign governments. Many domestic
companies are skeptical as to whether invitations from foreign
entities to enter into such agreements are made in good faith or
are attempts to tap into our existing technology base. These
views may change with the increased internationalization of
science and technology.
The Department of Commerce will continue to monitor this
situation so that it can advise federal laboratory directors when
barriers are encountered in specific countries. It is currently
participating in an interagency task force chaired by the
National Science Foundation which is aimed at developing concepts
for measuring the symmetricality of access in the context of the
recently-concluded U.S.-Japan Science and Technology Agreement.
The Committee's work should be useful in reviewing U.S. access in
other situations.
Congress' concern that agencies be sensitive to these various
international considerations is not surprising. Foreign
nations have been remarkably adept at identifying the sources
of valuable technology in the United States that will lead to
new products. The extent of foreign participation in federal
laboratory research was recently documented in an August 1988
report by the General Accounting Office entitled "U.S. and
Foreign Participation in R&D at Federal Laboratories"
(GAO/RCED-88-203BR).
It would be ironic if these foreign firms prove themselves to be
more farsighted in identifying opportunities for cooperation with
federal facilities - and in reaping the attendant technological
advantages - than our own domestic companies. As GAO's Report
found, given staffing and space constraints that limit the number
of outside researchers who can conduct R&D at federal
laboratories, "the best way to control foreign participation is
to stimulate U.S. participation." (Id., p. 52).
Accordingly, even though the relative newness of the FTTA and the
small number of agreements entered into thus far permit no
conclusions to be drawn, it will be necessary to monitor the
relative degree of foreign versus domestic interest in entering
into collaborative arrangements under the FTTA.
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7.
Statutory and Other Problems
a.
Computer Software
Because copyright law prohibits federal employees from obtaining
copyright protection for works created in the course of their
official duties, the incentives of proprietary protection and
royalty sharing - so vital in the case of inventions - are
unavailable to spur the development of computer software that for
legal or practical reasons cannot be patented. Such software can
have substantial commercial value.
DOE's GOCOs are not subject to this prohibition and their
experience reveals just how important proprietary rights can be
as a spur to the commercialization of software developed in
connection with federal programs. A good example is DOE's
encouragement of an Oak Ridge National Laboratory consortium.
This consortium is a cooperative agreement between twelve
sponsoring companies who are co-funding the development of user
friendly and intelligent software systems for more easily
accessing a highly complex set of finite element analysis models.
GOGO research should yield equally satisfying results. The
Department of Defense, for example, expends considerable effort
in developing computer-based vocational training materials which
may have significant commercial value for a wide range of
vocations and disciplines.
The Agriculture Department noted that virtually none of the
cooperative agreements signed or under negotiation dealt with
expert systems, artificial intelligence or other forms of
knowledge engineering, even though the systems approach and
software-derived technology reflected a growing portion of its
research. Indeed, USDA also noted that this problem antedated
the FTTA and that the government's inability to provide software
protection had been a major factor in its inability to interest
the private sector in its activities in such fields as crop
production, forage-livestock interaction, and food processing-
quality interaction.
It thus appears that the absence of an ability to convey
proprietary rights might result in the loss of significant
opportunities for federal-private sector cooperation in areas
of significant commercial potential.
Merely making software available without proprietary protection,
may be insufficient to ensure its effective commercialization.
Much of today's software is complex, containing thousands of
lines of code. It is often useless to businesses unless they are
willing to make substantial investments of time and money. For
software to be commercially valuable, it has to be debugged,
simplified and customized and training manuals must be available
as well. Without an appropriate license, a firm could not be
assured of recouping the necessary investment in providing such
services.
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Simply stated, the plain fact is that without an appropriate
policy dealing with the commercialization of federally-developed
software, the prospects for its development and commercialization
will probably be limited.
The drafters of the FTTA were certainly aware of this. The
legislation specifically required the Commerce Department to
study the issue and make appropriate recommendations. In May
1988 then Secretary of Commerce C. William Verity submitted the
required report recommending corrective legislation; at about the
same time, the General Accounting Office issued a report to
Congress (GAO/RCED-88-116BR) which also noted that the absence of
copyright protection for computer software was perceived by
laboratory and agency officials as a technology transfer
constraint.
The Department of Commerce, in consultation with other agencies,
is developing suggestions for legislation that could be reviewed
by the Administration. The Department and agencies will also
consider the question of whether a similar limitation on the
ability of federal scientists to obtain protection for
semiconductor chip mask works should also be lifted. Such works
are not protected by copyright but, rather, receive a sui generis
form of protection under Title 17. Nevertheless, the same
limitation applies.
b.
Freedom of Information Act
One major incentive for the establishment of cooperative
relations between a private firm and the government is the
existence of an expensive or unique research facility where
federal scientists and scientists employed by a firm can work
"shoulder to shoulder" on proprietary research. But, as GAO's
March 1988 report found, the opportunities for this are limited
at least in part by the government's inability to assure the firm
that the results will not be made public to its foreign or
domestic competitors under the Freedom of Information Act (FOIA).
The experience of the federal laboratories since that report was
issued confirms GAO's earlier finding. Many agencies reported
that protection of proprietary information was one of the first
issues raised by potential R&D partners. The frequency and
regularity with which the issue is raised to laboratories by the
private sector suggests that such concerns may have deterred many
firms from seeking cooperative arrangements with federal
institutions in the first place.
Accordingly, the Department will continue to work with agencies
to determine the extent to which FOIA may impede the negotiation
of advantageous cooperative research and development agreements.
Laboratory officials have informally advised the Department that
they believe that the objectives of FOIA, the goal of preserving
open scientific communication, and the proprietary interests of
sponsoring partners can be balanced by offering the sponsoring
partner a limited period of exclusivity after which the
information would be subject to disclosure under FOIA.
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C.
Personnel Matters
Personnel in federal laboratories often do not have the knowledge and
skills essential for effectively negotiating complex agreements
with the private sector. This limitation could undermine the
FTTA's basic objective of encouraging the laboratories themselves
to take an active role in promoting the transfer of federally
funded technology.
Accordingly, it would be helpful to consider methods that could
be used to improve the skills of technology managers and
scientists in negotiating agreements with the private sector.
Several agencies also have indicated that they may be unable to
hire enough patent attorneys to support their technology transfer
programs. These agencies note that patent lawyers command far
higher compensation in the private sector than federal agencies
can hope to offer. Contracting for such services may be an
available alternative. Patent counsel are essential to the
process of determining patentability, drafting technical
documents, and negotiating advantageous licensing arrangements.
The FTTA does authorize agencies to use royalties to pay for such
services. Perhaps as royalties increase this problem may be
somewhat eased.
At the present time, the Department of Commerce does not believe
it has sufficient data to justify any specific recommendations.
However, these personnel matters warrant careful monitoring. We
expect to return to it in the next biennial report.
d.
Conflicts of Interest
In September 1988 the U.S. Office of Government Ethics (OGE)
advised the Department of Commerce that royalty sharing under the
FTTA is "a form of compensation from the Government which does
not cause an employee to have a personal financial interest to
which the conflict of interest laws are applicable." OGE noted
that under the statutory scheme, a federal employee is not placed
into a direct relationship with the party paying royalty fees.
However, agency employees remain bound by the statutory
provision (18 USC 207) that bars a former federal employee from
representing another person before an agency on matters that the
ex-employee worked on while at the agency. Any matter in
connection with the invention in question would appear to bring
that section into play.
In addition, some agencies, while aware of OGE's opinion, believe
that their particular mission may obligate them to impose special
rules. The Food and Drug Administration, for example, has
expressed concern about potential conflicts that could arise when
its scientists stand to profit from inventions that cannot be
marketed without that agency's express approval. FDA is in the
process of reviewing its regulations to ensure that its concerns
are addressed without unduly limiting the ability of its
18
personnel to take advantage of the opportunities accorded them by
the FTTA.
The Commerce Department expects shortly to issue FTTA conflict of
interest guidelines to assist agencies in this area and will be
pleased to work with them individually, if requested.
8.
Conclusion
In summary, progress to date under the FTTA has been good.
O
Agency administrative personnel understand the Act's
merits and are anxious to make it even more effective.
O
Laboratory personnel are becoming more and more interested in
making their work useful to the private sector.
O
U.S. firms are becoming increasingly aware of the Act and in
many cases are finding out that the federal laboratories are
conducting research that can valuable to them.
There is still work to be done, but the Act's goal of fostering a
new era of scientific and technical cooperation between the
public and private sectors appears well on the way to becoming a
reality.
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