• PLI
    Production Linked Incentives Schemes in India
    KNOW MORE

Why small is the new big and how small industries can innovate in the defense sector

defense

Introduction

The defense industry has always been known for two important characteristics – being technological innovation-intensive and consolidated. Historically, sharp declines in government-backed spending often tend to result in dramatic instances of consolidation in the defence industry, as witnessed across several territorial jurisdictions, most notably the defence sectors in the USA and developed European nations (post 1980s). These strong waves of consolidation in the sector have resulted in the industry being more concentrated than ever, as evidenced by the dominating positions held by a few corporations – such as Lockheed Martin, Boeing, Northrop Grumman, European Aeronautic Defense and Space Company (colloquially referred to as ‘EADS’), Finmeccanica, Raytheon and General Dynamics, all of which boast of annual sales in the tens of billions of dollars thanks to the practice of eventually swallowing any upcoming industries through mergers, acquisitions and minority share purchases.

Whilst economies of scale often work to the advantage of the consumer in most industrial sectors, the same cannot be said to be true of the defence sector due to some of the qualities that set it apart from a traditional industry, such as (a) the vast amount of entry barriers (be it technological, financial or regulatory) that create roadblocks for any potential industry looking to venture into the sector; (b) the inversion of the classical economic markets in the form of a monopsony, where in a single country there is generally a singular buyer and multiple sellers; and (c) the lack of lobbying and military expertise that small-scale industries don’t possess. 

As the only customer for many products of the defence industry, DRDO and DDP (as any national defence organization proactively should) have recognized the need to identify and address potential effects of such consolidation and come up with appropriate mechanisms to deal with the same, one of which is through the incorporation of the ‘Technology Development Fund’ (“TDF”) that seeks to harness the potential prowess of the MSMEs in the country in order to ensure that such consolidation or concentration does not stifle the innovation in the sector. TDF poses the alternate solution to this, by providing direct research and development funding through the means of a grant to develop alternative suppliers or technologies.

TDF’s vision is also supplemented by the noteworthy premise, which may seem rather counter-argumentative considering the above-stated effects of consolidation vis-à-vis the benefits of attaining economies of scale for large cap / mega cap defence companies, that some of the most innovative weapon systems that have been utilized over the last two decades have been developed by industries that would be classified as small-scale industries, even if only in a comparative sense when measured against the norm in the defence sector.

Dynamics of Size and Innovation

Before this article opines on exactly how small industries will be innovation-drivers in the defence sector, it is pertinent to mention that the question of whether innovation is most effective when done by a small or a large-scale industry has already been debated by economists and policymakers at length, across a spectrum of sectors and economies. Across the vast literature on corporate entrepreneurship, innovation and capitalist development, one finds two streams of research: one line of work which emphasizes the importance of new ventures undertaken by individual entrepreneurs, and the other tangent stressing the role of corporate entrepreneurship and intrapreneurship in the renewal of large firms. Austrian political economist Joseph Alois Schumpeter for instance, through his vastly renowned conception of entrepreneurship as a process of innovation, has himself had two contrasting viewpoints on the role of the size of firms, and the market structure on the innovation in a particular sector. There is no clear-cut answer in that regard, as the relative / comparative innovativeness of a firm vis-à-vis its size has been noted to vary considerably with the economic sector and time period it is being observed for. For instance, in the pharmaceutical and computer technology sectors, there has been a shift from a point where small firms were hardly seen as sources of technological / research breakthroughs to playing the role of the driver of innovation. More peculiarly in the computer sector, there has been a shift from the earlier innovations being in the more capital and resource-intensive area of hardware research, to today's times wherein small firms with miniscule budgets drive the value through innovations in both the creation and deployment of software. In the context of the defence sector, however, M&A was used as a means to acquire external or complementary technologies, and this can also be gleaned from the difference in the proportions of R&D allocation relative to their turnover – acquiring companies tend to have lower R&D spends relative to their acquired / target counterparts.

In summation, the debate for large vs. small firms in relation to innovation will always be there, and this article does not seek to lend fuel to such a fire, but merely attempts to stand on its own two legs and depict how, in the defence sector of today, small may be the new big when it comes to innovation.

What are parameters that drive innovation in Defence and Aerospace

The analysis of what drives innovation in defence is something that has already been discussed in exquisite detail by scholars and policy analysts alike, possessing a breadth and complexity that cannot be encapsulated within the limits of this article. However, before moving on to why MSMEs are better poised to innovate in defence, it is vital to briefly go over just what drives innovations in defence.

Firstly, in most industries, there is a vast disconnect between the people who make the decisions for technology planning (from a corporate strategy perspective / POV) and those that actively work in the direct development of said technology. However, that does not seem to be the case in the defence and aerospace industries given the closeted, often skill-related nature and requirements of the industry. Although strategic planning at a corporate level are important factors for the growth, research and development of small firms in innovation-intensive industries, it is most often the larger firms who possess the managerial and analytical capabilities required for undertaking such tasks.

Second, any analyst evaluating the innovations in the defence sector must also realize that the question of who in this sector is able to innovate often depends on who is ‘funding’ or ‘bankrolling’ the innovation.  For instance, if it is the military demand that is driving the ‘funding’ for the innovations, then it will very often be the military and the services who get to decide who gets to be the ‘innovator’ eventually by being awarded the funds. On the other hand, if the innovation is driven by factors of intra-industry supply, or in the cases of dual-use technologies inter-industry supply, then firms with a larger, cross-sectoral presence will obviously possess a technical and developmental edge over their counterparts, often due to their ability to enlist and support a wide array of research specialists with commercial expertise and insights.

A third reason is what can be referred to as the “spill-over effect” wherein one country’s extensive defence and aerospace funding can spur other countries to match such efforts in a bid to remain competitive and ‘technologically relevant’. Take for instance the year 1957, when Soviet engineers and scientists fired a three-stage R7 intercontinental ballistic missile which eventually put the famous ‘Sputnik I’ into space. Consequently, in the USA, the launch of ‘Sputnik I’ was followed by a surge of military research and development (R&D) spending and a flurry of new science and technology (S&T) policies and agencies, including the setting up of institutions such as the Advanced Research Projects Agency (ARPA), the National Aeronautics and Space Agency (NASA), and the President’s Scientific Advisory Committee were formed, along with a slew of other reforms poised for fostering innovation through both financial and institutional initiatives undertaken by the government. This increased financial and institutional support for defence-related science and technology would result in a wave of military technology innovation. Military technologies developed as the result of this increased government support include, inter alia, ballistic missile defence systems (christened as the ‘DEFENDER’ and ‘ESAR’), rocket technologies (i.e., Juno V booster technology and the imaginatively named ‘Centaur’ rocket), nuclear test detection (VELA), and a satellite positioning system (Transit). The popular explanation for this sequence of events is that Sputnik’s launch heightened the perceived threat posed to the USA by the USSR, which, in turn, motivated US policymakers to invest heavily in military R&D. That is, an increase in the United States’ threat environment led to military technology innovation. Of course, the obvious caveat is also the fact that the domestic economic conditions in the United States in the late 1950s were such that organizations with a military technology development mandate had the capacity to effectively respond to increased demand on the part of policymakers.

Whilst some believe in the Schumpeterian view that ‘concentrated markets with large firms have more incentives and capacities for R&D expenditures,' and therefore lay stress on the importance of market power as a return to innovation output, there is actually nothing to suggest that the presence of large industrial giants is mandatory in all or even most industries in order to ensure rapid technological change and utilization of upcoming innovations and technology.  Although some will argue that in a concentrated industry like defence, the companies would be eager to innovate in order to differentiate their product and to deter the entry of rivals, it is but unmistakeable that certain extremely concentrated industries are extremely deprived of innovation, like tobacco, steel, newspapers, steel, shipbuilding, meatpacking, to name but a few.  That is not to say that industries will not have certain sectors that are extremely concentrated and some that are not, however, what is noticeable is that some of the most innovative ideas of recent time have been launched by small teams of researchers operating at either the fringes of these large corporations and conglomerates or outside this paradigm entirely through the incorporation of their own ‘startups’.  

Why are small firms poised to drive innovation in Defence?

There is growing belief backed by evidence, that there are certain industries and sectors where small firms generally have an advantage when it comes to market dynamics. Through the information present at hand, it would be correct to posit that such industries display four characteristics: 

  • First, the relative advantage for small firms in industries that are highly innovative but that are low in R&D intensity , and in which uncertainty about markets or future technological trajectories is high. It must be noted that when such a statement is made, we must categorize innovation as distinct from other forms of incremental development in order to identify the technologies and markets in which smaller enterprises are likely to thrive. Additionally, the uncertainty is something that is an underpinning characteristic of the defence sector, for instance even if sometimes the innovations are considered quite radical and revolutionary, it still does not guarantee deployment due to considerations of political suitability around such decisions.
  • Additionally, while small firms will not possess the kind of economies of scale and fund availability, both of an internal and external nature, small firms possess rapid and effective internal communication and formal networks which make it easier for them to respond to changing market niches with a faster response time. This advantage only gets exacerbated in cases of innovations that do not depend on the availability of high-level laboratories and scientific equipment, thereby making the process of research, discovery and development easier without a large expenditure. The uncertainty of the defence sector also means that smaller firms are generally more willing to take up the risks associated with the development of a certain technology as opposed to bigger firms. They are given the legroom to innovate without having to worry about suppressing weapon and systems concepts for the fears of eating away at the market share of some of their own products – a concern that is all too real for larger, more diversified defence corporations.
  • Further, smaller firms possess the edge in industries that, and this is more true for some subsectors of D&A than others, require a high proportion of skilled labor, i.e., production systems that are more skill-intensive than capital-intensive. Due to their nimble footed nature, the management and employees of a small firm are more likely to acquire the requisite combination of skills needed to effectively develop and field innovative weapons, components and systems.
  • Fourth, MSMEs may have the right mix of skill and resources in sectors that operate under the ‘learn by doing’ factor. That is to say, certain niche categories in any industry, even defence and aerospace, will always leave room for MSMEs to prosper. With medium learning curves, the advantage to be tapped into by MSMEs is twofold: the quantities of production in D&A are generally not so high so as to provide the bigger players with a headstart. Often, the quantities required by the armed forces are too low to allow for high-speed learning curves to take effect, which would mean that the large firms do not get to use their economies of scale to the extent that they would in other sectors.
  • An additional fifth element to the above-mentioned parameters affecting innovation may also be mentioned. However, it would not be incorrect to account for this as being more of a shortcoming for the large/ mega-cap firms as opposed to an advantage for the smaller firms. In terms of a behavioural differentiator, larger corporations will often be more risk-averse than smaller companies. Whilst their diversification would allow for the risk for a certain R&D cycle to be spread across better financially, shareholder pressure can be exerted in the form of demand for increased short-term success. Very often, the stringent regulatory hurdles experienced by large firms also accentuates their risk averse nature, which often leads to lower levels of innovation. 

Moreover, we see a trend in the D&A sector wherein the advancements in the sector have come about as a result of the assimilation and combined usage of already existing technology as opposed to critical breakthroughs in technology, specially in cases wherein well-coordinated, networked, long-range and time-constrained operations are used to assess actual, on-ground military capability of a nation. This requirement for having a framework for the overall integration of a multitude of systems and capabilities means that the future of defence systems and innovations may well be dictated by a continuous recombining of pre-existing technologies, particularly with the advent of information systems post the turn of the millennium. It is but undeniable that this changing paradigm has also increased uncertainty in how future weapons and systems will be created, making it harder than ever to predict how the development of weapons will pan out with time. These factors, coupled with the five dimensions mentioned above, make the defence and aerospace industry the perfect field to be in right now, particularly for MSMEs who can take advantages of the peculiarities of the industry.

How Small Can Be the New Big – Collaboration

One must not miss the massive opportunity that collaboration presents for defence and aerospace industries, both large and small. As a matter of fact, larger defence companies have over the years experienced signs of trouble whilst integrating the companies they acquired in the merger waves outlined in the first paragraph of the article. As larger companies swallowed up smaller ones through bullish M&A moves, they have failed to adequately assimilate them into their organizational framework, often failing to benefit from the potential impact that this synergy can generate.

MSMEs are better poised now to do that. The benefits of collaboration are multi-fold: for instance,

  • Sharing of risks and costs, specially for MSMEs is vital in order to cover their risk exposure moving forward;
  • In addition, the ability to access markets is also something that is often a deal-driving factor if one is to analyse the acquisitions in the defence and aerospace industries;
  • Third, the appropriability of intellectual property and assets is also a key factor in any collaborative venture being successful. The TDF initiative solves all three of these problems under a single umbrella.

Of the numerous benefits that MSMEs can assuage from this, these are but a few. First, TDF allows for MSMEs to share risks and costs, by providing grants-in-aid for the development of weapons and systems (even going down to a component level) which for MSMEs translates into the ability to innovate at a lesser risk exposure. Second, TDF provides them access to markets directly by acting as the intermediary between the MSMEs and the eventual end-users of their technologies – the armed forces and defence personnel of the government. Studies have often shown that M&A, joint ventures or even collaborative ventures between solely private players can often be a costly affair, with access to newer markets being one of the primary reason companies end up paying a premium either in acquisition or research. TDF provides MSMEs direct access to a previously untapped market in the form of the armed forces. Third, TDF guarantees that with the involvement of a secure governmental wing such as the DRDO, the amount of players in such a partnership are kept to the required minimum, which ensures that there is no chance of a ‘spilling-over’ of IPR in any project, thereby giving MSMEs the impetus to innovate and eventually benefit from the result of their innovation by partaking in the ownership of the patents and intellectual property they create, with the knowledge of such IPR being safeguarded appropriately. Smaller firms, therefore, must avail the benefits of TDF which provides them with a system more efficient than a single, integrated company through the creation of a framework which functions as a superior combination of risk and return than any other form of partnership.

Source