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Innovation Canada: A Call to Action

2. The Context of the Review

The purpose of this chapter is to provide a brief overview of the principal concepts as well as facts and figures regarding business innovation in Canada and in relation to our peer group of highly developed countries. It draws on reports by the Council of Canadian Academies (CCA) and the Science, Technology and Innovation Council (STIC), work by Statistics Canada and the Organisation for Economic Co-operation and Development (OECD), and background research conducted for the Panel.

Innovation and Productivity Growth

The material standard of living of a society depends on productivity – the value of goods and services produced per hour of work. A high level of employment is clearly important, and favourable movements in the world prices of a country's exports – for example, certain natural resources in Canada's case – can boost prosperity, at least for a time. But over the long run, it is labour productivity growth that drives increases in average per capita incomes and business competitiveness. Productivity growth, in turn, is primarily the result of innovation.

In a phrase, innovation means "new or better ways of doing valued things" (CCA 2009, p. 21). Innovation is not synonymous with invention, although the spark of invention or creativity is a necessary precedent for innovation. Business innovation occurs when a new or improved "something" – a good, a service, a process, a business model, a marketing tool or an organizational initiative – is put into practice in a commercially significant way. In more technical terms, the Oslo Manual (OECD and Eurostat 2005, p. 46) reflects the current international consensus that defines innovation as "the implementation of a new or significantly improved product (good or service), or process, a new marketing method, or a new organizational method in business practices, workplace organization or external relations" (see also Box 2.1).

The means by which an idea or prototype is transformed into a market-ready product is often referred to as commercialization and is at the core of the process by which invention becomes business innovation – the process from "mind to market." Commercialization is a multi-faceted and multi-stage phenomenon that, depending on the product, often involves design, engineering, production planning and the related research and development (R&D). Moreover, it almost always involves capital investment, market assessment and sales planning as well as financial and legal analysis, among other activities.

Some innovations – like the automobile, the Internet or penicillin – are game changers. But the vast majority of innovation is incremental – the continuous improvement of products and processes. Innovations must of course start somewhere but, unless and until an innovation spreads widely, it is of relatively little economic or social significance. In the context of productivity growth, the process of innovation diffusion and adaptation is most important, since most innovation that occurs in any given area or jurisdiction is through adaptation of significant innovations originating elsewhere (CCA 2009, p. 27). The adoption/adaptation by an individual enterprise of a new or better way of doing something is therefore also recognized as a form of business innovation – indeed, the most common. It often requires substantial creativity to redesign business processes, organization, training and marketing to take advantage of the adopted innovation.

Box 2.1 Types of Innovation and Their Support by Government

The Oslo Manual (OECD and Eurostat 2005) defines innovation broadly to encompass product, process, organization and market innovation. This four-part typology is elaborated upon by Lynch and Sheikh (2011) as follows.

  • Product innovation. New products (whether goods or services) that move up the value-added chain or are first to market typically carry higher profit margins because they face less cost competition than standardized products. New information and communication technology devices and software or new (pre-generic) pharmaceuticals are typical examples. Product innovation can be the result of R&D and/or of aggregating existing leading technologies in a new way that better meets customer demands, as illustrated, for example, by the "smart phone" (wireless telephony, GPS, email, camera, etc.).
  • Process innovation. The objective is to change how products are produced and delivered to reduce cost and/or to increase convenience for users. Topical examples include development of global supply chains, and Internet-based shopping. Many Canadian manufacturers have proven to be adept "plant floor" process innovators – for example, Canadian auto plants are regularly rated among the most productive in North America. Innovation by Canadian natural resources companies – in oil and gas, mining and forest products – has also focussed mainly on processes as distinct from the development of advanced machinery for resources production or leading-edge products derived from natural resources. A spectacular example of Canadian process innovation is the "steam-assisted gravity drainage" (SAGD) method for bitumen recovery from oil sands.
  • Organization innovation. The capacity to convert creativity, technology and knowledge about customers into marketable innovations requires a corporate focus on how to best organize and manage for innovation. Successful business innovation requires the integration of human capital management and training, technology management and strategic management into structures that are "innovation supportive."
  • Market innovation. Examples include entering a new geographical market (e.g., a high-growth emerging market like China, India or Brazil), or addressing a market in an entirely new way (e.g., via the Internet or a smart phone channel). This can shift a firm from fighting for market share in existing markets to a temporary "monopoly" position for its particular product in the new market.

Innovations in product, process and market will usually require complementary innovation in organizational form and behaviour in order to be fully effective. While all four types of business innovation are potentially mutually reinforcing, most government programs that support business innovation address directly product and process innovation and, more specifically, R&D and related investment in appropriately trained people, as well as risk sharing for investment in innovative early-stage companies. (The latter are usually built around a novel product or process.)

Organizational innovation is highly specific to an individual firm and therefore does not lend itself to direct support by government programs, although such innovation may be fostered indirectly by any policy or program that encourages business innovation generally. Market innovation is also usually firm specific, although there is scope here for government program support, particularly to facilitate access to important new geographic markets.

Canada has a business innovation problem. The most telling indicator is Canada's subpar productivity growth, which has averaged a mere 0.6 percent over the 2000–2009 period, or less than half the average of 1.5 percent for all OECD countries (OECD productivity database, accessed November 2010). Relative to the United States (US), as depicted in Figure 2.1, labour productivity in Canada's business sector has fallen from approximately 93 percent of the US level in 1984 to 71 percent in 2009 – a quarter-century of relative decline that cannot be explained by temporary or one-time factors.

The Canada–US gap has been analysed statistically in terms of the three principal factors that account for labour productivity growth:

  • workforce composition – changes in the level of education, training and experience of the workforce
  • capital deepening – growth in the amount of capital used to support workers
  • multifactor productivity (MFP) growth – a residual measure that captures all other factors that affect productivity. MFP reflects how effectively labour and capital are employed jointly to produce output. Investment by businesses in R&D is one important contributor to long-run MFP growth.

Analysis by Statistics Canada of the evolution of these three factors in Canada and the US over the years from 1961 to 2008 shows conclusively that Canada's productivity growth problem is due to persistently weak MFP growth, particularly during the past decade (Baldwin and Gu 2009; also see Figure 2.2). Although a multiplicity of factors is involved, longer-term MFP growth trends reflect the pace of business innovation (CCA 2009, pp. 36–44). It follows that Canada's subpar productivity growth is largely attributable to relatively weak business innovation. (There are of course a great many highly innovative Canadian businesses but, relative to many other advanced countries, they play a proportionally smaller role in Canada's economy.)

Figure 2.1 Relative Level of Labour Productivity in the Business Sector, 1947–2009
(Canada as a percentage of the United States)
Figure 2.1  Relative  Level of Labour Productivity in the Business Sector, 1947–2009 (differences in percentage growth rates: Canada minus the US)
Figure 2.2 Sources of Canada–US Gap in Average Annual Labour Productivity Growth
(differences in percentage growth rates: Canada minus the US) a
  1961–2008 1961–1980 1980–2000 2000–2008

a The numbers in the first line of the table – the difference between Canada and the US in average annual labour productivity growth – are equal to the sum of lines (i) through (iii), which decompose the productivity growth gap into components related to capital intensity, workforce composition and MFP (subject to rounding). (Return to reference a)

Source: Baldwin and Gu (2009).

Gap in labour productivity growth -0.3 0.4 -0.4 -1.9
(i) Capital deepening 0.4 0.8 0.2 0.1
(ii) Workforce composition 0.2 0.4 0.1 0.1
(iii) Multifactor productivity -0.9 -0.9 -0.6 -2.1
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Innovation and R&D

Investment by businesses in R&D is a key input to many kinds of innovation (Box 2.2). In view of the relatively weak R&D spending by Canadian businesses (Box 2.3), it is not surprising that MFP growth has also been weak.

The great majority of business R&D is undertaken to support defined market objectives and is thus at the "development" end of the R&D spectrum. (Activities characterized as "experimental development" make up about 80 percent of business R&D spending in Canada; see Statistics Canada 2009.) Although the business sector accounts for a much smaller percentage of total R&D in Canada than in countries such as the US, Germany, Japan or Sweden, business is nonetheless the largest R&D performer in the country, accounting for more than 50 percent of the total (OECD 2011).

Box 2.2 Defining R&D

The Frascati Manual (OECD 2002), first published in 1963, is the basis for the OECD's definition of R&D, which emphasizes the creation and novel use of knowledge. The measurement of R&D expenditure includes both current costs (labour costs and non-capital purchases of materials, supplies and equipment) and capital costs (land and buildings, instruments and equipment, and computer software) devoted to R&D, which covers three activities:

Basic research is experimental or theoretical work undertaken primarily to acquire new knowledge of the underlying foundation of phenomena and observable facts, without any particular application or use in view. Applied research is also original investigation undertaken in order to acquire new knowledge. It is, however, directed primarily towards a specific practical aim or objective. Experimental development is systematic work, drawing on existing knowledge gained from research and/or practical experience, which is directed to producing new materials, products or devices, to installing new processes, systems and services, or to improving substantially those already produced or installed.

(OECD 2002, p. 30)

The annual spending on R&D performed by a country's business sector is referred to as BERD (business expenditure on R&D), while that performed by the higher education sector is referred to as HERD (higher education expenditure on R&D). Reference is often made to "BERD intensity" or "HERD intensity," defined as the value of BERD or HERD expressed as a proportion of gross domestic product (GDP).

In the above definition of R&D, the emphasis on knowledge creation and novel use has important implications for the classification of scientific activities as "R&D" as distinct from "scientific or technological services." For example, the search for reserves of oil and gas qualifies as R&D only if new survey methods or techniques have been developed to undertake the search. Similarly, exploratory drilling is not R&D, but there may be cases where the development of new drilling methods or techniques would qualify as R&D.

While the definition of R&D has remained unchanged since the first edition of the Frascati Manual, its methodological guidelines have expanded and now include greater attention to the measurement of R&D in services. The Frascati Manual is accepted by consensus of all OECD countries, thus ensuring international agreement on the definition of R&D, as well as the application of guidelines for its measurement. There is nevertheless still some room for national differences of interpretation as well as variation in the depth and specificity of data collected by statistical agencies for indicators such as HERD and BERD. So while OECD data allow for meaningful international comparisons of R&D activity, perfect cross-national comparability remains an aspiration and not yet a reality.

Box 2.3 International Comparisons of R&D Spending

Canada is a middle-of-the-pack performer in the OECD with respect to gross domestic expenditure on R&D (GERD) as a percentage of GDP, ranking 15th in 2008 out of the 31 countries for which data are available. Total R&D can be broken down among three principal groups of performer – business, higher education and government (see also Figure 2.5).

In 2008, Canada ranked 18th among 31 OECD countries in respect of business expenditure on R&D (BERD) as a percentage of GDP. (In the figure to the right below, based on 20 comparable countries in terms of size and degree of development, Canada's BERD intensity was at the bottom of the third quartile.) At 1 percent of GDP, Canada's BERD intensity was well below the OECD average of 1.6 percent and, moreover, has declined steadily since the peak of the "tech boom" in 2001 (see the figure to the left below). In fact, business R&D spending, adjusted for inflation, has been declining every year since 2006 (Figure 1.1). This trend is both surprising and ominous. By contrast, Canada's higher education sector is a relatively strong R&D performer, ranking fourth in the OECD at 0.68 percent of GDP in 2008, although the trend of this ratio has been fairly flat since 2003. (International rankings fluctuate from year to year and are sensitive to inevitable inaccuracies in data. General positioning within comparable groups of countries and trends over time are the more relevant indicators in international comparisons.)

The amount of R&D performed by governments in Canada (not to be confused with the amount funded by governments) has been flat to slightly declining as a percentage of GDP for more than 10 years and, at 0.19 percent of GDP in 2008, was well below the OECD average of 0.26 percent.

BERD Intensity Trends, 1981–2008
BERD Intensity Trends, 1981–2008
BERD Intensity of Selected OECD Countries, 2008
BERD Intensity of Selected OECD Countries, 2008

In absolute terms, BERD in Canada is weighted toward a relatively small number of large firms in a limited number of sectors. About a third of BERD is performed by only 25 firms and about half by 75 firms (Statistics Canada 2011). However, while the vast majority of smaller businesses throughout the economy do not perform R&D, those that do so tend to be more R&D intensive than larger firms – that is, they spend more on R&D as a percentage of company revenue. Statistics Canada's preliminary data for 2008 indicate that R&D expenditure among the largest R&D-performing companies (those with revenues exceeding $400 million) represented about 1 percent of their revenue, whereas for the smallest R&D-performing companies (revenue of less than $1 million), the figure was almost 40 percent (Statistics Canada 2011).

BERD intensities (that is, business R&D as a percentage of GDP) vary widely across sectors, with the most intensive being within the broad manufacturing sector – particularly computer and electronic products, pharmaceuticals and medicine, and aerospace products and parts. From a regional perspective, there is also significant variation in BERD intensity (Figure 2.3). Ontario and Quebec account for roughly 80 percent of Canada's business R&D (Statistics Canada 2010b), reflecting the relatively high proportion of R&D-intensive industries such as information and communication technologies (ICT), pharmaceuticals and aerospace in those two provinces.

Figure 2.3 Provincial BERD Intensities in Canada, 2008 (business expenditure on R&D as a percentage of provincial GDP)
Figure 2.3 Provincial BERD Intensities in Canada, 2008 (business expenditure on R&D as a percentage of provincial GDP)

The Canada–US BERD Gap

The Canada–US gap in respect of BERD intensity (see chart in Box 2.3) had narrowed significantly by the time of the collapse of the "tech boom" in 2000–01, but has widened considerably since 2003. A sector-by-sector analysis of the gap over the 16-year period 1987–2003 (the most recent year for which a full set of comparable data is available) considered the effect of two key factors in contributing to the gap:

  1. variations in the sectoral composition of the Canadian and US economies and
  2. differing R&D intensities within the same sectors.

It concluded that "generally lower Canadian R&D spending within the same sectors in both the United States and Canada accounts for a greater portion of the gap … than does Canada's adverse sector mix – i.e., the greater weight in Canada's economy of resource-related and other activities that have inherently low R&D spending" (CCA 2009, p. 6). In other words, relative to the US, there is a pervasive weakness in BERD intensity across many sectors in Canada.

Differences between Canada and the US in the distribution of firm size could affect the business R&D gap. However, Canada's greater proportion of small firms does not explain a meaningful proportion of the gap (CCA 2009, p. 102, drawing on the work of Boothby, Lau and Songsakul 2008). This is because the fraction of total R&D performed by small firms – those with fewer than 20 employees – is very small and therefore the US–Canada difference in the proportion of such firms necessarily accounts for a very small part of the R&D gap. To the extent there is a size effect, it is within the largest firms – those with 500 or more employees. Such firms account for a large proportion of total R&D and Canada's share of them is relatively low. (As noted above, small firms that perform R&D tend to be more research intensive than larger firms; however, the latter have bigger revenue bases and, despite having lower average R&D intensities, account for the majority of total business R&D spending.)

The prevalence of foreign-controlled companies in Canada is also relevant to the BERD gap, since corporations often conduct the majority of R&D near their headquarters – the auto assembly industry being a prime example of particular significance for Canada. This contributes to the proportionately lower volume of business R&D performed in Canada (CCA 2009, pp. 97–102). Several caveats are nevertheless in order. First, a number of Canadian industries with extensive foreign ownership are quite R&D intensive – for example, pharmaceuticals, aerospace and computers. Second, even in instances where foreign multinationals conduct most of their R&D abroad, Canadian subsidiaries still benefit from R&D embodied in capital equipment and from the transfer of other innovative processes and know-how originating in the parent company. Finally and most importantly looking forward, global companies are increasingly doing R&D in the most advantageous locations all over the world. The job for Canada therefore is to create the conditions to attract an increasing share of the global market for R&D.

In summary, the level and pattern of R&D spending by the business sector in Canada – as well as the gap in BERD intensity between Canada and the US – are the result of an extraordinarily complex combination of influences. If there is one overarching factor at play, it is the lower commitment of Canadian businesses, taken as a whole, to innovation-based strategies relative to counterparts in the US and many other economically advanced countries. Well-designed public policies and programs can influence the business strategy choice toward a greater role for innovation, but the more powerful incentive will come from the forces in the marketplace identified in the following section.