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Innovation Ships Out

Innovation Ships Out

As US companies increasingly shift their R&D focus from new breakthroughs to product refreshes, they will be tempted to move that work offshore, where well-trained and well-educated engineers are available at a fraction of the cost of their US counterparts.

Buy a laptop anywhere in the world and there is a one-in-four chance that TJ Fang will process the order. You'll just never know it.

Fang's secret is cloaked in IT, in servers that consolidate purchase orders from name-brand American companies such as Dell, Hewlett-Packard, Apple and IBM. The order trail leads to Fang's ERP system at Quanta Computer in Taipei. Fang, assistant vice president and head of IT operations at Quanta, feeds those orders to his Taiwanese and Chinese suppliers and factories, and within five days, Quanta "drop ships" to the customer a laptop that the buyer himself configured on the brand-name Web site. No one at the company selling the laptop ever lays a finger on it.

Indeed, investment bank Morgan Stanley estimates that the manufacturing for 89 percent of brand-name laptops are outsourced today. What's more, many of these famous computer brand names don't even design their machines anymore. New models are chosen from a shelf of fully functioning prototypes offered up by a handful of Taiwanese companies. Quanta's ability to design and build new laptops from scratch has helped it gain a 25 percent share of all laptops sold in the United States. "In the past 10 years, [companies such as Quanta] have gone from undercover stealth to a massive global business," says Adam Pick, senior analyst for iSuppli, a market intelligence consultancy.

Outsourcing has reached the highest level of the manufacturing supply chain: R&D. By outsourcing R&D offshore, original equipment manufacturers (OEMs) can freeze a portion of their R&D budgets while growing their product offerings. Even R&D powerhouses such as IBM, HP and Motorola have frozen - or even reduced - their R&D budgets since 2000. "[Outsourcing] is a tremendous opportunity for cost savings on R&D," says Jack Faber, vice president of operations, enterprise systems for HP.

But there may be a downside to all this R&D reshuffling. Some economists say the outsourcing of manufacturing - and now design - is the leading edge of a longer-term trend toward reduced innovation and competitiveness among tech companies. As OEMs turn over the development of new products to outsourcers, it could have a withering effect on these companies' ability to create the next breakthrough, especially as many freeze R&D spending. Spending on R&D by US companies declined more in 2002 (3.9 percent) than it has since the National Science Foundation began tracking the number in 1953.

Though the technology slump that began in 2000 may play a big role in these declining R&D numbers, there is a larger, more disturbing trend at work, argues Gregory Tassey, senior economist at the National Institute of Standards and Technology (NIST). For the past 12 years, the proportion of R&D money going toward new innovation - the "R" in R&D - has also been going down, displaced by incremental product development (next year's laptop, for example). Product development - the "D" in R&D - swallows more resources than the "R" work, and it does not create new opportunities for revenue; it merely extends current product categories.

Meanwhile, US government spending on R&D has also been dropping over the same period. R&D spending in the United States now lags behind many countries, including Japan and Germany. Governments around the world are pumping money into private-sector R&D to boost innovation. In contrast, US government spending on R&D is almost all focused on specific programs - such as space, defence and health - rather than free-form research.

The US computer industry may be a bellwether for other industries that have not yet begun to send product development work to outsourcers. As US companies increasingly shift their R&D focus from new breakthroughs to product refreshes, they will be tempted to move that work offshore, where well-trained and well-educated engineers are available at a fraction of the cost of their US counterparts.

The trend is eerily similar to the offshore outsourcing of computer programming. Unemployment rates among both R&D engineers and IT programmers in the United States continue to trend downward, despite the recent economic rebound. As more valuable components of the manufacturing value chain progressively move offshore, will the ultimate value creators - advanced research and innovation - eventually move offshore too? How long can US companies continue to innovate when they no longer manufacture or update products? What will be left behind? Marketing?

For CIOs in electronics and other industries, the shift toward global manufacturing and R&D means big changes in the supply chain. Companies that outsource R&D or split it among different locations or suppliers will need IT linkages to enable better collaboration among engineers. And as companies outsource other pieces of the supply chain (customer service, shipping, and warranty and repair, for example), CIOs will need to replace direct oversight of processes with automated monitoring and reporting to ensure that suppliers are meeting quality metrics and shipping on time.

Of course, if outsourcing is truly complete - from design right on down to shipping, service and repair - there is a distinct possibility that companies could drastically cut back on internal IT as well, severely reducing the CIO's span of influence. Indeed, as OEMs turn more of their supply chain over to offshore electronic manufacturing services (EMS) companies, they will rely more and more upon the internal IT groups of these organizations to monitor their supply chain for them. "OEM has become a misnomer unless you change the M to marketing," says Kristian Talvitie, director of strategic marketing and communications for Plexus, a global EMS company based in the United States.

Moving Up the Food Chain

In the past 15 years, EMS companies here and abroad have moved steadily up the food chain in large part because the value of the work to which they laid claim has been driven down by price pressure and global competition. Indeed, the work that launched the EMS industry in the 80s, stuffing components such as microprocessors onto computer circuit boards for big-name computer manufacturers, has ceased to be profitable, industry insiders say. "Placing components on boards is commoditized. You have to offer a whole variety of services to win a new customer today," says John McManus, managing director and senior analyst for Needham & Company, an investment banking and research company.

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