Innovation Ships Out

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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To survive, EMS companies have had to continually take on higher-order, more complex pieces of the electronics supply chain to keep their hollow-cheeked profit margins (overall industry average is 2 percent to 5 percent) from disappearing altogether. Design work typically has higher gross profit margins, between 8 percent and 11 percent, according to iSuppli's Pick. This has led to the growth of upstart companies such as Quanta that specialize in total design, manufacturing and shipping solutions for customers. Traditional EMS companies, accustomed to focusing exclusively on the manufacturing portion of the supply chain, are now expanding their design services to compete. "[EMS companies] want to get more of the value added at the research end," Tassey says. "Innovation is where you capture the big value, the new markets."

Quanta, unlike its larger EMS competitors, does not swallow customers' old factories and try to squeeze profits out of them. Quanta emphasizes design and logistics in Taiwan and assembles a network of manufacturers, mostly in China, to build its products. And Fang can use lightweight IT connections to hook his supply chain together and keep customers apprised of where their products are in the process. Fang has created an Internet portal for his network of 700 small suppliers. Each morning, suppliers download their purchase orders from Quanta's Web site and print out bar codes that they slap on the side of the box so that Quanta can quickly direct the materials where they need to go at its Taipei logistics centre.

IT Makes Outsourcing Easy

IT has accelerated the outsourcing trend in electronics because it allows OEMs to monitor the processes they give up, such as manufacturing and design. IT can't replace a good assembly line foreman or a chief engineer who watches over things, but in many cases, monitoring the process is enough. For example, OEMs don't need to test each PC made by an EMS before it gets shipped if they have set up a testing process at the factory that is monitored by IT. The OEM just has to verify, via an IT-based reporting system, that PCs that didn't pass the agreed-upon test were not shipped. Monitoring reduces the number of people from the OEM needed onsite at the EMS's factory and virtually eliminates the need for the OEM to physically take possession of the products.

For big US companies with diverse product lines such as HP, it's impossible to get everything they need from a single EMS company. Nor would these companies want to, for competitive, intellectual property and security reasons. But HP, for one, does try to limit the number of EMS companies it deals with, partly to shave costs, and also because the increased IT demands of monitoring the EMS's processes can be quite expensive for highly configurable products such as high-end servers. "If we want to create a build-to-order process for customers with an EMS, there is a lot more intimacy required in the information we exchange with the EMS," says Faber. More product options means more monitoring of the EMS company's processes. "The information pipe will be a lot bigger and must be much more responsive to changes than when we're dealing with a commodity product," he says.

If an EMS can take over the entire product process, from design to manufacturing to shipping to customers, and OEMs can verify through relatively inexpensive IT controls that the EMS is performing all these processes up to snuff, it becomes a much more enticing package for OEMs. Splitting up linked processes such as design, manufacturing and shipping is hard; it costs more and requires more oversight from the OEM. That's why design is becoming a deal maker (or breaker) for new outsourcing business. "All of the [EMS] companies realize they have to get involved in the design effort at the early stage because that's how the business is won today," says Needham's McManus.

With the relentless margin pressure that exists in the computer industry today, OEMs are quickly coming to the view that there is no point in devoting a great deal of R&D resources to mature product categories that change as rapidly as PCs, laptops and mobile phones. R&D engineers are the most expensive nonmanagement employees these companies have. "The OEMs are building entirely new product families every few years. So you either keep building R&D capacity to do that, or you outsource it," says Chris Smith, president and CEO of RiverOne, a maker of supply chain management software. "It's driven by the pace of change in the industry."

Indeed, Quanta is not designing anything all that original. The company is unlikely (at least for now) to invent the next revolutionary new product category. But it is perfectly capable of designing and manufacturing the next version of a PC, laptop or, in a move up the value chain, storage server on its own. "These companies started with circuit boards and worked their way up to design over the years. They've built up a lot of trust with the OEMs," says iSuppli's Pick. These companies aren't simply providing cheap labour, either. Pick says many have instituted quality programs such as Six Sigma that rival Western producers. Factory capacity utilization among EMS companies averages 85 percent to 90 percent in the Far East, versus 65 percent worldwide.

Innovation Not Far Behind

Quanta's Fang is careful to point out that his company has no intention of developing its own brands and selling against its customers. But other offshore EMS's have already broken that taboo. For example, BenQ, another Taiwanese EMS, sells its own brands of mobile phones and computer accessories in the Far East and the United States.

Quanta could be forced to do the same in the not-too-distant future. The incredible growth of electronics outsourcing has masked a fundamental weakness in the business model: Nobody has yet learned how to make much profit doing it. Even design margins have begun to erode recently, as EMS companies flock to the model and OEMs push for lower prices. To avoid a race to the bottom, the industry is going to have to find a way to earn better returns. "I don't think there's anything stopping the outsourcing push," says Needham's McManus. "The issue is: Can you be a successful corporation with returns on capital that are no better than 15 percent?"

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Indeed, during a recent conference call, Jure Sola, chief executive officer of Sanmina-SCI, a large EMS company, told financial analysts: "There's no way in the world this industry can exist on the margins that we are delivering today".

Innovation is the route out of low-margin manufacturing. IBM, Xerox, AT&T and HP built their R&D capabilities with cash from unique products that commanded high margins - or, in the case of AT&T, from an outright monopoly. But those companies have a harder time justifying investments in research today. "It's difficult to make an ROI argument for creating fundamentally new scientific knowledge," says Mark Bernstein, president and centre director of PARC, the former Xerox think tank that was spun out into an independent subsidiary in 2002. "Faster product cycles and the increased focus on efficiency and productivity have made it harder for companies to have a long-term vision."

The loss of manufacturing and design could make it difficult for the traditional R&D powerhouses to innovate in the future. "Real breakthrough product development usually requires manufacturing and research to be located together," says NIST's Tassey. Supercomputers and high-tech weapons, for example, required close collaboration between engineers and manufacturers.

But PARC's Bernstein says R&D must become more global by necessity. "The breadth of research required to master a market these days is pretty significant," he says. "You're going to see a lot more partnering" around the globe to do research. Besides outsourcing manufacturing and design, many companies have opened their own dedicated R&D facilities in low-cost countries such as India and China. Innovation still occurs under the banner of a US corporation, but it happens elsewhere, employing lower-cost engineers.

To some observers, this may sound a death knell for the United States' current lead in technology innovation, but HP's Faber isn't overly worried. "I hate to sound like a Republican," he says, "but when I first came here 20 years ago, we had our own factories for sheet metal and screws and everyone thought we had to keep them. As we outsource, we just keep focusing on higher value-added work." HP's newer 64-bit servers are examples of products that are largely conceived and designed in the United States, he says.

It's clear, however, that this is a sensitive issue for the traditional R&D powerhouses. All but one (HP) declined to comment on the growing trend in outsourcing the "D" in R&D. At the same time, the EMS companies we spoke to denied they have any plans to expand into the "R" part of R&D or offer their own products for sale. Given their dependency on brand-name companies for business, it's unlikely that we'll see a "Quanta Labs" anytime soon. But as the EMS companies take on more and more design work and build up their engineering groups, there is little doubt that they will eventually have the capability to come up with their own ideas.

Quanta, for instance, has 1500 design engineers today. The plan is to expand that number to 7000 in the next couple of years. Fang thinks other EMS companies will follow suit. "The profits in manufacturing aren't large," he says. "So moving into design is an obvious choice. It's a natural evolution." Even if Quanta has no plans to sell its own products, surely one of those 7000 engineers will have a good idea up his or her sleeve.