[FoRK] [Fwd: [IP] Innovation Ships Out]

Adam L Beberg beberg at mithral.com
Thu Jan 20 21:45:49 PST 2005

Used to be that America had the best stuff, and people wanted the best 
stuff, and we always won. My parents and grandparents always bought 
things that lasted them "forever".

Not this generation. People want the cheapest crap they can get at 
China*Mart (aka wal*mart). You can't even find good things anymore (I 
try) becasue there is no market.

Americans will NEVER win in that marketplace. Period. Race to the bottom 
baby. Even if the dollar devalues by a factor of 5, we still can't win, 
becasue nothing is MADE here anymore that isn't immediately pirated. 
Noone here has any skills making or fixing things made of atoms anymore, 
and if they did, they wouldn't get their hands dirty.

Good thing we have illegal immigrants to harvest our food, or we would 
all starve.

Adam L. Beberg



(sorry, no text friendly version available)

Innovation Ships Out

U.S. computer makers such as Dell, Motorola and HP are outsourcing not just
the manufacture but the design of new products to offshore companies. Could
this be the end of America's innovative edge in electronics?


Buy a laptop anywhere in the world and there is a one-in-four chance that
T.J. 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 
Fang, assistant vice president and head of IT operations at Quanta, 
feeds those
orders to his Taiwanese and Chinese suppliers and factories, and within 
days, Quanta "drop ships" to the customer a laptop that the buyer himself
configured on the brand-name website. 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 American brand-name laptops are outsourced
today. What's more, many of these famous computer brand names don't even 
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 
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 

Outsourcing has reached the highest level of the manufacturing supply 
R&D. By outsourcing R&D offshore, original equipment manufacturers 
(OEMs) can
freeze a portion of their R&D budgets while growing their product 
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, 
systems for HP.

But there may be a downside to all this R&D reshuffling. Some economists 
the outsourcing of manufacturing—and now design—is the leading edge of a
longer-term trend toward reduced innovation and competitiveness among U.S.
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 
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, 
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

Meanwhile, 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. The changing mix of R&D spending in the 
United States
could have a major impact on U.S. competitiveness over the long term, 
says. Governments around the world are pumping money into private-sector 
R&D to
boost innovation. In contrast, U.S. government spending on R&D is almost 
focused on specific programs—such as space, defense and health—rather than
free-form research.

"We have the view in this country that private industry is capable of 
the necessary investments in R&D to keep the U.S. competitive," says 
"If that's the case, then every other country in the world is wrong."

The U.S. computer industry may be a bellwether for other industries that 
not yet begun to send product development work to outsourcers. As U.S.
companies increasingly shift their R&D focus from new breakthroughs to 
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 

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 
offshore, will the ultimate value creators—advanced research and
innovation—eventually move offshore too? How long can U.S. companies 
continue to innovate
when they no longer manufacture or update products? What will be left 

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 
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 
with automated monitoring and reporting to ensure that suppliers are 
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 
of influence. Indeed, as OEMs turn more of their supply chain over to 
electronic manufacturing services (EMS) companies, they will rely more and
more upon the internal IT groups of these organizations to monitor their 
chain for them. "OEM has become a misnomer unless you change the M to
marketing," says Kristian Talvitie, director of strategic marketing and 
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 
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 
a new customer today," says John McManus, managing director and senior 
for Needham & Co., an investment banking and research company.

To survive, EMS companies have had to continually take on higher-order, 
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 
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 
accustomed to focusing exclusively on the manufacturing portion of the 
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 
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 
Quanta's website 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 center.

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 
OEMs don't need to test each PC made by an EMS before it gets shipped if 
have set up a testing process at the factory that is monitored by IT. 
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 
from the OEM needed onsite at the EMS's factory and virtually eliminates 
need for the OEM to physically take possession of the products.

For big U.S. companies with diverse product lines such as HP, it's 
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 
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 
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 
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 
such as design, manufacturing and shipping is hard; it costs more and 
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 
as PCs, laptops and cell 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 
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 
"These companies started with circuit boards and worked their way up to 
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 labor, 
either. Pick says
many have instituted quality programs such as Six Sigma that rival Western
producers. Factory capacity utilization among EMS companies averages 85 
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 
EMS's have already broken that taboo. For example, BenQ, another Taiwanese
EMS, sells its own brands of cell 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 
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 
there's anything stopping the outsourcing push," says Needham's McManus. 
issue is: Can you be a successful corporation with returns on capital 
that are no
better than 15 percent?"

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

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 
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. 
difficult to make an ROI argument for creating fundamentally new scientific
knowledge," says Mark Bernstein, president and center 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 
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 
says NIST's Tassey. Supercomputers and high-tech weapons, for example, 
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 
he says. "You're going to see a lot more partnering" around the globe to do
research. Besides outsourcing manufacturing and design, many U.S. 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 U.S. 
but it happens elsewhere, employing lower-cost engineers. Though U.S.
corporations will continue to innovate under this model, the United 
States and its pool
of engineers will become lesser engines of that innovation.

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 
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 
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 1,500 design engineers today. The plan is to 
that number to 7,000 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 7,000
engineers will have a good idea up his or her sleeve.

Executive Editor Christopher Koch can be reached at ckoch at cio.com.

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CIO Magazine - January 15, 2005
© 2005 CXO Media Inc.

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