The integrator’s new advantage – The reassessment of outsourcing and production competence in a global telecom firm

European Management Journal (2008) 26, 314– 324

journal homepage: www.elsevier.com/locate/emj

The integrator’s new advantage – The reassessment of outsourcing and production competence in a global telecom firm Lars Bengtsson a,*, Christian Berggren b a b

¨vle, Department of Industrial Engineering and Management, SE-801 76 Ga ¨vle, Sweden University of Ga ¨ping, Department of Management and Engineering, SE-58183 Linko ¨ping, Sweden University of Linko

KEYWORDS Outsourcing; Production; Integration; Telecom; Ericsson

For a long time, the telecom equipment industry has been at the forefront of outsourcing and relocating production operations to contract manufacturing firms located in Asia and Eastern Europe. Recently, however, leading firms have begun to revise this strategy, based on their recognition of the continual importance of technological leadership and integration capabilities. Using a case study of a key company, this paper explores the dynamics of outsourcing and production strategies in the telecom equipment industry. One of the central aspects under study is the interaction of product development with industrialisation and production. The paper analyses issues such as component standardisation versus differentiation and technological integration, the value of deep integration capabilities for cost reductions, and why production competence and the rapid industrialisation of products incorporating new technologies have acquired renewed importance, despite the global trend towards lowest-cost locations. Ó 2008 Elsevier Ltd. All rights reserved.

Summary

Introduction ‘‘I recently learned about some shocking (at least for anybody in the telecom supply chain business) news about Ericsson’s plans to insource some of their manufacturing especially of radio base station transceivers. . .. It is shocking since everybody in the industry is actually doing the opposite. . . As you may know, we at Nortel actually went further than anybody else and practically outsourced our entire supply chain to Flextronics and

* Corresponding author. Tel.: +46 26 648802. E-mail address: [email protected] (L. Bengtsson).

within the next couple of years Nortel will have no manufacturing sites.” (Supply manager at Nortel, personal communication, November, 2005). In the debate about the structure of rapidly changing, technology-based sectors such as the telecom equipment industry, the disintegration, outsourcing and offshoring of manufacturing and other ‘‘non-core” functions have been seen as irresistible trends (Shi and Gregory, 2003, 2005; Sturgeon, 2002; Arnold, 2000). According to a consensus view, Western-based locations of these firms should concentrate on R&D, product development and marketing, whereas manufacturing and supply management should be outsourced to contract manufacturers, who are

0263-2373/$ - see front matter Ó 2008 Elsevier Ltd. All rights reserved. doi:10.1016/j.emj.2008.05.001

Outsourcing and production competence in a global telecom firm increasingly relocated to low-cost sites in Eastern Europe and Asia. One major telecom company to follow this trend has been Nortel. Ericsson, the leading system supplier of mobile networks, has also moved in this direction. Underlying these strategies was the assumption that key components in mobile telecom networks, for example in the radio base stations, were undergoing a rapid process of standardisation. Such a shift to a phase where efficiency is prioritised over innovation would give generic contract manufacturers superior economies of scale in purchasing and production. The PC industry was seen as the future model for the telecom industry as well. Based on studies in other fast-moving sectors, however, researchers such as Christensen have cast doubt on the belief in ‘‘irresistible trends”. Christensen’s analysis of the disk drive industry demonstrates the dynamic variation between periods of standardisation, when technological functionality is ‘‘good enough” and competition moves to cost and convenience, and other periods, in which new applications and customers increase the demand for technological performance, which gives integrated equipment makers the upper hand (Christensen et al., 2002).

Purpose Inspired by Christensen, this paper revisits firm structures and innovation dynamics in the telecom equipment industry. Taking the industry leader in mobile networks, Ericsson, as an example and using the framework developed by Christensen et al. (2002) as our theoretical lens, this paper will analyse the dynamics of different outsourcing strategies. In particular, we choose to focus on the roles of the industrialisation process and of production in overall product development. Whereas Nortel implemented full-scale outsourcing of production, Ericsson changed tack midway and since 2005 emphasizes the importance of internal industrialisation competence, including high-volume production. This shift has intrigued actors in the global telecom industry and prompts a reassessment of conventional wisdom. The case will illuminate the dynamics involved in achieving cost advantages through specialisation on the one hand, versus the need for innovation capability based on integration, on the other. In contrast to our initial expectations, it turns out that in the rapidly changing high tech areas we are studying, these pressures are converging in the same direction. Thus, the case illustrates the advantages of being a ‘‘deep system integrator” even in situations where there are plenty of cost-efficient contract manufacturers available worldwide. Furthermore, the case provides several arguments as to why production capability is still highly valuable in high tech innovation processes.

Methodology The analysis presented in this article is based on a case study approach combining comparative and longitudinal aspects. First we compare two companies at one point in time; and second we compare strategies at one of these companies at two points in time. The longitudinal perspec-

315

tive, inspired by Van de Ven and Huber (1990) and LeonardBarton (1990), is a key aspect of the paper, shedding light on strategic changes in production and outsourcing strategies and their rationale which would not be possible to uncover in a single-point comparative study. The first interview round took place in 2002 and was designed as a comparative case study, where we focused on the outsourcing and production strategies in the network divisions of Ericsson and Nokia. These two cases were chosen while they represented two contrasting approaches to outsourcing. Besides enhancing the validity this method is recommended for building theory from cases as it more clearly highlight the differences of the studied phenomenon (Yin, 1994; Voss et al., 2002). We formally interviewed individually over ten Ericsson managers and union representatives at both corporate and business unit level in Sweden. Of these were four sourcing and supply managers, one manager of product introduction, two production managers and several union representatives. At Nokia in Finland we interviewed two production managers, one general sourcing manager and two union representatives. In addition to these sources, we made use of non-public material such as consultant reports as well as official reports and company documents filed at the US Security and Exchange Commission. The comparison offered an opportunity for a more fundamental discussion of outsourcing than the narrow focus on implementation prevalent in the literature at that time. To validate the data we sent it back to the interviewees for corrections. The ensuing working report, later elaborated in Berggren and Bengtsson (2004) was extensively discussed with among both the company representatives. In 2005 and at the beginning of 2006, we got the opportunity invited to revisit Ericsson and meet managers and experts in sourcing, supply management and business structure at the corporate level. In this study we chose not to include Nokia Networks, since it basic productions strategies were basically unchanged. This opportunity was triggered by a re-evaluation of production and sourcing decisions, which had recently taken place within the company. In this longitudinal case study round we formally interviewed two sourcing managers and one supply management expert at corporate level, two supply managers and two production managers at business unit level. We essentially repeated the same questions on the motives, strategies and effects of outsourcing which we had investigated in the first round. In addition, we asked the respondents to explain how and why the company had re-evaluated their strategies. The answers were again checked by sending them back to the interviewees. Using this approach allowed us to systematically analyse the changes in both arguments and managerial actions over time. Additional information on Ericsson’s outsourcing and production strategies has been provided in discussions with company representatives at research seminars and courses held at our Universities during 2006 and 2007. The interviews have been complemented with official corporate information as well as internal information and analysis on changes of the industry structures. Because of the sensitive nature of the issues, and the competitive market situation some precise figures and details on components are not disclosed.

316 In this paper we disregard business cycle variations and focus on the long-term perspective, comparing previous and current motives and actions connected to the outsourcing of production. This comparison allows us to further understand the factors of importance in this context, in particular the interface between product development and production.

Outsourcing imperatives vs integration advantages Since the 1990s there has been a strong trend towards outsourcing in Western companies (Outsourcing Institute, 2005; Que ´lin and Duhamel, 2003; Kakabadse and Kakabadse, 2002, 2005). Although the initial focus of outsourcing was IT management, it is now used for a variety of activities, including core processes such as product development (Quinn, 2000) and production (McIvor, 2005; Bryce and Useem, 1998). Globalisation and the emergence of high-growth, low-cost economies in Eastern Europe and Asia have resulted in outsourcing increasingly meaning geographical relocation and offshoring. In this article we define outsourcing as the process when an internal activity, in our case production, is transferred to an external supplier (cf. Gilley and Rasheed, 2000). Insourcing is the opposite process, i.e. the re-internalisation of former outsourced activities (cf. Caputo and Palumbo, 2005). In line with GAO (2004), we distinguish outsourcing from offshoring. Outsourcing means externalising production activities to external suppliers. Offshoring refers to sourcing from an internal or external source located abroad. The focus in this paper is on outsourcing of production at Ericsson. Due to supplier relocation, this has increasingly also become the same as offshoring. There are a number of motives for outsourcing production. One is the expectation to reduce costs and investments. Another motive is that outsourcing enables a company to focus on core competencies, and to learn from innovative suppliers (Outsourcing Institute, 2005). At the same time, experience from advanced production and product development processes indicates that there are advantages in integrating and co-locating key processes, when a company is striving for both cost efficiency and innovation capability (cf. Ulrich and Ellison, 2005). In the following section we will discuss this ambiguity further by presenting the various results concerning the effects of production outsourcing on costs and on innovation capability reported in the literature. Moreover, since the case is related to the transformation of the telecom equipment industry, we will also discuss how industry dynamics affect motives and decisions on outsourcing and vertical integration.

Cost driven outsourcing Cost reduction is a main driver and motive for outsourcing. By outsourcing, the principal company wants to avoid investment in production facilities, to free resources and to take advantage of the supplier’s economies of scale and lower labour costs (Beaumont and Sohal, 2004; Outsourcing Institute, 2005). Despite its popularity, however,

L. Bengtsson, C. Berggren the outsourcing of production seems to have ambiguous effects on costs and firm performance. Several authors claim a positive relationship (e.g. Go ¨rg and Hanley, 2005) while others report no significant relationship between outsourcing and performance (Laugen et al., 2005; Mol et al., 2005; Gilley and Rasheed, 2000). Transaction cost economics (TCE) has been a popular framework to analyse the motives and effects of different types of outsourcing. According to this theory, assets and competencies with high specificity tend to be deeply embedded in existing routines and should be kept in house. Assets with low specificity could be outsourced. High risks of supplier opportunism make it more costly to externalise the activity, and visa versa (Williamson, 1975). In line with TCE assumptions, some studies indicate that separating activities with high specificity has negative impact on performance (Murray et al., 1995; Poppo and Zenger, 1998). In other cases, perceived cost advantages are consumed by additional transactional costs, such as logistics costs for longer transports and increased stock, longer lead-times and risks of delays in delivery and market introduction. There are also costs for managing the transfer of products, knowledge and equipment to the outsourcing partner (Harland et al., 2005; Hendry, 1995). These additional costs could reduce the expected benefits significantly (McKinsey, 2005; Jackson et al., 2001). The trade-off is well summarised by Mol et al. (2005) who conclude that outsourcing is a balancing act between lower manufacturing costs abroad and lower transaction costs locally.

Outsourcing as a vehicle for innovation There are also arguments for outsourcing which stress the link between outsourcing and innovation. One is that outsourcing may free resources from non-core activities, and that these resources could then be spent on innovation activities (Medina et al., 2005). This strategy is presented as a means to allow a company to focus on its core competence, which could increase its ability to implement fast product development (Harland et al., 2005). Another innovation argument is that outsourcing for market reasons may open up for new product and services (Loch et al., 2007). Further, it is argued that by outsourcing, firms can get access to new competencies at partner companies and in this way build new innovation capabilities (Loch et al., 2007; Baden-Fuller et al., 2000; Quinn, 2000; Quinn and Hilmer, 1994). This idea refers to the fact that advanced technological products are increasingly developed in inter-organisational processes, and involve webs of geographically dispersed firms and production sites (Brusoni et al., 2001). Thus, when their products incorporate a range of technologies, to be competitive firms have to rely on external partners. Some studies claim that external cooperation and partnering relations with outside specialists may be as efficient for innovation and knowledge creation as internal processes (Dyer and Nobeoka, 2000). In this wider context, the significance of production competence for innovation and competitiveness has been questioned and it has been suggested that product development could be completely separated from production (Arnold, 2000).

Outsourcing and production competence in a global telecom firm There are, however, other factors which call the overall rationality of extensive outsourcing into question; factors calling both for a reinterpretation of the basic idea of core competence and for a new look at the needs for successful knowledge integration.

Integration needs and advantages of internalising production In the literature, the general effects of outsourcing on firms’ innovation capability are not clear (Smith et al., 2007). This has several explanations. First, it seems important to distinguish outsourcing driven by cost motives from outsourcing driven by innovation motives. Some studies indicate that outsourcing for cost reasons may damage the industrialisation and innovation capability of the firm (Dankbaar, 2007; Berggren and Bengtsson, 2004). Similarly, Plambeck and Taylor (2005) argue that although contract manufacturing may help to improve capacity utilization and thus lower costs, it may also weaken the incentives for innovation by shifting the focus from innovation to costs. Secondly, outsourcing represents a learning dilemma. In theory, outsourcing may open doors to external expertise and support inter-firm learning processes. Several studies, however, point out that organisational fragmentation and a loss of critical internal skills, such as process expertise or the architectural knowledge needed for effective sourcing, make it difficult to realise this innovation potential (Sturgeon, 2002; Hoecht and Trott, 2006). These risks are particularly prominent in cases when systemic or interdependent innovations are involved (Chesbrough and Teece, 1996). The leads us to the need for a re-interpretation of the core competence model (Prahalad and Hamel, 1990), as it has been used in practice. The core/non-core distinction has often been used to justify whether an activity should be nurtured internally or externally. According to this line of reasoning, activities defined as non-core become candidates for outsourcing. Firm competencies, however, are often systemic, i.e. there is a dependency between core competencies and those competencies which support the core. This means that a firm’s ability to exploit its core competence may be damaged if everything defined as ‘‘outside the core’’ is outsourced. The problem is further aggravated by the fact that competencies are dynamic. Due to technological and market changes, the core of today may be noncore tomorrow, and vice versa. Compared to those studies, which focus on outsourcing, few have explicitly analysed the opposite phenomenon, the processes of insourcing and integration. One way of distinguishing the motives for insourcing is to simply look at the arguments against outsourcing, such as low capacity utilization, loss of competence, increased dependency on suppliers and reduced control over business processes (e.g. design and production) (Caputo and Palumbo, 2005).

Industry dynamics The outsourcing – internalising dilemma may also be analysed from the perspective of industry dynamics. Product life cycles are typically characterised by a shift in focus from functionality to process efficiency and cost reduction,

317

which are based on increasing levels of standardisation (Utterback, 1994). The standardisation of interfaces and modular product architecture make it possible to decompose products into independent subsystems which are easier to outsource to external actors (Sanchez, 1995; Baldwin and Clark, 1997; von Hippel, 1990). Strebel (1996) has added to this understanding by describing industry changes as an evolutionary cycle, characterised by one innovation phase in which firms compete by providing divergent customer values and one convergent phase in which competition focuses on efficiency. The shift between the two phases is called the breakpoint. One indicator for a breakpoint, leading to the start of a convergent behaviour is an increase in the similarity of products and services on the market. The breakpoint for divergence is harder to anticipate, but can be triggered by declining growth rates which induce increased experimentation, or technological breakthroughs, which attract new entrants. A fundamental basis for distributed innovation is specialisation through standardisation and product modularisation. Inversely, when product interfaces are insufficiently defined, there is a need for an interactive technical dialogue between research, development, production engineering, etc. and it is argued that these organisational interfaces are best internalised (Ulrich and Ellison, 2005). Several studies indicate that for complex and rapidly changing products, such integration capabilities are crucial, i.e., capabilities to rapidly industrialise and market the new products, and the knowledge to make proper sourcing decisions (Sturgeon, 2002; Ulrich and Ellison, 2005). Christensen et al. (2002) and Christensen and Raynor (2003) further explore these dynamics. They show how competing on standardisation, low cost and customer flexibility relates to disintegrated industrial structures, while competing on innovation and product functionality calls for close personal communication and integration of key functions like research, design, production and marketing. The logic behind this is as follows: In sectors where functionality is not good enough, firms compete on technology and more advanced products. In order to be at the forefront, product architects do not use industry standards but prefer interdependent architectures, which demand an unstructured technical dialogue between various specialists. The transaction costs are minimised through integrating and colocating design, production and procurement. In contrast, in sectors where functionality is more than sufficient, firms compete by means of speed, flexibility and customisation. Product architectures evolve towards modularity, enabling specialised and non-integrated providers to succeed, because structured technical dialogues have minimised transaction costs. As noted above, there is a tendency that over a long period industries evolve from integrated firms towards nonintegrated and specialised structures (Utterback, 1994). However, many industries also display a cyclical pattern (Strebel, 1996). In their study on the disc drive industry, Christensen et al. (2002) noted that occasionally performance gaps occur, and this is revealed by an increased customer demand for functionality. When this happens, the need for managerial and technological reintegration increases. Christensen et al. (2002) concluded: ‘‘if they consciously and capably manage the swings between

318 interdependence and modularity, integrated firms ought to have long-term performance advantages over non-integrated firms’’. To sum up, on the general level there seems to be justifications for both outsourcing and internalising production processes. Thus, there is a need for more differentiated, sector-level studies taking the possibly cyclical nature of industry dynamics into account and asking questions such as: When, under what circumstances, is the standardisation/separation logic prevalent? When will integration advantages carry the day? In this paper we address these issues by taking a closer look at the changing perception within the Ericsson Company of the significance of production competence for the innovation processes during the 2000– 2005 period.

Outsourcing production in the global telecom equipment industry – two contrasting models Disintegration, outsourcing and the offshoring of manufacturing have characterised the global telecom equipment industry since the late 1990s. Original equipment manufacturers (OEMs) of network products, such as Ericsson, Nokia, Alcatel and Nortel, have turned to contract electronics manufacturers like Flextronics, Sanmina-SCI and Solectron for the assembly of modules and subsystems. This has resulted in a dramatic growth in the industry for electronic manufacturing services (EMS). In the supposedly maturing telecom sector, those firms who serve several different OEM-customers, have been perceived to possess superior production efficiencies and economies of scale in purchasing. Suppliers of components, e.g. integrated circuits and processors, constitute a third important actor, not to be confused with the contract manufacturers. These component suppliers provide key technologies and auxiliary subsystems to both OEMs and contract manufacturers. In this paper, our focus is on the outsourcing relations between OEM and EMS firms, who together form emergent global manufacturing networks (Shi and Gregory, 2005). The general trend to outsource production to EMS-firms has been supported by a view modelled on the computer industry, according to which future OEM competitiveness requires a focus on core activities such as product development and marketing, while at the same time letting go of production and supply chain management (Arnold, 2000). The growth of the manufacturing services (EMS) sector started when EMS companies took over the responsibility for manufacturing plants in stagnant technology segments, such as equipment for fixed networks (Shi and Gregory, 2003, 2005; Lindroth and Ha ¨nstro ¨m, 2002). Gradually, these companies have built capacity for global sourcing and coordination of the purchasing activities of their local plants. During recent years contract manufacturing firms have started to move up the value chain, not only offering production capacity, but also industrialisation and design capability, as well as responsibility for supply chain logistics. A similar development within consumer electronics has lowered the barriers for new entrants (Shi and Gregory, 2005; Fraser et al., 2005) making it possible for OEMs without manufacturing knowledge to enter the market by exploiting the existing structure of contract manufacturers. All these

L. Bengtsson, C. Berggren factors indicate that there is an increasing specialization and de-integration, which explains the decision referred to in the initial quotation ‘‘we at Nortel actually went further than anybody else and practically outsourced our entire supply chain to Flextronics and within the next couple of years Nortel will have no manufacturing sites’’. All OEM-firms did not go down the same route however, and it turned out that industry dynamics were more cyclical and less linear than assumed in the PC-model view. In the following we will discuss the routes chosen by Nokia and Ericsson and why Ericsson changed tack at around 2005.

Two outsourcing models In 2004, North American Nortel Networks decided to take a decisive step. As part of its strategy to focus on areas which can provide ‘‘true competitive differentiation’’ the company announced its ‘‘intention to divest substantially all of its remaining manufacturing activities, including product integration, testing, and repair operations, including the management of the supply chain and related suppliers” (Light Reading, 22 January 2004). A few years earlier, the Ericsson network division had opted for a similar outsourcing logic. After having outsourced plants making modules and components for the stagnant fixed network business, Ericsson decided to apply the same solution to its bleeding mobile phones division. A strategy of disintegration was also developed for the company’s core product sector: mobile network equipment. According to the year 2000-version of this strategy, product design, test development and the industrialisation of radio modules and complete radio base stations were to be retained as core competencies. All other volume production was to be outsourced. Not all companies took this restructuring route, however. In a comparison between the Nordic competitors Ericsson and Nokia in 2002, we could discern the two different outsourcing models illustrated in Figures 1 and 2. One model could be described as the ‘‘Horizontally Integrated Model’’, which means that the OEM firm and its suppliers are each responsible for selected modules during the entire product life. The OEM maintains strategic modules and processes in-house: first and foremost the manufacturing of transceiver units (the heart of a radio base station) and the majority of the assembly and testing of complete radio base stations. Modules viewed as non-strategic are sourced from selected system and component suppliers with whom the OEM is working intimately. To safeguard overall flexibility and high levels of capacity utilization in its own plants, the OEM also utilizes contract manufacturers as capacity providers. The contrasting model could be called a ‘‘Vertically Divided Model’’. In this model, the product-owning company takes care of industrialising strategic modules and systems, while contract manufacturers are in charge of basically all volume production. At the end of the industrialisation process, a transfer project is set up to convey product and process knowledge and production technology, including dedicated test systems, to the selected contract manufacturers. As Figure 2 illustrates, it is a composite model which is both horizontally sliced and vertically divided. Key modules, as well as the testing system and the product as a whole, are developed and industrialised in-house, and then

Outsourcing and production competence in a global telecom firm

319

Capacity suppliers (EMS) Product-owning company (OEM): Core components, tests,final assembly and entire system

Product development Radio base stations

Systemand component suppliers: e.g.Integrated circuits, servers, filters, combiners,power units,cabinets, etc.

Industrialisation

Figure 1

After sales and repair

sfer

Pr o co duc as mp t co se on m m en pa bly ts n ,e ,te y: S nt st tr ire s, at sy fina egi ste l c m

Contract manufacturer: Strategic components,tests and complete station

System and component suppliers: e.g. IC, computer, signal cards power units, climate, mechanics

Industrialisation

Figure 2

Phasing out

A horizontally integrated model of outsourcing.

Tran

Product development Radio base stations

Volume production

Volume production

Phasing out

A vertically divided model of outsourcing.

transferred to contract manufacturer firms. For non-core modules, system suppliers are also responsible for the industrialisation. The vertically divided model applied by Ericsson around the year 2000 was justified by four main arguments, in accordance with specialisation logic:  Cost advantages. By collaborating with high-volume contract manufacturers, the company expected product cost to be reduced significantly.  Increased flexibility and reduced risk over-capacity in a turbulent global industry.  Capital advantages. In a booming market the outsourcing model would enable rapid output expansion with small investments.  Focus on ‘‘core competencies’’. Assuming an increasing degree of component standardisation, it was argued that Ericsson, as a ‘‘knowledge company’’, should focus on product and technology development and not on non-differentiating production processes.

‘‘We are no longer outsourcing: rethinking outsourcing and investing in manufacturing For several reasons the vertically divided outsourcing model was never fully implemented at Ericsson. One reason was the disastrous downturn in the telecommunications market in 2002–2003, which meant that no extra manufacturing capacity was needed. To safeguard internal capacity utilization in this downturn, Ericsson maintained substantial volume production in house. This, however, was not the only factor at play. When we revisited the sourcing strategy at

Ericsson in 2005–2006, we encountered a new perspective on the dynamics of the telecom equipment sector, related to standardisation and industrialisation capabilities. As the Nortel manager above observed, Ericsson had indeed started to re-evaluate the significance of having manufacturing competence and volume production in house. At this time, Ericsson had decided to insource production activities from low-cost regions in Eastern Europe to its Swedish plants. This decision was motivated by operational factors, such as a need to fill up free internal manufacturing capacity, and a dissatisfaction with the quality and productivity of a particular contract manufacturer. At the same time however, the company had begun a more general reassessment of the values of outsourcing and in-house production competence. In the revised outsourcing strategy espoused by our Ericsson interviewees, integrated industrialisation and manufacturing capabilities were to be kept in-house, including volume production of core modules such as radio units and the assembly of complete radio base stations (node production). The basic idea was to have one major node production plant in each of the company’s three supply chains, serving Europe, America and Asia, respectively. At the time, two key units, located in Sweden and China, combined competence in industrialisation with volume production capacity. The share of in-house production had increased and amounted to about 40% of the products designed by Ericsson. ‘‘We are no longer outsourcing. The long term contracts are running out and we have not planned to prolong them”, remarked a senior supply chain specialist in October 2005. This did not mean an end to outsourcing, however, rather it implied an open-ended position where both in-house production and outsourcing were possible.

320

L. Bengtsson, C. Berggren

The rebalanced sourcing strategy is similar to the integrated model depicted in Figure 1. This means that Ericsson seeks to maintain control over the entire process from specification, design and industrialisation to the production of core modules and final assembly. The production of core modules is located so as to maximise economy of scale and is to be close to R&D. Ericsson collaborates intimately with system and component suppliers, who produce various modules such as filters, computers, cabinets, etc. Advanced Application Specific Integrated circuits (ASICs) are designed by Ericsson but produced by independent manufacturers in Asia. The EMS companies are to a large extent used as capacity manufacturer for increased volume flexibility, rather than as fully-fledged manufacturing service companies responsible for production, industrialisation and design. The modules and sub-units produced by the EMS companies are mainly industrialised in Ericsson’s master plants in Sweden and China. The motives given at Ericsson for reducing outsourcing levels and upgrading its internal production concerned general price and risk considerations, but also included the importance of having integrated industrialisation capabilities to enable the Company’ to pursue further cost reductions.

The expected cost advantage of outsourcing decreases In the period studied, 2000–2005, while price competition had increased the cost advantage of outsourcing production had decreased. One reason had to do with the size of transfer costs. Ex-post cost analysis within Ericsson showed that hidden costs for the transfer projects, including increased logistics and lead times, and costs for risk elimination dramatically decreased the benefits of lower wages and materials at the EMS-firms. According to Ericsson experience, the transfer costs alone could amount to as much as 20–25% of the product costs. This figure corresponds to cost levels estimated by other studies (McKinsey, 2005; Harland et al., 2005; Jackson et al., 2001). According to corporate analysts at Ericsson, there were also other reasons for questioning previous cost arguments in favour of outsourcing. One of these reasons was that low labour costs had become less important. The miniaturisation and integration of electronic components, in combination with automation technology, had reduced the work content and its relative costs compared to material costs. Table 1 provides a comparison of the costs for producing a typical radio base station module in three different loca-

Table 1

tions: an Ericsson unit in Sweden (index 100%), an EMS unit in South America and an EMS unit in Asia. In the automated production units in Sweden, the costs, which add value (sum of production, material handling and tests) amount to about 14% of total costs, of which roughly half is wages. The corresponding sum is 2–3 times higher in the more manual EMS-plants located in so-called low-cost countries. The EMS profit adds to the total costs for Ericsson. Another reason for the increased emphasis on internal capabilities in our Ericsson interviews in 2005–2006 concerned standardisation. Around the year 2000, the company had expected a rapidly increasing share of standardised components in its radio base stations. This would have given the EMS-firms a clear cost advantage due to their bigger purchasing volumes. But contrary to these expectations, standardisation – measured in terms of component value – had actually fallen. The material costs for all purchased electronic components and subsystems in a radio base station constitute a dominant share of its total cost, amounting to 80% or more. In 2005, the proportion of Ericsson-specific components (designed and/or specified by Ericsson engineers) amounted to 85% of the total material costs compared to 80% five years earlier. The shrinking share of standardised items in this bill of materials significantly reduced the economies of scale in purchasing that the EMS manufacturers were supposed to enjoy (Figure 3). When standardisation is low, manufacturers of components (processors, memories, etc.) are eager to get OEMfirms such as Ericsson, to design-in their components. This gives Ericsson a bargaining advantage that EMS firms do not have. As a result of all these factors, in 2005 only 2– 3% of the purchasing volume had been entrusted to the EMS firms.

The significance of integrated processes for cost rationalisation ‘‘In order to industrialise effectively you need volume production competence’’, a sourcing manager at corporate level observed in an interview in January 2006, reflecting the new significance Ericsson attributed to manufacturing competence and volume production. The plants in Ga ¨vle, Sweden, and Nanjing, China, therefore incorporated capacity both for industrialisation and full-scale production. The shortening of product life cycles has made product redesign increasingly frequent and important, both for updating functionality and for using component integration as a means to drive cost reduction. A company like Ericsson

Comparison of cost structure for producing a typical module in 2005. Aggregation of Ericsson data Ericsson unit in Sweden (%)

EMS unit in South America (%)

EMS unit in Asia (%)

Material and components Production Material handling Tests Profit

86.4 5.8 3.9 3.9 0

86.4 15.0 3.1 2.8 5.3

86.4 20.3 5.4 7.7 6.2

Sum

100

112.5

126.1

Outsourcing and production competence in a global telecom firm Profit Profit Value added

Automation decreases VA

Specific components increases

Specific components

Specific components

Present situation

Future situation

Figure 3

Rapid industrialisation crucial for developing frontier technology

Value added Standard

Standard components

321

Changes in cost structure.

performs such product revisions once or twice every year. One conclusion from analyses at Ericsson is that this potential is best realised when the company controls design, industrialisation and production internally, making it a deep system integrator. Physical proximity, integrated work teams and comprehensive ICT support are all regarded as integration mechanisms in this process. Integrated processes have proven valid for cost reduction not only in complex subsystems but also in simple components like closure, due to increasingly stringent demands on rapid customer adaptations. When industrialisation and production are outsourced, effective cost reduction slows down. Contract manufacturers benefit from the general price reduction in electronic components, but lack position or competence to redesign and introduce new components by themselves (see Figure 4). Analyses within Ericsson (e.g. of transceiver units which is a core component) reveal that the potential for cost reduction by redesign and replacement of components amounts to about 20–25% of the total product cost for each new product revision. This could be compared to the general price index reduction in the industry of about 1% per month (or 10–12% per year), which is only half of the reduction based on product redesign. The ability to pursue such product-based cost reduction aggressively is a clear advantage for the integrated firms and the lack thereof a corresponding disadvantage for disintegrated firms, which have to depend on contract manufacturers.

Figure 4 The potential of cost reduction when redesigning products compared to price index.

The importance of maintaining technological leadership constituted a third motive for upgrading internal production competence at Ericsson, although this was not entirely explicit in the interview answers. Several examples showed the need for an integrated innovation process when developing frontier technologies, in spite of efforts to outsource both development and manufacturing. One example concerned the outsourcing of a digital platform. Since industrialisation is closely related to volume production capability, Ericsson experimented with outsourcing the entire industrialisation process to a contract manufacturer. The partner satisfied the requirements, and met its goals for time, costs and quality. After a few years, however, Ericsson decided to insource the product. The main reason was that the continued technological upgrading of the product required proximity to the product development functions and integration into the wider platform development. Another example concerned the use of ‘‘total outsourcing’’ (design, engineering and production). To benefit from a partner’s innovation capability, a black box model was tested. This meant that Ericsson purchased a function (module), where the entire development, design and production was outsourced. While the outsourcing in itself satisfied their demands, Ericsson nevertheless decided to insource the module. A key reason was that it was too hard to synchronise the continued development of this module with the overall technological development at Ericsson. Thus, this example demonstrated how outsourcing is dependent on a stable system of standardised modules and interfaces. Compared to the situation in consumer electronics or the automotive industry, the technological development of architecture and components in the telecom equipment industry proceed at a much faster pace, especially within the leading firms. Some peripheral equipment, such as power supply units and climate systems, is standardised, but all the core modules remain specific to the OEM-forms, and are subject to frequent changes. This tends to make outsourcing arrangements unstable.

Conclusion: reassessing the role of production in the innovation process Several observations, which demonstrate the dynamic balance between outsourcing trends and integration needs in this industry, can be made from the case. Around 2000, it was generally believed that the telecom equipment industry would follow the conventional industry life cycle and enter a process of rapid standardisation of key products and components. This opened up the market for generic manufacturers who could provide both economies of scale and low-cost locations. Ericsson and its competitors started to sell out its plants and planned to divest all volume production. These plans were implemented at Nortel, but never fully realised at Ericsson, partly due to a dramatic market decline. The crisis gave the company time to reconsider its position, and it was found that the idea of a radical shift to

322

L. Bengtsson, C. Berggren

‘‘PC industry logic” was not materialising. Instead, standardisation actually decreased between 2000 and 2005, leaving less room for generic manufacturers at the front end of the industry. In this environment, a strategy to maintain industrialisation and production competence during the entire product life cycle seems to give deep system integrators such as Ericsson an advantage. The sourcing strategy emerging in 2005 at Ericsson was guided by the following arguments:  Automation and a low share of standardised components undermine the economies of scale for EMS-firms.  Cost reduction based on the rapid introduction of new OEM-specified components requires deep system integration competence, including industrialisation and manufacturing and strengthens the role of OEM capabilities.  Black box outsourcing (both R&D and manufacturing) to contract manufacturers may reduce module cost but jeopardise platform synchronisation in a fast-changing industry. These arguments represent a shift from disintegration/ outsourcing logic to integration logic. The shift is summarised in terms of costs, innovation and competitive priorities in Table 2. The arguments and shift in logic indicate that it is advantageous for OEM-firms to retain comprehensive industriali-

Table 2

sation and production capabilities. The choice to reinternalise these competencies at Ericsson was based on the company’s leading role in technology, something which provided the opportunity to drive component design (and future standardisation). Firms competing on other parameters may arrive at different choices. The framework developed by Christensen et al. (2002) partly explains these industry dynamics. Christensen and colleagues found that in rapidly evolving sectors, such as the disk drive industry, competitive conditions may change direction, from technology to cost and convenience and then again back to technology. Such a change may support a process of re-internalisation, since competing on the forefront of technology and functionality favours integrated processes and companies. The case presented here demonstrates that these ideas also apply to the telecom equipment sector. Our findings can in two ways be contrasted to the arguments of authors who stress outsourcing as a vehicle for innovation (e.g. Loch et al., 2007; Baden-Fuller et al., 2000). First, these authors tend to ignore the fact that the technological interdependencies present in high tech sectors like the telecom equipment industry, call for integrated innovation processes (e.g. Dankbaar, 2007; Ulrich and Ellison, 2005). Second, they do not recognize that there are times when insourcing is a strategic option for building innovation capabilities. This alternative has been mentioned by McIvor (2005) in his analysis of the outsourcing process, but

Comparison of disintegration and integration logics

Disintegration logic—expectations

Lessons learned from outsourcing

Motives for new integration logic

Costs EMS-firms reduce costs through low-cost location and economies of scale

Wage share less important due to automation

Total cost and productivity improvements are more important than wage level. Rapid cost reduction requires integration of product design – production Component suppliers eager to negotiate directly with OEM-firms to get their components designed-in.

EMS-firms reduce material costs through large purchasing volumes

Contract manufacturing enhances flexibility and risk spreading and reduces investments Innovation Focus on core competence, outsource non-core

Production is a non-differentiating process. Competitive priority Focus on cost and flexibility based on modularisation and standardisation

Transfer costs are substantial. Bargaining power only applies to standard components The share of OEM-specific components increases. Flexibility is not free. Market volatility threatens EMS firms’ productivity and profit.

Control over the entire value chain is crucial. Contract manufacturer used mainly as capacity supplier

Disintegration makes technology upgrading and synchronisation harder to achieve Time-to-market is increasingly important.

The OEM firm needs integrated development processes to build innovation capability.

Industry dynamics are non-linear: competition both on cost and functionality, falling standardisation

Focus on both innovation capability and cost reduction based on rapid product redesign and industrialisation

Production competence crucial for an efficient innovation process

Outsourcing and production competence in a global telecom firm only in passing. Since our findings question the overall rationality of outsourcing, we believe that it would be fruitful to analyse the relation between insourcing and innovation in future studies. As discussed above, there is considerable evidence in the literature that general cost advantages promised by outsourcing are often reduced, or even dwarfed, by various hidden costs (McKinsey, 2005; Harland et al., 2005; Jackson et al., 2001). These factors also apply in this case. The most important finding, however, is that deep system integrators enjoy an advantage in cost reductions based on rapid product redesigns, an advantage not available to general contract manufacturers. Thus, in contrast to the findings by Christensen, the case demonstrates that in technologyintensive sectors characterised by high clock speed, deep integration capabilities are important for competing both on functionality and cost. The findings provide insights into why competence for industrialising and manufacturing products incorporating the newest technologies may acquire new importance for Western firms, in spite of the global search for lowest cost suppliers. In fast-paced industries, this capability could be decisive for the overall innovation process. The case adds complexity to the concept of distributed innovation, since it illustrates the advantages of being deep system integrators even in situations where there are plenty of high-volume contract manufacturers available worldwide. A reassessment of beliefs in irresistible global trends may have implications both for operations management and for product development management.

References Arnold, U. (2000) New dimensions of outsourcing: a combination of transaction cost economics and the core competencies concept. European Journal of Purchasing and Supply Management 6, 23–29. Baden-Fuller, C., Targett, D. and Hunt, B. (2000) Outsourcing to outmanoeuvre. European Management Journal 18(3), 285–295. Baldwin, C. and Clark, K. B. (1997) Managing in an age of modularity. Harvard Business Review (September–October), 84–93. Beaumont, N. and Sohal, A. (2004) Outsourcing in Australia. International Journal of Operations & Production Management 24(7), 688–700. Berggren, C. and Bengtsson, L. (2004) Rethinking outsourcing in manufacturing – a tale of two telecom firms. European Journal of Management 22(2), 211–223. Brusoni, S., Prencipe, A. and Pavitt, K. (2001) Knowledge specialization, organizational coupling and the boundaries of the firm: Why do firms know more than they make? Administrative Science Quarterly 46, 597–621. Bryce, D. and Useem, M. (1998) The impact of corporate outsourcing on firm value. European Management Journal 16, 635–643. Caputo, A. C. and Palumbo, M. (2005) Manufacturing re-insourcing in the textile industry – A case study. Industrial Management & Data System 105(2), 193–207. Chesbrough, H. W. and Teece, D. J. (1996) When is virtual virtuous? Harvard Business Review 74(January–February), 65–74. Christensen, C. M. and Raynor, M. E. (2003) The Innovator’s Solution. Harvard Business School Press, Cambridge, MA. Christensen, C. M., Verlinden, M. and Westerman, G. (2002) Disruption, disintegration and the dissipation of differentiability. Industrial and Corporate Change 11, 955–993.

323

Dankbaar, B. (2007) Global sourcing and innovation: The consequences of losing both organizational and geographical proximity. European Planning Studies(2), 271–288. Dyer, J. H. and Nobeoka, K. (2000) Creating and managing a highperformance knowledge-sharing network: The Toyota case. Strategic Management Journal 21, 345–367. Fraser, P., Minshall, T. and Probert, D. (2005) The distributed innovation paradigm: Evolution and dynamics. In Proceedings of the 6th CINet Conference, Brighton, UK, 4–6 September 2005. GAO. (2004) International trade: Current government data provide limited insight into offshoring of services. Report No. GAO-04932. US Government Accountability Office, Washington, DC. Gilley, K. M. and Rasheed, A. (2000) Making more by doing less: An analysis of outsourcing and its effects on firm performance. Journal of Management 26, 763–790. Go ¨rg, H. and Hanley, A. (2005) International outsourcing and productivity: Evidence from the Irish electronic industry. The North American Journal of Economics & Finance 16(2), 255–269. Harland, C., Knight, L., Lamming, R. and Walker, H. (2005) Outsourcing: Assessing the risks and benefits for organisations, sectors and nations. International Journal of Operations & Production Management 25(9), 831–850. Hendry, J. (1995) Culture, community and networks: The hidden cost of outsourcing. European Management Journal 13, 193–200. Hoecht, A. and Trott, P. (2006) Innovation risks of strategic outsourcing. Technovation 26, 672–681. Jackson, T., Iloranta, K. and McKenzie, S. (2001) Profits or Perils? The Bottom Line on Outsourcing. Hamilton, Mclean, VA, USA. Kakabadse, A. and Kakabadse, N. (2002) Trends in outsourcing: Contrasting USA and Europe. European Management Journal 20, 189–198. Kakabadse, A. and Kakabadse, N. (2005) Outsourcing: Current and future trends. Thunderbird International Business Review (March–April), 183–204. Laugen, B. T., Acur, N., Boer, H. and Frick, J. (2005) Best manufacturing practices. What do the best-performing companies do? International Journal of Operations & Production Management 25(2), 131150. Leonard-Barton, D. (1990) A dual methodology for case studies: Synergistic use of a longitudinal single site with replicated multiple sites. Organization Science 1(3), 248–266. Lindroth, R. and Ha ¨nstro ¨m, A. (2002) Improving supply chain interfaces – Development of OEM and EMS cooperation in high-tech industries. Working paper. Stanford University, Stanford, CA. Loch, C. H., Chick, S. and Huchzermeier, A. (2007) Can European manufacturing companies compete? Industrial competitiveness, employment and growth in Europe. European Management Journal 25(4), 251–265. McIvor, R. (2005) The Outsourcing Process. Cambridge University Press, Cambridge, UK. McKinsey & Company. (2005) One million jobs at risk: The future of manufacturing in California. Bay Area Economic Forum. http:// www.mckinseyquarterly.com, March, 2005. Medina, C. C., Lavado, A. C. and Cabrera, R. V. (2005) Characteristics of innovative companies: a case study of companies in different sectors. Creativity and Innovation Management 14(3), 272–287. Mol, M., van Tulder, R. and Beije, P. (2005) Antecedents and performance consequences of international outsourcing. International Business Review 14(5), 599–617. Murray, J. Y., Kotabe, M. and Wildt, A. R. (1995) Strategic and financial implications of global sourcing strategy: A contingency analysis. Journal of International Business Studies (1st Quarter), 181–202.

324 Plambeck, E. L. and Taylor, T. A. (2005) Sell the plant? The impact of contract manufacturing on innovation, capacity, and profitability. Management Science 51(1), 133–150. Poppo, L. and Zenger, T. (1998) Testing alternative theories of the firm: Transaction cost, knowledge-based and measurement explanations for make-or-buy decisions in information services. Strategic Management Journal 19, 853–877. Prahalad, C. K. and Hamel, G. (1990) The core competence of the corporation. Harvard Business Review 68, 79–91. Que ´lin, B. and Duhamel, F. (2003) Bringing together strategic outsourcing and corporate strategy: Outsourcing motives and risks. European Management Journal 21(5), 647–661. Quinn, J. B. (2000) Outsourcing innovation: The new engine of growth. Sloan Management Review(Summer), 13–29. Quinn, J. B. and Hilmer, F. G. (1994) Strategic outsourcing. Sloan Management Review(Summer), 43–55. Sanchez, R. (1995) Modularity flexibility and knowledge management in product and organization design. Strategic Management Journal 17, 63–76. Shi, Y. and Gregory, M. (2003) From original equipment manufacturers to total solution providers: Emergence of a global manufacturing virtual network in the electronics industry. International Journal of Services Technology and Management 4(4/5/6), 331–346. Shi, Y. and Gregory, M. (2005) Emergence of global manufacturing virtual networks and establishment of new manufacturing infrastructure for faster innovation and firm growth. Production Planning & Control 16(6), 621–631. Smith et al. (2007). The impact of outsourcing on an organisations ability to innovate. In Proceedings of the 14th International EurOMA Conference, 17–20 June, Ankara. Strebel, P. (1996) Breakpoint: How to stay in the game. Mastering Management Part 17, Financial Times. Sturgeon, T. (2002) Modular production networks: A new American model of industrial organization. Industrial and Corporate Change 11(3), 451–496. The Outsourcing Institute. (2005) The outsourcing institute’s annual survey of outsourcing end users. Available at: http:// www.outsourcing.com. Ulrich, K. T. and Ellison, D. J. (2005) Beyond make-buy: Internalization and integration of design and production. Production and Operations Management 14(3), 315–330.

L. Bengtsson, C. Berggren Utterback, J. (1994) Mastering the Dynamics of Innovation. Harvard Business School Press, Cambridge, MA. Williamson, O. E. (1975) Markets and Hierarchies. Free Press, New York. Van de Ven, A. H. and Huber, G. P. (1990) Longitudinal field research methods for studying processes of organizational change. Organization Science 1(3), 213–219. von Hippel, E. (1990) Task partitioning: An innovation process variable. Research Policy 19, 407–418. Voss, C., Tsikriktsis, N. and Frolich, M. (2002) Case research in operations management. International Journal of Operations & Production Management 22(2), 195–219. Yin, R. (1994) Case Study Research – Design and Methods. Sage Publication, Thousands Oaks. Lars Bengtsson is Professor in Innovation management at the University of Ga ¨vle, Sweden. He currently leads a research programme which focuses on the significance of manufacturing competence, outsourcing and integration strategies for continuous innovation capability in industrial firms.

Christian Berggren is Professor in Industrial management at the University of Linko ¨ping, Sweden and director for the KITE research program, Knowledge Integration and Innovation in Transnational Enterprise (http:// www.liu.se/kite). His current research focuses on the competition for sustainable vehicles in the automotive industry, and the importance of integration competence for combining complex technologies and achieving effective industrialization.