Systems Integrators as post-industrial firms?

1 Wednesday, 15 May 2002, 13:12 SPRU: Science and Technology Policy Research Mantell Building University of Sussex Brighton, BN1 9RF England Tel: 44 (0) 1273 68 67 58 Fax: 44 (0) 1273 68 58 65 E-mail: K.Pavitt@sussex.ac.uk k.pavitt@britishlibrary.net G.N.von-Tunzelmann@sussex.ac.uk Systems Integrators as post-industrial firms? by Keith Pavitt* *This is the first draft of the paper that will be the basis of the Welcome Lecture (What are advances in knowledge doing to the large industrial firm in the new economy?) on 6 June, 2002, at the DRUID Summer Conference on Industrial Dynamics of the New and Old Economy who embraces whom?. It will subsequently be expanded into a joint paper with Nick von Tunzelmann. Comments welcome.

2 SUMMARY Over the past 100 or more years, the close linkages between product and process innovations in manufacturing firms have been reflected in the dominance of in-house over contract R & D. However, decoupling in process innovation has increased progressively, following a succession of technological advances that have resulted in technological convergence in previously distinct manufacturing operations. The most recent advances in ICT have enabled the codification and convergence of an increasing range of manufacturing operations, and a progressive decoupling of product design from manufacture. Such decoupling will never be complete, given product complexity, rapid technological change, and the persistence of uncodified manufacturing knowledge. But it does point to a progressive division of labour between firms based on product design and systems integration, and those based on manufacture. If (as seems likely) the latter migrate to certain developing countries, the advanced countries will specialise in service firms providing softwaredominated product designs and systems integration, and based on technically advanced machinery, systems and skills, including those related to manufacturing.

3 1. Whither the Large Manufacturing Firm? Contemporary theories of the firm (e.g. resource-based, dynamic competencies) typically take as the object of their enquiry the large and diversifying manufacturing firm, as described by Penrose (1995) and Chandler (1977). The central task of such firms is seen as designing and producing physical things in large quantities for large and now even globalised markets. They emerged from, and still depend heavily on, technical changes in materials and their processing, energy sources, machines and transport. These changes have led to economies of scale, based on speed and throughput. At the same time, there have been economies of scope, with the emergence of major new product families, based on advances in knowledge generated by combining the activities of increasingly specialised scientists and engineers working in business firms and universities. The characteristics of these knowledge-creating activities have created problems and puzzles for the large manufacturing firm (Tunzelmann, 1995; Pavitt, 2001). Technology-based product diversification makes complete decomposition of activities into product divisions difficult, if not impossible. Entrepreneurial opportunities increasingly emerge from major scientific breakthroughs made outside established firms. Entrepreneurial resources are therefore not general-purpose, but specific to technological fields. And their exploitation may involve conflict, with the loss of power and influence of established, specialised (and previously successful) groups within the firm.

4 As a consequence of these features of technical change, large and established manufacturing firms have had a much rougher ride over the past 20 years in coping with technical change than had previously been expected by Penrose, Chandler and others. In this paper, we shall argue that the rough ride is likely to continue in future, but for another reason, namely, a major shift in the opportunities for major technical changes from the processing of materials into products, towards the processing of information. As a consequence, we shall argue that the locus of competition through innovation in leading companies will shift from discrete physical product and process innovations associated with manufacturing, to innovations in the design, development, integration and marketing of increasingly complex products, and to the design and development process itself. These shifts in the direction of technical change will lead to a progressive decoupling from product design from its manufacture, and re-inforce the shift of manufacturing towards lower-wage countries. However, the high-skilled services in which the high-wage countries specialise will not be immaterial in the conventional sense. They will comprise high-tech machines (processing information rather than materials), mastery of the knowledge underlying manufacturing, and a capacity for designing and integrating complex physical systems: in other words, the skilled activities that manufacturing firms undertake, except manufacturing itself. As we shall see in the next section, this process can be seen as a further stage in vertical disintegration of process innovation within manufacturing activities, based on successive significant advances in production-related technologies.

5 2. Product development and large-scale manufacturing 2.1 Technological Convergence and Vertical Disintegration The rise of the large manufacturing company since the 19 th century is closely associated with the economies of scale and speed made possible by a combination of major technical innovations in materials, machines and energy sources, with the major organisational innovation that was the vertically integrated company (Chandler, 1977). When the firm was manufacturing standard commodities with relatively simple production techniques, vertical disintegration and the emergence of a specialised machine-building sector happened relatively quickly (Rosengerg, 1963). However, when advances in the technologies of machinery and transport, chemicals, and electrical and electronic products enabled the combination of economies of scale and scope (i.e. new products), disintegration became less frequent. As Mowery (1983) has convincingly shown for the USA, a growing proportion of industrial R & D in the 20 th century was integrated within large manufacturing firms. Until about 10 years ago, business-funded R & D in all OECD countries was almost exclusively performed within manufacturing firms. Mowery explained this lack of vertical disintegration by the difficulties of writing contracts for an activity whose output is uncertain and idiosyncratic. Today, this writer would place greater emphasis on the advantages of integration co-ordinating product and process gange, which requires the combination of specialised and often tacit knowledge across functional boundaries, and where accumulated experience matters. In any event, the strongly recommended practice today in innovation management is ensuring close

6 collaboration and feedback between product design and production operations. There are many stories of product designs that turned out to be technically difficult (even impossible) to manufacture, and of the importance of largely informal processes that ensure effective feedback between the design of product and process (Iansiti and Clark, 1994). However, even in industries with heavy investments in product innovation, vertical disintegration in manufacturing process innovation has been happening since the 19 th century, stimulated at each stage by technological advances. Thus, Rosenberg (1963) has shown how specialised machine tool firms emerged in the 19 th century because advances in metal cutting and metal forming led to technological convergence in operations that were common to a number of manufacturing processes (e.g. boring accurate circular holes in metal was common to the making of both small arms and sewing machines). Although the skills associated with such machining operations were often craft-based and tacit, their output could be codified and standardised. The size of the market for such common operations was therefore large enough to sustain a number of small specialised firms. At the same time, large manufacturing customers could buy production machines incorporating the latest improvements fed back from use by their competitors, and therefore superior to what they could do by themselves. Similar processes involving technological convergence and vertical disintegration have been frequent since then. They include contract research firms specialising in materials analysis and testing (Mowery and Rosenberg, 1989), firms making measurement and control instruments used in continuous processes, systems of

7 computer aided design and manufacture originally developed in transport sectors, robots in metal manufacture, and specialised applications software in a whole range of industries. In the heavy chemical industry, vertical disintegration in production has gone further. Specialised chemical engineering firms now design and build complete large-scale continuous production facilities for a number of products, based on technological convergence emerging from improved understanding in the unit operations 1 of chemical processes (Landau and Rosenberg, 1992). Vertical disintegration in innovation in production machinery has spread to innovation in components and subsystems for products. In addition to the well-known advantages of disintegration in flexibility and incentives, this also reflects the increasingly wide range of technologies that are applicable in any product; for example, electronics and software today in automobiles. Product designer firms therefore rely increasingly on suppliers for components and subsystems that incorporate innovations whose knowledge bases are outside their core competencies (Brusoni et al., 2001) 2. 2.2 The disintegration of R & D and production: contract manufacturing More recently, we have begun to see the complete disintegration of product design from subsequent production. Sturgeon (2002) has documented the rise of contract 1 distillation, absorption, heat transfer, filtration, evaporation, reaction and the like. (Landau and Rosenberg, 1992, p.88) 2 Similar reasoning can be applied to the provision of knowledge by small specialised firms (e.g. in biotechnology) to the R & D laboratories of large, established firms (e.g. in pharmaceutical). (Tunzelmann, 1996)

8 manufacturing in electronics: namely, firms that take over electronic product designs from other firms, and do the detailed engineering and manufacture. He reports that contract manufacturing is also growing in other industries. The basic cause of this change is the application of improvements in ICT: codification and modification of practices in production operations have been made technically feasible and economic by the steep reduction in the cost of storing, transmitting and manipulating coded information (Cowan et al., 2001). According to Balconi (2002): The current wave of codification of technological knowledge, and the intelligent automation movement that it supports is grounded upon the availability at lower and lower cost of the means of quantifying the underlying physical transformations and the flow of materials through the process of production...the formalisation and proceduralisation of technological processes has opened the way to an unprecedented opportunity of continuously improving them... the modelling of physical processes helps to introduce improvements, compared to when their functioning was based on the tacit and opaque knowledge embodied in the heads of the operatives. Coupled with increasing standardisation of components, subsystems and interfaces, such codification has not only enabled product designers to reap the benefits of economies of scale and of component improvement, and to reduce technical risks. It has also resulted in technological convergence and automation across a range of routine production operations, and therefore created new possibilities for economies of scale and scope in production 3.

9 At the same time, vertical disintegration between product design and production has become less risky. ICT-based advances in simulation technology and modelling have increased the possibilities of learning before doing (Pisano, 1997), thereby reducing the risks of bugs and technical difficulties in subsequent production (D Adderio, 2001). ICT has also increased both the ease with which product information and codified knowledge can be transferred from product designer to producer, and production information and experience from producer to product designer. This process of codification, which began some twenty years ago when firms began installing integrated IT systems, has been progressive and involved much learning by doing (e.g. integrated enterprise software systems like PDM and ERP). As a consequence, the potential competitive advantage for product designer firms to be derived from an effective mastery of the interface between design and production is diminishing. At the same time, the risks and costs of outsourcing the production of a new design are also decreasing. In addition, outsourcing production transforms it from a sunk cost into a variable cost, the advantages of which increase with the uncertainty of demand. We can therefore expect the division of labour between manufacturers and product designers to increase in future. We shall now explore the factors affecting how far it will go. 3 According to Sturgeon (2002), contract manufacturers tend to specialise in a base process which is used to manufacture products in a wide range of end markets, or a base component which is used in a wide variety of end products, or base service for a wide variety of end-users.

10 3. The Limits to the Division of Labour 3.1 Product Designers: LEGOLAND or Systems Integrators? The economic pressures pushing towards a complete division of labour between product designers and manufacturers based on standard modular components, as described by Ullrich (1995), are considerable 4. However, product designers are typically dealing with products considerably more complex and technically demanding than the car trailers and desks that Ullrich (1995) uses are exemplars for modularity. For these, they will need a capacity for systems integration, namely, competencies and activities related to the design, manufacture and integration of their components and subsystems for the following reasons. As part of corporate strategy, some components and sub-systems will continue to be manufactured by product designers, because their technically demanding performance embodies a core competitive advantage that is difficult to imitate. This is the case for the core components in aircraft engines (Prencipe, 1997) and mobile phone systems (Davies, 1999). Certain critical manufacturing operations may be difficult to codify and automate, and therefore depend on the close personal interactions between manufacturing operatives and product designers facilitated by vertical integration. Thus, while Sturgeon (2002) points to the importance in contract manufacturing in electronics of the recent automation of routine assembly operations, Balconi (2002) insists on the difficulty of automating mechanical assembly (including welding), where 4 For example, in a Special Report on car manufacturing, The Economist (2002) points to market saturation, product differentiation and uncertainty of customer reactions as the factors behind the growing experimentation with modular components and subsystems, and with radically new product architectures.

11 components are often heavier and more cumbersome than those in electronics. Here the tacit knowledge of the skilled assembler remains crucial. Even when product design firms outsource all manufacture, they will often require skills that go beyond the product design process. As we have argued elsewhere (Brusoni et al., 2001), unexpected component interactions in complex systems (e.g. mechanical vibrations) requires that a capability to ensure that the system works when assembled, and to make corrections when it does not. This systems integration capability may well become more important in future with advances in digitalisation enabling ever-more interconnected systems (Pavitt and Steinmueller, 2001) Similarly, even in modular systems, imbalances in rates of development of component technologies may have wider systemic effects, and can open opportunities for important architectural innovations. Once again, product designers need in-house capabilities for systems integration, comprising technological competencies related to components the manufacture of which they outsource Even when firms design products purely on the basis of standard modularised components that are relatively easy to assemble, they deploy increasingly sophisticated technical skills (often based on ICT), for the logistics of the supply and the control of assembly of components, and of customer delivery and support (e.g. Dell).

12 3.2 Will manufacturing continue to migrate to developing countries? Will the above trends accelerate the migration of manufacturing to developing countries? Vernon (1966) was right is his prediction some 40 years ago that the emergence there of local demand, coupled with lower costs, would attract an increasing share of world manufacturing production. Much more recently Feenstra (1998) has written about the Integration of trade and disintegration of production in the global economy, showing that manufacturing firms are outsourcing an increasing share of their production to foreign locations. Vernon (1966) originally argued that relocations to developing countries would happen only in product in the third stage of the product cycle, when techniques had stabilised, the main skills were those of combining stable (and cheap) factors of production. Sturgeon (2002) now argues that contract manufacture is the precursor of the revival of US manufacturing capabilities. However, a number of factors point to a growing share of developing countries in contract manufacture. Above all, ICT and codification have facilitated both production knowledge transfer and production monitoring to distant countries. They have also increased the importance of formal education and generic skills in production operatives, compared to experience based craft skills (Balconi, 2002) 5. Recent developments in ICT will therefore enable developing countries that have invested in education and infrastructure to build their success somewhat beyond what Leamer and Storper (2001) call routine intellectual labour. They will be able to 5 Tacit skills which complement codified and automated manufacturing processes are those heuristic and interpretative skills which serve to decode and assign meaning to information-bearing messages (structured data inputs, codified know-how).. Controllers knowledge is more general and can, with some re-training, be redeployed across various sectors, whereas that of craftmen was extremely sector specific, or even specific to a particular step of a given process. (Balconi, 2002).

13 transform the higher order activities of invention and innovation immediately into manufacturing production. These trends can already be detected in the transformation of multinational firms into what Ernst and Kim (2002) call global production networks. The network flagships at the core of these networks resemble closely what we call systems integrators. 4. Conclusions As foreseen by Drucker (2001) 6 there will be an increasing division of labour between systems integration firms and manufacturing firms, following periodic increases over the past century in technological convergence in elements of production, and the consequent advantages of vertical disintegration. The most recent spate of disintegration in manufacturing follows the increasing codification and automation of the detailed elements of production following advances in ICT. An increasing share of manufacturing will probably migrate to selected developing countries that have invested strongly in education and ICT infrastructure. Systems integration firms will stay in advanced countries close to the knowledge base that is most centrally important to their competitive advantage, namely, ITC and its applications in codifying production and logistic operations, in simulations and modelling products and processes, and in production monitoring and control. These activities will be described as service activities, because software activities are considered immaterial. In fact they will have everything to do with manufacture, except manufacture itself. They will be far away from services for leisure, tourism 6 See his contrasting future visions of GM and Toyota (pp. 18-19)

14 etc., and will be the centre of high tech, with heavy investments in science and engineering activities, and in machines processing information rather than materials. In other words, the Visible Hand of manufacturing will not become invisible (Langlois, 2001), but continue to exploit economies of scale and scope. At the same time, the Visible Brain of product design and systems integration will become the dominant forms of business organisation in world s advanced countries.

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