Is Modern Production Needed Essay, Research Paper

Table of Contents

Introduction

1. From the Modern Corporation to Production Networks: A Paradigm Shift

2. Schumpeter’s Notion of Innovation in the Giant Firm

3. Turnkey Contract Manufacturing in Electronics

4. The Delinking of Production from Innovation in the Turnkey Network

5. Conclusion

Bibliography:

Endnotes:

Introduction

Evidence from the electronics industry suggests that a new American model of industry organization is emerging in the 1990s.

American electronics firms are outsourcing an increasing share of their production. As this practice grows, manufacturing

capacity is building up in turnkey production networks that consist of specialized and highly capable merchant suppliers that

provide the industry with a functionally coherent set of commodified production services. When firms that supply external

productive capacity develop a merchant character, as they have in the American-led electronics industry, manufacturing

capacity is essentially shared by the industry as a whole, reducing costs and spreading risks in an increasingly volatile world

market. As such merchant external economies develop, the link between innovative capacity and market share, on one hand,

and firm size and scope, on the other, begins to break down. This link was the cornerstone of Schumpeter’s conception of

industry structure and his explanation for the rise of the large, vertically integrated industrial firm in the early part of the twentieth

century.

Firms that outsource a large share of their manufacturing no longer have to carry the financial, administrative, and technical

burdens of fixed capital related to production (i.e., plant and equipment), allowing them to focus on innovation and become

more organizationally and geographically flexible. At the same time, such brand-name firms are no longer buffered from

competitive pressure by large in-house fixed capital. Barriers to entry are lowered because competitors can tap the same

turnkey production networks and therefore gain access to leading-edge, global-scale production capacity (unless specific

institutional constraints are present). Thus, for the innovating firm, competitive outcomes become more tightly tied to

product-level innovation (i.e., product definition, development, and design) as productive capacity migrates into turnkey

networks. At the industry level, turnkey production networks make it possible for market share to change hands without the

idling of any productive capacity, mollifying the “destructive” aspect of innovation predicted in Schumpeter’s conception of

“creative destruction.”

This paper explores the implications of the following hypothesis: that a significant share of American firms are adapting to

volatile and intensely competitive market conditions by “outsourcing” manufacturing functions to specialized merchant suppliers.

At the same time, “brand-name” firms have reasserted control over product definition, design, and marketing functions, which

are largely being kept in-house, despite the spate of high-profile “strategic alliances” formed in the 1990s. In essence, I argue

that market-creating innovative capacity is being hoarded in-house while market-supplying productive capacity is being allowed

to migrate into external economies that can be shared industry-wide. Such external scale economies are coming to reside in a

cadre of specialized merchant suppliers that offer access to a functionally coherent set of production functions as a service to

their customers, the brand name firms. The emerging organizational split between innovation and production is usually enabled

by highly formalized links at the inter-firm boundary.

The hypothesis is derived from research on product-level electronics manufacturing (computers, communications equipment,

consumer electronics, etc.), where such an organizational shift, from in-house to outsourced manufacturing, has been dramatic

in recent years. However, even superficial observations strongly suggest that comparable changes are underway in many other

sectors as well (e.g., apparel and footwear, toys, data processing, home furnishings and lighting, semiconductor fabrication,

food processing, automotive parts, brewing, enterprise networking, and pharmaceuticals). The aim of this paper is not to prove

that the shift is occurring in every American firm, or even to provide a detailed analysis of the changes in the electronics

industry. I have presented the latter evidence more fully elsewhere (Sturgeon, 1990, 1991a, 1991b, 1992, 1997; Sturgeon and

Cohen, 1996). Instead, the model of industry organization derived from the electronics case is exposed to one of the key

theoretical tools that have been developed to predict and explain industry structure and economic development: Schumpeter’s

notion of innovation in the giant firm. It is my opinion that the emerging split between product-level innovation and production in

American industry is clear enough to take the next step of testing, and perhaps modifying, the analytic tools that we currently

have at our disposal.

1. From the Modern Corporation to Production Networks: A Paradigm Shift

Through the mid-1980s, the dominant paradigm for the study of industrial organization and economic development was the

modern corporation as best defined by Chandler (1977). There was good reason for this focus. By the 1950s, the large

multidivisional (and increasingly multinational) enterprise, with its extensive managerial hierarchy, had become an undeniable

force in economic development, not only in its heartland, the United States, but also in other countries where its features were

adopted as a model for local firms. Regardless of analytic stripe (e.g., neoclassical, Weberian, Marxist), the large,

multidivisional, hierarchically-controlled corporation provided a set of ordering assumptions for theorists interested in explaining

its rise and inner logic (theories of the firm), as well as for those working on problems of economic development where the

modern corporation played a central role, such as literature on the transnational corporation and development (e.g.,

Gershenkron, 1962; Vernon, 1966, Williamson, 1975, 1981, Perrow, 1981). For many, the archetype of the modern

corporation that emerged from this work was held up as the pinnacle of capitalist development and for nearly all, the giant firm

was recognized as the central force in economic development. As an ideal type, it was well understood, and it was assumed

that firms would, over time, become closer to its image.

The work of Joseph Schumpeter too was deeply affected by the rise of the large corporation. Schumpeter’s early work The

Theory of Economic Development (1934), first published in German in 1911, focused on the role of the small-firm entrepreneur

in driving innovation. Entrepreneurs continually create disequilibrium in existing capitalism through the formation of new firms in

an environment of easy market entry. Schumpeter’s later work recognized the empirical reality of the rise of the large firm in

American industry during the first few decades of the twentieth century. By the time he wrote Capitalism, Socialism, and

Democracy (1942), Schumpeter’s focus had shifted from the innovative entrepreneur to innovation in the R&D laboratory, from

tacit to codified knowledge, from low to high market entry barriers, and from small to large firms (Nelson and Winter, 1982;

Malbera and Orsenigo, 1995). He argued that observable productivity increases in the American economy were largely due to

innovations delivered by the R&D laboratories of large firms in an environment of high barriers to market entry (Schumpeter,

1942).

During the 1970s and 1980s, changes in the world economy, particularly the failure of large American corporations to

adequately respond to new competition from Asia, cast doubt on ideas that used the modern corporation as an organizing

principle, plunging a wide range of fields into crisis and triggering research into aspects of industrial organization that had

previously been obscured.(1) Until the 1980s the shadow of the modern corporation had rendered alternative organizational

forms nearly invisible in the literature, but the faltering of some of the United States’ largest manufacturing firms in the face of

Asian competition signaled that something was very amiss with the modern corporation. The complacency that had set in over

so much of thinking about industry organization and economic development began to unravel.

Thus began the search for a new model. Some revisited the work on periodic crisis and instability that had been triggered by

the Great Depression (van Duijn, 1983), while others noted that many of the problems of the modern corporation could be

traced to the emergence of powerful new competitors from Europe and Asia (Bluestone and Harrison, 1982), and set about

analyzing industrial systems that did not fit the Anglo-American norm (Schonberger, 1982). Still others found pockets of

economic vitality based on networks of small firms, and offered new models of industrial development based on their findings

(Piore and Sabel, 1984). Much of this work suggested that the era of United States industrial hegemony had passed along with

the modern corporation, and that new, more dynamic models of industrial organization were stepping into the breach (Liepetz,

1983).

After more than ten years of research and debate, the task of building a new paradigm for industrial organization and economic

development is well underway, although consensus is still far from being reached. Some of what had been obscured has now

come into view. The focus has shifted away from the logic and ramifications of the seemingly inexorable expansion of the

internal structures of the modern corporation to the external economies created by the ongoing interactions between firms.

External economies have appeared in different guises in the literature, depending on the scale of analysis. At the most basic level

of firm-to-firm contracting, external economies are created when one firm “outsources” or “sub-contracts” an activity that had

previously been performed “in-house” to another firm. The totality of the external linkages created by contracting relationships in

larger amalgams of firms have been described as “production networks.” When such networks are spatially clustered, which

they often are, they make up “agglomeration economies” that tend to be located in sector-specific “industrial districts.” Ideas

about the importance of external economies have come from a variety of academic disciplines. Sociologists and organizational

theorists have provided ideas about how trust, reputation, and long-term “relational” contracting can create stable external

economies that resist the apparent tendency for capital to aggregate within the ever-larger control hierarchies of the modern

corporation (Richardson, 1972; Thorelli, 1986; Johanson and Matson, 1987; Powell, 1987; Lorenz, 1988; Jarillo, 1988;

Bradach and Eccles, 1989; Powell, 1990, 1991; Lorenz, 1992; Cooke and Morgan, 1993). Political scientists and country

specialists have provided nationally-specific models of industrial organization that rely extensively on external economies. These

models have been derived from research on the industrial systems of Japan (Schonberger, 1982; Dore, 1986; Sayer, 1986;

Aoki, 1987; Sako, 1989; Womack et. al., 1990; Florida and Kenny, 1993), Germany (Katzenstien, 1989; Sabel, 1989;

Herrigel, 1993), and Italy (Brusco, 1982; Brusco and Sabel, 1983; Piore and Sabel, 1984; Brusco and Righi, 1989).

Geographers and planners have provided insights into how the spatial and social propinquity of geographically clustered

industrial activity work to buoy ongoing external economies (Storper and Scott, 1988; Storper and Christopherson, 1988;

Scott, 1988; Storper and Walker, 1989; Saxenian, 1991, 1992, 1994).

Often these models have been constructed in an effort to explain why firms, industries, and national economies organized

according to their tenets outperform industrial systems organized according to the Anglo-American norm. External economies

allow for the development of trust; industry-, or at least locality-wide sharing of production capacity; greater opportunities for

learning and technology transfer within the system; and perhaps most important, a superior ability to reconfigure the functional

elements of production according to rapidly changing output requirements and the rise of new markets.

This work has generated a sorely needed set of alternatives to the paradigm of the modern corporation, but surprisingly, scant

attention has been paid to the industrial organization of American manufacturing companies as they have begun to adapt to the

new forms of competition that triggered the crisis.(2) Most often portrayed as desperately clinging to the outmoded attributes of

the modern corporation (e.g., Harrison, 1994), American firms have been held up as the antithesis of new, more dynamic

organizational forms that have emerged in Italy, Germany, and especially Japan.

The invisibility of American-led production networks in academic literature (but see Sabel, 1989; Donaghu and Bariff, 1991;

Levy and Dunning, 1993; Gereffi, 1994; Bonacich et. al., 1994; Saxenian, 1994; and Borrus, 1995) may stem from their

recent vintage. On the other hand, it also seems likely that some recent evidence of changes in the organizational characteristics

of American firms has been misinterpreted because the system has not evolved in the image of Japanese, German, or Italian

industry.

Today, more than twenty years after the crisis of the modern corporation began, we are seeing subtle but unmistakable

evidence of recovery by American manufacturing firms. In the electronics industry, for example, dire predictions that American

firms would continue to lose entire segments of the industry to foreign firms have proved unfounded. The continued dominance

of many market sectors for electronic hardware by American firms has surprised observers who warned only a few years ago

that Japanese electronics companies were poised to leverage their dominance in core components (e.g., memory chips and flat

panel displays) into dominance of markets for high-volume computer-related hardware, just as had happened in consumer

electronics (Hart and Borrus, 1992).

So, there are signs of life in the heartland of the modern corporation. Still, we cannot simply resurrect models of industrial

organization based on the modern corporation as if nothing has happened. Even a cursory examination of the industrial system

of the United States reveals organizational patterns that look not at all like the modern corporation (Tully, 1993, 1994). The

largest single employer in the country is not General Motors, but the temporary employment agency Manpower Inc. The largest

owner of passenger jets is not United Airlines, or any other major carrier, but the aircraft leasing arm of General Electric. Since

1992, IBM has literally turned itself inside-out, becoming a merchant provider of the basic technologies it had previously

guarded so jealously for exclusive use in its own products. If what we see seems to have little relation to the ideal type of the

modern corporation, there may be good reason. Perhaps the American industrial system has begun to adapt to the new, more

intense competitive environment that triggered the crisis in the first place. Perhaps we are witnessing the emergence of a new

American model of industrial organization, and not simply the crisis of the old.

2. Schumpeter’s Notion of Innovation in the Giant Firm

Schumpeter believed that the stability provided by oligopolistic market structures created a better environment for industrial

research. Large firms have the longevity and financial resources to build up the “knowledge base” required to apply scientific

principles to ever more complex innovative problems. As the importance of codified knowledge increased in the early twentieth

century, barriers of entry were erected that reduced the role of small-firm entrepreneurs who tended to base their innovations

on tacit knowledge.(3) In the context of monopoly theory, these ideas became known as the Schumpetarian hypothesis: “the

claim that a market structure involving large firms with a considerable degree of market power is the price that society must pay

for rapid technological advance” (Nelson and Winter, 1982, p. 278). In the long run, Schumpeter believed that oligopolistic

market structures would inevitably be torn asunder by ongoing rounds of innovation, competition, and new market creation.

Nelson and Winter (1982) build on Schumpeter’s conception of innovation as the motor of capitalist development in the

construction of their theory of “evolutionary economics.” To follow the biological metaphor of evolution used by Nelson and

Winter, the development of the economy moves according to a “survival of the fittest” logic, with the likelihood of survival

increasing with firm profitability. Profitability is determined by the effectiveness of company-specific routines (ways of doing

things) that are passed on as the firm develops in the same manner that genes are passed on in biological systems. The “search”

routines which firms apply to crisis situations (e.g., the need to respond to a competitor by developing an innovative new

product) determines the likelihood of their survival as they adapt, or “mutate,” in response to new situations.

Because successful firms tend to invest in additional productive capacity, the dynamic process of industrial evolution tends to

create larger firms and more concentrated market structures over time (up to the point where market concentration begins to

stifle competition and hence, innovation). Nelson and Winter devised computer simulations that produce these results, using the

variables of aggressiveness of investment policies, realization of potential productivity gains, the degree of difficulty in imitating

the firm’s innovations, and how successful the firm’s innovative efforts are. In the simulation where the value for the first variable,

aggressiveness of investment policies, was assigned a high value, imitation was made more difficult, latent productivity was

better realized, and as a result, industry structure showed markedly higher levels of concentration than in simulations where

capital investments were suppressed (in the real world, a firm might restrain investment to restrict output growth and keep

prices high).

The assumptions in this model point out the key problem with using the Schumpetarian approach to predict the evolution of

industry organization. In this schema, firms tend to get larger over time because successful innovations lead to higher profits and

greater investments in productive capacity that put them further ahead of their competitors. Aggressive capital investment

becomes a barrier to entry for new and existing firms and as a result, firms become larger and market structure more

concentrated over time. But what if we allow for the possibility that increases in market share can be organizationally delinked

from increases in firm-specific capital investment? In the American electronics industry, for example, firms are increasingly

relying on outside sources (i.e., contract manufacturers) for manufacturing capacity. If a firm successfully innovates (e.g.,

develops a personal computer with dramatically better price/performance characteristics than any existing competitor), it can

quickly ramp up production through its contract manufacturers without the lag or risk associated with building up internal

capacity. In the turnkey network market concentration may increase, but industry structure remains relatively disaggregated.

Moreover, barriers to entry based on the holding of productive capacity by leading firms fail to develop.

3. Turnkey Contract Manufacturing in Electronics

In April, 1996, Apple Computer announced that it was selling its largest United States personal computer (PC) manufacturing

facility in Fountain, Colorado to a little-known company called SCI Systems. Apple had just posted the largest quarterly loss in

its history ($740M) and had narrowly avoided being taken over by Sun Microsystems, so it may not have been suprising that it

was shedding some of its assets. What seemed strange about this deal was that, according to Apple management and industry

pundits alike, Apple’s troubles did not stem from poor demand, but from its inability to meet demand.(4)

Why would a company that is having trouble meeting demand sell one of its most important production facilities? One could

easily imagine an effort to improve responsiveness and efficiency at existing facilities, but a move to decrease capacity at such a

moment, on the face of it, seemed foolish. Did Apple plan to make up for the resulting loss in manufacturing capacity by

expanding its remaining facilities in Ireland or Singapore, moving production to lower-cost offshore locations? A closer look at

Apple’s restructuring strategy and its partner in the deal, SCI, provides some answers to this puzzle and serves as a thumbnail

sketch of the organizational sea-change that is currently underway in the electronics industry.

First, the sale to SCI did not mean that Apple computers would no longer be produced in the Colorado facility. On the

contrary, the deal included a three-year agreement for SCI to continue to manufacture Apple products in the plant. SCI is the

largest of an emerging cadre of specialized firms whose sole business is to provide electronics manufacturing services to the

industry on a contract basis; accordingly, companies like SCI are known as “contract manufacturers.” SCI had the right to use

the plant’s production lines to manufacture products for any of its other customers as well as Apple, which at the time included

more than fifty firms including Hewlett Packard and IBM, companies that compete directly with Apple in the PC market. The

majority of the five-year-old plant’s 1,100 workers were to stay on as SCI employees.

So, Apple wasn’t selling one of its U.S. plants to some burgeoning local electronics company and moving its own production

offshore: it was contracting with SCI to continue to manufacture Apple products in Colorado. According to Apple CEO

Gilbert Amelio, the company’s strategy was to outsource production to companies such as SCI in order to reduce Apple’s

manufacturing overhead and inventory carrying costs while concentrating the company’s resources more intensively on

marketing and product design (Electronics Buyers News, 1996). As Kwok Lau, Apple’s Director of operations put it, Apple

was moving to a “variable cost position” vis-?-vis its manufacturing operations. This meant that more of the company’s

manufacturing assets were to be held by outside companies. Instead of using fixed assets, namely production facilities owned

and operated by Apple, to manufacture computers and peripheral equipment bearing the Apple nameplate, the company was

to use the production assets of specialized outside suppliers, such as SCI. After the sale, Apple was able to alter the volume of

its production, upward or downward, on very short notice without installing or idling any of its own plants and equipment. Of

particular interest to Apple’s management was the improved “upside flexibility” (i.e., the ability to quickly ramp up production

volumes to meet unexpected surges in demand) that the deal with SCI provided.(5)

Another oddity about the press reports surrounding SCI’s acquisition of Apple’s Fountain plant was the following statement by

Fred Forsyth, Apple’s senior vice president of worldwide operations: “By outsourcing the manufacturing activities of our

Fountain site to a company of SCI System’s size, experience, and broad business base, Apple has the opportunity to benefit

from SCI System’s economies of scale” (Apple Computer, 1996). Although SCI is a large company, it is less than a third the

size of Apple. How could a company of SCI’s size achieve greater manufacturing and component purchasing scale economies

than a company whose market share in the PC industry has hovered between number one and three since the birth of the

industry in the late 1970s? The answer lies in the fact that SCI’s sole business is contract manufacturing. The company has no

internal product development capacity. Its sales and marketing activities are limited to developing its business as a manufacturer

of other firms’ products. In fact, despite its size, and the fact that it manufactures no products under its own name, SCI’s twenty

world-wide plants may well contain more manufacturing capacity than any other single electronics firm.(6)

Was the Apple/SCI deal unusual? Certainly not. If anything, according to some industry watchers, some of Apple’s problems

stemmed from the fact that it had been too slow to “outsource” its manufacturing operations, even though nearly 50% of the

company’s manufacturing was already performed by contractors prior to the sale. By selling the Colorado facility to SCI,

Amelio was simply placing Apple more completely on a bandwagon that was already well underway. Since the mid-1980s, and

particularly in the 1990s, large and well-known American electronics companies such as Apple, IBM, NCR, Philips, ATT,

Hewlett Packard, and DEC have been abandoning their internal manufacturing operations in droves and turning to contract

manufacturers such as SCI to build their products. At the same time, many younger, faster growing electronics firms, many of

them based in Silicon Valley, CA, have always used contract manufacturers; few have built internal manufacturing capacity even

as they have grown (e.g., Sun Microsystems, Silicon Graphics, and Cisco Systems).

Increased outsourcing has created an unprecedented boom in contract manufacturing revenues. From 1988 to 1992 the sum of

revenues generated by 1995’s largest twenty contractors grew at an annual rate of 30.7%. Since 1992, however, revenue

growth has been accelerating dramatically year by year: from 1992 to 1995, revenues grew 46.4% each year, with the fastest

growth coming from 1994 to 1995, when revenues expanded 51.2% (see Figure and Table 1). At the time of this writing, the

unprecedented growth in the industry is showing no sign of slowing down (for example, SCI’s revenues grew 65% to more than

$5.3B in calendar year 1996).

Revenue growth for contractors has come from several sources. First, the purchase of a customer’s facility often includes at

least short-term prospects for increased business as the contractor assumes responsibility for current and future production

volumes. Besides increased volume, contractor’s revenues have increased from component purchasing and the provision of new

services. Increasingly contractors have been purchasing components for their customers in what is known in the industry as a

“turnkey” contract. In this arrangement, the contractor essentially acts as a lender to its customers by purchasing and holding

component inventories. Cash outlays are only recouped as finished products are delivered to the customer. Turnkey component

buying increases the flow of capital through the contractor, driving up revenues and creating strong market linkages with

component suppliers. Also, contractors have been vertically integrating in relation to their specialty, manufacturing. Besides

basic electronics manufacturing processes, such as circuit board assembly, most contractors have added a range of back- and

front-end services, such as process R&D, design for manufacturability, product-specific process development and

documentation, various forms of testing, final product assembly, final packaging, software loading and document duplication,

and shipping to distribution. Some contractors have added repair services, not only for products manufactured in their plants

but by customer plants as well. The contractors that have grown the fastest have specialized in advanced manufacturing

processes, such as surface mount technology, which drive product miniaturization and performance forward.

Figure 1. Revenues; 1995’s Top Twenty Contract Manufacturers, 1986-1995

(billions of current dollars)

Table 1. Revenues; 1995’s Top Twenty Contract Manufacturers, 1988-1995

(thousands of current dollars)

CM Revenues (thousands of $)

Annual Average Growth Rates

‘88

‘92

‘95

‘88-’92

‘92-’95

‘94-’95

Top 5

1,077,366

2,433,127

7,772,792

24.4%

47.3%

51.9%

Top 6-20

606,000

1,534,200

4,672,382