Outsourcing Innovation Pete Engardio and Bruce Einhorn 1 HTC? Flextronics? Cellon? There’s a good reason these are hardly household names. The multimedia devices produced from their prototypes will end up on retail shelves under the brands of companies that don’t want you to know who designs their products. Yet these and other little-known companies are emerging as hidden powers of the technology industry. 2 They are the vanguard of the next step in outsourcing—of innovation itself. When Western corporations began selling their factories and farming out manufacturing in the 1980s and 1990s to boost efficiency and focus their energies, most insisted all the important research and development would remain in-house. 3 Today, the likes of Dell, Motorola, and Philips are buying complete designs of some digital devices from Asian developers. It’s not just cell phones. Asian contract manufacturers and independent design houses have become forces in nearly every tech device, from laptops and high-definition TVs to MP3 music players and digital cameras. 4 While the electronics sector is furthest down this road, the search for offshore help with innovation is spreading to nearly every corner of the economy. Boeing Co. is working with India’s HCL Technologies to co-develop software for everything from the navigation systems and landing gear to the cockpit controls for its upcoming 7E7 Dreamliner jet. Competitive Dangers 5 Underlying this trend is a growing consensus that more innovation is vital—but that current R&D spending isn’t yielding enough bang for the buck. With R&D as the biggest single remaining controllable expense to work on, companies either will have to cut costs or increase R&D productivity. 6 The result is a rethinking of the structure of the modern corporation. At a minimum, most leading Western companies are turning toward a new model of innovation, one that employs global networks of partners. These can include US chipmakers, Indian software developers, and Chinese factories. 7 The downside of getting the balance wrong, however, can be steep. Motorola hired BenQ Corp. from China’s Taiwan to design and manufacture millions of mobile phones. But then BenQ began selling phones last year in the prized China market under its own brand. Another risk is that brand-name companies will lose the incentive to keep investing in new technology. Yet if the innovation starts residing in the suppliers, you could endanger yourself to the point where there isn’t much left. 8 Such perceptions are a big reason even when companies that outsource heavily refuse to discuss what hardware designs they buy from whom and impose strict confidentiality on suppliers. 9 The concerns also explain why different companies are adopting widely varying approaches to this new paradigm. Dell, for example, does little of its own design for notebook PCs, digital TVs, or other products. Hewlett-Packard Co. says it contributes key technology and at least some design input to all its products but relies on outside partners to co-develop everything from servers to printers. The key is to guard some sustainable competitive advantage, whether it’s control over the latest technologies, the look and feel of new products, or the customer relationship. 10 Countries such as India and China, where wages remain low and new engineering graduates are abundant, likely will continue to be the biggest gainers in tech employment and become increasingly important suppliers of intellectual property. Some analysts even see a new global division of labor emerging: The rich West will focus on the highest levels of product creation, and all the jobs of turning concepts into actual products or services can be shipped out. 11 You can see this great division already taking shape in global electronics. The process started in the 1990s when China’s Taiwan emerged as the capital of PC design, largely because the critical technology was standardized on Microsoft Corp.’s operating system software and Intel Corp.’s microprocessor. Today, “original-design manufacturers” (ODMs) from China’s Taiwan, so named because they both design and assemble products for others, supply some 65% of the world’s notebook PCs. Quanta Computer Inc. alone expects to churn out 16 million notebook PCs this year in 50 different models for buyers that include Dell, Apple Computer, and Sony. 12 Now, ODMs from China’s Taiwan and other outside designers are forces in nearly every digital device on the market. Of the 700 million mobile phones expected to be sold worldwide this year, up to 20% will be the work of ODMs. About 30% of digital cameras are produced by ODMs, 65% of MP3 Players, and roughly 70% of personal digital assistants (PDAs) Sweeping Overhaul 13 India is emerging as a heavyweight in design, too. The top players in making the country world-class in software development, including HCL and Wipro, are expected to help India boost its contract R&D revenues from $1 billion a year now to $8 billion in three years. 14 Perhaps the most ambitious new entrant in design is Flextronics. Three years ago, it started losing big cell-phone and PDA orders to ODMs from China’s Taiwan. Since then, CEO Michael E. Marks has shelled out more than $800 million on acquisitions to build a 7,000-engineer force of software, chip, telecom, and mechanical designers scattered from India and Singapore to France and Ukraine. So far, Flextronics has developed its own basic platforms for cell phones, routers, digital cameras, and imaging devices. 15 In the 1990s, companies like Flextronics completely restructured the world’s electronics manufacturing. Indeed, some 80% of engineers in product development do tasks that can easily be outsourced—like translating prototypes into workable designs, upgrading mature products, writing user manuals, and qualifying parts vendors. What’s more, most of the core technologies in today’s digital gadgets are available to anyone. And circuit boards for everything from cameras to network switches are becoming simpler because more functions are embedded on semiconductors. 16 Why then should Nokia, Motorola, Sony-Ericsson, Alcatel and other brand-name companies all largely duplicate one another’s efforts? Why should each spend $30 million to develop a new smartphone or $200 million on a cellular base station when they can just buy the hardware designs? The ultimate result is that some electronics giants will shrink their R&D forces from several thousand to a few hundred, concentrating on proprietary architecture, setting key specifications, and managing Global R&D teams. Close to the Heart 17 Still, most companies insist they will continue to do most of the critical design work. A Motorola spokesman says it plans to keep R&D spending at around 10% for the long term. Lucent says its R&D staff should remain at about 9,000, after several years of deep cuts. And while many Western companies are downsizing at home, they are boosting hiring at their own labs in India, China, and Eastern Europe. This shows that companies have all realized if they want a sustainable competitive advantage, they will not get it from outsourcing. 18 Companies also worry about the message they send investors. If a company depends on outsiders for design, investors might ask, how much intellectual property does it really own, and how much of the profit from a hit product flows back into itself, rather than being paid out in licensing fees? That’s one reason Apple Computer lets the world know it develops its hit products in-house, to the point of etching “Designed by Apple in California” on the back of each iPod. 19 Yet some outsourcing holdouts are changing their tune. Nokia long prided itself on developing almost everything itself. No longer. Given the complexities of today’s technologies and supply chains, “nobody can master it all,” says its Chief Technology Officer. “You have to figure out what is core and what is context.” Lucent says outsourcing some development makes sense so that its engineers can concentrate on next generation technologies. 20 It’s also about brutal economics and the relentless demands of consumers. To get shelf space at a Best Buy or Circuit City often means brand-name companies need a full range of models, from a $100 point-and-shoot digital camera with 2 megapixels to a $700 8-megapixel model that doubles as a videocam and is equipped with a powerful zoom lens. On top of this, superheated competition can reduce hit products to cheap commodities within months. So they must get out the door fast to earn a decent margin. Consumer electronics have become almost like produce—they always have to be fresh. 21 Such pressures explain outsourcing’s growing allure. Take cell phones for example. Using a predesigned platform can shave 70% of development costs off a new model, estimates a senior vice-president for marketing at Cellon. That can be a huge savings. As a rule of thumb, it takes around $10 million and up to 150 engineers to develop a new cell phone from scratch. If Motorola or Nokia guess wrong about the market trends a year into the future, they can lose big. So they must develop several versions. Moving Up the Food Chain 22 Who will ultimately profit most from the outsourcing of innovation isn’t clear. The early evidence suggests that today’s Western titans can remain leaders by orchestrating global innovation networks. Yet if they lose their technology edge and their touch with customers, they could be tomorrow’s great shrinking conglomerates. Contractors like Quanta and Flextronics that are moving up the innovation ladder, meanwhile, have a shot at joining the world’s leading industrial players. What is clear is that an army of in-house engineers no longer means a company can control its fate. Instead, the winners will be those most adept at marshaling the creativity and skills of workers around the world. Notes 1. HTC (para. 1) 宏达国际电子股份有限公司(简称“宏达电子”,手机与平板电 脑制造商,总部位