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Another Outsourcing Product: Lost Knowledge

Get involved in discussions on EBN's message boards. You might learn something from the industry veterans who contribute blogs, shepherd discussions, and share useful tips gleaned from decades of hands-on experience in electronics design, procurement, manufacturing, and other supply chain activities.

I got such a valuable insight on Tuesday while exchanging comments with Ken Bradley, the president of Lytica Inc. and a regular contributor to EBN, about the re-emergence of vertical integration in the electronics manufacturing process. As Ken pointed out, vertical integration collapsed in the West but never really went away. In Japan and Korea, the vertically integrated manufacturing structure is still alive and kicking hard.

Under the old vertical manufacturing system, OEMs owned and controlled all parts of the production process. They owned semiconductor plants. They produced all other components, including commodity parts. They managed test and assembly, design, and manufacturing facilities. In other words, the OEM was not just the orchestra conductor. It actually owned all the instruments and the players. In the last couple of decades, Western OEMs have either outsourced or sold most of these activities to third-party service providers, flattening out the manufacturing process.

The old vertical structure may be making some sort of a comeback in the West, but Ken's point was deeper than this. By outsourcing or divesting certain parts of their operations, Western companies and countries lost more than manufacturing jobs as they focused on so-called core competencies. They also forfeited what Ken called “knowledge vertical integration.” It's a huge loss. Here's how he describes it:

The wave of changes that broke down the electronics industry's vertical manufacturing structure over the last two decades happened mostly with western companies and, as such, vertical integration didn't break down in the electronics industry, just in the western managed part of it. I believe these companies have thrown out the baby with the bathwater. Here, the baby is the key strategic bit that gives competitive advantage and the bathwater is the rest of the factory. I don't see any competitive advantage in assembling, for example, surface mount boards but I do see it in high end silicon, displays and other unique technologies…
I will use my Nortel Networks (a technology company) experience to illustrate the point. Every successful product that Nortel ever made had at its core a differentiating semiconductor technology. Whether it is the early adoption of customer silicon and software in its PBX (1970s), the filter-codecs enabling digital switching (1980s) or jitter free lasers allowing high speed optical networks (1990s), all of these products had market leading positions. Their wireless (2000s) products did not have such differentiation. This I feel is one often overlooked reason why the company is no longer with us.

Ken should know. He was chief procurement officer at Nortel during its hey days. (See: The Virtues of Vertical Integration.)

After reviewing his comment, I concluded that the mad rush to dump business units, outsource manufacturing, and concentrate on design and marketing alone has done significant damage to OEMs in the West. As companies exited critical operations, they also lost institutional memory and severed the crucial bonds between product conceptualization, design, and marketplace success. OEMs have become so specialized that their ability to see beyond and operate outside of niche products has withered completely.

A few companies still see a link between components and finished goods. {complink 379|Apple Inc.}, for instance, has built up in-house semiconductor design competence in recent years. It correctly assumed that such knowledge would be critical to its success in designing smaller form factor products or enhancing battery and storage capacity. Apple has been involved in the design of the microprocessor for its iPhone, iPod, and iPad and has even acquired component vendors to secure adequate supply and ensure access to valuable design knowledge.

I would put Apple's recent acquisition of the flash memory part vendor Anobit in this category. Apple reportedly paid $500 million for the Israeli company, which was already supplying flash storage to the company. Apple didn't offer any explanations for that move, but it is securing more than guaranteed flash supply. It is also gaining an in-house supplier that can now work more closely with its designers.

It's an edge worth having and one that is possible only in a world of knowledge vertical integration. That knowledge is being lost, unfortunately. It may never be regained.

7 comments on “Another Outsourcing Product: Lost Knowledge

  1. Barbara Jorgensen
    January 4, 2012

    I'd also point to another vertical integration success story–Foxconn (Hon Hai). They also, I believe, are Apple's biggest EMS provider. Foxconn has gone against conventional wisdon and has retained a connector manufacturing business and has added semiconductors along the way. It is now going to the other extent and building retail outlets. Whether you agree or disagree with many things about Foxconn, they are by far the biggest EMS provider in the world and show no signs of changing their strategy.

  2. Daniel
    January 5, 2012

    “Apple has been involved in the design of the microprocessor for its iPhone, iPod, and iPad and has even acquired component vendors to secure adequate supply and ensure access to valuable design knowledge”

    Bolaji, it's very interesting that Apple is planning for a chip development program; so far they are getting chips from Samsung facility at Austin.

    http://articles.businessinsider.com/2011-12-16/tech/30523822_1_ipad-iphone-samsung-electronics

  3. bolaji ojo
    January 5, 2012

    Jacob, The interesting thing about Apple is they don't leave any part of their supply chain to chance. When I said they are involved in the chip design process, I mean they are engaged with their suppliers in the roadmap development. They aren't just waiting for suppliers to tell them what's coming down the road.

    The company actively works with suppliers on next-gen products and some of these are exclusively developed for Apple. The goal is to separate the company from the pack. I don't necessarily see Apple establishing its own semiconductor fab (with $85 billion in the bank they may make such a move) but they engage closely to develop what they want with suppliers.

  4. Ken Bradley
    January 5, 2012

    Bolaji, I think we need to answer at least three questions if we are going to address this issue in a manner that has value for EBN readers and their companies. I am focusing on these questions and my ideas will form the basis of my next blog. The three questions are:

    1.        What exactly is the knowledge that market leading companies gain from vertical integration?

    2.        Can this knowledge be gained without integration and how?

    3.        If we concede that domestic companies have given up markets to vertically integrated Asian competitors, are there emerging technologies or scenarios that with the right investment (integration) western companies could recapture or rebalance market share in next generation products?

    Perhaps your readers will contribute their thoughts. 

  5. mfbertozzi
    January 6, 2012

    Thanks Ken for outlining three key points on the matter. I would like to present an individual thought; I believe it should be important to come back one step more in the sense the “outsourcing”, theoretically, means a process that, once adopted by a corporation, doesn't aim to lose anything, but to increase or enforce either positioning inside the addressed market and business/profitability. In case the discussion is coving matters as “losing something”, maybe outsourcing process was adopted for addressing other needs, basically cutting costs without other strategy. Am I right?

  6. Eldredge
    January 6, 2012

    I would include lost skills in the equation as well. While these are more general competencies as opposed to core competencies, the western world is erroding it's ability to build things by the loss of infrastructure and the skills to produce goods.

  7. Jennifer Read
    January 6, 2012

    Great post, Bolaji. Our research indicates that when you dig deep this lost knowledge is related to outsourcing, but not caused by it. We've blogged on it recently: “Institutional continuity is what is elemental in an organization. It  relates to the way business is conducted, the company's history and purpose; and how and why it exists. Does outsourcing in itself break institutional continuity? Not necessarily. But when you outsource everything – not just manufacturing, but design, logistics, customer service, accounting, IS/IT, and human resources – the system does break down, and I see that happening in some OEMs, especially in the past few years. So many pieces have been removed from the flow of the organization's value stream that the value begins to leak out the holes.”

     

    Here's a link to the entire article, FYI:

    http://charliebarnhart.com/archives/risk-factor-6-loss-of-institutional-continuity/

     

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