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4 External Relationships in Corporate Technology Policy and Innovation Strategy The trend toward increasing reliance on external relationships in corporate technology policy and innovation strategy in both the United States and Japan is widespread, and has both domestic and international aspects. It is driven by the globalization of markets, the high cost of keeping abreast of new technologies, and the complexity of high technology products and systems which force companies to focus their resources on the most important corporate assets. Companies must therefore rely more and more on capabilities outside the firm. Some hope this will result in mutual sourcing and symbiotic competition worldwide. The trend toward greater reliance on external relationships takes at least two forms: (1) external sourcing of technology and innovation accompanied by deemphasis on vertical integration, and (2) voluntary associations or consortia of firms for the purpose of agreeing on de facto standards through which architectures and interfaces are agreed on to foster market growth through the stimulation of interoperability. The latter relationships are prominent in software and other areas of information technology. External Sourcing of Technology and Innovation Greater reliance on external sourcing, the search for and acquisition of technology and innovation from sources outside one's own firm, is, in the judgment of t he task force, the most important trend in global technology management. The practice of acquiring technology and innovation from outside the firm, a long-standing operational practice in Japan, is growing. A survey of companies around the world illustrates that firms anticipate a growing reliance on external sources of technology (Figure 4-1). Several recent reports and indicators confirm the existence of this trend in the United States. According to a 1996 report by the Council on Competitiveness, the aircraft, automotive, chemical, electronics, information technologies and pharmaceuticals industries are increasing their focus on alliances, R&D partnerships, and other mechanisms aimed at tapping or leveraging external capabilities.1 Table 4-1 shows the extent of R&D outsourcing by U.S.-based companies in 1993 and 1996. The figures show outsourcing rising significantly over that period. The trends should be interpreted with some caution, because they may reflect better coverage of nonmanufacturing industries in recent R&D surveys. Table 4-2 shows R&D funding paid to outside organizations by Japanese companies for 1993 and 1996. The U.S. and Japanese data may not be directly comparable due to differences in the surveys and accounting methods. Still, the figures show that Japanese firms do fund R&D outside the firm at a significant level. The Japanese government also keeps track of payments to foreign organizations. In recent years, R&D payments to foreign organizations by Japanese companies has been slightly under ten percent of total outside payments.2 Some experts suggest that outsourcing is the key to corporate innovation strategy in both countries.3 At the same time, the nature of external relationships is changing as the level of dependence on outside affiliations for critical technology increases. In general, the level of supplier control increases in proportion to the sophistication of the technology provided to the
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Figure 4-1 Percentage of companies with high reliance on external sources for technology. Source: Edward B. Roberts, "Benchmarking the Strategic Management of Technology," Research-Technology Management, January-February 1995, p. 55. original equipment manufacturer (OEM), and consequently the level of OEM control decreases. Another way of looking at it is that as the level of technology controlled by suppliers increases, OEMs must enter into more equal relationships with them. Therefore partnering between OEMs and suppliers is becoming more frequent. External sourcing of technology and innovation generally occurs within two types of institutional relationships. One is the relationship between OEMs and suppliers.4 Outsourcing is the term usually applied to this type of relationship. The other is the formation of strategic technology partnerships between corporations, usually for a limited time and purpose. The terms alliance and consortium are commonly used to describe this form of relationship. External sourcing as used in this report includes both types of relationships. It also encompasses a broad range of activities from a growing reliance on suppliers for increasingly independent and sophisticated engineering and design work to encouraging suppliers and universities to conduct research and development which can be integrated into the corporate innovation process. Vertical and Diagonal Relationships in Outsourcing The relationships of trust between suppliers and OEMs and the benefits to technological innovation that such relationships can bring are characteristic of many of the Japanese vertical alliant business groups (vertical keiretsu). U.S. firms have been adopting aspects of the Japanese vertical keiretsu model by reducing the number of suppliers, giving those suppliers more scope to innovate (sometimes by providing functional specifications), and increasing the level of
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TABLE 4-1 Company-financed R&D Contracted to Outside Organizations by R&D-performing Companies, 1993 and 1996, million dollars 1993 1996 Total Manufacturing 3,462 5,833 Nonmanufacturing 2,339 4,293 Total as a percentage of company-financed R&D 3.6 4.9 SOURCE: National Science Foundation, Division of Science Resources Studies, Survey of Industrial Research and Development: 1996. TABLE 4-2 Japanese Industry R&D Funding Paid to Outside Organizations, 1993 and 1996, million dollars 1993 1996 Total 4,722 5,113 Manufacturing 3,576 3,824 Nonmanufacturing 1,146 1,289 Total as a percentage of company-financed R&D 8.6 9.1 NOTE: Purchasing power parity values used for currency conversion. SOURCE: Government of Japan, Management and Coordination Agency, Report on the Survey of Research and Development, various surveys 1993-1997 technological cooperation between original equipment manufacturer and supplier. This trend is facilitated by the use of computer-aided design and manufacturing systems linked through computer networks, allowing co-development in the OEM supply chains. Japanese OEMs have enjoyed more or less exclusive vertical relationships with their suppliers, and conducted research and development jointly with commitment by the OEM to buy and by the supplier to produce. Although the evidence is mainly anecdotal at this point, members of the Japanese working group point to a trend in which more Japanese suppliers are expanding to diagonal relationships, diversifying their research, and expanding markets, leading to higher levels of outsourcing in the Japanese economy. Japan's vertical keiretsu are an interesting model for U.S. firms. Some may wonder whether U.S. firms may make the mistake of mimicking old keiretsu, after Japan has moved to "diagonal" relationships across vertical alliance boundaries. However, it is unlikely that arrangements similar to Japan's traditional keiretsu would be allowed under U.S. law. Still, U.S. manufacturers such as Chrysler and Eaton have adapted aspects of Japanese supplier
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relationships to their own circumstances.5 Driving this trend is increasing global competition across industries which pushes companies to develop and produce higher quality, competitively priced products quickly for demanding end users. At the same time, it should also be noted that although some U.S. companies have emulated aspects of Japan's vertical keiretsu, few or none have emulated the horizontal alliant business groups composed of major manufacturers, large banks, and trading companies, which are also referred to by the term keiretsu . Horizontal keiretsu remain a dominant and distinguishing feature of Japanese business which is not mirrored in the U.S. system, although German business is also known to have a main bank structure. Rising foreign direct investment by manufacturing firms has also encouraged sourcing beyond the immediate group as companies search for high quality, low cost suppliers to support their production operations around the world. Also contributing is the fact that suppliers are required to have significant capacity to conduct R&D and to innovate alongside end-users. For example, Johnson Controls, a large U.S. automotive components supplier, has become the lead supplier of seat subassemblies to Toyota's global assembly operations, providing seats to Toyota assembly plants in Georgetown (Kentucky), Fremont (California), Ontario (Canada), and Cardiff (Wales). Diversification vs. New Firm Creation in Relation to Outsourcing of Innovation As outsourcing becomes more prevalent, the capabilities of external sources of technology becomes an important issue. Large Japanese firms are often said to be adept at internal diversification using both foreign and domestic assets.6 Yet the effectiveness of this strategy has been brought into question. In the United States, diversification takes place primarily through the creation of new firms and secondarily through mergers and acquisitions. The creation of new firms is important for new emerging technologies (biotech, computer hardware, software) but not for later stage growth or stable fields. The advantages of diversification through acquisition are that it is faster and requires less R&D resources. However, only acquisitions in closely related businesses have a good track record, and they are the basis for only modest degrees of diversification. Unrelated acquisitions have high failure rates. Internal diversification through R&D has less initial risk, is more flexible, and provides broader business scope.7 In addition, it is typical for large Japanese electronics firms to sell to the OEM component market while also consuming their component output in their vertically integrated businesses, which can facilitate diversification in electronic components and end products. The advantages and disadvantages of various routes to business growth through innovation can be seen in recent U.S. and Japanese examples. Several of the leading Japanese integrated electronics companies have successfully launched liquid crystal display (LCD) manufacturing in recent years on the foundation of their existing business and technological bases (diversification through internal R&D). Other attempts by large Japanese manufacturers during the late 1980s and early 1990s to diversify into high technology fields far removed from their original businesses have yielded fewer examples of success. Some believe that internal diversification's dependence on existing organizations can constrain the search for new technologies and thus may be less suited than new firm creation and even mergers and acquisitions for creating entirely new business opportunities. In the United States, the investment community and business pressures have an important influence on strategic decisions to enter new businesses, as opposed to Japan, where company management has been more free to formulate and pursue long-term strategies without external pressures. The U.S. investment climate is currently not favorable to firms that stray far from their
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core businesses through acquisitions or internal R&D programs. Indeed, the current climate has encouraged some large companies to consolidate to achieve critical mass in fields as diverse as defense and entertainment. Similar pressures have encouraged other U.S. firms to divest or spinoff noncore businesses (successful or not), a phenomenon which is very rare in Japan. Several Japanese members observed that in some acquisitions talented individuals in the acquired company do not fit into the new corporate environment, and are thus lost in the acquisition process. New firm creation is another vehicle to commercialize new technologies. Clearly, this mechanism has been and continues to be very important in the United States. In the post World War II period, a number of strong Japanese companies were founded and achieved rapid growth, although in recent years examples of Japanese high technology start-ups that have achieved outstanding success are relatively rare. Recent Japanese policy changes and pronouncements have been aimed at encouraging new firm creation in high technology industries. Nevertheless, it appears that the Japanese innovation system's relative strength in new technology commercialization by existing firms and the relative strength of new firms in the U.S. system is one continuing difference between the two countries that is likely to persist for the foreseeable future. Lack of Data to Measure the Extent of Foreign Sourcing of Innovation Although a number of studies have provided substantial insights into foreign sourcing of innovation, lack of data in this area is perhaps the most serious impediment to understanding trends and emerging issues.8 Table 4-1 shows R&D outsourcing by U.S. firms, and figures on off-shore R&D performed by U.S.-based companies is provided in Chapter 3. However, statistics on outsourcing to organizations based outside the United States are not broken out of the total outsourcing figures at this point. Business surveys, such as the Bureau of the Census' survey of manufacturers and the National Science Foundation's survey of industrial R&D, contain valuable aggregate data on U.S. industrial sectors. However, more is needed not only to make it possible to quantify the extent to which outsourcing relationships are being created across national boundaries, but also to determine whether the relationships are in the form of off-shore laboratories, joint ventures, alliances, or agreements with suppliers and subcontractors. Some of these data has been collected by NSF in a pilot study of 1,000 U.S. companies, but even less is known about non-U.S. companies.9 In addition, some of these data are being collected in a new collaborative U.S.-Germany-Japan global benchmarking study aimed at updating the 1992 MIT work.10 Impact of External Sourcing of Innovation Several questions are raised by this trend toward increased outsourcing of R&D. What are the barriers on each side to successful use of outsourcing? For example, can the needed relationships of trust be consistent with diagonal business relationships in Japan? Will concern about changes in U.S. firm management, personnel turnover, and the frequency of mergers and acquisitions inhibit these relationships in the United States? One idea that was discussed by the Joint Task Force is the possibility that U.S. and Japanese OEMs might work together to raise the innovative capabilities of suppliers in developing and rapidly industrializing countries.11 This sort of "mutual outsourcing" would probably be more straightforward to implement in cases
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where U.S. and Japanese companies have existing joint venture or alliance relationships aimed at Asian markets or Asian procurement. In recent years, industry supported basic research has remained fairly stable in the United States (see Figure 4-2). However, some have argued that restructuring of corporate R&D of the type undertaken by a number of firms which have downsized central labs and refocused work on nearer term business needs, will result in inadequate funding of long-range, industry-sponsored, basic research in the global economy. Even if outsourcing of innovation accelerates OEM innovation rates, suppliers may have relatively short time horizons. Their access to new ideas from university research becomes a critical link in the national system of innovation, and poses a policy problem for government to find ways to enhance this linkage. Others have argued that increased focus and efficiency in U.S. corporate R&D is a fundamentally healthy response to competitive pressure. Firms that outsource increasing fractions of their innovation needs are likely to do so at the expense of their fundamental industrial research, as the scope of the latter is narrowed. This increased reliance on other institutions (universities and other public research institutions) may well result in an overall reduction in long range research investments, or it may create a clearer demand for such research. Some experts predict that the U.S. corporate central lab will increasingly play a scanning, mediating, and strategic role, quickly linking the firm's business needs to internal and external sources of necessary technology and informing technology strategies through research-based technology road maps. In this formulation, the central lab will put relatively less emphasis on internal research and relatively more on managing rapidly evolving innovation networks comprised of partnerships and alliances of various forms.12 It is also possible that firms will fail to maintain a critical mass of internal capability needed to identify and absorb the help they need. It will be important to track this trend, since the small and medium enterprises and universities to which innovation is outsourced may be innovative but may prove unable to contribute to basic industrial research. However, this also differs from industry to industry. For example, small U.S. start-up firms have played a major role in commercializing basic knowledge in biotechnology and computer software. In some industries and technical fields, industry-university partnerships, sometimes with government participation and support, appear to be effective in leveraging research efforts. Precompetitive Research Partnerships, Alliances, and Consortia In recent years the number of corporate alliances has been growing rapidly, particularly cross-border alliances (Figure 4-3). Such alliances have many purposes including gaining flexible access to the innovative capabilities of suppliers with specialized technical skills. As revealed in a recent survey of executive managements in Japan, the United States and Europe, in the case of development, alliances were second after internal R&D as a source of technology.13 For some time, support for R&D consortia has been an important element of Japan's technology policy. In recent years, the United States has expanded programs of public support for research consortia to develop civilian, precompetitive technologies. Notwithstanding continuing debate in the United States over the appropriate federal role in civilian technology development, the increasing importance of partnerships and alliances in innovation has raised several challenging questions in recent years, particularly for the United States. For example, when is public support justified? For publicly supported research consortia, when is foreign corporate participation appropriate? How should collaboration be structured and managed so that consortia are most
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Figure 4-2 Sources of funds for basic research in the United States. NOTE: Data are in current U.S. dollars. SOURCE: National Science Board, Science and Engineering Indicators 1998. Figure 4-3 Distribution of strategic technology alliances between economic blocs, 1990-1994. SOURCE: John Hagedoorn, Maastricht Economic Research Institute on Innovation and Technology, Cooperative Agreements and Technology Indicators database, unpublished tabulations as presented in National Science Board, Science & Engineering Indicators-1996 (Washington, D.C.: U.S. Government Printing Office, 1996).
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effective?14 One expert on Japanese consortia concluded that their real value was not in developing precompetitive R&D nor in the pursuit of significant technological advances but rather in fostering competitiveness. 15 The inability of U.S. and Japanese semiconductor companies to unite in a common effort to develop new manufacturing technologies to process 12-inch silicon wafers illustrates that international cooperation is difficult to structure, even where the technological rationale is strong.16 However, some joint ventures such as the IBM-Toshiba production of flat panel displays seem very successful. Consortia for Informal Standardization and Related Technology Development A final example of increased reliance on external sources of innovation are alliances and consortia formed to develop or diffuse de facto standards. These consortia are increasingly prevalent in information technology-related businesses. Products and services are becoming more intertwined, with customers expecting more complete systems solutions to their needs. With strong competition, few firms can for long dominate all the elements in a service/product system so that many are now embracing open systems that enable competition at the subsystem level. Access to complementary assets is an increasingly important competitive factor. This has given rise to large numbers of industrial consortia, created to negotiate standard interfaces and protocols in the quest for de facto standardization. The computer and communications industries are a particular focus. With outsourcing of components and subsystems rising, standards processes are unlikely to remain domestic for very long. The rise in de facto standardization is due to the fact that the formal standards process is too slow and too open to meet all the needs of firms, especially in information industries, to find a path to open systems that is consistent with their business objectives. The formal system is intended to ensure fairness through broad participation of manufacturers and users and through consensus decision-making. It is most often used to harmonize mature technologies, while the de facto standardization addresses anticipatory standards for systems not yet widely available in the market. The rapid rise of business consortia for the purpose of negotiating consensus in the industry on standard interfaces is leading to more open product systems, itself a welcome trend that will encourage trade. De facto standardization also raises international policy challenges in areas such as antitrust and competition policies, which up to now have been set and enforced in a national context. Where the de facto standard is the proprietary product of a particular company or group of companies, such as MS-DOS, antitrust questions that were previously domestic in nature may assume international significance. At the same time, national governments and groups of companies may seek to develop their own standards to compete with emerging market-driven standards, and use these as trade barriers. Some consortia that fall into this category are from a single country, and many are transnational. Antitrust exposures may be latent in their operations. So far informal standards consortia in the United States, and presumably in Japan, appear to have worked relatively well, in the sense that competing standards have not significantly delayed the introduction of new technologies. To date, the potential abuse of market power by standards developers appears to have been held in check by U.S. competition policies, enabled by the fact that the United States constitutes the largest market for advanced information technology products. This may not necessarily be the case in the future.
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In addition, a second concern might well deserve the attention of technology leaders. It is well known from almost every example in consumer electronics how tightly linked standards questions are to competitive issues. The straggle to define HDTV standards around the world is one example, and there are many others. Another example is Digital Versatile (or Video) Disk standards. The agreement of five U.S. computer related firms (IBM, Compaq, Hewlett-Packard, Microsoft and Apple) to adopt a single standard for the DVD storage media in 1995 removed a major barrier to the development of the DVD industry by bringing together two rival groups led by Sony and Toshiba.17 In 1997, however, new obstacles arose as splits again occurred among the ten companies that originally agreed on a single standard.18 This example not only highlights the importance of de facto standards alliances, but also indicates the key role which de facto standards-setting plays in the complex relationships among Japanese and U.S. companies. What steps might be taken to ensure opportunities for equitable participation and returns as the number and influence on markets of such consortia grow? What are responsibilities of and legitimate roles for governments in such consortia? This deserves more in depth study to divert what seems likely to become a growing source of friction, as debates about the WTO role in technology already illustrate.19 Notes and References 1 Council on Competitiveness, Endless Frontier, Limited Resources , Washington, D.C., 1996. 2 Government of Japan, Management and Coordination Agency, Report on the Survey of Research and Development, various issues, 1993-1997. 3 Tsuneo Nakahara, "Strategic Mutual Outsourcing between the U.S. and Japan for Innovation and Technology Transfer in the Post Cold-War Age," paper delivered at the meeting of the U.S.-Japan Joint Task Force on Corporate Innovation, Makuhari, Japan, September 11-13, 1994. 4 It is important to note that the suppliers of large Japanese manufacturers are often affiliated in a keiretsu, and these relationships are not arms-length. 5 See Rajan R. Kamath and Jeffrey K. Liker, "A Second Look at Japanese Product Development," Harvard Business Review, November-December, 1994, pp. 168-169. 6 For examples of the diversification strategies of several major Japanese companies, see Branscomb and Kodama, op. cit., pp. 38-53. 7 Ibid., p. 46. 8 See Florida, op. cit., and Roberts, op. cit. 9 See Science and Engineering Indicators 1996 (Arlington, Va.: U.S. Government Printing Office, 1996). For other countries, including Japan and Germany, OECD provides data of R&D performance by industry including aggregate numbers for "total services" (i.e., non-manufacturing industries R&D performance). See OECD, DSTI (STAN)ANBERD), 1994, Appendix Tables 6-4 (U.S.), 6-5 (Japan), and 6-6 (Germany). 10 Roberts, op. cit. 11 Remarks by Tsuneo Nakahara at the meeting of the U.S.-Japan Joint Task Force on Corporate Innovation, Makuhari, Japan, September 11-13, 1994. 12 Richard S. Rosenbloom and William J. Spencer, eds., Engines of Innovation: U.S. Industrial Research at the End of an Era (Cambridge, Mass.: Harvard Business School Press, 1996). 13 Roberts, op. cit. Alliances are followed by central corporate research, supplier-provided technology, and licensing. For research (not development) universities were the third most important source after central corporate research and divisional research. The survey also suggests that Japanese firms benefit more than do U.S. firms from university relationships, with U.S. universities rather than Japanese universities being most prominent as the source of benefits.
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14 In the U.S. context, these issues have also been explored in a national assessment of U.S. commercial technology policy commissioned by the Competitiveness Policy Council in 1998. See Branscomb and Keller, op. cit. 15 See Gerald J. Hane, "The Real Lessons of Japanese Research Consortia," Issues in Science and Technology Winter 1993-94, pp. 56-62. 16 Dean Takahashi, "U.S.-Japan Chip Pact Could Facilitate Push to Manufacture Larger Equipment," The Wall Street Journal, August 5, 1996, p. B5. 17 "IBM Nado Kikaku-an: Bei Go-sha Yuza Shudo e Kessoku," (Standards agreement between IBM and others: five American user-companies take the lead), Nihon Keizai Shimbun, May 5, 1995, p. 1. 18 Reuters, "Wait and See on DVD, Analysts Say," August 15, 1997. 19 Toward the end of the Uruguay Round negotiations, concerns were raised in the United States about the implications of emerging rules governing R&D subsidies. The U.S. government sought and achieved modification of these provisions.
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