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Innovation Depends on a Robust Manufacturing Sector

When too many companies outsource their manufacturing, the industrial ecosystem can suffer long-term consequences.

It’s called moving up the economic value chain: U.S. companies are increasingly conceiving and creating products that are built elsewhere. Prosaic manufacturing, with its razor-thin profit margins and ruthless competition, has been outsourced to Asia. But researchers who study innovation are starting to see a worrisome after-effect: the ability to innovate sometimes disappears with the manufacturing.

Manufacturing matters: Willy Shih, a Harvard business professor and a former manager at IBM and Kodak, argues that there are ripple effects throughout an industry when a company hands off manufacturing of its products.

Harvard Business School professors David Pisano and Willy Shih set many businesspeople to rethinking whether manufacturing matters with a 2009 Harvard Business Review article titled “Restoring American Competitiveness.” Besides lamenting that outsourcing manufacturing reduces U.S. job prospects and worsens the trade imbalance, the academics argued that economies where manufacturing skills vanish are less likely to harbor future innovation. Because American companies stopped making LCD displays, for example, there was no domestic expertise to build screens for Amazon’s Kindle reader, even though its crucial technology was developed in Cambridge, Massachusetts. Because expertise in thin-film deposition has moved to Asia with most semiconductor production, Chinese companies have a leg up in solar panel manufacturing.

The academics characterize the ecosystem of innovation as a kind of industrial commons. Every company shares the skills and knowledge that underpin an industry. “The tragedy of the commons is that when a company takes the short-term view, they don’t worry about the value of the commons,” Shih says.

The commons problem is easily seen in an industry like fishing. If one fisherman doubles his effort, he can double his income, but if all of them double their effort, the fishery will be rapidly depleted. Industrial commons are somewhat different, because participants are contributing to the knowledge base and supply chain rather than just consuming resources, but when a company outsources manufacturing it depletes the commons just as surely as overfishing does.

When companies outsource their manufacturing work, suppliers close or move, engineers learn different skills, local colleges drop some job-training courses, and the whole ecosystem shrinks. Even if a given company employs just as many engineers and designers as before, they will be part of a smaller community. In their article, Pisano and Shih noted that lots of knowledge is still transferred among engineers in face-to-face meetings and that according to some research, most industrial knowledge is transferred when people switch jobs. A smaller ecosystem in which manufacturing is delegated to offshore organizations makes such transfers more difficult.

Moreover, offshore manufacturers tend to build on their manufacturing expertise. Driven by pressure to boost profits, they take on a growing share of the design work for many products. Today, except for Apple’s products, nearly all laptops are not only built in Asia but designed there as well.

Shih, who is 57, was a veteran manager at IBM and Eastman Kodak before coming to Harvard in 2007. From his fourth-floor office in a building he shares with marketing and finance professors, he says that now he is able to understand issues that he “couldn’t quite articulate” when he was at Kodak.

For example, he says, he once investigated building a highly automated $400 million plant to build CCD sensors for digital cameras in Kodak’s industrial park in Rochester, New York. But he soon realized that the equipment to make the sensors was available only in Japan, where the video-camera industry had demanded the devices. Kodak could have imported the equipment, but Shih worried that when glitches occurred he would have to wait weeks to get a technician to Rochester, while Japanese competitors could have one on site in minutes. He ultimately decided to form a joint venture with a Japanese company to build a factory in Japan.

Pisano and Shih suggest that both industry and government could make changes to restore American innovation capabilities. In the private sector, they argue, companies should spend more on creating products and less on marketing; articulate a credible long-term strategy to Wall Street and stick to it; accept that R&D outcomes are hard to predict; reinvigorate basic research; and add a committee dedicated to science and technology to each board of directors.

For federal policy, they warn against trying to pick winners among existing companies and industries. (They opposed the auto bailout, although Shih now says it appears to have succeeded, in part by accelerating a needed bankruptcy). They say the federal government should expand funding of basic research and applied research that affects many companies. For example, the Human Genome Project and NASA’s support of work on composite materials have boosted many companies. They also urge funding for research on “grand challenges” like combating climate change, ensuring access to potable water, and developing substitutes for coal; such research, they say, fosters collaboration among academia, government, and industry, creating a new commons. Shih recently told a congressional hearing that the Pentagon should consider the impact on innovation as it cuts its budget.

To illustrate the importance of maintaining a U.S. innovation ecosystem even when an innovation’s value isn’t apparent immediately, Shih points out that rechargeable batteries didn’t seem very important to U.S. companies when the University of Texas licensed lithium-ion technology to Sony two decades ago; hardly anyone in the United States was making consumer electronics. But after Sony introduced the technology in its Walkman in 1991, other Asian consumer-electronics companies also developed rechargeable-battery technology. Later, as rechargeable batteries became an important component of laptop computers, the battery makers honed their skills with manufacturers, which in turn transferred expertise with small consumer electronics into building laptops in Asia. Today, with hybrid and electric cars on the rise, manufacturers in Japan, Korea, and China have a big head start on the technology behind those vehicles.

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