Scandinavia and outsourcing - the importance of continual high investments in both R&D and manufacturing

Scandinavia and outsourcing – the importance of continual
high investments in both R&D and manufacturing
Christian Berggren, Professor in Industrial Management, Linköping University,
presentation EIAS workshop Brussels 061108

Measured by traditional economic parameters Scandinavia incl. Finland is in a very good
position. Together Finland, Sweden and Denmark ranked as no. 2, 3 and 4 on the recently
published list on overall national competitiveness from World Economic Forum. We enjoy
strong economic growth, trade surplus and solid public finances. Actually, it could be argued
that Scandinavia incl. Finland constitutes the most robustly competitive region in the OECD
area. So are there no reasons for worries?

Yes, there are. For at the same time the global economic order is undergoing a major upheaval
driven by an unprecedented “supply shock”, when 100s of millions of new, reasonably well
educated, workers are rapidly entering the world market. Do economists underestimate this
shift? According to a recent study by Swedish economists Mats Persson & Marian Radetzky
they certainly do (ED 1/2006). Their conclusion: ”Either the supply shock will lead to
depressed real wages, or to increasing unemployment.”

The danger is real. In Germany of today we see both. Compared to previous periods of global
industry shifts, there is one important difference. Competition and restructuring is no longer
limited to “low-tech”, “unskilled” sectors, which were successively phased out from countries
such as Sweden in the 1960s and 1970s. Today, competition and restructuring threats are
everywhere: From advanced machining to SW programming to dental services, to financial
back offices. And the supply shock has only started – there are 500 million Indians under age
19. Currently less than 10%, that is 50 millions, graduate from high schools. But in a not too
distant time these numbers may be 20% and 100 million graduating Indians per year. There is
also a supply shock in goods markets. A recent overview in Business Week (Jan. 2006)
presents three examples. In just 4 years, from 2004 to 2008 Chinas is expected to increase its
capacity in
+ Automobiles: from 4 millions per year to 9 millions per year
+ Flat steel: from 130 million to 220 million tonnes yearly

+ In semiconductor manufacturing, a doubling of capacity in the same period.

When manufacturing is outsourced and relocated, politicians tend to talk about upgrading to
more “advanced” activities: media, design, R & D. But such a concentration would never be
able to support an inclusive and differentiated labour market and an ageing population.
Further, these sectors are also under threat, since these growing economies are moving rapidly
up the skill ladder: “A new study that will be presented today to the National Academies, the
nation's leading advisory groups on science and technology, suggests that more and more
research work at corporations will be sent to fast-growing economies with strong education
systems, like China and India. In a survey of more than 200 multinational corporations on
their research center decisions, 38 percent said they planned to ´change substantially´ the
worldwide distribution of their research and development work over the next three years.”
(Steve Lohr, Outsourcing Is Climbing Skills Ladder NYT Febr. 16, 2006

A recent study of Swedish firms i n China concluded: “Our conclusions for the future of
Swedish firms is that in the (increasingly global) environment, a very strong pole of attraction
is required, in the shape of cooperation in cross-functional clusters for development of
leading-edge competence. Otherwise, key operational parts of firms will be systematically
closed-down in Sweden.” (Teknikföretagen 2005). How to cope with and strategically adapt
to this changing international division of labour is a strategic issue, not only for individual
firms but also for national economies. There are no guarantees against falling down. The
report emphasised:
1. “Key operational functions in companies are closely linked to each other.
This (could ) lead to a systematic pattern of relocation: from manufacturing, to product
adaptation and engineering to R&D.”
2. “In less than 10 years the knowledge revolution in China will hit the global market very
powerfully. The crucial question is to make advanced competence in Swedish operations
more competitive and thus safeguard its future here.”
3. “The very low investment level in Swedish industries is worrying.
If staying at the low level of recent years, there is a risk of major production relocations.”
4. Also in the long run, China will exert very strong pull in terms of costs and market
opportunities - both for R&D and manufacturing. This will keep up the pressure to outsource
not only production but also innovation.

The importance of cross-functional clusters for development of leading-edge competence,
highlighted in this report, means it is time to revisit the outsourcing issue and study industries
and employment from the perspective of the filière, the value and production chain. Here it is
important to note differences between industries. In textile and fashion, a radical separation
between design and manufacturing and off shoring of production is perfectly possible. In
other sectors, with interdependent and complex engineering products, the integration of key
competencies seems to be crucial for innovation capabilities, the capability of rapid product
industrialization and market introduction, and the knowledge to make proper sourcing
decisions. Here physical collocation of critical functions, including manufacturing remains
critical importance for successful and timely industrialization and market launch. In these
sectors, a high level of investments in Europe is a prerequisite for long-term sustainable
development. Further, investments need to be linked to an understanding of the close links
between key functions, links between marketing, R&D, manufacturing.

For several years, I and my colleague have conducted studies into the costs and consequences
of outsourcing in the telecom and engineering industries. The results, pointing out the hidden
price-tag of relocation decisions, have attracted a lot of interest and attention in Swedish
industries, and contributed to a more nuanced debate on the importance of manufacturing in
an advanced knowledge economy. Despite the popularity of outsourcing, however, there are
few systematic studies trying to determine the effects on overall firm performance, especially
the effects of outsourcing manufacturing. The long-term effects of outsourcing on firm
competence and innovation capability are even harder to evaluate.

For companies – and industry clusters - competing in complex technology and product
development, there seems to be a real globalization paradox: Global communication has
never been so easy and global transportation never so inexpensive. But because of constantly
increasing pressure to bring new products to market ever more rapidly, the importance of co-
locating R&D and manufacturing is increasing in many technology-leading firms. Below
three examples from Sweden are presented. These examples demonstrate the importance of
continual investment in both R&D and manufacturing in if we are going to take advantage of
globalization.

Case 1. SSAB – Oxelösund. This is heavy steel, a rolling mill for heavy plates at Oxelösund,
south of Stockholm. But why this example? What about the massive Chinese expansion in
flat steel, adding 90 million ton capacity in just 4 years? Isn´t this an industry of the past, soon
to be steamrolled from the East? No, not in this particular segment of the industry.

SSAB has been profitable since the early 90s. Currently, return on capital employed before
tax is 30%, and the prospects for next 8-10 years very good (more we can never know).
What is the secret? SSAB is not competing with Chinese makers. Since 1980s, they have
transformed this facility completely.

One aspect is specialization and Mass customisation. Oxelösund is a very small player in the
world steel industry. But within its niche, quenched heavy plate, it´s a world leader. And this
niche is much more profitable than the general market. In the 1970s, the sold their plates to
shipyards, thousands of tons to each customer. Bulk production and bulk sales. Now they sell
to thousands of customers, world-wide, and only a few ton to each. They produce 650 000
tons of steel per year, and almost every single plate is individually ordered by a customer and
tracked through the production process.

Another aspect is a consistent effort to move from commodity to brand. An example is the
sign “Hardox in my body”, a sign that a customer buying an earth-moving bucket, a truck
body or a container, can trust he has equipment with abrasion resistant steel. This is a way of
making quality pay – but only on the basis of collaboration research, engineering and
marketing. The steel plates from Oxelösund combine high hardness, strength and wear-
resistance, with excellent weldability and machinability, making it much easier to work with
than specialty, high-alloyed steels.     The development of these grades demands a close
interaction marketing – development – process engineering.

And they do require investments, investments, investments – and combining investments
with in-dept in-house process knowledge.          For example: When buying a new rolling
equipment or quenching line, they never order “turnkey deliveries”. They do the automation
part, the key to uninterrupted production, to productivity and precision, in-house.             No
commercial system is good enough. This takes decades to develop, and cultivate it every day,
otherwise it will be lost.

Case 2, Micronic Laser Systems, is a completely different story. Micronic started in the
1990s as a spin-off from university research in laser tech, and was lucky to meet advanced
and patient Korean customers, eager to beat the Japanese with new technology. Now Micronic
is a world leader in laser-based pattern generators for photomasks, which are used for
producing flat screens. From 2002 – 2004 revenues increased with 100%. They continue to
increase as the market expands and the company launches new machines, for example pattern
generators for the much larger semiconductor market, competing head-on with entrenched
Japanese suppliers. List price for a machine of this type could be at least 10 million USD.

Micronic is an R&D intensive organization, almost 50% of its employees are employed in
R&D, and its operating in a very international context. Key suppliers are international, and
located in countries from Germany to the U.S. All customers are Japanese or Korean or
Taiwanese.
An interesting thing is that they also do machine assembly at their man site in Sweden. It
takes several 1000 hours to build and test each machine in Micronic´s assembly plant north of
Stockholm. During the final weeks in the clean room, customer representatives participate
and check all the tests. Then the machine is prepared for transportation, and together with the
installation team sent by air to Korea or Taiwan. Here the team spends several more weeks in
installing and commissioning the machine before returning to Sweden. So why not separate
R&D from manufacturing, and do all assembly in East Asia, close to customers?

The simple answer is: Because machines are so technologically complex, technologies are
developing so rapidly, quality requirements so high and production runs so small – Micronic
never builds any prototype machines. Each pattern generator is delivered to a customer.
And because of all that: Constant interaction between R&D and assembly is an absolute
requirement, and there is also an intensive interaction when customers visit the clean room
during final assembly and testing. The test & commissioning team of the plant then goes to
the customer sites, and then comes back with new lessons…..
Micronic       this   combines   separation   and   integration:   far-flung   internationalisation,
specialization and spread in some areas requires intensive collocation and interaction in some
other areas.

Case 3 is about a mature product, easy to understand: SCANIA heavy trucks. Consistently,
over business cycles, Scania has been the most profitable heavy truck producer in the world.
If you look at American truck building companies – only few are left – production simply
equates assembly of components developed and manufactured by others. Quite the opposite at
Scania. This company both develops and manufactures all key components (except injection
systems). Less than 10 years ago, the company discussed to close the final chassis assembly
at their main site in Södertälje, and move all these type of activities to a large-scale plant in
continental Europe. Why did they choose not to? The basic reason is the need for extended
and intensive interaction development – manufacturing. You may think this is a mature
product, same basic architecture for a century. And yet there is a strong need for intensive
collaboration. The reason is simple: Communication systems may have improved, but at the
same time the pressure on lead time, quality and delivery precision when customer production
starts has increased even more.

Now, some of you might argue that the telecom industry is quite different; here companies
such as Nortel and Ericsson have been able to completely outsource manufacturing. True,
Nortel has done so. But that’s mainly because they´ve been on the ropes, very close to
bankruptcy. Ericsson adopted an official policy in year 2000, outsourcing all volume
manufacturing, while keeping industrialization in-hose. This was never fully implemented.
Currently Ericsson stresses the importance of having important parts of the volume
manufacturing process of core products in-house. Otherwise there will be no efficient
industrialization. An important reason is the rapid technological development .Introducing
new products and components are more important than squeezing the production costs in
existing lines,

As pointed out in the introduction, there are few studies on the consequences of outsourcing
manufacturing. Last year one of the first international publications was released, based on a
systematic study of 200 Dutch manufacturing firms (Mol, van Tulder and Beije in
International Business Review, 14, 2005). They arrived at similar conclusions as our study:
“The empirical evidence presented in thus paper also suggests international outsourcing is not
the performance-enhancing tool that some ascribe it to be….Although firms may gain from
internationalisation of sales, assets and manufacturing, they do not gain noticeably from
internationalisation of outsourcing. …/Thus/ International outsourcing is a balancing act
between lower production costs abroad and lower transactions costs locally.”

These findings and the cases presented above provides insights why competence for
industrializing and producing products incorporating the newest technologies may acquire
new importance for Western firms, in spite of the global search for lowest-cost locations. A
reassessment of simplistic beliefs in irresistible relocation trends would have implications
both for R&D management within firms, and for the broader industry and science policies in
Europe.

References to research
Berggren, C. and S. Laestadius. 2003. Co-development and Composite Clusters - the Secular
Strength of Nordic Telecommunications. Industrial and Corporate Change, 12, 1, 91-114.

Berggren, C. & Bengtsson, L. 2004. Rethinking outsourcing in manufacturing – a tale of two
telecom firms. European Journal of Management, Vol. 22, No. 2, 211-223.

Berggren, C. 2004. Global dreams – local teams. International Journal of Innovation
Management. Vol. 8, 3, 115-145.

Bengtsson, L., Berggren, C., Lind, J. (ed) 2005. Alternativ till outsourcing: Lund: LIBER.

Lakemond, N. & Berggren, C., 2006. Co-locating NPD? The Need for Combining Project
Focus and Organizational Integration. Technovation. 26, 807-819.

Berggren, C. & Lars Bengtsson, 2006. The integrator´s new advantage - reassessing
outsourcing and production competence in the global telecom industry, R&D Management
Conference, 5-7 July Lake Windemere, England