Feature

Innovation Ships Out

U.S. computer makers such as Dell, Motorola and HP are outsourcing not just the manufacture but the design of new products to offshore companies. Could this be the end of America's innovative edge in electronics?

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By Christopher Koch

January 15, 2005 — CIO — Buy a laptop anywhere in the world and there is a one-in-four chance that T.J. Fang will process the order. You'll just never know it.

Fang's secret is cloaked in IT, in servers that consolidate purchase orders from name-brand American companies such as Hewlett-Packard, Apple and IBM. The order trail leads to Fang's ERP system at Quanta Computer in Taipei. Fang, assistant vice president and head of IT operations at Quanta, feeds those orders to his Taiwanese and Chinese suppliers and factories, and within five days, Quanta "drop ships" to the customer a laptop that the buyer himself configured on the brand-name website. No one at the company selling the laptop ever lays a finger on it. Indeed, investment bank Morgan Stanley estimates that the manufacturing for 89 percent of American brand-name laptops are outsourced today. What's more, many of these famous computer brand names don't even design their machines anymore. New models are chosen from a shelf of fully functioning prototypes offered up by a handful of Taiwanese companies. Quanta's ability to design and build new laptops from scratch has helped it gain a 25 percent share of all laptops sold in the United States. "In the past 10 years, [companies such as Quanta] have gone from undercover stealth to a massive global business," says Adam Pick, senior analyst for iSuppli, a market intelligence consultancy.

Outsourcing has reached the highest level of the manufacturing supply chain: R&D. By outsourcing R&D offshore, original equipment manufacturers (OEMs) can freeze a portion of their R&D budgets while growing their product offerings. Even R&D powerhouses such as IBM, HP and Motorola have frozen—or even reduced—their R&D budgets since 2000. "[Outsourcing] is a tremendous opportunity for cost savings on R&D," says Jack Faber, vice president of operations, enterprise systems for HP.

But there may be a downside to all this R&D reshuffling. Some economists say the outsourcing of manufacturing—and now design—is the leading edge of a longer-term trend toward reduced innovation and competitiveness among U.S. companies. As OEMs turn over the development of new products to outsourcers, it could have a withering effect on these companies' ability to create the next breakthrough, especially as many freeze R&D spending. Spending on R&D by U.S. companies declined more in 2002 (3.9 percent) than it has since the National Science Foundation began tracking the number in 1953.

Though the technology slump that began in 2000 may play a big role in these declining R&D numbers, there is a larger, more disturbing trend at work, argues Gregory Tassey, senior economist at the National Institute of Standards and Technology (NIST). For the past 12 years, the proportion of R&D money going toward new innovation—the "R" in R&D—has also been going down, displaced by incremental product development (next year's laptop, for example). Product development—the "D" in R&D—swallows more resources than the "R" work, and it does not create new opportunities for revenue; it merely extends current product categories.