Modularity and innovation in knowledge intensive business services the case of IT outsourcing.doc

modularity and innovation in knowledge intensive business services: the case of it outsourcing our first acknowledgement is to the financial support of the anglo german foundation. we are grateful for research assistance from paulina ramirez who helped to formulate the interview questions and organise and conduct some of the interviews. we are also grateful for the contribution of matthias knuth and thorsten kalina who helped to formulate the interview questions and organise two interviews in germany. an earlier version of this paper was presented at the workshop knowledge-intensive services and changing organisational forms, institute of innovation research, umist/ university of manchester, november 26-27, manchester 2003. we are grateful for the comments of the participants: rod coombs, jeremy howells, glenn morgan, bart nooteboom, mikkel overby, bruce tether, richard whitley and leslie willcocks. we are especially grateful for the detailed comments of mark lehrer, which helped to reformulate the main argument. marcela miozzo and damian grimshaw,manchester school of management,umist, p o box 88,manchester m60 1qd, ukmarcela.miozzoumist.ac.ukdamian.p.grimshawumist.ac.ukmarch 2004abstractdrawing on case-study research on it outsourcing in germany and the uk, this paper explores the relevance of modularity for understanding it outsourcing. standard contracts have been agreed between suppliers and clients; however, because of the inseparability of information from production technologies, the interface between the client and supplier organisations requires extensive management effort. this includes the need to transfer staff with firm-specific skills and the retention of an in-house organisation to coordinate the link between the it and business strategies of the client. conflicting objectives between client and suppliers may bring into question the sustainability of innovation, calling for policy to realise the presumed beneficial effects of the growth of knowledge-intensive business services.keywords: it outsourcing, knowledge-intensive business services, modularitymodularity and innovation in knowledge intensive business services:the case of it outsourcingintroductionalthough it outsourcing has been an accepted business practice for over two decades, it has shown remarkable growth in recent years and has been the engine of growth for the software and computer services market. its nature, however, has changed dramatically. it outsourcing has matured from a commodity service to risk/rewards partnerships. in several countries (such as the uk, the usa and germany), large contracts (mega-outsourcing) have been agreed between a small number of multinational computer services suppliers and large client organisations, including central and local governments and large services and manufacturing firms. many of these contracts were seen as having a number of problems, including excess fees, declining services, inability to adapt to changing business and technology needs, loss of power to monopoly suppliers and inability of the clients to manage the interface with the suppliers (lacity and hirschheim 1995, willcocks and fitzgerald 1994a, lacity and willcocks 2001). however, and despite the above problems, large-scale it outsourcing is still continuing. one of the problems in explaining the continuity of large-scale it outsourcing is that existing studies apply theoretical approaches which offer limited explanatory power. for example, it is argued that firms externalise their it activities because they can either save on costs/risks (the transaction cost perspective) or focus on their core competences (lacity et al. 1994a). little attention has been paid to wider changes in production systems. indeed, while there have been a number of contributions examining the nature and impact of it outsourcing (starting with buck-lew 1992, lacity and hirschheim 1993, loh and venkatraman 1992) and its implications for it management (early examples include grant 1992, huber 1993, quinn 1992), less attention has been paid to it outsourcing in the context of broader organisational strategy and the implications for innovation and for the distribution of expertise in emergent organisational forms. this paper draws on the literature on modular production systems (baldwin and clark 1997, langlois and robertson 1995, sanchez and mahoney 1996) to explore it outsourcing. virtually all the literature on modularity concerns manufactured goods. examples of products with modular design include aircrafts (woolsey 1994), software (cusumano 1991, von hippel 1994), personal computers (langlois and robertson 1992) and power tools (utterback 1994). this paper seeks to open up the research agenda by focusing on modularity - especially the standards and interfaces - of knowledge-intensive business services.knowledge-intensive business services are those services that support business processes and which require high levels of skills and knowledge, advanced technology (especially information and communication technologies) and strategic input (miles 2001). examples include management consultancy services, computer and software services, legal and accountancy services, engineering services and research and development services. the rise of knowledge-intensive business services is, to a significant, extent, the outcome of the increased technical and social division of labour within manufacturing production (miozzo and soete 2001, daniels and moulaert 1991). given the rapid rate of technological change and the sophistication and variety of the services required, there has been a tendency to contract services from outside independent service producers or to set up subsidiary service firms. thus, knowledge-intensive business services, which were historically internalised in the large corporations have been externalised over the last three decades. but a great deal of the growth of knowledge-intensive business services is more than simple externalization as many outsourced service functions are significantly different from those supplied previously in-house and respond to new needs by client firms (miles 2003).there is much evidence to suggest that client organisations benefit from external sourcing of knowledge-intensive business services. knowledge-intensive business services tend to be very it-intensive, and are thus expected to play a desirable role in shaping economic growth through the diffusion of technology (antonelli 1998, katsoulacos and tsounis 2000). they are also expected to promote investment in workers skills (peneder et al. 1999, wolff 2002). moreover, they form important intermediaries and nodes in innovation systems and may even complement the traditional knowledge infrastructure of government labs, research organisations and universities (den hertog 2000, miles 2002). however, there has been much less analysis of what happens at the interface of individual firms. one of the fundamental characteristics of knowledge-intensive services is client participation in the production of the service (also called co-production). because of the intangibility of services, uncertainty regarding the quality of services often requires close and continuous interaction between clients and suppliers (miles 1993). indeed, customer involvement in the provision of services has been referred to variously as interface, interaction, co-production, servuction, socially regulated service relationship and service relationship (gadrey and weinstein 1997). this suggests that the capacity to interface effectively with knowledge intensive business services will strongly shape the impacts of their use (tomlinson 2001, miozzo and miles 2002, miles 2003) this paper addresses modularity and innovation in knowledge-intensive business services by drawing on evidence of it outsourcing in germany and the uk. section 1 reviews the arguments in the innovation literature on how increased vertical disintegration, aided by the standardisation of the rules of the game, can provide fertile ground for innovation. section 2 examines the particular case of it outsourcing, which poses additional questions regarding the boundaries, co-ordination and control of the modern firm. section 3 presents our case study findings from it outsourcing contracts around three issues: inseparability of production and information technologies, new forms of coordination and control, and conflict between supplier and client organisation. section 4 draws implications of it outsourcing for the modularity of knowledge-intensive business services. 1. vertical disintegration and the theory of the firm vertical disintegration and specialisation is perhaps the most significant contemporary organisational development of the corporation. information technology is seen as a critical component both in driving organisational change and in enabling enterprise restructuring. to understand these developments, economists are reaching out for their dusty copies of the books of adam smith and alfred marshall. as argued by krugman,“the end of the corporation as we know it a victim of information technology, which ended up deconstructing instead of reinforcing the corporation. the millenial economy turns out to look more like adam smiths vision- or better yet, that of the victorian economist alfred marshall than the corporatist future predicted by generations of corporate pundits.” (krugman, 1999)vertical disintegration and specialisation can be seen at two levels. on the one hand, small entrepreneurial firms in traditional small-firm networks in italy and germany and the high tech firms in silicon valley are able to exploit horizontal synergies of large organisations (best 1990, 2001, brusco 1982, herrigel 1993, sabel et al. 1989, saxenian 1994, piore and sabel 1984). on the other, large firms in japan decentralise their production to subcontractors, enjoying the scale of large firms and the flexibility of small production units (best 1990, aoki 1990). more recently, attention has turned to the vertical (and horizontal) disintegration of large us firms, which increasingly outsource and refocus their activities (zenger and hesterley 1997, holmstrom and roberts 1998, prahalad and hamel 1990). shortening lifecycles, faster technology development and increasing product differentiation are seen as placing severe pressures on the capacity of the firms in all areas, with firms seeking to outsource non core functions. by tapping production networks, leading firms are finding new ways to exert market power without the costs and risks of supporting a gigantic organisation (sturgeon 2002).these changes in organisation form and their impact on innovation have been analysed by a variety of authors. there is some agreement that internal organisation is superior to arms-length-contracting for innovation. different explanations have been offered for this. for teece (1986), the key lies in complementary assets, for silver (1984) the advantages are in informational terms. the danger of de-verticalisation is that firms may shed competences that could become core in the future. indeed, teece (1986) argues that appropriation of returns on core capabilities require access to complementary assets. therefore, many non core competences may be important too. however, recent contributions in the innovation literature suggest that the large integrated firm may be less relevant to innovation in periods of rapid technological change. langlois and robertson (1992) suggest that large size and vertical integration are of little benefit in coordinating across the boundaries of the larger system, especially in the early stages of development, where experimentation is a much more important concern than coordination. when innovation is not systemic, it may proceed faster in a decentralised system because of its ability to utilise a more diverse set of information (langlois and robertson 1993, 1995). also, the danger of de-verticalisation can be averted by retaining absorptive capacity (nooteboom 2003). as argued by cohen and levinthal (1990), a firm needs to develop absorptive capacity in order that it may read its external technological environment and that it can draw upon that external knowledge as and when appropriate. this absorptive capacity is largely a function of the firms level of prior related knowledge.also, in complex products and production processes, there are strong technical interdependencies between what firms develop and make themselves, and what they require from their suppliers of machinery, components, software and materials (grandstand et al. 1977). in addition to a focus on a number of distinctive technological competences, management in large firms needs to sustain a broader (if less deep) set of technological competences in order to coordinate continuous improvement and innovation in the corporate production system and supply chain. furthermore, they must do this in order to explore and exploit new opportunities emerging from scientific and technological breakthroughs (ibid.). indeed, the technologies and other capabilities required for certain innovations are now less frequently located within single firms and increasingly distributed across a range of firms and other knowledge-generating institutions. as a result of this increasingly complex division of labour in the generation of technology, innovations require the coordination of these existing capabilities and possibly, the generation of new combinatorial capabilities (coombs and metcalfe 2000)building on these ideas, the developments in the literature on innovation in complex products and systems (davies and brady 2000, gann and salter 2000, hobday 2000, prencipe 2000) focus on how innovation occurs in complex, high value capital goods (such as telecommunication exchanges, aircraft engine control systems and intelligent buildings) produced by firms working together in projects. a key characteristic of loosely coupled network organisations is the presence of a systems integrator firm, which outsources detailed design and manufacturing to specialised suppliers while maintaining in-house concept design and systems integration capabilities to coordinate the work of suppliers.the literature on modular production systems presents the characteristics and advantages of building a complex product or process from smaller subsystems that can be designed independently yet function together as a whole (sanchez and mahoney 1996, baldwin and clark 1997). first, modularity is said to give full rein to the benefits of the division of labour by reducing the degree of interdependency among, and thus the costs of communicating across, the parts of the system (langlois 2002). the advantages include that suppliers can improve capabilities narrowly and deeply (langlois and robertson 1995). second, a modular system is said to open the technology to a much wider set of capabilities, and can benefit from external capabilities of the entire economy (langlois 2003). a modular system is said to facilitate the testing of many approaches simultaneously and allow for many entry points for new ideas (rapid trial-and-error-learning) (nelson and winter 1977) for autonomous (rather than for systemic) innovation. third, modularity can generate economies of substitution (garud and kumaraswamy 1995) or external economies of scope (langlois and robertson 1995) which substitute for internal coordination. by designing modularly upgradable systems, firms can reduce product development time, leverage their past investments, and provide customers with continuity. two important system attributes for realizing economies of substitution are modularity (the ease with which system designers can substitute components) and upgradability (the opportunity to work on an established technological platform) (langlois and robertson 1995).langlois (2003) has recently attempted to explain the origins of vertical disintegration (without rejecting chandlers contribution). he argues that vertical disintegration (the vanishing hand) is a further continuation of the smithian process of division of labour in which chandlers managerial revolution was a way-station (langlois 2003). the vanishing hand is driven not just by changes in coordination technology but also by changes in the extent of markets (see adam smith and young 1928), “in many respects the structure of this new model looks like that of the antebellum era than like that of the era of managerial capitalism. production takes place in numerous distinct firms, whose outputs are coordinated through market exchange broadly understood. it is in this sense that the visible hand of management is disappearing. unlike the antebellum structure, however, the new economy is a high-throughput system, with flows of work even more closely coordinated that in a classic chandlerian hierarchy.” (langlois 2003, p. 373)langlois (2003) argues that this decentralised production involves a broadening of capabilities and decoupling from specific products, carrying on from the chandlerian firm. just as did the high-throughput technologies of classical mass production, modular systems require and arise out of standardisation albeit in a particular form. langlois (2003) points out the difference with mass production,“unlike classical mass-production technologies, which standardise the products or processes themselves, modular systems standardise something more abstract: the rules of the game by taking standardisation to a more abstract level, modularity reduces the need for management and integration to buffer uncertainty. one way in which it does so is simply by reducing the amount of product standardisation necessary to achieve high throughput.” (langlois 2