Decline and fall of Western Manufacturing - a pessimistic reading of Pisano and Shih (2009)

Those who don't know history are condemned to repeat it.

Unfortunately those of us who do know history get dragged right along with the others, because we live in a world where everything is connected to everything else.



Above is my visualization of Pisano and Shih's 2009 Harvard Business Review article "Restoring American Competitiveness." This is a stylized version of a story that has happened in several industries.

Step 1: Companies start outsourcing their manufacturing operations to companies (or countries) which can perform them in a more cost-effective manner. Perhaps these companies/countries have cheaper labor, fewer costly regulations, or less overhead.

Step 2: Isolated from their manufacture, companies lose the skills for process engineering. After all, improving manufacturing processes is a task that depends on continuous experimentation and feedback from the manufacturing process. If the manufacturing process is outsourced, the necessary interaction between manufacturing and process engineers happens progressively more inside the contractor, not the original manufacturer.

Step 3: Without process engineering to motivate it, the original manufacturer (and the companies supporting it in the original country, in the diagram the US) stops investing in process technology development. For example, the companies that developed machine tools for US manufacturers in conjunction with US process engineers now have to so do with Taiwanese engineers in Taiwan, which leads to relocation of these companies and eventually of the skilled professionals.

Step 4: Because of spillovers in technological development between process technologies and product technologies (including the development of an engineering class and engineering support infrastructure), more and more product technology development is outsourced. For example, as fewer engineering jobs are available in the original country, fewer people go to engineering school; the opposite happens in the outsourced-to country, where an engineering class grows. That growth is a spillover that is seldom accounted for.

Step 5: As more and more technology development happens in the outsourced-to country, it captures more and more of the product innovation process, eventually substituting for the innovators in the original manufacturer's country. Part of this innovation may still be under contract with the original manufacturer, but the development of innovation skills in the outsourced-to country means that at some point it will have its own independent manufacturers (who will compete with the original manufacturer).

Pisano and Shih are optimists, as their article proposes solutions to slow, stop, and reverse this process of technological decline of the West (in their case, the US). It's worth a read (it's not free but it's cheaper than a day worth of lattes, m'kay?) and ends in an upbeat note.

I'm less optimistic than Pisano and Shih. Behold:

Problem 1: Too many people and too much effort dedicated to non-wealth-creating activities and too many people and too much effort aimed at stopping wealth-creating activities.

Problem 2: Lack of emphasis in useful skills (particularly STEM, entrepreneurship, and "maker" culture) in education. Sadly accompanied by a sense of entitlement and self-confidence which is inversely proportional to the actual skills.

Problem 3: Too much public discourse (politicians of both parties, news media, entertainment) which vilifies the creation of wealth and applauds the forcible redistribution of whatever wealth is created.

Problem 4: A generalized confusion between wealth and pieces of fancy green paper with pictures of dead presidents (or Ben Franklin) on them.

Problem 5: A lack of priorities or perspective beyond the immediate sectorial interests.

We are doomed!

Two quick thoughts about Microsoft's purchase of Skype

1. Valuation of a property like Skype is a lot more than just some multiple of earnings.

Quite a few bloggers, twitterers, and forum participants jumped on Facebook, Google, and Microsoft for their billion-dollar valuations of Skype. Usually the criticism was based on Skype's lackluster earnings. This is a massively myopic point of view.

One can acquire a company for many reasons beyond its current revenue stream: the company may own resources that it is not adequately exploiting, such as technology or highly valuable personnel; it may have a valuable brand or a large user base (which is certainly true for Skype); it may have valuable information about its customers (again true for Skype as the communication graph -- not just the link graph -- is valuable); and finally, the company may have untapped revenue potential, just not with their current revenue model.

As a general rule, just because one cannot think of a way to monetize something, it doesn't mean that there is no way to monetize that thing.

Another possible reason to buy a company is strategy at a corporate level: to stop it from developing into a competitor for some of our products, to stop competitors from buying it (and therefore becoming better competitors), and to signal commitment to a specific market.


2. Perhaps there's a little Winner's Curse going on here, or perhaps not

When three companies (Google, Facebook, and Microsoft) compete for the same company, there's always the possibility of a little Winner's Curse effect:

 Assume that the value of Skype to these companies includes a big fraction that is common, meaning that it will be realized independent of the owner. Call that true common value $v$. To simplify, for now, assume that there are no synergies or strategic advantages for any of the buying companies; so the whole value is $v$.

Using all the information available, Google, Facebook, and Microsoft estimate $v$, each coming up with a number: $\tilde v_G$, $\tilde v_F$, and $\tilde v_M$. Note that these are estimates of the same $v$, not a representation of different actual value that Skype might have for these three companies. The estimates are different because each company uses different financial models and has access to different information or weighs it differently.

In a competitive market the winner will be the company who has the highest estimate, so we can assume that $\tilde v_M > \tilde v_G$ and $\tilde v_M > \tilde v_F$. The question now becomes: is what Microsoft paid for Skype higher than $v$ (the true $v$)?

Probabilistically the winning $\tilde v$ is likely to be higher than $v$,* since it's the maximum of three unbiased estimates -- one hopes these three companies have good financial advisers -- of the true $v$. Microsoft knows this and may shade its offer down a little from $\tilde v_M$. But even so, there's a chance that it paid too much.

Except that we're ignoring all the non-common value: synergies, strategic fit with Microsoft's other properties, and signaling to the market that Microsoft isn't yet a zombie like IBM was in the '90s.

There's a lot going on between Skype and Microsoft that the online comentariat missed. Then again, that's the fun of reading it.

(Hey, I finally wrote a business post in this blog that I repositioned as a business blog over a month ago!)

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* If the distribution of the errors in estimates of $v$ is symmetrical around zero (ergo the median of $\tilde v$ is $v$), the probability that the maximum of three observations $\tilde v$ is higher than $v$ is $7/8$.