The dominance of SMEs: a source of flexibility

SMEs have been the main carriers of Taiwan’s rapid development and remain

important today. In 1993, SMEs accounted for 96 percent of the total number of

companies, 69 percent of total employment, and 55 percent of Taiwan’s

manufactured exports (Chen et al. 1995). Taiwan today is home to more than 4,

000 electronics firms that produce a broad mix of PC-related products and

electronic components. With a few exceptions, such as the Tatung group, almost

all of these companies started out as small enterprises.

The role of SMEs as engines of growth and industrial transformation sets

Taiwan apart from South Korea, where huge and highly diversified

conglomerates (chaebol) have been the main carriers of the development of the

electronics industry.10 Almost without exception, the chaebol have targeted those

segments of the electronics industry that require huge investment outlays and

sophisticated mass production techniques for fairly homogeneous products such as

microwave ovens (MWOs), TV sets, VCRs, computer monitors, picture tubes,

and computer memory, especially dynamic random access memory (DRAM).

The result has been a heavy focus on assembly-type mass production activities

related to lower end consumer products and standard electronic components, and

weakness in more design-intensive sectors of the computer industry.

Why have Taiwanese firms succeeded in the computer industry while their

much larger and resource-rich Korean counterparts have largely failed? The answer lies in the fundamental characteristics of an industry in which high

volatility and uncertainty put a premium on flexibility and the capacity to adjust

to abrupt and frequently unexpected changes in demand and technology. Small

firm size is even an advantage.11 By combining incremental product innovation

with incredibly fast speed-to-market, Taiwanese firms have been able to establish

a strong international market position relatively early in the product cycle.

The primary source of this flexibility appears to be the specific organization of

the domestic supply base in Taiwan, especially for parts and components. Two

main features of this domestic supply base have contributed to the flexibility of

Taiwanese producers, the first being an extreme form of specialization. By

engaging in single tasks and by producing, purchasing, and selling in small lots,

subcontractors avoid heavy fixed capital costs. This, in turn, makes it relatively

easy to shift production at relatively short notice, and with a minimum of costs. The

second feature is a certain network structure of multiple, volatile and short-term

links that involve only limited financial and technology transfers. Spot-market

transactions play an important role, but so do “temporary spider web”

arrangements that are assembled for the duration of a particular job.12

The result of these characteristics is an extreme form of open and volatile

production networks, arguably even more so than the highly flexible production

networks that characterize California’s Silicon Valley.13 Firms maximize the

number of jobs in order to compensate for the razor-thin profit margins; as a

result, they avoid being locked into a particular production network. Domestic

supplier networks thus have been highly flexible and capable of rapid change but

are short-lived and foot-loose.

If flexibility constitutes one prerequisite for Taiwan’s competitive success in

computers, economies of scale and scope and speed-to-market have been of equal

importance.14 Entry barriers have increased for those stages of the value-chain

that are of critical importance for competitive success, including particularly

component manufacturing, where production-related scale economies remain

important. But the epicenter of competition has shifted beyond manufacturing to

R&D and other forms of intangible investment required to complement price

competition with product differentiation and speed-to-market. Only those

companies that are able to get the right product to the highest volume segment of

the market at the right time can survive. Being late is a disaster, and often forces

companies out of business.

In sum, what really matters for competitive success are substantial investments

in the formation of a firm’s technological and organizational capabilities. How

were Taiwanese computer companies able to successfully compete in an industry

where size-related advantages are of critical importance? And, more specifically,

what kind of organizational innovations have enabled Taiwanese firms to

overcome their size-related disadvantages?

In order to answer these questions, we need to examine issues of specialization

and coordination. Andersen (1996) has recently provided an interesting theoretical

explanation why excessive specialization may involve substantial trade-offs.15 He shows that as an economy becomes more specialized it increases the pressure for

standardization. This, in turn, may constrain innovation.16 The solution to this

dilemma is the establishment of tight linkages between firms along the supply

chain that enhance the prospects for inter-firm learning, for instance between end

product manufacturers and component suppliers.17

To understand how Taiwan avoided the dangers of excessive specialization and

established tight inter-firm linkages, it is important to correct some popular

misconceptions of the Taiwanese model. This is not an economy characterized by

atomistic competition. SMEs do play an important role, yet they survive as a

result of a combination of four forces: government policies that facilitated market

entry and upgrading; strong linkages with large Taiwanese firms and business

groups; the presence of foreign sales and manufacturing affiliates; and early

participation in international production networks.

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Firm-specific

Finally, firm-specific features also play an important role in shaping the

organization of international production; I focus here on two: size and strategic

focus.

One of the peculiar features of Japan’s international production networks in

electronics is the substantial role played by small and medium-sized enterprises

(SMEs).21 SMEs have higher OPRs than their large, vertically integrated

counterparts. This is true for smaller firms that produce final products but have a

quite narrow product focus, such as Aiwa (whose OPR exceeds 85 percent) or

Uniden (with an OPR close to 100 percent), but it is also true for the hundreds of relatively small subcontractors and component suppliers that have moved

production offshore to Southeast Asia and China.

This finding is somewhat surprising. Small firms have limited resources and

capabilities, many of them lack strong proprietary assets, and international

production involves transaction costs that most SMEs may simply be too small to

shoulder. Small firms can bypass such size-related barriers to internationalization if

they are part of a network centered around a core firm that reduces the

transaction costs involved in international production, such as the hierarchical

supplier networks that traditionally have characterized the Japanese electronics

industry. Small firms can also compensate for their size-related disadvantages by

limiting the geographic scope of their foreign investments. While large firms have

dispersed their production activities around the world, medium-sized firms cluster

their overseas operations in Taiwan, Korea, and Singapore; small firms are

concentrated mainly in Taiwan, but recently have expanded into China. Despite

a rapid growth of international production, smaller Japanese electronics firms rely

on a very limited international division of labor.

Even if product and size are held constant, however, it is important to

underline that substantial differences may remain across firms. This can be seen by

looking at consumer electronics and comparing Sanyo, the pioneer in establishing

Asian production networks, with the Matsushita group and Sony.

Sanyo’s founder was the brother-in-law of Konosuke Matsushita, who took

over most of the operations of the Matsushita group when it was broken up

under the US Occupation Authority. In Japan, Sanyo always remained a secondtier

competitor, and compensated with an aggressive early shift into international

production. In the early 1970s, Sanyo developed the so-called “one-third”

strategy for manufacturing capacity—one-third domestic manufacture for the

domestic market; one-third domestic manufacture for foreign markets (especially

higher-end segments); and one-third foreign manufacture for foreign markets. Sanyo aggressively focused its international production and sourcing on East Asia

in the second half of the 1970s, much earlier than any of its Japanese rivals.

Matsushita Electric Industrial Co. Ltd (MEI) is the world’s largest manufacturer

of consumer electronics and household appliances. Since the mid-1980s, it has

diversified aggressively into communications and factory automation equipment,

semiconductors, and video software, with the result that today the share of

industrial electronics and electronics components in its overall sales is roughly

equal to the share of consumer and household goods. For quite some time, this

giant conglomerate has been run like a loose network of (almost) independent

business units, with headquarters playing the neutral role of an arbiter. As long as

markets kept growing, this loose network organization was widely considered to

be a great strength, as it enabled the company to remain reasonably flexible

despite its huge size (Imai 1988). However, as demand growth slowed the hidden

costs of excessive decentralization and decision autonomy, such as duplication,

foregone economies of scale and self-generated price pressures became apparent.

Matsushita’s core competencies traditionally have been size-related advantages

in distribution and high-end manufacturing (in specialized affiliates like

Matsushita Kotobuki). It had tight control over the domestic distribution

channels for consumer electronics, and thus its expansion activities in East Asia

were geared more to the heavily protected domestic markets than to the

establishment of low-cost export platform production. Once Matsushita decided

to move to export platform production, however, it was able to do so on a

massive scale, rapidly neutralizing whatever first-mover advantages Sanyo may

have developed.

Sony, together with Sanyo, has one of the highest OPRs among large

diversified Japanese electronics firms; yet, its overseas production has remained

focused almost exclusively on the United States and Europe. Only since the late

1980s has the company begun to invest seriously in the development of an Asian

production network. Sony’s approach to international production reflects some

peculiar features of this company that have shaped its strategy. In 1952, when

Sony purchased a license for Western Electric’s transistor patent and began to

produce transistor radios under the model name Sony, the company decided to

focus on the high-income and high-growth markets in the United States and

Europe. Right from the beginning, the firm sought to develop its own brand name

image. Akio Morita, the company’s charismatic co-founder, spent considerable

time and energy on developing direct links with large US retailers to ensure that

Sony’s products would receive sufficient floor space.

Owing to the tremendous success of this strategy, Sony was under much less

pressure to internationalize than its rivals, who lacked similar image recognition

and concentrated on Asian markets. Sony was also reluctant to shift to export

platform production in East Asia and invested heavily in the automation of its

European and North American plants, including those in Mexico. Today Sony’s

Asian production networks are still relatively underdeveloped, but they are also

much less burdened than Sanyo and Matsushita with “deadwood,” surplus

capacities and duplication.

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The Taiwanese model in the computer industry

It would seem self-evident that small companies would not be competitive in a

knowledge-intensive industry that is highly globalized.1 Small firms, by

definition, have limited resources and capabilities and thus are unlikely to possess

substantial ownership advantages. They also have a limited capacity to influence

and shape the development of markets, market structure, and technological

change. One would thus expect SMEs to be ill-equipped to compete in an

industry that requires a broad range of fairly demanding technological and

organizational capabilities.

The disadvantages of small size for firms are compounded if they come from small

countries. Small nations are confronted with four types of size-related

disadvantages:2 (1) the small domestic market places tight restrictions on the ability

to function as a buffer against heavy fluctuations in international demand; (2) it

constrains the development of sophisticated “lead users”3 that could stimulate

innovation; (3) it also limits the scope for technological spillovers;4 and (4) the

limited size of the national knowledge and capital base restricts the choice of

industries in which such small nations might successfully specialize.

Taiwan’s experience, however, tells a different story: SMEs have been the main

carriers of its rapid development. Despite the dominance of SMEs, Taiwan today

has the most broadly based computer industry in Asia outside of Japan. The

country has diversified beyond core PC-related products into a variety of related

high-growth market segments; it has improved its domestic production capabilities

for a number of high value-added components; and it has been able to move

beyond manufacturing into a range of higher end support services.

This article inquires into how this was possible. Its message can be

summarized by paraphrasing John Stopford (1996), “innovations in strategy and

organization can change the ‘rules of competition’ and overturn many scale

advantages to permit David to grow in the shadow of Goliath.” I argue that two

factors have been critical for this outcome: active, yet selective and continuously

adjusted industrial development policies; and a variety of networking linkages

with large firms, both domestic and foreign. I show how government policies

facilitated the initial market entry of SMEs and were adjusted over time to

promote continual upgrading and adjustment. Industrial development policies on

their own, however, are insufficient to explain Taiwan’s success.

Taiwanese computer companies also benefited from the specific form of the

production networks they created. These offer a variety of linkages that facilitate

learning and capability formation. Such linkages include strong ties with large

Taiwanese business groups, foreign sales and manufacturing affiliates and an early

participation in international production networks (IPNs) established by foreign

electronics companies. By and large, these features that sustain Taiwanese leadership

in many segments of industrial electronics have been little altered by the Asia

crisis. If anything, the crisis has reinforced Taiwanese advantage: benefiting from a

domestic economy least affected by the region’s economic problems, Taiwanese

firms have invested aggressively to enhance their regional position and expand the

scope and capability of their production networks.

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A move towards systemic rationalization

Confronted with drastic changes in technology as well as in its major markets, the

Japanese electronics industry is undergoing a period of turmoil. Two fundamental

changes in technology are upsetting prevailing market structures. First,

digitalization implies that performance features of consumer devices are defined

by integrated circuits, with the result that market leadership positions based on

analog technology can no longer be taken for granted. Second, the spread of

“multimedia” applications implies a convergence of computing, communications,

and consumer-related technologies. Computer companies have entered

competition for consumer mass markets, and software and entertainment

programming capabilities have grown in significance.

Japan’s big integrated electronics makers have been able to strengthen their

position in the consumer sector. For example, Toshiba recently succeeded in

establishing its DVD (digital video disk) format as the de facto industry standard for

the next generation of recording disks, and traditional leaders in the consumer

electronics industry, especially the Matsushita group, Sony, and Sanyo, have

transformed themselves into integrated electronics makers by strengthening their

position in components, computers and telecommunications. Particularly

noteworthy in this context are the aggressive strategies pursued by both

Matsushita and Sony to become leaders in display technology.

Pressures have been particularly intense for smaller companies with a much

more limited product focus. The typical example is Aiwa, which has radically

reduced its product mix and which now produces 87 percent of its overall

production value abroad, mostly in East Asia. This extreme reliance on overseas

production has not guaranteed success. Aiwa failed to complement overseas production with product upgrading and differentiation; as a result, the benefits of

overseas production have been wiped out by increased competition from lowcost

competitors, especially in Korea and China (FT, 15 May 1996).

Although experimentation and “strategic drift” continue to prevail to some

extent, most firms appear to be committed to moving toward what I will call

“systemic rationalization”—the attempt to move beyond partial rationalization of

individual business functions (such as factory automation or JIT procurement

systems) to generate closer, faster, and more cost-effective interactions between all

stages of the value-chain across all production locations.

First, Japanese electronics firms are implementing for the first time formal

financial control systems; performance is now measured for every plant and every

business unit. Tighter financial control is expected to slim down “fat” product

portfolios and reduce excessive investment outlays. With stringent financial

control systems in place, parent companies are now granting greater local decision

autonomy, which, sooner or later, will erode the centralized governance structure

that has characterized Japanese IPNs.

Second, Japanese firms are introducing a strategy of procurement rationalization

and internationalization to reduce dependence on high-cost domestic supply

sources and to generate larger economies of scale. Rationalization means paring

down a company’s supply base. Internationalization means that a firm can choose

the best suppliers in the world, in terms of cost, quality and delivery performance,

no matter where their operations are located. Rationalization and

internationalization together mean that the size of each contract on average is

likely to increase. As a result, the client firm can request that each supplier offers

more favorable unit prices and delivery schedules. If the contract is big enough,

the client firm may even be able to ask the supplier to set up shop at a particular

location.

Firms must make important changes if they wish to reap the potentially huge

scale economies of international procurement. For example, procurement

decisions for low-volume, low-cost commodities (especially those with high

transportation costs) can be left to regional headquarters or even to individual

affiliates. Within the firm, procurement decisions need to be based on close and

continuous interaction among purchasing, engineering, finance, and quality

assurance. Improved inter-firm networking and administration are thus

increasingly crucial to the effective implementation of inter-firm networks.

Third, Japanese electronics firms are experimenting with new approaches to

innovation management, which, again, may have far-reaching implications for the

organization of their Asian production networks. Japanese firms are well known

for their capacity to reduce the development cycle for new products and thus to

accelerate speed-to-market for products that remain within a given technology

paradigm.25 Continuous refinement of product design and process engineering

have been hallmarks of the Japanese approach to innovation management.

However, recent research has highlighted that international innovation

management strategies of Japanese electronics firms lack a clear focus and have

been plagued by costly trial and error methods.26 Compared with their American

and European counterparts, Japanese firms are still at a relatively early stage of

R&D internationalization, and so far have very limited experience in organizing

international R&D networks. Moreover, in their attempts to internationalize

R&D, Japanese firms face even greater cross-cultural communication problems

than for manufacturing, and have failed to integrate ideas and concepts developed

abroad into the firm’s domestic R&D agenda.27 Japanese firms are finding it more

difficult than their American and European counterparts to recruit first-class non-

Japanese researchers, remain reluctant to localize the management of their

overseas R&D activities, and thus have failed to fully tap into local and regional

science and technology communities.

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Explaining Japanese production networks in Asia

Why have Japanese electronics firms adopted a different approach to the

organization of their Asian production networks than American and European

firms? And why have they organized their Asian production networks differently

from their production networks in North America and Europe? I suggest that

nationality of ownership does matter, and can be traced to definable institutional

features of the Japanese production system, particularly the absence of tight

financial control and a domestic bias of the procurement system. Yet these

national characteristics must be placed in the context of other industry and even

firm-specific factors. First, until the early 1990s, Japanese firms focused on very

different product groups and markets from American firms, i.e. consumer

electronics and household appliances. Second, as latecomers to international

production, it took Japanese firms time to develop the capacity to manage IPNs.

As a result, networks were organized in a highly centralized manner to minimize

risk. Third, East Asia’s close proximity to Japan enabled Japanese firms to

implement centralized and Japan-centered IPNs in a relatively efficient fashion.

And, finally, firm size and strategic focus have shaped the organization of Japanese

IPNs.

Peculiar features of the domestic Japanese production system

There is no doubt that certain basic features of the domestic Japanese production

system have shaped the organization of Japanese IPNs in East Asia.First, until

the “bursting of the bubble economy” in 1991, one of the key features of

corporate governance in Japan has been a lack of tight financial control (Dobson

1995; Stopford 1998; Kester 1996) that has forced Japanese firms to establish

other forms of control.

Kester distinguishes two types of corporate governance: those

associated with the separation of ownership and control (the control of “agency

costs”), and those associated with the establishment and maintenance of

contractual exchange among separate enterprises. Kester (1996) shows that the chief shortcoming of Japanese governance is its low ability to control…

agency costs…. In modern Japanese business history, controlling agency

costs has been of second-order importance…. So long as attractive real

growth opportunities were abundant and product and factor market rivalry

was fierce, corporate managers were unlikely to deploy resources in a highly

disciplined way. High rates of real growth, moreover, can do much to

attenuate disputes among corporate stakeholders by relieving pressures to

compare one group’s gains to those of another from a zero-sum

perspective. So long as growth could be sustained, virtually all stakeholders

benefited and conflict among them could be held to a minimum.

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