II. PRIMER ON GLOBAL VALUE CHAINS AND INTERNATIONAL PRODUCTION NETWORKS

3 II. PRIMER ON GLOBAL VALUE CHAINS AND INTERNATIONAL PRODUCTION NETWORKS 3 A. Context: Evolution of international business 4 The proportion of goods and services conceived, produced and consumed entirely within one country is rapidly shrinking. This is the result of two complementary and interdependent dynamics the reorganization and the relocation of the production of goods and services that are transforming international business and the global economy, with important implications for the competitiveness of firms and the prosperity of nations. The first dynamic, reorganization, involves decisions by enterprises as to what activities should remain within the firm as core competencies, versus functions or activities that will be purchased from other firms (outsourcing). This is made largely possible by technological and managerial innovations that allow the fragmentation or modularization of production-related activities and their distribution among different enterprises. The second dynamic, relocation, involves decisions by firms on which activities should move from ones home country to different geographic locations (offshoring). This internationalization of production is facilitated by the integration of product markets, i.e., removing obstacles to flows of goods, services and capital. The two dynamics of reorganization and relocation are leading to the emergence of global value chains and associated international production networks involving the dispersal, coordination and re-integration of production-related activities among groups of firms in geographically dispersed locations. Global value chains and associated production networks are emerging as the organizing framework for production, investment and trade in an expanding range of product groups such as garments, agro-industry, furniture, automobiles/ automotive parts, consumer electronics, telecommunications and ICT, as well as services (see UNCTAD, 2002). This has resulted in increasing task-related specialization by firms in the production of goods and services, and the corresponding acceleration of growth in intra-industry and intraproduct trade, as compared with traditional trade in final products. The fragmentation of production and corresponding firm specialization in tasks is leading towards the development of a new paradigm for international trade. 5 However, it should be noted that, while specialized and fragmented production, integrated through global value chains and production networks is a key dynamic driving the evolution of international business, there are firms that compete effectively on global product markets with widely different organizational strategies, retaining a range of activities in-house and/or onshore. 6 3 This section draws on Abonyi 2003 and 2004. 4 See the annex for further discussion of implications for organizational strategy. 5 An important contribution to the development of a new paradigm for international trade is by Grossman and Rossi-Hansberg (2006a and 2006b). See also Blinder (2005). 6 See the annex for a discussion of organizational and strategic options in international business. 4 Although many large multinational enterprises continue to provide a variety of products and services on global markets, they now increasingly purchase inputs and components from smaller companies in widely dispersed locations that serve particular industry niches. Global export markets increasingly involve exports of parts, components and services within the framework of GVCs and associated production networks. In this context, many companies, particularly smaller enterprises, are finding that success and creating value may be achieved through specialization in a limited set of activities, outputs and market niches. For example, even simple components such as hubcaps can be produced for regional and global markets by a supplier in the production networks of Toyota Motor Corporation or Ford Motor Company; specialized niche markets such as organic fruit and vegetables can be regional and even global in nature through access to global retailers such as Carrefour or Tesco. Therefore, as the international production system evolves, the key role of GVCs and IPNs in a growing number of industries provides an increasingly effective mechanism for SMEs to access global and regional markets as suppliers within global value chains and associated networks. However, in order to participate in such value chains and networks, firms must be able to deliver a specified product, in the right quantity, with the required quality, at the right time and meet an expanding range of increasingly stringent global market standards, for example on labour conditions and the environment. The payoffs from participating in GVCs and IPNs can be potentially high for SMEs, but generally so are the requirements for entry. B. Global value chains Value chains: The production of any good or service may be represented as a sequence of linked functions, some involving tangible outputs, others intangible services. A value chain then refers to the full range of value added activities required to bring a product from its conception, through design, sourcing raw materials and intermediate inputs, production, marketing, distribution and support to final consumers. It presents a systemic perspective that incorporates all key activities related to the production, exchange, distribution and after-sales support for a given product or service, e.g., personal computers. Therefore a value chain describes the organization of production of particular products or services. A value chain can span enterprises in a local economy, a national economy, a subregional or regional grouping of economies such as GMS or East Asia and the global economy. A simplified generic value chain is presented in figure 1. A particular firm may choose to focus on one specific activity (and associated outputs) in the value chain, such as manufacturing or sales, or several activities as in the case of a more vertically integrated enterprise. A more comprehensive and complex picture of a generic value chain in figure 2 illustrates how value chains for all products and services are supported by a variety of institutions and activities in an economy, such as educational institutions for training and infrastructure services for logistics. 5 Figure 1. A simplified value chain Source: United Nations Industrial Development Organization, Inserting Local Industries into Global Value Chains and Global Production Networks (Vienna, UNIDO, 2004), p. 6. Disposal and recycling Marketing and sales Manufacturing Design and product development A simplified and partial representation of the garment/apparel value chain is presented in figure 3. Global value chains: Value chains become global when their component activities are geographically dispersed across borders to multiple country locations. In general, the proportion of products conceived, manufactured and consumed entirely within the geographic boundaries of a single country is shrinking. Even services such as financial, consulting and customer support services are becoming mobile across borders. A more complex representation of the global garment/apparel value chain is presented in figure 4, reflecting the internationalization of apparel production. Value chain versus supply chain: Although often used interchangeably, a supply chain has traditionally referred to the inbound and outbound logistics of particular firms. A value chain, as used here, encompasses the entire range of productive activities associated with a given product or service, irrespective of firm boundaries. For example, in the apparel value chain in figure 4 the supply chain of a firm producing yarn would include the backward or input sourcing-related linkages to suppliers of natural fibres and the forward or output delivery-related linkages to the immediate customers who are producers of fabrics. The apparel global value chain, however, includes the entire set or system of production-related activities from raw material inputs to sales, independent of particular firms involved. Value chains and industries: The value chain of the apparel industry in figure 4 also demonstrates potential differences between the traditional industry and value chain perspectives. Apparel production straddles more than one industry: it is closely linked to both agro-industry (e.g., wool, silk and cotton as inputs) and petrochemicals (e.g., synthetics). 6 Figure 3. Garment/apparel value chain Source: Compiled by the United States Trade Commission. Spinning Fibres Yarns Grey fabrics Finished fabrics Cut garment pieces Finished garments Weaving or knitting Dyeing, printing and finishing Cutting Sewing Source: T.J. Sturgeon, How Do We Define Value Chains and Production Networks , Special Working Paper Series, MIT IPC Globalization Working Paper 00-010, Industrial Performance Centre,
Massachusetts Institute of Technology, April 2001. Figure 2. Generic value chain and supporting inputs Value Chain X Human Resource Inputs e.g., schools, colleges, universities Service Inputs e.g., accounting, consulting, leasing, transportation, construction Disposal/Recycling After-sales Service Retail Sales End Use Consumer Marketing Buying/Trading Final Assembly Sub-Assembly Components Materials Raw Materials Infra- structure Inputs e.g., roads, ports, communications, energy, water Capital Equipment Inpurts e.g., computers, production equipment, vehicles, real estate Key activities
for lead firms Product-related
Product Strategy
Product Conception
Product Design Conceptual Design Visual Design Detailed Design 7 Figure 4. Apparel global value chain Source: G. Geref fi and O. Memedovic, The Global Apparel V alue Chain (V ienna, UNIDO, 2003). Natural fibres Synthetic fibres Cotton, wool, silk, etc. Oil, natural gas Raw material networks Component networks Production networks Export networks Marketing networks T
extile companies Apparel manufacturers Retail outlets Y
arn (spinning) Fabric (weaving, knitting, finishing) United States garment factories (designing cutting, sewing, buttonholing ironing Petrochemicals Synthetic fibres Domestic and Mexican/Caribbean Basin subcontractors Asia Asian garment contractors Domestic and overseas subcontractors Brand-named apparel companies Overseas buying of fices T
rading companies All retail outlets All retail outlets Department stores Specially stores Mass merchandise chains Discound chains Of f-price, factory outlet, mail order , others North America 8 These inter- or multi-industry linkages are reflected in the value chain representation, the focus of which is on key activities related to particular product groups, irrespective of industry or sector boundaries. Furthermore, value chain-related activities include manufacturing and services. In this context, non-manufacturing activities increasingly with high intellectual content, such as R & D, engineering, design, sales, marketing, information systems and customer service contribute most of the value added in many manufactured products and are represented explicitly in the value chain framework (see Quinn, 1992). C. International production networks Production networks: A production network represents linkages within or among a group of firms in a particular global value chain for producing specific products such as particular types of computers, mobile phones and cars. It represents how lead firms such as Toyota, Cisco Systems Inc. and Nike Inc. organize their particular networks of subsidiaries, affiliates and suppliers to produce a given product, e.g., the Travelmate C110 produced by Acer Inc. What distinguishes lead firms from non-lead firms in a network is that they control access to key resources and activities such as product design, international brands and access to final consumers. This generally gives them leverage over the other enterprises suppliers in the production network. As will be touched on later, these activities, often but not always, generate the most profitable returns. International production network: Production networks become international when the distribution and coordination of geographically dispersed activities within and/or among enterprises takes place across borders in multiple countries. Examples of international production networks are given in figure 5 (for Acers Travelmate C110) and in box 1 (for Levi jeans). Box 1. A production network within the global apparel value chain To produce a line of garments, a global retailer such as Levi Strauss & Co. might purchase yarn from the Republic of Korea that would be woven and dyed in Taiwan Province of China by a subsidiary. Then it would send the fabric to be cut in Bangladesh by a subcontractor; and ship the pieces for final assembly to an affiliate in Thailand, where the garments would be matched with Japanese zippers. It would deliver the finished product to geographically dispersed affiliated retailers in North America and Europe. This set of firm-specific linkages, within the framework of the global apparel value chain (figure 4) constitutes a particular international production network (e.g., Levis IPN for manufacturing jeans). a a See J.S. Brown, S. Durschlag and J. Hagel III, Loosening up: How process networks unlock the power of specialization, McKinsey Quarterly , No. 2, 2002. 9 Intra-firm international production networks: A production network may be primarily within the boundaries of a firm, involving ownership linkages among subsidiaries and affiliates in different geographic locations. This is the classic multinational, vertically integrated enterprise, where production is relocated offshore, but remains essentially within the control of the firm through ownership. In this case the coordination and control of production and related activities is internalized to the firm, though it may stretch across borders. Figure 5. Production network for Acer Travelmate C110 laptop computer Hitachi Maxell Mitsubishi Engineering Plastic Corp. Toshiba Electric Co., Ltd. Toshiba Matsushita Lite-On Electronic Inc. Ambit Sumida Xtreme Technology Taipei Multipower Electronics Co., Ltd. Aopen Inc. Sanyo Various manufacturers IBM Japan Ltd. Fujitsu Ltd. Hitachi Global Storage technologies Toshiba Corp. Y-E Data Inc. Lithium battery LCD bezel LCD Panel Switching power supply Fax/modem card (optional) 802.11 a/b (wireless) (RF) module DC/AC inverter transformer DC/AC inverter External 1394 DVD-ROM/CD RW (optional) CD-ROM (external use) (optional) Battery pack (optional) Floppy disk (external use) (optional) PCB HDD Beijing Acer Information China Acer Information Services China Wistron Corporation Taiwan Province of China IMS B.V. The Netherlands Wistron infoComm (Philippines) Corporation Philippines Travelmate C110 Acer Incorporated Component manufacturer Critical component Contract manufacturer Product Source: B. Slob, Acer Incorporated: Company Profile, (Amsterdam, Stichting Onderzoek Multinationale Ondernemingen (Centre for Research on Multinational Corporations), December 2005),
p. 18. 10 Box 2. Intra-firm international production network: Denso The Japanese company Denso Corporation is the worlds fourth largest automotive component manufacturer. It was spun off in 1949 by Toyota Motor Corporation, which still retains a 23 per cent ownership interest. Denso has a broad portfolio of automotive products related to thermal systems, powertrain control systems, electronic and electrical systems. It employs about 70,000 people in subsidiaries and affiliates in 25 countries, with two thirds of them being in Japan, around 10 per cent each in North America, Europe and India. Denso relies heavily on a geographically distributed and coordinated production network, primarily in Asia. Densos regional production network in South-East Asia is presented in figure 6. a a Based on Global Production Networks in Europe and East Asia: The Automotive Components Industry , GPN Working Paper 7, May 2003. Inter-firm production network: Increasingly, production networks involve non-equity linkages, in which formally independent enterprises suppliers, producers and retailers are linked through a variety of relationships such as subcontracting, licensing, common technical standards, marketing contracts and shared network product- and process-related standards. This involves both the relocation and reorganization of production activities offshore and outside the boundaries of the firm. In an increasing number of industries, producers sell into final markets through such non-equity-based production networks; usually coordinated by lead firms which set the standards for supplier participation. 7 A given firm may belong to more than one such network. For example, in the apparel GVC a firm specializing in dyeing may be simultaneously a supplier in the production networks of Levi Strauss & Co., Nike and Wall Mart Stores, Inc. Similarly, the major global automotive parts supplier Lear is a member of the production networks of a number of lead auto assemblers, including among others General Motors Corporation (GM), Ford, Toyota and Volkswagen A.G. 7 The term international production network will be used primarily to refer to such inter-firm networks, unless otherwise indicated. Box 3. Cisco, Nike and the role of lead firms in chains and networks Cisco Systems Inc. and Nike Inc. act as lead firms in the telecommunications/ information technology and the shoe/garment industries, respectively. Although in very different industries, Cisco and Nike both play a critical role as lead firms in setting product and process standards; determining which producers are incorporated into the network; which market segments a producer will serve; with what product mix; which functions producers will undertake, e.g., production, design and marketing; and in which areas a producer will be allowed to upgrade, e.g., move upstream from manufacturing to design. a a From G. Abonyi, Linking Asia together, Asian Wall Street Journal, 5 December 2000. 11 D. Types of global value chains/networks In simple terms, there are three general types of value chains and associated production networks, with the first two, the producer-driven and buyer-driven chains, being the most prevalent. As will be illustrated in the context of particular GVCs (Section III), they have differing implications for participating enterprises. Producer-driven chain or network: This was the initial type of global value chain/ network to emerge as a major force in reorganizing international production. It is one where the lead firm, often a large multinational manufacturer, such as Toyota or the Samsung Group, plays a central role in exercising relatively close control in coordinating a geographically distributed network of subsidiaries, affiliates and suppliers. The lead firm generally retains control of R & D, basic product design and innovation. This type of chain/network tends to be characteristic of capital- and technology-intensive industries, such as automobiles, telecommunications, ICT and semiconductors. As a consequence, to be a supplier to this type of chain/network requires a certain level of technical capability and sophistication, as well as associated investments in both technology and skills. However, Figure 6. Densos regional production network in South-East Asia Source: Based on Global Production Networks in Europe and East Asia: The Automotive Components Industry , GPN Working Paper 7, May 2003. p. 51. Functions: Manufacturer
A/C system G. plug Radiator Horn Cooling fan Air cleaner
Starter Oil filter Altemator Wiper system Spark plug Washer system Thailand DNTH Production: $ 158 m Exports: 24% Malaysia DNMY Production: $ 209 m Exports: 30% Functions: Manufacturer A/C system Relay Radiator Flasher Cooling fan A/C amp Starter Wiper system Alternator Arm & blade E/G ECU Washer system Indonesia DNIA Production: $ 198 m Exports: 20% Functions: Manufacturer A/C system Horn Radiator Air cleaner Cooling fan Oil filter Starter ISCV Alternator P/W motor Spark plug Washer system Japan DNJP Corporate headquarters Singapore DIAS Functions: Complementation HQ Centralized purchasing of raw materials Centralized cash management DE sales centre (ASEAN Taiwan Province
of China) Singapore DISP Functions:
After-market sales company for non-Denso subsidiaries
(22 countries) SMC export distribution of regional production
for after-market After-market marketing centre for Asia, Australia, Middle East Functions: Manufacturer A/C system Canister Radiator Cluster Cooling fan Washer system Air cleaner Cable Australia DIAU Production: $ 190 m Exports: 6% Philippines PAC Production: $ 23 m Exports: 12% Functions: Manufacturer A/C system R. tank Radiator Air cleaner Cooling fan Cluster Taiwan Province of China DNTW Production: $ 85 m Exports: 8% Functions: Manufacturer A/C system Alternator Heater Air cleaner Radiator Cluster Cooling fan Wiper system Starter 80% 100% 51% 73% 58% 100% 100% 95% 12 technology and knowledge transfers can be an important benefit of supplier participation in such producer-driven chains, as illustrated by the automotive parts and ICT industries. As an example, Sony Corporation sourcing worldwide imposes very high standards on suppliers, requiring strong technological capability, flexibility in response, strong customer service orientation and the capacity to work with its ICT-based e-procurement system. Buyer-driven chain or network: This is a relatively more recent development in international production where large retailers and brands (e.g., Carrefour in food, Levi in garments) play the lead role sourcing from decentralized networks of independent suppliers, defining product and process specifications and standards. It tends to be characteristic of labour-intensive, consumer goods industries such as apparel, footwear, agro-industry and consumer electronics. The participation requirements although they can be quite stringent as in the case of the IKEA International Group (see below) are relatively lower in this type of chain/network, offering many opportunities for developing country producers, including SMEs, capable of meeting the buyers requirements. The requirements may be upgraded over time. As an example, IKEA, the Swedish home furnishing retailer, has a worldwide sourcing strategy involving more than 2,000 suppliers, governed by IKEAs own technical product and process specifications, as well as by other types of standards such as those that relate to environmental and labour requirements. Multi-polar chain or network: This less prevalent type of chain/network is characterized by multiple power centres in different parts of the value chain. There is no overall dominant lead firm with power to determine the ultimate shape of final products and therefore exert control over key activities throughout the chain. For example, although Intel Corporation, Microsoft Corporation and Dell Inc. are lead firms in their own production networks within the personal computer global value chain, a specific personal computer marketed by Dell reflects a kind of balancing of forces reflecting Microsofts software strategy, Intels strategy in semiconductors and Dells customer-based branded assembly and marketing strategy. E. The why of GVCs and IPNs: An organizational perspective Challenge of coordination: Global value chains and associated production networks reflect the evolution of organizational form and strategy driven by technological change, managerial innovation and competitive pressures, as noted previously. More specifically, the basic organizational or management challenge for an enterprise is the coordination of its activities in the value chain (e.g., sourcing, design, production, distribution and service), particularly when such activities cross borders. Traditionally, one approach to the challenge of coordination of production has been to bring activities along the value chain within the control of the firm, and coordinate and control them through ownership and direct managerial oversight. This gave rise to coordination through a vertically integrated hierarchy . The firm together with subsidiaries, affiliates and joint ventures retains ownership and control of inputs, components and products, as they are transformed along the value chain. The traditional hierarchical, vertically integrated automobile manufacturers such as Ford and GM provided (until recently) perhaps the clearest examples of such a hierarchy. 13 Alternatively, activities along a value chain may be coordinated by arms length transactions through markets. In this case, products change ownership as they move between activities of discrete enterprises along the industry value chain, with no overall coordination or overt control of production linkages among firms. An example is a clothing manufacturer purchasing yarn on the open international market, or a supermarket purchasing fresh fruit on the market from any available supplier. Dismantling hierarchies: Increasing competitive and cost pressures are leading hierarchical, vertically integrated firms to reorganize and focus on a few selected core activities through the outsourcing of activities and the corresponding shedding of what are seen as non-productive assets. Advances in information and communication technology are reducing the need for ownership or equity-based control of activities in the value chain, enabling lead firms to ask much more of their suppliers in terms of rapid response, design collaboration and lower costs; in addition, they provide for closer product and process monitoring. At the same time, the rising competence of suppliers enables them to take on added responsibilities. As a consequence, firms are increasingly focusing on their core competencies activities they see themselves doing well and that enable them to capture higher returns while outsourcing non-core activities. 8 Given technological and logistical advances, suppliers need not be located in the same vicinity or even the same country, adding relocation or offshoring to the strategic options for firms. This is transforming traditionally vertically integrated hierarchical firms in a variety of industries into networks. (e.g., Levi Strauss in apparel) or into a hybrid forms of hierarchy with network characteristics (e.g., Ford and GM in the automotive industry). Box 4. From producing globally to buying globally Levi Strauss & Co. , the most prominent brand name in jeans, has historically prided itself on its own global production structure. This was maintained even in the 1990s, as competitors in the industry increasingly outsourced production capacity, usually offshore. Towards the end of the 1990s, however, significant declines in both profits and market share forced the company to close half its 22 plants in North America. Production capacity was increasingly outsourced to contractors throughout the world and, by the first half of 2004, the United States clothing giant had shifted all of its company-owned North American manufacturing to outside suppliers in Asia and other low-cost areas of the world. However, Levi Strauss is retaining key value-added functions such as brand management, marketing and product design, and defining standards for suppliers to participate in and upgrade its production network. a General Motors Corporation (GM) and Ford Motor Company were the classic examples of a hierarchically integrated firm in the automotive industry. However, by the late 1990s both GM and Ford had spun off much of their parts-manufacturing operations to Delphi 8 This also enables off-loading of associated risks and costs to suppliers, for example fluctuations in demand and inventory. On the related risks associated with the emergence of GVCs, see Lynn
(2005). 14 Automotive Systems Corporation and Visteon Corportation, respectively. Today, Ford and GM mostly design and assemble vehicles, and their suppliers mostly make what goes into them. Although Levi Strauss and Ford are in very different industries, under the pressure of increasingly intense global competition, their transformation from vertically integrated hierarchical enterprises has meant moving non-core assets and activities to external suppliers, but within the framework of coordinated production networks. a From G. Abonyi, Challenges of Industrial Restructuring in a Globalizing World: Implications for Small- and Medium-scale Enterprises (SMEs) in Asia , ISEAS Working Paper: Visiting Researchers Series No. 3, 2003, Institute of Southeast Asian Studies, Singapore. Controlling markets: Global buyers increasingly want more information and control with respect to their suppliers, increasingly further back in the value chain. This is driven by a number of factors. Competitive pressures are forcing firms to eliminate stocks and reduce time-to-market to lower costs and risks, and improve flexibility. At the same time, final product markets are increasingly characterized by consumer demands simultaneously for higher quality, lower prices, speed (e.g., rapid response in production and distribution, shorter product life cycles), flexibility (e.g., build-to-order, configure-to-order), as well as adherence to increasingly stringent global standards. The latter include general standards such as SA8000 on labour, industry-specific standards such as phytosanitary standards in agro-industry and firm-specific standards such as the requirements of in-house brands of global retailers such as Carrefour. Therefore, in industries as diverse as electronics, computers, apparel and fresh vegetables the trend is away from arms length market-based transactions to some form of linkages or alliance among firms along the value chain: this is the basis of production networks. 9 Emergence of network orchestrators: The transformation of production through outsourcing and offshoring is also creating conditions for firms to emerge from the outset as networked firms, such as Cisco, Dell and Nike. These are firms that never owned production facilities and are essentially network orchestrators the basic role of which and the basis for their competitive advantage involves coordinating and integrating activities along a given value chain. Because they own fewer assets and leverage the resources of partner companies, network orchestrators generally require less capital and often generate higher revenues than traditional firms, under both expanding and adverse market conditions, in a growing range of product markets (Hacki and Lighton, 2001). Global suppliers are a particular type of network orchestrators that support lead firms in a variety of industries by organizing the supplier process, in particular GVCs/IPNs (see boxes 6-8 for illustrations). 9 See for example discussion of the fresh fruit and vegetable industry in Section III. 15 F. Structure of GVCs: Governing lead firm/supplier relations Global value chains and associated production networks are evolving a tiered structure. As noted, the key role in the network is played by the lead firm, e.g., Levi Strauss in apparel, Ford in autos and Carrefour in fresh fruit and vegetables. These lead firms are supported by an increasingly smaller number of preferred first-tier (often global) suppliers, surrounded by lower-tier suppliers of parts, components and other inputs. These lower tier suppliers, further back in the network, are often SMEs doing low-skill, low value added activities, producing relatively simple outputs, often competing on the basis of low cost, with limited capacity and/or options for upgrading. In general, it is easier to enter into a chain/network as a lower-tier supplier. However, this is likely to be an unstable position for a firm, since it is easier to be replaced by other for example lower cost suppliers. The challenge therefore for an SME is to enter the chain/network as a higher-tier supplier, or alternatively as a lower-tier supplier but with the opportunity to upgrade to move up the value chain and increase the value content of activities (see figure 7). Figure 7. How small and medium-sized enterprises fit into global and value chains/international production networks Source: United Nations Industrial Development Organization, Integrating SMEs in Global Value Chains (Vienna, UNIDO, 2001), p. 6. Original equipment manufacturer (large firm, perhaps TNC) First-tier supplier (large firm, perhaps TNC) Second-tier supplier (large firm) Third-tier supplier (SME) Second-tier supplier (SME) Third-tier supplier (SME) Fourth-tier supplier (SME) Fourth-tier supplier (SME) Third-tier supplier (large firm) Firts-tier supplier (large firm) 16 The organization of production networks may be seen as an implicit agreement or bargain between the lead or higher-tier firms and lower-tier suppliers (e.g., SME). The lead firm, such as IKEA in wood furniture or Carrefour in fresh fruit and vegetables, provides market and technical information, directly or through higher-tier suppliers, with the expectation that lower-tier suppliers will perform to global standards set by the lead firm. Lower-tier producers on the other hand, such as small suppliers to IKEA in Viet Nam producing bamboo furniture, invest in equipment, specialization and skills, with the expectation that lead firms (or higher-tier suppliers) will continue to use their outputs, and ideally over time, provide opportunities for the firms to upgrade within the chain/network. Key characteristics of global value chains and production networks of particular importance in the lead firm/lower-tier supplier relationship include the following: Governance: strategies of lead firms, including with respect to the role of suppliers; Upgrading and innovation: the basis for strengthening competitive performance, pricing power and achieving sustainable returns within chains and networks; Standards: product and process standards both as market-driven requirements and as the basis for ensuring consistency and reliability in the chain/network; Role of global suppliers: emergence of global suppliers as key players in organizing participation in value chains and production networks. Governance: Generally, lead firms try to control the rules of the game in a chain/ network that govern the role of suppliers. This includes control of who can be a supplier; what will they produce (outputs of suppliers in the network); how it is to be produced (e.g., quality and other product and process standards although some standards may also be externally set, for example as related to food and pharmaceuticals); how much is to be produced by each supplier and when; which activities or functions will the suppliers be allowed to undertake in the network (e.g., manufacturing, design and marketing); and in which of these areas will suppliers be allowed to upgrade (e.g., moving from manufacturing into design). Lead firms often exert operational control through increasingly ICT/e-commerce- based management and logistics systems that integrate supplier activities within the network. In general, lead firms try to retain and guard value chain activities with the highest returns and value added. For example, in the case of a producer-driven network such as automobiles, this means control by lead firms such as Toyota and Ford of functions such as basic R & D and fundamental product innovation even if these are partially outsourced. In the case of a buyer-driven network such as apparel, this means control by firms such as Levi, Nike or IKEA of functions such as design, branding, marketing and distribution. 17 Box 5. Governance strategies: Intel, Limited Brands, Toyota, Ericsson a Intel Corporation: Semiconductors were the most dynamic products in global trade between 1985 and 2000, with exports growing from $26 billion to $235 billion. During this period, Intel vaulted from seventh to first in sales in the industry; today the company is by far the largest chipmaker in the world. The firm has exploited its manufacturing competence by integrating its production network and establishing plants in a diversity of locations. Intel has kept its production process internalized, creating a producer-driven international network in which ownership (equity) links form the basis for network governance. It manages a hierarchical international production network, where individual affiliates specialize in particular stages of innovation or production, which are then closely integrated into Intels global production network. Limited Brands: Clothing remains an important component of global trade, increasing from $41 billion to $174 billion between 1985 and 2000. Limited Brands is a leading retailer of intimate and other apparel and non-apparel (e.g., beauty and personal care) products. Founded in the United States in 1963, its net sales doubled from $5 billion in 1990 to $10 billion in 1999. Limited Brands established a buyer-driven network based on non-equity relationships, which it operates based on its two principal advantages: retail sales outlets and brand management. Toyota Motor Corporation: The automobile industry has grown from $149 billion in 1985 to $486 billion in 2000. Unlike electronics, automobile production networks have tended to be national or regional rather than global. Home markets continue to be central to automobile manufacturers, even though the production networks are becoming increasingly internationalized. Toyota, the third largest automobile manufacturer in the world by vehicle production (2001), has a mixture of equity and non-equity linkages in its IPN. In 1990 Japanese production accounted for 86 per cent of its global sales. By 2000 foreign production increased to 30 per cent, including 12 plants in Japan and 43 plants in 26 other countries. In general, Toyota maintains its ownership advantage in the most modern and competitive part of its IPN. Parts are to a large degree outsourced. Toyota combines close links among its fully owned assembly subsidiaries with a multitiered network of formally independent subcontractors (e.g., Denso Corporation). As part of its network governance strategy, affiliates in the Thailand and United States have been given regional product mandates for certain product lines. Toyota has recently indicated that it will extend its production network around core regional markets to lower-cost sites such as Mexico for North America, and Turkey and the Czech Republic for Europe. Ericsson: Telecom equipment was among the most dynamic exports during the period 1985-2000, exceeding $173 billion. A sharp downturn after the boom of the late 1990s has triggered dramatic restructuring of the telecom equipment global value chain. Against this backdrop, Ericsson, the worlds largest supplier of telecom equipment, has evolved from a largely equity-based production network, to an almost fully non-equity based IPN while retaining direct control over product lines related to its core focus on innovation and design. It has reduced its production plants from about 70 to fewer than 10 worldwide, outsourcing previously in-house production to global contract manufacturers 18 such as Flextronics International Ltd. and Solectron Corporation. It has retained two types of foreign affiliates in the equity-based part of its international production networks: plants needed for the development and manufacturing of key new, non-standard products, and the most cost-efficient plants for the more standardized products. In the telecom equipment value chain, Ericsson now focuses on design, R & D, product development and sales and marketing, outsourcing most manufacturing activities. b a See the annex for further discussion of key factors related to such governance decisions. b UNCTAD, Part Two, World Investment Report 2002 (Geneva, 2002). Upgrading and innovation: Continuous innovation and upgrading throughout the value chain is becoming a requirement in an increasing range of product groups. This is the consequence of the growing intensity of global competition, shortening of product life cycles and falling barriers to entry in some industries. Innovation and upgrading by a given firm can allow it to reposition itself and improve its pricing power and competitive position within a given network or value chain. The key issue is that value creation can occur anywhere in the value chain . It is not necessarily associated only with high end activities such as design or branding. For example, a wood furniture manufacturer may strengthen its performance in the value chain and network by improving the efficiency of its manufacturing activities, or alternatively, by moving from manufacturing to product design. Key innovations can also be the source of competitive advantage for a given production network as a whole within a global value chain. For example, product innovation by Toyota (perhaps in collaboration with its first-tier supplier, Denso) can strengthen the competitive position of the set of firms in the Toyota-led production network including its lower-tier automotive parts suppliers against other such networks, such as Fords, within the automobile industry. In general, there are four ways for a firm to improve its position, or create additional value, through innovation and upgrading: 1. Process innovation: increasing efficiencies in the production process, for example through improvements in production technology or labour productivity; 2. Product innovation: improving existing products, or developing new products; 3. Functional innovation: changing the mix of value chain activities undertaken by a supplier; for example, moving upstream from manufacturing to product design; 4. Chain innovation involves using existing capabilities to upgrade to a new and more attractive value chain, for example the shift of some firms in Taiwan Province of China from producing microwaves to higher value personal computers. Standards: Product and process standards are increasingly shaping production, especially within the framework of global value chains. There is growing pressure in key markets, such as the United States and European Union, for global producers to adjust 19 their operations to reflect not only profitability, but also social and environmental objectives (e.g., corporate social responsibility requirements). In addition, within the framework of GVCs, standards play the key role in ensuring product and process consistency and reliability along the chain. Therefore, producers wishing to participate within GVCs increasingly have to meet stringent requirements of a growing multiplicity of standards in a wide range of industries (e.g., wood furniture, automobiles and electronics). Examples of the diversity of standards include internationally agreed standards, such as ISO 900 (quality), ISO 14000 (environment), SA8000 (labour) and G3 for cellular phones; industry-specific standards, such as phytosanitory standards and hazard analysis and critical point in the food industry; region-specific standards, such as QS 9000 (quality in autos originating in the United States); and firm-specific standards, supporting brand names (e.g., Volkswagen quality standard, Carrefours in-house brand standards). Emergence of global suppliers: Leading firms in an increasing number of industries are reconfiguring their strategies and reorganizing their production networks; in the process, they are placing lead suppliers in a key role within such networks. This is particularly evident in two important industries: electronics and automobiles . Lead firms in these industries are becoming increasingly reliant on global suppliers, often based close to home, but supported by subcontractors globally. This spreads the risks and lowers the costs of doing business for lead firms. Global suppliers, in turn, are reorganizing networks within value chains, redefining the role and relationships of lower-level suppliers/producers, further back in the chain. In this context, lead firms and their supporting global suppliers are increasingly looking for firms that already have the requisite production capabilities, not firms that need to be brought up to required standards posing new challenges to both enterprises and Governments. This reorganization of networks, although most pronounced in electronics (see box 6) and automotives (see box 7) is becoming a factor in an increasingly wider range of industries, for example garments (see full package providers in box 8) and fresh fruit and vegetables (see Section III). As a consequence, global suppliers are emerging as key global investors, 10 with significant influence on the export competitiveness of host countries and on the fortunes of SMEs. 10 For example, Flextronics International Ltd., until recently the leading and now second largest global contract manufacturer in electronics, invests in large industrial parks, including $100 million in
India. Box 6. Global contract manufactures in the electronics global and value chains: Hon Hai Beginning in the second half of the 1990s, lead firms in the electronics global and value chains, for example in the computer and networking sectors, (e.g., International Business Machines (IBM) Corporation, Hewlett-Packard Co., Ericsson, Nokia Corp. and Alcatel-Lucent) have been consolidating their contract manufacturing relationships, giving a larger share of production to a smaller group of large, technologically sophisticated contract manufacturers, requiring a global presence. This trend is expected to accelerate. 20 A survey conducted in 2002 by Bear Stearns Companies Inc. of brand name electronics firms found that these firms expected to outsource 73 per cent of total production on average, 40 per cent stating their intention ultimately to outsource 90-100 per cent of final product manufacturing. The following example of the impact of such firms is instructive. In 2005, low-profile firm, Hon Hai Precision Industry Co., Ltd., or Foxconn Technology Group as it is called in the United States, became the leading electronics contract manufacturer in the world with $21 billion in revenues, as compared with almost $15.6 billion for Flextronics Incorporated Ltd., the previous leader for most of the past six years. a Started in 1974 in a garage with 10 employees making plastic parts for black-and-white televisions, Hon Hai opened its first production facilities in Taiwan Province of China in 1993. It now has five industrial parks there housing both its own factories and those of its suppliers. By the end of the 1990s it had R & D centres in the United States and Japan, and smaller production facilities in the Czech Republic, Ireland, Scotland and the United States, in addition to its main facilities in China and Taiwan Province of China, sourcing components globally from smaller suppliers. Hon Hai manufactures connectors, modules and housings for personal computers; consumer electronics and telecommunications equipment; and assembles desktop personal computers, electronic games and mobile handsets. Its customers include Cisco Systems Inc., Nokia, Intel Corp., Dell Inc., Hewlett-Packard, Acer Co., Ltd., Apple Computer Inc., Sony Corp., Motorola Inc. and Nintendo Co., Ltd. Other global contract manufacturers such as Flextronics (Singapore/United States) and Solectron Corp. (United States 2005 revenues $10.2 billion) play a similar role in organizing global production for lead firms in electronics/ICT industry value chains. a Source: H. Baldwin, How Foxconn surpassed Flextronics, Movers and Shakers 2006, 7 th ed. (New York, Reed Business Information, 22 June 2006). Box 7. Global suppliers in the automotive global and value chains: Lear Corporation Lear Corporation is one of the worlds largest suppliers of automotive interior modules and systems. It provides complete seat systems, electronic products, electrical distribution systems and a wide range of other interior products to a large number of global automotive brands. Lear is headquartered in the United States, and has 115,000 employees in 282 locations in 34 countries, sourcing globally from lower-tier suppliers of parts and components. Its 2005 sales totalled $17.1 billion, and it was ranked 127 th among the Fortune 500 companies. 21 Box 8. Li & Fung: A full-package provider in the garment global and value chains Li & Fung: Limited does not own any production facilities. Instead, it manages or orchestrates the process of producing garments by a global network of specialized suppliers for private-label manufacturing on behalf of mostly United States and European retailers, Levi Strauss & Co., Limited Brands, Reebok, Laura Ashley, Guess, and Abercrombie & Fitch. The firm manages for its clients the full package of product development, product sourcing and product delivery, including quality control and on-time delivery. The headquarters of Li & Fung is in Hong Kong, China; in 2004 the company employed about 6,000 people worldwide, operating through a network of 68 offices in 40 countries, with annual sales of over US$ 5.5 billion. The firm had about 700 customers, mainly retailers in the United States (75 per cent) and Europe (21 per cent). From its original role as a regional sourcing agent in the 1970s, the firm began in the late 1980s to provide complete garment programmes for specific buyers. As the manufacturing of garments became more highly complex and geographically dispersed in the 1990s, the firm expanded its activities and network extensively. By 2001 it was involved in managing 10 of the 15 steps in the garment manufacturing value chain. Li & Fung does high-value front-end (e.g., design, production planning) and back-end (e.g., quality control) tasks in Hong Kong, China. It organizes lower value added stages through manufacturing contracts with a network of 7,500 suppliers, of whom 2,500 are reportedly active at any given time, giving it employment links with an estimated 1.5 million workers. Its network of suppliers is located primarily in Asia, including China, Bangladesh, India, Pakistan and Sri Lanka, as well as in Egypt, Madagascar, Morocco and South Africa. The firm generally takes between 30 per cent and 70 per cent of a given suppliers output, providing a balance between the clout to secure needed capacity, but not making it overly dependent on a given supplier. For a specific product or client such as Limited Brands (United States), Li & Fung assembles a set of specialized suppliers to handle everything from product development to the sourcing of raw materials, production planning and management and shipping. It then orchestrates the process according to well-defined milestones and standards. For example, Li & Fung gives a dyer in Taiwan Province of China the specifications for the end product to be delivered, such as the exact colour, the quality standards it must meet and the date when the fabric must be shipped to the cutter in Bangladesh, for example. However, it does not try to influence the way each supplier accomplishes its part of the process. The company monitors quality by verifying that product specifications have been met at every milestone in the process. Given its networks wide span, Li & Fung can leverage global economies of scope to deliver high-quality, low-cost products, reliably and quickly to customers. a a UNCTAD, Part Two, World Investment Report 2002 (Geneva, 2002); and J.S. Brown, S. Durschlag and J. Hagel III, Loosening up: How process networks unlock the power of
specialization, The McKinsey Quarterly, No. 2, 2002.

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