VERTICAL SPECIALIZATION AS A DRIVER OF

TECHNOLOGICAL AND INNOVATION CAPABILITY

BUILDING IN AUTOMOTIVE INDUSTRY1

Yan Rianto, Chichi Shintia Laksani, Dian Prihadyanti

Center For Science and Technology Development Studies, Indonesia Institute of Sciences

Widya Graha Building 8th Floor, Gatot Subroto Kav. 10, South Jakarta 12720, Indonesia

yan.rianto@lipi.go.id, chic001@lipi.go.id, dian013@lipi.go.id

Abstract

One of the key features of the current process of globalization is

increased tr1ade in intermediate inputs. This input trade results in part

from multinational firms choosing to outsource input processing to their

foreign affiliates, thereby creating global production networks in

which each actor is vertically specialized. For developing

countries, include Indonesia, companies are usually involved as part

supplier in vertical specialization. For suppliers in developing

countries such contracts can be an important source of technology

transfer. For long term, this condition is expected to increase

technological and innovation capability in developing countries.

Therefore, this paper tries to analyze how the phenomenon of vertical

specialization happens in Indonesia, and how it boosts up

1 Sub Theme: Innovation and economic growth

technological and innovation capability in its industry. An in-depth

analysis through case study in automotive sector is conducted.

Results of the study shows that Indonesia’s automotive industry is

included in second pattern of vertical specialization patterns based

on classification by Nordas (2007), supported by market demand, time

and distance, and industrial organization. In this pattern, the lead firm

owns a trademark and provides product design, engineering and other

key inputs. Vertical specialization in automotive industry is proven to

increase technological and innovation capability in local companies

who play role as part supplier. Through subcontracting and OEM,

the local company could gain benefit from the presence of technology

transfer.

Keywords: vertical specialization, automotive industry, technological

and innovation capability

Introduction

One of the key features of the current process of globalization is increased

by trade in intermediate inputs. In the recent decades, growth of overall world

trade has been driven in large part by the rapid growth of trade in intermediate

inputs. This input trade results in part from multinational firms choosing to

outsource input processing to their foreign affiliates, thereby creating global

production networks in which each actor is vertically specialized. According to

Hummels, Rapoport, and Yi (1998), vertical specialization is considered as

another term for fragmentation which means the splitting of production processes

into separate parts that can be done in different locations, including in different

countries. Hummels, Ishii, and Yi (2001) identify vertical specialization –

production arrangements in which a good is made via multiple stages located in

multiple countries—as an important aspect of intermediate-input trade.

For developing countries, include Indonesia, companies are usually

involved as part supplier in vertical specialization. For suppliers in developing

countries such contracts can be an important source of technology transfer

(Nordas, 2007). Technology transfer is defined as a process of sharing of skills,

knowledge, technologies, and methods of manufacturing. It needs technological

learning of companies in developing countries. Technological learning will have

positive implication for technological capability because technological learning is an

active process to accumulate technological capability that is an active process for

learning, mastering, and developing technology (Rianto, et al, 2004). This is simply

drawn in the following figure. Therefore, in long term, vertical specialization in

developing countries will create impact in the development of technological

capability.

Fig 1. Relationship between Technological Learning

and Technological Capability

Source: Rianto et al, 2004.

This paper tries to analyze how the phenomenon of vertical specialization in

Indonesia, and how it boosts up technological and innovation capability in its

industry. An in-depth analysis through case study in automotive sector is

conducted. The automotive industry has always been a leading industry in terms of

organizational innovations and technologies. Concept of JIT and TQM are

developed in this sector.

Concept of Vertical Specialization

The story of globalization is a story about specialization. Today, countries

focus more and more on producing a relatively narrow range of goods and

services. They exchange the fruits of their specialization for other goods and

services. The traditional notion of specialization is horizontal—firms or countries

become adept at producing particular goods and services from scratch and then

export them. We show, however, that an increasingly significant characteristic of

world trade is vertical specialization.

Based on Hummels, Rapoport, and Yi (1998) there are three conditions which

must be hold for our definition of vertical specialization to occur: (1) a good must

be produced in multiple sequential stages, (2) two or more countries must specialize

in producing some, but not all, stages, and (3) at least one stage must cross an

international border more than once. In other words, vertical specialization occurs

when a country uses imported intermediate parts to produce goods it later exports.

This definition captures the idea that countries link sequentially to produce a final

good.

Within a vertical specialization framework, there are several possible trade

patterns. Nordas (2007) identified two patterns of vertical specialization. One

possibility is sequential stages of production where raw materials constitute the first

stage and subsequent stages add value through further processing until the final

stage assembles the components and market the final product. It is often assumed

that the lower stages are less capital and skills-intensive than the late stages. In that

case the lower stages would be produced in low-cost countries that are relative

abundant in labor, while intermediate stages would be located in middle-income

countries with relatively low costs, but reasonably well endowed with skills. The

final stages would be produced in a country relative abundant in skills, which also

tends to be a relative rich country with a significant market for the final goods.

Another pattern of specialization is one where the lead firm owns a trademark

and provides product design, engineering and other key inputs. Production of

intermediate products is then distributed on a number of second tier producers which

may be located in several countries and may or may not have lower-tier

subcontractors locally or in yet other countries. The production of inputs is

coordinated and ideally synchronized by the lead firm, which eventually market the

final goods for the local market and exports. In this structure, the early stages of

production can be the most capital and skills intensive while the late stages of

assembly are often labor-intensive and located in a low-cost country. So-called

outward processing agreements are common trade policy measures that support this

kind of vertical specialization. The textiles sector is for example more capital and

skills-intensive than the apparel sector and the same goes for some

pre-production activities such as cutting the fabric. Also electronics is of this

nature where the production of micro parts is more capital and skills-intensive

than the final stages of assembly.

Concept on Technological and Innovation Capability

According to Kim (2001), technological capability can be defined as the

ability to make effective use of technological knowledge in production,

engineering, and innovation in order to sustain competitiveness in price and

quality. By sufficient technological capability, a company is able to assimilate, to adapt,

and to develop, technology. By technological capability, company can also develop

new technology, product, or process as a respond for economic change. Indeed,

World Bank confirmed that technological capability is the source of company’s

competitiveness. In other words, technological capability is what firms need to be able

to use technology for strategic competitive advantage. The better a company’s

technological capability, the stronger will the company’s competitiveness. In

developed countries, technological capability is mostly accumulated through

learning by research to develop technology frontier. In the other hand, technological

capability in developing countries is mainly built through imitating learning

process through imitative learning by doing.

For concept of innovation, there are many early literature defined

innovation. From those, we concluded that innovation generally means renewal that

may be related to several objects, such as new products, new technologies, new

work/production processes, new management, etc. Based on that, we define an

innovation as a development and successful implementation of new or improved

product, service, technology, production process or management directed towards

gaining a competitive advantage. To be able to realize a permanent flow of

innovations, an enterprise must have sufficient innovation capability. According to

Romijn and Albaladejo (2000), innovation capability refers to the ability to make

major improvements and modifications to existing technologies, and to create new

technologies. The notion of innovation capability applies to process technology,

product technology as well as the way in which production is organized and

managed. Its importance derives from the fact that it is presumed to contribute to

dynamic competitive advantage of companies since it enhances their capacity to keep

up with, to respond, and to initiates technological change on an ongoing basis. It is

crucial in a competitive economic environment characterized by rapid change.

However, adequate measurement of innovation capability is difficult. Since skills

and knowledge were not directly observable, one has to resort to proxies that

capture observable qualities that reflect them. The best measures relate to the outputs

that result from the utilization of a firm's capabilities, i.e. its innovations. In this

case, innovation includes product innovation, process innovation, and management

innovation.

Vertical Specialization in Indonesia’s Automotive Industry

Automotive Industries of ASEAN are dominated by multinational

companies from Japan. Japanese car firms account for over 80 percent of car

production in ASEAN, and parent companies in Japan account for a large share of

imports. Since most of the automotive manufacturing of ASEAN concentrates in 4

big ASEAN countries: Thailand, Malaysia, the Philippines and Indonesia.

Indonesia’s automotive component industry has great varieties and includes wide

range of product type. For example, GIAMM, an association of component and

OEMs has 136 members with 22 groups of OEMs, starting from shock-breaker,

brake system, to wiring harness.

Indonesia’s automotive industry is included in second pattern of vertical

specialization patterns based on classification by Nordas (2007). In this pattern,

the lead firm owns a trademark and provides product design, engineering and other

key inputs. Production of intermediate products is then distributed on a number of

second tier producers which may be located in several countries and may or may not

have lower-tier subcontractors locally or in yet other countries. The production of

inputs is coordinated and ideally synchronized by the lead firm, which eventually

market the final goods for the local market and exports.

It is indicated Indonesia’s automotive industry largely operates through a

vehicle assembly model, with three major assemblers: the Astra Group, the

Indomobil Group and Krama Yuda Tiga Berlian that usually called as the first tier

supplier. These companies are joint venture companies, mainly with Japanese and

Korean vehicle producers, e.g. Toyota, Honda, Mitsubishi, Suzuki, Hyundai and Kia.

Currently there are 20 car assemblers operating in Indonesia, producing 22 brands

of automobile. Total capacity of the assembling manufacturers is more than

700,000 units per year.

The automotive components produced by domestic companies are intended

to be assembled to the newly produced car, small or big part of sales as OEMs

products, and the one for non-brand vehicles. For components legalized by OEM, the

production is started after the order is sent by the world vehicle producer (e.g.

Toyota, Honda, etc) to the first tier supplier (e.g. PT Astra Honda Motor). As what

has been mentioned earlier, only few joint venture companies in Indonesia assemble

components of automotive components from domestic producers as a complete

vehicle. This is caused by the high cost to enter the market, includes the cost of

technology, tools, or even the cost to meet quality standard to obtain certification by

the first tier supplier, e.g. ISO 9000 or ISO 14000, audited by the representative of

foreign manufacturers. After receiving an order, the first tier supplier split the demand

as special module. Recognizing the particular component to be produced, the first

tier supplier is then subcontracting the real production to the second tier supplier by

giving its detail specification. The second tier suppliers are generally specialized in

a particular field of production, and therefore, they are not able to produce all of the

necessary components needed to produce a vehicle. Even tough, the first tier

suppliers are used to subcontracting the production to the second tier supplier in the

same time to maximize the accurateness and minimize the time.

In fact, there are some driving forces to create vertical specialization in

Indonesia’s automotive component industry. They include the followings:

1. Market Demand

The huge amount of Indonesia’s citizens, around 220 million people results in

Indonesia to be potential market for automotive industry. This condition definitely

causes this industry to be a potential business to be developed in Indonesia. This can

be seen from the increasing sales of vehicles in this country, except in crisis period.

Domestic sales of passenger cars reached nearly 400,000 units in 2004 up from

350,000 units in 2003. Roughly 70 percent of this volume is 8-seater vehicles. The

market is expected to continue growing to reach sales of around 480,000 units in

2005 and 760,000 units by 2009, a compound annual growth rate of around 14

percent from 2004.

2. Time and Distance

Regarding the great demand in Indonesia’s market, there is necessity to

decrease operational cost, includes the distribution cost, communication cost, etc.

and also to have shorter time to meet customer expectation, vertical specialization

becomes an important concept to be implemented. Production sharing is

conducted, especially for meeting the domestic demand. For example, Toyota that

produces its product namely ‘Toyota Kijang’ is only marketed in Indonesia. In other

countries, product with almost similar characteristics is also produced but it has

different brand. To achieve high efficiency and effectiveness of time and distance,

most of the component production and Kijang’s assembly tasks are conducted by

Indonesia’s companies, through tight controlling from Toyota in Indonesia (e.g. PT

Toyota Astra).

3. Industrial organization

In Indonesia, the first tier supplier plays its part as assembler, in form of

multinational company, while the second tier consists of smaller companies

producing the components. The second tier suppliers are generally small-medium

sized companies (SMEs) that ripe their benefits in increase of technological

capability. The first tier gives standard of the product. Therefore, in one hand, only

SMEs with sufficient ability in particular level that are able to fulfill the

requirements. This condition forces the SMEs to increase its technological capability.

In the other hand, if the SMEs have achieved the standard, they would also receive

benefit, by means of technology transfer.

Impact of Vertical Specialization to Technological and Innovation Capability of

Indonesia’s automotive industry

In automotive industry vertical specialization, Indonesia places its position in

component supplier. Industrial actors of Indonesia’s automotive component industry

until 2004 was still being hold by multinational corporations and 46% of them are

Japanese companies. Most of Indonesia’s automotive component companies are

joined in association of motorcycle and car industry (GIAMM) (Table 1).

Table 1. Number of Automotive Component Companies in Indonesia (2004)

No. Types of Company MNC Domestic Total1 Member of GIAMM 72 59 1312 Japanese company 60 - 603 Companies of automotive component

of car and motorcycle

20 10 30

4 Engine Part producer 30 18 485 Filter producer 2 7 96 Alternator producer 5 - 57 Engine Starter producer 5 - 58 Radiator producer 2 2 4

Source: GIAMM, 2004

Considering those aspects, impact of vertical specialization to

technological capability can be identified through GIAMM member’s

technological capability. The capability is measured based on the level of

capability in nine technological activities category developed by CENTRIM in a

project funded by World Bank..

Result of the identification of technological capability of the member of

GIAMM has been conducted by Rianto, et al (2005). It shows that automotive

component companies are included in category of strategic and

creative/innovative companies. More than 50% of the automotive component

industries are included in strategic category. The companies in this category are

they who have good awareness to the role of technology related with company’s

sustainability. In-house capability is strongly built in the company and it conducts

strategic approach on technology related with company’s sustainability, while the

rest (37%) are included in category of creative/innovative. Companies in this

category have well developed technological capability. Policy and strategy

developed in the companies are directed to the creation of creative and innovative

process and product creation to keep its competitiveness in automotive component

industry.

Innovation capability of automotive component companies in Indonesia is

provoked by the presence of vertical specialization. As component producer in the

automotive part which will be assembled, the local companies are demanded to

achieve required product specification. This condition stimulates them to produce

new technology and production process which able to create product according to its

specification. Nevertheless, the condition is tending to happen in local companies

(100%), compared with joint venture companies or multinational corporations

(MNC). Research conducted by Rianto et al (2007) shows that company with

foreign direct investment will tend to have the lower innovation capability. It is

because all of production activities are determined by holding company, so that the

company only becomes executor of holding company plants. This condition causes

company cannot create innovation. While company which its investment type is

joint venture, will tend to more able to create innovation. Even though the

innovation created is simple and incremental but holding company still gives

opportunity for company to create innovation, especially innovation in production

process. Different from two types of company previous, the company with local

investment will be able to create innovation in the high level. It is because company

must determine all of the production process itself. This condition stimulates

company to make major improvements and modifications to existing

technologies, and to create new technologies or products.

Technological and innovation capability of automotive component

industry in Indonesia are strongly related with their technological learning. In

vertical specialization, because Indonesia’s automotive component companies are

having their role as supplier of large companies, then the local companies receive

transferred-technology from large firms by Original Equipment Manufacturer

(OEM) or product specification from the principal. Technological transfer also

occurs through reverse engineering.

The production activities of Indonesia’s auto part company generally

representing their effort to respond the market demand. Market for products of

Indonesian automotive part company consists of after-market and principal. In After

Market, Indonesia’s auto part company production activities do not depend on

product specification. They produce goods according to requirement and market

demand. Principal means Indonesia’s auto part companies sell their products to large

company that becoming their principal. This market claim Indonesia’s auto part

company to produce goods according to the standard and product specification that

had been agreed before with their principal. Difference of market type creates

difference also at technological learning orientation conducted by Indonesia’s auto

part company. It’s because learning orientation of Indonesia’s auto part company

represents respond from demand and market requirement.

In the technological learning process at Indonesian auto parts company,

learning orientation not only consider the product but also the process. This matter

because of characteristic of Indonesian auto parts industry producing existing

component with the clear product specification. Others, some of Indonesian auto

parts Indonesia’s auto part company representing auto parts supplier for large

company (principal), it also causes learning orientation is not only consider at the

products. The clear product specification given by principal makes technological

learning orientation of Indonesia’s auto part company shifting to process

innovation motive. So that component in learning orientation variables of

technological learning process of Indonesian auto parts Indonesia’s automotive

component company consisted of product and process.

Learning Orientation at the product occurred when Indonesia’s auto part

companies sell their products to market directly (after market). This matter

because Indonesia’s auto part companies are unattached by the product

specification which must be fulfilled when they become supplier for principal.

Learning orientation of firm also can be aimed at process innovation motive. This

matter became of Indonesia’s auto part company supplying their product for principal.

As supplier of auto parts, products yielded by Indonesia’s auto part companies have

to fulfill standard and product specification which had been agreed on before by

their principal. Thereby the Indonesia’s auto part companies tend to orient to process

innovation, which is how company able to produce goods fulfilling standard and

product specification with efficient and more effective production process. Process

Innovation must be done by Indonesia’s auto part companies in order to maintain its

product have competitiveness in the market, that fulfill QCD conditions requested

by principal.

Innovation in production process can be done by design process technology

or by cutting short production process (time line). Process innovation can reduce

cost production and short time production. It will improve firm productivity so that

the firm able to hold out and have high competitiveness in the market.

Existence of Market for Indonesia’s auto part company not only influence

production activities but also have important role in technological learning

process. It’s because market will determine firm’s technological learning

orientation and learning orientation of course will have an effect on absorptive

capacity and expeditious learning at technological learning process.

Based on the case study in one of the Indonesia’s SMEs producing

automotive component, vertical specialization also becomes means to transfer

new management concepts to Indonesia’s automotive industry as the first tier in the

supply chain management. This can be seen from case of NKP as the supplier for

AHM. According to their fields, the new concepts include quality management,

marketing management, information system management and customer-relationship

management (CRM). In quality management area, vertical specialization brings new

perspective to the company’s philosophy on quality. Before the company become

the 1st tier in supply chain, quality management activities was only created through

final inspection in the production process. After NKP becomes the supplier of AHM,

it start to learn on concept whether quality can be controlled along the production

process, then it will reduce cost of quality, either included in appraisal or failure cost.

The company started to implement new concept of quality by implement new

quality activities. NKP started to control its incoming material and its production

process. This shows that NKP is implementing TQM although the company

does not realize it. Besides, the company is even certified with ISO which can be

said to be ‘costly’ for it’s business scale. Even though, the company considers it as

investment not as cost. By implementing ISO, NKP wishes to be ‘permanent supplier’

of AHM, and obtain wider market for more customers.

To keep up their customers, NKP also implement new information system in

its company. This also needs high cost, but it trusts the new system to be a tool for

gaining competitiveness. This also means that all process in the company is change

from the manual to the automatic one and can be considered as business process

reengineering. Related with information system, the company also improves its

website. This is also a new breakthrough, not only for their marketing but also

in implementing concept of CRM. When there is complain about the defective

products, NKP will easily track it through its information system. NKP makes its

customer ‘comfortable’ to have business with it and feel high satisfaction. Therefore,

it obtains wider market which means more customers. It now supplies many

multinational corporations in Indonesia because it is succeed to offer just-in-time

principles. This makes NKP becomes qualified companies, especially in it’s class

which only in SMEs scale. Its capability brings it in high level of competitiveness,

through technological and innovation capability.

CONCLUSION

In the recent decades, growth of overall world trade has been driven in large

part by the rapid growth of trade in intermediate inputs. This input trade results in

part from multinational firms choosing to outsource input processing to their foreign

affiliates, thereby creating global production networks in which each actor is

vertically specialized. Indonesia’s automotive industry is included in second

pattern of vertical specialization patterns based on classification by Nordas (2007). In

this pattern, the lead firm owns a trademark and provides product design,

engineering and other key inputs. There are some driving forces to create vertical

specialization in Indonesia’s automotive component industry. They include

market demand, time and distance, and industrial organization.

Technological and innovation capability of automotive component

industry in Indonesia are strongly related with their technological learning. In

vertical specialization, because Indonesia’s automotive component companies are

having their role as supplier of large companies, then the local companies receive

transferred-technology from large firms by Original Equipment Manufacturer

(OEM) or product specification from the principal. Technological transfer also

occurs through reverse engineering.

Based on the case study in one of the Indonesia’s company producing

automotive component, vertical specialization also becomes means to transfer

new management concepts. All the concepts bring the local companies of

automotive component to have high competitiveness through TQM and JIT and

shows that they are well developed in this sector.

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