Vol. 26, No. 4, April 2017, pp. 617–632 DOI 10.1111/poms.

12665
ISSN 1059-1478|EISSN 1937-5956|17|2604|0617 © 2016 Production and Operations Management Society

Using Value Chains to Enhance Innovation

Hau L. Lee
Graduate School of Business, Stanford University, Knight Management Center, 655 Knight Way, Stanford, California 94305, USA
haulee@stanford.edu

Glen Schmidt
David Eccles School of Business, University of Utah, Spence Fox Eccles Business Building, Salt Lake City, Utah 84112, USA
glen.schmidt@utah.edu

ast research (along with our experience) suggests that a firm’s supply chain (i.e., value chain) plays an integral role in
P its ability to not only reduce cost via process innovation, but also in its ability to develop new products and services.
Evidence suggests the value chain is playing an ever-more-important role, with greater prevalence of distributed product
development (spanning geographic, organizational, or firm boundaries) and open innovation (performed outside the
firm). We discuss some of the trends with regard to supplier and customer involvement in the innovation process, and
summarize some of the research exploring the rationale behind those trends and the research offering advice on how
firms can use external resources to further improve their innovation performance. We present a number of examples that
illustrate some best practices.

Key words: new product design; supply chain management; innovation; open innovation; modularity
History: Received: October 2015; Accepted: April 2016 by Cheryl Gaimon, after 2 revisions.

profits, which can in turn lead to superior stock mar-

1. Introduction
Apple is the world’s most valuable company by a
wide margin (PWC, 2015) and is recognized as one of
the world’s most innovative companies (e.g., Apple
has been a perennial winner of Bloomberg’s (2010)
rankings of innovative companies). Simultaneous
with its sustained innovative prowess, Apple is
known for sustained leadership in supply chain man-
agement practices (e.g., it is one of only two firms rec-
ognized in Gartner’s (2015) inaugural “masters”
category for supply chain management). Another
company with dual leadership in both innovation and
supply chain management is Amazon (e.g., winner of
Gartner’s (2015) “Supply Chain Top 25,” and 11th in
the Bloomberg (2010) rankings on innovativeness).
Both of these companies rely extensively on supply
networks to manufacture and deliver their products—
neither company itself manufactures or internally
delivers anything of substance so it is no surprise that
their success relies in part on strong supply chain
management skills. But in addition to the role of a
supply chain in the manufacturing and delivery of
products, we argue that a firm’s supply chain plays
an integral role in its innovation performance. The
goal of this article is to offer some perspectives on
how the supply chain (or value chain as we and
others prefer to call it) can contribute to innovation
and thus help spur the firm’s growth in revenues and
617
ket returns as achieved by firms such as Apple and
Amazon (we return to the examples of Apple and
Amazon in section 6 of the study).
The process of innovation has itself undergone sig-
nificant innovation in the past several decades – it has
in many cases moved from more of an “internal”
model where a firm generates, develops, and markets
its own innovations, in the direction of an “external”
model where a firm relies heavily on a variety of out-
side sources for its ideas and its technology (Ches-
brough 2003 uses the terms “open” vs. “closed”
instead of external vs. internal). For example, Ro et al.
(2007) document the shift in the automotive industry,
where suppliers now take on a large part of the
responsibility for the design of components in addi-
tion to the subsequent production of those compo-
nents. The trend is not limited to the auto industry;
similar shifts have occurred in other industries such
as aircraft (as exemplified with Boeing’s development
of its 787) and electronics (as illustrated by the Flex-
tronics case study, Huckman, 2010). In addition, firms
are looking beyond their component suppliers to help
achieve innovation successes. For example, Von Hip-
pel (2005) has studied the way firms use “lead cus-
tomers” to help generate product improvement ideas.
Cui et al. (2012) illustrate and study how one firm,
Siemens, has used Universities, start-up companies,
competitors, customers, and component suppliers as

618 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
participants in a firm’s quest for innovation. Billing-
ton and Davidson (2013) identify an array of
platforms – such as InnoCentive, Innovaro, and
Spigot—which provide a forum where “seekers” can
present their problem and “solvers” can offer candi-
date solutions (following the perspective of Terwiesch
and Ulrich 2009, p. 3, we adhere to the notion that an
innovation is “a new match between a need and a
solution”).
Even in instances where the innovation activities lie
within the firm, these activities are now often widely
distributed geographically or across internal organi-
zational boundaries. This environment of “distributed
product development” (DPD) creates a myriad of
challenges such as working across time zones, com-
municating clearly in spite of language and cultural
differences, and dealing with disparate organizational
cultures. Thus, while the current environment offers
the firm many opportunities for greatly broadening
its access to innovative ideas and cost-effective solu-
tions, it simultaneously creates many managerial
challenges.
In addition to broadening the span of activities in
which suppliers and customers hold responsibility
(such as extending supplier responsibility to include
product design), the new operating paradigm height-
ens the expectations of supplier performance and/or
participation within each activity. For example, on the
upstream side of the supply chain, contract manufac-
turers may now be expected to reduce cost by several
percent per year by generating their own process
innovations (such as implementing lean operations).
On the downstream side, B2B customers may be
expected to pass demand information upstream. In
other words, the supply chain is not only becoming
more “distributed” and “open” but the expectation is
also that a firm’s suppliers and customers become
more collaborative, participative, and responsive in
whatever roles they take on.
As the above discussion implies, the firm is now
exposed to more opportunities to utilize other supply
chain partners in its quest for innovation – but with
these opportunities comes the challenge of deciding
how to best capitalize on that potential. A contribu-
tion of our work is to offer a bit of structure around
how to think about how a firm’s value chain might be
organized to best fit into its innovation strategy (how-
ever as will become evident in reading the study, any
useful structure that we might offer simply builds on
existing knowledge and past research). Effectively we
seek to begin to understand how firms might address
two key questions: (i) Where might it best “source”
each of the various phases of the innovation cycle
(should it perform the work internally or should it
outsource parts of it to suppliers, customers, or some
other entity)? And, (ii) given the firm’s sourcing
Lee and Schmidt: Using Value Chains to Enhance Innovation
decisions, what are the managerial implications that
stem from these sourcing decisions? Of course, in
making its sourcing decisions the firm should use
backwards induction (it should first think about the
implications of its decisions before making those deci-
sions). Thus, in this study, we review some of the
research in this area, and relate a number of examples
from our own experience. We also identify some
topics that might be ripe for further research.
2. Background – Seven Phases of the
Product Innovation Cycle
What is the process Apple might use to come up with
a new innovation to extend it offerings beyond the
iPod, iPad, iPhone, and iWatch? Is Apples’s process
in any way similar to the process Amazon might use
to develop an innovative delivery system that super-
sedes even its two-day “Prime” offering? What about
similarities to the way IDEO might develop a new
innovative shopping cart (see IDEO, 1999)?
Indeed, research has shown that successful innova-
tions are often created through a rigorous process
involving multiple key phases. A very simplistic rep-
resentation of this framework is depicted in Figure 1—
while we list seven phases it should be recognized
that the exact number of phases and terminology for
each phase may differ across projects, or may be
described differently within various textbooks (e.g.,
Ulrich and Eppinger 2016, show five phases in their
Figure 1.4; see also Krishnan and Ulrich 2001, for a
review of research surrounding product development
decisions). While we do not claim that Figure 1 below
Figure 1 Seven Phases of the Product Innovation Cycle [Color figure
can be viewed at wileyonlinelibrary.com]
Boutique suppliers (any combination of phases)
6- Maintenance
development
7- End of life
2- Evaluation
5- Launch &
4- Testing &
validation
3- Design &
(concept)
ramp-up
1- Ideation
Contract Mfg, CM
Contract Design Mfg, CDM
Original Design Mfg, ODM
Vertical integration, VI
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
is the one perfect representation of the innovation
cycle, we delineate these seven phases in order to help
structure our thinking about where (and how) the
value chain can enhance innovation.
Note that Figure 1 is titled the “Seven phases of
the product innovation cycle” (emphasis added to the
word “product”). By using the word “product,” we
do not mean to exclude services—we consider a
“service” to be a type of product. In addition, we do
not mean to diminish the role and importance of
process innovation. For example, a given product
innovation many not be commercially attractive
without some accompanying level of process innova-
tion (the product may be too expensive or even tech-
nically infeasible without the associated process
innovation). In fact, product and process innovation
are often inextricably intertwined and, as our
upcoming examples in section 3 will show, the value
chain’s contribution to the product innovation pro-
cess may emanate in process innovation. See Gaimon
et al. (2017) for a further discussion of some of the
interactions and synergies between product and
process innovation.
The innovation cycle (or innovation timeline)
begins with an idea generation or “ideation” stage
(phase 1 in Figure 1) in which brainstorming gener-
ates a host of possible concepts or opportunities—in
general, the more ideas the better, and the higher the
variability in quality, the better (Girotra et al. 2010).
The ideas are then evaluated in phase 2, beginning
with a screening process in which ideas are judged
along multiple dimensions such as the strategic fit
within the firm, the financial potential, and the ability
of the value chain to be able to execute the idea. Ter-
wiesch and Ulrich (2009) have helped revolutionize
the way ideas are screened by structuring this “fuzzy
front end” process around innovation tournaments.
For a more comprehensive review of much of the
research surrounding phases 1 and 2 (generation and
selection of ideas) see Kornish and Hutchison-Krupat
(2017).
In conjunction with this process of screening out
the least-attractive ideas, each remaining idea is fur-
ther conceptualized and product attribute targets are
identified. Rapid experimentation is conducted until
key uncertainties are resolved—or deemed unresolv-
able and the concepts dropped from further consider-
ation. (The process is sometimes depicted as a
“product development funnel” because a broad
assortment of “wild ideas” are funneled down into a
small set of ideas that are actually viable.) Viable
ideas that survive this second evaluation phase (also
referred to as the concept phase) are presumed enter
phase 3, the design and development stage. At this
point a stage-gate (sometimes called a phase-gate)
product development process is often used—the
619
product must pass several “gates” which are effec-
tively go/no-go decision reviews. Product architec-
ture is solidified during the design and development
phase and issues such as design-for-manufacturabil-
ity become of paramount importance. This is followed
by phase 4, a testing and validation phase during
which time the product is evaluated against customer
expectations and against goals regarding quality and
reliability.
At the completion of phase 4 (testing and validation),
the product is ready to launch and production is
ramped up to full volume in phase 5. Even after the
product reaches full production there may continue to
be design issues that must be addressed, during a
“maintenance” phase (phase 6). For example, the
design may need to be altered because of a material
shortage, or because a part proves to yield an unfavor-
able failure rate and a substitute part must be
approved. These types of developments would necessi-
tate making a “running change” in the bill of materials.
The last phase shown in Figure 1 is that of “end of
life,” phase 7. Even at this stage, there may be design
issues—along with inventory issues—that the sup-
plier can help address. For example, maybe a low-
volume, lower-end component can be discontinued
and a higher-end version approved as a substitute to
be used across all models, or maybe the supplier can
produce a lifetime supply of product (Cattani 2005,
Cattani and Souza 2003).
The seven phases as just described (and as depicted
in Figure 1) are not meant to definitively portray the
exact evolution of every innovation; these phases may
be customized (expanded or diminished) as needed.
For example, possibly a firm may “stumble upon” a
promising idea without going through a formal idea
generation phase. However, this generic description
of the product innovation cycle will serve as a tem-
plate under which we can further consider the
involvement of the value chain in a firm’s pursuit and
delivery of new products.
Historically, supplier involvement has typically
become more direct and specific as one progress
down through the funnel. However, value chains
vary in the extent to which the various phases of the
product innovation cycle are involved in these phases
of product design and development. In almost all
instances, it will be appropriate to, at a minimum,
involve a component supplier in design-for-manufac-
turing (DFM) activities during the design and devel-
opment phase. The extent of involvement may go
much deeper in some cases include complete out-
sourcing of some of the activities to the supplier, or to
a separate outside design firm such as IDEO, or to
entrepreneurs.
In the next section, we offer a number of concrete
examples of how different firms have benefitted from

620 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
supplier involvement of one or more of the seven
phases of the product innovation cycle. Most of our
examples involve companies using manufacturing
suppliers who support the OEM’s (original equip-
ment manufacturers) product design process. These
suppliers may be CMs, CDMs, or ODMs (as defined
in section 3 and depicted in the lower portion of Fig-
ure 1). But it is also possible that the contributing
value chain partners are from the customer side. For
example, consider the notion of using “lead users”
(Von Hippel 2005). Lead users may include those cus-
tomers who have exceptional needs, to the extent that
the customers themselves may even make major
physical adaptions to the product. The needs of these
lead users may often foreshadow the needs of the
broader market, and thus the firm can build on the
work of the lead users in developing next-generation
products. Entrepreneurs are another potential source
of new product ideas, as are external intermediary
networks (see e.g., Billington and Davidson 2013).
Effectively, this amalgamation of upstream and
downstream resources constitutes a set of what we
will call “boutique suppliers;” suppliers who the firm
can look to as a provider of any one (or more than
one) of the phases of the product innovation cycle (as
depicted at the top of Figure 1).
3. Evolution of Practice – Inclusion of
Value Chain Partners in One or
more Phases
In the 1980s, it was recognized that the “over the
wall” approach to new product development (NPD)
was suboptimal – designing the product and then
throwing the specification drawings (blueprints) over
the wall to production resulted in the need for signifi-
cant debugging of the manufacturing process during
the pilot production run and even during ramp-up to
full production (Whitney 1988). This gap, between the
actual design specifications vs. what was readily man-
ufacturable, could be especially pronounced when
production was outsourced. As a result, the concept
of design for manufacturability (DFM) took hold,
with manufacturing departments (and suppliers, if
product components were outsourced) being more
closely integrated into the NPD process in order to
provide input as to how to design the product to be
easier and less costly to produce. Many suppliers took
an even bigger step by vertically integrating upward
– that is, by developing design capabilities of their
own. While an OEM like Ford would previously
design most car components internally and then take
the design drawings to suppliers like Johnson Con-
trols (who produces seats and other interior compo-
nents) and ask the supplier to simply manufacture the
Lee and Schmidt: Using Value Chains to Enhance Innovation
components, now Ford could give Johnson Controls
the general specifications (such as the interior dimen-
sions) and have the supplier complete the design. The
overarching system design architecture and integra-
tion of the supplier-designed components would
remain the primary responsibility of the OEM (see
also our later discussion of integration in section 5.2
of this study), however the supplier would finalize
the component design details with the goal of
reduced manufacturing cost. See Ro et al. (2007) for a
description of this progression in the automobile
industry, and Feng and Lu (2011) for a perspective on
the trend in the electronic manufacturing services
(EMS) industry.
Through this evolution, many suppliers transi-
tioned from being contract manufacturers (CMs) who
were simply asked to build the product to the draw-
ings they were given, to being contract design manu-
facturers (CDMs) who were given the additional
responsibility of product design. In fact, some suppli-
ers developed even further capabilities to generate
the general design specifications and create finished
products without direct input from the OEM cus-
tomers (these suppliers are called ODMs, original
design manufacturers—they effectively create a cata-
log of “off-the-shelf” products that the OEM can select
from). The span of activities that CMs, CDMs, and
ODMs cover is illustrated in the lower portion of Fig-
ure 1. It should again be noted that Figure 1 is general
and does not describe the richness of possibilities. For
example, while it implies a CM’s involvement in the
launch phase through the end-of-life phase, the CM
may not get involved until the product has already
been launched (the launch may first be achieved in
the OEM’s own lower-volume facility); or the CM
may have little responsibility for any “design mainte-
nance” during the maintenance phase; or the produc-
tion may be moved out of the CM’s facility into
another lower-volume “job shop” for the end-of-life
phase.
With the rise of CDMs and ODMs, original equip-
ment manufacturers (OEMs) like Ford could now
choose between designing the product themselves
and hiring a CM supplier to produce it vs. provid-
ing the general specifications to a CDM who would
design and manufacture parts or all of the product
vs. buying a finished product from an ODM. In
addition, design firms such as IDEO (founded in
1991) sprang up and grew as independent providers
of the full range of NPD activities (phases one
through four); but as firms who did not typically
provide significant manufacturing capability. In
complex products such as semiconductor chips, it is
now difficult for an individual company to design
complete products without involving other design
houses and/or the foundries that ultimately
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
manufacture the products—inputs from other value
chain partners is crucial.
In the remainder of this section, we give examples
of how value chain partners can make significant con-
tributions to the different phases of the NPD activi-
ties. Table 1 summarizes the upcoming examples and
the phases they address.
3.1. Phases 1 and 2: Ideation and Concept
Evaluation
Quirky was founded based on the notion that taking
an idea from conception through to a product on a
retail shelf was a daunting proposition (Hoyt and
Marks 2013). It aimed to help inventors with crowd
sourcing to vet ideas and refine concepts, including
determining specific physical features such as color,
and marketing features such as product name, tag-
line, and price. The product development process fol-
lowed by Quirky involved participation of both an
online community and in-house staff.
The process began when someone (the “inventor”)
submitted an idea to the company website (quirky.
com). After an idea was submitted, the member com-
munity voted for those ideas that they liked, com-
mented on the ideas, suggested improvements, or
expressed concerns. Each week some of the ideas
were selected to be discussed at a Thursday product
evaluation meeting. These meetings were run by
Quirky staff and included a live audience through
webcast, so that online participants could observe,
submit comments, and vote for the ideas they liked
best. While the focus here is on Quirky’s facilitation of
the ideation and concept evaluation stages, commu-
nity participation could extend into a collaborative
design process, after which products were “launched”
into the Quirky website’s “Upcoming” section.
Quirky products were available in 35,000 stores at
the end of 2012. In early 2013, about 90% of Quirky
sales were achieved through retail chains with the rest
through the company’s online store, Quirky.com.
However, the startup company did not ultimately
survive, since success depends not only on innova-
tions in Phases 1 and 2 (Ideation and Concept Genera-
tion) but also on innovation and execution in the
subsequent phases. These subsequent phases became
the bottleneck for the company’s success.
Table 1 Examples of Using Value Chains in Multiple Phases of the
Product Innovation Cycle
1–2:
Ideation and 3: Design 4: Testing 5–6: Launch,
concept and and ramp-up and
Phase evaluation development validation maintenance
Case Quirky Xbox, Nike TSMC Xbox,
examples and Cisco Chobani
PCH International
621
3.2. Phase 3: Design and Development
By leveraging the knowledge of suppliers, firms
can enter markets and expand their product lines
in a way that might otherwise be impossible or
cost prohibitive. For example, consider Microsoft’s
entry into the video gaming market. In late 2000
when Microsoft began planning the original Xbox,
the company did not have deep experience in hard-
ware design and manufacturing, and certainly not
in consumer electronics (Hoyt 2006). Microsoft thus
looked to a supplier with such expertise, choosing
Flextronics as its EMS supplier for the Xbox. Flex-
tronics became a close design partner, to ensure
that the 1000 components all worked together
seamlessly (roughly 200 firms were involved in
supplying components such as the DVD drive, Eth-
ernet port, processor, graphics chip, printed circuit
boards, DRAM, flash memory, power supplies, disk
drive, and so forth). Flextronics was also charged
with designing the enclosures, the tooling to pro-
duce certain mechanical parts, and the equipment
needed to test finished products to ensure quality
and reliability. Microsoft successfully launched the
Xbox in December 2001—the 14 month new-pro-
duct-introduction cycle time compared very favor-
ably to that of the market leader at the time
(Sony’s Playstation 2 took 20 months). The ability
to leverage the capabilities of the value chain
partners, notably Flextronics, was the key to this
success.
Another example is that of Nike. In April 2002,
executives at Nike set out to design a new golf shirt
with a wrinkle-free high-quality collar that could
withstand heat and humidity. Such a design project
required expertise in textile and garment manufactur-
ing, something that Nike lacked since it outsourced
manufacturing of its apparel. Nike contacted one of
its CMs Esquel, to re-engineer the golf-shirt collar
from scratch. Esquel was a vertically integrated shirt
manufacturer, with deep experience and R&D capa-
bilities in cotton spinning, fabric knitting and weav-
ing, and garment sewing. It experimented with
different technologies, and within weeks had multiple
prototypes ready to be tested. By October 2002, Esquel
mass-produced the new line of shirts (see Peleg-Gillai
and Lee 2013).
A third example involves Cisco’s development of
its most powerful (at the time) edge router, the ASR
9000, code-named Viking (see Shao 2009a). This pro-
duct, to be launched in November 2008, consisted of
300,000 components, contributing to immense techni-
7: End cal complexity. Under Cisco’s outsourcing model, the
of life
manufacturing partner would put all the pieces
ERP together with the highest quality, reliability and
on-time performance, as required in the demanding
service provider market.

622 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
In mid-November 2007, Cisco made a bold deci-
sion: it awarded the Viking manufacturing job to Fox-
conn, a fast-growing CM with vertically-integrated
operations in China. Foxconn’s broad and extensive
capabilities were an advantage, as Cisco could lever-
age these supplier skills to complement its own
design capability. Cisco carved out a broad role for
Foxconn. The CM would be responsible for manufac-
turing all major subassemblies, except power mod-
ules, fans, and optical technology plug-ins, which
would come from other vendors. Foxconn would
assemble the router’s chassis, “backplane,” circuit
boards, power tray, and fan-trays in Shenzhen. These
subassemblies would be trucked to Foxconn’s “direct
fulfillment” site in Hong Kong. The Hong Kong site
would complete final assembly, testing and configure
the product to individual customer specifications,
after which it would be shipped out by a third-party
logistics company.
Aside from Foxconn, Cisco also engaged suppliers
of 65 custom Viking parts early on, to incorporate
their feedback when building prototypes and to help
simplify not only the product design but also the
manufacturing processes. Getting Foxconn closely
involved early in development was effectively a way
of lowering risk and ensuring success. Foxconn sent
its Chinese engineers with manufacturing process
expertise to work alongside Cisco’s product design
engineers in San Jose, CA. Later, Cisco sent its engi-
neers to Shenzhen to collaborate with Foxconn. The
first two batches of Viking prototypes were built at
Foxconn’s prototype facility in San Jose, only a few
miles away from Cisco headquarters, while the third
batch was made in Shenzhen, marking an unusually
early shift from lab to manufacturing site. Cisco suc-
cessfully launched the ASR 9000 on time, a result only
made possible by intensive collaboration with, and
leveraging of, its value chain partner.
3.3. Phase 4: Testing and Validation
Design testing and validation requires rapid proto-
typing and extensive evaluation, followed by design
revisions, re-testing and more validations. In the
semiconductor industry, this process can be a lengthy
and costly, due to the increasing complexity of inte-
grated circuit designs, and the high costs of prototyp-
ing. TSMC (Taiwan Semiconductor Manufacturing
Corporation), the world’s largest “foundry” (a term
for a CM of semiconductors), has leveraged its manu-
facturing capabilities and technological know-how to
accelerate the testing and validation of the customers’
products (see Shneorson 2006).
An important component in the semiconductor
manufacturing process is the photomask, or simply,
the mask. A mask contains precision images of the
integrated circuit, and is used as a “master” by the
Lee and Schmidt: Using Value Chains to Enhance Innovation
chipmaker to optically transfer images onto semicon-
ductor wafers. Since the dice on the wafer are manu-
factured layer by layer, each requiring a unique mask,
up to forty masks might be needed in order to manu-
facture a single chip. TSMC manufactured clients’
masks in one of the world’s largest mask-making
facilities. Traditionally, customers ordered the set of
masks in the prototyping stage in order to verify a
design before starting volume production, and
though masks were expensive to make, they had to be
remade with every design revision. As a result, cus-
tomers’ nonrecurring engineering (NRE) expenses
were typically high, from $10,000 for a simple technol-
ogy to $1 million for the latest technology. To help
reduce customer costs, TSMC came up with the con-
cept of multiple modules wafers, where multiple cus-
tomers could share the same set of masks (and the
wafer would be split to be used by multiple cus-
tomers). This enabled customers to debug and refine
their designs without having to invest in the whole
set of masks with each iteration. Customers simply
had to log into the TSMC website, get information
about the next shuttle (mask in production) schedule,
and book mask area on the next available shuttle for
their design.
While this section of the satudy focuses on the test-
ing and validation phase, it should be noted that
TSMC often also engages a customer early in the
design phase to enhance the design and its manufac-
turability. TSMC works with Electronic Design
Automation (EDA) companies to create specialized
libraries of the software tools used by design engi-
neers. As transistor geometry continues to shrink,
making ever-larger chips possible, several functions
can be combined into one chip (known as a system-
on-a-chip, or SOC). However, few companies origi-
nally had the expertise or resources necessary to
design all the intellectual property (IP) needed for a
true SOC. As a result, a merchant semiconductor IP
industry arose to provide off-the-shelf designs appli-
cable over a wide range of applications. TSMC offered
these third-party IP core designs on its website,
including verification of their quality and manufac-
turability.
3.4. Phases 5 and 6: Launch, Ramp-Up and
Maintenance
Innovation does not end when the new product is
successfully produced. In the launch of new prod-
ucts, new challenges often emerge unexpectedly.
For example, customers may not react favorably to
a new product and thus design modifications will
be needed, or the demand for the new product may
take off beyond the firm’s projection, or a competi-
tor might respond by cutting prices (necessitating
cost reduction by the innovating firm). The value
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
chain of the new product has to be prepared to
adapt to these challenges.
In the previous example of Microsoft’s Xbox, the
product was built in Mexico and Hungary, and was
successfully launched in November 2001 as previ-
ously noted (Hoyt 2006). In early 2002, Sony
responded by reducing the price of its Playstation 2
(PS2) console from $299 to $199. Microsoft had no
choice but to similarly reduce the Xbox price from
$299 to $199. Again, Microsoft leveraged the global
network of its manufacturing partner Flextronics,
who promptly moved production to its industrial
park in Doumen, China, in order to reduce costs.
Due to great success and strong sales of the Xbox,
Microsoft needed a second manufacturing partner, in
particular one that could absorb peak Holiday sales.
Microsoft contracted with Wistron Corp. to build
Xboxes in its Zhongshan, China plant, providing
incremental volume and helping support the Xbox
rollout into additional countries.
In 2005, Microsoft was working on the next genera-
tion Xbox, the Xbox 360. Microsoft wanted to own
more of the design of the critical chips, so that it
would be able to go to any contract chip manufacturer
in order to continually reduce costs. It replaced the
processor supplier Intel with IBM, and the graphics
chips supplier Nvidia with ATI. But for the overall
product design, incorporating more than 1000 parts,
Microsoft also brought its existing Xbox manufactur-
ers, Flextronics and Wistron, into the design process
in order to optimize production for the Xbox 360.
The above examples are success stories; the exam-
ple of Chobani is a case where an entrepreneur seem-
ingly could have benefitted from working closely
with a set of value chain partners to help avert quality
and supply problems (Gasparro 2015). Chobani was
instrumental in growing the US market for Greek
yogurt, with Chobani’s sales growing from $25 mil-
lion to $1 billion within five years of introduction.
However, quality and supply were somewhat erratic,
and the company lost 15 points of market share along
with a loss of $115 million in the second half of 2013,
while being saddled with $700 million in debt (Sup-
ply Chain Digest, 2015). An appropriate set of value
chain partners presumably could have provided addi-
tional expertise in procurement of raw materials, pro-
duction, and distribution to help ease Chobani’s
growing pains.
3.5. Phase 7: End of Life
Many companies have to wrestle with the problem of
what to do with the product at the end of its life cycle.
There may be numerous stringent environmental reg-
ulations and implications related to how products are
to be treated at the end of their useful lives. At this
stage, the value chain can also be leveraged to
623
effectively and cost-efficiently handle such challeng-
ing problems.
In the case of electronics, disposal at the end of life
has been a big problem for manufacturers. Electronic
products are potentially hazardous to the environ-
ment if disposed of improperly. Additionally, impro-
per disposal means that the firm foregoes recovery of
any value that could have been captured via reuse of
materials. Thus the first call to action for companies
like Hewlett Packard (HP) is to design products that
have less hazardous waste and more recyclable or
reusable components. But firms also have to develop
a reverse supply chain which facilitates the return of
obsolete products and captures residual value. After
recognizing that the cost to manage product recycling
individually would be excessive, a few electronics
manufacturers sought an innovative approach for col-
laboration in multiple value chains spanning more
than one product industry.
The European Recycling Platform (ERP) was a
joint venture of Hewlett-Packard, Electrolux, Sony,
and Gillete, created as an independent business
operation that spanned many countries in Europe
to collect and recycle e-wastes (Shao 2009b). The
fundamental structural change was to create a Pan-
European recycling organization that would spark
competition and drive down costs. Prior to ERP,
waste collection in each country was often domi-
nated by a single, government-sanctioned provider
(e.g., Duales System Deutschland GmbH in Ger-
many). ERP would break the monopoly in each
country. The operation gained economies of scale
through its pan-European approach, and competi-
tive forces led to the company’s focus on lean pro-
cesses for super-efficiency. ERP has steadily
increased its tonnages and the scope of products
managed, and has also increased its coverage to
include a wider set of countries. In countries where
ERP is operating, producers have seen reductions
in the costs of recycling ranging from 10% to 35%.
By mid-2009, ERP had collected more than
700,000 metric tons and membership had climbed
to more than 1300 customers in 11 nations, includ-
ing 34 Europe-wide members. The four founding
companies accounted for about 70% of its recycling
volume. Other members included Apple Computer,
Dell, Microsoft, Nike and Nokia. The ERP estimated
in 2009 that its market share ranged from 10% to
35% in each country where it directly operated.
3.6. Phases 3–6: Aiding Multiple Phases of the
Product Innovation Cycle
As mentioned earlier, an increasing number of service
providers can now support the multiple phases of
product development, from design and development,
testing and validation, all the way to product launch

624 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
and support. PCH International is one such example
(Hoyt 2013; Tung 2008).
PCH is targeted at filling the needs of entrepreneurs
and young enterprises who seek to introduce a new
physical product but who lack extensive technical
knowledge of hardware design and sourcing for
accessories of consumer electronics. To help entrepre-
neurs get their products to market quickly and avoid
costly redesign (time and money are in short supply
for a startup enterprise), PCH provides end-to-end
sourcing, manufacturing, logistics and order fulfill-
ment services. With its acquisition of LimeLab it also
offers design and engineering services. In early 2015,
PCH acquired the remains of Fab, a once-highflying
e-commerce startup, to build a platform to sell the
startup clients’ PCH-made products on Fab.com. As a
result, new companies can broadly leverage PCH’s
value chain capabilities to launch new products with
minimal time and monetary investments.
To further expand its services, PCH set up an
“Accelerator” program to help venture-funded early-
stage companies design, manufacture, and ship prod-
ucts, using PCH’s China supply chain. PCH Accelera-
tor focused on hardware items, particularly those
with difficult challenges in getting their products to
market. In addition to the aforementioned support,
Accelerator clients were provided mentors and coa-
ches. The first product launched through this pro-
gram was one that enhanced sleep patterns; the
founder of the company (Lark) was a first-time entre-
preneur.
Beyond PCH’s original focus on accessories of con-
sumer electronics, many startups have leveraged
PCH’s value chain support to accelerate their product
development cycles, introducing products such
as smart wearable jewelry (Ringly), electronics kits
(Littlebits), drones (3D Robotics), and health track-
ers (Cue). PCH recently also added PCH Access, a
program that helps startups scale up their manufac-
turing capabilities.
4. The Strategic Decision Regarding
Outsourcing
To reiterate, Figure 1 portrays the notion that a firm
has a host of possible routes to take in executing the
seven steps of the innovation cycle. The firm can: (i)
choose to internally perform all seven stages in a ver-
tically integrated fashion; (ii) maintain responsibility
for all of the design responsibilities (phases one
through four); (iii) outsource only the production
using the services of a CM. Or, it can leverage the sup-
plier involvement by outsourcing to a CDM or an
ODM; or (iv) use a boutique supplier for one or more
portions of the cycle. Given all of these possibilities,
we return to the first of the two questions identified in
Lee and Schmidt: Using Value Chains to Enhance Innovation
the Introduction; where might it best “source” each of
the various phases of the innovation cycle?
The degree to which suppliers are involved often
becomes a strategic decision of the firm. In exploring
the question of where to source each phase of the
innovation cycle, we begin in section 4.1 below by
developing a simplified two-by-two matrix (as
depicted in upcoming Figure 2) that considers
whether the design of the product is outsourced,
along with whether the manufacturing is done inter-
nally. We then consider how the R&D capabilities
required to bring the innovation to market—and
hence the outsourcing strategy—depend on the
“type” of innovation being pursued (as illustrated in
upcoming Figures 3 and 4). Collectively, these discus-
sions (as summarized by Figures 1–4) provide a bit of
structure to aid in thinking about the outsourcing
decision.
4.1. The Simplified 2 3 2 Outsourcing Matrix
Rather than consider all seven phases of the product
innovation cycle, we consolidate the cycle into two
broad phases, which we will refer to as “design” and
“production” following Ulrich and Ellison (2005).
Outsourcing of the design phase might be thought of
as outsourcing steps one through four (or steps two
through four with the OEM continuing to perform
step one) while outsourcing of the production phase
may be thought of as outsourcing of steps five and six
(and possibly seven). Given the two phases of “de-
sign” and “production” the firm has four choices, as
shown in Figure 2. It can choose to design the product
internally or outsource the design (as shown on the
“x” axis), and similarly it can choose to either
Figure 2 Possible Outcomes of the Make–Buy Decision Involving
Design and Production [Color figure can be viewed at
wileyonlinelibrary.com]
Original Design
Manufacturing of the product
Contract and Mfg.
Outsourced
Manufacturing (ODM)
only Contract
(CM) the Design
& Mfg. (CDM)
Contract
In-house
Vertical Design only
Integration (Rarely
(VI) observed)
In-house Outsourced
Design of the product
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society 625

Figure 3 Strategic Buckets (Adapted from Terwiesch and Ulrich 2009) outsource one or more of phases one through four;
[Color figure can be viewed at wileyonlinelibrary.com] more on this later).
Ulrich and Ellison (2005) go on to develop hypothe-
Nonexistent

ses regarding the conditions under which the firm

Radical
should opt for VI, CM, or CDM/ODM. Factors that
(high risk,
high reward) argue for outsourcing an activity by an OEM (be it
design or production) include economies of supplier
scale (including pooling benefits), competition among
Exists, but we
don’t serve it

suppliers, and lower capital investment by the OEM.

Market

Factors that argue for keeping an activity in-house

include avoidance of transaction costs (including the
possibility of “hold up”), loss of intellectual property,
and bargaining losses. Integrating both activities
within one firm (be it the OEM or supplier) is benefi-
We serve it

Incremental cial when information is hard to codify and when the

(low risk, potential supplier’s “effort” would be hard to observe
low reward) (leading to the classic principle-agent problem). Using
data from the bicycle industry, Ulrich and Ellison
Exists, but we (2005) empirically support their general hypotheses.
We use it Nonexistent
don’t use it The Flextronics case study (Hackman and Pisano
Technology 2010) illustrates how the framework might apply in
practice, and demonstrates how the decision may
change over time within a given product category.
New product designs are often higher-end offerings
Figure 4 Encroachment Patterns (from Schmidt and Van der Rhee
2013)
that sell primarily on the basis of features and less on
price (Van Orden et al. 2011, find that about 90% of
+$$ new products are of the “new and improved” type,
Ancillary Attribute Performance

Strong
Moderate
–$
Weak
Lower
manufacture the product internally or outsource the
production (as depicted on the “y” axis). In the ver-
nacular of our previous discussion, the lower-left
quadrant is one of vertical integration (VI) where the
firm performs both tasks (design and production); the
upper-left quadrant is one where the OEM outsources
to a CM; and the upper-right quadrant involves the
services of a CDM (if the OEM maintains responsibil-
ity for phase one) or an ODM (if the OEM outsources
that responsibility to the supplier as well). The lower-
right quadrant, rarely observed in practice, is where
an OEM solicits the services of a design firm to inde-
pendently come up with products for it to manufac-
ture (this is not to say that an OEM does not
New-Market introduced at the high end). Since the OEM often has
Detached-Market
low-end high-end the first-hand knowledge and expertise regarding
marketing needs and wants, the OEM often opts for
+$ internalization (rather than outsourcing of the design)
Fringe-Market New-Attribute and then either produces internally—or the OEM uses
low-end high-end
a CM for manufacturing. As a product matures it typ-
+$ ically diffuses down-market, where price and hence
production cost become more important, suggesting
Immediate Immediate
low-end Original high-end
that integration (of design and manufacturing)
product becomes critical, arguing in favor of using a CDM. At
full maturity the product category may effectively be
Unchanged Higher
comprised of mid-to-lower-end items that sell in rela-
Core Attribute Performance tively larger volumes but sell primarily on the basis of
price. At this point, an ODM supplier can indepen-
dently proceed to develop new product versions
within the category.
4.2. Open Innovation Heightens the Complexity of
the Outsourcing Decision
As discussed previously, the possibilities for out-
sourcing of various individual phases of the product
innovation cycle are greatly magnified under the
paradigm of open innovation. Thus the 2 9 2 matrix
presented in Figure 2 is an oversimplification; a large
number of possible combinations are possible. If one
considers that each of the seven phases of the pro-
duct innovation cycle (as shown in Figure 1) can be
either outsourced or performed internally, the deci-
sion possibilities of Figure 2 become 7-dimensional,

626 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
rather than 2-dimensional. Furthermore, another
possibility is that the OEM may choose to “dupli-
cate” the work of any one phase; for example it may
choose to both manufacture internally in addition to
outsourcing some of the production (see Parmigiani
2007, for a discussion of the reasons a firm might
choose to do so).
In fact, as some of our earlier examples illustrate, a
firm might leverage its value chain partners to
improve the outcome of one of the seven phases in
Figure 1 without fully outsourcing that given phase
to the value chain partner. For example, chip compa-
nies that ask TSMC to provide them with libraries of
design code are just seeking “inputs” from a supplier,
without outsourcing the design to the supplier. Alter-
natively, a firm that uses the “crowd” to help evaluate
a concept or refine a design (by utilizing Quirky) is
again not fully outsourcing that phase of the innova-
tion process, but is simply asking for inputs in order
to expand or enhance the internal process.
While we point out the myriad of possibilities, we
do not do so with the intent of making the decision
process appear hopelessly complex. The point here is
to illustrate how the decision process can be struc-
tured in terms of the stages of the product innovation
cycle, and to provide some context for considering the
managerial implications of the alternatives.
4.3. The Outsourcing Decision as a Function of the
Strategic Bucket and Innovation Type
An additional consideration regarding the out-
sourcing decision is to view the decision in the context
of the “strategic bucket” as depicted in Figure 3. The
concept of the strategic bucket categorizes an innova-
tion on the basis of whether it involves new technol-
ogy, and/or a new customer market. The “newer” the
product the more risky it is, the longer the time hori-
zon for launching the product and/or growing the
market, and presumably, the higher the expected
return (if the expected return is not commensurate
with the risk, the innovation will not be deemed
viable).
The optimal involvement of different value chain
partners in the various phases of the innovation pro-
cess will to some extent be a function of which strate-
gic bucket the innovation lies. The identification of
more-radical innovations (the upper-right corner of
Figure 3) may be more likely if outside influences are
involved early, in the ideation phase—start-ups and
external intermediary networks may be potential
sources of radical ideas. Chao and Kavadias (2008)
show that the search for radical innovations is partic-
ularly relevant when many product attributes interact
– they term this an environment of complexity. Fur-
thermore, radical innovations involving new technol-
ogy may require involvement of Universities or other
Lee and Schmidt: Using Value Chains to Enhance Innovation
research organizations to help prove the technology.
In some cases, the firm may largely forego pursuit of
internal radical innovation with the intent of simply
acquiring innovations (or even firms) developed by
others.
At the other end of the spectrum, incremental inno-
vations (sometimes called “derivative” products since
they are derived from existing items) may require less
outside involvement, although a CDM or ODM sup-
plier may be an essential driver of the innovation pro-
cess. Thus we posit that external involvement may
optimally be highest at the extremes of the spectrum;
radical innovations may more heavily rely on the
value chain to generate ideas and new technologies
while derivative products will be more price-sensitive
and thus may best be developed by suppliers who
have intimate knowledge regarding production pro-
cesses. Validating (or refuting) this hypothesis may be
an opportunity for future research.
In addition to whether a new product is incremen-
tal or radical, another dimension of its “disruptive-
ness” is whether it first encroaches on a market (i.e.,
takes market share away from existing products) at
the high end or the low end. Tesla has adopted the
high-end encroachment strategy—it started with a
high-end car and is encroaching down-market with
each new model introduction. Conversely, Toyota
adopted a low-end encroachment strategy in growing
its US market share—it started with an inexpensive
car and encroached up-market, eventually succeeding
with its Lexus brand. Schmidt and Van der Rhee
(2013) further identify a 2 9 3 matrix of possible
strategies (see Figure 4), as a function of whether the
performance of the core product attribute is enhanced
or diminished (leading to high-end and low-end
encroachment, respectively), along with whether an
ancillary attribute adds weak, moderate, or strong
supplemental performance (weak performance is
associated with incremental innovation and strong
performance with radical innovation).
The most “disruptive” innovations, and the ones
that are often hardest to implement internally, are
those involving radical innovation and/or low-end
encroachment. Most innovations are of the incremen-
tal high-end type—think of the plethora of products
that are marketed as “new and improved” versions of
existing products (Van Orden et al. 2011). This is
incremental high-end encroachment. Radical high-
end innovations (such as the Tesla) receive a lot of
press, but are much less frequent and constitute a
much smaller fraction of revenues for the vast major-
ity of companies. Low-end encroachment is typically
unexciting and also relatively more difficult for a firm
to implement internally, although Nintendo’s Wii is
an example of an incumbent’s very successful inter-
nally-generated disruptive innovation. (The Wii was
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
a fringe-market innovation of the type represented by
the middle-left box in Figure 4, in that it diminished
performance along the key dimensions of graphics
and processing speed, but offered a new ancillary fea-
ture, the motion-sensitive controller.)
Easier access to outside sources for innovative ideas
and for development of these ideas should potentially
increase a firm’s ability to succeed with radical inno-
vation as well as low-end encroachment. Low-end
products may also be strong candidates for outside
involvement of value chain partners due to the fact
that such products do not typically appeal to existing
high-valued customers. Internally, the firm is often
focused on meeting the needs of its “best customers”
and may thus miss opportunities for innovating at the
low end of the market.
4.4. Opportunities for Future Research on the
Outsourcing Decision
Opportunities abound for future research regarding
the outsourcing decision. With increased access to
CDMs, ODMs and boutique suppliers (refer back to
Figure 1), how should the firm determine which tasks
to outsource and which to perform internally? Is the
progression from CM to CDM to ODM as described
in section 4.1 (always) optimal and if so, at what rate
should it proceed? Are there empirical data that vali-
date and quantify the superiority of one strategy
versus another?
Further opportunity exists to expand the work of
Ulrich and Ellison with regard to the ideation phase,
along with the end-of-life phase. The outsourcing
decision has implications on the management of end-
of-life, in addition to the usual consideration of the
ramp-up and mature phase. Should a company retain
the same outsourced provider to handle product
repair and potentially disposal at the end-of-life? Some
companies diversified its risk by having two different
outsourced providers (e.g., in 2001, Microsoft used
Flextronics as the CM to build Xbox, while Solectron
was selected to handle product repair). On the other
hand, recycled products may enable components to be
used for the manufacturing of new products, so that it
would be efficient to have the same outsourced provi-
der to handle the product in all phases its life cycle.
There are also cases in which an entirely new out-
sourced provider, cutting across multiple industries, is
created to manage product recycling. The earlier
example of ERP described such a case.
5. Managing Outsourcing of
Innovation
Once the decision has been made to outsource some
phase(s) of innovation, a major managerial question is
how to best manage these outside providers, to take
627
advantage of their expertise while avoiding pitfalls
such as excessive transaction costs, losing competitive
advantage that accrues to proprietary technology, or
falling prey to the hold-up problem. We discuss
below some of the implications, with reference to
research findings within the field (also see, e.g., Tsay
2013).
5.1. The Need to Align the Value Chain with the
Product Architecture
Simultaneous with making decisions regarding the
structure of the value chain, the firm should carefully
consider the “architecture” of its products (for a defi-
nition and discussion of product architecture see for
example Baldwin and Clark 2000 along with Ulrich
1995). There is some evidence to suggest that the sup-
ply chain should “mirror” the product architecture
(e.g., Fine 2005). This means that if the product archi-
tecture is integral, such that the design of one compo-
nent hinges on the design of other various
components, then the supply chain overseeing the
designs of these various components should also be
integral (meaning that one firm should be responsible
for the design of all these various components). On
the other hand, if the supply chain is modular, such
that different “modules” (i.e., firms) are responsible
for the design of the various components, then the
product architecture should also be modular (mean-
ing that there are well-defined interfaces that separate
the various components – the interactions between
components have been largely eliminated).
Misalignment between the value chain and the pro-
duct architecture can have dramatic consequences.
For example, the failure of the merger between
Chrysler and Daimler Benz (Mercedes) is reported by
Fine (2005) to have resulted from such misalignment.
Prior to the merger, Chrysler followed the modular
architecture/modular supply chain strategy (with
key sub-system suppliers responsible for design of
their individual sub-systems) and achieved competi-
tive advantage via relatively more rapid iterations of
new product introductions, while Mercedes followed
an integral architecture/integral supply chain strat-
egy and achieved competitive advantage from supe-
rior product performance. When the two companies
were merged, an attempt was made to force-fit the
Mercedes integrative supply chain management
approach to Chrysler’s value chain, along with a (rec-
ognizably more limited) attempt within Mercedes to
adopt elements of Chrysler’s modular approach to
supplier management. The outcome was not success-
ful within either firm; Chrysler saw deterioration in
its reputation for relatively fast product development
times and cost-competitive designs, while Mercedes
experienced cases of quality and performance deteri-
oration.

628 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
While the mirroring principle described above is a
€ u and Schmidt (2011) show
good rule of thumb, Ulk€
that it may not always be an optimal strategy. They
make an analogy between a modular architecture in a
design setting, and inventory in a production setting.
In the Toyota production system inventory is consid-
ered a waste. But inventory can be a “necessary
waste;” it can be optimal to hold inventory, to decou-
ple production from demand and mitigate the effect
of uncertainty in demand or other undesirable reali-
ties. Similarly, a modular design is a waste, in the
sense that it yields performance loss—the ultimate
product performance (with no over-design of any
component) is achieved with an integral design. How-
ever, modularity may be a necessary waste, to decou-
ple one sub-system from another and mitigate the
undesirable effects of collaboration costs, an adversar-
ial relationship with suppliers, or imperfect supplier
design capabilities. See also Kamrad et al. (2016) for
further discussion of factors that guide the architec-
tural decision—suffice it to say that the interaction
between product architecture and the value chain is a
management challenge that should not be over-
looked.
5.2. The Need for “Integrators”
Anderson et al. (2007) offer a review of research in
distributed product development (DPD), which they
define as PD that spans across geographical, organiza-
tional, or firm boundaries (see also Anderson and
Parker 2013). Since outsourcing (of any of the seven
phases) spans firm boundaries, the discussion in this
study falls under the umbrella of DPD. Anderson
et al. (2007) find that DPD creates the need at the
OEM for supply chain integrators, who typically must
possess a broad set of skills including business acu-
men as well as some engineering knowledge. These
integrators effectively become ultra-lightweight pro-
ject managers (to extend Clark and Fujimoto’s 1991
terminology) in the sense that they have no direct-line
responsibility over many of the PDP participants.
However, they bear a “heavy weight” nonetheless in
that they are responsible for ensuring progress of the
program. Thus, the program manager may need
strong organizational behavioral skills in addition to
business and engineering skills. This is a demanding
position, and not all managers are successful at navi-
gating this landscape. Consider the Boeing 787 pro-
gram, which went through several managers and
experienced numerous delays and cost overruns
(Tang and Zimmerman 2009).
The OEM must also be wary of being burnt by
what we call the “integrator incinerator.” Our experi-
ence suggests that as an OEM firm moves from
designing components in-house to outsourcing the
design to a CDM, it is initially in a very favorable
Lee and Schmidt: Using Value Chains to Enhance Innovation
position to internally recruit integrators. The OEM’s
most-outstanding component engineers are now
available to work as integrators, or to help transition
the architecture from integral to modular (refer to the
previous discussion on “mirroring”). However, since
the OEM no longer designs components internally, it
neither builds new component knowledge nor
cultivates retention of current knowledge (at least not
to the extent as if it maintained internal component
design responsibility). With time, attrition “inciner-
ates” the healthy stock of component engineers, and
the OEM finds it more difficult to staff the all-
important integrator role. Anderson and Parker
(2002) similarly suggest that when an OEM out-
sources a component the OEM fails to learn how to
better integrate the component into the overall design
(see Fine and Whitney 1999, for further discussion of
this integration capability).
5.3. The Need to Build and Protect Brand Equity
Choosing the CDM or ODM model is not without risk
to the OEM. In outsourcing some of the elements of
innovation, the OEM risks giving up some (or much!)
of the profit that accrues to the value chain from inno-
vative activity. Consider the experience of IBM, who
at one point was a vertically integrated computer
mainframe company with control over the design of
computer software and microprocessors. IBM was
able to appropriate nearly all the profits stemming
from computer design and production. Then, as the
computer industry began to move toward personal
computing around 1980, IBM largely outsourced its
software to Microsoft and its microprocessor develop-
ment and production to Intel. Effectively, IBM
adopted a CDM model that ultimately resulted in a
loss of control over those two key computer compo-
nents. In 2005 IBM sold the personal computer divi-
sion to Lenovo, while Microsoft is now one of the
world’s five biggest firms and Intel competes (with
IBM) for the 30th spot in the S&P 500 (comparisons
are based on market capitalization, PWC 2016). In
2011, Intel and Microsoft together are estimated to
have earned triple the combined profits gained from
sales of PCs across all manufacturers ($35 billion vs.
$10–$12 billion, Yoffie, 2012). A key lesson from the
IBM case is that a firm cannot afford to lose control
over the activities that are critical to its future strategic
competitive advantage (this does not mean out-
sourcing cannot be considered, but it means the firm
has to carefully manage its execution).
Another example of lost brand equity is the ser-
ver market, where the supplier Quanta is now sell-
ing directly to the customer market as opposed to
selling through IBM and Dell (Dou 2014). In the
automotive industry, Ro et al. (2007) speculate on
whether a similar “Intel inside” phenomenon might
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
occur, as manufacturers outsource entire systems.
What may be preventing this to date is the possibil-
ity that there is no single dominating component in
the automobile as there is in the computer—the
microprocessor acts as the “brain” of the computer
while the automobile has a relatively larger number
of major systems including the engine, drivetrain,
cabin, electronics, and other systems. Since none
dominates the others, no one system can command
the customer’s primary attention.
5.4. Other Considerations and Insights
The above discussion regarding product architecture,
integration, and brand equity are just a few of the con-
siderations associated with the outsourcing decision.
Additionally, Billington and Davidson (2013) suggest
that firms seeking codified (as opposed to tacit)
knowledge will manage suppliers differently than
those seeking tacit knowledge. Elicitation of codified
knowledge calls for a “gladiatorial” processes in
which gladiators (subject experts) vie for the award
for best solution. Elicitation of tacit knowledge calls
for a “whirlwind” processes in which cross-functional
teams develop multiple potential solutions which can
be tested via rapid experimentation.
Cui et al. (2012) examine the supplier selection
decision (here, we use the term “supplier” to mean
the supplier of a given phase of the product innova-
tion cycle), and the subsequent management of the
selected supplier based on a dataset from Siemens.
Supplier selection should depend on the “match”
between the outsourcing needs and the provider’s
capabilities (matching on requirements regarding
cost, market, technology, manufacturing, strategy,
and organization). Management methods should be
customized as a function of provider type (they dis-
cuss five: universities, competitors, customers, start-
ups, and component suppliers). Key themes across
provider type are: (i) facilitating trust, communica-
tion, and the provider’s organizational stability,
(ii) identifying measurable deliverables, and (iii)
aligning incentives.
Xiao and Gaimon (2013) highlight the value to the
buyer of manufacturing at least a portion of a compo-
nent in-house in order to benefit from the knowledge
transfer for future NPD projects. Both knowledge
development and knowledge transfer are impacted
by relationships across the value chain, as discussed
by Gaimon et al. (2017).
Iyer et al. (2005) suggest that one reason a buyer
might aid the supplier is to gain information about
the supplier’s capability, which in turn reduces the
information rent otherwise to be extracted by the sup-
plier. In this context, the authors discuss Toyota and
other Japanese manufacturers as examples in the
automotive industry. In the pharmaceutical industry,
629
they discuss how drug discovery involves a “lead-i-
dentification step” in which buyers may share
resources with the supplier.
5.5. Opportunities for Future Research on How to
Best Manage Outsourcing
Future research is needed to examine how to manage
the outsourcing of various phases of the product inno-
vation cycle to members of a firm’s external supply
chain. For example, the issues raised in sections 5.1–
5.4 are far from being fully resolved. Several addi-
tional areas in which we see firms seeking further
insight are as follows—certainly, this is a very incom-
plete list.
Extant research regarding successful new ventures
(and entrepreneurs) has focused on factors such as
industry dynamics, the characteristics of the entrepre-
neurs/founders, funding availability, and talent
recruitment. More research is needed on how the
value chain characteristics impact success. In other
words, is the (perceived) shift to open innovation
actually driving higher levels of success? Under what
conditions?
Customer needs and demands are continually shift-
ing, resulting in uncertainty as to not only the imme-
diate potential for new product acceptance but also
the duration of its potential life cycle. How can a firm
best manage uncertainty? In the fashion industry,
researchers have developed a framework called “ac-
curate response” in which an early demand signal is
created and then used to better allocate production
across “speculate” and “reactive” manufacturing
capacities (see e.g., Fisher et al. 1994). Is there an
equivalent way that firms can better manage the
uncertainties in product acceptance and the duration
of product life cycles—for example, using rapid pro-
totyping and by leveraging the capabilities of various
value chain partners?
The OEM often needs to dynamically respond to
unexpected events during ramp-up and production.
In addition to the conventional concept of flexible
manufacturing that is based on a specific production
facility being able to switch from one product to
another or to rapidly vary production mix, firms may
want to create flexible value chains—value chains that
are even more adaptable as compared to our earlier
Xbox example involving relocation of manufacturing.
(How) can such flexibility be created in a cost-effec-
tive manner? How does a firm (or should a firm even
attempt to) cultivate long-term relationships with
suppliers and customers while at the same time
achieving the flexibility to continually reconfigure its
value chains?
Value chains need to be integrated into a firm’s sus-
tainability efforts throughout the product life cycle to
increase the use of recyclable materials in product

630 Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
design, reduce energy use during production, and
properly treat hazardous materials at end of life. For
example, much of the used cardboard is currently
shipped from the United States to China, where it is
recycled for use in the packaging of newly manufac-
tured electronic and consumer goods. How can sus-
tainability efforts be maximized across the value
chain?
Sometimes the success of one firm’s innovation is
largely tied to a synchronous innovation of another
firm. For example, Intel’s Pentium 4 achieved only
limited success until Microsoft launched Windows XP.
The portmanteau “Wintel” was coined to describe the
synchroneity between innovations in Windows and
Intel microprocessors. Research surrounding these
types of synchronous innovations is still scant. For
example, what is the appropriate form of coordination
and level of synchronization in such cases?
As emerging economies enhance their CDM and
ODM capabilities, there is the potential for brand
owners to offshore more of the up-front elements of
the product innovation cycle. Such outsourcing inher-
ently increases the risk of leakage of intellectual prop-
erty (due for example to country-to-country
differences in patent laws). Even at present, there are
many piracy cases involving knockoff products such
as cell phones or luxury goods—often known as
Shanzhai products (Siu and Tseng 2010). How can
intellectual property be protected to ensure brand
equity (along with product safety)?
6. Discussion and Summary
The firm has increasing flexibility in the manner in
which it carries out the seven phases of the innovation
cycle (Figure 1). Chesbrough (2003) attributes this
trend (from closed innovation—doing it yourself—to
open innovation—looking outside the firm for partici-
pants in the ideation phase forward), to two factors:
an expanded number of mobile knowledge workers,
and greater access to private venture capital (which
allows entrepreneurs to venture out on their own
rather than be confined to work within a larger firm).
However, in the past, firms often looked internally to
innovate (that is, to find solutions to problems), they
now have broader access to various other outside
resources. As stated by Billington and Davidson
(2013, p. 1464): “business problem solving changes
from solving problems to finding answers.” Finding
solutions that already exist can be much cheaper than
having to develop the solution in-house; Billington
and Davidson (2013) offer the example of Goldcorp,
who increased its output by a factor of nine while
reducing its cost per unit mined by a factor of 6. From
this example we see that the incentives to outsource
some elements of the innovation cycle are strong, as
Lee and Schmidt: Using Value Chains to Enhance Innovation
this can lead to enhanced innovation outcomes at dra-
matically reduced R&D costs.
This should not be taken to mean that all firms are
best served by outsourcing all the phases of the cycle
of innovation, or that there is a one-size-fits-all solu-
tion. At the outset of this study, we provided the
examples of Apple and Amazon as companies who
have far outperformed the stock market over the past
decade, while simultaneously outperforming along
two operational dimensions (innovativeness and sup-
ply chain performance). Apple tightly controls the
intellectual capital surrounding its physical products,
largely retaining responsibility for product design
while relying on firms such as Foxconn and Quanta
for manufacturing. On the other hand, Apple relies
heavily on outside firms to supply software applica-
tions or “apps” and has configured its software
system to facilitate this supply. Apple relies on intro-
ducing a new “blockbuster” product every several
years (the iPod, iPad, iMac, iPhone, Watch) with
subsequent incremental upgrades of each.
Amazon also has its own approach. For example,
with “Amazon Web Services,” it has become a sup-
plier of innovative solutions for firms looking to
acquire similar capabilities in managing their Internet
infrastructure. Amazon Turk is another innovation
that was developed to solve an internal need but then
made available more broadly. With regard to physical
distribution of goods, Amazon works with other large
retailers such as Eddie Bauer and with manufacturers
such as Procter and Gamble to drop-ship directly to
customers from the retailer’s or manufacturer’s ware-
houses, rather than go through an Amazon ware-
house. Amazon has also worked with the US Postal
Service to implement Sunday delivery. Unlike Google
that manufactures its servers in-house, Amazon relies
on providers such as Synnex to manufacture its mas-
sive network of servers. In sum, Amazon works
extensively with its value chain to develop and imple-
ment a wide range of innovations.
While the trend toward outsourcing of various
phases of the innovation cycle is promising, pitfalls
remain, as Boeing found out all too painfully (Elahi
et al. 2014, McDonald and Kotha 2015, Tang and Zim-
merman 2009). Boeing relied more heavily on the
CDM approach for the development of its 787 Dream-
liner, but experienced dramatic delays and cost over-
runs. A major motivation for Boeing was to push
some of the development cost onto its suppliers,
thereby reducing Boeing’s risk. Ultimately, Boeing
pulled some of the work back inside the company
and actually bought some supplier assets due to out-
sourcing problems in its value chain. Broadly speak-
ing, Boeing failed to achieve three essential
components of good supply chain management: (i)
they failed to establish transparency across the supply
Lee and Schmidt: Using Value Chains to Enhance Innovation
Production and Operations Management 26(4), pp. 617–632, © 2016 Production and Operations Management Society
chain, making the right information available to all
parties as needed; (ii) they failed to create proper
incentives within the supply chain, such that each
party participates optimally; and (iii) they failed to
create a robust process which could react in a timely
fashion to the problems that inevitably arise. As evi-
denced by the fact that Boeing went through four pro-
gram managers in developing the 787, the role of the
integrator is of paramount importance in achieving
the necessary level of transparency, incentive compat-
ibility, and process robustness. In the framework of
Schmidt (2008), Boeing failed to adhere to the TIRP
principles of transparency, incentive compatibility,
robustness, and pinch point (in the context discussed
here, the integrator needs to act as the “pinch point,”
or controller, of the system).
The success stories offered herein illustrate the
huge potential that exists for enhancing innovation
via collaborations with outside suppliers, while the
experiences of Boeing and others illustrate some of
the challenges. Opportunities for further research are
plentiful, to determine exactly how to decide what
steps of the innovation cycle to outsource, and how to
manage the suppliers of those outsourced activities.
We look forward to learning from the research com-
munity as further knowledge is generated, and to
hearing of many success stories from practitioners as
this knowledge is applied throughout industry, to
improve the world in which we live.
Acknowledgments
The authors greatly appreciated the repeated input and
feedback from Professor Cheryl Gaimon, along with the
helpful comments of an anonymous reviewer.
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