He runs it like it's a bank (this is where he comes from), not a patent office
THE EPO is doomed. Sorry to say this, EPO staff. Many of you know this deep inside and have said this to us over the years.
And over time, over the past 21 years even , I have seen these telecommunication companies develop. We all remember Bell Labs, and in the Netherlands, KPN Neherlab, when telecommunications companies were innovators, and they were the first to do many things, and when they did actual research.
And over the past 20 years, I’ve seen the extremely sad decline of all these communications companies into branding and financing bureaus, and this has impacted my own business, because I used to sell software, and now I sell services, because no one can buy my software anymore, because none of these telecommunications companies are technical companies anymore.
I spend a lot of time thinking about that, why? Why is that going on? And why is it bad? And that brings me to the central question of this presentation.
In any organization, in any company, in any group, any country and even any continent, what level of technical capability, do we need to retain? How technical do we need to stay to remain viable as a company or a country or a continent? And is there a point of no return?
If you outsource too much? Is there a point where you cannot go back and relearn how actually making things work?
Reducing costs is another buzzword that is often used to argue pro outsourcing. Considering the apparent first-order effects, it makes intuitive sense that offloading a certain segment of a business to a third party will reduce costs via lower labour costs and overheads, depreciation and capital outlays. In fact, this is one of the allures of the globalised world and the internet; the means of outsourcing work to lower-wage countries are cheaper than ever before in history.
However, the second-order effects of outsourcing are rarely considered. The first fundamental rule of ecology is that in a complex system you can never only do one thing. As all parts of a complex system are intricately linked, perturbing the system in one area will have inevitable knock-on effects in another area. Additionally if the system behaves non-linearly to the external stimuli, these knock-on effects are non-intuitive and almost impossible to predict a priori. Outsourcing an entire segment of a project should probably be classed as a major perturbation, and as all components of a complex engineering product, such as an aircraft, are inherently linked, a decision in one area will certainly effect other areas of the project as well.
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Hypothetically, in the extreme case when every bit of design and manufacturing work is outsourced the only remaining role f0r the original equipment manufacturer (OEM) of the aircraft is to serve as a systems integrator. However, in this scenario, all profits are outsourced as well. This reality is illustrated by a simple example. The engines and avionics comprise about 50% of the total cost of construction of an aircraft, and the remaining 50% are at the OEM’s discretion. Would you rather earn a 25% profit margin on 5% of the total work, or rather 5% profit margin on 25% of the total work? In the former case the OEM will look much more profitable on paper (higher margin) but the total amount of cash earned in the second scenario will be higher. Hence, in a world where 50% of the work naturally flows to subcontractors supplying the engines, avionics and control systems, there isn’t much left of the aircraft to outsource if enough cash is to be made to keep the company in business. Without cash there is no money to pay engineers to design new aircraft and no cash on hand to serve as a temporary buffer in a downturn. If there is anything that the 20th century has taught us, is that in the world of high-tech, any company that does not innovate and purely relies on derivative products is doomed to be disrupted by a new player.
Second, subcontractors are under exactly the same pressure as the OEM to maximise their profits. In fact, subcontractors have a greater incentive for fatter margins and higher returns on investment as their smaller size increases their interest rates for loaned capital. This means that suppliers are not necessarily incentivised to manufacture tooling that can be reused for future products as these require more design time and can not be billed against future products. In-house production is much more likely to lead to this type of engineering foresight. Consider the production of a part that is estimated to cost the same to produce in-house as by a subcontractor, and to the same quality standards. The higher profit margins of the subcontractor naturally result in a higher overall price for the component than if manufactured in-house. However, standard accounting procedures would consider this as a cost reduction since all first-order costs, such as lower labour rate at the subcontractor, fewer employees and less capital tied up in hard assets at the OEM, creates the illusion that outside work is cheaper than in-house work.
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The purpose of this paper is to describe and explain some highlights associated with the contemporary business practice of out-sourcing more and more of a companies’ activities in the belief that doing so will increase profitability. A strong case is made that it will not always be possible to make more and more profit out of less and less product and that, worse, there is a strong risk of going out of business directly as a result of this policy. The point is made that not only is the work out-sourced; all of the profits associated with the work are out-sourced, too. The history of the former Douglas Aircraft Company is cited as a clear indication of what these policies have done – and as a warning of what more may be done. The subcontractors on the DC-10 made all of the profits; the prime manufacturer absorbed all of the over-runs. The circumstances under which out-sourcing can be beneficial are also explained. They involve better access to improved facilities with which to make more precise detail parts to reduce the cost of final assembly. A strong warning is included about the perils of sub-optimum solutions in which individual costs are minimized in isolation. Indeed, the importance of thorough planning, accounting for all interdepartmental interactions, cannot be over-emphasized. A case is made that it is better to fill up “excess capacity” with additional work, even if unrelated to the core business, rather than to close it down and sell it off. Such practices can even be necessary for retaining the skills and facilities required to produce the prime products, but which would otherwise be under-utilized and become targets for elimination. The inherent traditional imbalance between budgets and head-counts can be resolved in this manner. The paper includes some observations about European experiences, good and bad, with out-sourcing. It closes with a list of recommendations by the author about how to operate and maintain profitable businesses.