How to Build a Globally Competitive High-Tech Firm with no Internal R&D- Contractual Innovation in the Brazilian Aeronautics Industry (2009)

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How to Build a Globally Competitive High-Tech Firm with no Internal

R&D: Contractual Innovation in the Brazilian Aeronautics Industry1

Sergio Salles-Filho2 Marcio da Silveira Luz3

Maria Beatriz Bonacelli4

Abstract: This article discusses whether a globally competitive high-tech firm is sustainable withoutbeing associated with a sufficiently dense sectoral innovation system. It focuses on Embraer and henceon the aeronautics industry. Despite not benefiting from a highly subsidized process regardingtechnological and financial modernization, Embraer has become the world’s third-ranking producer of commercial jets thanks to institutional innovations, especially in producing and managing contractswith suppliers and risk-sharing partners. The conclusion drawn is that the competitiveness of theBrazilian aircraft industry depends to a dangerous extent on the continuing supply of technology ininternational markets. Technological restrictions imposed for geopolitical reasons, or even for marketreasons, could fatally undermine the development model adopted by the industry.

Key Words: aeronautics, globally competitive high-tech firms, internal R&D, contractual innovation,partnership.

1. Introduction

The innovativeness and global competitiveness of the Brazilian aeronautics industry has recentlyenabled Brazil to reach third place among producers of commercial aircraft, especially regional jets,sold around the world. This is largely due to the introduction of institutional innovations by Embraer,the leading Brazilian aircraft manufacturer. In particular, the company has developed new forms of contractual relationship with suppliers of parts, systems and technology. Thus Embraer embodies amodel for developing a high-tech industry without the internalization of research and developmentactivities, which are mission-critical for the aeronautics industry. The main question raised by thisarticle is how sustainable aircraft manufacturing can be when its technological input depends basically

on the market.

The Brazilian aeronautics industry is an exception to the rule in terms of the pattern observed inthis type of venture worldwide, because it does not benefit from public-sector procurement. Thedefense industry has no significant presence in contracts for aircraft development, and the supplychain is predominantly internationalized. Moreover, it invests little in research and development(R&D) compared with its peers. Five key competencies explain Embraer’s recent success: outstandingcapabilities in engineering design, assembly, and systems integration; contractual innovation; and theability to obtain the required technology wherever it can be found.

This article, based on the findings of a two-year research project (Montoro & Migon, 2009),discusses how institutional innovations relating to global technology transfer and commercializationhave enabled Brazil to develop a global leader in the aircraft manufacturing industry. The centralhypothesis is that contractual innovations involving partnerships with the main suppliers of parts andsystems, in conjunction with in-house engineering design capabilities, enabled a high-tech aeronauticsindustry to emerge without domestic technological and productive density.

1 Presented at the 21th Annual Meeting on Socio-Economics (Economic Regulation and Social Solidarity afterthe Fall of Finance Capitalism), Paris, France, July 16-18, 2009 (www.sase.org).2 Professor, Department of Science and Technology Policy (DPCT), Institute of Geosciences (IG), University of Campinas (Unicamp), P.O. Box 6152, Barão Geraldo, CEP 13087-970, Campinas, São Paulo, Brazil. Email:[email protected] Senior Advisor of Aerospace Technological Center (CTA), São José dos Campos, SP, Brazil. Email:[email protected] 4

Professor, Department of Science and Technology Policy (DPCT), Institute of Geosciences (IG), University of Campinas (Unicamp), P.O. Box 6152, Barão Geraldo, CEP 13087-970, Campinas, São Paulo, Brazil. Email:[email protected]



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It is important to bear in mind that international sourcing is a current trend in response to marketglobalization. This leads directly to the following question: Could it be otherwise? The answer is yesand no. From a strictly economic standpoint, it could not be otherwise: factor mobility andspecialization in production, with a division of labor based on the specific competencies of eachmanufacturer, comprise a business model that underpins a dynamic and innovative aircraft industrywith low transaction costs. Hence the centrifugal nature of procurement, favorable to a global marketin parts and systems. From the political standpoint, however, it could well be otherwise: theaeronautics industry is strongly determined by elements of a strategic nature (geopolitics), preciselyowing to the presence of dual-use technologies considered critical or sensitive. In this perspectivethere is a centripetal force that acts counter to internationalization and full factor mobility. Theenvironment in which Embraer has developed depends on this dual movement of forces.

Like the automotive industry and others with tightly integrated, highly specialized supply chains,the aeronautics industry operates under the internalized R&D model but also (and increasingly) underthe global sourcing model, which entails the integration of parts and systems supplied by globalsuppliers, each with its specific competencies, according to a basic design. Aircraft wings or nosescannot be bought off the shelf. Like all aeronautical systems, noses and wings are fabricated accordingto the aircraft integration design, a highly specialized process. Thus the supply chain is highly

integrated from scratch. However, the degree of globalization involves elements whose logic is notstrictly economic.

The next question that should be asked is to what extent a company in the aeronautics industry canmaintain a competitive position in the global marketplace (as Embraer has) without a locallyestablished production chain, sourcing a large proportion of its parts and systems internationally andwith a very low level of local R&D. In other words, to what extent does a company that designsaircraft and integrates parts and systems developed elsewhere risk losing competitiveness for extra-economic reasons, especially lack of access to the technology it needs to continue designing andintegrating aircraft? The questions raised above orient the discussion developed in this article, whichfocuses on the case of Embraer and its sourcing and integration model, defined for present purposes asan institutional innovation.

Section 2 discusses the specificity of the systemic arrangements involving high-tech businessventures, with particular attention to aircraft systems (including a brief description of the global andBrazilian context) and the evolution of Embraer’s value chain. Section 3 analyzes make-or-buydecisions and transaction costs involving high-tech systems, using transaction cost economics to do so.Finally, Section 4 presents conclusions.

2. The specificity of systemic arrangements in high-tech business ventures

The OECD classifies industries according to technology intensity by sector and by end-product.Research conducted by the OECD shows that R&D intensity can also be used as an indicator forclassifying industries. Thus, OECD (1997) takes into account not only production but also the degree

of technology use or of embodied technology diffusion. In this case, the “high-tech sector” is taken tomean aerospace, biotechnology, information technology, nanotechnology, and robotics.

Aerospace is a high-tech industry because it embodies with increasing sophistication and speed thelatest developments in science and technology. In some cases, moreover, a project is begun withoutprior knowledge of all the technology required to solve the problems involved, and this technology hasto be developed during the course of the project. Examples include the projects developed byLockheed’s Skunk Works and Boeing’s Phantom Works, as well as the Concorde and Airbus A-380.In all these cases it was known early on that later developments would fill technology gaps not solvedin the design stage, and the technological risk involved in the process was therefore significant.

The systems approach is useful when studying innovation organization and dynamics in countries,regions and sectors, precisely because it shows the composition and above all the interrelations

between components (both the components and their interrelations are variable). There is no set modelor recipe for success in creating innovative arrangements, but in high technology there is a consensus



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in the literature that the existence of a robust production-innovation system in the sector – be itregional, national or global – is key to success in this type of undertaking (Freeman, 1987; Lundvall,1992; Nelson, 1993; Edquist, 1997; Kim, 1997).

Nelson (1990) shows that the most successful innovation systems are the best interrelated andcoordinated, not necessarily the most complete. This is especially valid for sectoral innovation systems

(see Malerba, 2002). On the other hand, it must be acknowledged that certain types of industrialorganization display similarities in their various innovation systems. Even in these systems, however,there may be organizational and institutional innovations (in contract management, for example) thatchange the structure in place so as to compensate for its deficiencies and fill any gaps in technical andscientific competencies using innovative managerial solutions. This is the point discussed below:production and technology densities may be more or less necessary to enhance a sector’s globalcompetitiveness, but what seems to be most important is the ability to build relationships, alongsidethe existence of flows of product and process technology offerings, which are decisive for success in acomplex high-tech industry.

In sum, given the composition of hard and soft competencies required to produce an innovation,how such gaps are addressed is important. If components such as production structure and R&D,

among others, are not at world-class levels, some form of compensation for this has to be found. Thecontractual innovation introduced by Embraer is an important step in this direction, but how long itwill stand up is a different matter, as also discussed below.

2.1. Aeronautical systems: a brief description of the global and Brazilian context

The global aeronautics industry is highly concentrated at present. Formation of the Boeing andLockheed-Martin conglomerates in the U.S., EADS, BAer and ATR in the European Union andBombardier in Canada resulted from major mergers and acquisitions designed to strengthen thisstrategically important sector financially and technologically. Governments openly contributed to theM&A process via funding in most cases. The companies involved were mostly set up by aviationpioneers, growing stronger during world war two and the cold war, especially thanks to the boom indefense contracts following the emergence of the military-industrial complex in the U.S. These

contracts drove the development of technology frequently embodied in civilian applications.In February 2006, the Russian government set up the United Aircraft Corporation (UAC) to

become globally competitive in both defense and civilian aircraft manufacturing. UAC is the largestRussian conglomerate ever and involves practically the entire industrial sector.5 China merged itsaircraft manufacturers to form China Aviation Industry Corporation (AVIC), later split into AVIC I(which focuses on civilian regional jets and military aircraft and is launching the 78- to 100-seatregional jet ACAC ARJ 21, known as the Xiangfeng or Flying Phoenix), and AVIC II (which makessmaller aircraft) (AVIC1, 2008). Japan’s Mitsubishi has also launched a program to develop theMitsubishi Regional Jet (MHI, 2008). Figure 1 presents in summary form the consolidationtrajectories of the largest aircraft manufacturers in the West.

The intense process of mergers and acquisitions in the U.S. and Europe has resulted in an

interlocking of the economic and financial interests of aerospace manufacturers and integrators andtheir respective prime contractors, suppliers of key systems and subsystems and/or critical items.Canada’s aerospace production and innovation system can be understood as immersed in the U.S.system. The U.S. and European aeronautics industry’s innovation systems also involve the space anddefense sectors. Given the convergence of their interests it is hard to separate them, so that theircivilian aeronautics continuously benefit from spinoffs of space and defense developments,particularly the latter. This type of advantage, which is considered commercially legitimate, means forexample that engines developed for military aircraft are globally sold for use in civilian aircraft, as inthe case of the GE TF34 turbofan engine (GE, 2008).

5 Irkut (Beriev, Irkut Aviation Plant, Russian Avionics Design Bureau, Irkut AviaStep Design Bureau, Beta Air),

Mikhoyan-Gurevich, Sukhoi, Ilyushin, Tupolev, Antonov and Yakovlev, plus more recently TAPO inUzbekistan). Its flagship project is the Sukhoi Superjet 100, a midrange regional jet in the 75- to 95-seat category(UAC, 2008).



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Figure 1. Consolidation Trajectories of the World’s Leading Aircraft ManufacturersSource: Embraer (2004)

Embraer is the only major player in the global aircraft industry that does not owe its origins to acorporate consolidation program and one of the few that does not serve as a space-defense link. Itscompetencies were built up from scratch. It can also be said that Brazil is a new entrant in the sector:after decades of attempts at attracting aircraft manufacturers, Brazil decided to relaunch the activity

itself. In 1964 Max Holste, an experienced French aeronautical engineer and entrepreneur, accepted aninvitation to lead the design and fabrication of an aircraft at Centro Técnico Aeroespacial (CTA), aresearch and development center set up by the Brazilian Air Force. Holste used his vast experience inaircraft manufacturing to teach Brazilian engineers practically every stage of the production process.The Bandeirante, a 15- to 21-seat turboprop designed by Holste, resulted from this collaborative effortand the perseverance of air force officers led by Ozires Silva. The first prototype was designed andbuilt between 1965 and 1968 (Silva, 1998; Forjaz, 2005). However, private enterprise was notinterested in aircraft manufacturing, so in the late 1960s the military government decided to set up astate-owned company. The result was the birth of Embraer (Empresa Brasileira de Aeronáutica), withthe federal government owning 51% and the rest belonging to private investors (Forjaz, 2005).

Besides the Bandeirante, the air force commissioned Embraer to produce under license the Italian

light military jet Aermacchi MB 326, renamed Xavante, to expand its portfolio. To these were added,in a run of commercial successes, the Ipanema (for agricultural use, mainly crop dusting), the Tucano(a military aircraft for pilot training and light attack), and the Brasília (a commuter airliner). Exportsbegan in 1975, eventually proving Embraer’s international competitiveness. A watershed wasEmbraer’s participation in the program to build the AMX ground attack aircraft in partnership withAermacchi and Aeritalia. This gave Embraer access to state-of-the-art aeronautical technology,enabling it to update and greatly extend its stock of competencies. The experience was to prove vitallyimportant a few years after privatization (1994) when it achieved huge commercial success with the E-Jet Series, especially the 170 and 190, which assured fourth place for Embraer among the world’sleading aircraft makers. Another measure of Embraer’s success is that in 1970 it had 1,035shareholders, with only 18% private participation in its share capital. By 1981, the number of shareholders had risen to 226,506 and private participation to 93% (Fundação Museu de Tecnologia de

São Paulo, 2007; Bernardes, 2000; Forjaz, 2005; Silva, 1998).

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The Brazilian aeronautics industry is organized around four major buyers of products and services:Embraer, an integrator of regional, executive and military jets; Helibrás, a joint venture withEurocopter, which in turn is part of EADS, one of the world’s top three aerospace groups; theBrazilian Space Agency (AEB), with sounding rockets, a satellite launch vehicle (VLS1) andsatellites; and the Ministry of Defense, to which the air force, army and navy are subordinated. Some40 companies orbit around these four major buyers; they include global players as well as small localfirms, but most of the large suppliers produce little or not at all in Brazil, let alone carry on local R&Dactivities (AIAB, 2008; Ciesp, 2009).

Embraer leads the regional jet market but is not a major player in other segments. Nevertheless, itstrajectory in the past ten years includes some impressive numbers: it is now the third-largest civilianaircraft manufacturer in the world, surpassing Canada’s Bombardier in sales of regional jets; it hassome 24,000 employees and an order book worth more than US$21.6 billion; and it exports singleaisle aircraft seating up to 118 passengers to North America, Europe and Asia. It delivered 169 and204 aircraft in 2007 and 2008 respectively, and projects some 245 deliveries in 2009 even when theeffects of the ongoing economic crisis are taken into account (Embraer, 2008). This process of transformation from local champion into global player has been amply highlighted in the literature(Bernardes, 2000; Oliveira, 2005; Montoro & Migon, 2009; Goldstein, 2002, 2008).

Once again, therefore, it can be seen that Embraer’s success has been obtained under a set of verypeculiar structural conditions, which contrast starkly with those of its main competitors: Embraer isnot part of a robust and complete science, technology and innovation (ST&I) system; it does notbenefit significantly from government procurement; it does not have material links to the defenseindustry; it did not originate in a process of corporate consolidation, with all the synergies andacquisition of extra competencies that would have entailed; and it does not invest heavily in R&D.Embraer is an exception in such a technologically dynamic and economically globalized sector. Thuswe have a paradox: a weak system with a strong company. The question that naturally arises is how afirm in a typical high-tech sector can be globally competitive without these structural conditions,which in principle would appear to be a sine qua non. What innovative conditions has Embraerleveraged in order to become an important global player? (Furtado & Costa-Filho, 2009; Quadros et

al ., 2009, Salles-Filho et al . 2009).2.2. Embraer’s value chain and technology sourcing process

Any aircraft manufacturer, as an integrator of complex high-tech systems, depends heavily on itssupply chain. Esposito & Raffa (2006, 2007) surveyed the literature on the evolution of supply chains,starting in the 1960s and 1970s, when “growth poles theory” predominated in research on customer-supplier relations (Perroux, 1961). Several of the concepts created at that time are still in circulation,e.g. capacity supplying, specialization supplying, and supply-type supplying (Sallez & Schlegel, 1963;Sallez, 1975; Chaillou, 1977; Berthomieu et al., 1983; Imrie & Morris, 1992). In the 1980s researchersturned their attention to Japanese business practices, especially with regard to mutual trust andalliances among firms (Klein et al., 1978; Williamson, 1979; Aoki, 1984; Fletcher, 1993; MITI, 1991;Sako, 1992; Oliver & Wilkinson, 1992; Colombo & Mariotti, 1998).

From the mid-1990s on, global sourcing emerged as a strategy used by firms in this industry toleverage their competitive advantages and those of their suppliers, now seen as partners in the process(Motwani et al., 1998; Kotabe & Murray, 2004; Trent & Monczka, 2005). The industry clusters thatemerged in the automotive industry were a more advanced form of global sourcing.6 In this systemsuppliers are not mere sellers of inputs but global partners in a global undertaking, assuming theirshare of risk but also profit. In the case of aerospace, the cost of new aircraft projects has risen 15%per year on average (equivalent to quadrupling every ten years in real terms), according to Augustine(1986). Embraer took this idea on board for its own global sourcing process. All the other major

6 Volkswagen’s Resende truck plant in Brazil was the first in the world to operate under this “modularconsortium” model (ECLAC, 2003).



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vendors of commercial jets (Airbus, Boeing and Bombardier) are also seeking “risk-sharing partners”.7 Chart 1 below illustrates the concepts used in supply chain analysis over the past 40 years.

Chart 1. Evolution of concepts in sourcing logistics during past 40 years

Phase of supplyrelationship

Typology of supply

Organizational

structure of relationship

Keycapabilities

Relationships

Supply System1970s

capacity specializationcomplex

one customer to manysuppliers

technicalfirst exchanges of

technological knowledge

Supply System1980s


well-developed

pyramid structure;strong links withwell-developed

suppliers based ontrust

technicalrelational

intense exchanges of information and

knowledge with evolvedsuppliers

FluctuatingSupply SystemEarly 1990s


well-developed

pyramid structure;weaker links withevolved suppliers

technicalrelational

intense exchanges of information and

knowledge with evolvedsuppliers

Supply Network Late 1990s


well-developedcooperation

pyramid structure;links between buyer

and supplierconsortiums

technicalrelational

organizational

vertical exchanges of information and

knowledge;intense horizontalexchanges within

consortium

Globalized Industrial Clusters

Late 1990s

capacityspecialization

complexproject/product risk

sharing

pyramid structure;links betweensubsystems

integrators, who arepartners, and mainsystems integrator

technicalrelational

organizationalmarketingfinancial

intense horizontalexchanges within cluster;

deverticalization;joint ventures;partnerships

Source: Esposito & Raffa (2006) and the authors.

To make its increasingly complex aircraft feasible, Embraer currently coordinates a network of strategic partners. These partners are the foundation of Embraer’s value chain (as indeed in the case of all civilian aircraft makers today) and each of them in turn has its own network of suppliers. As well aspartners, Embraer also has direct suppliers from whom it sources lower value added goods andservices. The company’s role as a strategic center can be seen from Figure 2. Layers represent a valuegradient: key subsystems and subassemblies with the highest complexity, specificity and technologicalcontent are at the top, simpler components and services at the bottom. Materials flows (solid lines) andknowledge flows (dotted lines) make up the final value of the integrated aircraft. Avionics andequipment are developed by more than one layer.

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Risk-sharing partners are firms that bring capital to a project by supplying subsystems, component parts andengineering without payment until the aircraft is sold. This gives partners in development a definite interest inmarketing the finished product.



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Figure 2. Internal Flows of Materials & Information in an Aeronautical Innovation SystemSource: Esposito & Raffa (2006)

Embraer has developed its strategy in accordance with the global trend whereby aircraftmanufacturers’ value chains revolve mainly around horizontalization and sharing of the technologicaland commercial risks involved in the development of each product family, defined as a single project.Embraer’s value chain has evolved, starting from the ERJ 135/145. Initially Embraer appears as theaircraft maker: in that stage it was responsible for systems integration as well as fabrication of all themain components, so that it was obliged to perform manufacturing tasks far less complex and with farless value added than its final integration function. It was also forced to deal with a large number of suppliers and bear most of the costs of development itself. These are non-recurring costs, typicallyrequiring the sale of some 400 aircraft to cover the investment (Lima et al, 2005). Thus the aircraftmaker needs considerable credibility to persuade suppliers to become risk-sharing partners.

Embraer’s current policy aims to reduce the number of suppliers and increase that of risk-sharingpartners, as shown in Chart 2 below.

Chart 2. Evolution of Risk Partnership in Embraer’s Projects

Aircraft familyEngine

typeMaidenflight

No. of seats

No. of suppliers

No. of risk-sharing

partnersEMB 120 Brasília Turboprop 1991 30 500 –ERJ 135/145 Turbofan 1997 37-50 350 4ERJ 170/190/195 Turbofan 2002 70-90-108 22 11Source: Embraer (2004); Quadros et al. (2009); Furtado & Costa-Filho (2009)

The process of deverticalization with partnering undertaken by Embraer involves integrators of systems and subsystems. Thus in any given project Embraer develops and coordinates a network of partners and suppliers who orbit around it; engages in and encourages others to engage in strategicoutsourcing and the development of capabilities; and promotes the sharing of capabilities betweenpartners. In this sense Embraer tends to transform its partners into centrally strategic firms like itself,with a network of collaborative relationships around each one and all these networks sharingcompetencies (Hitt et al., 2003). This strategy leads to a combination of two distinct types of governance in the value chain. It is worth noting that all of Embraer’s partners are much larger firmsthan Embraer (Quadros et al ., 2009).

Embraer’s aggressive vision of the value chain, which evolved into a system of value networks,

resulted from overriding necessity. Shortly after privatization the new management, who had comefrom the banking sector and private equity funds, drastically downsized the workforce overall and in

Integration

Third Production Level

Avionics &

Equipment

Second Production Level

First Production Level

AirframeEngine

Materials Flows

Knowledge Flows

Integrated System(aircraft)

Principal Subsystems(risk partners)

Critical Items(technologically dense)

Non-Critical Items



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particular the engineering staff. Moreover, at the time Embraer lacked the financial resources to investin the leap from the EMB 120 turboprop (Brasília) to the ERJ 135/145 jet family. The idea of partnering with suppliers as investors appeared to be the most natural solution and probably the onlyfeasible one (Bernardes, 2000; Bernardes & Pinho, 2001; Bernardes & Oliveira, 2002; Qudros et al .,2009; Furtado & Costa-Filho, 2009). Thus Embraer adopted the “dragon multinational” strategyoutlined by Mathews (2006), first out of necessity and then because the strategy was genuinely fit forpurpose.

In the ERJ 170/195 program, besides growing and deepening partnerships Embraer also grew anddiversified the participation of local suppliers, especially in engineering services and industrialprocesses. However, with few exceptions Embraer’s network of partnerships in production andinnovation remained internationalized, and the company showed no propensity to bring these activitiesto Brazil. Indeed, Embraer is a high-tech company that invests very little in R&D compared with anycompetitor. Buying, installing and operating virtual reality and rapid prototyping laboratories orhaving an IT system that controls the entire company (such as SAP, CATIA or Primavera) are notexamples of R&D efforts but of modernization to stay at the cutting edge, the state of the art. Thecompany typically presents itself to the market as a “creative follower” with strong design capabilities

and excellent transactional competencies both in contracting with partners and in selling aircraft. Itsoption to build relationships with partners rather than suppliers contributes to the outsourcing of engineering and R&D. The schematic representation of R&D activities in Figure 3 shows Embraeroperating in the region that encompasses creative engineering and engineering development, as well aspart of the contiguous gray zones. It cannot enter the region of innovation development proper becauseit is not organized for this purpose.

Figure 3. Different Combinations of R&D

Investment in R&D by the main actors is a central aspect of any innovation system. Thus the flowof investment determines the main technological trajectories and pipelines in the system (Park & Park,2003).

3. Make-or-buy and transaction costs in high-tech systems

Embraer evidently got the make-or-buy decision right under the prevailing world and domesticeconomic, technological and contractual conditions. It lacked a strong tradition of technologydevelopment but had outstanding competencies in aircraft design, assembly, certification and

Research Intensity

N--!--1-

Development IntensityB--" --=-

Gray Zone

Gray Zone

Gray Zone Gray Zone

P&DBlue Sky Science

P&DBreakthrough

Innovation!

P&DFine CreativeEngineering!

R&DEngineering Development

Evolutive Innovation

Embraer



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marketing. Thus the key strategic decision was to outsource the most specific and least availablecomponents of an aircraft, such as fuselage, wing, propulsion, avionics and interior systems, amongothers. This was done in an innovative way to enable a firm without a tradition in R&D or majortechnology contracts to obtain state-of-the-art technology and become a global player at the top end of regional jets and the low end of long-range jets. In other words, its central skill, which enables it to fillthe gaps in the technology available elsewhere, is producing and managing contracts with its suppliers.Hence the suitability of transaction cost economics as a tool for analyzing this case (Williamson,1985).

There is no universally accepted definition for transaction costs. However, for present purposesthey can be defined as costs incurred by individuals when they exchange property rights on economicassets and strengthen their exclusive rights (Eggertsson, 1990). In other words, transaction costs areincurred by the functioning of the economic system with regard to the identification, explanation andattenuation of contractual risks (Rezende, 1999). They are similar to friction in a mechanical system inthe sense that they increase entropy and dissipate economic resources (Williamson, 1985). Thus intransaction cost economics the contract plays a central role and in this sense the key function of governance is to reduce transaction costs.

The main issue in governance for integrators, especially in high-tech and/or complex products, isthe decision to make or buy, i.e. whether to verticalize or horizontalize production. A firm thatverticalizes production can reduce risk and technological uncertainty. At the same time, however,commercial risk increases because the firm has no one to share it with. Horizontalization starts withsupplier development via outsourcing. A more advanced extension of outsourcing is partnering,whereby suppliers are developed into co-investors in the project. In fact, what is involved here isdesigning a foundation for the make-or-buy decision (Prahalad & Hamel, 1990; 1995).

Embraer leveraged its core competencies as a specialized buyer. This involved various risks andcosts, but also opportunities. For example, by developing partners as a way of reducing transactioncosts Embraer also transferred to partners the responsibility for dealing with a great many suppliers.This in turn meant that its partners began producing ever-larger subsystems and physical sections(Furtado & Costa-Filho 2009). As a result, Embraer became more dependent on these partners andvulnerable to opportunistic behavior. This risk first materialized in an episode involving the wing of the E190/195, Embraer’s flagship product family. The wing was originally outsourced to Kawasaki,which on winning a contract to supply the fuselage for the Boeing 787 and not feeling able to fulfillboth contracts apparently preferred to break with the Brazilian company in order to concentrate on thecontract with Boeing (Reuters, 2008).

In the case of the aerospace industry, the specificity of assets includes another element referred toabove as geopolitical.8 The threat of a rupture in the supply of technology hangs permanently overhigh-tech companies that internationalize their value chains, as in the case of Embraer, pointing toother risks. For example, technological control regimes such as the “Missile Technology Control Regime” (MTCR) or “Nuclear Suppliers Group” (NSG) act like “clubs” of technology owners andattempt to limit trade in the technologies in question, which are classified as “sensitive” (because they

are dual-use, i.e. have military as well as civilian applications) or “critical” (because they give theowner a commercial or strategic advantage). There is a sort of “Index Scientiarum Prohibitorum”covering sensitive technologies: it is constantly updated and certainly increases transaction costs.

Embraer therefore needs all the information it can get to support a make-or-buy decision,calculating the risks and opportunities under circumstances such as those described above.Considering the inputs it requires (products, processes and services), its ability to develop them itself,the difficulty of acquiring them externally, and their strategic importance or specificity (in accordancewith Prahalad & Hamel, 1995), the strategy is as follows:

1. perform activities that are core competencies of Embraer and cannot be outsourced;

8 An example was the sale of Embraer’s Super Tucano light attack turboprop to Venezuela, blocked by a U.S.veto on the use of Honeywell avionics in defense materiel supplied to Chávez (Sequeira, 2006).



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2. engage in strategic alliances for highly specific activities in which the company does not havesignificant competencies;

3. develop products, processes or services of medium strategic importance (specificity), where thecompany’s competencies are sufficient (medium);

4. outsource simple, relatively unimportant services in order to focus on the core business;

5. buy or discontinue products that require high-level competencies but are not strategicallyimportant, deactivating the respective lines.

Buying from a supplier or developing and producing internally becomes a permanent decisionmatrix: a large part of the technology can be outsourced only when trust between the parties is strongand even so requires a minimum of internal technical competence. The important issues that cannot beoverlooked in this case are the specificity of the product, process or services in question and the non-economic factors involved, i.e. factors relating to military strategy. These bring transaction costs andthe role of local and national innovation systems back to the center of the analysis regarding theevolution of the Brazilian aeronautics industry.

4. Conclusion

Embraer’s success shows that it is possible to create a globally competitive high-tech companywithout significant in-house R&D and without substantially internalizing the value chain inside thecompany’s home country. This is due to its core competencies, particularly innovating in contractualrelationships with major technology suppliers, and strong design engineering capabilities. To this mustbe added a third competency that is no less important: the capacity to sell aircraft. However, thefragility of this model resides in the fact that its long-term sustainability depends on external factors,especially continuity of the supply of high-density technologies with a highly specific content. In otherwords, it depends strongly on factors that Embraer cannot control.

The durability of partnerships such as those entered into by Embraer depend on its ability to attract

and retain partners, and this ability in turn varies according to the potential gains as well as therestrictions on global trade in critical or sensitive technologies. The present global financial crisis hastriggered a return to nationalism and restrictions on markets for prime contractors, owing to tougherrules on access to critical technology. This affects not just suppliers but also (indeed far more) themarket for civilian aircraft. Moreover, the geopolitical environment is key to the long-termsustainability of the value chain governance model adopted by Embraer. Changes in this environmentare frequent and unpredictable.

Another key element that must be taken into account when considering the future of Embraer’sbusiness model is the matter of new entrants, which can already be seen in countries with aerospacetechnology such as China, Japan and Russia. In this regard, Embraer’s model of assembling high-techproducts based on a sectoral and national innovation system with very low productive andtechnological density could be seriously threatened. There can be no doubt that if Embraer is to remainone of the leading global aircraft makers it will need the support of a sectoral system of research,development and above all innovation located in Brazil.

The absence of installed technological density and the main economic agents in the aeronauticalvalue chain represents a far from negligible weakness for both Embraer and Brazil. Embraer willsurvive only if it constructs a new type of competency that enables it to participate directly innegotiations on next-generation aircraft. This means going beyond aircraft design, assembly andmarketing skills, as well as innovations in contracting out and governance, to create competencies inresearch and development, which in turn entails technological densification. Productive density maynot be a sine qua non for its survival, but technological and knowledge density is (Salles-Filho et al .,2009).

Last but not least, the virtual absence of demands from the defense sector is also a factor of vulnerability. Actually, this feature entails both a kind of fragility in terms of technological, productiveand commercial sustainability. Again, surviving without this sort of demand (and industrial



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integration) means dependency on market factors in a sector where market factors are stronglyinfluenced by geopolitical events. The presence of military demand seems to be another important(now absent) factor of long term competitiveness.

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How to Build a Globally Competitive High-Tech Firm with no Internal R&D- Contractual Innovation in the Brazilian Aeronautics Industry (2009)