ABSTRACT Firms continue to develop new ways to decentralize non-core activities to outside parties. Scholars have approached this issue with modularity theory, suggesting a continuum of arrangements ranging from hierarchy to market. Hierarchy relies on fiat, while partially modular forms, those forms between hierarchy and market, require greater coordination, communication and relationships between firms than do fully modular (or market) forms. While modularity theory identifies this continuum, the associated empirical literature tends to dichotomize modularity: firms are either modular or they are not. Nor does the empirical literature examine the performance outcomes of modular arrangements within this continuum. By examining firms that vary between full integration and partial modularity with a continuous modularity measure, this paper empirically examines the performance outcomes associated with a range of modularity levels. We derive this measure from a peculiar inventory option available within the electronic manufacturing services (EMS) industry. Our data include observations on 260 firms over five years. We find that more firms rely on partially modular arrangements, the lower their performance. We suggest explanations for this result, and areas of future research meant to pursue it. KEY WORDS: Modularity, vertical integration, contract manufacturing, inventory The range of options between hierarchies and markets, supported by varying levels of modularity, has become a popular topic in the strategic management literature (e.g. greatly increasing the flexibility of a system" (Schilling, 2000: 213). Modularity allows modular partners to assume responsibility for tasks outside the core competency of the focal firm We first suggest rationales for why more modular firms might be expected to outperform less modular firms (as the literature generally assumes or suggests). We go on to discuss why this relationship might also be non-monotonic or alternatively, why more modular firms might be expected to perform worse than less modular firms. We generate hypotheses on the basis of these rationales. We then examine our hypotheses in the context of the electronic manufacturing services (EMS) industry, an industry particularly useful for examining modular structures Modularity and Firm Performance For this study, partial modularity, as with traditional modularity definitions, refers to the use of an external party to complete an important aspect of the value chain. In this study we investigate the use of arrangements that are not completely modular, and thus may be associated with considerable communication and coordination costs for both parties. The use of partial modularity, while potentially creating costs, however, may also be creating efficiencies. For illustration, we use the relationship between an architect and a construction firm. Many times, the architect and the builder are completely separate firms who must come together to solve a complex problem, one that will often necessitate revision and frequent communication. inherent complexity of their communication needs. Traditional approaches and definitions of modularity do not well accommodate this relationship, as most studies tend to dichotomize between vertical integration and fully modular systems. The relationship between the architect and the construction firm is clearly not a hierarchy nor fully modular; it exists in between conceptions of hierarchy and modularity. We call these types of arrangements "partial modularity". Partially modular arrangements do not rely on fiat, nor can they rely simply on the formal and clear language of markets and instead rely on coordination (formal and informal) mechanisms between firms. Recently, Makadok and Coff (2009) discussed a similar concept, though they refer to partial modularity as "quasi-integration". In their model, as in ours, a partially modular (or quasi-integrated) arrangement is characterized by a long-term relationship between the supplier and buyer and strong incentives for cooperation, but the arrangement is not well governed by a contract, as would be required in a traditional modular/market type arrangement. They highlight the tight integration between Toyota Motors and its supply chain as an example, where Toyota knows detailed information about their suppliers' costs and uses that information to facilitate exchange. The exchange between the firms functions at a middle point between a purely market exchange and that of a fully integrated firm. Toyota does not use its information to extract unusual rents from its supplier, instead it uses it facilitate trust and efficiency. In our analysis, firms vary in the extent to which they own the individual components of the value chain, thus we use the term partial modularity to differentiate from Makadok and Coff's conception where each firm is entirely separate. In our setting, we observe firms trying to run their business like Toyota as well as firms who are trying to operate as fully integrated suppliers, along with significant variance in between. We investigate below whether or not the increasing use of partially modular relationships across partners is good for the focal firm's performance. Positive relationship The predominant view of firm modularity focuses on the use of coordinating mechanisms, such as standard product architecture and other industry norms to coordinate activities between firms (e.g. Where firms cannot fully outsource a particular input because of a lack of suitable outsourcing partners or the absence of standard product architecture and other industry norms, many firms will utilize only partially modular structures. Thus, this view suggests that partial modularity, although perhaps not as effective as complete modularity, will still provide positive benefits to firms. Hypothesis 1: Partial modularity is positively associated with firm performance. However, while its focus on coordinating mechanisms leads much of modularity theory-with its equilibrium-based perspective-to suggest a positive causal relationship between modular organization (partial or otherwise) and performance, other considerations suggest that the use of such organizational structures does not positively influence performance, but rather that this relationship should be non-monotonic or negative. We first turn to non-monotonic, and later to negative, relationships. Non-monotonic/curvilinear relationship The use of modularity is the choice between specialization and control Similarly, the more a firm integrates the components of its production, the more difficult it will be to develop a specialized learning base in any one particular component of the value chain Finally, research into the application of modularity theory suggests boundaries to its application. Hypothesis 2: Partial modularity is positively but non-monotonically associated with firm performance. Negative A less well-explored path regarding modular organization suggests how modularity might lead to poor performance and comes from the network literature. Within that literature, some authors have emphasized the potentially negative influence of organizational ties. Powell (1990), most prominently, points out that networks can lead to a lack of innovation because it is difficult to create the intra-process connections necessary for innovation The EMS Industry 1 The EMS industry began in the 1960s, as several firms established themselves to meet the developing outsourcing needs of original equipment manufacturers (OEMs). The first major EMS firm, Sparton, for example, began operations in 1961 as a producer of military control assemblies and spacecraft equipment for the aerospace industry. SCI (now Sanmina-SCI, one of the five major EMS firms in 2002 2 ), began operations around the same timeopening shop as a producer of electronic assemblies for the US Government (www.sci.com). EMS firms were originally often hired to either absorb unanticipated demand that the OEM's internal production capacity could not support or produce products that were too specialized for OEMs to manufacture internally. As a result, EMS firms were subject to extreme market volatility and frequent bankruptcy. While originally exclusive providers to one or two customers, over time EMS firms began to offer services to an increasing number of clients, allowing them to take advantage of economies of scale. During the early 1980s, OEMs began to take greater advantage of the economies associated with outsourcing larger portions of their manufacturing needs to EMS firms, and the EMS industry became somewhat more stable. Today, EMS firms have increasingly become the sole producers of the OEMs' finished products, while the OEMs remove themselves from manufacturing entirely. In addition to economies of scale in manufacturing, OEMs realize other benefits from such outsourcing: a smaller capital base related to factories or warehouses, and the additional flexibility of manufacturing closer to customers worldwide than OEMs could afford alone. In an effort to make products more manufacturable, EMS firms are additionally taking over more of the design functions that OEMs once controlled. Under these arrangements, product design engineers at the OEM specify the requirements of a particular electrical device, and the EMS design team designs an easily assembled component that meets the customer's functional requirements. Understanding the electrical component production process is critical to keeping the cost of production down, so the EMS firm is better equipped than the OEM to design individual assemblies. There are two main technologies in this industry, and they are fundamentally different in their impact on the firm. The first and more recent technology is surface mount technology (SMT). SMT components are made of very small components placed on a circuit board. The parts are secured in place with a paste-like compound that turns into a metallic connection when heated. The placement of the components on the board is extremely precise and the entire process is completely automated. The only laborers required to construct these kinds of components are the test personnel and an employee to monitor the process during operation. This technology requires high levels of capital, and the relevant machines must be utilized a considerable portion of the day to ensure a return on a firm's investment. The SMT technology is often used to generate the control components that are required by the more robust boards-built with the other major technology, through-hole assembly. The second technology, through-hole, generates a product that looks very much like a stereotypical circuit board. These boards have large components that protrude from their surface. Pins from the component run through the circuit board and extend beyond the bottom of the silicon board. Resistors, connectors, capacitors and transformers are all placed on these boards, and they generally must be placed by hand due to their size and shape. Laborers on an assembly line must insert the parts. The components that go into this technology must be prepared before the laborer can insert them. The complexity of the insertion process means that the factory must employ laborers to alter the parts when they come from the suppliers, employees to insert the parts on the final assembly, and technicians to check and finish the final assembly once it leaves the assembly line. This is a very labor-intensive process and factories will generally be placed in areas that offer inexpensive labor. The capital requirements of a through-hole process are generally lower than those of SMT processes. However, in addition to the costs of manual assembly, through-hole components require extensive touch-up and error checking once they have left the assembly area, a requirement that further increases labor costs. These extensive labor requirements make through-hole manufacturing the more inefficient production method, negatively affecting operational efficiency. Firm Partial Modularity and Performance 581 Downloaded by [Institutional Subscription Access] at 12:13 26 August 2011 Given the focus of OEMs on cost, the key performance determinant for EMS firms is operating efficiency. EMS firms that cannot compete on price are not viable competitors within the industry because there are not many effective strategies for EMS firms to differentiate themselves. Because there are few opportunities for differentiation, firms often seek out ways to increase their service offering and their revenue. Larger EMS firms have developed a global footprint to meet the needs of their clients, some have entered into distribution agreements, and EMS firms are increasingly moving up the value chain into product design. Because OEMs are entirely dependent on the quality of the EMS manufacturing, these two firms are absolutely dependent on one another. The OEM cannot determine the quality of the EMS's manufacturing effort because electronic components are extremely susceptible to electro-static discharge. Any contact with a charged surface can be extremely damaging to an electronic component. Generally, any failure of an electronic component within two years of normal operation is a result of poor manufacturing quality. As a result, poor manufacturing quality by the EMS can mean a poor reflection on the OEM, even after several years. In short, OEMs have a strong incentive to maintain a good relationship with their EMS suppliers. Similarly, if the OEM feels that the EMS firm is abusing its relationship it can ruin the reputation of the EMS within the industry and destroy its business-making the EMS dependent on the OEM for its reputation as well as its business. This customer -supplier dyad is incredibly strong and important for the success of both firms. One outcome of this dyad is the way that the two firms organize their inventory management. EMS firms tend not to make their own raw components. Instead, they either buy them themselves or allow their customers (OEMs) to buy them. Inventory controlled by the EMS is referred to as "turnkey" inventory, while inventory controlled by the customer is called "consignment" inventory. Consignment inventory lowers the cost of the inventory for the EMS, while the OEM can then ensure the quality of the components entering its product. Because high quality/low costs are the key determinants of success for EMS firms, being given their inventory might be in their best interest as well as in the OEM's. EMS firms who participate in consignment inventory agreements are dependent on the OEM for their productivity and success. If the OEM fails in its inventory control for the EMS, the EMS firm will be forced to engage in costly production line stoppages and plant closures, costs which are pushed back to the OEM. In short, consignment inventory forces the two firms to be more dependent on one another than the existing coupling resulting from the use of contract manufacturer. Methods The Sample To look at the use of modular structures and their impact on firm efficiency, we chose the five-year period prior to 2000 because the EMS industry experienced considerable globalization after 2000, as well as a dramatic decrease in previously inflated valuations after 2001 that overshadowed all transactions past that point. Our data comes from Electronic Buyers ' News, 1995-99 of all contract electronic manufacturing firms in existence in the USA and Canada. The annual survey lists services in through-hole, SMTs, manufacturing-related services, distribution, quality programs, percentage of contracts where the company purchases its own inventory, employees, number of factory facilities and revenue. EMS firms have a good incentive to submit information to this survey, as this is a primary means of communication with OEM firms. However, the survey is limited to characteristics of EMS firms, and thus our analysis only examines the performance implications of consignment relationships for the EMS firms. Because not all firms reported in every year and there was considerable entry and exit during this time period, panel data analysis is the most insightful. After removing firms who did not report all the variables of interest (in particular, firms tended not to report their revenue statistics), we had data on 252 firms over five years totaling about 513 useable observations. Supplemental analysis showed no difference between the firms who reported versus those who did not report in terms of number of employees and number of facilities. The Model Traditionally, these data would best be modeled using a fixed-effects regression, to control for differences between firms and over time. However, because firms in this industry were contracted for their services, there is not a considerable amount of variance within each firm over the five-year time period. For instance, if a firm is using consignment inventory with its partners in 1995, it is very likely to have the same amount of consignment inventory five years later. Because there is not a great deal of variance within firms on our independent variable (within-firm change mean ¼ 0, SD ¼ 7), we have chosen to look at the impact of consignment inventory between firms using a between-effect regression. This technique regresses our variables of interest on the mean for each firm. We have thus ignored the variance within each firm over time, reducing our sample to 260. Typically, the problems associated with balancing between the use of a within-firm regression (traditional fixedeffect) and the variance between firms can be solved by employing a random-effects regression. Although random-effects models can be used when there are few time periods for each panel and the individual data does not vary much over time (Wooldridge, 2002: 286), we found that our data does not support the assumptions of a random-effects model using the Breusch and Pagan test for random effects (X 2 ¼ 39.16, p , 0.01). Because the nature of the contracts between firms does not vary considerably within firms over time, we employ a between-effects model. However, the use of a between-effects regression technique would be ineffective if we were unable to classify the other operations for each firm that might impair its efficiency. Fixed-effect regressions would allow us to control for individual aspects of the firm, aside from our data, by removing the firm average from each panel and only examining the impact of consignment inventory or our control variables. By removing the panel aspect of our data, we are only looking at the effect that occurs when comparing one firm to another, not the change that occurs within each firm following an adjustment to one of the independent variables. Thus, the data have become cross-sectional over the five years of our data. In addition, because our efficiency variable has a strong right-hand skew, we have log-transformed the dependent variable to address this violation of normality Independent variable. We measured partial modularity in the EMS industry as the percentage of inventory (ranging from 0 to 100) that is managed externally to the firm. A zero on this measure means that the firm manages its inventory exclusively (turnkey inventory). Alternatively, a 100 on this measure means that firms are completely dependent on their modular partner for inventory acquisition (consignment inventory). A firm engaged in a higher percentage of consignment inventory entrusts more of its inventory control to its customers. Control variables. Because we are using efficiency as our dependent variable, our study requires a considerable amount of statistical control in order to effectively isolate the influence of modularity. In addition to the method the EMS uses to control its inventory, several other characteristics might influence the firm's efficiency because they influence the complexity of the firm's operations. These characteristics include firm size, scope of service offerings, the manufacturing technology employed and their use of quality control programs. Controlling for firm size accounts for the difficulties associated with coordinating a larger firm. We used a composite measure of firm size developed by factor scoring the size of the firm's largest manufacturing plant, the number of overseas facilities it has and the number of surface mount technology lines the firm has to generate a composite score for the firm's size. This was done to ensure a more robust representation of each firm than would have been possible with a single measure. All of these measures were correlated greater than 0.6 and they generate a factor structure with only one factor (eigenvalue of first factor ¼ 2.1 and eigenvalue of second factor less than 0.5). In order to further isolate the importance of inventory policy on firm performance, we needed to control for the vast differences in services that exist between firms in this industry. We measure scope in service offerings-also presumably associated with higher coordination costs-as the number of different services a firm offers, grouped by the Electronic Buyers' Guide broad service categorizations. To verify the industry publication's categorization of services, we asked a strategic planning manager at one of the largest six firms in the EMS industry to examine the service categories. His opinion confirmed our belief that beyond offering basic services, increasing the number of services within each category represented meeting a niche need for clients that involves higher capital investment and training time-and thus lower efficiency
