When American companies move pieces of their operations overseas—often because manufacturing and labor costs are much cheaper—they run the risk of moving the expertise, innovation, and new growth opportunities just out of their reach as well.

Take Eastman Kodak, for example, the 120-year-old American company that filed for bankruptcy protection in January. The company developed the first digital camera in 1975. Yet Kodak was never able to ride the digital wave over the long haul, and the company's invention ironically served to thwart its success.

HBS Professor of Management Practice Willy C. Shih served as president of Kodak's Digital & Applied Imaging business through the turn of the 21st century. Shortly after starting at Kodak, he visited the company's highly automated production line and realized that all the significant pieces used to make Kodak's digital cameras—lens, shutters, electronic screen displays—were manufactured far from the factory floor in Rochester, New York, largely because American companies had ceded much of the camera-related technology to Japan years earlier.

Worse, he knew that mobile phones, which were also being made outside the United States, would start stealing business away from digital cameras.

"Much of the camera technology was invented in the United States, but US companies gave it all up," says Shih, an expert on industrial competitiveness who joined the HBS faculty in 2007. "Because of the decisions of managers in the distant past, the United States had lost its capability to make all the critical components that were needed to put together digital cameras."

Disastrous fallout

Outsourcing manufacturing operations has been occurring for decades, based on the assumption that moving grunt work overseas wouldn't affect US companies' competitive edge in the global marketplace.

But this assumption is wrong, and the fallout has been disastrous, Shih says.

In reality, developing and executing a manufacturing process often sparks ideas that lead to creation of innovative new products, Shih explains. So when American companies allow the production of high-tech products like televisions and memory chips to disappear from the local landscape, they also inadvertently risk losing expertise to produce the next generation of cutting-edge products like high-end servers and electronic paper displays for e-readers.

Outsourcing ends up chipping away at what Shih calls America's "industrial commons," the collective R&D, engineering, and manufacturing capabilities that are crucial to new product development. This concentration of expertise can be found in places like Silicon Valley, where clusters of experts and firms feed growth and spur innovation.

Much of the damage to American competitiveness in the science and technology fields has already been done. The United States has lost a great deal in the area of energy storage and green energy production, for example, including lithium ion batteries for cell phones and laptops, silicon solar cells, and power semiconductors for solar panels. As a result, Shih says, the country risks losing thin-film solar cells, the latest solar-power technology.

America's lead in the advanced rechargeable battery business also slipped through its fingers when manufacturers retreated from investing in them, choosing to focus instead on disposable batteries that had been their bread and butter. The Japanese filled the void in rechargeable battery production, leveraging their capabilities first in portable audio products, like the Walkman, then in camcorders, notebook computers, and mobile phones—and most recently in hybrid and electric vehicles.

"In an electric car, the battery is 50 percent of the bill of materials," Shih says. "We don't have the capability for making rechargeable batteries in the United States today, and that's because the decisions made by other industries let that [industrial] commons wither away."

Executives who defend outsourcing argue that there aren't enough American workers with the right skills or American factories with the same speed of production found in other countries. And besides, by moving work outside the United States, they contend that enough profits can be generated to stoke innovation at home.

Until recently, Apple manufactured its products in the US, and even built its own factory. But today, iPhones, iPads, and other Apple products are made overseas, largely because a country like China is able to get the job done without the time and expense that the company would expect to incur domestically.

The problem for US policymakers and companies competing in a global marketplace is this: the trend toward outsourcing has gone beyond simple assembly-line work.

Heading upstream

As low-paying production jobs have disappeared from the United States, so too have more sophisticated, higher-paying design positions. Nearly all notebook computers, cell phones, and other handheld devices are now designed in Asia. The domestic software industry, which initially outsourced only simple code-writing projects to Indian firms, has more recently signed on with outside companies for more complex work, like designing architectural specifications.

Letting go of the design work is dangerous, Shih says, because it could block American companies' chances of designing the newest high-tech products and learning from those experiences. "Companies will certainly limit their ability to innovate," he adds.

The United States didn't always allow technological innovation to run adrift. In the post-World War II era, the country had a tradition of global leadership, spurred in the 1950s and '60s by innovation in semiconductors and in the 1960s through '80s in chip design, aeronautics, and satellite communications. Many high-tech products could only be found in the United States. These successes were due in large part to government investment in basic science research and mass production.

"During World War II, the American public believed science won the war with the atom bomb, radar, computer technology, antibiotics," Shih says. "There was a feeling that if we invest in science and technology, it would lead to jobs and prosperity, and for that, the United States was an unquestioned leader."

The government continued to feed scientific exploration with a healthy dose of funding through the 1990s, but these investments began to falter in 2003 and have remained flat or slightly lower ever since.

Government's role

If the United States wants to keep from slipping further in its ability to compete on the industrial stage, Shih says, the government must increase support of scientific research and collaborate with the business and academic world. In addition, government officials and business leaders need to map out a long-term plan focused on efforts to keep important capabilities in the United States with the idea that they might bear future innovative fruit—perhaps by attempting to correct some of the biggest challenges today, like climate change, oil dependence, and life-threatening diseases.

Outsourcing by itself is not evil, Shih says. In many cases it makes perfect sense, but "we need to be more thoughtful and take a more sensible approach."

US companies need to continue making long-term investments in R&D, and at the same time, management needs to stop "exaggerating the payoff and discounting the danger" of outsourcing production and cutting R&D, Shih says.

Shih and HBS Professor Gary P. Pisano have been studying how other countries have performed in the high-tech and science-based industries, and they believe the United States could learn some lessons from other countries that have grabbed certain industries by the horns.

In China, for example, in 1986 four Chinese academics met with government officials to develop a "wish list" of strategic capabilities for the country to focus on, with great success. Today China has captured the supply chain in the electronics industry and will be a dominant player for years to come.

Likewise, Taiwan is a relatively small country of about 23 million people, and yet it owns 70 percent of global semiconductor foundry capacity. That commons helped Taiwan to tap into the same capabilities to make it a critical player in flat-panel displays and energy-efficient lighting, all because the country was tenacious in its investment in technology.

"The United States is still the world's richest and largest economy," Shih says. "But at some point we need to have a discussion on the national agenda about what kinds of capabilities are important for the United States in the twenty-first century, and we need to invest in them. People are less convinced today that science can solve our problems, but science is crucial to the care and feeding of the [industrial] commons. By the time people figure it out, I hope it is not too late."

Author Abstract

This paper contrasts traditional, internal organization-centered models of innovation with more recent work on open innovation. These fundamentally different and inconsistent innovation logics are associated with contrasting organizational boundaries and organizational designs. We suggest that when critical tasks can be modularized and when problem-solving knowledge is widely distributed and available, open innovation complements traditional innovation logics. We induce these ideas from the literature and with extended examples from Apple, NASA, and LEGO. We suggest that task decomposition and problem-solving knowledge distribution are not deterministic but are strategic choices. If dynamic capabilities are associated with innovation streams, and if innovation types are rooted in contrasting innovation logics, there are important implications for the firm, and its boundaries, design, and identity.

We have created a housing hybrid in America, refashioning the single-family home into a mini debtors' prison. Almost 11 million dot the landscape. In Las Vegas and Phoenix, over 50 percent of homeowners live in one.

Forget the notion of the home as "castle," protecting the owner from greedy landlords. Forget too the expectation that a physical nest will morph into a nest egg. For 22 percent of people who hold mortgages, those notions are anachronistic—relics of a long-ago era before unemployment soared, the Dow plummeted, and credit default swaps surfaced. In today's jargon, these owners are underwater—they owe more than the value of their homes.

But underwater is a misnomer. People underwater either swim or drown.

These underwater owners linger, trapped in their very own debtors' prisons. Their task is Sisyphean: they work, pay the monthly debt to the lender, yet see a perpetual gap between payments and value. The payments can seem like an extortion episode from The Sopranos.

Exit strategies are few. If an owner sells the house for less than the mortgage, the owner must pay the lender the difference. Owners will still need to find someplace else to live.

An owner can walk away from the loan and join the "strategic defaulters," who defaulted not because they could not pay but because they did not want to. Their house was a bad investment. The advantage of this maneuver is real: strategic defaulters save money. Sometimes they can rent a comparable home. But they risk a lower credit rating, which could bar them from buying another home for up to seven years.

Understandably, most owners do not grab either of these solutions; instead, they live shackled in what the Chinese call fang nu—slaves to their house.

One owner's misery is personal; when over a fifth of mortgage-holders are shackled, the personal misery becomes national. For the country, these homes are an economic shackle, hobbling the housing market. They also distort the labor market: people offered jobs far afield stay put, reluctant (and unable) to leave their underwater homes. Since the recovery of the housing market will undergird any broader recovery, we must address these debtors' prisons.

Novel solutions

The solutions will force lenders to throw out their textbooks.

First, lenders can recognize the wisdom of short sales, accepting less than the face value of the mortgage. Currently banks do accept short sales but only after protracted negotiations. One advice columnist recently advised sellers eager to unload an underwater house to keep trying—on the third try, a bank might relent. A short sale will put the house on the market, opening it to another buyer, letting the seller move. Lenders could proactively set prices for short sales.

Second, lenders can reduce the principal as part of loan modification. Consider a commonplace scenario. The value of a house has dropped 30 percent from its mortgage. The owner has already lost whatever equity she sank into the down payment. There is very little chance of an immediate surge in value. The owner cannot sell the house, is considering abandoning it, and has cut back on maintenance, which depresses the value further. If a few houses on a block are underwater, the blight will depress the values even of well-kept homes. Accepting this new reality, lenders might allow the entire mortgage payments to go toward the reduction of principal.

Third, lenders can transfer the mortgage-holder's status from "owner" to "renter." Often the owner has so little equity in the house anyway that the lender is in effect the owner. But making this shift from "owned" real estate to "rental" real estate will unshackle the occupant from the house. When the owner-turned-tenant makes his monthly payment, he will not be seeing a Sisyphean gap. If the rent is too high, the occupant will move. If the rent is low enough, he will stay. The occupant is free to decide. Lenders may be reluctant to morph into landlords, but they already own millions of empty units. At least the rental units will be generating revenue. Sometimes goals dovetail: in this case, the country needs rental housing as much as underwater owners need rescue.

Tony Soprano was not compassionate; the plight of his debtors would not have moved him. But he was pragmatic. I suspect that he would have modified these loans, releasing homeowners from their prisons.

In the late 1990s, a group of faculty at the Harvard Business School proposed a new approach to the teaching of a subject for which the School had been well known for decades: general management. The old way, centered around cases involving the leadership of large corporations, was not working. (I can speak from experience, because I led one of the unsuccessful efforts.) Student interests had shifted to the world of startups and self-employment. So a required course called The Entrepreneurial Manager was created.

TEM focused on financing and development of new ventures, with a few cases dealing with entrepreneurial managers in large organizations included. The course quickly rose from one of the lowest-rated in the required curriculum to the highest.

The course orientation fits with popular conceptions of the world of small business, offering visions of highly energized individuals passionate about doing their own thing developing new ideas and creating most of the jobs in an economy. This vision extends back in history, at least to the farms of Europe and the US. It helps explain laws to protect small business from the ravages of the A&Ps and Walmarts. It increasingly drives politics as well as government policy. It is especially attractive at times of low growth and low employment, because this ideal of small business as the center of economic development can be held up as a possible antidote to macroeconomic stagnation. That's why a recent article by Charles Kenny caught my eye.

Kenny, a fellow at the Center for Global Development and the New America Foundation, cites a growing body of evidence that suggests that a reassessment may be in order. Consider the conclusions from some recent research: Small businesses may not be a strong source of prosperity. Not only are they less productive than their larger counterparts, they have, according to a World Bank study, a lower rate of productivity growth because they invest only a small proportion of total R&D money. They therefore charge higher prices and pay lower average wages.

An analysis of census data by economists Erik Hurst and Benjamin Pugsley found that companies employing fewer than 20 people made up 90 percent of the six million businesses with one or more employees in the US in 2007. Most were small entrepreneurs creating what might be considered "lifestyle" jobs for themselves, intending to stay small and avoid employing many others. Eighty percent that were studied in detail didn't create a single job between the years of 2000 and 2003. Another study, The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By, by Scott Shane, found that while small businesses create more jobs than their larger counterparts, they also destroy more jobs. While they created jobs in the year of their founding, they netted out destroying jobs in years two through five as most of them failed, suggesting less job security than in larger organizations.

At the international level, economists Rafael La Porta and Andrei Schleifer conclude that a nation's wealth is inversely proportional to the share of jobs provided by small businesses. Again, this is due in part to the lower productivity of such jobs.

They conclude, as have some others, that a better strategy for job creation would be to attract large multinational corporations with better-educated managers and more stable financing. In fact, large global companies to which jobs were formerly outsourced have begun setting up operations in the US and United Kingdom.

Is it time to recognize the advantages of bigness when it comes to employment and economic development? If so, what does this mean for government policy? Are tax policies and other support for small businesses misguided? Does it suggest a return to an emphasis on big business management by pioneers in MBA training such as Wharton and Harvard? What do you think?

To read more:

Erik Hurst and Benjamin Pugsley, What Do Small Businesses Do?, Brookings Conference on Economic Activity, Fall, 2011.

Charles Kenny, Rethinking the Boosterism About Small Business, Bloomberg BusinessWeek, October 2011.

Rafael La Porta and Andrei Schleifer, The Unofficial Economy and Economic Development, National Bureau of Economic Research Paper No. 14520, December, 2008.

Scott Shane, Case Western Reserve University, The Illusions of Entrepreneurship: The Costly Myths That Entrepreneurs, Investors, and Policy Makers Live By , 2009.

Jim Heskett's latest book,The Culture Cycle, was published in September.

Author Abstract

In an experimental newsvendor setting we investigate three phenomena: Level behavior—the decision-maker's average ordering tendency; adjustment behavior—the tendency to adjust period-to-period order quantities; and observation bias—the tendency to let the degree of demand feedback influence order quantities. We find that the portion of mismatch cost due to adjustment behavior exceeds the portion of mismatch cost due to level behavior in three out of four conditions. Observation bias is studied through censored demand feedback, a situation which arguably represents the majority of newsvendor settings. When demands are uncensored, subjects tend to order below the normative quantity when facing high margin and above the normative quantity when facing low margin, but in neither case beyond mean demand (a.k.a. the pull-to-center effect). Censoring in general leads to lower quantities, magnifying the below-normative level behavior when facing high margin but partially counterbalancing the above-normative level behavior when facing low margin, violating the pull-to-center effect in both cases.

Firms in the United States, Japan, and Germany tend to be managed especially well, while firms in Brazil, China, and India tend to be managed poorly.

Those are among the initial findings of the World Management Survey (WMS), a huge international research initiative to measure differences in organizational management practices all over the world.

The project was borne of a widely perceived gap in economic research. In business academia, there is an optimistic tendency to assume that managers generally make decisions in the best interest of their firms' performance. Reality is more frustrating. The fact is, some companies are managed beautifully, others dismally.

"It's very tough to believe that there are such wide differences in management out there," says Raffaella Sadun, an assistant professor at Harvard Business School who coleads the WMS with Nicholas Bloom of Stanford University and John Van Reenen of the London School of Economics. "If you really want to be convincing, it's important to have large-scale statistical evidence," she adds.

To that end, over the past seven years, large teams of affiliated WMS analysts have interviewed managers at some 10,000 organizations in 20 countries, setting out to determine how and why management practices differ vastly in style and quality.

Best practices

The researchers used an evaluation tool designed by a leading consultancy firm that broadly rated management practices in three areas: monitoring—how well managers keep track of what's happening in a firm and make good use of that information; targets—how well organizations set appropriate goals and outcomes, and whether they take action if the two are inconsistent; and incentives—whether organizations promoted and rewarded employees based on performance and tried to keep the best performers from quitting.

To collect the data, the researchers hired teams of MBA students who could interview managers in their respective native languages. The respondents chosen for the survey included primarily middle managers in manufacturing plants, although over time the data collection was extended to other industries, such as retail, schools, and hospitals. The approach was to interview those who were high enough on the corporate totem pole to have a good overview of management practices, but low enough that they were familiar with day-to-day operations. The researchers also chose to target primarily small and medium-sized firms, employing between 100 and 5,000 workers, to maximize the chances that the interview would capture salient features of the whole organization, as opposed to the characteristics of single plants.

Rather than limiting the responses with multiple choice or yes/no questions, the interviewers kept the questions open-ended to get a complete picture of the actual practices adopted in the organization. This method was also useful to build an effective bond between the interviewer and the manager, which sometimes led to answers that were both thoughtful and entertaining. (Responding to a question about staff retention, for instance, one manager said, "I spend most of my time walking around cuddling and encouraging people. My staff tells me that I give great hugs.")

"We had very interesting experiences," Sadun recalls. "Once, a student was interviewing a manager, and during the interview she got a marriage proposal. The manager wanted her to marry his son."

Key findings

The researchers have summarized the initial results of the study in a new working paper, Management Practices across Firms and Countries,—also coauthored by Christos Genakos of the Athens University of Economics and Business—and have posted a comprehensive collection of the survey data on the World Management Survey website. The WMS site also features individual policy reports for manufacturing, education, health-care, and retail organizations, providing a management benchmark for executives in any of those fields.

On average, based on the evaluation tool, the research showed that firms in the United States, Japan, and Germany tend to be the best-managed in the world, while firms in Brazil, China, and India scored poorly.

Of the 20 countries in the survey, the United States received the highest overall management scores in retail, health care, and manufacturing. But US schools scored comparatively lower, coming in fourth behind the United Kingdom, Sweden, and Canada.

"US schools in particular tend to be particularly poor at incentives management—that is, promoting and rewarding high-performing teachers, and retraining and/or firing badly performing teachers," the paper states.

In the United States, India, and China, managerial use of incentives are much more common than the use of monitoring and target-setting, especially in the manufacturing field. In Japan, Sweden, and Germany, monitoring and target-setting far exceed the use of incentives.

But the differences surpassed international boundaries. "There is so much dispersion, even within the same industries and same countries," Sadun says, explaining that the researchers managed to discover certain ownership patterns that help to explain the dispersion.

For instance, government-owned organizations tend to receive low management scores across all the sectors and countries in the study. "They are particularly weak at incentives," the paper explains. "Promotion is more likely to be based on tenure (rather than performance), and persistent low-performers are much less likely to be retrained or moved."

Family-owned businesses scored even lower—particularly those run by a firstborn son who inherited the role of CEO. Family-owned businesses that employed a non-related CEO scored much higher. "The finding there is not so much that family ownership per se is associated with lower scores, but rather family ownership when the selection of the CEO is not meritocratic," Sadun says. "Especially in Europe, you have a lot of companies where the transmission of leadership is based on criteria completely unrelated to your ability to lead."

Also receiving low management scores across the board: organizations at which the company founder was also the CEO. "We systematically find that founders have lower levels of scores," Sadun says. "One possible explanation is that founders are great at the start-up phase because they have the vision and the motivation. But as the firm grows, to do the ongoing management on a daily basis requires a different set of skills."

Market competition appears to be good for management. The research showed that a company's overall management score wass directly related to how many competitors a firm faces—the higher number of reported competitors, the higher the management score. And multinational firms scored higher than their domestic counterparts across all the industries and countries in the survey.

Education makes a difference, too. The data showed that the greater the percentage of employees with a college degree in manufacturing and retail firms, the greater the management scores. In hospitals, a greater management score correlated with the percentage of managers who also had clinical experience.

Next steps

With the initial data tracked and scored, the researchers are now working with the US Census Bureau to build an even larger set of management data. Last spring they conducted a survey of more than 48,000 US companies, using the questions and the evaluation tool from the initial WMS survey. The Census Bureau already keeps general track of firms' financial performance in the United States. The WMS team plans to match the management survey data against the financial performance data in order to investigate the link between management quality and the bottom line across an even larger number of organizations.

The researchers have also started to work on management experiments, modeled on the randomized control trials adopted in the medical field. This experimental approach is much more costly and labor- intensive than the survey methodology, Sadun says, but it allows them to identify with much greater precision the causal link between management and performance.

"We want to get at the causality between management and performance," she says. "And to do that, you have to go beyond surveys and start running experiments with firms. That's the most challenging but also the most interesting part of where this research is going."