Owing to complexity in technology and the need for better, faster, smarter product development models, businesses are finding new ways to innovate and collaborate in new product design and development. Joint product development between firms is becoming more the norm between technology firms and their suppliers and pharmaceutical firms with their bio-tech counterparts. Many other industries are also finding this approach necessary when product design and development capabilities can be distributed across different firms. New research by ITOM Professor Sreekumar Bhaskaran of SMU Cox and Vish Krishnan of University of California at San Diego analyzes the under-studied concepts in co-development as a strategic choice in product development.

In “Effort, Revenue, and Cost-Sharing in Contractual New Product Development,” the authors argue that co-development can be structured in two fundamentally different forms: investment sharing, when the firm shares the development expense and innovation sharing where a firm undertakes part of the development work itself. So, when should a firm invest and outsource development work while agreeing to share the development expense and when should it take part in the process of innovation? To answer this question, let us first break down the two major types of agreements and identify their inner workings.

Investment Sharing

A pattern of multi-firm product development where the collaborating companies share the development expense, with one firm doing the bulk of the work, is investment sharing. Investment sharing is a more “detached mode of product development” according to Bhaskaran. For example, since the invention of recombinant insulin in 1982, the application of bio-technology to the creation of therapeutic drugs has grown dramatically. Small bio-tech companies often work with large pharmaceutical companies because of the know-how required in R&D and the large investments needed for commercialization.

The authors conducted an in-depth field study of the agreement between a small bio-tech concern (Alpha) and a large pharma company (Mega). Alpha and Mega agreed to share equally in the development investment, with Mega making an upfront investment based on an estimate of the development costs. Alpha performed the drug development, while Mega helped to commercialize and distribute the product with its vast global sales force. In return, the firms shared the revenues at a previously agreed ratio: 30% of US domestic revenues and 80% of international revenues accrued to Mega, and the remainder went to Alpha. The contract-driven drug development partnership was a success with FDA approval for the diabetes drug in 2005.

Interestingly, although Mega had considerable infrastructure to handle the development work, they chose to fund the development work at Alpha rather than share in the development and testing. In pharmaceuticals, there is a large degree of ‘technology’ uncertainty (whether chemical compounds will work). In addition, one firm may be more dominant than the other and thus could direct more of the benefits to itself. Under such conditions, the authors show that investment sharing may be more appropriate, with firms contributing the proper amount of effort for a just reward.

Innovation Sharing

Alternatively, the case of innovation sharing can be recognized in the product development work of computer maker Dell. Innovation sharing occurs when the development work is shared without an upfront transfer of money. While Dell is widely known as a direct and lean manufacturer of computers, it leverages the technological capabilities of its component suppliers. Dell’s product design processes are deliberately designed to support and complement supplier innovation with its strengths in customer needs identification, complementary hardware/software development, component qualification and testing, system integration, beta testing and market feedback. For example, Dell worked closely with Lexmark Corp. in 2002 and enhanced Lexmark’s printer technology with an innovative Dell-developed cartridge replenishment software and both firms shared the revenues. Dell has also built its other product lines such as laptops, servers, and storage products through joint development arrangements with component suppliers; in this case Dell shares downstream development and testing work with its suppliers.

In the late ’90s, Dell’s product development approach helped it corner a significant share of the business market for laptops. A key ingredient of this successful strategy was Dell’s collaboration with Sony in lithium ion battery technology development. The introduction of lithium ion battery technology gave business people what they wanted—longer battery life to keep productive. Dell’s joint development approach is in contrast to the investment sharing approach used by Mega as it participates in the development work areas of qualification, testing, and system integration.

Whither Investing or Innovating?

While both investment and innovation sharing approaches signals a firm’s commitment to its suppliers, the more pertinent issue relates to the effect of these approaches on the extent of product development and profits. Also important are the roles of technology and market uncertainty on the choices between cost, revenue, and effort sharing.

“Distributing product development across multiple firms introduces technical uncertainty when you try to integrate processes,” Bhaskaran says. “This makes it difficult for firms in industries like pharmaceuticals, where technological uncertainty is already very high, to engage in innovation sharing.” Alternatively, if technological uncertainty is low, each firm can specialize according to advantages through innovation sharing. For example, Dell knows how to integrate the lithium battery into a laptop, and Sony understands battery technology. Bhaskaran continues, “Product quality relies on multiple dimensions— both the technological part and the integration part. By concentrating on their respective strengths, and distributing the innovation across firms, partners can focus their attention, ensuring a quality product with more cost efficiencies and economies of scale.” Innovation sharing can be more cost effective and profitable than investment sharing when partners compliment each other’s distinctive strengths and power relations are in balance.

But innovation sharing requires a greater bandwidth of communication. Bhaskaran relays, “Dell needs to have an understanding of the development about the battery at the Sony level. Firms engaging in co-development have to understand the development processes of each other to properly execute the integration process. Partners need to observe the progress made and be part of it. It’s no longer just a price and quantity equation.”

A Higher Order Globalization

With greater complexity in product design and technology, more of these types of arrangements are expected. In Bhaskaran’s world view, ‘A product is a combination of many characteristics, not just one thing.’ The battery only works well if the battery technology is good, and it works in its vehicle (the laptop), and is thus properly integrated.  “When a product itself becomes modular in terms of components, it’s easy for firms to build up capabilities with respect to these individual components. Economies of scale go up, and manufacturing costs come down,” Bhaskaran comments. It is then cheaper to develop high-quality products at a low price over time. Thus specialization and the formalization of supply chains have led to outsourcing, which has contributed to greater globalization as capability gets spread across the world. 

This collaboration pulls all the pieces of product development and production together in a smart way.  “Collaboration doesn’t divide the pie, but increases the size of the pie, and increases the value that each of the firms derive out of it,” Bhaskaran notes. “With innovation sharing, the work of both firms are actually strategic complements. When one firm puts in a certain amount of investment, your partner has incentives to put forth even more investment or effort. When firms work together, they have greater incentives to create something better.”

This form of joint product development and its inherent collaboration and integration goes beyond the typical reportings of partnerships and their terms often seen in the business press. This research focuses attention on why firms would choose to have this type of contractual agreement—what are the driving forces in the industry or in partnerships that would make this an attractive way to engage in business. The manner in which product development agreements are structured have significant consequences in terms of product quality and innovation, technological uncertainty, and ultimately, profitability.

“Effort, Revenue, and Cost-Sharing in Contractual New Product Development” by Sreekumar Bhaskaran and Vish Krishnan is currently under review.

Summary by Jennifer Warren.