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Modular Product Design:

Creating Technologically Separable Interfaces

Kirsten Foss
Department of Industrial Economics and Strategy
Copenhagen Business School
Nansensgade 19,6
1366 Copenhagen K
November 1998

This paper discus the relationship between a physical product design and the
definition of tasks in integral and modular product development strategies. It is
argued that there are different criteria for defining tasks depending on the types of
advantages of specialization one tries to realize. Moreover, task definition is also
influenced by the costs of coordinating tasks. The physical product design strongly
influences the trade-off between benefits of specialization and costs of coordination.

This paper represents work in progress and is still very preliminary. Comments from
Ron Sanchez on an earlier draft of the paper are gratefully acknowledged.

I. Introduction
The primary theme of this paper is to discuss the relation between the physical
product design and the definition and organization of product development tasks.
Tasks delimit in a more or less precise way the activities carried out by one
individual from those activities that are carried out by another individual1. The
creation of tasks as a minimum requires what Williamson (1985) calls
technologically separable interfaces between activities. The paper explores the
relation between technologically separable interfaces in product development
activities, the definition tasks and technical interdependencies between components
in the products that are to be developed.
Highly integral and highly modular products represent two extremes with respect to
the degree of interdependence between components. Modularization is a product
development strategy where different functions of a product are implemented by
different and relatively independent physical components whose interfaces are
defined by a set of interface standards. This differs from an integral design strategy
where each component may implement many functions and where each function is
implemented by many different components. The independence between
components in modular products implies that an implementation of improvements
in one function have relatively little bearing on other functions. 2
The aim of a modular product design strategy is to reduce complexity in product
design. One can say that with a modular product development strategy one creates a
number of relatively closed systems of interdependent parts, which are contained
within different components.
A modular product design strategy aims at reducing the complexity of the product in
order to reduce the uncertainty and complexity in product development activities.
The success of such a strategy hinges on the relation between the complexity in

I distinguish between activities and tasks. Tasks may encompass one or more discrete separable types
of activities. It is difficult to pin point what makes activities separable. Some activities, such as
sneezing, clearly cannot be separated for physical reasons. Other activities such as conducting or
creating a sculpture may easily be separated into a number of distinct activities. However, it may be
difficult to achieve the best result possible if the separable activities are to be carried out as separate
tasks. Problems arise because skills or talents cannot be transferred instantly in the form of
instructions. A long term of continually interaction may be required and event then talents may not be
fully reproduced.

According to Ulrich ad Eppinger (1995) modular and integral production strategies are not just
different ways of producing the same products. Modular designs often results in less elegant products.
They claim that where the important functions depend on size, shape and mass an integrated product
architecture may be preferable to a modular. It should be noted that products are rarely strictly
modular or integral. Even in a modular product there may be strong interdependencies within
components at the level of detailed design where the implementation of the ancillary functions are to
be solved. With a more advanced modularization strategy there may not be this simple relationship
between components and functions. Some functions may be implemented by different components
where the interfaces required to implement the function are well specified. Focus in this paper os on
the more simple kinds of modularization.

product design and the complexity in product development activities.3 The most
important indicator of such a relationship is the extent to which a decomposition of
product development activities is made easier by the decomposition of the product
into independent components.
Decomposing problems into sub-problems is as pointed out by Simon (1969) a way of
reducing complexity in problem solving. In product development a part of the
problem solving activities consists of discovering unknown types of
interdependencies between different design solutions. A decomposition of the
product into nearly independent components constrains the search for causes of
functional failures in products and speeds up the testing of the feasibility of different
design solutions. Therefore, when successfully carried out a modularization strategy
should make it is easier to identify the nature of interaction between components as
well as within components. Modularization thus can be thought of as a way of
increasing the rate of uncertainty reduction with respect to design decisions so that it
becomes possible to specify in great detail the interfaces between components in a
product architecture. Once the architecture is fully specified the uncertainty in
product development is confined to problems of identifying feasible solutions which
will improve the functionality of the product within the constraints set by the predefined interface standards.
The choice of a modular product development strategy over an integral strategy also
has strong implications for the benefits of specialization in product development. In
order to reap the benefits of specialization, product development activities have to be
separated into various tasks which are carried out by different individuals. A main
point of the paper is that task definition and the way in which the product
development problem is presented have great implications for the possibilities of
reaping benefits of specialization at lowest possible cost of coordination.
The paper identifies to types of rationales for task division. One is to economizing on
bounded computational capacity and saving costs of information processing. The
other is to increase the rate of learning by doing and innovativeness in problem
solving. I shall argue that from the perspective of economizing on bounded
computational capacity the identification of interdependencies in product solving
activities is an important criterion by which one ought to identify tasks while from
the perspective of realizing the benefits of learning by doing repetition of activities
and similarities in the underlying knowledge are important criteria
Benefits from specialization cannot be realized without costs of coordination. Costs
of coordination increase with the need for more communication, as more tasks are
defined or more importantly with the way in which tasks are specified. For example,
it may greatly save costs of communication if tasks are defined in ways, which allow
for the communication of results rather than of the premises on which the results are
to be reached. Furthermore, tacit knowledge or sticky information (von Hippel,
1998) may be a problem of coordination between tasks which require the creation a

coordination mechanism. Another aspect of coordination is incentive coordination.

Here measurement costs problems (Alchian and Demsetz, 1972; Barzel, 1985) and
problems of asset specificity (Williamson, 1985; Hart, 1995) are of profound
importance in determining the costs of coordination. Again task definition may
influence costs of coordination. For example, it may be possible to reduce costs of
coordination by defining tasks in ways, which make it easier to measure the outcome
of tasks.
I argue that with a choice of a modular over an integral product development strategy one is
able to define tasks in ways which provides greater opportunities for realizing the benefits of
specialization with less costs of coordination. Essentially, this is because with a modular
design strategy, it is possible to economize on bounded computational capacity and
reap benefits of learning by doing by defining tasks of detailed design in ways,
which correspond to the problems of improving relatively independent components.
Moreover, a fully specified architecture limited the needs to transfer of tacit
knowledge, reduces externalities between tasks and makes it possible to rely on less
extensive monitoring of tasks completion.
The remaining part of the paper is organized as follows. Section II, What Are
Technologically Separable Interfaces?, discusses the meaning of this thorny concept, In
section III, The Product Development Process: Integral and Modular Product Development
Strategies, I use Ulrich and. Eppingers (1995) representation of a product
development process as a basis for discussing the differences in product
development activities in an integral and a modular product development strategy,
respectively, while section IV, Task Definition and Benefits of Vertical Specialization in
Integral and Modular Product Development Strategies, gives an account of the benefits
of vertical specialization in general and in product development processes in
particular. Finally, section V, Cost of task coordination takes up the discussion of
coordination and task definitions in product development.

II. What Are Technologically Separable Interfaces?

Technologically separable interfaces define the boundaries of tasks between which
transactions may occur. According to Williamson (1985), [a] transaction occurs
when a good or service is transferred across a technologically separable interface.
One stage of activity terminates and another begins (p.1). In fact, as pointed out by
Furubotn and Richter (1997), ... [t]he term transactions is restricted to a situation in
which resources are actually transferred in the physical sense of delivery (p.41).
Technologically separable interfaces between distinct activities are demarcated by the
possible of exchanging physical objects or knowledge as either embodied in physical
objects or as codified knowledge. From this well-known definition of transactions,
Williamson sets out to understand the characteristics of transactions that
discriminate with respect to the choice between different governance structures as
means of organizing transactions.

It is a main argument of this paper that the way in which tasks are defined and
technological separate interfaces are created have profound implication for the net
benefits of specialization. The cost of codifying and transferring information along
with the possibility of realizing advantages from specialization is of great importance
in determining tasks.
To Williamson, technologically separability is taken as a datum and the creation of
tasks is not considered a decision variable. Williamson does not considered task
definition part of a problem-solving activity, nor is it considered a way of dealing
with the problem of coordination. Williamson perhaps implicitly assumes that tasks
are defined in ways that maximize the benefits of specialization given the constraints
of, for example, the laws of nature, the techniques used the state of technological
knowledge, and the extent to which it is possible to codify information.
But technologically separable interfaces in the Williamson sense are not given; they
have to be discovered. Most likely a very great number of alternative technologically
separable interfaces can be defined in any product development process or indeed in
any production activity. It is obvious -for those interested in product development
(for practical or academic purposes)- that the uncertainty or complexity, which
characterize the product design problem, makes it difficult to specify ex-ante all the
possible types of exchange of objects and information, which will be needed in order
to create a new product.
Moreover, transactions between technologically separable interfaces do not occur
unless there is a separation of activities into tasks performed by different individuals.
The best way of defining tasks may vary according to the benefits of specialization
one seek to realize and according to the design problem and the design strategy.
Although we cannot specify in detail all the activities in any product development
process we can anticipate how the choice of a modular over an integral product
development strategy may influence the nature of activities and the types of
interdependencies one encounter. The following section provides a short description
of product development activities with an integral and a modular product
development strategy.

III. The Product Development Process:

Integral and Modular Product Development Strategies
The purpose of product development is to create a new product with certain more or
less well-defined quality characteristics and functions or to upgrade the quality of an
established product. The outcome of such a process is a description of a product
concept with a set of technical specifications on how the various functions of the
product are to be implemented in the product. In general terms, product
development can be seen as consisting of activities such as information collection,
information processing, creative thinking and problem solving.

There are many different ways of carrying out these activities and many different
tools and guidelines have been developed in order to aid product development
teams in carrying out these activities (e.g., Wheelwright and Clark, 1992). In the
following sections, I give a brief description of the methodology developed by Ulrich
and Eppinger (1995), since this methodology is developed with a focus on ...
products that are engineered, discrete and physical (p.2). These are the types of
products, which are the focus of this paper. The methodology they suggest consists
of a highly structured search and evaluation process. I use this methodology to
illustrate the more specific differences in product development activities between an
integral and a modular design as well as a basis for discussing the creation of
technologically separable interfaces between tasks in product development.
According to Ulrich and Eppinger, the product development process can be
described as taking place in five sequential phases, which are: Concept development;
system-level design; detailed design; testing and refinement, and production rampup. All of these phases can be described by a number of distinct activities that have to
be performed. In the following, I shall limit my attention to the concept development
and system level design phases, since many of the differences between modular and
integral design strategies arise from the different ways of tackling the information
processing and problem solving activities in these two phases. I shall start by giving
a brief presentation of the various steps in integral product development process,
followed by a short indication of how this process differs from a modular design

III. i. The Integral Product Development Strategy

The Concept Development Phase
The purpose of the concept development phase is to generate the product concept for
the product. A product concept ... is an approximate description of the technology,
working principles, and form of the product4 (Ulrich and Eppinger, 1995, p.78).
With the kind of structured approach to concept generation advocated by Ulrich and
Eppinger, the concept generation process begins with the identification of customer
needs. Customer needs should be expressed in ways that do not indicate technical
solutions. Once customer needs are ranked they have to be transformed into a set of
target specification.5
In most designs it is necessary to divide the design problems into more simple subproblems. Ulrich and Eppinger suggest that this requires what they call a functional

Ulrich and Eppinger use the word product concept in a different way compared to the general use in
the marketing literature where a product concept is considered to be a package of functions that is

A target specification consists of a statement of what the product has to do (a metrics) and a target
value expressed in a measurement standard (for example: average time to assemble is a metric and 75
seconds a value). This is sometimes referred to as an implementation.

decomposition where the desired functions of the product are decomposed into
functional elements to create a more specific description of what the elements of the
products do in order to implement the overall functions of the product. 6 7 With the
completion of the functional decomposition the search for physical design solutions
begin. Since each component typically implements many different functions which
may interact in more or less unpredictable ways one continuously have to take into
consideration the interaction between different design solutions. Component and
product design therefore co-evolve and as the architecture of the product gradually
is finalized by the definition of all the component interfaces.
The search for a product concept starts by the selection of a sub problem for further
scrutiny that is believed to be critical and constraining for other solutions. Then, a
number of different concepts of how to solve the sub-problem are developed. These
solution concepts can be systematically explored by using a concept classification
tree where each branch represents a combination of conceptual solutions. For each
promising branch a sketch should be made of the possible technical solutions which
will implement the desired overall function. Finally, the product concept can be
selected by evaluating the most promising combinations of technical solutions
against the target specifications and costs constraints. The evaluation of a technical
solution may require that models are built -which contain the critical design
parameters- in order to determine their interactions with respect to the target
The System Level Design
At the system level of design product specifications have to be established along with
the architecture of the product. Target values, defined in the beginning of the concept
development phases, may have to be refined as models and tests of design solutions
for all the different sub-problems reveals different types of constraints on the
technical solutions. The architecture of the product is gradually finalized as all the
different solutions to sub-problems are developed.

III.ii. The Modular Product Development Strategy

One of the main differences between a modular design strategy and an integrated
design strategy is that with the former strategy the designers intentionally create a
higher degree of independence between components (Sanchez and Mahoney, 1996).

Functional decomposition is not the only possible way of decomposing a problem. For example, one
can decompose by sequence of user actions or by key customer needs (Ulrich and Eppinger, 1995).
Ulrich and Eppinger mentions different techniques which can be used to aide the functional
decomposition of product development problems.

A functional element consists of the individual operations and transformations that contribute to the
overall performance of the product. Each functional element is described in a way that does not imply
a specific technical solution.

The development process can be organized in sequential tasks or it can be organized with
overlapping tasks. The latter may reduce losses of tacit information. ( See Sanchez and Mahoney, 1996)

The architecture of the product is developed before any of the detailed design
solutions and design-information is partitioned into visible design rules and hidden
design parameters. The visible design rules include:
1. The architecture that prescribes what modules will be part of the system and what
their functions will be.
2. Interfaces which describes the interdependence between these modules or chunks
(chunks, in the terminology of Ulrich and Eppinger, 1995).
3. Standards for testing conformity and quality (Baldwin and Clark, 1997).

Concept Development
With a modular design strategy the concept of the architecture is laid down first and
the interfaces specified. The specification of interfaces often set narrow limits to the
choice of concepts and implementations for the auxiliary functions of the product.
Once the architecture of the product is finalized product development consist of
altering the components of the products within the limits defined by the architecture.
Because interfaces between chunks (major components) are pre-specified and
because each component carries out a separate function, the improvements of
components (chunk) requires information of only limited and known functional
interactions with other chunks.
The System Level Design
The system level design is finalized by the choice of a concept for the architecture
and by the specification of interfaces between the major chunks of components,
which implement the most important functions of the product.
Compared to an integral product design, a modular design strategy means greater
independence between the different functions that are embodied in the product,
more components as each component implements only a few functions and less
interdependence between components. From the above brief sketch of the design
methodology of integral and modular designs it should also be clear that with a
choice of a modular product design informational interdependencies between
problem solving activities and therefore also the amount of iterative processes
needed to solve a problem is strongly reduced. This could of course imply that the
total amount of transactions would be less with a modular design. However,
iterations can be carries out by a single person and by defining tasks to reduce the
need for communication across interfaces it is possible to reduce the amount of
transactions. Of course other consideration than the amount of iteration will have to
determine the definition of tasks and in that case it may not be economically
beneficial to have one person perform all the iterations needed to solve the problem.
The consideration I have in mind here are the benefits of economizing on bounded
rationality, of specialized knowledge, and of learning by doing.

IV. Task Definition and Benefits of Vertical Specialization in

Integral and Modular Product Development Strategies
The benefits of vertical specialization and costs of coordination determine the extent
of specialization. But the way in which tasks are defined what benefits can be
realized from specialization As already mentioned it is possible to identify different
kinds of advantages of vertical specialization, such as economize with bounded
rationality to reduce problem solving time or increase the rate of learning by doing.
In this section, I take up the discussion of how task partitioning may influence, first,
the benefits of economizing with bounded computational capacity and, second, the
possibilities of increasing the rate of leaning by doing. I compare an integral and
modular design strategy with respect to different criteria for task definitions to be
used in order to reap the above mentioned benefits of vertical specialization.

IV.i. Defining Tasks to Economize with Bounded Computational

Capacity and Maximize Parallel Search
One aspect of bounded computational capacity of individuals may be that there are
sharply diminishing returns to information processing and problem solving as
increased complexity of problem solving increases the load of information
processing. Diminishing returns may show up as inferior solutions or as more than
proportional time is spent on problem solving. One way of overcoming the problems
of diminishing returns is to divide a complex system9 of problems into smaller and
less complex problem (Simon, 1969). According to Simon (1969) complex systems
tend to be organized into hierarchies where there is much more interaction within
sub-systems than between sub-systems. In fact, whenever there are some interaction
between sub systems the entire systems is only nearly decomposable.
Solving relatively independent problems can to a large extent be described as a
search through a maze (Simon, 1969, p.95). By dividing a problem into sub
problems, the problem solver can concentrate on the interactions between a lot fewer
elements at a time. It is possible to reduce problem solving time by solving one of the
sub problems since this reduces the amount of random trails which will be needed to
identify a solution to the problem in its entirety10. Moreover, because a solution to a
sub problem often can be transferred into a piece of codified information, it can be
put aside without the risk of being lost.11 All of this helps economize on bounded

Complex in the sense that it is made up of a large number of parts that interact in a non simple
way (Simon, 1969, p.86).


Simon (1969) explains how the numbers of trail in opening a safe with 10 dial with 100 settings can
be reduced from 50 billions to 500 if it is possible to sequentially determine the correct setting of each
dial. Solving sub-problems is equal to setting a dial correct.


Simon (1969) uses the parable of the two watchmakers Hora and Tempus to illustrate how the time
of component assembly of a watch may be reduced if the watch is decomposed into sub components.

computational capacity.
Many design problems can be conceived of as complex systems, which belong to the
category of only nearly decomposable systems. As with other nearly decomposable
systems it is possible economized on bounded computational capacity and reduce
problem solving time by identifying and solving sub problems. Design solutions
emerges as the designer searches through a maze of conceptual and physical
solutions in pursue of a workable solution. Trail and error is a dominant feature of
this process as different concepts and physical solutions are constructed and
evaluated against the target specifications. If search is carried out randomly on
average many more trails and errors will be needed to reach a workable solution. But
if search is guided by either experience, technological knowledge or by the
identification of a solution to a sub-problem these trails and errors will be greatly
In any product design one of the difficult parts consists in defining independent
problems, which makes up the hierarchy of sub-design problems. The fact that it is
often possible to create a great number of functional decomposition of a design
problem goes to show that it is possible to construct many hierarchies of design
problems. Furthermore, for each functional decomposition a great number of
conceptual solutions can be constructed and for each conceptual representation it is
possible to define a great number of physical solutions.
One of the problems of choosing how to decompose the design problem rest in the
difficulties of trying to anticipating the strength and nature of interdependencies
between functions and among components. Experience of course help one construct
one set of relatively independent problems in ways that can give rise to great
improvements in the functionality of the product. The process however, is greatly
eased with a modular design strategy since with such a strategy the product is
conceived of in a way that greatly reduces the complexity of tracing the
interdependencies between and within components. Once a fully specified
architecture is arrived at a decomposition of design problems can take place along
the line of components. The search for specific design solutions to will then be much
faster since the search strategies are already constrained by the pre-determined
interface standards. However, as pointed out by Sanchez and Mahoney (1996) To
fully specify component interfaces in a modular product architecture, a firm must
have, or have access to, advanced architectural knowledge about relevant
components and their interactions. (p.70)
Decomposing design problems into nearly separable sub-problems is a way of
For Hora, who had not decomposed the watch into sub-components, the watch fell apart every time it
had to be put down due to interruptions. Tempus, who has decomposed the watch into subcomponents, lost only the assembly of the last component when interrupted. There are parallels to this
parable in problem solving. Non codified experience from previous trails, conjectures and ideas may
be lost in case of interruptions. If a problem is decomposed into sub problems with codified solutions
there may not be so great loses of tacit knowledge.

economizing with bounded computational capacity even if only one person is

involved in the problem solving activities (Simon, 1969; Radner, 1992). However, if
different individuals solve different parts of the problem it may be possible to
economize even more on bounded computational capacity. Then, what sort of
heuristics can be used to define product development tasks in ways that economize
the most with bounded computational capacity? Within the sphere of social systems
the solution proposed by Simon (1969) is to construct sub systems and hierarchies
by making a chart of who interact most intensely with each other then ..the clusters
of dense interaction in the chart will identify a rather well defined hierarchic
structure (ibid. p.88). The underlying assumption must be that task definitions,
which economize on bounded computational are the ones, which also reduce the
need for communication most. In product design Eppinger, Withney, Smith and
Gebala (1994) have suggested a similar approach. Based on case studies they found
that iterations in product development tasks are reduced most when tasks are
defined on the basis of a chart of the interaction between the design parameters
specified by the designers. 12 Now, the amount of iterative processes in product
development design depends on the extent to which it is possible to specify
interfaces between parts and components ex-ante to the development process and on
the amount of interdependencies between parts and components in the product
design13. A modular product development strategy reduces the interdependencies in
parts and makes it easier and faster to specify their interfaces
Even if there is almost complete knowledge of the interactions between components
and parts there is some definitions of tasks which economize more on bounded
computational capacity than others. von Hippel (1990) has illustrated this point very
well in an example of the develop an airplane where the product development
problem is subdivided in two different ways. In the first case one task is to develop
the rare end and the other to develop the front end of the plane whereas in the
second case one task is to develop the engine and the other to develop the aircraft
body. If tasks are defined by allocating the design of the rare and front part to
different teams each team have to be fully informed about many more design variables
than if tasks are defined by allocating the design of the frame to one team and the
design of the machine to the other team.. Moreover, in case where knowledge of
interdependencies are less complete task division in accordance with the first
example most likely would imply many iterations between problem definition, and
target specifications, on the one hand and the problems solving tasks on the other
hand as the two design teams discover incompatibilities in their solutions14.

Other factors beside information exchanges may also be of importance in defining tasks. Eppinger,
Withney, Smith and Gebala (1994) mentions task duration, the degree of dependence as measured in
for example ..task communication time, functional coupling, physical adjacency, electrical or
vibration characteristics, parameter sensitivity, historical variance of task results, certainty of planning
estimates, or the volume of information transfer (p.4)


It of course also depends on whether one wants an optimal design or not.


Another indication of a difference between the two approaches is that it is much easier to reach an
optimal design with the second approach than with the first approach.


In comparing task definitions of an integral and a modular design strategy attention

should be given to the fact that functions in modular product are implemented by
relatively independents components. For most incremental improvements of
functions the important interdependencies between design variables to be explored
are likely to be concentrated within components rather than between components.
This implies that a definition of design tasks in accordance with the components that have to
be developed most likely will be the one, which reduces the need for iteration and the need for
information about design variables most. In the case of the integral design it is not quit
so easy to determine what heuristic for detailed task definition will be most feasible
with respect to reducing iteration processes.
Decomposing complex problems into relatively independent and less complex
problems help to raise the quality of problem solving while simultaneously save
problem solving time. Another way of economizing on bounded computational
capacity is to reduce the information processing of individuals by taking advantage
of the possibility of parallel problem solving. This always requires that more than
one individual is engaged in the product development activities.
If one is to benefit from parallel problem solving the problem to be solved in its
entirety has to be characterized by what Radner (1992) calls associative operations.
With associative operations the sequence in which the sub operations are carried out
do not matter to the entire result. Linear information transformation and pattern
matching are the two paradigm cases of associative operations. Linear
transformation takes place when a set of information is transformed into another set
of information by the use of some sort of algorithm of transformation. Computing
the value of 100 kilo gold from US $ into Singapore $ is an example of the
employment of a linear decision rule. Pattern matching takes place when a sets of
data is compare with a reference set of date in order to find the closest match. An
example of this may the activity of comparing the dimensions of many different bolts
in order to find the one which match a set of specifications.
In product development there are a lot of activities, which may be characterized as
transformation by some sort of linear decision rule. One example is the
transformation of customer statements into target specification. Most likely it is not
possible to specify explicitly how this transformation is to be performed but
individuals with the same education and experience may employ some of the same
tacit heuristics in performing this activity. Thus, it may be possible to allocate this
type of activity to different individuals with the same education and have them
perform the translation in parallel. Other activities, which may be characterized by
linear transformation are the combining of all the different conceptual solutions to
functional decomposed problems in the creation of branches in a concept
combination tree or the transformation of these combinations of conceptual solutions
into suggestions for physical solutions. Parallel search then take place when different
individuals create different branches of the tree or when different individuals makes
the transformations of the conceptual solutions into physical solutions.


Pattern matching activities in product development are mostly of the type where one
solution is selected on the basis of a comparison with the pre-specified requirements.
For example, pattern matching activities take place when a choice is made between
various combinations of conceptual solutions in the concept combination tree or
when a product concept is selected by comparing various solutions to the target
specifications. These judgments can be carries out by more than one person. Different
individuals can compare sub-sets of solutions and find the best solutions of the subsets which then can be compared by another group and so forth until the best
solution is found. This may be a time saving strategy if there are many solutions to
be evaluated. Since most often there is no definite algorithm by which the best
solution of a sub-set is to be found the judgment of the various individuals may play
an important role in determining which of the proposals are selected. 15
Parallel transformation and pattern matching economize on the bounded rationality
of individuals, it saves time in product development and it may also be employed as
a way of creating more variety in solutions. As mentioned above the ways in which
transformations are performed are likely to vary with educational background and
experience. Since the solution to the design problems in its entirety is likely to differ
with the solutions suggested parallel search can be used as a way of increasing the
variation in the suggestions of design solutions by having different individuals
engaged in the transformation processes.
In order to realize the benefits of parallel search associative processes will have to be
identified from those problem solving activities which have to be carried out
sequentially and tasks will have to be defined as sub sets of these associative
processes. Since there are increasing costs to parallel problems solving activities task
definition of course will have to reflect these costs. The cost consists of delays or
problems of utilizing capacity fully. Delays occurs as parallel sub-problems are
synthesized by sequentially eliminating or transforming sub-solutions until a final
solution is arrived at. Delays can sometime be reduced by defining more tasks to be
carries out by more individuals. An efficient problem-solving network is one where
there is an optimal tradeoff between serial and parallel processing. If problem
solving is not an ongoing process and if idle capacity represents no costs this is
achieved when for a given amount of information ..the number of processors cannot
be decreased without increasing the delay, or vice versa" (Radner, 1992, p.1395).
When information arrive continually one can typically reduce delay time by
expanding the network as compared to the optimal one shot problem-solving
What then are the implication of a modular and an integral design strategy
respectively from the perspective of enjoying the advantages of parallel search? First,
and foremost it should be noted that it is possible to conduct parallel search with

The distribution of suggestions among individuals and the sequence of decisions may have a great
influence on the final choice (Miller, 1992)


both a modular and an integral product development strategy. However, a modular

product and a fully specified architectural design represent a nearly decomposed
system of design problems. Many of the detailed design activities are therefore
nearly associative operation because the sequence in which sub design problems
are solved does not matter much and it is therefore possibility to carry out the
detailed design of components in parallel.16
In the integral design where there are many physical interdependencies between
components any parallel search for a solution to sub problems continuously has to be
adjusted to new information about solutions to other sub-problems. This implies that
the algorithm of pattern matching continually has to be altered and some of the
processing may have to be re-done. In order to minimize the re-doing of pattern
matching or transformation activities the sequencing of the various types of pattern
matching and transformation activities is important.
To sum up, in order to reap benefits of economizing on bounded computational
capacity and reduce information processing time task partitioning is often necessary.
In specifying tasks one needs to consider; how to reduce the amount of information
each person needs to receive and communicate; how to reduce the amount of design
variables each person needs to be aver of; and how partition the search for
information in ways which reduces delays and cost of idle capacity.
A first approximation to achieve this is to decompose the design problem into
relatively independent problems so that for each sub task one only needs to discover
interactions between a more limited number of design variables. This of course
require some understanding of the nature of interdependencies between problems
and therefore also of the nature of interdependencies in the product design. In this
respect a modular product design strategy is a strategy of reducing complexity since
the product is intentionally designed to be decomposable into its components. In fact,
if the product represents a system which is not nearly decomposable any attempted
decomposition of problem solving activities will require more information
processing within tasks than if the product is decomposable.
However, even with a perfectly decomposable product information exchange
between product development activities can be further reduced if it is also possible to
specify ex-ante the interfaces between parts and components. With a modular design
strategy where interactions between components are intentionally kept simple one
may faster be able to reduce some of the uncertainty associated with the specification
of interfaces between components. Once it is possible to fully specify the architecture
of the product, the remaining problem of task definitions consists of specifying tasks
in ways, which economize with information processing, increase benefits of learning

With a flexible design strategy (as opposed to an optimal) sub-functions of the product are
implemented by developing independent physical solutions which are within the range of
interactions, which are established by the set of interface standards. One can often optimize the design
by performing iterations between product development activities. If optimizing is the aim one
typically cannot carry out the sub-design as totally independent parallel processes.


by doing and reduce costs of coordination. I shall turn to the latter in section VI. In
the following section I shall concentrate on the benefits of learning by doing.

IV.ii. Defining Tasks to Benefit from Learning by Doing

An important rationale behind the creation of technologically separable interfaces
between product development activities rests in the kinds of gains from
specialization which was emphasized by Adam Smith (1776) in The Wealth of
From Smith we know that specialization in productions is one of the main sources of
improvements in labor productivity. Specifically, he ascribes productivity gains to
improvements in a workers skills, in time that is saved from avoiding having to
switch from one task to another, and in labor saving innovations. Even though
product development activities differ from production activities it is possible to
realize these kinds of benefits by specialization in product development activities.
In product development almost all activities have some elements of skill. For
example, in the activities we normally label market research there are elements of skills
in the design of the market research, in the identification of the sample to question
and in presenting the questions and recording the answers. The skill element in those
activities labeled concept development by Ulrich and Eppinger (1995) may consist of
the heuristics one uses for decomposing design problems; for searching for
conceptual solutions. Skills may also consist in the ability to engage in creative
processes one engage in when trying to conceptualizing new types of solutions or the
care and accuracy with which the problem solvers design and conduct experiments
or use simulation models.
Repetition of the same types of activities over and over is the key to accumulation of
all these diverse skills. If it is possible to initiate and finish more product
development projects within the same time period it may be possible to increase the
rate of repetition of activities in product development activities without
specialization. However, if individuals perform certain activities more often with
specialization than without specialization, specialization tend to increase the rate of
skill accumulation. To increase the rate of accumulation of skills tasks will have to be
defined around activities, which can be repeated by solving the same types of
problems. Someone specialized in market analysis may for example, perform many
of the same types of activities over and over in producing the customer statements
needed for input to different product development projects.
An increased repetition of a task depends on how extensively one is able to use the
use the outcome of the task. In order to ensure that there is a sufficient demand for
outcomes of the specialized activities the costs of transacting between tasks has to be
lower than the benefits gained from specialization. 17 Finally, tasks have to be defined

Transaction costs depend partly on the way in which tasks are defined (Barzel, 1989) partly on the


in a way which economize with the receiver competence (Eliasson, 1990) needed to
decode or otherwise use the output from a task. Output which requires less
knowledge to use than to produce fulfill such requirements (Demsetz, 1991).
One of the side benefits of defining tasks around repetitive activities may be reduced
switching costs and increased innovativeness. In product development switching
costs may arise when it takes time for an individual to change his mindset in order
to perform a different type of activity. Such switching costs may, for example, arise if
one has to switch between market analysis activities and concept development
activities or even if one has to switch between the development of different types of
components. This may be because the structure of knowledge is quiet different for
these different types of activities. 18
Defining tasks in ways, which accommodate differences in the knowledge structure
may also increase the rate of knowledge accumulation and enable innovativeness in
problem solving. Innovativeness in problem solving can be described as the ability of
an individual retrieve a potentially useful piece of information from ones
memory and then adapting that information to the problem in hand (Ulrich and
Eppinger, 1995, p.88) or put a bit different to recombine knowledge in new ways (as
in the Schumpeterian notion of innovations).
Innovativeness can result in different kinds of innovations. Henderson and Clark
(1990) have classified innovations as: incremental, modular, architectural and radical
depending on whether the innovation leave the core concept unchanged or not and
whether linkages between core concepts and components are left unchanged or not.
Incremental innovations result in the rearranging of old and well-known conceptual
solutions. Modular innovations introduce new conceptual solution based on new
principles for the implementation of a certain function. When such innovations have
an impact on the way in which components are linked together they are radical
innovations. Finally, an architectural innovation occur when incremental innovations in
components leave the core concepts of components unchanged but not the way in
which components are linked together in the product architecture.
In any case most innovativeness requires accumulation of knowledge. Tsome of the
factors which influence the process of knowledge accumulation is the extent to which
knowledge is cumulative and the nature of the feedback processes from activities.
Knowledge may be more or less cumulative in the sense that knowledge of prior
way in which transactions are organized within firms or across markets (Alchian and Demsetz, 1972;
Williamson, 1985; Hart, 1990). In section VII I take up the discussion of how task definition effect
transaction costs.

The architectural knowledge embodied in dominant design often set the agenda for the
accumulation of component specific knowledge (Clark, 1985; Henderson and Clark 1990). In fact, the
differences in the structure of knowledge which underlie architectural and component innovations
emerge with the gradual shift from a pre-paradigmatic to a more mature state of technological


advances within a field is necessary in order to assimilate information on new

advances. In such cases the rate at which new knowledge can be accumulated
increase with the stock of existing knowledge (Cohen and Levinthal, 1990). Thus by
defining tasks in a way which permit individuals to focus attention on a more limited
area of expertise one may greatly enable the growth in their stock of knowledge. For
example, if one define tasks in accordance with components one may greatly increase
the rate of accumulation of component knowledge. However, by defining tasks very
narrowly one may inhibit the accumulation of architectural knowledge about the
ways in which components are integrated and linked together or the accumulation of
the kind of deep knowledge of core design concepts and their implementation, which
is required for radical innovations (Henderson and Clark, 1990). One of the reasons
why a very narrow definition of tasks may inhibit some kinds of learning is that
knowledge accumulation depends on the feedback which enable individuals to trace
the impact or consequences of a trail. If task definition is to narrow one will have to
rely on extensive information exchange in order for individuals to trace the
consequences of their experiments.19
It is possible to realize benefits of specialization in terms of increased skill
accumulation, reduced switching costs and increased innovativeness with both an
integral and a modular product development strategy. However, a modular design
strategy with a fully specified architecture creates better possibilities of setting up
independent experiments in order to determine the effect of design choices against
the specified interface standards and the target specifications chosen for the
particular component in question. With an integral product design it will often be
necessary to design experiments and simulation activities across many more
variables in order to determine the nature of feedback (interaction) between
components. Moreover, with a modular product design strategy which allow for a
great deal of specialization between architectural development actives and
component development activities one may also accommodate the accumulation of
component knowledge based on different structures of scientific and technical
knowledge. Finally, with a modular product (and a flexible design strategy) it may
also be possible to use components across different architectures thus increasing the
rate of accumulation of skills in component development activities and making
specialization in component development an attractive route to follow. With an
integral product development strategy specialization in component development
may not result in great increases in repetition of development activities. This is
because components fits thigh together and cannot be put used in a great number of
different architectures.
To sum up, specialization in product development activities may increase
productivity in problem solving by increasing the rate of skill and knowledge
accumulation and by lowering the costs from switching attention to different areas of
activities. Three principles are important in defining tasks to maximize these benefits:
1) increase repetition of the same type of activities, 2) create a more homogeneous

Se the discussion of coordination in the following section.


structure of knowledge within tasks and 3) create tasks which makes it possible for
individuals to trace the effects of their actions. Compared to an integral product
development strategy a modular product development strategy with a task
definition along the lines of architectural development and component development
tasks more easily comply with at least principles one and three. However, since
knowledge accumulation of individuals tend to be structured by the way in which
their tasks are defined accumulation of architectural knowledge and knowledge
needed for more radical innovation may be inhibit -unless some types of information
coordination mechanism is set in place.

V. Task definition and cost of coordination

The word coordination carries many connotations. It may for example mean that one
makes sure that complementary assets fits together, that activities are properly timed
so that there is minimum delays and idle resources or that supply match demand in
all markets. All of these examples of problems of coordination can be described as a
general problem of ensuring that scarce and valuable resource (including
information and knowledge) is used in their best alternative uses.
Different strands of literature emphasize different types of coordination problems
and different constraints to coordination. Within the strand of literature concerned
with the informational constraints to coordination emphasis is on how to make the
best possible use of information available at lowest possible costs. Prominent
representatives of this branch are for example, Radner, 1992; Carter, 1995; Casson,
Within the strand of literature concerned with the constraints of conflicting
preferences and asymmetric information focus is on how it is possible to ensure that
agents have the proper incentives to use resources in their best possible uses given
the information available about these uses. Representative of this branch of literature
are Alchian and Demsetz, 1972; Fama, 1980; Grossman and Hart, 1986; Hart and
More, 1990; Jensen and Meckling, 1992; Barzel, 1989; Williamson, 1985 and Hart,
In the following section I first discuss coordination of dispersed information in
product development. Then I move on to a discussion of how one can ensure that
individuals have the incentives necessary to ensure that they make use of the
information and the skills and knowledge they posses in solving product
development problems. I shall also discuss whether these various coordination
mechanisms may remedy some of the cost of specialization when interdependencies
in products makes it impossible to fully decompose product development activities
as with an integral design.

V.i. Information Coordination


Up till now, the discussion of the division of labor in product development activities
has been based on the premise that a person can reach an at least equally good
decision without access to the to the entire set of information on decision premises as
with this information. In other words it has been assumed that the tacit information
which is important to those who solve the more or less independent sub-problems is
of no relevance to the solution of the entire problem.
Ulrich and Eppinger (1995), provide a fine example from the development of a fork
for a mountain bike where this is not the case. Those who performed the market
analysis identified customer needs as easy to install. For those who perform the
translation of customers needs into target specification this a to ambiguous statement
since it could be translated into a number of different technical specifications such as
time to assembly or assembled by use of simple tools and simple movements.
Tacit information may also be important in connection with the development and
choice of a physical solution to a sub design problem. As pointed out by Sanchez and
Mahoney (1996), ..information and assumptions underlying upstream design
decisions may not be transferred intact to downsteam stages of development.
Technical incompatibilities between interdependent components may then actually
be desinged into downsteam components (p. 69). For example, it may sometimes
be important for designers of complementary components to know how a certain
solution concept react to changes in different parameter rather than just to know that
this solution concept has been chosen.
According to Ulrich and Eppinger (1995) and Sanchez and Mahoney (1996) the
problems which arise in connection with ambiguous information can be solved by
creating an overlap in tasks. But the influence of tacit and sticky information on task
definition in product development can be solved by other means than by creating
overlapping tasks as suggested above. According to Casson (1994) the extent to
which a problem at hand is characterized by what he calls decisiveness is the key to
whether or not individuals will share tacit information in some sort of consultation
... [d]ifferences in decisiveness mean that some problems have a logical structure
which supports solutions without consultation and some do not (Casson, 1994,
p.50). What Casson calls natural decisiveness occurs when a problem can be solved
equally well by consultation as by substituting knowledge about the other parties
tacit information with knowledge of their plans. Natural decisiveness is
advantageous when tacit information is more costly to transmit than information
about the plans and decisions one has reach on the basis of the tacit information.
Even if problems are not characterized by natural decisiveness it may be possible to
solve them without having to communicate all the tacit knowledge. One may simply
impose decisiveness on problems by dispensing with the communication of tacit
information. This may be done if the consequences of an incorrect decision are
perceived of as small relative to the costs of communicating the tacit knowledge.
Extensive consultation or overlapping activities are only necessary if each party hold
information which is highly likely to be decisive or if the costs are high of not making
the correct decision if lacking some of the tacit information.


Problem decomposition, natural decisiveness and task definition are strongly

interdependent. A problem, which is nearly decomposable, has a logical structure
that supports naturally or imposed decisiveness as long as tasks are defined along
the lines of the relatively independent problems.20 The problem solving activities
then can be perfectly coordinated by having individuals communicate their results as
specified by the logical sequence of problem solving which is determined by the
chosen decomposition.21
Imposing decisiveness on product development activities is one way of creating
informational independence between activities so that they more easily can be
carried out in relatively independent tasks. This makes it possible to economizing on
bounded computational capacity (less information needs to be taken into account)
and to benefit from specialization in learning by doing in problem solving. Defining
tasks by imposing decisiveness requires a good understanding of not only the
pattern of communication of plans and decisions but also about the importance of the
tacit knowledge on which these plans and solutions are developed. If decisiveness
cannot be imposed no mater how a problem is decomposed there is only limited
possibilities of realizing the full benefits of specialization in problems solving
activities since some overlap and consultation between activities are needed.
It should be noted that the logical structure of problems which gives rise to natural
decisiveness is different from that which give rise to parallel problem solving
activities. In fact, natural decisiveness imposes a certain sequence on problems
solving since those who hold decisive information have to solve their part of the
problem first in order for those who do not have decisive information to reach their
decisions.22 The coordination of product development activities where decisiveness is
imposed requires that decision rules are made which determine who is going to
make decision based on what kind of information. The decision rules which
determines the sequence of problem solving and transmission of tacit information
(decision premises) or information about plans (decisions) depends on the benefits of
specialization in problem solving and the perceived probability about who is most
likely to posses decisive tacit information.


Situations may exist where there is a need to transfer tacit information between relatively
independent problems. However, if problems are relatively independent this information will have to
be non-vital to the solving of each problem so that decisiveness can be imposed.


In the case of associative processes there are no logical sequence to follow. However, the
communication will be structured by the way in which one has chosen to organize problem solving
into an efficient hierarchical network (Radner, 1992)


Decisiveness and associative process do not preclude one another. It is possible to decompose
problems so that one identifies both associative process and impose natural decisiveness which defines
the sequence in which different types of the associative process are to be carried out. Moreover, there
may be elements of tacit knowledge in carrying out associative processes. The algorithms used to
transform information may for example be partly tacit. However, this only indicates that some
individuals are better at performing the associative processes than others -it do not impose a certain
sequence in problem solving.


Decisiveness creates a division of labor between one the one hand those who solve
problems and on the other hand those who define problems, evaluate and select
solutions.23 The maximum division of labor in decision making is obtained when
there is central planning by a specialist, who orders others to carry out the plan. In
product design one may, for example, have a specialized product development
group who defines development projects on the basis of their estimates of both
market and product technology trends. One can improve these decisions by having
non-decision takers report their tacit knowledge to the decision taker. Such
improvements occur only if the costs of transmitting the tacit information is less than
the benefits in terms of improved decisions. Costs may (as suggested by Carter, 1995)
be time and lack of accuracy in reporting. Finally, with no specialization in decision
making, product development projects are jointly defined between those who posses
relevant tacit knowledge. This is most likely to result in a correct decision but it also
increases costs due to overlapping activities. Another way of reducing information
transmission costs is to define task more broadly. With less division of labor between
tasks fewer errors are likely to occur since decision takers have access to the tacit
information they need. However, the gain in terms of better decisions are achieved at
the cost of less specialization.
The concept of decisiveness indicates that the best way of defining tasks is to
minimize the need for exchange of tacit communication between tasks. This reduces
costs of communication while at the same time ensures that tacit knowledge is
available to those who make decisions. Moreover; it may not be possible to
decompose a problem so that one can avoid either loosing or having to transfer tacit
knowledge. However, other considerations such as benefits from learning by doing
may be important.
The concept of decisiveness is important in comparing the cost of coordination
between a modular design strategy and an integral design strategy receptively. With
the modular design strategy and a fully specified product architecture much of the
tacit knowledge is confined to the problems of developing relatively independent
components. Furthermore, with the modular strategy the importance of some types
of tacit information, such as for example, market information, is greatly reduced.
This all suggests that even with a high degree of specialization only relatively little
effort needs to be put into coordination of information.
With an integral design strategy the decomposition of the design problem is likely to
result in tasks where there are many benefits from communicating information
including tacit knowledge. Of course some of the cost of coordination between

Carter (1995) talks about routine decisions, market- or production dominated firms, market- or
production led firms or pooled information. Routine decisions occur when tacit information is
suppressed. With market- or production dominated decisions the party with tacit information make
the decision without any knowledge of the other partys tacit information, while with marketproduction led decisions those who do not make the decision transmit the tacit information in a report
to the decision maker. Finally, in pooled information the tacit knowledge of all parties is fully used as
they join in making the decision.


relatively independent tasks can be reduces by imposing decisiveness on problem

solving. If it is possible to impose some decisiveness it may be much easier to take
advantage of parallel search since decisiveness limits the amount of new information
which arrives at the information processing networks .
All in all it is most likely that the coordination mechanisms needed with an integral
design strategy are more extensive and more costly to operate. It may be so much
more expensive that less specialization is preferred with an integral design strategy
relative to a modular design strategy.
Finnlay, it should be noted that defining the proper division of labor between
decision making and actual design activities and the proper decision rules to
implement this division is costly and not likely to be beneficial unless they can solve
recurrent design problems. In this connection modularization and interface
specification can be seen as a set of decision rules where the interface standards
represents the plan/design decision which is necessary for other parties to determine
what they are going to do. When the architecture allows for a great deal of flexibility
in component design, the costs of setting up these rules are spread over many
recurrent design processes.

Vii. Incentive Coordination

One aspect of coordination is to ensure the lowest cost use of local knowledge in
decision making another is to ensure that individuals have the proper incentives to
carry out their tasks. The problem of aligning incentives is the subject matter of many
different branches of transaction costs theory (se Williamson, 1985). Of all of these
different branches the agency and the measurement branch of transaction cost theory
are those which are most concerned with the links between the structure of reward
and the cost of measuring outcomes. Of these two branches the measurement costs
branch is the only one which is applicable to the question of how task definition
influences the cost of providing a proper incentive alignment.
The agency theory applies to all those situations in product development where there
is a specialization between decision making and implementation of decisions.
Principal agency relation thus emerge with all problem decompositions which makes
it possible to rely on natural or imposed decisiveness as a way of coordinating
information. This also applies to the decomposition of associative processes to take
advantage of parallel search. More generally an agency relationship is said to exist
when a principal delegates the right to carry out a pre specified task to an agent who
is bound by a formal or informal contract to represent the interest of the principle
(Sappington, 1991). Individuals or teams of individuals may simultaneous be a
principal and an agent. In product development there may be principal agency
relationships between: the group of managers who decide to allocate resource to
product development and the product development team which carries out the
development activities; between those who define the product concept and those


who carry out the detailed design and between those who delimit the associative
processes in connection with, for example, search for conceptual solutions or
evaluation of physical solutions and those who carry out these processes.
The principal agency literature is generally concerned with how asymmetric
information, risk and different risk preferences between principal and agents
influences the structure of efficient contracts. In the principal agency theory it is
assumed that the agent has more information than the principal about the details of
the tasks he (or they) have been assigned, about the possible courses of actions which
should be taken and about his (their) own abilities and preferences. The principal
thus is unable to write a contract which states the level of effort, which should be
performed by the agent or the exact solutions agents should come up with. However,
the principal (as well as any other third party) is assumed costlessly to be able to
observe the outcome of the agents activities. The principal agency literature
emphasize the tradeoff between cost owing to poor information (lack of tacit
knowledge) and costs owing to inconsistent objectives. According to Jensen and
Meckling (1992) the problem of centralization contra decentralization in firms is due
to exactly this tradeoff.24
The timing of the interaction between the principal and the agent is as follows. First
the principal designs the terms of the contract, which specifies the payments the
agent will receive depending on the observed performance. The principal then offers
the contract to the agent, who if accepting the terms decide how much effort to put
into the task. Under certain circumstance it will be possible for the principal to
induce agents to behave exactly as the principal would if the principal shared the
agents skills and knowledge. The trick is to specify payments so that they depend on
the observed outcome of the task -that is to make the agent the residual claimant of
his own effort.
The contract design becomes somewhat more complex if it is assumed that the
outcome of the task depends one the effort performed by the agent as well as on
state of nature -that is other factors which cannot be influenced by the individual
who carry out the pre specified task. In product development such factors may be
changes in the market conditions for the new product or it may be the externalities in
problem solving activities which arise from interdependencies between components
in the product. In the case where the agent is risk averse and the principal risk
neutral the best solution is to make the agent bear only part of the risk.25

In the literature on information coordination (Radner, 1992, Casson, 1994, Carter, 1995) focus is on
coordinating the use of valuable tacit knowledge with out any concern for incentive problems. In the
principal agency literature the tradeoff between agency cost and the use of valuable private
information is important not just in connection with activities where agents are expected to have or to
accumulate advantages in task completion but also in connection with parallel search activities where
a principal delegates the right to an agent to search for solutions or to evaluate solutions. In the latter
case complications may arise if the principal had preferred a different solution than that preferred by
the agent had he himself engaged in the search for and evaluation of solutions (see, e.g., Aghion and
Tirole, 1995) .


It is generally assumed that contracts cannot be renegotiated. This means that when an unfavorable


It is assumed that the agent as well as the principal is fully aware of the risks and that
they share expectations of these risks. For many product development activities this
is not a very suitable assumption on which to base a contractual design. In the case of
radical, modular and architectural innovation uncertainty and the complexity of
determining the impact of an innovation makes it difficult to estimate the possible
outcomes and thus the risk associated with a bad outcome. However, also the
assumptions that it is without cost to make a complete specification and monitoring
of the activities agents are to perform is often an unrealistic assumption in connection
with product development.26
As opposed to the principal agency theory the measurement cost branch emphasize
that there are high costs of defining contractual obligations and high costs of
monitoring the compliance of agent to these obligations. Since principals are acting
economically rational they only specify and monitor task obligations to an extent
where marginal cost equal marginal benefits. With respect to product development
this implies that tasks are specified in those dimensions which are of value to the
principal net of the cost of specifying and monitoring contractual specifications. One
of the consequences of this is that agents often have discretion in more dimensions
than just the effort they perform.27
In order to reduce incentives to engage in non productive discretionary behavior it is
advocated in the measurement cost literature that the rights to the residual income
(value) from the use of resources (including human capital) has to be allocated to
those who are best able to influence the outcome. Barzel (1982, 1989) has argued that
costs due to shirking and other non productive types of discretionary behavior are
particularly predominant if the value that can be produced varies unpredictably
since then it is more costly to determine what the outcome should have been in any
particular case. Consequently it is also costly to determine whether one of the
contractual parties have acted discretionary in a way which benefit that party at the
expense of the other party (ies) to a transaction. In order to restrict such discretionary
state of nature occurs the agent is unable to renegotiate the contract despite the looses he expects from
carrying out the task. Nor can the principal hold up the agent after the agent has excerted costly effort.
The problems of contract renegotiation is the subject matter of property rights theory developed by
Hart and More (1990) and Hart (1995) and the transaction cost theory developed by Williamson (1985).

The costs of specifying and metering task outcomes depends on the extent to which measurement
standards and tests are developed which can be used for the purpose. With more mature technologies
more standards may be developed and this will greatly reduce contract specification costs.


Task obligations can be specified in many ways but one can generally distinguish between
specifications in terms of output and specification in terms of input (routines and operations to be
undertaken). The choice between these two types of specifications depends on the cost of specifying
and metering input relative to output (Eisenhardt, 1989). It may be least costly to defined tasks in
terms of input specifications for problem solving activities based on associative operations. For
detailed design activities where the outcome is embodies in components a definition in terms of the
characteristics of the component and the functions it is to implement may be the least costly way of
defining tasks obligations.


actions one should make the person who is most likely to influence the mean value the
residual claimant.
In product development discretion may cause errors, unexpected lags, waste of time
or it may cause incompatibility between problems solving activities. Such problems
of discretionary behavior depend on the cost of specifying and metering tasks and on
the degree of interdependence in problem solving activities. If the design problem is
not perfectly decomposable into independent sub problems task completion may be
subject to externalities because with interdependencies in tasks it may be particular
costly to determine what the value of the outcome should have been in any particular
case. Consequently it is also costly to determine the amount of shirking in task
completion. In particular unrecognized interdependencies between tasks combined
with discretionary behavior may be sources of variation in the value of the output
from any particular tasks -a source which is independent of the effort performed by
the person who is carrying out a particular task.
To the extent that interdependencies in product development tasks stem from
interdependencies in components one may limit externalities by decomposing the
problem into relatively independent problems with a task definition which reflects
this decomposition. Defining interface standards between components then reduce
externalities in problems solving between tasks. The incentive problem then depends
on the costs of determining the quality of the input or output (components) from the
independent tasks and reward effort accordingly. In this respect a product
architecture with a set of interfaces standards between interdependent components
mark a set of minimum requirements which task output has to comply to and make
reward depend on the extent to which these requirements are fulfilled.
With a high degree of independence in components and very limited externalities
between tasks one can in certain cases use market competition as a way of making
those who carry out tasks residual claimants on their innovative performance.28
However, other externalities may arise if one is not be able to test solutions
individually. These externalities can be reduced if tasks are grouped so that
individuals form relatively independent teams whose outcome can be tested. When
grouping tasks together one will be faces with the classical team production problem
of inducing team members to display an -from the point of view of the team- efficient
level of effort (Alchian and Demsetz, 1972). To avoid such problems one may employ
a monitor with the rights to allocate residual income to team members and to exclude
shirkers from the team.29

The extent to which it is economically feasible to use market competition as a governance structure
also depends on asset specificity (Williamson), and the costs of market transactions relative to in-house
production (Coase, 1937). If market competition can not be used one has to rely on monitoring of tasks.
In that case private information, high costs of metering the level of performance may make it
uneconomic to totally restrict non-productive discretionary behavior.


In addition to monitoring one may rely on the use of a forcing contract to provide the team with the
right incentives. With a forcing contract the team receives the residual income of team effort (the extra
income above the income individuals could expect to earn outside the team) provided that the team


If design problems are not perfectly decomposable either because the product design
is not decomposable or because specialization is taken beyond the point of
independence in activities one can try to impose decisiveness and decision rules to
create relative independent tasks. This does not eliminate incentive problems since
the decision taker will have to have the proper incentives to make use of his decision
skills or his tacit knowledge. If decisions are based on one partys tacit knowledge
the status as residual claimant should be allocated to that person since he is in a
better position to influence outcome.
When decisions are improved by sharing tacit knowledge in consultations or in
performing overlapping activities it is harder to identify the best way of allocating
the residual claimant status since all may have equally possibilities of contributing to
the joint outcome. With this type of team production one is faced with two slightly
different incentive problems. One, is to provide team members with incentives to
share information the other, is to provide them with incentives to use the information
in the best possible way. With respect to the former problem Williamson (1985) has
argued that information sharing may better be accommodated within a hierarchical
firm where it is possible to combine the use of low powered incentives (wages
independent of effort) with monitoring of the team to induce information sharing.
With respect to the latter problem one may rely on a combination of team
monitoring, forcing contracts or tournaments to discipline team members to make
the right use of information.
Now, if there are interdependencies between tasks which are recognized as being a
priori unknown to the designers sequential adaptation of tasks (Williamson, 1985)
may be the least costly way of reducing the consequences of the externalities which
are due to these interdependencies30. However, sequential adaptation between
interrelated activities may be costly in terms of search for the right information and
in terms of defining the proper terms of information exchange. In order to reduce
such transaction costs transfers of information may have to be organized within the
structure of a Coasian firm in which low cost adaptation is made possible by the use
of an open-ended employment contract where managers have rights to direct
employees and thereby fill the holes of such a contract. 31 This contractual
delivers the specified result otherwise the monitor receives the residual income. The forcing contract is
not a perfect solution since the monitor will have incentive to collude with team members in order to
have at least one shirk so that the monitor receives the residual (Miller,1992 ).

Unknown in the sense that product developers recognize that they have incomplete knowledge
(Knight, 1921) of all types of interdependencies.


Later on Coase (1991) has remarked that he was aware that the analogy between the employment
contract and the firm could give an incomplete picture of the nature of the firm and advocates for the
amendment that .. a full firm relationship will not come about unless several such contracts are made
with people and for things which cooperate with one another (Coase, 1991, p.64). This amendment
can be interpreted to mean that managerial decisions fill the holes of open-ended contracts in cases
where coordination of a large number of interdependent activities are required.


arrangement may reduce cost of discovering the nature of interdependencies in

problem solving activities (Foss, 1998). Since managers are responsible for filling out
the holes of the contract in a way which maximize the value of the team output one
can argue that they should be made residual claimants.
Up until now only the negative effects of discretion have been in focus but discretion
need not always result in productivity losses. Discretion may give way for learning
by doing in task completion, which in turn may result in innovations. Innovative
activities give rise to problems of incomplete contracts since neither can the
innovation be perfectly specified in contracts nor can the kind of activities, which
leads to innovations. However, if it is possible to specify in contract criteria by which
one can judge improvements in the functionality of the product, in the overall design
solution or in the design solutions implemented in the individual components one
can differentiate payments according to the specification. This creates incentives to
improve products.32 One will have to be aware that differentiated payments attack
attention to those criteria, which are rewarded. Moreover, agents will tend to
emphasize development activities where the outcome is easily recognized by the
principal and where payments are high relative to costs. However, the incentive
system may have unexpected consequences in terms of misallocated innovative
effort if specifications are not based on an sufficient understanding of al the
important interdependencies, if the specification of tasks obligations do not perfectly
reflect all the important characteristics of interfaces between tasks, or if one does not
differentiate rewards in accordance with the expected net benefit. Another problem
arise from the fact that innovations often are based on a recombination of knowledge
possessed by many different individuals and it may be hard to trace ideas to
individuals and to award them accordingly. Again this is a team problem which can
be solved by making the team the residual claimant.
From the above discussion it should be clear that the cost of incentive coordination at
least to some extent depend on possibilities of reducing externalities in task
completion. With a modular product design strategy and a fully specified
architectural design it is possible to reduce at least those externalities which are
caused by component interdependencies. When these externalities are reduced one
may -at least to the extent that it is possible to specify tasks in terms of an easily
measurable output- rely on market transactions and competition as a mean of
disciplining discretionary behavior. However, to the extent that components are
specific to a certain architectural design there may be both team problems as well as a
hold up problem between those who are responsible for the architectural design and
those who deliver components. In that case component supplies may have to be

In the incomplete contract literature it is assumed that the outcome of innovative effort cannot be
specified in ways which can be verified by a third party. Therefore, high sunk cost investments in
innovative effort is subject to hold up problems which reduces incentives to invest in such effort. Hart
(1995) has argued that ownership over complementary physical assets creates the necessary protection
of such investments. In cases where innovations requires complementary investments in human
capital the physical assets needed to make use of the investment should be owned by the person whos
investment contributes most to the joint output.


organized within firms. Finally, if component development is contingent on tacit

knowledge of elements of the architectural design one will have to establish
overlapping teams between the component and the architectural design teams and
allocate the residual claimant status to the ones who have to make use of their tacit
knowledge. This situation however, is most likely to occur with new architectural
innovations, which are sparked by some unforeseen innovations in components.

VI. Conclusion
This paper has had an ambitious, yet focused agenda: to explore the relation between
the physical design of products and the definition and organization of organization
of product development tasks.
It has been argued that the tasks of detailed design should be defined in ways so that
the technologically separable interface between activities reflect technically separable
sub design problems as determined by the physical layout of the product. This way
of defining tasks would economize on bounded computational capacity as well as
reduce costs of information and incentive coordination. However, if the aim is to
realize full benefits from learning by doing tasks should be defined around activities,
which can be repeated in different product development projects and strong
differences in the underlying knowledge needed to carry out these tasks. In some
cases these different requirements may not be fully compatible.33
When it comes to the activities of problem definition and decomposition one may
distinguish between the activities of defining and decomposing the overall problem
and the more detailed activities of defining and decomposing sub problems. With
respect to the former one may benefit from different individuals with different
perspectives on problem definition and decomposition. However, this requires a
coordination process of consultation accompanied by the incentive coordination
provided by monitoring. With respect to the latter kinds of activities there may be
some gains in terms of learning by doing and in terms of economizing on bounded
computational capacity by having different individuals define and decompose sub
solutions. However, these benefits may be overruled by the high costs of information
and incentive coordinating if tacit information is needed in order for these
individuals to make the right choice.
The extent to which the benefits of specialization can be realized depend to a large
extent on the explicit knowledge of interdependencies in products which in turn
depend on the complexity of the product design. It has been argued that it is possible
realizing more of the advantages from specialization with modular product design
strategy relative to an integral product design strategy. This is because a modular

For those problem solving processes which can be characterized as associative processes there is no
conflict between defining tasks in ways which economize with bounded computational capacity and
which increases learning by doing in carrying out the associative processes. Only costs which are due
to lags and unused capacity may set limits to the amount and kind of specialization in these activities.


product development strategy strives for a more simple design based on explicit
knowledge of interface constraints.
The argument has relied on sources and ideas that are arguably somewhat unusual
in the literature on modularity in management, such as Herbert Simons ideas on the
limits to problem decomposability, Adam Smith on the advantages of specialization,
the work of economists of the coordination of information (Casson, Radner, Carter),
and, finally, theories from organizational economics, such as theories of
measurement costs and principal/agent theory. This mixed bag of influences and
ideas has allowed to me analyze the organization of modular product design strategy
in a novel way namely in the comparative-institutional mode of analysis
characteristic of organizational economics and to pinpoint how this strategy allow
for greater advantages in specialization. Moreover, I have devoted ample space to
discussions of the costs of these strategies, a topic that is arguably somewhat
neglected in the literature. Future research will more intensively address aspects of
organizational learning in connection with integral modular product design
strategies, as well as a deeper inquiry into the issue of how modularity influences the
market/firm choice (the boundaries of the firm issue). The present paper represents
only a first stab at these important issues.


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