VERTICAL SPECIALIZATION AS A DRIVER OF

TECHNOLOGICAL AND INNOVATION CAPABILITY

BUILDING IN AUTOMOTIVE INDUSTRY1

Yan Rianto, Chichi Shintia Laksani, Dian Prihadyanti

Center For Science and Technology Development Studies, Indonesia Institute of Sciences
Widya Graha Building 8th Floor, Gatot Subroto Kav. 10, South Jakarta 12720, Indonesia
yan.rianto@lipi.go.id, chic001@lipi.go.id, dian013@lipi.go.id

Abstract
One of the key features of the current process of globalization is
increased tr1ade in intermediate inputs. This input trade results in part
from multinational firms choosing to outsource input processing to their
foreign affiliates, thereby creating global production networks in
which each actor is vertically specialized. For developing
countries, include Indonesia, companies are usually involved as part
supplier in vertical specialization. For suppliers in developing
countries such contracts can be an important source of technology
transfer. For long term, this condition is expected to increase
technological and innovation capability in developing countries.
Therefore, this paper tries to analyze how the phenomenon of vertical
specialization happens in Indonesia, and how it boosts up
1

Sub Theme: Innovation and economic growth

technological and innovation capability in its industry. An in-depth

analysis through case study in automotive sector is conducted.
Results of the study shows that Indonesias automotive industry is
included in second pattern of vertical specialization patterns based
on classification by Nordas (2007), supported by market demand, time
and distance, and industrial organization. In this pattern, the lead firm
owns a trademark and provides product design, engineering and other
key inputs. Vertical specialization in automotive industry is proven to
increase technological and innovation capability in local companies
who play role as part supplier. Through subcontracting and OEM,
the local company could gain benefit from the presence of technology
transfer.
Keywords: vertical specialization, automotive industry, technological
and innovation capability

Introduction
One of the key features of the current process of globalization is increased
by trade in intermediate inputs. In the recent decades, growth of overall world
trade has been driven in large part by the rapid growth of trade in intermediate
inputs. This input trade results in part from multinational firms choosing to
outsource input processing to their foreign affiliates, thereby creating global
production networks in which each actor is vertically specialized. According to

Hummels, Rapoport, and Yi (1998), vertical specialization is considered as

another term for fragmentation which means the splitting of production processes
into separate parts that can be done in different locations, including in different
countries. Hummels, Ishii, and Yi (2001) identify vertical specialization
production arrangements in which a good is made via multiple stages located in
multiple countriesas an important aspect of intermediate-input trade.
For developing countries, include Indonesia, companies are usually
involved as part supplier in vertical specialization. For suppliers in developing
countries such contracts can be an important source of technology transfer
(Nordas, 2007). Technology transfer is defined as a process of sharing of skills,
knowledge, technologies, and methods of manufacturing. It needs technological
learning of companies in developing countries. Technological learning will have
positive implication for technological capability because technological learning is an
active process to accumulate technological capability that is an active process for
learning, mastering, and developing technology (Rianto, et al, 2004). This is simply
drawn in the following figure. Therefore, in long term, vertical specialization in
developing countries will create impact in the development of technological
capability.

Fig 1. Relationship between Technological Learning

and Technological Capability

Source: Rianto et al, 2004.

This paper tries to analyze how the phenomenon of vertical specialization in
Indonesia, and how it boosts up technological and innovation capability in its
industry. An in-depth analysis through case study in automotive sector is
conducted. The automotive industry has always been a leading industry in terms of
organizational innovations and technologies. Concept of JIT and TQM are
developed in this sector.

Concept of Vertical Specialization

The story of globalization is a story about specialization. Today, countries
focus more and more on producing a relatively narrow range of goods and
services. They exchange the fruits of their specialization for other goods and
services. The traditional notion of specialization is horizontalfirms or countries
become adept at producing particular goods and services from scratch and then
export them. We show, however, that an increasingly significant characteristic of
world trade is vertical specialization.
Based on Hummels, Rapoport, and Yi (1998) there are three conditions which
must be hold for our definition of vertical specialization to occur: (1) a good must
be produced in multiple sequential stages, (2) two or more countries must specialize
in producing some, but not all, stages, and (3) at least one stage must cross an
international border more than once. In other words, vertical specialization occurs
when a country uses imported intermediate parts to produce goods it later exports.

This definition captures the idea that countries link sequentially to produce a final
good.
Within a vertical specialization framework, there are several possible trade
patterns. Nordas (2007) identified two patterns of vertical specialization. One
possibility is sequential stages of production where raw materials constitute the first
stage and subsequent stages add value through further processing until the final
stage assembles the components and market the final product. It is often assumed
that the lower stages are less capital and skills-intensive than the late stages. In that
case the lower stages would be produced in low-cost countries that are relative
abundant in labor, while intermediate stages would be located in middle-income
countries with relatively low costs, but reasonably well endowed with skills. The
final stages would be produced in a country relative abundant in skills, which also
tends to be a relative rich country with a significant market for the final goods.
Another pattern of specialization is one where the lead firm owns a trademark
and provides product design, engineering and other key inputs. Production of
intermediate products is then distributed on a number of second tier producers which
may be located in several countries and may or may not have lower-tier
subcontractors locally or in yet other countries. The production of inputs is
coordinated and ideally synchronized by the lead firm, which eventually market the
final goods for the local market and exports. In this structure, the early stages of
production can be the most capital and skills intensive while the late stages of
assembly are often labor-intensive and located in a low-cost country. So-called

outward processing agreements are common trade policy measures that support this
kind of vertical specialization. The textiles sector is for example more capital and
skills-intensive than the apparel sector and the same goes for some
pre-production activities such as cutting the fabric. Also electronics is of this
nature where the production of micro parts is more capital and skills-intensive
than the final stages of assembly.

Concept on Technological and Innovation Capability

According to Kim (2001), technological capability can be defined as the
ability to make effective use of technological knowledge in production,
engineering, and innovation in order to sustain competitiveness in price and
quality. By sufficient technological capability, a company is able to assimilate, to adapt,
and to develop, technology. By technological capability, company can also develop
new technology, product, or process as a respond for economic change. Indeed,
World Bank confirmed that technological capability is the source of companys
competitiveness. In other words, technological capability is what firms need to be able
to use technology for strategic competitive advantage. The better a companys
technological capability, the stronger will the companys competitiveness. In
developed countries, technological capability is mostly accumulated through
learning by research to develop technology frontier. In the other hand, technological
capability in developing countries is mainly built through imitating learning
process through imitative learning by doing.

For concept of innovation, there are many early literature defined

innovation. From those, we concluded that innovation generally means renewal that
may be related to several objects, such as new products, new technologies, new
work/production processes, new management, etc. Based on that, we define an
innovation as a development and successful implementation of new or improved
product, service, technology, production process or management directed towards
gaining a competitive advantage. To be able to realize a permanent flow of
innovations, an enterprise must have sufficient innovation capability. According to
Romijn and Albaladejo (2000), innovation capability refers to the ability to make
major improvements and modifications to existing technologies, and to create new
technologies. The notion of innovation capability applies to process technology,
product technology as well as the way in which production is organized and
managed. Its importance derives from the fact that it is presumed to contribute to
dynamic competitive advantage of companies since it enhances their capacity to keep
up with, to respond, and to initiates technological change on an ongoing basis. It is
crucial in a competitive economic environment characterized by rapid change.
However, adequate measurement of innovation capability is difficult. Since skills
and knowledge were not directly observable, one has to resort to proxies that
capture observable qualities that reflect them. The best measures relate to the outputs
that result from the utilization of a firm's capabilities, i.e. its innovations. In this
case, innovation includes product innovation, process innovation, and management

innovation.
Vertical Specialization in Indonesias Automotive Industry
Automotive Industries of ASEAN are dominated by multinational
companies from Japan. Japanese car firms account for over 80 percent of car
production in ASEAN, and parent companies in Japan account for a large share of
imports. Since most of the automotive manufacturing of ASEAN concentrates in 4
big ASEAN countries: Thailand, Malaysia, the Philippines and Indonesia.
Indonesias automotive component industry has great varieties and includes wide
range of product type. For example, GIAMM, an association of component and
OEMs has 136 members with 22 groups of OEMs, starting from shock-breaker,
brake system, to wiring harness.
Indonesias automotive industry is included in second pattern of vertical
specialization patterns based on classification by Nordas (2007). In this pattern,
the lead firm owns a trademark and provides product design, engineering and other
key inputs. Production of intermediate products is then distributed on a number of
second tier producers which may be located in several countries and may or may not
have lower-tier subcontractors locally or in yet other countries. The production of
inputs is coordinated and ideally synchronized by the lead firm, which eventually
market the final goods for the local market and exports.
It is indicated Indonesias automotive industry largely operates through a
vehicle assembly model, with three major assemblers: the Astra Group, the
Indomobil Group and Krama Yuda Tiga Berlian that usually called as the first tier

supplier. These companies are joint venture companies, mainly with Japanese and
Korean vehicle producers, e.g. Toyota, Honda, Mitsubishi, Suzuki, Hyundai and Kia.
Currently there are 20 car assemblers operating in Indonesia, producing 22 brands
of automobile. Total capacity of the assembling manufacturers is more than
700,000 units per year.
The automotive components produced by domestic companies are intended
to be assembled to the newly produced car, small or big part of sales as OEMs
products, and the one for non-brand vehicles. For components legalized by OEM, the
production is started after the order is sent by the world vehicle producer (e.g.
Toyota, Honda, etc) to the first tier supplier (e.g. PT Astra Honda Motor). As what
has been mentioned earlier, only few joint venture companies in Indonesia assemble
components of automotive components from domestic producers as a complete
vehicle. This is caused by the high cost to enter the market, includes the cost of
technology, tools, or even the cost to meet quality standard to obtain certification by
the first tier supplier, e.g. ISO 9000 or ISO 14000, audited by the representative of
foreign manufacturers. After receiving an order, the first tier supplier split the demand
as special module. Recognizing the particular component to be produced, the first
tier supplier is then subcontracting the real production to the second tier supplier by
giving its detail specification. The second tier suppliers are generally specialized in
a particular field of production, and therefore, they are not able to produce all of the
necessary components needed to produce a vehicle. Even tough, the first tier
suppliers are used to subcontracting the production to the second tier supplier in the

same time to maximize the accurateness and minimize the time.

In fact, there are some driving forces to create vertical specialization in
Indonesias automotive component industry. They include the followings:
1. Market Demand
The huge amount of Indonesias citizens, around 220 million people results in
Indonesia to be potential market for automotive industry. This condition definitely
causes this industry to be a potential business to be developed in Indonesia. This can
be seen from the increasing sales of vehicles in this country, except in crisis period.
Domestic sales of passenger cars reached nearly 400,000 units in 2004 up from
350,000 units in 2003. Roughly 70 percent of this volume is 8-seater vehicles. The
market is expected to continue growing to reach sales of around 480,000 units in
2005 and 760,000 units by 2009, a compound annual growth rate of around 14
percent from 2004.
2. Time and Distance
Regarding the great demand in Indonesias market, there is necessity to
decrease operational cost, includes the distribution cost, communication cost, etc.
and also to have shorter time to meet customer expectation, vertical specialization
becomes an important concept to be implemented. Production sharing is
conducted, especially for meeting the domestic demand. For example, Toyota that
produces its product namely Toyota Kijang is only marketed in Indonesia. In other
countries, product with almost similar characteristics is also produced but it has
different brand. To achieve high efficiency and effectiveness of time and distance,

most of the component production and Kijangs assembly tasks are conducted by
Indonesias companies, through tight controlling from Toyota in Indonesia (e.g. PT
Toyota Astra).
3. Industrial organization
In Indonesia, the first tier supplier plays its part as assembler, in form of
multinational company, while the second tier consists of smaller companies
producing the components. The second tier suppliers are generally small-medium
sized companies (SMEs) that ripe their benefits in increase of technological
capability. The first tier gives standard of the product. Therefore, in one hand, only
SMEs with sufficient ability in particular level that are able to fulfill the
requirements. This condition forces the SMEs to increase its technological capability.
In the other hand, if the SMEs have achieved the standard, they would also receive
benefit, by means of technology transfer.

Impact of Vertical Specialization to Technological and Innovation Capability of

Indonesias automotive industry
In automotive industry vertical specialization, Indonesia places its position in
component supplier. Industrial actors of Indonesias automotive component industry
until 2004 was still being hold by multinational corporations and 46% of them are
Japanese companies. Most of Indonesias automotive component companies are
joined in association of motorcycle and car industry (GIAMM) (Table 1).

Table 1. Number of Automotive Component Companies in Indonesia (2004)

No.
1
2
3

Types of Company
Member of GIAMM
Japanese company
Companies of automotive component

MNC
72
60
20

Domestic
59
10

Total
131
60
30

4
5
6
7
8

of
car and
motorcycle
Engine
Part
producer
Filter producer
Alternator producer
Engine Starter producer
Radiator producer

30
2
5
5
2

18
7
2

48
9
5
5
4

Source: GIAMM, 2004

Considering those aspects, impact of vertical specialization to

technological capability can be identified through GIAMM members
technological capability. The capability is measured based on the level of
capability in nine technological activities category developed by CENTRIM in a
project funded by World Bank..
Result of the identification of technological capability of the member of
GIAMM has been conducted by Rianto, et al (2005). It shows that automotive
component companies are included in category of strategic and
creative/innovative companies. More than 50% of the automotive component
industries are included in strategic category. The companies in this category are
they who have good awareness to the role of technology related with companys
sustainability. In-house capability is strongly built in the company and it conducts
strategic approach on technology related with companys sustainability, while the
rest (37%) are included in category of creative/innovative. Companies in this

category have well developed technological capability. Policy and strategy

developed in the companies are directed to the creation of creative and innovative
process and product creation to keep its competitiveness in automotive component
industry.
Innovation capability of automotive component companies in Indonesia is
provoked by the presence of vertical specialization. As component producer in the
automotive part which will be assembled, the local companies are demanded to
achieve required product specification. This condition stimulates them to produce
new technology and production process which able to create product according to its
specification. Nevertheless, the condition is tending to happen in local companies
(100%), compared with joint venture companies or multinational corporations
(MNC). Research conducted by Rianto et al (2007) shows that company with
foreign direct investment will tend to have the lower innovation capability. It is
because all of production activities are determined by holding company, so that the
company only becomes executor of holding company plants. This condition causes
company cannot create innovation. While company which its investment type is
joint venture, will tend to more able to create innovation. Even though the
innovation created is simple and incremental but holding company still gives
opportunity for company to create innovation, especially innovation in production
process. Different from two types of company previous, the company with local
investment will be able to create innovation in the high level. It is because company
must determine all of the production process itself. This condition stimulates

company to make major improvements and modifications to existing

technologies, and to create new technologies or products.
Technological and innovation capability of automotive component
industry in Indonesia are strongly related with their technological learning. In
vertical specialization, because Indonesias automotive component companies are
having their role as supplier of large companies, then the local companies receive
transferred-technology from large firms by Original Equipment Manufacturer
(OEM) or product specification from the principal. Technological transfer also
occurs through reverse engineering.
The production activities of Indonesias auto part company generally
representing their effort to respond the market demand. Market for products of
Indonesian automotive part company consists of after-market and principal. In After
Market, Indonesias auto part company production activities do not depend on
product specification. They produce goods according to requirement and market
demand. Principal means Indonesias auto part companies sell their products to large
company that becoming their principal. This market claim Indonesias auto part
company to produce goods according to the standard and product specification that
had been agreed before with their principal. Difference of market type creates
difference also at technological learning orientation conducted by Indonesias auto
part company. Its because learning orientation of Indonesias auto part company
represents respond from demand and market requirement.
In the technological learning process at Indonesian auto parts company,

learning orientation not only consider the product but also the process. This matter
because of characteristic of Indonesian auto parts industry producing existing
component with the clear product specification. Others, some of Indonesian auto
parts Indonesias auto part company representing auto parts supplier for large
company (principal), it also causes learning orientation is not only consider at the
products. The clear product specification given by principal makes technological
learning orientation of Indonesias auto part company shifting to process
innovation motive. So that component in learning orientation variables of
technological learning process of Indonesian auto parts Indonesias automotive
component company consisted of product and process.
Learning Orientation at the product occurred when Indonesias auto part
companies sell their products to market directly (after market). This matter
because Indonesias auto part companies are unattached by the product
specification which must be fulfilled when they become supplier for principal.
Learning orientation of firm also can be aimed at process innovation motive. This
matter became of Indonesias auto part company supplying their product for principal.
As supplier of auto parts, products yielded by Indonesias auto part companies have
to fulfill standard and product specification which had been agreed on before by
their principal. Thereby the Indonesias auto part companies tend to orient to process
innovation, which is how company able to produce goods fulfilling standard and
product specification with efficient and more effective production process. Process
Innovation must be done by Indonesias auto part companies in order to maintain its

product have competitiveness in the market, that fulfill QCD conditions requested
by principal.
Innovation in production process can be done by design process technology
or by cutting short production process (time line). Process innovation can reduce
cost production and short time production. It will improve firm productivity so that
the firm able to hold out and have high competitiveness in the market.
Existence of Market for Indonesias auto part company not only influence
production activities but also have important role in technological learning
process. Its because market will determine firms technological learning
orientation and learning orientation of course will have an effect on absorptive
capacity and expeditious learning at technological learning process.
Based on the case study in one of the Indonesias SMEs producing
automotive component, vertical specialization also becomes means to transfer
new management concepts to Indonesias automotive industry as the first tier in the
supply chain management. This can be seen from case of NKP as the supplier for
AHM. According to their fields, the new concepts include quality management,
marketing management, information system management and customer-relationship
management (CRM). In quality management area, vertical specialization brings new
perspective to the companys philosophy on quality. Before the company become
the 1st tier in supply chain, quality management activities was only created through
final inspection in the production process. After NKP becomes the supplier of AHM,
it start to learn on concept whether quality can be controlled along the production

process, then it will reduce cost of quality, either included in appraisal or failure cost.
The company started to implement new concept of quality by implement new
quality activities. NKP started to control its incoming material and its production
process. This shows that NKP is implementing TQM although the company
does not realize it. Besides, the company is even certified with ISO which can be
said to be costly for its business scale. Even though, the company considers it as
investment not as cost. By implementing ISO, NKP wishes to be permanent supplier
of AHM, and obtain wider market for more customers.
To keep up their customers, NKP also implement new information system in
its company. This also needs high cost, but it trusts the new system to be a tool for
gaining competitiveness. This also means that all process in the company is change
from the manual to the automatic one and can be considered as business process
reengineering. Related with information system, the company also improves its
website. This is also a new breakthrough, not only for their marketing but also
in implementing concept of CRM. When there is complain about the defective
products, NKP will easily track it through its information system. NKP makes its
customer comfortable to have business with it and feel high satisfaction. Therefore,
it obtains wider market which means more customers. It now supplies many
multinational corporations in Indonesia because it is succeed to offer just-in-time
principles. This makes NKP becomes qualified companies, especially in its class
which only in SMEs scale. Its capability brings it in high level of competitiveness,
through technological and innovation capability.

CONCLUSION
In the recent decades, growth of overall world trade has been driven in large
part by the rapid growth of trade in intermediate inputs. This input trade results in
part from multinational firms choosing to outsource input processing to their foreign
affiliates, thereby creating global production networks in which each actor is
vertically specialized. Indonesias automotive industry is included in second
pattern of vertical specialization patterns based on classification by Nordas (2007). In
this pattern, the lead firm owns a trademark and provides product design,
engineering and other key inputs. There are some driving forces to create vertical
specialization in Indonesias automotive component industry. They include
market demand, time and distance, and industrial organization.
Technological and innovation capability of automotive component
industry in Indonesia are strongly related with their technological learning. In
vertical specialization, because Indonesias automotive component companies are
having their role as supplier of large companies, then the local companies receive
transferred-technology from large firms by Original Equipment Manufacturer
(OEM) or product specification from the principal. Technological transfer also
occurs through reverse engineering.
Based on the case study in one of the Indonesias company producing
automotive component, vertical specialization also becomes means to transfer
new management concepts. All the concepts bring the local companies of
automotive component to have high competitiveness through TQM and JIT and

shows that they are well developed in this sector.

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