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Knowledge and Process Innovation in manufacturing firms.

Evidence from developing countries


Johnson Bosco RUKUNDO* Mikaela Backman* Per Olof Bjuggren

* Jnkping University, Sweden

Abstract
This paper examines the role of firms internal knowledge in the firms innovation process in
the manufacturing sector using firm level data from three countries of the east African region.
The paper contributes to the understanding how firms increase process innovation as a result of
internal knowledge. Our model builds on the theoretical argument that firms knowledge plays
an important role in influencing its innovation processes. The findings show that the internal
knowledge of a firm does not influence the level of process innovation. Firms rather apply
technology licensed from abroad and internal training to undertake process innovation.

Keywords: firms, knowledge, process innovation, manufacturing, developing countries

JEL classification codes: O31, L25

1. Introduction
Innovation processes involves the search for new ideas that have commercial potential (Laursen
et al, 2006). Innovation is necessary for survival at all stages throughout a firms life-cycle
(Schumpeter, 1934) and firms are driven to innovate in order to grow and obtain both stability
and legitimacy in the market (Agarwal and Gort, 2002; Agarwal and Audretsch, 2001). As
competition intensifies and the pace of change accelerates, firms need to renew themselves by
exploiting existing competences and exploring new ones (Floyd and Lane, 2000). Innovation
tend to be as either product or process innovation. Even though process innovation has attracted
less attention of scholars than product innovation, it remains an important element of firm
growth and theories of innovation. Process innovation in developing countries tends to be slow
and poorly understood which makes manufacturing firms vulnerable to competition from
foreign firms in developed countries. The discussion of the paper focus is on the firms
perspective on innovation, where the amount of resources, development time, changes to
technology are necessary for firms to undertake radical innovation (Hall and Andriani, 2003).
Firms in developing countries have of recently, focused on investing money, time and other
resources in search for innovative opportunities, in order to be more competitive. This
investment process increases the potential to create, and use existing knowledge for possible
new opportunities. Firms also acquire new knowledge from internal and external sources which
adds more value in their innovation process. In developing countries, transmission of
knowledge occurs through different channels; foreign partners, foreign suppliers or direct trade
and this can be vital for technological adoption across firms (Hoekman and Javorcik, 2006). A
common theme in more recent process literature has been the search for approaches that allow
formalizing domain knowledge into structures, patterns of frameworks which can be reused to

facilitate process redesign and support systems development (Arlow and Neustadt, 2003). The
main objective of these structures is to accelerate and simplify process innovation.
Accordingly, firms successfully innovate by drawing in knowledge and expertise from a wide
range of external and internal sources. Firms invariably depend on both internal and external
knowledge for their innovativeness. Firms ideas and knowledge of internal actors in their
innovation processes play an important role in process innovation. Small and medium firms
which are the majority of manufacturing firms in developing countries, focus on the internal
matters, other than orienting their potentiality towards outside opportunities (Floyd and Lane,
2000). Knowledge sharing within a country and outside could induce new innovations that
could transform the firms production status, but also basing foundations on internal knowledge
matters.
The purpose of the study is to analyze how internal knowledge affects process innovation
among manufacturing firms in developing countries of the east African region while controlling
for firm characteristics, and country effects. First, process innovation facilitates firms to gain a
competitive advantage, thus, understanding the role of internal knowledge provides the means
by which firms can be competitive. Secondly, process innovation can contribute to increased
productivity. A better understanding on internal knowledge effects could increase firm growth
through increased productivity. Third, process innovation is important for government policy
orientation, with a potential for new innovative policies to be developed.
The rest of the paper is organized as follows: section 2 describes the relationship between
knowledge and process innovation. Section 3 presents the data, description of variables and the
model applied. Section 4 presents and discusses the results, while section 5 concludes.

2. Process Innovation and Knowledge


Knowledge is source of competitive advantage in firms. There are various theoretical and
empirical studies examining the relationship between knowledge, innovation and firm
performance. These studies find that the higher the level of knowledge acquired or accumulated,
the greater the level of firm innovation. For example, McEvily et al (2002), find that the
complexity and tacitness of the firms technological knowledge contributed to shielding its
product innovation from imitation, hence reinforcing the importance of knowledge based
advantage as a source of sustained firm performance. The role of internal knowledge is based
on the firm human capital level which increases own productivity, and the average level of
human capital in the firm, which increases the efficiency of all production factors (Lucas, 1988).
Increasing the firms potential to undertake process innovations such as new task specifications,
work and flow information mechanisms, equipment use to produce a product or provide a
service largely depends on how knowledge is used. According to Green et al (1995), knowledge
deficits can be categorized as; lack of new knowledge on creation representing substantial
challenge, lack of knowledge on the use of skills and equipment, lack of creation of knowledge
for development of new business practices, and limited investments in the acquisition of
knowledge. The conceptualization of innovation suggests that the degree of innovation should
be represented as a continuum related to various types of knowledge deficits.
Human capital examined in terms number of years of schooling, and the workers experience
affects the innovative behavior of the firm. The increased mobility of knowledge workers has
made it difficult for firms to appropriate and control their research and development
investments. Every firm needs to continuously acquire new knowledge in order to be able to
renew capabilities and innovate. New and reserved products are more likely to be developed in

firms that have a greater amount of internal knowledge (Romer, 1990). Further, Griffith et al.
(2003) find that internal knowledge of firms positively affects their absorptive capacity.
A firm possessing a high level of human capital with adequate skills has the potential to
combine internal and external knowledge to improve innovation. Other firms knowledge can
be more easily adopted and imitated by firms with higher levels of human capital (Ballot et al.,
2001). Cohen and Levinthal (1990) find that the firms ability to recognize external knowledge
and to exploit new information is to a large extent determined by its internal knowledge. Even
though most firms rely on external knowledge for innovation purposes, the ability to innovate
is shaped largely on the firms access to internal workers with a knowledge rich base. Firms
may have to actively encourage their employees to seek external knowledge that is useful for
opportunity exploitation and to disseminate the knowledge internally (Matusik, 2002). The
firms organizational design should also reflect the need for timely information processing and
knowledge transfer (Tushman and Nadler, 1978). The best for the firm is to develop
coordination mechanisms that ensure the use of knowledge gained from external sources in
opportunity exploitation. The first hypothesis is;
H1: Firms internal knowledge has a positive association with process innovation
2.1 Firm level process innovation and internal knowledge
Recent theoretical models suggest that firms will favor product innovation where there is a high
level of product differentiation and competition is severe (Weiss, 2003). Process innovation
will be undertake by the firm where products are less differentiated and there is less competition
in the industry. Bonanno and Haworth (1998) make this distinction by referring to high-versuslow quality firms, reflecting the choices that firms make about which strategy (type of
innovation) to adopt. Martinez (2000) found that experience in product innovation encouraged
process innovation and that firms which achieved process innovation were 27.3 percent more

likely to be product innovators. Rouvinen (2002) find that process innovation is associated with
firms in industries with low appropriability and high capital intensity. He further found that the
use of external sources of knowledge and cooperation with nonacademic partners were
correlated with process innovation. Cabagnols ad Le Bas (2002) find that firms belonging to
highly concentrated industries are more likely to be process innovators than product innovators.
They also find that upstream external sources of knowledge, such as suppliers, is one of the key
differentiation of process and product innovators. Furthermore, they also find that managerial
strategies associated with product flexibility and quality are associated with process innovation.
Generally, innovators heavily rely on different external sources of knowledge for their
innovations. Both Rouvinen (2002) and Cabagnols and Le Bas (2002) find that process
innovators are likely to draw on knowledge from upstream sources, such as suppliers. It can be
expected therefore, that knowledge from suppliers be correlated with firm level process
innovation. However, the role played by external sources on the innovative activities of process
innovators is less clear. But there is a link between a firms R&D expenditures and process
innovation. Expenditure on R&D may reflect the presence of absorptive capacity and in the
case of process innovation, where firms need to exploit new technologies using external
sources, the ability to capture knowledge from outside may help firms to become process
innovators (Zahra and George, 2002). Mairesse and Mohnen (2005) find a strong relationship
between process innovation and R&D intensity for both high and low tech centers in France, a
result supported by the finding of Baldwin et al. (2002) showing a correlation between process
innovation and R&D. These studies confirm what we expect from theory and practice in that
R&D expenditures will be associated with radical process innovations. Firms are therefore
expected to be process innovators if they are large with investments in R&D, which draw
suppliers for knowledge for innovation.

2.2 Process innovation and its types


Process innovation can be defined as new elements introduced into an organizations production
or service operations with the aim of achieving lower cost and or higher product quality
(Utterback, 1994; Freeman and Soete, 1997). Process innovation has been described as a grubby
and pedestrian side of innovation process involving little of great events that characterize
product innovation (Rosenberg, 1982). Indeed, most process innovations involve small scale
changes in method of production often involving routinely improvements in operations.
However even for changes, studies show a significant contribution of process innovation to firm
productivity. For example, Vivero (2002) find that the ability of a firm to achieve a process
innovation have a significant impact on productivity. Process innovation is usually linked to
the introduction of new machinery and the existence of learning by doing and learning by
using. As firms become more experienced in the use of capital equipment, they are able to
increase their productivity (Cabral and Leiblein, 2001). Firms process innovations involve both
technological and organizational changes. For example, lean production is a major process
innovation which often involves the use of wide range of new material-processing technologies
as well as new work practices (Womack et al., 1990).
Process innovations are subject to considerable variations in their economic and technological
impact (Tushman and Anderson, 1990). Freeman and perez (1988) make a distinction between
new technological systems which may involve the creation of new industries through the
combination or fusion of a range of technologies, and radical innovations, which may be fairly
localized in one particular market segment and may be relatively common. Freeman (1991)
argues that both empirical and theoretical research has long demonstrated the importance for
successful innovation of both external and internal networks of information and collaboration.
Firms access to external networks need to have internal built organization. Subramaniam and
Youndt (2005) argue that to pursue exploitative innovation, organizational units need to

efficiently draw on and prevailing knowledge. Linkages within organizational units of a firm
facilitate improving the existing knowledge resources, and increases units potential for process
innovation. The fact that firms are in competition, its always difficult for them to understand
whether their process innovation is new to the industry. Bloodgood and Bauerschmidt (2002)
argue that despite the fact that industry managers are generally well informed about their
competitors activities, it is often difficult for them to know whether or not their process
innovations are the first for their industry.
3. Data, Variables and Descriptive Statistics

3.1 Data
This paper use firm level survey data collected by the World Bank in three developing countries
of the east African region (Uganda, Kenya and Tanzania) in 2013. A sample was designated
and represents the total population of firms in the manufacturing sector in each country. The
data set comprise of firm level data, about employees, and the innovation process. We use a
sample consisting of 1, 237 observations for small, medium and large firms.
3.2 Variables
Dependent Variables
The dependent variable in this paper is process innovation defined as the implementation of a
new or significantly improved production or delivery method (including significant changes in
techniques, equipment and/or software). Minor changes or improvements, an increase in
production or service capabilities through the addition of manufacturing or logistical systems
which are very similar to those already in use, ceasing to use a process, simple capital
replacement or extension, changes resulting purely from changes in factor prices,
customisation, regular seasonal and other cyclical changes, trading of new or significantly

improved products are not considered innovations1." In this paper, it is a dummy variable equal
to 1 (i) if a firm introduced any innovative methods of manufacturing products (ii) if a firm
introduce any innovative logistics, delivery distribution methods for inputs products or services
(iii) if a firm introduced any supporting activity for processes, such as maintenance systems or
operations for purchasing, accounting or computing. Any one of the three, indicates a firm
experienced process innovation.
Explanatory Variables
The firms internal knowledge is proxied by the average number of years of education of a
typical permanent full time production worker employed in the firm. Internal knowledge
includes the firms full time employees with basic education, tertiary training, and university
degree.
Control variables include Age which is calculated as the year of survey, minus the year when
the firm started operations, Size which is the logarithm of the total number of employees
working at the firm, Training, which is a dummy variable equal to 1 if a firm provides formal
training to any of its employees specifically for the development and or introduction on
innovative products or services and processes

training to its workers, research and

development, a dummy variable equal to 1 if the firm conducted internal R&D2 in the last two
years. Other control variables are presented by the firms degree of competition, a dummy
variable equal to 1 if the firm competes against unregistered or informal firms and technology
use also a dummy variable equal to 1 f the firm use technology licensed from a foreign owned

Cf definition in OSLO manual, Guidelines for Collecting and Interpreting


Innovation data, 3rd edition, Organization for Economic Cooperation and
Development, 2005.
2 Defined as creative work, undertaken to increase knowledge for developing
innovative products and processes.

company, excluding office software. Finally we include total sales as a variable in the measure
of performance of firms in the manufacturing sector.
Table 1 Descriptive statistics for firms with in the manufacturing sector, 2013
Variables

Mean

Median

Standard Deviation

Min

Max

Processing Innovation

0.617

0.486

Internal Knowledge (log)

2.319

2.484

0.498

3.218

Size(log)

3.053

2.708

1.465

8.987

Age

19.91

16

15.524

107

Training

0.364

0.567

11

R&D

0.279

0.448

Degree of competition

0.630

0.482

Technology Licenced abroad

0.206

0.405

Total Sales (log)

12.129

11.88

2.851

5.075

21.441

Table 1 reports the descriptive statistics for the firms in the manufacturing sector, in terms of
mean, median, standard deviation, minimum and maximum values. The mean is somehow close
to the median for all variables. Therefore we interpret the mean value for the population
average. The mean for internal knowledge shows that approximately 23 percent of the firms
have employees with a type of degree from a higher education program. Firms in the
manufacturing sector have an average age of approximately 20 year in the sector while the
degree of competition among the firms is approximately 0.6 percent.

4. Empirical Method, Results and Analysis

10

This section is divided into two subsections. The first subsection presents the empirical method
and models used. In the second subsection, we estimate the model to obtain regression results
that are discussed and analyzed.
4.1 Empirical Method
The empirical method used is based on firms deciding on whether or not to engage in process
innovation. As we seek to analyze how a firms internal knowledge affects its process
innovation, we use a dataset with two levels of analysis; firms i, and country j. We adapt and
assume a linear for of regression to estimate process innovation as follows:

Yij=xij+j+ij

(1)

The yij is the dependent dummy variable that equals to 1 if a firm reports engaging in process
innovation. The xij represents a vector of firm characteristics, such as age, firm size, and level
of training of employees, research and development, degree of competition and total sales. i
are country effects and ij captures unobservable firm and country characteristics. For this
functional form, modelling the probability of a successful outcome (firm i innovates, i.e Yi =1)
is:

Pr (Yi =1 / X1i, .., Xki; o,, k) = (o+ kk 1 k)

(2)

Where (.) is the cumulative distribution of the standard normal distribution.


Assuming that the residuals are normally distributed, we estimate equation 2 by maximum
likelihood (probit) model. Standard errors are clustered to allow for possible correlations in

11

process innovation across firms within the same country. The marginal effects at mean values
of the variables of interest for different specifications of equation 1 are indicated in table 2.

4.2 Regression Results and Analysis


Table 2 presents the marginal effects for the model that analyzed the firms internal knowledge
and its process innovation in equation (1). In this model we observe that the probability of a
firm undertaking a process innovation decreases with an increase in internal knowledge.
Internal knowledge is 0.1 percentage points less likely for a firm to have process innovation.
This may be due to the fact that most firms rely on external knowledge and knowledge of
suppliers. This is similar to the findings of Cabagnols and Le Bas (2002), where they find that
process innovators are likely to draw on knowledge from upstream sources, such as suppliers.
Results from the regression (Table A2 in Appendix) indicate internal knowledge is not
significant in the firms process innovation. Furthermore, based on the results indicating that
the degree of competition is significant and is 8.6 percentage points more likely for firms to
undertake process innovation, it confirms the earlier finding of Weiss, (2003) where process
innovation is undertaken if there is less competition in the industry and products are less
differentiated.
The findings in table 2 also indicate interesting patterns. First, there is a negative relation
between R&D and process innovation. Usually expenditure on R&D may reflect the presence
of absorption capacity and firms need to exploit new technologies from other firms in their own
processes. In this study, we find no relationship between R&D and process innovation.
Research and development in firms is 0.1 percent less likely to induce firms to process
innovation. This is in line with findings of Rouvinen (2002) who found no relationship between
firm level R&D and process innovation, though, in theory R&D expenditure will be associated

12

with both incremental and radical process innovations. The findings indicate that size of the
firm, training, degree of competition and technology licensed abroad are significant as firm
characteristics. Firm size in this study is positively related to process innovation and a firms
size has 5.1 percentage points more likely for it to undertake process innovation. Size provides
firms with the resources to purchase and amortize new equipment and therefore to develop new
process innovations. This study suggests that it can be expected that large firms will be more
likely to be process innovators and is consistent with the work of Cohen and Klepper (1996a).
Table 2 Marginal effects results of a firms internal knowledge on process innovation
Explanatory Variables
Internal Knowledge (log)
Size(log)
Age
Training
R&D
Degree of competition
Technology Licenced abroad
Total Sales (log)

All
-0.0013
(0.0056)
0.0514**
(.0203)
-0.0016
(.0013)
0.1369**
(0.042)
-0.0192
(0.0435)
0.0861**
(0.0399)
0.0835**
(0.0493)
0.0006
(0.0109)

Tanzania
-0.0153
(0.0122)
0.0648**
(0.0368)
-0.0009
(0.0032)
0.2203**
(0.0763)
-0.2417**
(0.0908)
0.2411**
(0.0694)
0.2123**
(0.1015)
0.0106
(0.0234)

Kenya
-0.0035
(0.0103)
0.0551
(0.0337)
-0.0008
(0.0017)
0.0147
(0.0692)
0.0781
(0.0693)
-0.0376
(0.0645)
0.0889
(0.0811)
-0.0066
(0.0183)

Uganda
0.0060
(0.0074)
0.0768**
(0.0391)
-0.0050**
(0.0028)
0.1080
(0.0707)
-0.0182
(0.0678)
-0.1093
(0.0883)
-0.0691
(0.0749)
-0.0013
(0.0177)

Source: Authors calculations using data from the Enterprise Surveys.


Notes: The table reports marginal effects (at means values) on the firms propensity to innovate standard
errors are in parentheses. *, **, and *** indicate significance at 10%, 5% and 1% confidence levels.

In the analysis of country specifics, results indicate a negative relation between internal
knowledge and process knowledge for the two countries (Tanzania and Kenya) and a positive
relation for only Uganda. R&D in Tanzania, significantly contributes to process innovation with
a 24.2 percentage points less likely for a firm to adopt process innovation. Firm characteristics

13

differ across the three countries of the east African region and this sheds light on the level of
manufacturing in the region. For example the level of training provided by firms and the R& D
undertaken by firms seems to be different in the three countries. Although the majority of the
results seem similar to the combined results, there is some weak evidence that suggest
differences in firms in different countries. Thus, comparing results, on the overall and country
specific, results indicates that firms internal knowledge is negatively related and insignificant
to process innovation. Total sales as a measure of performance is insignificant
5. Conclusion
The purpose of this paper has been to examine the role of internal knowledge on the firms
process innovation in the manufacturing sector of the developing countries in the east African
region. The basic characteristics of a firm are influenced by the level of the size and the number
of the people it employees who contribute knowledge to produce goods and services. The
analysis makes a distinction between a firms internal knowledge and the firms potential to
undertake process innovation, in which the former reflects the capacity of the employees to use
their knowledge to influence process innovation.
The results in this study indicate that firms process innovation is not largely influenced by
internal knowledge and internal knowledge is insignificant. However, this does not rule out the
importance of having skilled individuals in the firms. The firms process innovation is
influenced by the technology licensed from abroad, trainings offered and the size of the firm.
Large firms are likely to undertake process innovation and continuous training of the employees
contributes to the potential of the firm to undertake process innovation. Findings indicate that
most firms use technology licensed from abroad which, required a combination of internal
knowledge to be able to undertake process innovation. Even though internal knowledge does
not influence process innovation, it contributes through a combination with other variables.

14

The results further indicate the importance of firm characteristics and how these vary across the
developing countries. The variation across countries explains small differences. Thus while
comparing the different firms in different countries, the important factors that influence process
innovation are within the firm and complemented by the external factors.
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Appendix

Table A1 Correlation matrix for dependent and explanatory variables.


Internal
Processing Knowledge
Innovation
(ln)
Processing
Innovation
Internal
Knowledge
(ln)
Age

Age

Size(ln)

Training

R&D

Degree
Technology Total
of
Licenced sales
competition
abroad
(ln)

1.0000
0.0523

1.0000

0.0430

0.1394

1.0000

0.2141

0.2897

0.3586 1.0000

0.1766

0.0357

0.1578 0.2278

1.0000

0.0751
Degree of
competition 0.0669
Technology
Licenced
0.1392
abroad
Total sales
(ln)
0.1624

0.1648

0.1793 0.3201

0.2747

1.0000

-0.0539

-0.0646 -0.1053

-0.0046

-0.0577 1.0000

0.1718

0.1211 0.3311

0.1779

0.2477

0.0184

1.0000

0.3547

0.4091 0.7789

0.2466

0.3183

-0.1458

0.3312

Size(ln)
Training
R&D

Source: Authors calculations using data from the Enterprise Surveys

18

1.0000

Table A2 Regression results for the effect of internal knowledge process innovation.
Process Innovation

Internal Knowledge (log)

Size(log)

Age

Training

R&D

Degree of competition

Technology Licenced abroad

Total Sales (log)

Constant

Coef.

Tanzania

Kenya

Uganda

-0.0035

-0.0393

-0.010

0.025

(0.0154)

(0.0313)

(0.028)

(0.031)

0.1409**

0.1666**

0.150

0.316**

(0.0556)

(0.0945)

(0.092)

(0.164)

-0.0044

-0.0024

-0.002

-0.021**

(0.0036)

(0.0083)

(0.005)

(0.012)

0.3747

0.5660**

0.040

0.445

(0.1151)**

(0.1966)

(0.188)

(0.293)

-0.0526

-0.6211**

0.212

-0.075

(0.1192)

(0.2337)

(0.188)

(0.279)

0.2356

0.6194**

-0.102

-0.451

(0.1094)**

(0.1787)

(0.175)

(0.367)

0.2286**

0.5454**

0.242

-0.285

(0.1351)

(0.2610)

(0.220)

(0.311)

0.0017

0.0273

-0.018

-0.005

(0.0299)

(0.0603)

(0.050)

(0.073)

-0.2631

-0.6644

0.147

0.460

(0.2928)

(0.5463)

(0.619)

(0.758)

Source: Authors calculations using data from the Enterprise Surveys, Standard errors are in parentheses

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