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Modular Product Design:Creating Technologically Separable Interfaces

by

Kirsten FossRESPECT

Department of Industrial Economics and StrategyCopenhagen Business School

Nansensgade 19,61366 Copenhagen K

Denmarkeskimp@cbs.dk

November 1998

AbstractThis paper discus the relationship between a physical product design and thedefinition of tasks in integral and modular product development strategies. It isargued that there are different criteria for defining tasks depending on the types ofadvantages of specialization one tries to realize. Moreover, task definition is alsoinfluenced by the costs of coordinating tasks. The physical product design stronglyinfluences 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.

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I. Introduction

The primary theme of this paper is to discuss the relation between the physicalproduct design and the definition and organization of product development tasks.

Tasks delimit in a more or less precise way the activities carried out by oneindividual from those activities that are carried out by another individual1. Thecreation of tasks as a minimum requires what Williamson (1985) callstechnologically separable interfaces between activities. The paper explores therelation between technologically separable interfaces in product developmentactivities, the definition tasks and technical interdependencies between componentsin the products that are to be developed.

Highly integral and highly modular products represent two extremes with respect tothe degree of interdependence between components. Modularization is a product

development strategy where different functions of a product are implemented bydifferent and relatively independent physical components whose interfaces aredefined by a set of interface standards. This differs from an integraldesign strategywhere each component may implement many functions and where each function isimplemented by many different components. The independence betweencomponents in modular products implies that an implementation of improvementsin one function have relatively little bearing on other functions.2

The aim of a modular product design strategy is to reduce complexity in productdesign. One can say that with a modular product development strategy one creates a

number of relatively closed systems of interdependent parts, which are containedwithin different components.

A modular product design strategy aims at reducing the complexity of theproduct inorder to reduce the uncertainty and complexity in product development activities.The success of such a strategy hinges on the relation between the complexity in

1I distinguish between activities and tasks. Tasks may encompass one or more discrete separable typesof activities. It is difficult to pin point what makes activities separable. Some activities, such assneezing, clearly cannot be separated for physical reasons. Other activities such as conducting orcreating 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 separatetasks. Problems arise because skills or talents cannot be transferred instantly in the form ofinstructions. A long term of continually interaction may be required and event then talents may not befully reproduced.

2 According to Ulrich ad Eppinger (1995) modular and integral production strategies are not justdifferent 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 productarchitecture may be preferable to a modular. It should be noted that products are rarely strictlymodular or integral. Even in a modular product there may be strong interdependencies withincomponents 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 componentswhere the interfaces required to implement the function are well specified. Focus in this paper os onthe more simple kinds of modularization.

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product design and the complexity in product development activities.3 The mostimportant indicator of such a relationship is the extent to which a decomposition ofproduct development activities is made easier by the decomposition of the productinto independent components.

Decomposingproblemsinto sub-problems is as pointed out by Simon (1969) a way ofreducing complexity in problem solving. In product development a part of theproblem solving activities consists of discovering unknown types ofinterdependencies between different design solutions. A decomposition of the

product into nearly independent components constrains the search for causes offunctional failures in products and speeds up the testing of the feasibility of differentdesign solutions. Therefore, when successfully carried out a modularization strategyshould make it is easier to identify the nature of interaction between components aswell as within components. Modularization thus can be thought of as a way ofincreasing 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 aproduct architecture. Once the architecture is fully specified the uncertainty inproduct development is confined to problems of identifying feasible solutions whichwill improve the functionality of the product within the constraints set by the pre-defined interface standards.

The choice of a modular product development strategy over an integral strategy alsohas strong implications for the benefits of specialization in product development. Inorder to reap the benefits of specialization, product development activities have to beseparated into various tasks which are carried out by different individuals. A mainpoint of the paper is that task definition and the way in which the productdevelopment problem is presented have great implications for the possibilities ofreaping benefits of specialization at lowest possible cost of coordination.

The paper identifies to types of rationales for task division. One is to economizing onbounded computational capacity and saving costs of information processing. Theother is to increase the rate of learning by doing and innovativeness in problemsolving. I shall argue that from the perspective of economizing on boundedcomputational capacity the identification of interdependencies in product solvingactivities is an important criterion by which one ought to identify tasks while fromthe perspective of realizing the benefits of learning by doing repetition of activitiesand similarities in the underlying knowledge are important criteria

Benefits from specialization cannot be realized without costs of coordination. Costsof coordination increase with the need for more communication, as more tasks aredefined 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 allowfor the communication of results rather than of the premises on which the results areto be reached. Furthermore, tacit knowledge or sticky information (von Hippel,1998) may be a problem of coordination between tasks which require the creation a

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coordination mechanism. Another aspect of coordination is incentive coordination.Here measurement costs problems (Alchian and Demsetz, 1972; Barzel, 1985) andproblems of asset specificity (Williamson, 1985; Hart, 1995) are of profoundimportance in determining the costs of coordination. Again task definition mayinfluence 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 outcomeof tasks.

I argue that with a choice of a modular over an integral product development strategy one isable to define tasks in ways which provides greater opportunities for realizing the benefits ofspecialization with less costs of coordination. Essentially, this is because with a modulardesign strategy, it is possible to economize on bounded computational capacity andreap 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 lessextensive monitoring of tasks completion.

The remaining part of the paper is organized as follows. Section II, What AreTechnologically Separable Interfaces?, discusses the meaning of this thorny concept, Insection III, The Product Development Process: Integral and Modular Product DevelopmentStrategies, I use Ulrich and. Eppingers (1995) representation of a productdevelopment process as a basis for discussing the differences in productdevelopment 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 benefitsof vertical specialization in general and in product development processes inparticular. Finally, section V, Cost of task coordination takes up the discussion ofcoordination 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 occurswhen 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 inwhich resources are actually transferred in the physical sense of delivery (p.41).Technologically separable interfaces between distinct activities are demarcated by thepossible of exchanging physical objects or knowledge as either embodied in physicalobjects or as codified knowledge. From this well-known definition of transactions,Williamson sets out to understand the characteristics of transactions thatdiscriminate with respect to the choice between different governance structures as

means of organizing transactions.

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It is a main argument of this paper that the way in which tasks are defined andtechnological separate interfaces are created have profound implication for the net

benefits of specialization. The cost of codifying and transferring information alongwith the possibility of realizing advantages from specialization is of great importancein determining tasks.

To Williamson, technologically separability is taken as a datum and the creation oftasks is not considered a decision variable. Williamson does not considered taskdefinition part of a problem-solving activity, nor is it considered a way of dealingwith the problem of coordination. Williamson perhaps implicitly assumes that tasksare defined in ways that maximize the benefits of specialization given the constraintsof, for example, the laws of nature, the techniques used the state of technologicalknowledge, and the extent to which it is possible to codify information.

But technologically separable interfaces in the Williamson sense are not given; theyhave to be discovered. Most likely a very great number of alternative technologicallyseparable interfaces can be defined in any product development process or indeed inany production activity. It is obvious -for those interested in product development(for practical or academic purposes)- that the uncertainty or complexity, whichcharacterize the product design problem, makes it difficult to specify ex-ante all thepossible types of exchange of objects and information, which will be needed in orderto create a new product.

Moreover, transactions between technologically separable interfaces do not occurunless there is a separation of activities into tasksperformed by different individuals.The best way of defining tasks may vary according to the benefits of specializationone 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 developmentprocess we can anticipate how the choice of a modular over an integral productdevelopment strategy may influence the nature of activities and the types ofinterdependencies one encounter. The following section provides a short descriptionof product development activities with an integral and a modular productdevelopment 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 orless well-defined quality characteristics and functions or to upgrade the quality of anestablished product. The outcome of such a process is a description of a productconcept with a set of technical specifications on how the various functions of theproduct are to be implemented in the product. In general terms, productdevelopment can be seen as consisting of activities such as information collection,

information processing, creative thinking and problem solving.

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There are many different ways of carrying out these activities and many differenttools and guidelines have been developed in order to aid product developmentteams in carrying out these activities (e.g., Wheelwright and Clark, 1992). In thefollowing sections, I give a brief description of the methodology developed by Ulrichand Eppinger (1995), since this methodology is developed with a focus on ...

products that are engineered, discrete and physical (p.2). These are the types ofproducts, which are the focus of this paper. The methodology they suggest consistsof a highly structured search and evaluation process. I use this methodology toillustrate the more specific differences in product development activities between anintegral and a modular design as well as a basis for discussing the creation oftechnologically separable interfaces between tasks in product development.

According to Ulrich and Eppinger, the product development process can bedescribed as taking place in five sequential phases, which are: Concept development;system-level design; detailed design; testing and refinement, and production ramp-up. 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 developmentand system level design phases, since many of the differences between modular andintegral design strategies arise from the different ways of tackling the informationprocessing and problem solving activities in these two phases. I shall start by givinga brief presentation of the various steps in integral product development process,followed by a short indication of how this process differs from a modular designstrategy.

III. i. The Integral Product Development Strategy

The Concept Development PhaseThe purpose of the concept development phase is to generate the product concept forthe 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 andEppinger, the concept generation process begins with the identification of customerneeds. Customer needs should be expressed in ways that do not indicate technicalsolutions. Once customer needs are ranked they have to be transformed into a set oftarget specification.5

In most designs it is necessary to divide the design problems into more simple sub-problems. Ulrich and Eppinger suggest that this requires what they call a functional

4Ulrich and Eppinger use the word product concept in a different way compared to the general use inthe marketing literature where a product concept is considered to be a package of functions that isunique.

5A 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 75seconds a value). This is sometimes referred to as an implementation.

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decomposition where the desired functions of the product are decomposed intofunctional elements to create a more specific description of what the elements of theproducts do in order to implement the overall functions of the product. 6 7With thecompletion 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 intoconsideration the interaction between different design solutions. Component andproduct design therefore co-evolve and as the architecture of the product graduallyis finalized by the definition of all the component interfaces.

The search for a product concept starts by the selection of a sub problem for furtherscrutiny that is believed to be critical and constraining for other solutions. Then, anumber of different concepts of how to solve the sub-problem are developed. Thesesolution concepts can be systematically explored by using a concept classificationtree where each branch represents a combination of conceptual solutions. For eachpromising branch a sketch should be made of the possible technical solutions whichwill implement the desired overall function. Finally, the product concept can beselected by evaluating the most promising combinations of technical solutionsagainst the target specifications and costs constraints. The evaluation of a technicalsolution may require that models are built -which contain the critical designparameters- in order to determine their interactions with respect to the targetvalues.8

The System Level DesignAt the system level of design product specifications have to be established along withthe architecture of the product. Target values, defined in the beginning of the conceptdevelopment phases, may have to be refined as models and tests of design solutionsfor all the different sub-problems reveals different types of constraints on thetechnical solutions. The architecture of the product is gradually finalized as all thedifferent 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 ahigher degree of independence between components (Sanchez and Mahoney, 1996).6Functional decomposition is not the only possible way of decomposing a problem. For example, onecan 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 functionaldecomposition of product development problems.

7A functional element consists of the individual operations and transformations that contribute to theoverall performance of the product. Each functional element is described in a way that does not implya specific technical solution.

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

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The architecture of the product is developed before any of the detailed designsolutions and design-information is partitioned into visible design rules and hiddendesign 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 DevelopmentWith 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 thechoice of concepts and implementations for the auxiliary functions of the product.Once the architecture of the product is finalized product development consist ofaltering 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 ofcomponents (chunk) requires information of only limited and known functionalinteractions with other chunks.

The System Level Design

The system level design is finalized by the choice of a concept for the architectureand 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 greaterindependence between the different functions that are embodied in the product,more components as each component implements only a few functions and lessinterdependence between components. From the above brief sketch of the designmethodology of integral and modular designs it should also be clear that with achoice of a modular product design informational interdependencies between

problem solving activities and therefore also the amount of iterative processesneeded to solve a problem is strongly reduced. This could of course imply that thetotal 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 theneed for communication across interfaces it is possible to reduce the amount oftransactions. Of course other consideration than the amount of iteration will have todetermine 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 boundedrationality, of specialized knowledge, and of learning by doing.

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IV. Task Definition and Benefits of Vertical Specialization inIntegral 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 berealized from specialization As already mentioned it is possible to identify differentkinds of advantages of vertical specialization, such as economize with boundedrationality 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, thepossibilities of increasing the rate of leaning by doing. I compare an integral andmodular design strategy with respect to different criteria for task definitions to beused in order to reap the above mentioned benefits of vertical specialization.

IV.i. Defining Tasks to Economize with Bounded ComputationalCapacity and Maximize Parallel Search

One aspect of bounded computational capacity of individuals may be that there aresharply diminishing returns to information processing and problem solving asincreased complexity of problem solving increases the load of informationprocessing. Diminishing returns may show up as inferior solutions or as more thanproportional 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 andless complex problem (Simon, 1969). According to Simon (1969) complex systemstend to be organized into hierarchies where there is much more interaction withinsub-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 asearch through a maze (Simon, 1969, p.95). By dividing a problem into subproblems, the problem solver can concentrate on the interactions between a lot fewerelements 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 toidentify a solution to the problem in its entirety10. Moreover, because a solution to asub problem often can be transferred into a piece of codified information, it can beput aside without the risk of being lost.11 All of this helps economize on bounded

9Complex in the sense that it is made up of a large number of parts that interact in a non simpleway (Simon, 1969, p.86).

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

11Simon (1969) uses the parable of the two watchmakers Hora and Tempus to illustrate how the timeof component assembly of a watch may be reduced if the watch is decomposed into sub components.

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computational capacity.

Many design problems can be conceived of as complex systems, which belong to thecategory of only nearly decomposable systems. As with other nearly decomposablesystems it is possible economized on bounded computational capacity and reduce

problem solving time by identifying and solving sub problems. Design solutionsemerges as the designer searches through a maze of conceptual and physicalsolutions in pursue of a workable solution. Trail and error is a dominant feature ofthis process as different concepts and physical solutions are constructed andevaluated against the target specifications. If search is carried out randomly onaverage many more trails and errors will be needed to reach a workable solution. Butif search is guided by either experience, technological knowledge or by theidentification of a solution to a sub-problem these trails and errors will be greatlyreduced.

In any product design one of the difficult parts consists in defining independentproblems, which makes up the hierarchy of sub-design problems. The fact that it isoften possible to create a great number of functional decomposition of a designproblem goes to show that it is possible to construct many hierarchies of designproblems. Furthermore, for each functional decomposition a great number ofconceptual solutions can be constructed and for each conceptual representation it ispossible to define a great number of physical solutions.

One of the problems of choosing how to decompose the design problem rest in thedifficulties of trying to anticipating the strength and nature of interdependencies

between functions and among components. Experience of course help one constructone set of relatively independent problems in ways that can give rise to greatimprovements in the functionality of the product. The process however, is greatlyeased with a modular design strategy since with such a strategy the product isconceived of in a way that greatly reduces the complexity of tracing theinterdependencies between and within components. Once a fully specifiedarchitecture is arrived at a decomposition of design problems can take place alongthe line of components. The search for specific design solutions to will then be muchfaster since the search strategies are already constrained by the pre-determinedinterface standards. However, as pointed out by Sanchez and Mahoney (1996) Tofully specify component interfaces in a modular product architecture, a firm musthave, or have access to, advanced architectural knowledge about relevantcomponents 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 ithad to be put down due to interruptions. Tempus, who has decomposed the watch into sub-components, lost only the assembly of the last component when interrupted. There are parallels to thisparable 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 solutionsthere may not be so great loses of tacit knowledge.

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economizing with bounded computational capacity even if only one person isinvolved in the problem solving activities (Simon, 1969; Radner, 1992). However, ifdifferent individuals solve different parts of the problem it may be possible toeconomize even more on bounded computational capacity. Then, what sort ofheuristics can be used to define product development tasks in ways that economize

the most with bounded computational capacity? Within the sphere of social systemsthe 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 clustersof dense interaction in the chart will identify a rather well defined hierarchicstructure (ibid. p.88). The underlying assumption must be that task definitions,which economize on bounded computational are the ones, which also reduce theneed for communication most. In product design Eppinger, Withney, Smith andGebala (1994) have suggested a similar approach. Based on case studies they foundthat iterations in product development tasks are reduced most when tasks aredefined on the basis of a chart of the interaction between the design parametersspecified by the designers. 12 Now, the amount of iterative processes in productdevelopment design depends on the extent to which it is possible to specifyinterfaces between parts and components ex-ante to the development process and onthe amount of interdependencies between parts and components in the productdesign13. A modular product development strategy reduces the interdependencies inparts and makes it easier and faster to specify their interfaces

Even if there is almost complete knowledge of the interactions between componentsand parts there is some definitions of tasks which economize more on boundedcomputational capacity than others. von Hippel (1990) has illustrated this point verywell in an example of the develop an airplane where the product developmentproblem is subdivided in two different ways. In the first case one task is to developthe rare end and the other to develop the front end of the plane whereas in thesecond 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 todifferent teams each team have to be fully informed about many more design variablesthan if tasks are defined by allocating the design of the frame to one team and thedesign of the machine to the other team.. Moreover, in case where knowledge ofinterdependencies are less complete task division in accordance with the firstexample most likely would imply many iterations between problem definition, andtarget specifications, on the one hand and the problems solving tasks on the otherhand as the two design teams discover incompatibilities in their solutions14.

12Other 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 infor example ..task communication time, functional coupling, physical adjacency, electrical orvibration characteristics, parameter sensitivity, historical variance of task results, certainty of planningestimates, or the volume of information transfer (p.4)

13It of course also depends on whether one wants an optimal design or not.

14Another indication of a difference between the two approaches is that it is much easier to reach anoptimal design with the second approach than with the first approach.

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In comparing task definitions of an integral and a modular design strategy attentionshould be given to the fact that functions in modular product are implemented byrelatively independents components. For most incremental improvements offunctions the important interdependencies between design variables to be exploredare 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 tobe developed most likely will be the one, which reduces the need for iteration and the need forinformation about design variables most.In the case of the integral design it is not quitso easy to determine what heuristic for detailed task definition will be most feasiblewith respect to reducing iteration processes.

Decomposing complex problems into relatively independent and less complexproblems help to raise the quality of problem solving while simultaneously saveproblem solving time. Another way of economizing on bounded computationalcapacity is to reduce the information processing of individuals by taking advantage

of the possibility of parallel problem solving. This always requires that more thanone individual is engaged in the product development activities.

If one is to benefit from parallel problem solving the problem to be solved in itsentirety has to be characterized by what Radner (1992) calls associative operations.With associative operations the sequence in which the sub operations are carried outdo not matter to the entire result. Linear information transformation and patternmatching are the two paradigm cases of associative operations. Lineartransformation takes place when a set of information is transformed into another setof 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 theemployment of a linear decision rule. Pattern matching takes place when a sets ofdata is compare with a reference set of date in order to find the closest match. Anexample of this may the activity of comparing the dimensions of many different boltsin order to find the one which match a set of specifications.

In product development there are a lot of activities, which may be characterized astransformation by some sort of linear decision rule. One example is thetransformation of customer statements into target specification. Most likely it is notpossible to specify explicitly how this transformation is to be performed butindividuals with the same education and experience may employ some of the sametacit heuristics in performing this activity. Thus, it may be possible to allocate thistype of activity to different individuals with the same education and have themperform the translation in parallel. Other activities, which may be characterized bylinear transformation are the combining of all the different conceptual solutions tofunctional decomposed problems in the creation of branches in a conceptcombination tree or the transformation of these combinations of conceptual solutionsinto suggestions for physical solutions. Parallel search then take place when differentindividuals create different branches of the tree or when different individuals makesthe transformations of the conceptual solutions into physical solutions.

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Pattern matching activities in product development are mostly of the type where onesolution 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 betweenvarious combinations of conceptual solutions in the concept combination tree or

when a product concept is selected by comparing various solutions to the targetspecifications. These judgments can be carries out by more than one person. Differentindividuals can compare sub-sets of solutions and find the best solutions of the sub-sets which then can be compared by another group and so forth until the bestsolution 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 bestsolution of a sub-set is to be found the judgment of the various individuals may playan important role in determining which of the proposals are selected.15

Parallel transformation and pattern matching economize on the bounded rationalityof individuals, it saves time in product development andit may also be employed asa way of creating more variety in solutions. As mentioned above the ways in whichtransformations are performed are likely to vary with educational background andexperience. Since the solution to the design problems in its entirety is likely to differwith the solutions suggested parallel search can be used as a way of increasing thevariation in the suggestions of design solutions by having different individualsengaged in the transformation processes.

In order to realize the benefits of parallel search associative processes will have to beidentified from those problem solving activities which have to be carried outsequentially and tasks will have to be defined as sub sets of these associativeprocesses. Since there are increasing costs to parallel problems solving activities taskdefinition of course will have to reflect these costs. The cost consists of delays orproblems of utilizing capacity fully. Delays occurs as parallel sub-problems aresynthesized by sequentially eliminating or transforming sub-solutions until a finalsolution is arrived at. Delays can sometime be reduced by defining more tasks to becarries out by more individuals. An efficient problem-solving network is one wherethere is an optimal tradeoff between serial and parallel processing. If problemsolving is not an ongoing process and if idle capacity represents no costs this isachieved 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 byexpanding the network as compared to the optimal one shot problem-solvingnetwork.

What then are the implication of a modular and an integral design strategyrespectively 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

15The distribution of suggestions among individuals and the sequence of decisions may have a greatinfluence on the final choice (Miller, 1992)

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both a modular and an integral product development strategy. However, a modularproduct and a fully specified architectural design represent a nearly decomposedsystem of design problems. Many of the detailed design activities are thereforenearly associative operation because the sequence in which sub design problemsare 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 betweencomponents any parallel search for a solution to sub problems continuously has to beadjusted to new information about solutions to other sub-problems. This implies thatthe algorithm of pattern matching continually has to be altered and some of theprocessing may have to be re-done. In order to minimize the re-doing of patternmatching or transformation activities the sequencing of the various types of patternmatching and transformation activities is important.

To sum up, in order to reap benefits of economizing on bounded computationalcapacity and reduce information processing time task partitioning is often necessary.In specifying tasks one needs to consider; how to reduce the amount of informationeach person needs to receive and communicate; how to reduce the amount of designvariables each person needs to be aver of; and how partition the search forinformation in ways which reduces delays and cost of idle capacity.

A first approximation to achieve this is to decompose the design problem intorelatively independent problems so that for each sub task one only needs to discoverinteractions between a more limited number of design variables. This of courserequire some understanding of the nature of interdependencies between problemsand therefore also of the nature of interdependencies in the product design. In thisrespect a modular product design strategy is a strategy of reducing complexity sincethe product is intentionally designed to be decomposable into its components. In fact,if the product represents a system which is not nearly decomposable any attempteddecomposition of problem solving activities will require more informationprocessing within tasks than if the product is decomposable.

However, even with a perfectly decomposable product information exchangebetween product development activities can be further reduced if it is also possible tospecify ex-ante the interfaces between parts and components. With a modular designstrategy where interactions between components are intentionally kept simple onemay faster be able to reduce some of the uncertainty associated with the specificationof interfaces between components. Once it is possible to fully specify the architectureof the product, the remaining problem of task definitions consists of specifying tasksin ways, which economize with information processing, increase benefits of learning

16 With a flexible design strategy (as opposed to an optimal) sub-functions of the product areimplemented by developing independent physical solutions which are within the range ofinteractions, 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 onetypically cannot carry out the sub-design as totally independent parallel processes.

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by doing and reduce costs of coordination. I shall turn to the latter in section VI. Inthe 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 interfacesbetween product development activities rests in the kinds of gains fromspecialization which was emphasized by Adam Smith (1776) in The Wealth ofNations.

From Smith we know that specialization in productions is one of the main sources ofimprovements in labor productivity. Specifically, he ascribes productivity gains toimprovements in a workers skills, in time that is saved from avoiding having toswitch from one task to another, and in labor saving innovations. Even thoughproduct development activities differ from production activities it is possible torealize these kinds of benefits by specialization in product development activities.

In product development almost all activities have some elements of skill. Forexample, in the activities we normally label market researchthere are elements of skillsin the design of the market research, in the identification of the sample to questionand in presenting the questions and recording the answers. The skill element in thoseactivities labeled concept development by Ulrich and Eppinger (1995) may consist ofthe heuristics one uses for decomposing design problems; for searching forconceptual solutions. Skills may also consist in the ability to engage in creativeprocesses one engage in when trying to conceptualizing new types of solutions or thecare and accuracy with which the problem solvers design and conduct experimentsor use simulation models.

Repetition of the same types of activities over and over is the key to accumulation ofall these diverse skills. If it is possible to initiate and finish more productdevelopment projects within the same time period it may be possible to increase therate of repetition of activities in product development activities withoutspecialization. However, if individuals perform certain activities more often withspecialization than without specialization, specialization tend to increase the rate ofskill accumulation. To increase the rate of accumulation of skills tasks will have to bedefined around activities, which can be repeated by solving the same types ofproblems. Someone specialized in market analysis may for example, perform manyof the same types of activities over and over in producing the customer statementsneeded for input to different product development projects.

An increased repetition of a task depends on how extensively one is able to use theuse the outcome of the task. In order to ensure that there is a sufficient demand foroutcomes of the specialized activities the costs of transacting between tasks has to belower than the benefits gained from specialization. 17Finally, tasks have to be defined

17Transaction costs depend partly on the way in which tasks are defined (Barzel, 1989) partly on the

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in a way which economize with the receiver competence (Eliasson, 1990) needed todecode or otherwise use the output from a task. Output which requires lessknowledge 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 switchingcosts may arise when it takes time for an individual to change his mindset in orderto perform a different type of activity. Such switching costs may, for example, arise ifone has to switch between market analysis activities and concept developmentactivities or even if one has to switch between the development of different types ofcomponents. This may be because the structure of knowledge is quiet different forthese different types of activities.18

Defining tasks in ways, which accommodate differences in the knowledge structuremay also increase the rate of knowledge accumulation and enable innovativeness inproblem solving. Innovativeness in problem solving can be described as the ability ofan individual ..to retrieve a potentially useful piece of information from onesmemory and then adapting that information to the problem in hand (Ulrich andEppinger, 1995, p.88) or put a bit different to recombine knowledge in new ways (asin 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 radicaldepending on whether the innovation leave the core concept unchanged or not andwhether linkages between core concepts and components are left unchanged or not.Incremental innovations result in the rearranging of old and well-known conceptualsolutions. Modular innovations introduce new conceptual solution based on newprinciples for the implementation of a certain function. When such innovations havean impact on the way in which components are linked together they are radicalinnovations. Finally, an architectural innovationoccur when incremental innovations incomponents leave the core concepts of components unchanged but not the way inwhich components are linked together in the product architecture.

In any case most innovativeness requires accumulation of knowledge. Tsome of thefactors which influence the process of knowledge accumulation is the extent to whichknowledge 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 effecttransaction costs.

18 The architectural knowledge embodied in dominant design often set the agenda for theaccumulation of component specific knowledge (Clark, 1985; Henderson and Clark 1990). In fact, thedifferences 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 technologicalknowledge.

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advances within a field is necessary in order to assimilate information on newadvances. In such cases the rate at which new knowledge can be accumulatedincrease with the stock of existing knowledge (Cohen and Levinthal, 1990). Thus bydefining tasks in a way which permit individuals to focus attention on a more limitedarea 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 increasethe rate of accumulation of component knowledge. However, by defining tasks verynarrowly one may inhibit the accumulation of architectural knowledge about theways in which components are integrated and linked together or the accumulation ofthe kind of deep knowledge of core design concepts and their implementation, whichis required for radical innovations (Henderson and Clark, 1990). One of the reasonswhy a very narrow definition of tasks may inhibit some kinds of learning is thatknowledge accumulation depends on the feedback which enable individuals to tracethe impact or consequences of a trail. If task definition is to narrow one will have torely on extensive information exchange in order for individuals to trace theconsequences of their experiments.19

It is possible to realize benefits of specialization in terms of increased skillaccumulation, reduced switching costs and increased innovativeness with both anintegral and a modular product development strategy. However, a modular designstrategy with a fully specified architecture creates better possibilities of setting upindependent experiments in order to determine the effect of design choices againstthe specified interface standards and the target specifications chosen for theparticular component in question. With an integral product design it will often benecessary to design experiments and simulation activities across many morevariables in order to determine the nature of feedback (interaction) betweencomponents. Moreover, with a modular product design strategy which allow for agreat deal of specialization between architectural development actives andcomponent development activities one may also accommodate the accumulation ofcomponent knowledge based on different structures of scientific and technicalknowledge. Finally, with a modular product (and a flexible design strategy) it mayalso be possible to use components across different architectures thus increasing therate of accumulation of skills in component development activities and makingspecialization in component development an attractive route to follow. With anintegral product development strategy specialization in component developmentmay 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 ofdifferent architectures.

To sum up, specialization in product development activities may increaseproductivity in problem solving by increasing the rate of skill and knowledgeaccumulation and by lowering the costs from switching attention to different areas ofactivities. 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

19Se the discussion of coordination in the following section.

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structure of knowledge within tasks and 3) create tasks which makes it possible forindividuals to trace the effects of their actions. Compared to an integral productdevelopment strategy a modular product development strategy with a taskdefinition along the lines of architectural development and component developmenttasks more easily comply with at least principles one and three. However, since

knowledge accumulation of individuals tend to be structured by the way in whichtheir tasks are defined accumulation of architectural knowledge and knowledgeneeded for more radical innovation may be inhibit -unless some types of informationcoordination 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 timedso that there is minimum delays and idle resources or that supply match demand inall markets. All of these examples of problems of coordination can be described as ageneral problem of ensuring that scarce and valuable resource (includinginformation and knowledge) is used in their best alternative uses.

Different strands of literature emphasize different types of coordination problemsand different constraints to coordination. Within the strand of literature concernedwith 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,1994.

Within the strand of literature concerned with the constraints of conflictingpreferences and asymmetric information focus is on how it is possible to ensure thatagents have the proper incentives to use resources in their best possible uses giventhe information available about these uses. Representative of this branch of literatureare Alchian and Demsetz, 1972; Fama, 1980; Grossman and Hart, 1986; Hart andMore, 1990; Jensen and Meckling, 1992; Barzel, 1989; Williamson, 1985 and Hart,1995.

In the following section I first discuss coordination of dispersed information inproduct development. Then I move on to a discussion of how one can ensure thatindividuals have the incentives necessary to ensure that they make use of theinformation and the skills and knowledge they posses in solving productdevelopment problems. I shall also discuss whether these various coordinationmechanisms may remedy some of the cost of specialization when interdependenciesin products makes it impossible to fully decompose product development activitiesas with an integral design.

V.i. Information Coordination

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Up till now, the discussion of the division of labor in product development activitieshas been based on the premise that a person can reach an at least equally gooddecision without access to the to the entire set of information on decision premises aswith 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 isof no relevance to the solution of the entire problem.

Ulrich and Eppinger (1995), provide a fine example from the development of a forkfor a mountain bike where this is not the case. Those who performed the marketanalysis identified customer needs as easy to install. For those who perform thetranslation of customers needs into target specification this a to ambiguous statementsince it could be translated into a number of different technical specifications such astime to assembly or assembled by use of simple tools and simple movements.Tacit information may also be important in connection with the development andchoice of a physical solution to a sub design problem. As pointed out by Sanchez andMahoney (1996), ..information and assumptions underlying upstream designdecisions 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 sometimesbe important for designers of complementary components to know how a certainsolution concept react to changes in different parameter rather than just to know thatthis solution concept has been chosen.

According to Ulrich and Eppinger (1995) and Sanchez and Mahoney (1996) theproblems which arise in connection with ambiguous information can be solved bycreating an overlap in tasks. But the influence of tacit and sticky information on taskdefinition in product development can be solved by other means than by creatingoverlapping tasks as suggested above. According to Casson (1994) the extent towhich a problem at hand is characterized by what he calls decisiveness is the key towhether or not individuals will share tacit information in some sort of consultation... [d]ifferences in decisiveness mean that some problems have a logical structurewhich supports solutions without consultation and some do not (Casson, 1994,p.50). What Casson calls natural decisiveness occurs when a problem can be solvedequally well by consultation as by substituting knowledge about the other partiestacit information with knowledge of their plans. Natural decisiveness isadvantageous when tacit information is more costly to transmit than informationabout 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 tosolve them without having to communicate all the tacit knowledge. One may simplyimpose decisiveness on problems by dispensing with the communication of tacitinformation. This may be done if the consequences of an incorrect decision areperceived of as small relative to the costs of communicating the tacit knowledge.Extensive consultation or overlapping activities are only necessary if each party holdinformation which is highly likely to be decisive or if the costs are high of not makingthe correct decision if lacking some of the tacit information.

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Problem decomposition, natural decisiveness and task definition are stronglyinterdependent. A problem, which is nearly decomposable, has a logical structurethat supports naturally or imposed decisiveness as long as tasks are defined alongthe lines of the relatively independent problems.20 The problem solving activitiesthen can be perfectly coordinated by having individuals communicate their results as

specified by the logical sequence of problem solving which is determined by thechosen decomposition.21

Imposing decisiveness on product development activities is one way of creatinginformational independence between activities so that they more easily can becarried 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. Definingtasks by imposing decisiveness requires a good understanding of not only thepattern of communication of plans and decisions but also about the importance of thetacit knowledge on which these plans and solutions are developed. If decisivenesscannot be imposed no mater how a problem is decomposed there is only limitedpossibilities of realizing the full benefits of specialization in problems solvingactivities since some overlap and consultation between activities are needed.

It should be noted that the logical structure of problems which gives rise to naturaldecisiveness is different from that which give rise to parallel problem solvingactivities. In fact, natural decisiveness imposes a certain sequence on problemssolving since those who hold decisive information have to solve their part of theproblem first in order for those who do not have decisive information to reach theirdecisions.22The coordination of product development activities where decisiveness isimposed requires that decision rules are made which determine who is going tomake decision based on what kind of information. The decision rules whichdetermines the sequence of problem solving and transmission of tacit information(decision premises) or information about plans (decisions) depends on the benefits ofspecialization in problem solving and the perceived probability about who is mostlikely to posses decisive tacit information.

20 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 tobe non-vital to the solving of each problem so that decisiveness can be imposed.

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

22 Decisiveness and associative process do not preclude one another. It is possible to decomposeproblems so that one identifies both associative process and impose natural decisiveness which definesthe sequence in which different typesof the associative process are to be carried out. Moreover, theremay be elements of tacit knowledge in carrying out associative processes. The algorithms used totransform 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 certainsequence in problem solving.

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Decisiveness creates a division of labor between one the one hand those who solveproblems and on the other hand those who define problems, evaluate and selectsolutions.23 The maximum division of labor in decision making is obtained whenthere 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 developmentgroup who defines development projects on the basis of their estimates of bothmarket and product technology trends. One can improve these decisions by havingnon-decision takers report their tacit knowledge to the decision taker. Suchimprovements occur only if the costs of transmitting the tacit information is less thanthe 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 decisionmaking, product development projects are jointly defined between those who possesrelevant tacit knowledge. This is most likely to result in a correct decision but it alsoincreases costs due to overlapping activities. Another way of reducing informationtransmission costs is to define task more broadly. With less division of labor betweentasks fewer errors are likely to occur since decision takers have access to the tacitinformation they need. However, the gain in terms of better decisions are achieved atthe cost of less specialization.

The concept of decisiveness indicates that the best way of defining tasks is tominimize the need for exchange of tacit communication between tasks. This reducescosts of communication while at the same time ensures that tacit knowledge isavailable to those who make decisions. Moreover; it may not be possible todecompose a problem so that one can avoid either loosing or having to transfer tacitknowledge. However, other considerations such as benefits from learning by doingmay be important.

The concept of decisiveness is important in comparing the cost of coordinationbetween a modular design strategy and an integral design strategy receptively. Withthe modular design strategy and a fully specified product architecture much of thetacit knowledge is confined to the problems of developing relatively independentcomponents. Furthermore, with the modular strategy the importance of some typesof tacit information, such as for example, market information, is greatly reduced.This all suggests that even with a high degree of specialization only relatively littleeffort needs to be put into coordination of information.With an integral design strategy the decomposition of the design problem is likely toresult in tasks where there are many benefits from communicating informationincluding tacit knowledge. Of course some of the cost of coordination between

23 Carter (1995) talks about routine decisions, market- or production dominated firms, market- orproduction led firms or pooled information. Routine decisions occur when tacit information issuppressed. With market- or production dominated decisions the party with tacit information makethe decision without any knowledge of the other partys tacit information, while with market-production 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 asthey join in making the decision.

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relatively independent tasks can be reduces by imposing decisiveness on problemsolving. If it is possible to impose some decisiveness it may be much easier to takeadvantage of parallel search since decisiveness limits the amount of new informationwhich arrives at the information processing networks .

All in all it is most likely that the coordination mechanisms needed with an integraldesign strategy are more extensive and more costly to operate. It may be so muchmore expensive that less specialization is preferred with an integral design strategyrelative to a modular design strategy.

Finnlay, it should be noted that defining the proper division of labor betweendecision making and actual design activities and the proper decision rules toimplement this division is costly and not likely to be beneficial unless they can solverecurrent design problems. In this connection modularization and interfacespecification can be seen as a set of decision rules where the interface standardsrepresents the plan/design decision which is necessary for other parties to determinewhat they are going to do. When the architecture allows for a great deal of flexibilityin component design, the costs of setting up these rules are spread over manyrecurrent design processes.

Vii. Incentive Coordination

One aspect of coordination is to ensure the lowest cost use of local knowledge indecision making another is to ensure that individuals have the proper incentives tocarry out their tasks. The problem of aligning incentives is the subject matter of manydifferent branches of transaction costs theory (se Williamson, 1985). Of all of thesedifferent branches the agency and the measurement branch of transaction cost theoryare those which are most concerned with the links between the structure of rewardand the cost of measuringoutcomes. Of these two branches the measurement costs

branch is the only one which is applicable to the question of how task definitioninfluences the cost of providing a proper incentive alignment.

The agency theory applies to all those situations in product development where thereis a specialization between decision making and implementation of decisions.Principal agency relation thus emerge with all problem decompositions which makesit possible to rely on natural or imposed decisiveness as a way of coordinatinginformation. This also applies to the decomposition of associative processes to takeadvantage of parallel search. More generally an agency relationship is said to existwhen a principal delegates the right to carry out a pre specified task to an agent whois bound by a formal or informal contract to represent the interest of the principle(Sappington, 1991). Individuals or teams of individuals may simultaneous be aprincipal and an agent. In product development there may be principal agencyrelationships between: the group of managers who decide to allocate resource toproduct development and the product development team which carries out thedevelopment activities; between those who define the product concept and those

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who carry out the detailed design and between those who delimit the associativeprocesses in connection with, for example, search for conceptual solutions orevaluation 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 agentsinfluences the structure of efficient contracts. In the principal agency theory it isassumed that the agent has more information than the principal about the details ofthe tasks he (or they) have been assigned, about the possible courses of actions whichshould be taken and about his (their) own abilities and preferences. The principalthus is unable to write a contract which states the level of effort, which should beperformed 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 toobserve the outcome of the agents activities. The principal agency literatureemphasize the tradeoff between cost owing to poor information (lack of tacitknowledge) and costs owing to inconsistent objectives. According to Jensen andMeckling (1992) the problem of centralization contra decentralization in firms is dueto exactly this tradeoff.24

The timing of the interaction between the principal and the agent is as follows. Firstthe principal designs the terms of the contract, which specifies the payments theagent will receive depending on the observed performance. The principal then offersthe contract to the agent, who if accepting the terms decide how much effort to putinto the task. Under certain circumstance it will be possible for the principal toinduce agents to behave exactly as the principal would if the principal shared theagents skills and knowledge. The trick is to specify payments so that they depend onthe observed outcome of the task -that is to make the agent the residual claimant ofhis own effort.

The contract design becomes somewhat more complex if it is assumed that theoutcome of the task depends one the effort performed by the agent as well as onstate of nature -that is other factors which cannot be influenced by the individualwho carry out the pre specified task. In product development such factors may bechanges in the market conditions for the new product or it may be the externalities inproblem solving activities which arise from interdependencies between componentsin the product. In the case where the agent is risk averse and the principal riskneutral the best solution is to make the agent bear only part of the risk.25

24In the literature on information coordination (Radner, 1992, Casson, 1994, Carter, 1995) focus is oncoordinating the use of valuable tacit knowledge with out any concern for incentive problems. In theprincipal agency literature the tradeoff between agency cost and the use of valuable privateinformation is important not just in connection with activities where agents are expected to have or toaccumulate advantages in task completion but also in connection with parallel search activities wherea principal delegates the right to an agent to search for solutions or to evaluate solutions. In the lattercase complications may arise if the principal had preferred a different solution than that preferred bythe agent had he himself engaged in the search for and evaluation of solutions (see, e.g., Aghion and

Tirole, 1995) .

25It is generally assumed that contracts cannot be renegotiated. This means that when an unfavorable

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It is assumed that the agent as well as the principal is fully aware of the risks and thatthey share expectations of these risks. For many product development activities thisis not a very suitable assumption on which to base a contractual design. In the case ofradical, modular and architectural innovation uncertainty and the complexity of

determining the impact of an innovation makes it difficult to estimate the possibleoutcomes and thus the risk associated with a bad outcome. However, also theassumptions that it is without cost to make a complete specification and monitoringof the activities agents are to perform is often an unrealistic assumption in connectionwith product development.26

As opposed to the principal agency theory the measurement cost branch emphasizethat there are high costs of defining contractual obligations and high costs ofmonitoring the compliance of agent to these obligations. Since principals are actingeconomically rational they only specify and monitor task obligations to an extentwhere marginal cost equal marginal benefits. With respect to product developmentthis implies that tasks are specified in those dimensions which are of value to theprincipal net of the cost of specifying and monitoring contractual specifications. Oneof the consequences of this is that agents often have discretion in more dimensionsthan just the effort they perform.27

In order to reduce incentives to engage in non productive discretionary behavior it isadvocated 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 tothose who are best able to influence the outcome. Barzel (1982, 1989) has argued thatcosts due to shirking and other non productive types of discretionary behavior areparticularly predominant if the value that can be produced varies unpredictablysince then it is more costly to determine what the outcome should have been in anyparticular case. Consequently it is also costly to determine whether one of thecontractual parties have acted discretionary in a way which benefit that party at theexpense 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 fromcarrying 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).

26The costs of specifying and metering task outcomes depends on the extent to which measurementstandards and tests are developed which can be used for the purpose. With more mature technologiesmore standards may be developed and this will greatly reduce contract specification costs.

27Task 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 beundertaken). The choice between these two types of specifications depends on the cost of specifyingand metering input relative to output (Eisenhardt, 1989). It may be least costly to defined tasks interms of input specifications for problem solving activities based on associative operations. Fordetailed 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 ofdefining tasks obligations.

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If design problems are not perfectly decomposable either because the product designis not decomposable or because specialization is taken beyond the point ofindependence in activities one can try to impose decisiveness and decision rules tocreate 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 decisionskills or his tacit knowledge. If decisions are based on one partys tacit knowledgethe 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 inperforming overlapping activities it is harder to identify the best way of allocatingthe residual claimant status since all may have equally possibilities of contributing tothe joint outcome. With this type of team production one is faced with two slightlydifferent incentive problems. One, is to provide team members with incentives toshare information the other, is to provide them with incentives to use the informationin the best possible way. With respect to the former problem Williamson (1985) hasargued that information sharing may better be accommodated within a hierarchicalfirm where it is possible to combine the use of low powered incentives (wagesindependent of effort) with monitoring of the team to induce information sharing.With respect to the latter problem one may rely on a combination of teammonitoring, forcing contracts or tournaments to discipline team members to makethe right use of information.

Now, if there are interdependencies between tasks which are recognized as being apriori unknown to the designers sequential adaptation of tasks (Williamson, 1985)may be the least costly way of reducing the consequences of the externalities whichare due to these interdependencies30. However, sequential adaptation betweeninterrelated activities may be costly in terms of search for the right information andin terms of defining the proper terms of information exchange. In order to reducesuch transaction costs transfers of information may have to be organized within thestructure of a Coasian firm in which low cost adaptation is made possible by the useof an open-ended employment contract where managers have rights to directemployees 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 isnot a perfect solution since the monitor will have incentive to collude with team members in order tohave at least one shirk so that the monitor receives the residual (Miller,1992 ).

30Unknown in the sense that product developers recognize that they have incomplete knowledge(Knight, 1921) of all types of interdependencies.

31Later on Coase (1991) has remarked that he was aware that the analogy between the employmentcontract and the firm could give an incomplete picture of the nature of the firm and advocates for theamendment that .. a full firm relationship will not come about unless several such contracts are madewith 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 caseswhere coordination of a large number of interdependent activities are required.

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arrangement may reduce cost of discovering the nature of interdependencies inproblem solving activities (Foss, 1998). Since managers are responsible for filling outthe holes of the contract in a way which maximize the value of the team output onecan argue that they should be made residual claimants.

Up until now only the negative effects of discretion have been in focus but discretionneed not always result in productivity losses. Discretion may give way for learning

by doing in task completion, which in turn may result in innovations. Innovativeactivities give rise to problems of incomplete contracts since neither can theinnovation be perfectly specified in contracts nor can the kind of activities, whichleads to innovations. However, if it is possible to specify in contract criteria by whichone can judge improvements in the functionality of the product, in the overall designsolution or in the design solutions implemented in the individual components onecan differentiate payments according to the specification. This creates incentives toimprove products.32One will have to be aware that differentiated payments attackattention to those criteria, which are rewarded. Moreover, agents will tend toemphasize development activities where the outcome is easily recognized by theprincipal and where payments are high relative to costs. However, the incentivesystem may have unexpected consequences in terms of misallocated innovativeeffort if specifications are not based on an sufficient understanding of al theimportant interdependencies, if the specification of tasks obligations do not perfectlyreflect all the important characteristics of interfaces between tasks, or if one does notdifferentiate rewards in accordance with the expected net benefit. Another problemarise from the fact that innovations often are based on a recombination of knowledgepossessed by many different individuals and it may be hard to trace ideas toindividuals 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 atleast to some extent depend on possibilities of reducing externalities in taskcompletion. With a modular product design strategy and a fully specifiedarchitectural design it is possible to reduce at least those externalities which arecaused by component interdependencies. When these externalities are reduced onemay -at least to the extent that it is possible to specify tasks in terms of an easilymeasurable output- rely on market transactions and competition as a mean ofdisciplining discretionary behavior. However, to the extent that components arespecific to a certain architectural design there may be both team problems as well as ahold up problem between those who are responsible for the architectural design andthose who deliver components. In that case component supplies may have to be

32 In the incomplete contract literature it is assumed that the outcome of innovative effort cannot bespecified in ways which can be verified by a third party. Therefore, high sunk cost investments ininnovative 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 protectionof 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 whosinvestment contributes most to the joint output.

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organized within firms. Finally, if component development is contingent on tacitknowledge of elements of the architectural design one will have to establishoverlapping teams between the component and the architectural design teams andallocate the residual claimant status to the ones who have to make use of their tacitknowledge. 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 betweenthe physical design of products and the definition and organization of organizationof product development tasks.

It has been argued that the tasks of detailed design should be defined in ways so thatthe technologically separable interface between activities reflect technically separablesub design problems as determined by the physical layout of the product. This wayof defining tasks would economize on bounded computational capacity as well asreduce costs of information and incentive coordination. However, if the aim is torealize full benefits from learning by doing tasks should be defined around activities,which can be repeated in different product development projects and strongdifferences in the underlying knowledge needed to carry out these tasks. In somecases these different requirements may not be fully compatible.33

When it comes to the activities of problem definition and decomposition one maydistinguish between the activities of defining and decomposing the overall problemand the more detailed activities of defining and decomposing sub problems. Withrespect to the former one may benefit from different individuals with differentperspectives on problem definition and decomposition. However, this requires acoordination process of consultation accompanied by the incentive coordinationprovided by monitoring. With respect to the latter kinds of activities there may besome gains in terms of learning by doing and in terms of economizing on boundedcomputational capacity by having different individuals define and decompose subsolutions. However, these benefits may be overruled by the high costs of information

and incentive coordinating if tacit information is needed in order for theseindividuals to make the right choice.

The extent to which the benefits of specialization can be realized depend to a largeextent on the explicit knowledge of interdependencies in products which in turndepend on the complexity of the product design. It has been argued that it is possiblerealizing more of the advantages from specialization with modular product designstrategy relative to an integral product design strategy. This is because a modular

33For 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 andwhich increases learning by doing in carrying out the associative processes. Only costs which are dueto lags and unused capacity may set limits to the amount and kind of specialization in these activities.

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product development strategy strives for a more simple design based on explicitknowledge of interface constraints.

The argument has relied on sources and ideas that are arguably somewhat unusualin 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 ofmeasurement costs and principal/agent theory. This mixed bag of influences andideas has allowed to me analyze the organization of modular product design strategy

in a novel way namely in the comparative-institutional mode of analysischaracteristic of organizational economics and to pinpoint how this strategy allowfor greater advantages in specialization. Moreover, I have devoted ample space todiscussions of the costs of these strategies, a topic that is arguably somewhatneglected in the literature. Future research will more intensively address aspects oforganizational learning in connection with integral modular product designstrategies, as well as a deeper inquiry into the issue of how modularity influences themarket/firm choice (the boundaries of the firm issue). The present paper representsonly a first stab at these important issues.

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REFERENCESAghion, Philippe and Jean Tirole (1995), Some Implications of growth forOrganizational Form and Ownership Structure, European Economic Review, 39, 440-455.

Alchian, Arman A. and Harold Demsetz (1972), Production, Inf