Innovation and exports of vietnamese SMEs evidence from firm level data

The influence of subcontracting activities on the innovation

UNIVERSITY OF ECONOMICS

December 5, 2017

ERASMUS UNVERSITY ROTTERDAM

HO CHI MINH CITY

INSTITUTE OF SOCIAL STUDIES

VIETNAM

NETHERLANDSTHE

VIETNAM – THE NETHERLANDS
PROGRAMME FOR M.A IN DEVELOPMENT ECONOMICS

THE INFLUENCE OF SUBCONTRACTING
ACTIVITIES ON THE INNOVATION IN VIETNAMESE
SMALL AND MEDIUM-SIZED ENTERPRISES

A thesis submitted in partial fulfillment of the requirements for the degree of
MASTER OF ARTS IN DEVELOPMENT ECONOMICS
By
NGUYEN QUANG HUNG

Academic Supervisor:
LE VAN CHON PhD.

HO CHI MINH CITY, December 2017


The influence of subcontracting activities on the innovation

December 5, 2017

ABSTRACT
This study investigates the impact of subcontracting activities on the
innovativeness of Vietnamese subcontractors in Small and Medium-Sized
Enterprise (SME) sector. The study approached two main theories of
transaction cost (TCE) and knowledge-based theory. The data was drawn
from the rich data set of Vietnamese SMEs in 2015. The empirical test used
the probit model to examine 271 subcontractors to give the evidence that
subcontracting activities with the foreign-invested contractor are likely to
innovate rather than with domestic contractors. In addition, the results have
suggested that the absorptive capacity is very important for innovation of a
small firm. In this thesis, based on the paper of Cohen and Levinthal (1990),
the formation of the absorptive capacity is generated by skilled staffs and
training activities in the firm. The findings showed that the innovative
probability of subcontractors is positively affected by subcontracting
activities in foreign-invested sectors and the absorptive capacity.
Key words: knowledge, innovation, subcontracting activity, Vietnamese SME
ABBREVIATION
FDI

Foreign direct investment

LEs

Large firms

MNCs

Multinational Corporations

OECD

Organization for Economic Co-operation and Development

R&D

Research and Development

SOEs

State-owned enterprises

SME

Small and Medium-sized Enterprise

TCE

Transaction cost economics

TFP

Total factor productivity

The influence of subcontracting activities on the innovation

CHAPTER 1.

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INTRODUCTION 4

1.1

Research context ................................................................................ 4

1.2

Problem statement............................................................................. 5

1.3

Research objective ............................................................................. 8

1.4

Research question .............................................................................. 9

1.5

Scope of the study .............................................................................. 9

1.6

Structure of thesis.............................................................................. 9

CHAPTER 2.

LITERATURE REVIEW .................................................... 10

2.1

Theoretical framework ................................................................... 10

2.2

Innovation in subcontracting ......................................................... 12

2.3 The role of the subcontractor in the supply chain and its
innovative capability ................................................................................. 15
2.4

Transaction cost theory (TCE) ...................................................... 20

2.5

Knowledge-based theory................................................................. 23

2.6

Empirical review ............................................................................. 32

CHAPTER 3.

3.1.

DATA AND RESEARCH METHODOLOGY .................. 34

Data and sample .............................................................................. 34

3.1.1

Small Medium – sized Enterprises (SMEs) ............................... 34

3.1.2

Data of Vietnamese Small and medium-sized enterprises ......... 35

3.1.3

Sampling ..................................................................................... 36

3.2.

Definition and classification ........................................................... 37

3.2.1

Definition of Innovation ............................................................. 37

3.2.2

Definition of Subcontracting ...................................................... 39

3.3.

Research methodology .................................................................... 41

3.3.1

Transaction cost approach .......................................................... 42

3.3.2

Knowledge-based approach ....................................................... 43

3.4.

Analytical frmework ....................................................................... 48

3.5.

Variables and measurement ........................................................... 48

3.5.1

Data description .......................................................................... 48

3.5.2

Dependent variable ..................................................................... 50

3.5.3

Independent variables ................................................................. 51
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3.5.4
3.6.

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Description of variables and expected sign ................................ 55

Analytical method ........................................................................... 58

3.6.1

Empirical model, estimation method.......................................... 58

3.6.2

The identification strategy .......................................................... 60

CHAPTER 4.

EMPIRICAL RESULT ........................................................ 61

4.1

Descriptive statistics ........................................................................ 61

4.2

Regression Results ........................................................................... 62

4.3

Results interpretation ..................................................................... 63

CHAPTER 5.

CONCLUSION AND POLICY IMPLICATION ............... 72

5.1.

Conclusion ........................................................................................ 72

5.2.

Implications...................................................................................... 74

5.2.1.

Policy implication ....................................................................... 74

5.2.2.

Managing implication ................................................................. 75

5.3.

Limitations ....................................................................................... 75

5.4.

Future research ............................................................................... 76

REFERENCES ............................................................................................... 77
APPENDIX ..................................................................................................... 87

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List of Figure
Figure 1 Theoretical framework ............................................................................. 12
Figure 2. The mutual benefit relationships between contractors and
subcontractors ......................................................................................................... 16
Figure 3. Structure of subcontracting system ......................................................... 17
Figure 4. Knowledge-creation process - SECI model ............................................ 29
Figure 5. The level of subcontractor in chain structure .......................................... 41
Figure 6. Analytical frmework................................................................................ 48

List of Table
Table 1. Summary of advantages of star- and tier-shaped structure ...................... 18
Table 2. Classification of Small-, and Medium-sized enterprises .......................... 35
Table 3. Sample of Vietnamese subcontractors ...................................................... 37

Table 4. The rate of innovation of subcontractors .................................................. 49
Table 5. The rate of innovation of subcontractors of foreign-invest enterprises
of the sample ........................................................................................................... 49
Table 6. Statistic of number of innovators of the sample by type of enterprise ..... 50
Table 7. Statistic of enterprises of the sample classification by total labor
force ........................................................................................................................ 50
Table 8. Independent variables ............................................................................... 55
Table 9. Summarizing the variables ....................................................................... 61
Table 10. Regression Results .................................................................................. 62

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CHAPTER 1.

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INTRODUCTION

1.1 Research context
After nearly three decades, Vietnam officially began to adopt ‘Doi Moi’
(renovation) policy under the pressure in economic reform but until the year
of 1989 Vietnam implement indeed a comprehensive and radical reforming
program; Vietnam has shifted from centrally planned economy to socialistoriented market economy, aims to stabilization and openness. As a result, the
economy experienced rapid growth during the period of the 1990s, Vietnam
became one of the fastest-growing countries in the world with the annual
average growth rate of this period was up to 7.76%1. Vietnam has attained
impressive achievements and succeeded to process of international economic

integration.
Since launching the renovation programme in the early 1990s, small and
medium-sized enterprises (SMEs) emerge as a dynamic force, they account
for a large proportion of Vietnamese enterprises. In line with renovation
policy, they are on top of structured transformation. In the meaning of
development, the reform of economic environment has positively affected
entire Vietnam economy in general and on the development of small and
medium-sized enterprises in particular. Vietnamese small and medium-sized
enterprises and the private sector are continuously the main engines of
contribution to growth in Vietnam economy.
With the dominant force in the economy, small and medium-sized
enterprises are playing a critical role, which has overwhelmed Vietnam
economy’s development. At end of 2015, the number of small and mediumsized enterprises accounts for 98%2 of entire enterprises in nationwide; the
velocity of the number of small and medium-sized enterprises in the period
2000 - 2015 is averagely 18.1%. They are a prime source of job creation,
1

Statistic from Work bank data (2016)
45th Small and Medium Enterprises Working Group Meeting organized 13 September 2017 in Ho
Chi Minh City (link: />2

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wealth distribution, poverty alleviation, and innovation as well. Therefore,
they become an important part of the national development and have been

viewed as the backbone of the economy.
In the early stage of transition, Vietnamese small and medium-sized
enterprises were facing many inherent constraints on an underdeveloped
country, such as lack of production land, capital for business activities,
market information, skilled labor force, modern technology, and investment,
etc. Thanks to the open-door policy, traditional barriers were gradually
detached. Vietnamese enterprises have approached opportunities for
integrating with the rest of the world. In the globalization and technological
information era, the challenge also increases the threat from their counterparts
in international play-fields. These are public issues debating in many
literatures and it is also concerns of many researchers and policymakers.
Theorists and scholars have shown that the innovation is an appropriate
solution for firms to create and maintain the competitive advantage. So,
studying in innovation is necessary for Vietnamese Small and medium-sized
enterprises in the context of globalization.
1.2 Problem statement
In Vietnam, Small and medium-sized enterprises account for a large
portion of total enterprises. The major roles of Small and medium-sized
enterprises in the economic development of a country are job creation,
nurturing the growth of the labor market, and reducing the development gap
among localities, and countries. In their evolution progress, small and
medium-sized enterprises have faced almost constraints and significant
challenges such as high production costs, poor quality of products and
services, low degree of innovation, many difficulties in access finance, weak
management skills and expertise, lack of market information, and so forth.
Competitive abilities of Small and medium-sized enterprises in local and
global markets are also weak due to obstacles of information, domestic and

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international regulations, absorbing and accessing technological advantage,
and so on.
The globalization process has dramatically changed. This process
increases abilities of countries to access new information and markets in both
domestic and international. Vietnamese economy has integrated into the
international economy that has opened a great opportunity for Vietnamese
small and medium-sized enterprises to take part in the production chains.
However, they did not develop full awareness and did not pay adequate
attention to the participation in and appreciate the benefits of participation in
production chains nor take into account it as a tool, a means of survival, of
adding value and of improving the efficiency of their production process.
Moreover, the globalization process gives rise to the capital flows move in
the developing countries, and thus it also increases the opportunities for
foreign countries to take part in the exploitation of the domestic market size,
as a result, the competitive degree becomes larger in the host countries.
However, the globalization and competition commonly do not always create
the threat for enterprises in the host countries. In a certain aspect, the
challenges from the globalization produce motivation for firms to
development by enhancing operational effectiveness and productivity. For
this reason, the ideal ways for the firm to survive are the innovation and
participation in regional and/or global production chains (Harvie, Narjoko, &
Oum, 2010).
The innovation is extremely important for development and sustaining
the productivity, growth, and development of a country in general as well as a
firm in particular. In the macro level, the innovation is the shortest way to fill

the development gap between countries. For firm level, the recognition of
innovation is a vital factor. A large number of studies have documented that
innovation is a key driver to lead an increase in competitive advantages.
In the last decades, most studies of creativeness and/or innovativeness in
enterprises concentrate on exploiting the relationships between innovation
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and trade, innovation and productivity, or finding the determinants effect on
innovation. In fact, studies of the relationship between the innovation and
subcontractor are a little, especially in the developing world. Subcontracting
activities are becoming a key factor of industrialization in most countries in
the world. In the Organization for Economic Co-Operation and Development
(OECD) countries, subcontractors are crucial elements for establishing
production

value

chains.

The

integration

companies

require

their

subcontractors having the innovativeness to contribute to value chains.
Contractors and subcontractors together set up an ecosystem, which is formed
industrial clusters for development and enhancing competencies. In which,
innovative activities are a primary concern.
In Vietnam, subcontractors are firms that almost take part in the
processing, assembling, or manufacturing peripheral products for large
companies (e.g. multinational corporations), or foreign direct investment
(FDI) enterprises. Excluding several industries that involved the foreigninvested sector, most domestic manufacturing enterprises have operated in the
low added-value industries. In addition, most subcontractors lack the
cohesion or it is very weak. Accordingly, their competitive and innovative
capabilities are low (even in cognition). Due to low innovative ability,
Vietnamese small and medium-sized enterprises concentrate on low laborcost or labor-intensive production activities that they have the competitive
advantage compared to regional counterparts.
Many papers focus on analyzing the role of the subcontractor in
developed countries (e.g. OECD countries) where the development and the
technological degree are very high, and they involve into global value chains
from the initial stages (e.g. design stage) to ultimate stages (e.g. end-used
product stage). Studies of the manufacturing subcontractors in Vietnamese
small and medium-sized enterprises sector are virtually rare. Most research of
Vietnamese small and medium-sized enterprises accrue to the subcontracting
activities in supporting industries (automobile, electronics, and electricity). In
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these industries, enterprises are relatively mature and larger than small and
medium-sized enterprises. Besides, some existing theories cannot be applied
to examine the innovativeness of the Vietnamese small enterprises due to the
knowledge and technology gap. Therefore, this study will contribute
significant findings and open the new direction to attract policy-makers,
scholars for deeply study in this field in order to enhance competencies of
Vietnamese small and medium-sized enterprises in general and the
subcontractor in particular.
1.3 Research objective
Since the innovation plays the important role in the survival and
maintains the competitive advantage for the subcontractor, so the main
objective is to explain the innovativeness of them through subcontracting
activities. For that reason, the thesis will discuss the issue involved the
subcontracting activities of Vietnamese subcontractor in the SME sector
through subcontracting agreements and investigate their knowledge-creation
abilities through the absorptive capacity that enhance the innovation
likelihood of the firm.
Firstly, the thesis will examine the innovativeness in subcontracting
activities of the subcontractor through subcontracting agreements. In which,
the subcontracting relationships, with contractors in the domestic and foreigninvest sectors, are separated into two groups. Based on that, the thesis
specifically assesses the subcontracting activities at which sector are more
likely to innovate. Secondly, the thesis will investigate the innovation of
subcontractors across building the knowledge base that will form the
absorptive capacity of the firm. More specifically, the thesis examines the
elements of quality management, education, and training activities will
contribute to the absorptive capacity.
Based on the literature, the thesis will conduct other determinant factors
that affected the innovation of the firm. Next, a regression model will be built

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to test the influence of subcontracting activities on the innovativeness of
subcontractor in the SME sector. In addition, the thesis will suggest
implications that may support to improve the development of subcontractors
in particular and entire Vietnamese SMEs in general.
1.4 Research question
For the reasons that mentioned above, this thesis aims to evaluate the
innovativeness of the subcontractor and draw implications for helping them to
recognize and build an appropriate strategy for the innovation process.
Accordingly, the research question of this thesis is:
How do subcontracting activities influence on the innovativeness
of Vietnam Small and Medium-sized enterprises’ manufacturing
subcontractors?
1.5 Scope of the study
To achieve objective, this thesis mainly concentrates on exploring the
effect of subcontracting activities on innovation decision of the subcontractor
in manufacturing sector of Vietnamese small and medium-sized enterprises.
The data used for this thesis extracted from the rich dataset of Vietnamese
small and medium sized enterprises survey in 2015.
1.6 Structure of thesis
After introduction chapter, the rest of thesis structured as follows.
Chapter 2 provides the literature review in general and empirical review of
innovation and subcontracting activities. Chapter 3 presents the methodology
and modeling strategies. Chapter 4 presents the empirical results and chapter

5 is the conclusion.

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CHAPTER 2.
2.1

December 5, 2017

LITERATURE REVIEW

Theoretical framework

In recent years, the globalization process has dramatically changed. This
process increases the ability to access information and new markets in both
domestic and international. As a result, the degree of global competition is
higher, and new formations of organization are shaped to organize the global
value chains (Eurostat, 2005, Lehtinen, 1999; EIM, 2009). On the other hand,
traditional value chains are gradually breaking up to be smaller parts that socalled ‘fragmentation’. Those reasons are giving smaller firms the
opportunities to gain benefit from specialized activities. Ample authors are
convinced that the internal structure of firm is reorganizing to adapt this
tendency. It is believed that information technology is driving the
organizational structure of the large firms to become leaner by reducing rigid
hierarchy as well as narrowing down the size of the firm. The world becomes
flat and firms thus have trends to outsource easily their non-core activities to
their subcontractors (Lahtinen, 2001) or their labor-intensive production
phases to low-cost countries, such as China or India (EIM, 2009). Moreover,

according to OECD (2005), the change in organization is to adapt the
technological change and facilitate the innovation processes, as a result, foster
the firm’s performance. Furthermore, both processes of technological change
and internationalization are the platforms for supporting smaller firms involve
innovative activities, as a result, those firms become more flexible and
dynamic (Acemoglu, Aghion, Griffith, & Zilibotti, 2004).
The re-organizing production chain is taken place either inside or
outside of the firms (Chen, 2017). This leads to assign labor reasonably and
thus increases outsourcing incentives. The outsourcing activity becomes more
and more popular in most enterprises. To take the advantage of production
cost, firms decide to outsource their certain functions, non-core production
activities, or even entire production stages to external providers. These
activities have made the current economic environment, in which
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organizational structure of enterprises and global value chains completely
changes, are reorganized more efficiently than ever.
On the view of the contractor, plenty of research has indicated the
reason behind the outsourcing decision of the firm. According to Abraham
and Taylor (1993), employers take into account to rely on outside suppliers to
perform their in-house production processes for at least three reasons. First, a
firm with high labor cost is able to contract out to the low labor-cost
organization in order to take benefit. Second, when the output temporarily
highly exceeds firm’s current capacity due to seasonal or cyclical factors the
firm will contract out at the highest period of tasks. In contrast, firm in the

normal status quo encourages keeping the core labor force by not contract
out. Finally, a firm contract out because the suppliers have specialized
services that emphasizes economics of scale rather than another market
factors (Abraham & Taylor, 1993). In another research, the enterprise decides
to outsource when it faces a technical problem in the assembly line or to
smooth at the peak of workload. Moreover, the enterprise may have
subcontractors provide services related to high skill experts, advanced
equipment or specialized parts that they do not possess. This may be the fact
that to enjoy the highest returns the firm pays attention for its own sake by
producing core activities (EIM, 2009).
In the globalization era, when technology and production techniques
have changed rapidly, the product lifecycle becomes shorter (Bayarçelik,
Taşel, & Apak, 2014), and products become more sophisticated (EIM, 2009);
firms thus are facing the fierce competitiveness. Taking into the fact that
innovation is an important factor for companies’ survival. Innovation helps
firms adapt the instability of external environment. Moreover, innovation is
the key driver for creating and maintaining competitive advantage, growth,
and development. As a result, the innovation plays a critical role for firms to
the growth of output and productivity.

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Figure 1 Theoretical framework

SUB CONTRACTOR

SUB CONTRACTOR

SYSTEM
SUPPLIER

OEM

TRANSACTION-COST THEORY
&
KNOWLEDGE-BASED THEORY

INNOVATION

2.2

Innovation in subcontracting

It is well recognized in the literature that innovation plays a central role
to maintain the competitive advantage, productivity, and growth of the firm
or nation. Innovation is an extensive concept that encompasses a wide area of
all aspects of the economy, such as technical, economic, scientific,
technological, organizational, financial and commercial fields and it is
recognized is not just high-technology products. Innovation motivations are
usually expected to create the market power or survival in the severe
competitive markets. Innovation constantly entails the learning, creation,
invention as well as comprises of factors such as new technology, patents,
new manufacturing process, or new creative design. The success of
innovation is the commercialization of new or improved products or services
and proposed new customer value (Carlson & Wilmot, 2006).

At the macro level, the innovation is firstly mentioned by Schumpeter
(1934) and it also has developed in the production function as the studies of
Solow (1957). In the years 1990, Romer (1990) developed the growth pattern
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of economies in the endogenous growth model based on the technology
change. Besides, it also is approached to growth theories of many economists
or in the international trade theory of Krugman (1979). Theories and models
of production have seen innovation as total factor productivity (TFP) to
explain the differences in development through economies. For the developed
countries, they have to keep innovation in order to sustain competitive
advantage and “must continually innovate, not just to grow, but even to
maintain their real incomes” (Krugman, 1979). For the less developed and
developing countries, the progress of new products is mostly slow or, even
not due to the gap of technological development. In those countries, their
technologies are come from developed countries by technology transfer
(Cassiman & Martinez-Ros, 2003). Moreover, based on the learning-byexporting hypothesis, firms adapt new technologies and then take part in
innovation process through the foreign markets by learning from their foreign
contracts or sub-contracts (Palangkaraya, 2012). The paper of Ghazal and
Zulkhibri (2015) shows that through the international trade, firms in host
countries (e.g. developing countries) participate to the process of technology
transfer through foreign direct investment (FDI) flows, joint venture or
multinational companies. In developing countries, FDI attractive strategies
are built on the commitment from local governments, foreign firms are
encouraged to transfer more advanced technologies than multi-national

corporations (MNCs) do for their subsidies. Furthermore, due to the risk of
nationalization in some developing countries technology transfer for
MNCs’subsidies are often older or lower than those in developed countries.
At the firm level, studies of innovation virtually focused on the
definition, nature, research and development (R&D) activities, and
productivity. According to Harris and Moffat (2011), R&D not only induces
innovation but also creates intangible assets for firms through the process of
learning and absorbing new knowledge from research and practices. Cohen
and Levinthal (1990) also share the common view by stating that innovation
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is as a by-product of R&D activities. Innovation is an important factor that
makes the differentiation among firms; innovators thus obtain higher
expected returns than non-innovators do. Owing to the benefit of innovation,
firms have incentives to maximize their profit by seeking investment
opportunities and expanding their markets (Teece, 1986). Moreover,
innovation is taken into account as economic performance of the enterprise. It
is expected that innovation help firms obtain and sustain their competitive
advantage in both domestic and global markets by the monopoly position. On
the other hand, due to the innovative motivation, innovation firms are pricemakers (Hirsch & Bijaoui, 1985) and have choices to decide whether or not
entered in foreign markets (Cassiman & Martinez-Ros, 2003).
In the view of business and marketing, market size and structure are a
key determinant of success. Market-orientation firms have considered doing
the research market to explore potential customer’s needs and wants by using
skills and resources themselves. In this context, those firms can detect new

knowledge and technologies. From that point, new products or improve
existing products or process will be innovated to satisfy customer needs.
Therefore, Le Bars et al. (1998) showed that innovation is a “result of
marketing capabilities”.
While the innovation of the large companies is heavily given rise to
R&D activities and patents, the innovation of small firms mostly has based on
the interaction of external environment and internal force within firms. The
internal force is usually the core-competencies (Cohendet & Llerena, 2005)
that come from entrepreneurs’ abilities and skilled staffs (Avermaete, Viaene,
& Morgan, 2004). For innovation studies in small firms, the innovation has to
be suitable for firm’s attributes and human resources. Moreover,
innovativeness in small firms largely depends on the factors of external
environments, such as information or other inputs. The external environment
is very often related to the information that firms may obtain from their
customers, clusters or from doing market research. There is some evidence
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proved that although the external information supports the innovation it
should be taken into account the relevant sectors and the quality of
information. Therefore, those factors are very important for innovativeness of
the small firms. Some scholars suggested that the QSE (Qualified Scientist
and Engineers) indicator have seen a capability of science and technology
within firms. Yet, other researchers proved that QSE indicators seem less
suitable for firms that are low and medium technology (Avermaete, Viaene,
& Morgan, 2004).

Although

external

business

environment

leads

to

innovation,

entrepreneurs still play the powerful role in innovation recognition.
Avermaete et al. (2004) also state that the innovation recognition of the
entrepreneur is influenced by seminal work of Schumpeter (1934, 1942) and
Mascitelli (2000). He illustrates that entrepreneur’s abilities are very powerful
for small enterprises because their recognition of innovation is very important
to set up the competitive strategies.
2.3

The role of the subcontractor in the supply chain and its
innovative capability

The development of new technologies and production techniques make
enterprises

increasing

the

specialized

capability.

Meanwhile,

the

competitiveness is severe more and more by not only price or quality, but also
by technological features of products and customers’ satisfaction. In this
context, large enterprises, on one hand, tend to focus on activities that create
high adding value, such as R&D, design, marketing and, on the other hand,
delegate specialized subcontractors to take responsibilities for other
production phases. For some reasons, while the large firms actively move out
their resources to the developing world and collaborate with local enterprises
for production, the local enterprises as subcontractors use their own entire
resources to associate with to exploit the economics of scale. On the other
hand, these subcontracting relationships have opened a chance for
subcontractors so that they can take the technology transfer and practiced by
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modern technology and equipment. As results, they have leaned, developed
new skills and characteristics, and increased the competitiveness (Kumar &

Subrahmanya, 2011). Thus, this shapes reciprocal relationships between
prime contractors and subcontractors (EIM, 2009). The mutual benefit
relationships between contractors and subcontractors are illustrated in figure
2 as below.

Figure 2. The mutual benefit relationships between contractors and
subcontractors

Greater market
share

Improved national
& international
competitiveness

Increased
revenue

Job
creation

Greater
organizational
productivity

Economic
of Scale

Product
differentiation

Focus on
strategic and
core activities
(R&D)

I
II

Enhanced labor
& capital
productivity

 Improved quality
 Cost reduction
 Response to
fluctuation

Subcontracting
agreement
Use spare capacity

Job creation

Increased output

Economic of Scale

I – Benefit of Contractors
II – Benefit of Subcontractors

Improved labor &
capital productivity

Source: EIM (2009)

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The relationship between the contractors and subcontractors is important
to build an efficient structure. Two ideal structures is based to organize
subcontracting system are star-shaped and tier-shaped structure (see figure 3)
(Lahtinen, 2001).
Figure 3. Structure of subcontracting system

SC
SC

OEM
SC
System
supplier

OEM

SC

SC
SC

SC

SC

SC

SC

SC

SC

SC
Star-shaped structure

SC

Tier-shaped structure
Source: (Lahtinen, 2001)

 In a star-shaped structure, subcontractors are organized as a wide
network with the original equipment manufacturer (OEM). The
subcontractors and OEM contact directly with each other, in
which the OEM plays the central role in information and material
flows. This structure restricts several indirect subcontractors. The
structure will be efficient if applying in the cases that customer

offers highly fluctuate or environmental change because of easy
shifting.


A tier-shaped structure is organized as a pyramid vertical
organization with multilayer subcontractors. In this structure, the
OEM plays two roles: controlling the end-use products and
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monitoring the first-tier subcontractors. This structure has applied
widely in the assembly manufacturing (automobile, electronics,
aircraft…) during last decades. This is a narrow structure aims to
reduce the number of direct subcontractors and suppliers at firsttier level. The structure is well known as “Toyota model”.
Table 1. Summary of advantages of star- and tier-shaped structure
Advantages of broad networks:
- adaptable to change
- more switching opportunities
- hedge against uncertainty
- cost competitive.

Advantages of narrow networks:
- collaborative innovation
- rigid and strong
- wider access to knowledge
- dense flows of information

- shared destiny
- higher confidentiality.
Source: Harland (1996b)3

The three prime features of the structure of subcontracting system are:
(i) The number of the supply chain
(ii) The structure dimension of the network, and
(iii) The distinct kinds of process nexuses to the other in the supply
chain
During last decades, the structure and evolution of the subcontractor
have been an evident trend towards the tier-shaped structure that is the goal of
OEM to narrow the number of subcontractors and suppliers down because the
large size firms are organized too complexly and difficulty. Therefore, the
tier-shaped structure is being become the best practice model for supply chain
in the case of complex products. The efficiency of information flows of this
model facilitates the technology exchange between OEM and subcontractors
and supports the supply chain participants to manage more easily.

3

Harland C M. (1996b) Supply Chain Management: Relationships, Chains and Networks.

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The subcontractor is, in recent year, not only delegated to produce

peripheral or simple products but also manufactured highly specialized
products required knowledge-intensive contents. In the paper of Bocquet
(2011) found that there ample of studies try to shed light on the new
“collaborate outsourcing mode” based on arm’s length transactions, but little
empirical research shows the subcontractors’ key role (Lahtinen, 2001) and
their capacity of innovative application as well as technology transfer related
to this “new mode” (Bocquet, 2011). It is believed that subcontracting come
to be more important in the production networks. In fact, the role and position
of subcontractors become more crucial in developing innovative solutions
and enhancing firm’s productivity and performance for both themselves and
contractors. However, there is little empirical study was done on this matter
(Lahtinen, 2001; Bocquet, 2011).
There are many basic theories related to approaching the important role
of the subcontractor in the economy. According to Kimura (2001), he
suggested the theoretical background to subcontracting by four approaches.
The first approach is transaction cost theory, the second is networking
approach, the third is game theory approach, and the fourth is the economics
of information approach. In the two first approaches, the author described the
chosen subcontractor was based on its owned specified resources, such as
certain specific-assets, or specialized technologies, or even unskilled labor.
Besides, thanks to the long-term relationship firms might save cost from
market transactions. For the game theory approach, the relationships of
subcontractor rely on the stable and dependent nature of the subcontracting
agreement. The last theory that author mentioned is constructed on the trust
so that the firm can save the monitoring cost. On the other hand, the paper of
Bocquet (2011) presented two approaches to subcontracting. Firstly, similar
to the study of Kimura (2001), she applied transaction cost theory to show
that the subcontracting arrangement is a solely cost-reduction device. In this
case, contractors have seen the subcontractor as traditional and they are
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delegated to produce peripheral products. Yet, in the manufacturing process
itself, the labor assignment and machine arrangement are considered as
innovative operation. For that reason, there is the existing knowledge that
generated by the manufacturing process. Secondly, she approaches the
subcontractor’s process-by-learning bases on abilities of absorption and
creation of knowledge through the relationship between contractors and
subcontractors. In her view, the success of such a relationship is the practices
and tools that guarantee to meet a given requirement.
The role of innovation capability of subcontractors is not mentioned
much in recent studies. In recent years, most research approached the concern
of subcontractor through contractors’ viewpoints it thus skips innovative
abilities of subcontractors (Nobeoka et al., 2002). To assess the innovation
capabilities of the subcontractor it needs empirical and theoretical studies to
explain and shed light on this issue. For this reason, the paper will approach
transaction cost theory and emphasizes the important role of knowledge
creation process of the subcontractor through knowledge-based theory.
2.4

Transaction cost theory (TCE)

According to the transaction cost theory, the economic transactions are
formed by organizational mode that allows firms to compare between internal
cost and external cost in order to make an optimal decision based on the
assumption that human is opportunism and bounded rationality.

In the paper “The nature of the firm”, Coase (1937) explain why firm
exists and first mentions the term “transaction cost”. Previous economists
argued that there was an economic system, in which it automatically operated
by a “price mechanism”. In this context, price mechanism plays the role of
privilege in the allocation of resources. However, in this case, people still
anticipate its operation in the short-term to cope with it. Owing to the
operation of resource allocation, cost of organizing production process is
different for similar products. Coase showed that “there is a cost of using
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price mechanism” to determine “relevant prices” is what he tried to give the
explanation of the reason why the firm was established to substitute this price
mechanism. In the fact that, the long-term contracts took more advantages
than the short-term contracts, thank to reducing risks and transaction costs.
However, the prediction of contingencies was difficult, firm, in this case,
appeared to resolve the short-term problems. This paper also described the
firm’s decisions related to “make or buy” that, if the transaction costs were
higher firm would carry out activities within firm and therefore the firm size
that measured by number of transactions increased. In contrast, outside
provider would perform activities if the transaction costs were lower than the
firm do, as a result, the firm size decreased.
In the perspective of transaction cost economics theory, the firm is
described as an economic organization with incentive is increasing economic
efficiency by reducing transaction costs (Williamson O. E., 1989). Knight
(1941) also stressed that, in general, the economic concern of a person is

commonly expecting their tasks and their business “efficient”.
Williamson (1989) stated that the agents who are participating in
economic transactions have assumed two prominent characteristics of
behavior are, based on the traditional concept of maximization, bounded
rationality and self-interest but opportunism. In the one hand, Herbert Simon
views the behavior of bounded rationality of the economic actors are
“intendedly rational, but only limitedly so” (Simon 1961, p.xxiv). Bounded
rationality of an individual within a firm is a limitation on human mental
abilities and on human language. The former limitation hinders human
abilities from foreseeing entire attainable contingencies and estimating their
best activities. The later obstructs the ideal communicated environment for
known-knowledge.

These

limitations

create

information-exchange

mechanism becomes too costly (Cohendet & Llerena, 2005). Williamson
states that individual human beings have “intended rationality” to their
economizing activities. He also cited the quotes of Herbert Simon [Simon
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(1975, p.199)] that natural nature of human beings is limited knowledge that
“organizations are useful investments for the achievement of human purpose”
(Williamson O. , 1989). On the other hand, self-interest behavior is taken into
account to react to information from external environment. Furthermore, it
encourages a sly behavior and firm thus plans manipulative strategy to take
advantages. Evidently, self-interest behavior expresses as “opportunism”,
“moral hazard”, and “agency” (Williamson O. E., 1989).
Transaction cost differs depending on both (1) the nature of
transactions, and (2) the governance structure. Different transactions require
differences of attributes of transacting purpose. Therefore, governance
structure is established to resolve asymmetric information. According to
Williamson (1989), there are three main dimensions to describe attributes of
the nature of the transaction are (1) the frequency of transaction, (2) the
uncertainty of transaction, and (3) the specificity of assets. Williamson also
emphasizes that although all of them are critical, the specificity of assets is
the most important (Williamson O., 1989). He has classified asset specificity
into five types, including (1) site specificity; (2) physical asset specificity; (3)
human asset specificity; (4) dedicated asset; and (5) brand name capital.
Transaction cost economics also suggests the transaction as basic component
of analysis that requires alternative governance structures to determine
transacting activities. Governance structure is as the way organized to make a
configuration through three ways: (1) the frequency (via market), (2) the
uncertainty degree and type (vertical integration), and (3) the condition of
asset specificity (via contracts).
Similar to principal theory, in the transaction cost theory, the
relationships between firms is asymmetric, and information is imperfect
which allows opportunistic agent to find rent-seeking, so firm needs the
governance structure to avoid these problems. In this perspective, firms are
considered as “processor of information” means that if the input of

information is the same firm will produce the same result of action, However,
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Cohendet and Llerena (2005) have rejected that point and consider firm as a
rational entity (Cohendet & Llerena, 2005). The adoptation of the way to
approach the transaction cost theory as the contractual approach and
behavioral assumption of bounded rationality show that cognitive capabilities
of agents is limited. This approach is obviously extremely restricted; the
assumption seems to ignore learning and innovative capabilities of firms.
Some scholars stated that even in such circumstance the passive learning
process is still taken place by improving processes within firm (Bocquet,
2011; Cohendet & Llerena, 2005). For this reason, it needs complemented
theories to examine this problem in the extensive scope; this allows us to
analyze learning capabilities of firm deeply.
2.5

Knowledge-based theory

In recent years, science and technology are rapidly developing; it is a
foundation to economies and industries to build a new economic growth
model based on the knowledge. For that, science and technological
development lead industries to pace in the new period. The development
trend permits them exploit the advantage of global value chain and the
international market (ADB, 2014). The value chains are requiring a larger
proportion of knowledge than ever. Production and distribution activities of

firms reflect this trend by investing and applying hi-tech equipment, using
skilled labor in order to enhance productivity and growth. Shortly, it is said
that knowledge is a driver of the development of an enterprise, or a country.
Nonaka et al. (2008) state that knowledge and information are similar;
both

knowledge

and

information

have

common

features

as

the

systematicness, replication and reproduction in low cost, externality
(depending on number of people), and they are too hard to evaluate.
Nevertheless, knowledge is not a direct synthesis of information, it is
differentiated other resources by generating from the human interactions. The
knowledge is an extensive concept thus needs to understand in specific sense.
Many theories of information still have viewed organization as a ‘processor
23