Knowledge Capital Writedown at Boeing?

According to a story from the Seattle Times, Boeing’s Dreamliner is bogged down in problems.

A top Federal Aviation Administration (FAA) official 10 days ago warned Boeing that without further proof of the plane’s reliability, it won’t be certified to fly the long intercontinental routes that airlines expect it to serve.

Meanwhile, on the production side, one veteran employee on the 787 said he’s witnessing “the perfect storm of manufacturing hell.”

The global supply chain is at a standstill, and outside the Everett factory the rows of partly finished jets will take many months to complete.

But really, what’s going on here is a breakdown of Boeing’s outsourcing strategy, and a possible breakdown of Boeing (BA) as well. As the story notes,

Boeing has bet its future on the 787, which made its maiden flight one year ago. The company aimed to reduce the cost and risk by outsourcing an unprecedented share of manufacturing and design work to partners around the globe.

It’s the first new Boeing jet in more than 15 years, and the first airliner built largely from light, tough carbon-fiber-reinforced composite plastic. And it’s been a marketing blockbuster: Despite a total of 120 cancellations, Boeing still has 846 orders.

Yet the 787 has run into more trouble than any previous Boeing jet.

The company’s original internal target for its own development costs was $5 billion. But with yet another delay, several Wall Street analysts estimate that fixing the litany of manufacturing problems, plus paying penalties to suppliers and airlines, has piled on an additional $12 billion to $18 billion.

In the short run, outsourcing may have increased the risks and costs rather than decreased them. Part of the problem is low quality of parts from partners who were supposed to shoulder a lot of the burden.

Horizontal tails poorly built by Alenia in Italy are still being reworked. With the workmanship on the tails varying from one plane to the next, mechanics have to painstakingly customize the fixes plane by plane.

These problems can all be fixed, at a cost.  In the longer term, the outsourcing strategy may be exposing Boeing to “knowledge capital writedown.”  In a long Harvard Business Review blog post about a year ago,  Dick Nolan, a professor at the Foster School of Business at the University of Washington  wrote:

But there’s a dark side to this story. In trying to keep down Airbus, Boeing may be creating a much more dangerous competitor, one that likely will come from Japan, China, or India — countries that will own the markets for new airplanes in the near future and are in various stages of building their own commercial-airplane-manufacturing industries.

To finance the development of the 787 and secure global orders, Boeing agreed not only to outsource an unprecedented amount of the plane’s parts to partners in Europe, Japan, and China, but also to transfer to them unprecedented know-how. Before the 787, Boeing had retained almost total control of airplane design and provided suppliers precise engineering drawings for building parts (called “build to print”). The only exception was jet engines, which have long been designed and manufactured by suppliers such as GE, Rolls-Royce, and Pratt & Whitney.

The 787 program departed from this practice. Boeing effectively gave Tier 1 suppliers a large part of its proprietary manual, “How to Build a Commercial Airplane,” a book that its aeronautical engineers have been writing over the last 50 years or so. Instead of “build to print,” Boeing provided suppliers with performance specifications for parts and components and collaboratively worked with them in the design and manufacturing of major components such as the wing, fuselage section, and wing box

The first shoe may have just dropped, as  Commercial Aircraft Corp of China has just taken the first set of orders for the C919, a potential competitor to the immensely profitable Boeing 737.

China’s new competitor to Boeing’s 737, the C919, landed 100 orders in the first day of the Zhuhai Air Show in China on Nov. 16, including orders from GE Capital Aviation Services, based in Stamford, Conn., as well as several Chinese carriers.

The Chinese carriers include Air China, China Southern, China Eastern and Hainan Airlines.

All of these have been customers for Boeing’s 737, with Air China ordering 20 of the aircraft during 2010. The fact that the C919 is now winning orders raises the question of to what degree the Chinese aircraft will now start replacing 737s and A320s for new orders.

Knowledge capital writedown.

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About Michael Mandel 126 Articles

Michael Mandel was BusinessWeek's chief economist from 1989-2009, where he helped direct the magazine's coverage of the domestic and global economies.

Since joining BusinessWeek in 1989, he has received multiple awards for his work, including being honored as one of the 100 top U.S. business journalists of the 20th century for his coverage of the New Economy. In 2006 Mandel was named "Best Economic Journalist" by the World Leadership Forum.

Mandel is the author of several books, including Rational Exuberance, The Coming Internet Depression, and The High Risk Society.

Mandel holds a Ph.D. in economics from Harvard University.

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