A Chinese firm is currently designing a rough equivalent of the iPad, Apple’s smash-hit tablet computer. The Chinese version is expected to retail for about $80, or a fifth of the iPad’s $499 base price at launch. A European carmaker is also midway through a new design — for vehicles targeting several emerging markets. The company is borrowing design features and manufacturing ideas from its joint venture partner in India. And Fiat Brazil’s Fiat Mio, an urban-targeted compact car, is being designed in Brazil for global markets.

Product development efforts at these three companies underline an accelerating trend of sourcing innovation from within mostly large, rapidly developing economies for end users in home markets, but also for export, including to the developed world. Once viewed as low-cost copycats, companies from China, India and Brazil are moving up the value chain, creating innovative products with global appeal. Ignore them at your own peril — especially as a new “two-speed” world emerges. This duality is characterized by high incomes but slow GDP growth in the developed countries of Western Europe, the U.S. and Japan; and explosive GDP growth but low household incomes in rapidly developing economies — most notably China, India and Brazil. This parallel dynamic is likely to continue for years. In this article, experts from Wharton and The Boston Consulting Group (BCG) look at the importance of innovation as a source of competitive advantage in this two-speed world.

Innovate to Differentiate

To compete in both the high- and low-speed worlds, companies need a fundamentally better value proposition than their competitors so that customers are willing to switch. Taking market share is the name of the game, either from established incumbents in the developed world, or to gain a foothold in rapidly growing economies. Customers need a reason to do business with your company — either a lower price or a better mousetrap.

New products and services are important differentiators in both markets, but especially in slower growing developed economies. “In the low-growth (typically Western) markets, the primary way for companies to grow is to gain share,” says Joe Manget, senior partner at BCG and global leader of the firm’s operations practice. “They can’t rely on market or population growth to drive their revenue growth.” And share gain requires fundamentally better products and services, especially given the pace and intensity of emerging market competitors entering the developed markets, says Manget. As a result, companies will need to focus more on innovation and product development. “We need better products, faster, at a lower cost.”

It’s not just a matter of creating lower cost, scaled-down products for developing nations and premium ones for mature markets, says Christian Terwiesch, Wharton professor of operations and information management. For one thing, Western markets have a growing population of people who cannot afford high-value, high-cost products. Job losses and the weak employment market, a result of the economic downturn, have exacerbated that trend. High personal debt, a weak housing market and high health care costs have changed the complexion of markets in developed countries.

Jim Andrew, a senior partner in BCG’s Chicago office and head of the firm’s global innovation practice, agrees with this assessment. “Given the slow growth and the stagnating real incomes in much of Europe, the U.S. and Japan, affordability continues to move up the list of most important buying criteria. That is one reason why many of the innovations that occur in high-growth countries will also be applied rapidly back into developed markets.”

The Call of Growth in Emerging Economies

For many western companies, the size of these emerging markets is a major attraction, but the growth potential is an even bigger driver, says BCG’s Andrew. “Companies love growth. Wall Street and other equity markets greatly reward it. But most Western companies still have about 75% of their sales in the developed markets, which most observers believe will have a growth rate only in the low single digits,” he notes. “At that rate, your stock is essentially a fancy bond disguised as a stock. Real growth needs to come from somewhere else if you want to increase your market value.”

The big question for many Western companies in developed markets is where to find that growth, Andrew says. “There are really three places you can find it. You can take market share in your established markets, which generally requires strong innovation capabilities. The second option is to buy your growth through acquisitions, but that comes with all the deal risks and integration problems that cause most M&A efforts to fail.” The third option is to build positions in the high-growth emerging markets of China, India and Brazil, among others, including some in the Middle East. But that is easier said than done.” To successfully compete in rapidly developing economies, where Western companies typically have much lower market shares and much less well-established positions, they must bring something new to the party. Frequently, that involves innovation, Andrew points out. “They often can’t rely on their strong brand names, they usually don’t have go-to-market and distribution strengths, and they rarely have the lowest costs.”

Sachin Nandgaonkar, partner and director at BCG India, believes it makes sense for Western companies to partner with Indian collaborators to develop products well suited for the two-speed economy. “In many cases, it is about leveraging the existing Indian product platform to improve offerings for the Indian market and to open new markets in other emerging economies. The partnerships can also help Western companies access some niche market segments in developed countries,” notes. “The idea is to leverage the Indian platform, test it for suitability in other markets, make the required modifications and build a cost-competitive global supply chain.” Emerging markets can offer double-digit growth opportunities.

Low Costs Are Still a Draw

Cost advantages, of course, are often the immediate drivers for multinational companies sourcing innovation from high-growth countries. The manufacturing cost for the $80 Chinese version of the iPad now in development is about $40, says Idris Mootee, CEO of Idea Couture Inc., a design consulting firm. His company is working with a Chinese manufacturer of telecom equipment on the product. How are they able to knock off so much cost? “It is a combination of factors. There are some savings on quality control and even more savings on customer service — there is no 1-800 number to call,” he says. “Also, there are no marketing, branding or R&D budgets. It is extremely lean manufacturing.” The Chinese manufacturer expects to earn gross profit margins of up to 40%.

Low costs are also helping Narayana Hrudayalaya, a hospital chain based in Bangalore, attract a steady stream of international patients, says Ravi Aron, a senior fellow at Wharton’s Mack Center for Technological Innovation. In this case Westerners are drawn to the hospital’s high quality and low prices — which more than offset the travel costs.

Narayana Hrudayalaya has perfected a way to deliver cardiac surgery at dramatically lower costs than in Western countries. India’s health care industry “does not need a magic pill or the fastest scanner or a new procedure,” the nine-year-old hospital chain’s founder, Dr. Devi Shetty, told India Knowledge at Wharton. Instead, it requires improvements and innovations that lower costs and make medical services more widely available. He calls his model “the Walmart approach.”

Cardiac surgery in the U.S. costs about $50,000, compared to $5,000 to $7,000 in India. Shetty attributes his hospital chain’s lower costs to a combination of process improvements, lower construction costs, and bulk buying of equipment and supplies from vendors. He now wants to build a series of 5,000-bed “health cities” across India. “We want to have 30,000 beds in the next five years,” says Shetty. “As our volume increases, we will get further economies of scale. In the next five years we want to be able to do a heart operation for $800 from point of admission to point of discharge. We believe it is possible.”

Aron points to other examples:

  • Aravind Eye Care System, a chain of hospitals based in Madurai, India, has fine-tuned its processes to deliver low-cost eye surgeries and related treatments at a fraction of what they would cost in developed countries. Last year alone, Aravind says it performed more than 300,000 eye surgeries and examined more than 2.5 million patients.
  • GE Healthcare cuts the price of its medical imaging system by 10 % by making it in Bangalore vs. in the U.S. By manufacturing the system locally for local markets, it speeds deliveries, reduces waiting periods and further boosts sales. “The innovations from here could lead to an entirely new line of products, which in turn could create whole new market opportunities for us,” notes John Dineen, GE Healthcare’s president and CEO.

Scaling Down to Scale Up

Western companies sourcing innovation from high-growth countries might start small, but could have big gains further down the road, says Aron. “Initially, companies profit by creating lower-cost products for developing markets. Some of these will remain just that — lower cost products that find a mass market in the large, populous markets of the developing world.” But an equally important aspect of innovation is increasing the value of these products by improving their performance without increasing the cost — a process Arun calls “scaling down to scale up.”

Notes Arun, “The first step of the scale-upwards movement is actually scaling down; that is, creating a radically different, much lower-cost product that is a simpler version of the sophisticated product sold in developed economies. The next step is to take this scaled-down product and start increasing quality without adding significant cost. The resulting “scaled-up” product begins to resemble the original, more sophisticated offering sold in developed markets, but at a far lower cost.” In later stages, it is easier to start adding features — while holding down costs — to this scaled down version rather than trying to lower the costs of manufacturing of the sophisticated product. “By starting at the opposite end, pruning the cost of manufacturing the original product in the first-world market, you might get a 4%-8% improvement at best,” Aron says. “By taking a completely different product and scaling it up, it is far more likely that the performance to cost ratio will see an order of magnitude change.”

Sourcing design and innovation from low-cost, high-growth countries is about more than cutting engineering and manufacturing costs. It extends to reconfiguring products to increase flexibility. Besides the cost savings, Mootee says his Chinese client is looking to improve the “Apple user experience … by 50% by freeing users from the world of iTunes,” Apple’s online music store. Says Mootee: “There are lots of people who like Apple but don’t like the idea that they have to buy music only from Apple. They would like an open-source equivalent.” The product will be on the market before mid-2011, he adds.

Also on tap for 2011 is Fiat Brazil’s novel design for an urban concept car. Fiat Brazil is developing the Fiat Mio (or “My Car”) using input from a public “suggestion box” posted on the company’s website. Fiat launched this innovative, “crowd-sourcing” approach in early 2009, with a goal of unveiling the new car’s design in the fall of 2010 at the International Automobile Show in San Paulo.

Few companies, even among big Western multinationals, have a clear strategy for how to tap opportunities in emerging-country markets, and suffer from a myopic, “U.S.-centric” mindset, contends Mootee. But some companies, like Siemens of Germany, have well-calibrated plans. Inspiration struck Siemens’ global CEO Peter Loscher after he visited India and drove around New Delhi in the $2,500 “people’s car” developed by India’s Tata Motors for the local market. Not long after the visit, Siemens announced a plan to invest US $3.7 billion in India, China, Russia and Brazil to develop more than 80 “base level” products for “financially constrained markets,” according to a report in the Financial Times. Those products will include wind-power generators, voltage switchgear, traffic management systems and steam turbines, and will cost 70% less to develop, the report says. The entire innovation effort could increase Siemens’ Indian sales alone 10-fold, it adds.

Making Innovation Work at Both Speeds

Innovations in design and manufacturing can flow comfortably in both directions, as India’s Tata Motors showed with its recent acquisition of Jaguar Land Rover of the U.K. Europe’s tough emission standards will force Jaguar Land Rover to look at smaller engines — such as those already made by Tata Motors, notes P.M. Telang, the company’s managing director, in an interview with The Economic Times. At the same time, Tata Motors will use Jaguar Land Rover’s expertise in design to reduce engine noise and vibration, and to make cars that are more sophisticated than its current offerings, which include the Nano, the Indigo sedan and the Indica hatchback. In fact, the two companies plan to look at jointly developing engines.

Having a local presence also helps companies find needed skills and talent, says BCG’s Andrew. “Talent is a real driver in many of these cases.” The big advantage is “being able to attract and hire talent that knows the market better and has the necessary technical skills. Some of the more developed markets have a shortage of certain types of technological talent,” he notes. This is less of a problem in some of the emerging, high-growth economies, which have a tremendous number of highly qualified technical graduates. According to some projections, India will graduate 600,000 engineers, mathematicians, technicians, and scientists by 2010, while China will produce 800,000 graduates with engineering and other technical degrees in the same time period. By contrast, the U.S. graduated about 75,000 engineers in 2008.

As companies from developed markets increasingly turn to emerging economies for innovation and talent, they must weigh the pros and cons of various business models. When does it make sense to set up a wholly owned R&D operation overseas, for instance, rather than partnering with an established local player? Is it smarter to start with a technical or marketing collaboration or a licensing arrangement, and take equity stake later, if things work out?

“It’s all about managing tradeoffs,” Andrew says. Ownership and control issues come to the fore, especially when intellectual property rights are involved. “The question is, what tradeoff do you want to manage? If you want to do everything yourself, that’s perfectly fine and there are many reasons why a company might want to do that. But you are also likely to have some challenges around speed, resources and managerial bandwidth if you go it alone,” he contends. “Are those challenges worth dealing with for what is likely to be more control over the outcome and a lower risk of losing valuable intellectual property?” The answer varies by company and situation.

Aron offers these guidelines:

  • When intellectual property is at risk, companies tend to own the innovation-producing business unit, as is often the case in China.
  • Companies are unlikely to share ownership with third-party innovation partners whose chief strength is in navigating local regulations.
  • A local partner that understands how to get an innovation to market and get quick feedback will likely be used as a distribution channel. The innovating company will retain ownership.
  • Innovation may be a joint activity when the local partner offers significant product insight and/or is skilled at creating new products. For example, Cisco’s partnership with India’s HCL Technologies is more of a “peer-to-peer” relationship.

Companies like Procter & Gamble tend to acquire smaller companies with innovative products. “P&G is as open to innovations that come from its own labs as it is to innovations from the labs of the companies it acquires” Aron says.

Copy-paste vs. Reapplied Learning

The regional cross-fertilization of innovative ideas is as exciting as it is challenging. But BCG’s Andrews cautions that any back-and-forth exchange stands less chance of success if it is merely transactional. “Western companies that source innovation from developing countries should be aiming for more than just a cheaper product for their home markets,” he says. Just as it’s often difficult to take a product designed for developed markets and copy-paste it successfully into an emerging market, it’s equally difficult to copy-paste in the other direction. The real gains, according to Andrews, “come through deeper insight into the techniques and capabilities of innovators in developing countries that can be applied more generally in developed markets — and are therefore more sustainable.”

And those insights should come from as many sources as possible. “If you believe the next high tech idea will come from Silicon Valley, chances are you’re right, but it is a dangerous strategy to pursue,” says Terwiesch. It might just come from the engineering student that dropped out of some university in India or China.” A good innovator will identify multiple sources of ideas from different parts of the world and then isolate the best ideas through a process of elimination and filtering. Companies that understand and are quick to internalize these new realities will gain a leg up on those who wait for herd instincts to kick in down the road.