(FORTUNE Magazine) – HERE'S the good news: American business's campaign to improve quality is paying off so well that in many areas the Japanese no longer enjoy a clear lead. Now the bad news: While the quality gap narrows, the world's best competitors are suiting up for an even more challenging contest. It's called flexibility, and its watchwords are change fast, keep costs low, and respond quickly to customers. In the race between the U.S. and Japan, guess who's ahead. Says Aleda Roth, a manufacturing expert at Duke University's business school: ''Most American companies are a generation behind -- as far behind as they were on quality.'' The theory behind flexibility is simple. If you and I are competing and I can read the market quicker, manufacture many different products on the same line, switch from one to another instantly and at low cost, make as much profit on short runs as on long ones, and bring out new offerings faster than you -- or do most of these things -- then I win. I can parry your every thrust, attack niches in your market that you're too bulky to squeeze into, improve faster, and maintain or even fatten profits while forcing you to follow my lead on prices. Manufacturers and service companies alike will have to play the game to prosper. Many manufacturers will have to install a sophisticated battery of machine tools called a flexible manufacturing system (FMS), which in a single factory turns out immense varieties of product with computer-controlled robots. All companies will have to overhaul their information systems, methods of developing new products, and other techniques to respond to customers in a quick, versatile, and economical way. To see flexibility in action, look east. That's the message of a revealing study released in July by Deloitte & Touche consultants. They asked 900 U.S. and Japanese companies to describe their key manufacturing strategies. Among the findings:

-- The Japanese stress flexibility. While American manufacturers emphasize product quality (durability, conformance to specifications, and on-time delivery), the Japanese take those as a given. Their focus: more and better product features, flexible factories, expanded customer service, and rapid outpourings of new products.

-- They rate themselves ahead in nearly all aspects of the game, including rapid changes in production methods and the number of new products they can create. That advantage will grow: Japanese manufacturers are about a third more likely than Americans to say increased flexibility figures importantly in their plans.

-- They are committed to staying ahead through advanced technology. From a list of 38 technologies, such as computer-aided design, automated material handling, and robotics, Deloitte & Touche turned up just six in which Americans claimed more experience. Looking toward the future, Japanese companies are 25% more likely to emphasize leading-edge manufacturing, and have bigger investment plans for 33 of 42 advanced techniques. Eventually, flexibility means dramatically changing one's ideas about how to run a business. In a visionary study that drew on people from 77 U.S. companies, the Iacocca Institute of Lehigh University concluded, ''We stand at the threshold of a new era in manufacturing.'' Beyond mass and lean production beckons ''agile production,'' where factories are small and modular and machinery is reprogrammable to make an almost infinite variety of new or customized goods at low unit cost. Says the institute's operations director, Roger Nagel: ''Whatever you thought your breakeven could be, that figure can be a lot smaller today -- usually less than half.'' In an age of demanding consumers, mass production won't cut it. MANY top-flight U.S. companies are working hard to develop these abilities -- Figgie International, General Electric, and Motorola, for example. Baxter Healthcare is testing the ultimate in modularity -- an intravenous solutions factory that can be shipped anywhere, set up in a week, and moved anytime -- and considers itself one of the world's standard-bearers in a mind-boggling technology called ''rapid prototyping.'' In Deerfield, Illinois, Baxter routinely makes working prototypes of complex medical instruments for its Belgian design center, shipping them just 24 hours after receiving the specs. As a group, however, the Americans are no match for their transpacific rivals. The Japanese have invested in flexibility for the better part of a decade, but it's only now becoming clear how strong a weapon it is. Says MIT professor Charles Sabel: ''The strategy is becoming more and more explicit -- to make progress by splitting markets. The goal is a totally plastic production system, one that -- within some reasonable area -- allows a factory to turn out anything.'' Even more exciting (or alarming, depending on whose ox is gored), some manufacturers -- Toyota, for one -- have begun to learn about flexibility what they taught the world about quality: It can actually save money. Japan's flexibility drive was fueled by a boom in capital spending -- $3 trillion in domestic plant and equipment from 1986 to 1991, says Kenneth Courtis, senior economist of Deutsche Bank in Tokyo. Though Japanese investment leveled off as the economy slowed, private industry bought new plant and equipment worth $5,320 a person in Japan last year, vs. $2,177 in America. Those figures are adjusted to reflect the fact that Japan's capital- equipment market is so competitive that prices are 30% lower than in the U.S. No one knows how much of that money went into flexibility, because investments can serve more than one end. But an analysis by Taka Ananuma of the Tokyo office of the A.T. Kearney consulting firm shows that in one area -- spending for information technology -- three out of four manufacturers cited as one of their aims flexibility enhancement through such means as FMS and computer-integrated manufacturing, almost twice the number naming the next-leading purpose (office automation). FLEXIBILITY is an explicit goal at Toshiba, whose $35.5 billion in sales last year came from products as diverse as appliances and computers, light bulbs and power plants. Okay, so the slogan ''synchronize production in proportion to customer demand'' probably made few hearts leap when Toshiba workers first heard it in 1985. The idea, explains Toshiba President Fumio Sato, is to push Toshiba's two dozen factories to adapt faster to markets. Says Sato: ''Customers wanted choices. They wanted a washing machine or a TV set that was precisely right for their needs. We needed variety, not mass production.'' Sato hammered home his theme in an almost nonstop series of factory visits. The key to variety: finding ways to make money from ever shorter production runs. Sato urged managers to reduce setup times, shrink lead time, and learn to make more products with the same equipment and people. He says: ''Every time I go to a plant I tell the people, 'Smaller lot!' '' If that's your creed, says Lester Thurow, dean of the Sloan School of Management at MIT, a visit to Toshiba's computer factory in Ome, 30 miles from downtown Tokyo, ''is like being in heaven.'' Toshiba calls Ome an ''intelligent works'' because a snazzy computer network links office, engineering, and factory operations, providing just-in-time information as well as just-in-time parts. Ome workers assemble nine different word processors on the same line and, on an adjacent one, 20 varieties of laptop computers. Usually they make a batch of 20 before changing models, but Toshiba can afford lot sizes as small as ten. Workers on the lines have been trained to make each model but don't need to rely on memory. A laptop at every post displays a drawing and instructions, which change when the model does. Product life cycles for low-end computers are measured in months these days, so the flexible lines allow the company to guard against running short of a hot model or overproducing one whose sales have slowed. Sato's next goal: to get managers thinking about how to ship small lots fast and cheaply, with quicker feedback from stores, so sales and distribution are as flexible as the factories. He could do worse than check out Kao Corp., Japan's biggest soap and cosmetics company and the sixth largest in the world, with 1991 sales of $4.7 billion. James Abegglen, chairman of Gemini Consulting (Japan), says no company can match the flexibility of Kao's distribution. It derives from a stunning information system that allows the company and its wholly owned ( wholesalers to deliver goods within 24 hours to any of 280,000 shops, whose average order is for just seven items. THE GOAL at Kao isn't flexible manufacturing per se. Rather, says Masayuki Abe, a systems development manager, ''the purpose is to maximize the flexibility of the whole company's response to demand.'' That's done by collecting and distributing data with an Orwellian obsessiveness -- ten gigabytes of it at any one time, enough to fill 128,000 pages of text. One system links everything: sales and shipping, production and purchasing, accounting, R&D, marketing, hundreds of shopkeepers' cash registers, thousands of salesmen's hand-held computers. According to Abegglen, Kao boasts that the information is so complete that its accountants can turn out a year-end closing statement by noon of the first day of the new year.

Some American consumer products companies collect point-of-sale data -- executives may receive information on the previous day's sales, for example -- but at Kao the split-second linkage extends back to the factories and labs as well. Brand managers see daily sales, stock, and production figures. Within a day they can learn if a competitor is running a sale, and adjust accordingly. When Kao brings out a new product, it melds point-of-sale information from 216 retailers with a test-marketing operation called the Echo System, which uses focus groups and consumers' calls and letters to gauge public response faster than market surveys do. Says William Best of A.T. Kearney's Tokyo office: ''Kao can know if a product will be successful within two weeks of launch. They know who's buying it, whether the packaging works, whether to change anything.'' That helps explain how Kao stormed into the highly profitable cosmetics business, going from nowhere to No. 2 in Japanese market share in less than ten years. Kao's network virtually eliminates the lag between an event in the market (Ms. Watanabe buys a bar of soap) and the arrival of the news at the company. That makes Kao less dependent on sales forecasts and buffer inventory. As George Stalk of the Boston Consulting Group, an expert on Japanese corporations, has shown, speedy information lets a company even out production levels and increase variety without drowning in stock; indeed, though Kao makes 564 household products today, vs. 498 in 1987, average inventory as a percent of sales is down to 8.6% from 9.2%. As Toshiba and Kao demonstrate, flexibility comes when information feeds the < ability to exploit it. A flexible factory is useless if you don't know what's selling, and it doesn't help to know the market cold if you can't react to it back in the plant. The plunging cost of computing power, combined with low-cost capital, put flexibility within reach even of second-tier companies in Japan. Take Fuji Electric, Japan's fourth-largest maker of electrical machinery (after Hitachi, Toshiba, and Mitsubishi Electric). Fuji's investment in FMS and the like soared starting in 1987 -- the effort consumes 30% of the capital budget -- as come-hither prices for computers and numerically controlled machine tools coincided with cheap money. Says Takashi Kurihara, senior engineer for production technology: ''We set a target of reducing lead time 30%, labor costs 70%, and work-in-process inventory 50%. We had to, because these are our customers' goals too.'' When Fuji gets an order for an electric motor switch, 20% of the time the buyer wants -- and gets -- 24-hour delivery. Another 40% must arrive within two days. Fuji didn't narrow its product line: Those schedules are for customized work. The thanks go to flexible manufacturing. For example, at its plant in Saitama prefecture, Fuji makes magnetic contactors used to control motors in machine tools. Beginning in 1988, Fuji installed flexible, computer-integrated lines where setup, parts selection, and assembly are all automated using bar codes that tell the machines what to do. Before those lines, Fuji filled orders in three days. Now Fuji needs 24 hours, using one-third as many workers and almost one-third less inventory -- making about 8,000 varieties, three times more than before. Investment in flexibility isn't cheap, but over time it can save money. That's counterintuitive for managers raised to seek economies of scale. Flexibility offers economies of scope -- the ability to spread costs across many products. Frank Andrusko, vice president of Amoco Fabrics & Fibers, has seen the contrast. His company and Nisseki Plastics, a Nippon Oil subsidiary, are partners in a joint venture to make nonwoven fabric used to strengthen foil and paper packaging. ''We like long runs,'' he says. ''We use the same equipment, but they make very short runs at higher cost, with more differentiation that lets them get a higher price.'' The two also approach customers differently: ''Their salespeople don't carry data sheets describing what's available. They ask, 'What do you want?' then make it. They need more people in research than we do.'' Scale will always matter, but economies of scope have awesome, and sometimes superior, power. Explains Joel Goldhar, a professor at the Illinois Institute of Technology business school: ''Compared with a million-unit factory, a two- million-unit factory will always be more economical. But a factory that makes 10,000 units of 200 different products can be just as economical -- and with customization you can get unique products, which means monopoly prices.'' In a flexible factory, scale and scope reinforce each other. No more vivid example exists than the auto industry. Japanese carmakers are rebuilding the heart of their factories to become even more versatile and labor-efficient -- an effort that could once again give them fundamental cost advantages and protect their lead in the time and cost of bringing new cars to market. Both Toyota and Nissan have zeroed in on the body assembly process, the stage where the separate stampings that make up underbody, side panels, cowl, and roof are welded together. This ''body in white'' is then rustproofed, painted, and sent to final assembly, where the engine, seats, and controls go in. Body assembly is the least flexible stage of production and therefore the point of greatest leverage; it is also a big user of time and money in model changes. For example, Ford shut two truck plants for the summer to retool for new models. While many American auto plants still devote a production line to a single model, Toyota began installing flexible lines in the mid-Eighties. Toyota director Mikio Kitano, a bearded, voluble production engineer, says there is no theoretical limit to how many body types these lines can handle, ''but four is good enough.'' Counting sunroofs and other options, that might mean 20 variations. The secret: ''intelligent pallets,'' computer-controlled fixtures each programmed to hold the panels for a different model. The pallets work in rotation, picking up parts for various models as they come down the line and holding them together to be tack-welded by robots. A line can weld a Camry one minute, a Lexus the next, then a Crown, with no pause. Setting up for a new model takes half the man-hours it used to, just four months -- vs. nine of old -- while the line continues to manufacture other cars; when all is ready, only one shift is needed to get a new model rolling with the others. As these lines went in, Toyota's capacity utilization climbed steadily, from 75% in 1982 to 95% today. The main reason, says Kitano: the one-shift model change.

Nissan's high-tech Intelligent Body Assembly System, or IBAS, accomplishes the same thing, though its ultimate ambition is more vaulting. Japan's No. 2 carmaker installed its first IBAS in Tochigi, north of Tokyo, in 1989; now it's in place at three other factories in Japan and in Smyrna, Tennessee. The heart of the IBAS is a cluster of 51 robots that grasp body parts, line them up to an accuracy within 0.1 millimeter, weld them, and inspect them, all in 46 seconds. In principle, they can be of any kind; on average, Nissan builds three models in each IBAS, some with several body types. IT TAKES three months to prepare a Nissan factory for a new model (it used to take 12), mostly to program robots and set up peripheral operations while the line keeps running. Says Yoshitada Sekine, engineering general manager at Nissan's plant at Zama, near Yokohama: ''It will one day be possible for data created in Japan to be transmitted by phone or satellite and begin production of a new model simultaneously in any plant in the world.'' Nissan describes its strategy as ''five anys'': to make anything in any volume anywhere at any time by anybody. IBAS is a big step toward the goal, says Sekine: ''Minimum economic scale is now linked to the total output of a plant, not the individual model.'' That is, an IBAS can handle about 20,000 cars a month, but it doesn't much matter which models use the capacity. As U.S. automakers think about dropping whole car lines, Nissan is gearing up to fill market niches with more lines. In 1981, Honda, its supremacy in motorcycles challenged by Yamaha, countered by introducing 113 new or revamped models in just 18 months. Yamaha cried uncle after managing 37 changes, announcing it was content to be No. 2. Will a similar ''variety war'' break out in cars? Says George Stalk of BCG: ''I don't think they can stop. The war's destroying Saab, Renault, and Volvo. For GM and Ford, it's come down to new products -- if they blink, they're gone.'' THE MINISTRY of International Trade and Industry (MITI) has prodded Japan's carmakers to slow their model changes. With all Asia before them like a ripening honeydew, why risk worse political heat in the U.S. and Europe? But model changes mean less as more cars are built to customer specifications. And history suggests that the Big Three ought not to count on their rivals' forbearance. Even without a variety war, the Japanese will gain immensely from flexibility. The new lines cost more to build (10% more at Toyota, 20% at Nissan), but a single model change pays more than the difference due to lower tooling and other costs. Toyota claims a 60% saving compared with its old lines. Greater capacity utilization has saved Toyota the cost of building five production lines, and the company predicts that the number of workers on the body lines will fall 30% by 1994 from its level in 1986. By then, Toyota says, total savings will top half a billion dollars. When it comes to hardware for flexible manufacturing, the Japanese lead is, if anything, widening. Okuma Corp., which makes the world's broadest machine- tool product line in two factories in the hills outside Nagoya, sells 14 flexible manufacturing systems in Japan for every one it exports to America. Though U.S. purchases of industrial robots are at record highs, Japan has already installed 390,000 to America's 45,000, according to Donald Vincent, executive vice president of the Robotic Industries Association. Brian Carlisle, CEO of California robot maker Adept Technology, says this represents a 15- to 20-year lead unless the U.S pace picks up dramatically. Eric Mittelstadt, CEO of GMFanuc Robotics, a U.S.-Japanese joint venture that makes robots, says that when American companies automate, they tend to favor fancy, special-purpose lines to speed mass production rather than flexible systems or inexpensive robots that can be configured to serve many purposes. The $40 billion that GM spent on automation in the 1980s is a classic example but not unique. It took a major effort by managers and employees at GE Appliances in Kentucky to coax versatility out of inflexible labor-saving equipment bought a decade ago. Just having the right equipment isn't enough, though; more important is how you use it. Six years ago Harvard business school professor Ramchandran Jaikumar reported that the typical American company with an FMS used it to turn out ten different items, Japanese companies 93. Says George Stalk: ''We're still seeing that in spades. If you spend $700,000 on a big machining center, the factory manager wants to get his utilization rate up. So he uses it for his highest-volume products, defeating the purpose of the investment.'' That wouldn't happen if U.S. companies saw flexibility as a strategic asset. Most don't, says Eric Mittelstadt, the robot maker: ''Few of our customers have thought this through. They usually have a specific project in mind, like a model change, rather than a plan to use robotics to make the whole process flexible.'' For a flexible manufacturer, the focus of competition begins to shift. Capital spending matters less when a factory can change its product line by upgrading and reprogramming existing equipment rather than by replacing it: Witness the 60% drop in the cost of tooling up for a new model on Toyota's body assembly lines. The savings show up in lower prices or enhanced features, or can be directed upstream to R&D and downstream to customer service. Japanese companies surveyed by Deloitte & Touche plan to emphasize both lower-priced products and those with high R&D content -- a formidable pairing. Hitachi, Toshiba, Fujitsu, Canon, and others now spend more in R&D than on plant and equipment. They can afford to because of flexible factories, says Fumio Kodama, professor of innovation policy at Saitama University near Tokyo: ''The introduction of FMS has paradoxically brought about the situation in which we will not have to worry about manufacturing anymore.'' Follow the money, economist Courtis says: ''The objective of the unprecedented level of investment in innovation and R&D is clearly to become the world's new-product laboratory -- the role the U.S. had in the Fifties and Sixties.'' Can America catch up? Absolutely, say Craig Giffi, Gregory Seal, and Douglas Shinsato, who conducted the Deloitte & Touche study. And now's the time. They say manufacturing follows an unavoidable progression from product quality (doing it right) through reliability (always doing it right) and only then to flexibility -- adding variety and speed. Many U.S. companies can take that step. Says Adept Technology's Carlisle: ''We spent the Eighties on the basics -- inventory management, quality control, reducing bureaucracy -- stuff the Japanese did in the Sixties and Seventies. Most of that is out of the way now.'' Just in time, as a window of opportunity opens. Fortunately for their competitors, Japanese companies have pushed the pause button as their economy struggles and industry adjusts to a post-bubble financial market. Also, says Paul-Josef Lantz of Baring Securities in Tokyo, the flexibility of Japan's industry has overwhelmed its transportation network. Just-in-time deliveries of ever smaller quantities of ever more goods have clogged roads, forcing some companies to curtail variety proliferation. In response, the Ministry of / Transport says it will spend more than $3 trillion in the next ten years on automated distribution centers and rail, harbor, and road improvements -- encouraged by the U.S. government in the mysterious belief that the investment will help America compete. (At least it isn't corporate investment, the theory goes, and U.S. contractors might win some business.) When Japan catches its breath, its companies will roar back. To exploit this fleeting moment American companies must acknowledge that quality is just a start. The flexibility wars are coming. It's not hard to know you're in one, says Eric Mittelstadt: ''You see your competitor making lots more products, but he's still meeting you on price, and he's still making a profit, and he's starting to beat you on the content -- to get a technology lead -- because he can make changes quicker.'' If that's happening to you -- or could -- you'd better get going.

CHART: NOT AVAILABLE CREDIT: FORTUNE CHART/SOURCE: DELOITTE & TOUCHE CAPTION: FLEXIBILITY RANKS HIGH IN JAPAN'S MANUFACTURING STRATEGY, BUT NOT IN AMERICA'S