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8.2 To Outsource or Not to Outsource

Few companies, especially ones with a global presence, are self-sufficient in all of the activities that make up their value chain. Growing global competitive pressures force companies to focus on those activities they judge as critical to their success and excel at—core capabilities in which they have a distinct competitive advantage—and that can be leveraged across geographies and lines of business. Which activities should be kept in house and which ones can effectively be outsourced depends on a host of factors, most prominently the nature of the company’s core strategy and dominant value discipline.Special report on outsourcing (2006, January).

In principle, every functional or value-adding activity, from research to manufacturing to customer service, is a candidate for outsourcingThe performance of a functional or value-adding activity by an outside firm.. It is hard to imagine, however, that operationally excellent companies would consider outsourcing activities that are critical to the efficacy of their supply chain. Similarly, companies operating with a customer-intimate business model should be reluctant to outsource customer-service-related functions, while product leaders should nurture their capacity to innovate. That is why Toyota made continuous investments in its production system as it globalized its operations, Procter & Gamble focused on strengthening its world-class innovation and marketing capabilities as it expanded abroad, and Wal-Mart continued to refine its supply-chain management capabilities.

Firms tend to concentrate their investments in global value chain activitiesActivities that provide strategic flexibility and contribute to an international firm's competitive advantage. that contribute directly to their competitive advantage and, at the same time, help the company retain the right amount of strategic flexibility. Making such decisions is a formidable challenge—capabilities that may seem unrelated at first glance can turn out to be critical for creating an essential advantage when they are combined. As an example, consider the case of a leading consumer packaged-goods company that created strong embedded capabilities in sales. Its smaller brands showed up on retailers’ shelves far more regularly than comparable brands from competitors. It was also known for the efficacy of its short-term R&D in rapidly bringing product variations to market. These capabilities are worth investing in separately, but, together, they add up to a substantial advantage over competitors, especially in introducing new products.

Outsourcing and offshoringThe transfer of component manufacturing and support services to foreign locations to reduce value chain costs so that a firm can focus on its core business activities. of component manufacturing and support services can offer compelling strategic and financial advantages including lower costs, greater flexibility, enhanced expertise, greater discipline, and the freedom to focus on core business activities.

Lower Costs

Savings may result from lower inherent, structural, systemic, or realized costs. A detailed analysis of each of these cost categories can identify the potential sources of advantage. For example, larger suppliers may capture greater scale benefits than the internal organization. The risk is that efficiency gains lead to lower quality or reliability. Offshoring typically offers significant infrastructure and labor cost advantages over traditional outsourcing. In addition, many offshoring providers have established very large-scale operations that are not economically possible for domestic providers.

Greater Flexibility

Using an outside supplier can sometimes add flexibility to a company such that it can rapidly adjust the scale and scope of production at low cost. As we have learned from the Japanese keiretsuA loose confederation of related firms. and Korean chaebolA large South Korean conglomerate firm, typically family-owned. conglomerates, networks of organizations can often adjust to demand more easily than fully integrated organizations.

Enhanced Expertise

Some suppliers may have proprietary access to technology or other intellectual property advantages that a firm cannot access by itself. This technology may improve operational reliability, productivity, efficiency, or long-term total costs and production. The significant scale of today’s offshore manufacturers, in particular, allows them to invest in technology that may be cost prohibitive for domestic providers.

Greater Discipline

Separation of purchasers and providers can assist with transparency and accountability in identifying true costs and benefits of certain activities. This can enable transactions under market-based contracts where the focus is on output rather than input. At the same time, competition among suppliers creates choice for purchasers and encourages the adoption of innovative work practices.

Focus on Core Activities

The ability to focus frees up resources internally to concentrate on those activities at which the company has distinctive capability and scale, experience, or differentiation to yield economic benefits. In other words, focus allows a company to concentrate on creating relative advantageA firm’s ability to maximize the economic value of its distinctive competitive capabilities or proprietary access to resources. to maximize total value and allows others to produce supportive goods and services.

While outsourcing is largely about scale and the ability to provide services at a more competitive cost, offshoring is primarily driven by the dramatic wage-cost differentials that exist between developed and developing nations. However, cost should not be the only consideration in making offshoring decisions; other relevant factors include the quality and reliability of labor continuous process improvements, environment, and infrastructure. Political stability and broad economic and legal frameworks should also be taken into account. In reality, even very significant labor cost differentials between countries cannot be the sole driver of offshoring decisions. Companies need to be assured of quality and reliability in the services they are outsourcing. This is the same whether services are outsourced domestically or offshore.