Chapter 8 Globalizing the Value Chain Infrastructure

8.1 Core Competencies

Core competenciesUnique capabilities that allow a firm to build a competitive advantage. represent unique capabilities that allow a company to build a competitive advantage. 3M has developed a core competency in coatings. Canon has core competencies in optics, imaging, and microprocessor controls. Procter & Gamble’s marketing prowess allows it to adapt more quickly than its rivals to changing opportunities. The development of core competencies has become a key element in building a long-term strategic advantage. An evaluation of strategic resources and capabilities must therefore include assessments of the core competencies a company has or is developing, how they are nurtured, and how they can be leveraged.

Core competencies evolve as a firm develops its business model and incorporates its intellectual assets. Core competencies are not just things a company does particularly well; rather, they are sets of skills or systems that create a uniquely high value for customers at best-in-class levels. To qualify, such skills or systems should contribute to perceived customer benefits, be difficult for competitors to imitate, and allow for leverage across markets. Honda’s use of small engine technology in a variety of products—including motorcycles, jet skis, and lawn mowers—is a good example.

Core competencies should be focused on creating value and should be adapted as customer requirements change. Targeting a carefully selected set of core competencies also benefits innovation. Charles Schwab, for example, successfully leveraged its core competency in brokerage services by expanding its client communication methods to include Internet, telephone, offices, and financial advisors.

Hamel and Prahalad suggest three tests for identifying core competencies. First, core competencies should provide access to a broad array of markets. Second, they should help differentiate core products and services. Third, core competencies should be hard to imitate because they represent multiple skills, technologies, and organizational elements.Prahalad and Hamel (1990, May/June).

Experience shows that only a few companies have the resources to develop more than a handful of core competencies. Picking the right ones, therefore, is the key. A key question to ask is, which resources or capabilities should be kept in-house and developed into core competencies and which ones should be outsourced? Pharmaceutical companies, for example, increasingly outsource clinical testing in an effort to focus their resource base on drug development. Generally, the development of core competencies should focus on long-term platforms capable of adapting to new market circumstances; on unique sources of leverage in the value chain in which the firm thinks it can dominate; on elements that are important to customers in the long run; and on key skills and knowledge, not on products.

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.

8.3 The Growth in Knowledge-Based Outsourcing

In the last 20 years companies have outsourced many activities, including manufacturing, back-office functions, information technology (IT) services, and customer support. Now the focus is shifting to more knowledge-intensive areas, such as product development, R&D, engineering, and analytical services.Myers and Cheung (2008, Summer). For example, as noted above, pharmaceutical companies depend on a steady pipeline of new products from R&D. The competitive pressures on these firms to bring out new products at an ever rapid pace to meet market needs are increasing. With it, the pressures on the R&D function are increasing. In order to alleviate the pressure, firms have to either increase R&D budgets or find ways to utilize the resources in a more productive way. There are situations when a firm should consider outsourcing some of its R&D work to contract research organizations or universities, for example, when (a) in-house new product design is ineffective or too slow, (b) the company is plagued by consistent project time and cost overruns, (c) loss of key talent has slowed new product development, (d) there is a need for an immediate competitive response, or (e) when problems of quality or yield reduce R&D effectiveness.

The growth in knowledge-based outsourcing is mainly driven by cost imperatives, but, increasingly, shortages of talent in home markets and the growing availability of skills in nations such as India, China, and Russia play a role. A second driver behind the growth in knowledge-based outsourcing is the increasing “commoditizationOccurs when all competing products or services have adopted the same or similar features or attributes, making them appear virtually identical to consumers.” of standard business processes and IT services, depressing margins on such activities for outsourcers. This has further encouraged service providers to switch to other activities for which profits are potentially greater—including “innovation services” such as new product development (NPD), R&D, and engineering. According to Booz & Company, there has been 95% growth in the provision of such capabilities since the millennium.Bliss, Muelleer, Pfitzmann, and Shorter (2007). At the same time, providers of standardized services have come to recognize that they need to focus on efficiency and more seamless client integration if they are to continue making sufficient returns. By contrast, innovation services, including everything from prototype design to credit analysis, are more complex and client-specific, and therefore are more likely to command a premium.

For companies considering knowledge-based outsourcing, the lack of standardization means that partner vetting is critical and that outsourcers need to consider investing in captive or near-captive operations that can be sufficiently customized. That may mean turning to smaller providers—that is, those with fewer than 500 employees—that are better able to meet exacting requirements. The process of contracting with multiple, small service providers in different parts of the world is challenging. Many companies are still struggling to integrate more standardized processes with their existing core operations. Outsourcing knowledge-intensive activities will involve a whole new level of managerial complexity, potentially upending fundamental notions of how companies see themselves and what they do. Outsourcing vital activities such as prototype design and engineering support will be fraught with risk, with potentially significant downsides. However, organizations will have little choice: the need to identify talent outside the home territory will force them to work with partners overseas, whatever the pitfalls.

Companies that successfully manage knowledge-based outsourcing are looking to create collaborative management models that share responsibilities, risks, and rewards, enabling both sides to reach their objectives. This “comanagement” approach involves outsourcers treating contractors as valued collaborators even in cases where competitors are employing the same company. It will also necessitate joint investment in offshore staff development, helping providers to retain talent and maintain their revenue margins.

Increased use of knowledge-based offshoring could have significant ramifications on how companies are organized. Rather than multinational organizations with business units staffed by expatriate managers and orchestrated from a central headquarters, the organization of the future will be more globally distributed, with managers seeking out talent wherever it is located and plugging in capabilities when needed. Unlike the outsourcing of the past, knowledge-based offshoring is not simply about labor arbitrage; it is about transforming companies into more nimble, flexible entities.

8.4 Risks Associated With Outsourcing

Outsourcing can have significant benefits but is not without risk.Raiborn, Butler, and Massoud (2009) Some risks, such as potentially higher offshoring costs due to the eroding value of the U.S. dollar, can be anticipated and addressed through contracts by employing financial-hedging strategies. Others, however, are harder to anticipate or deal with.

As a general principle, functions that have the potential to ‘‘interrupt’’ the flow of product or service between a company and its customers are the riskiest to outsource. For example, delegating control of the distribution process to an online retailer can result in customers not receiving goods promptly; outsourcing call-center responsibilities can result in customers being dissatisfied with the product or service and, thus, in higher product returns, lower repurchases, or complaints that could endanger the company’s reputation.

The second riskiest type of activity to outsource is one that affects the relationship between a company and its employees. Outsourcing the human resources function, for example, can affect employee-hiring quality; outsourcing payroll and benefits processing can result in information breaches that generate identity theft issues and resultant legal issues; or outsourcing software design can generate a decline in organizational innovation. By contrast, support functions such as accounts payable and maintenance are less risky to outsource because they have few direct links to customers or internal organizational processes.

More formally, risks associated with outsourcing typically fall into four general categories: loss of control, loss of innovation, loss of organizational trust, and higher-than-expected transaction costs.

8.5 Locating Value-Added Activities

The search for growth is a primary driver of manufacturing relocation.KPMG (2009). Emerging economies have significantly higher trend rates of growth than mature economies. This is the inevitable result of the arrival of large-scale capital investment in low-wage and low-cost economies.

This phenomenon is clearly evident in the automotive industry—an industry challenged by low sales growth and declining margins in mature markets. The world’s automotive assemblers want to capture market share in the fastest growing markets of the near future, and they want their chosen suppliers to be with them. Suppliers, for their part, also want to be part of the growth story, serving not only their traditional global Original Equipment Manufacturer OEM customers but also the emerging local automakers that are capturing new markets with low cost and often innovative products, such as China’s Chery Auto and India’s Tata Motors.

Reducing cost is a second powerful driver of manufacturing relocation. A recent survey by KPMG Peat Marwick showed that among companies that are primarily motivated by costs to invest in new markets, the opportunity to lower material costs is considered marginally more important than labor or capital costs.KPMG (2009). This somewhat surprising result reflects the fact that companies still find that the costs of internationally traded raw materials and partially processed commodities, such as automotive steel, remain cheaper in some lower-cost economies. The same survey showed that even if costs can be reduced, companies remain concerned about the cost of complexity that may be introduced when operations become distributed over several locations that may be separated by large distances and may be in numerous jurisdictions. The companies interviewed also cited a wide range of other cost drivers of relocation. These include government incentives, regional interest rates, wages, and trade agreements.

The relative importance of a third driver—innovation—is increasing as the center of gravity of global business activity continues to shift eastward. In the automobile industry, for example, a vehicle manufactured today has, on average, 10 times the number of electronic functions of a vehicle manufactured 10 years ago. But while innovation has intensified, the sales volume to support the costs of this product innovation has failed to materialize. Price and income trends mean that sales volumes are unlikely to be rebuilt in the developed industrial markets; on the contrary, they are likely to fall further. In these markets, the average price of a new car has doubled over the last 20 years, but average incomes have only risen by 50%, and this price-income gap continues to widen, implying further falls in sales volumes if costs cannot be cut.

These trends are driving a multidirectional globalization of innovation in the supplier industry. Established companies in the automotive triad need both to cut the costs of innovation and find new sources of technology and process innovation. Suppliers in emerging economies need to acquire, rather than just develop, technologies and R&D skills in order to gain the innovation critical mass that will allow them to compete as global suppliers.

Companies participating in the KPMG’s Supplier Survey divide roughly equally between those who believe that R&D should be located close to production and those who are happy with geographically separated R&D and production. These responses suggest that a minority of companies plan to relocate R&D to emerging markets, despite cost pressures.

Companies who believe that R&D should be located close to production tend not to be planning R&D relocations. They believe that R&D for process improvement is more important than R&D for application engineering, and their R&D centers are most likely to be located in Western Europe and Asia, followed by North America. In contrast, companies willing to operate R&D centers remote from production are predisposed to relocating production facilities, although most of these companies say that innovation is a less important criterion than cost, growth, or risk.

These primary drivers—the need to find growth, to reduce costs, and to facilitate innovation—must be balanced by a company’s capacity to manage risks. Yet, in many cases, the upside and downside of all these factors may be more subtle or less clear than companies commonly suppose. Where markets offer the promise of growth, companies should consider how consistent that growth would be over the term of the investment. They might consider whether it is necessary to locate in a given economy, or even region, to access the expected growth. Where companies seek to reduce costs, they should also consider whether direct cost reductions in areas like labor and raw materials are accompanied by indirect cost increases in areas like logistics and quality assurance. Where companies seek to facilitate innovation, they should consider whether risks and costs are best balanced by a conservative strategy of centralized R&D or a radical strategy of globally distributed R&D. And, in seeking to manage risks, companies need to understand that globalized operations may offer risk mitigation opportunities through the hedging of production, currency exposure and raw materials sourcing, as well as the increased risk challenges inherent in global operations.

8.6 Partnering

Formulating cooperative strategies—joint ventures, strategic alliances, and other partnering arrangements—is the complement of outsourcing. For many corporations, cooperative strategies capture the benefits of internal development and acquisition while avoiding the drawbacks of both.

Globalization is an important factor in the rise of cooperative ventures. In a global competitive environment, going it alone often means taking extraordinary risks. Escalating fixed costs associated with achieving global market coverage, keeping up with the latest technology, and increased exposure to currency and political risk all make risk-sharing a necessity in many industries. For many companies, a global strategic posture without alliances would be untenable.

Cooperative strategiesStrategies used by firms to complement outsourcing, share risks, and optimize investments while obtaining the benefits that normally accrue from internal development and acquisition. take many forms and are considered for many different reasons. However, the fundamental motivation in every case is the corporation’s ability to spread its investments over a range of options, each with a different risk profile. Essentially, the corporation is trading off the likelihood of a major payoff against the ability to optimize its investments by betting on multiple options. The key drivers that attract executives to cooperative strategies include the need for risk sharing, the corporation’s funding limitations, and the desire to gain market and technology access.Harbison (1993).

8.7 Points to Remember

1. Globalizing a company’s value creation infrastructure—from the sourcing of raw materials and components to manufacturing and R&D to distribution and customer service—has three primary dimensions: (a) deciding which activities to perform in house and which ones to outsource, to whom and where; (b) developing the right partnerships to support a company’s globalization efforts, and (c) implementing a suitable supply-chain management model for integrating them into a cost-effective, seamless, value-creating network.
2. Core competencies represent unique capabilities that allow a company to build a competitive advantage. Experience shows that only a few companies have the resources to develop more than a handful of core competencies. Picking the right ones, therefore, is the key.
3. Few companies, especially ones with a global presence, are self-sufficient in all the activities that make up their value chain. Growing global competitive pressures force companies to focus on those activities that they judge 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.
4. Outsourcing and offshoring 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.
5. In the last 20 years, companies have outsourced many activities, including manufacturing, back-office functions, IT services, and customer support. Now the focus is shifting to more knowledge-intensive areas, such as product development, research and development, engineering, and analytical services.
6. Outsourcing can have significant benefits but is not without risk. Some risks, such as potentially higher offshoring costs due to the eroding value of the U.S. dollar, can be anticipated and addressed through contracts by employing financial hedging strategies. Others, however, are harder to anticipate or deal with. Risks associated with outsourcing typically fall into four general categories: loss of control, loss of innovation, loss of organizational trust, and higher-than-expected transaction costs.
7. The search for growth is a primary driver of manufacturing relocation. Others include cutting costs and innovation.
8. Formulating cooperative strategies—joint ventures, strategic alliances, and other partnering arrangements—is the complement of outsourcing. For many corporations, cooperative strategies capture the benefits of internal development and acquisition while avoiding the drawbacks of both.
9. The key drivers that attract executives to cooperative strategies include the need for risk sharing, the corporation’s funding limitations, and the desire to gain market and technology access.
10. The Boston Consulting Group divides alliances into four groups on the basis of whether the participants are competitors or not and on the relative depth and breadth of the alliance itself: expertise alliances, new business alliances, cooperative alliances, and M&A-like alliances.
11. BCG found that while new-business alliances compose a clear majority (over 50%), expertise-based alliances are most favored by the stock market, and M&A-like alliances are least favored. The latter is not surprising since such alliances are created in response to unfavorable regulatory or market conditions.