Strategic benefits and problems Outsourcing may face the organization with a range of benefits and problems. Cost reduction Cost reduction has been the predominant motive for outsourcing (Ford et al. , 1993), the decision taking the form of a make-or-buy decision that was largely addressed through accounting information. While outsourcing contracts commonly target a minimum of 15 percent cost saving and sometimes 20-25 percent (Lankford and Parsa, 1999) failure to achieve anticipated cost improvements is a frequently occurring aspect of outsourcing (Cross, 1999; Darling, 1999).
The level of achieved saving may average 9 percent, although a large proportion of outsourcing clients may only break even or even find their costs increase (Embleton and Wright, 1998). Ketler and Walstrom (1993) provide further evidence for the underachievement of cost reduction targets, finding that initial vendor bills were usually 20 percent higher than anticipated due to a low vendor estimate and/or honest misunderstanding of the contract. On occasion in-house supply can provide lower costs (D’Aveni and Ravenscraft, 1994).
Large organizations may find prospective suppliers unable to match their own internal economies of scale and many specialist suppliers may have an effective scale that is no greater than that of their customers (Alexander and Young, 1996). Even if outside suppliers possess greater efficiency, cost savings may not be obtainable when a few vendors dominate a specialized market (Greer et al. , 1999). While outside supply can reduce cost, there are examples of organizations, such as Harley Davidson, that have reduced cost by reinstating in-house supply (The Economist, 1991).
To achieve reduced cost while maintaining standards requires that the supplier has access to superior cost drivers, such as economies of scale, learning and low cost locations. However account also has to be taken of transaction costs, the costs of search, negotiation and contract enforcement, which may be greater for highly differentiated services and components. In addition there is the need to ensure that, following outsourcing, the outsourced activity’s associated overhead is reduced (Bettis et al. , 1992).
Consideration also needs to be given to the longer term effects of developments in the supply market, the implications of any increase in monopoly power and the developing knowledge possessed by successful bidders that may be used in future negotiation. Access to superior quality In principle outsourcing can provide access to “best in the world” quality for particular activities or components (Quinn et al. , 1990). However, in the absence of fully developed service level monitoring the development of quality may on occasion be illusory.
On occasion organizations may experience a lowering of service standards requiring the service to be redeveloped in-house. Jennings (1996) cites the case of building society security services being repeatedly returned to in-house supply following disappointment with the standard of successive external providers. The use of external supply can also imply a reduction in the opportunities with which to achieve differentiation through the use of more widely available activities and components (Alexander and Young, 1996). Flexibility
Outsourcing presents organizations with the opportunity to avoid the constraints of their own productive capacity in meeting changes in the volume of sales. In situations where the pattern of sales displays seasonal or cyclical characteristics the penalties of under used in-house capacity may be avoided. However care has to be taken in ensuring that a viable supply base is maintained that is capable of meeting peak levels of demand. The adoption of lean supply by Boeing has at times resulted in the company being unable to meet cyclical increases in the demand for aircraft.
Lacking sufficient in-house production capacity the company has found that attempts to increase capacity have resulted in their drawing resources away from the company’s suppliers (The Economist, 1997). The potential for improved flexibility may apply not only to the volume of output but also the ability of the organization to change the product range in response to market conditions. Within fashion apparel retailing Richardson (1996) describes how rapid information exchange, rather than ownership of the various stages of production, enables companies to respond to the industry’s short life cycles and abrupt changes in fashion.
Such an approach allows The Limited to achieve delivery of product to its stores within 1,000 hours of design conception. Focus, leverage and diversification A number of authors (including Quinn et al. , 1990) emphasise the benefits of outsourcing in providing increased focus upon a set of core activities and reduction in the functional scope of the organization, enabling the development of a more focused organization capable of increased responsiveness to market change. The complementary use of outside resources can also provide opportunities for enhanced leverage of the organization’s core resources.
In the garment industry Benetton has sustained (1982-1997) an average annual sales growth of 14 per cent developing a network of 7,000 franchised sales outlets in 110 countries. While Benetton directly employs 6,000 people the company provides work (through outsourced manufacture and franchised sales outlets) for an additional 70,000 (Frery, 1999). The use of outsourcing may also facilitate the development of economies of scope through product diversification (Reve, 1990). This may be achieved indirectly, through reduced functional complexity and greater focus upon core activities facilitating the development of product/market complexity.
More obviously, organizations in the course of diversification may choose to buy-in activities, expertise and components that they lack or would find it inappropriate to develop. Such development occurred throughout the UK financial services industry during the 1990s as many building societies increased their product range. Similarly many of the diversifications undertaken by the Virgin group of companies involve the use of joint ventures and outsourcing, serving to avoid industry entry barriers, lower risk and provide a speedier response to market opportunities.
Loss of critical skills and knowledge, appropriating final product value While an organization’s managers may share a concern to avoid outsourcing core or near core activities (Jennings, 1997), the frequent absence of formal policy guidelines (Jennings, 1996) can allow the incremental loss of key competencies to take place and hence undermine capability leading to a loss of critical skills, cross function working and creation of the “hollow corporation” (Bettis et al. , 1992).
As a consequence cross-functional processes, such as innovation, may become more difficult. This is illustrated by situations where manufacturing and retailing are undertaken by separate organizations; retailers have a greater opportunity to develop knowledge of customer demand and may come to see manufacturers as out of touch with market developments (Howe, 1998). The use of outside supply may also provide a situation in which there is a leakage of critical knowledge concerning processes and customers leading to the creation of potential competitors.
Within the automobile industry the extensive use of components suppliers has enabled a number of component producers to develop to a stage where they are capable of themselves becoming producers of entire vehicles (The Economist, 1998). Such outsourcing enables car companies to concentrate upon their core products, such as high-volume vehicles, but also furthers the ability of component producers to enter the car market with their own vehicles. Within the fashion apparel industry The Gap used backward integration to transform itself from one of Levi’s largest customers to one of its strongest competitors (Richardson, 1996).
Vertical development can be seen as an attempt by organizations operating at the various stages of production to appropriate a greater share of industry value (Cox, 1999). Such developments can reoccur over a prolonged period of an industry’s history. Within the US cinema industry film studios have periodically entered the cinema industry as first-run exhibitors of their films, at times controlling all stages of the distribution chain from studio (manufacturing), film exchanges (wholesaling) to movie theatres (retailing) (Wolfe, 1994).
The need to develop the organization’s own sourcing strategy While it is clear that within certain industries, such as the motor industry and apparel retailing, there has been a general development towards the use of outside supply, the correct balance between vertical integration and the use of outside supply will differ between industries (Van Hoek, 1999), firms within an industry (Blumberg, 1998) and product characteristics (Fisher, 1997). An organization’s sourcing strategy needs to reflect the organization’s own approach to developing competitive advantage and its business context.
Appendix 2 contrasts the competitive and sourcing strategies followed by two companies within the home games industry. The make-or-buy decision: a contextual model A wide literature is available concerning factors influencing the decision to provide an activity in-house or through outside supply. The model provided in Figure 1 proposes that the decision needs to focus upon the consequences for competitive advantage, with competitive advantage being based upon a matching of capability to conditions in the competitive environment (Kay, 1993; Hofer and Schendel, 1978). The model helps to provide a structure for he complex set of factors to be evaluated when considering the outsourcing of non-peripheral activities. Competitive environment An organization’s sourcing strategy needs to be consistent with competitive conditions and the development of competitive advantage (Quinn and Hilmer, 1994; Harrigan, 1986). The short-term implications of the sourcing strategy can be assessed by use of Porter’s (1980) model of industry analysis. Appendix 3 examines the implications of a particular in-house strategy, the combination of in-house manufacture and retailing by Thorntons, a specialist company in the UK chocolate confectionery industry.
The analysis shows the effectiveness of the sourcing strategy in meeting the structure of the industry, but in a number of ways it is a static analysis that does not explore the implications of the strategy for resource leverage and hence development, the effects of (seasonal) demand variation upon the company’s use of manufacturing and shop capacity, nor the ability of the strategy to respond to the longer term consumer and competitive changes that come to change the structure of an industry. The level of environmental uncertainty may affect the sourcing decision.
Harrigan’s (1985) study concluded that uncertainty concerning final product demand and volatile competition can mitigate the advantages of in-house investment through presenting the risk of over-capacity. Seasonality may require development of the product range, as practised by Thorntons (Appendix 3), to provide a more constant annual sales pattern. Market saturation and decline indicate the need to readdress product characteristics and capabilities. In the event of decline the reduced asset base provided through outsourcing provides a reduction in exit barriers. [pic]
Figure 1 The outsourcing decision [pic] Figure A1 Thorntons: sourcing, strategy and industry structure References Appendix 1. Outsourcing the value chain In principle, outside supply can be used to provide the entire range of value chain activities: • Inbound logistics. In a range of industries, from supermarkets to automobile manufacture, suppliers provide quality assurance and stock holding. • Operations. In producing the Smart car Daimler Chrysler outsourced the assembly of the car to an operation based upon seven factories, each occupied by a different systems partner.
Previous to this development assembly had been regarded as a core competence in the automobile industry (Time, 1999). • Outbound logistics. Physical distribution can often be provided through an external contract. • Marketing and sales. While brand is often part of an organization’s unique value creating activity, market research, the development of promotional material and media buying are often outsourced in order to access specialist expertise. In developing sales, franchising can provide a rapid growth of sales outlets. • Service.
After sales service may be delivered by a third party, as in the use of the Halfords motor parts and service chain to provide service support for Daewoo customers. • Procurement. Firms can access specialist buying knowledge and economies of scale in purchasing through outside supply and collaborative activity. Thorntons, the chocolate manufacturer and retailer, purchase liquid chocolate from a specialist outside supplier, providing access to purchasing economies beyond those available through an individual firm’s requirements.
Similarly small financial service providers have formed software user groups to provide a forum for discussing developments and to reduce the cost of purchased software. • Technology development. Within the motor industry, three-quarters of the engineering for a new Toyota or Nissan is undertaken by suppliers (The Economist, 1998). • Human resource management. While it is desirable to retain labour relations, employee relations and performance management in-house, a wide range of HR activities, such as training (but not its design) may be outsourced (Greer et al. , 1999). • Firm infrastructure.
The familiar use of outside consultants for strategy development, planning and reorganization has been extended to include aspects of treasury management as a means of accessing specialist skills in areas of increasing complexity. Appendix 3. Thorntons: combining manufacture and retailing in the confectionery industry Thorntons, the UK’s largest manufacturer and retailer of specialist chocolates, was founded in 1911 by Joseph Thornton. From the beginning to the present day Thorntons has devised its own recipes, self-manufactured confectionery and operated its own retail outlets.
Thorntons believes its competitive features include a fresh tasting product, made to closely guarded recipes with high quality ingredients, good service, the in-store personalization of some products such as Easter Eggs and a strong brand name. The core products compete in the ? 5 to ? 10 gift market against the products of retailers such as Body Shop and KnickerBox, floral gifts and postal gifts of wine and seasonal products. A total of 30 percent of Thorntons sales are made in the (six-week) Christmas sales season, a further 25 percent of sales are for Easter, Valentines Day and Mothering Sunday.
The company operates 390 own shops together with 110 franchised outlets in secondary locations. A company owned shop can cost ? 80 to ? 100,000 to fit-out, with the investment written off over four years for wear and tear. Manufacturing investment is also substantial during 1997-1999 the company invested a total of ? 53m in manufacturing, warehousing and till systems. In 1996 Thorntons appointed a new chief executive who concluded that the company’s existing shops appeared “tired and increasingly off-pitch”, many were too small and in poor locations. Thorntons’ directors adopted a “retail led” strategy.
By October 1996 a three-year plan had been developed to rapidly increase the number of own shops, their size and sales. The product range was also to be developed to provide a wider range of products with a greater emphasis on everyday sales. The company would continue to make 70 percent of its products, outsourcing the manufacture of the more basic chocolate bars and recently introduced sugar based confectionery products. Figure A1 shows the sourcing, strategy and industry structure of Thorntons. http://www. emeraldinsight. com/Insight/ViewContentServlet? Filename=Published/EmeraldFullTextArticle/Articles/0010400103. html