Strategic Outsourcing

Two new strategic approaches, when properly combined, allow managers to leverage their companies’ skills and resources well beyond levels available with other strategies:

• Concentrate the firm’s own resources on a set of “core competencies” where it can achieve definable preeminence and provide unique value for customers.1
• Strategically outsource other activities — including many traditionally considered integral to any company — for which the firm has neither a critical strategic need nor special capabilities.2

The benefits of successfully combining the two approaches are significant. Managers leverage their company’s resources in four ways. First, they maximize returns on internal resources by concentrating investments and energies on what the enterprise does best. Second, well-developed core competencies provide formidable barriers against present and future competitors that seek to expand into the company’s areas of interest, thus facilitating and protecting the strategic advantages of market share. Third, perhaps the greatest leverage of all is the full utilization of external suppliers’ investments, innovations, and specialized professional capabilities that would be prohibitively expensive or even impossible to duplicate internally. Fourth, in rapidly changing marketplaces and technological situations, this joint strategy decreases risks, shortens cycle times, lowers investments, and creates better responsiveness to customer needs.

Two examples from our studies of Australian and U.S. companies illustrate our point:

• Nike, Inc., is the largest supplier of athletic shoes in the world. Yet it outsources 100 percent of its shoe production and manufactures only key technical components of its “Nike Air” system. Athletic footwear is technology- and fashion-intensive, requiring high flexibility at both the production and marketing levels. Nike creates maximum value by concentrating on preproduction (research and development) and postproduction activities (marketing, distribution, and sales) linked together by perhaps the best marketing information system in the industry. Using a carefully developed, on-site “expatriate” program to coordinate its foreign-based suppliers, Nike even outsourced the advertising component of its marketing program to Wieden & Kennedy, whose creative efforts drove Nike to the top of the product recognition scale. Nike grew at a compounded 20 percent growth rate and earned a 31 percent ROE for its shareholders through most of the past decade.
• Knowing it could not be the best at making chips, boxes, monitors, cables, keyboards, and so on for its explosively successful Apple II, Apple Computer outsourced 70 percent of its manufacturing costs and components. Instead of building internal bureaucracies where it had no unique skills, Apple outsourced critical items like design (to Frogdesign), printers (to Tokyo Electric), and even key elements of marketing (to Regis McKenna, which achieved a “$100 million image” for Apple when it had only a few employees and about $1 million to spend). Apple focused its internal resources on its own Apple DOS (disk operating system) and the supporting macro software to give Apple products their unique look and feel. Its open architecture policy stimulated independent developers to write the much-needed software that gave Apple II’s customers uniquely high functionality. Apple thus avoided unnecessary investments, benefited from its vendors’ R&D and technical expertise, kept itself flexible to adopt new technologies as they became available, and leveraged its limited capital resources to a huge extent. Operating with an extremely flat organization, Apple enjoyed three times the capital turnover and the highest market value versus fixed investment ratio among major computer producers throughout the 1980s.3

How can managers combine core competency concepts and strategic outsourcing for maximum effectiveness? To achieve benefits like Nike’s or Apple’s requires careful attention to several difficult issues, each of which we discuss in turn:

1. What exactly is a “core competency”? Unfortunately, most of the literature on this subject is tautological —“core” equals “key” or “critical” or “fundamental.” How can managers analytically select and develop the core competencies that will provide the firm’s uniqueness, competitive edge, and basis of value creation for the future?
2. Granting that the competencies defining the firm and its essential reasons for existence should be kept in-house, should all else be outsourced? In most cases, common sense and theory suggest a clear “no.” How then can managers determine strategically, rather than in a short-term or ad hoc fashion, which activities to maintain internally and which to outsource?
3. How can managers assess the relative risks and benefits of outsourcing in particular situations? And how can they contain critical risks — especially the potential loss of crucial skills or control over the company’s future directions — when outsourcing is desirable?

Core Competency Strategies

The basic ideas behind core competencies and strategic outsourcing have been well supported by research extending over a twenty-year period.4 In 1974, Rumelt noted that neither of the then-favored strategies — unrelated diversification or vertical integration — yielded consistently high returns.5 Since then, other carefully structured research has indicated the effectiveness of disaggregation strategies in many industries.6 Noting the failures of many conglomerates in the 1960s and 1970s, both financial theorists and investors began to support more focused company concepts. Generally this meant “sticking to your knitting” by cutting back to fewer product lines. Unfortunately, this also meant a concomitant increase in the systematic risk these narrower markets represented.

However, some analysts noticed that many highly successful Japanese and American companies had very wide product lines, yet were not very vertically integrated.7 Japanese companies, like Sony, Mitsubishi, Matsushita, or Yamaha, had extremely diverse product offerings, as did 3M or Hewlett-Packard in the United States. Yet they were not conglomerates in the normal sense. They were first termed “related conglomerates,” redeploying certain key skills from market to market.8 At the same time, these companies also contracted out significant support activities. Although frequently considered vertically integrated, the Japanese auto industry, for example, was structured around “mother companies” that primarily performed design and assembly, with a number of independent suppliers and alliance partners — without ownership bonds to the mother companies — feeding into them.9 Many other Japanese high-tech companies, particularly the more innovative ones like Sony and Honda, used comparable strategies leveraging a few core skills against multiple markets through extensive outsourcing.

The term “core competency strategies” was later used to describe these and other less diversified strategies developed around a central set of corporate skills.10 However, there has been little theory or consistency in the literature about what “core” really means. Consequently, many executives have been understandably confused about the topic. They need not be if they think in terms of the specific skills the company has or must have to create unique value for customers. However, their analyses must go well beyond looking at traditional product or functional strategies to the fundamentals of what the company can do better than anyone else.11

• For example, after some difficult times, it was easy enough for a beer company like Foster’s to decide that it should not be in the finance, forest products, and pastoral businesses into which it had diversified. It has now divested these peripheral businesses and is concentrating on beer. However, even within this concept, Foster’s true competencies are in brewing and marketing beer. Many of its distribution, transportation, and can production activities, for example, might actually be more effectively contracted out. Within individual functions like production, Foster’s could further extend its competitive advantage by outsourcing selected activities — such as maintenance or computing — where it has no unique capabilities.

The Essence of Core Competencies

What then is really “core”? And why? The concept requires that managers think much more carefully about which of the firm’s activities really do — or could —create unique value and which activities managers could more effectively buy externally. Careful study of both successful and unsuccessful corporate examples suggests that effective core competencies are:

1. Skill or knowledge sets, not products or functions. Executives need to look beyond the company’s products to the intellectual skills or management systems that actually create a maintainable competitive edge. Products, even those with valuable legal protection, can be too easily back-engineered, duplicated, or replaced by substitutes. Nor is a competency typically one of the traditional functions such as production, engineering, sales, or finance, around which organizations were formed in the past. Instead, competencies tend to be sets of skills that cut across traditional functions. This interaction allows the organization to consistently perform an activity better than functional competitors and to continually improve on the activity as markets, technology, and competition evolve. Competencies thus involve activities such as product or service design, technology creation, customer service, or logistics that tend to be based on knowledge rather than on ownership of assets or intellectual property per se. Knowledge-based activities generate most of the value in services and manufacturing. In services, which account for 79 percent of all jobs and 76 percent of all value added in the United States, intellectual inputs create virtually all of the value added. Banking, financial services, advertising, consulting, accounting, retailing, wholesaling, education, entertainment, communications, and health care are clear examples. In manufacturing, knowledge-based activities —like R&D, product design, process design, logistics, marketing research, marketing, advertising, distribution, and customer service — also dominate the value-added chain of most companies (see Figure 1).
2. Flexible, long-term platforms — capable of adaptation or evolution. Too many companies try to focus on the narrow areas where they currently excel, usually on some product-oriented skills. The real challenge is to consciously build dominating skills in areas that the customer will continue to value over time, as Motorola is doing with its focus on “superior quality, portable communications.” The uniqueness of Toys “R” Us lies in its powerful information and distribution systems for toys, and that of State Street Boston in its advanced information and management systems for large custodial accounts. Problems occur when managers choose to concentrate too narrowly on products (as computer companies did on hardware) or too inflexibly on formats and skills that no longer match customer needs (as FotoMat and numerous department stores did). Flexible skill sets and constant, conscious reassessment of trends are hallmarks of successful core competency strategies.
3. Limited in number. Most companies target two or three (not one and rarely more than five) activities in the value chain most critical to future success. For example, 3M concentrates on four critical technologies in great depth and supports these with a peerless innovation system. As work becomes more complex, and the opportunities to excel in many detailed activities proliferate, managers find they cannot be best in every activity in the value chain. As they go beyond three to five activities or skill sets, they are unable to match the performance of their more focused competitors or suppliers. Each skill set requires intensity and management dedication that cannot tolerate dilution. It is hard to imagine Microsoft’s top managers taking their enthusiasm and skills in software into, say, chip design or even large-scale training in software usage. And if they did, what would be the cost of their loss of attention on software development?
4. Unique sources of leverage in the value chain. Effective strategies seek out places where there are market imperfections or knowledge gaps that the company is uniquely qualified to fill and where investments in intellectual resources can be highly leveraged. Raychem and Intel concentrate on depth-in-design and on highly specialized test-feedback systems supporting carefully selected knowledge-based products — not on volume production of standardized products — to jump over the experience curve advantages of their larger competitors. Morgan Stanley, through its TAPS system, and Bear Stearns, through its integrated bond-trading programs, have developed in-depth knowledge bases creating unique intellectual advantages and profitability in their highly competitive markets.
5. Areas where the company can dominate. Companies consistently make more money than their competitors only if they can perform some activities — which are important to customers — more effectively than anyone else. True focus in strategy means the capacity to bring more power to bear on a selected sector than any competitor can. Once, this meant owning and managing all the elements in the value chain supporting a specific product or service in a selected market position. Today, however, some outside supplier, by specializing in the specific skills and technologies underlying a single element in the value chain, can become more proficient at that activity than virtually any company spreading its efforts over the whole value chain. In essence, each company is in competition with all potential suppliers of each activity in its value chain. Hence, it must benchmark its selected core competencies against all other potential suppliers of that activity and continue to build these core capabilities until it is demonstrably best. Thus the basic nature of strategic analysis changes from an industry analysis perspective to a horizontal analysis of capabilities across all potential providers of an activity regardless of which industry the provider might be in (see Figure 1).

6. Elements important to customers in the long run. At least one of the firm’s core competencies should normally relate directly to understanding and serving its customers — i.e., the right half of the value chain in Figure 1. High-tech companies with the world’s best state-of-the-art technology often fail when they ignore this caveat. On the other hand, Merck matches its superb basic research with a prescription drug marketing know-how that is equally outstanding. By aggressively analyzing its customers’ value chains, a company can often identify where it can specialize and provide an activity at lower cost or more effectively to the customer. Such analyses have created whole new industries, like the specialized mortgage broker, syndication, secondary market, transaction-processing, escrow, title search, and insurance businesses that have now taken over these risks and functions for banks and have disaggregated the entire mortgage industry.
7. Embedded in the organization’s systems. Maintainable competencies cannot depend on one or two talented stars — such as Steven Jobs and Stephen Wozniak at Apple or Herbert Boyer and Arthur D. Riggs at Genentech — whose departure could destroy a company’s success. Instead the firm must convert these into a corporate reputation or culture that outlives the stars. Especially when a strategy is heavily dependent on creativity, personal dedication, and initiative or on attracting top-flight professionals, core competencies must be captured within the company’s systems — broadly defined to include its values, organization structures, and management systems. Such competencies might include recruiting (McKinsey, Goldman Sachs), training (McDonald’s, Disney), marketing (Procter & Gamble, Hallmark), innovation (Sony, 3M), motivation systems (ServiceMaster), or control of remote and diverse operating sites within a common framework and philosophy (Exxon, CRA, Inc.). These systems are often at the heart of consistent superior performance; in many cases, a firm’s systems become its core competencies.12

Preeminence: The Key Strategic Barrier

For its selected core competencies, the company must ensure that it maintains absolute preeminence. It may also need to surround these core competencies with defensive positions, both upstream and downstream. In some cases, it may have to perform some activities where it is not best-in-world, just to keep existing or potential competitors from learning, taking over, eroding, or bypassing elements of its special competencies. In fact, managers should consciously develop their core competencies to strategically block competitors and avoid outsourcing these or giving suppliers access to the knowledge bases or skills critical to their core competencies. Honda, for example, does all its engine R&D in-house and makes all the critical parts for its small motor design core competency in closely controlled facilities in Japan. It will consider outsourcing any other noncritical elements in its products but builds a careful strategic block around this most essential element for all its businesses.13

Most important, as a company’s preeminence in selected fields grows, its knowledge-based core competencies become ever harder to overtake. Knowledge bases tend to grow exponentially in value with investment and experience. Intellectual leadership tends to attract the most talented people, who then work on and solve the most interesting problems. The combination in turn creates higher returns and attracts the next round of outstanding talent. In addition to the examples we have already cited, organizations as diverse as Bechtel, AT&T Bell Labs, Microsoft, Boeing, Intel, Merck, Genentech, McKinsey, Arthur Andersen, Sony, Nike, Nintendo, Bankers Trust, and Mayo Clinic have found this to be true.

Some executives regard core activities as those the company is continuously engaged in, while peripheral activities are those that are intermittent and therefore can be outsourced. From a strategic outsourcing viewpoint, however, core competencies are the activities that offer long-term competitive advantage and thus must be rigidly controlled and protected. Peripheral activities are those not critical to the company’s competitive edge.

Strategic Outsourcing

If supplier markets were totally reliable and efficient, rational companies would outsource everything except those special activities in which they could achieve a unique competitive edge, i.e., their core competencies. Unfortunately, most supplier markets are imperfect and do entail some risks for both buyer and seller with respect to price, quality, time, or other key terms. Moreover, outsourcing entails unique transaction costs —searching, contracting, controlling, and recontracting — that at times may exceed the transaction costs of having the activity directly under management’s in-house control.

To address these difficulties, managers must answer three key questions about any activity considered for outsourcing. First, what is the potential for obtaining competitive advantage in this activity, taking account of transaction costs? Second, what is the potential vulnerability that could arise from market failure if the activity is outsourced? Conceptually, these two factors can be arrayed in a simple matrix (see Figure 2). Third, what can we do to alleviate our vulnerability by structuring arrangements with suppliers to provide appropriate controls yet provide for necessary flexibilities in demand?

The two extremes on the matrix in Figure 2 are relatively straightforward. When the potentials for both competitive edge and strategic vulnerability are high, the company needs a high degree of control, usually entailing production internally or through joint ownership arrangements or tight long-term contracts (explicit or implicit). For example, Marks & Spencer is famous for its network of tied suppliers, which create the unique brands and styles that underpin its value reputation. Spot suppliers would be too unreliable and unlikely to meet the demanding standards that are Marks & Spencer’s unique consumer franchise. Hence, close control of product quality, design, technology, and equipment through contracts and even financial support is essential. The opposite case is perhaps office cleaning where little competitive edge is usually possible and there is an active and deep market of supplier firms. In between, there is a continuous range of activities requiring different degrees of control and strategic flexibility.

At each intervening point, the question is not just whether to make or buy, but how to implement a desired balance between independence and incentives for the supplier versus control and security for the buyer. Most companies will benefit by extending outsourcing first in less critical areas — or in parts of activities, like payroll, rather than all of accounting. As they gain experience, they may increase profit opportunities greatly by outsourcing more critical activities to noncompeting firms that can perform them more effectively. In a few cases, more complex alliances with competitors may be essential to garner specialized skills that cannot be obtained in other ways. At each level, the company must isolate and rigorously control strategically critical relationships between its suppliers and its customers.

Competitive Edge

The key strategic issue in insourcing versus outsourcing is whether a company can achieve a maintainable competitive edge by performing an activity internally —usually cheaper, better, in a more timely fashion, or with some unique capability — on a continuing basis. If one or more of these dimensions is critical to the customer and if the company can perform that function uniquely well, the activity should be kept in-house. Many companies unfortunately assume that because they have performed an activity internally, or because it seems integral to their business, the activity should be insourced. However, on closer investigation and with careful benchmarking, its internal capabilities may turn out to be significantly below those of best-in-world suppliers.

• For example, Ford Motor Company found that many of its internal suppliers’ quality practices and costs were nowhere near those of external suppliers when it began its famous “best in class” worldwide benchmarking studies on 400 subassemblies for the new Taurus-Sable line. A New York bank with extensive worldwide operations investigated why its Federal Express costs were soaring and found that its internal mail department took two more days than Federal Express to get a letter or package from the third floor to the fortieth floor of its building. In interviews with top operating managers in both service and manufacturing companies concerning benchmarking, we frequently encountered a paraphrase of, “We thought we were best in the world at many activities. But when we benchmarked against the best external suppliers, we found we were not even up to the worst of the benchmarking cases.”

Transaction Costs

In all calculations, analysts must include both internal transaction costs as well as those associated with external sourcing. If the company is to produce the item or service internally on a long-term basis, it must back up its decision with continuing R&D, personnel development, and infrastructure investments that at least match those of the best external supplier. Otherwise, it will lose its competitive edge over time. Managers often tend to overlook such backup costs, as well as the losses from laggard innovation and nonresponsiveness of internal groups that know they have a guaranteed market. Finally, there are the headquarters and support costs of constantly managing the insourced activity. One of the great gains of outsourcing is the decrease in executive time for managing peripheral activities — freeing top management to focus more on the core of its business.

Various studies have shown that, when these internal transaction costs are thoroughly analyzed, they can be extremely high.14 Since it is easier to identify the explicit transaction costs of dealing with external suppliers, these generally tend to be included in analyses. Harder-to-identify internal transaction costs are often not included, thus biasing results.

Vulnerability

When there are many suppliers (with adequate but not dominating scale) and mature market standards and terms, a potential buyer is unlikely to be more efficient than the best available supplier. If, on the other hand, there is not sufficient depth in the market, overly powerful suppliers can hold the company ransom. Conversely, if the number of suppliers is limited or individual suppliers are too weak, they may be unable to supply innovative products or services as well as a much larger buyer could by performing the activity in-house. While the activity or product might not be one of its core competencies, the company might nevertheless benefit by producing internally rather than undertaking the training, investment, and codesign expenses necessary to bring weak suppliers up to needed performance levels.

Another form of vulnerability is the lack of information available in the marketplace or from individual suppliers; for example, a supplier may secretly expect labor disruptions or raw material problems but hide these until it is too late for the customer to go elsewhere. A related problem occurs when a supplier has unique information capabilities; for example, large wholesalers or retailers, market research firms, software companies, or legal specialists may have information or fact-gathering systems that would be impossible for the buyer or any other single supplier to reproduce efficiently. Such suppliers may be able to charge what are essentially monopoly prices, but this could still be less costly than reproducing the service internally. In other cases, there may be many capable suppliers (e.g., R&D or software), but the costs of adequately monitoring progress on the suppliers’ premises might make outsourcing prohibitive.

Sometimes the whole structure of information in an industry will militate for or against outsourcing. Computing, for example, was largely kept in-house in its early years because the information available to a buyer of computing services and its ability to make judgments about such services were very different for the buying company (which knew very little) than for the supplier (which had excellent information). Many buyers lacked the competency to either assess or monitor sellers and feared loss of vital information. A company can outsource computing more easily today in part because buyers’ computer, technical management, and software know-how are sufficient to make informed judgments about external suppliers.

In addition to information anomalies, Stuckey and White note three types of “asset specificity” that commonly create market imperfections, calling for controlled sourcing solutions rather than relying on efficient markets.15 These are: (1) site specificity, where sellers have located costly fixed assets in close proximity to the buyer, thus minimizing transport and inventory costs for a single supplier; (2) technical specificity, where one or both parties must invest in equipment that can be used only by the parties in conjunction with each other and has low value in alternative uses; and (3) human capital specificity, where employees must develop in-depth skills that are specific to a particular buyer or customer relationship.

Stuckey and White explain the outsourcing implications of information and specificity problems in the case of a bauxite mine and an alumina refiner. Refineries are usually located close to mines because of the high cost of transporting bauxite, relative to its value. Refineries in turn are tuned to process the narrow set of physical properties associated with the particular mine’s bauxite. Different and highly specialized skills and assets are needed for refining versus mining. Access to information further compounds problems; if an independent mine expects a strike, it is unlikely to share that information with its customers, unless there are strong incentives. As a result, the aluminum industry has moved toward vertical integration or strong bilateral joint ventures, as opposed to open outsourcing of bauxite supplies — despite the apparent presence of a commodity product and many suppliers and sellers. In this case, issues of both competitive advantage and potential market failure dictate a higher degree of sourcing control.

Degree of Sourcing Control

In deciding on a sourcing strategy for a particular segment of their business, managers have a wide range of control options (see Figures 3 and 4. for the most basic). Where there is a high potential for vulnerability and a high potential for competitive edge, tight control is indicated (as in the bauxite case). At the opposite end is, say, office cleaning. Between these extremes are opportunities for developing special incentives or more complex oversight contracts to balance intermediate levels of vulnerability against more moderate prospects for competitive edge. Nike’s multi-tier strategy offers an interesting example (see the sidebar).

The practice and law of strategic alliances are rapidly developing new ways to deal with common control issues — by establishing specified procedures that permit direct involvement in limited stages of a partner’s activities without incurring the costs of ownership arrangements or the loss of control inherent in arm’s-length transactions. As they work their way through the available options, managers should ask themselves a series of strategic questions:

1. Do we really want to produce the good or service internally in the long run? If we do, are we willing to make the back-up investments necessary to sustain a best-in-world position? Is it critical to defending our core competency? If not,
2. Can we license technology or buy know-how that will let us be best on a continuing basis? If not,
3. Can we buy the item as an off-the-shelf product or service from a best-in-world supplier? Is this a viable long-term option as volume and complexity grow? If not,
4. Can we establish a joint development project with a knowledgeable supplier that ultimately will give us the capability to be best at this activity? If not,
5. Can we enter into a long-term development or purchase agreement that gives us a secure source of supply and a proprietary interest in knowledge or other property of vital interest to us and the supplier? If not,
6. Can we acquire and manage a best-in-world supplier to advantage? If not, can we set up a joint venture or partnership that avoids the shortcomings we see in each of the above? If so,
7. Can we establish controls and incentives that reduce total transaction costs below those of producing internally?

Flexibility vs. Control

Within this framework, there is a constant trade-off between flexibility and control. One of the main purposes of outsourcing is to have the supplier assume certain classes of investments and risks, such as demand variability. To optimize costs, the buying company may want to maintain its internal capacity at relatively constant levels despite highly fluctuating sales demands. Under these circumstances, it needs a surge strategy.

• For example, McDonald’s, with $8 billion in sales and 10.1 percent growth per year, needs to call in part-time and casual workers to handle extensive daily variations yet be able to select its future permanent or managerial personnel from these people. IBM has had the opposite problem; since its core demand has been declining, the company has had to lay off employees. Yet it needs surge capacity for: (1) quick access to some former employees’ basic skills; (2) available production capacity without the costs of supporting facilities full time; and (3) the ability to exploit strong outside parties’ specialized capabilities through temporary consortia — for example, in applications software, microprocessors, network development, or factory automation. Strategically, McDonald’s has created a pool of people available on “call options,” while IBM — through spinouts of factories with baseload commitments to IBM, guaranteed consulting employment for key people, flexible joint ventures, and strategic alliances — has created “put options” to handle surge needs as it downsizes and tries to turn around its business.

There is a full spectrum of outsourcing arrangements, depending on the company’s control and flexibility needs (see Figure 4). The issue is less whether to make or buy an activity than it is how to structure internal versus external sourcing on an optimal basis. Companies are outsourcing much more of what used to be considered either integral elements of their value chains or necessary staff activities. Because of greater complexity, higher specialization, and new technological capabilities, outside suppliers can now perform many such activities at lower cost and with higher value added than a fully integrated company can. In some cases, new production technologies have moved manufacturing economies of scale toward the supplier. In others, service technologies have lowered transaction costs substantially, making it possible to specify, transport, store, and coordinate inputs from external sources so inexpensively that the balance of benefits has shifted from insourcing to outsourcing. In certain specialized niches, outside companies have grown to such size and sophistication that they have developed economies of scale, scope, and knowledge intensity so formidable that neither smaller nor more integrated producers can effectively compete with them (e.g., ADP Services in payroll, and ServiceMaster in maintenance). To the extent that knowledge about a specific activity is more important than knowledge about the end product itself, specialized suppliers can often produce higher value added at lower cost for that activity than almost any integrated company.

Strategic Benefits vs. Risks

Too often companies look at outsourcing as a means to lower only short-term direct costs. However, through strategic outsourcing, companies can lower their long-term capital investments and leverage their key competencies significantly, as Apple and Nike have done. They can also force many types of risk and unwanted management problems onto suppliers.

• For example, Gallo, the largest producer and distributor of wines in the United States, outsources most of its grapes, pushing the risks of weather, land prices, and labor problems onto its suppliers. Argyle Diamonds, one of the world’s largest diamond producers, outsources virtually all aspects of its operation except the crucial steps of separation and sorting of diamonds. It contracts all its huge earth-moving operations (to avoid capital and labor risks), its housing and food services for workers (to avoid confrontations on nonoperating issues), and much of its distribution (to De Beers to protect prices, to finance inventories, and to avoid the complications of worldwide distribution). By outsourcing to best-in-class suppliers in each case, it further ensures the quality and image of its operations.

Important Strategic Benefits

Strategically, outsourcing can provide the buyer with greater flexibility, especially in the purchase of rapidly developing new technologies, fashion goods, or the myriad components of complex systems. It decreases the company’s design-cycle times, as multiple best-in-class suppliers work simultaneously on individual components of the system. Each supplier can both have more personnel depth and sophisticated technical knowledge about its specific area and also support more specialized facilities for higher quality than the coordinating (buyer) company might possibly achieve alone. In the same vein, strategic outsourcing spreads the company’s risk for component and technology developments among a number of suppliers. The company does not have to undertake the full failure risks of all component R&D programs or invest in and constantly update production capabilities for each component system. Further, the buyer is not limited to its own innovative capabilities; it can tap into a stream of new product and process ideas and quality improvement potentials it could not possibly generate itself.

In the world’s advanced economies, increased affluence has forced much greater attention to new product ideas, to quality details, and to customization. Because small specialized suppliers’ often offer greater responsiveness, and new technologies have decreased the size needed to achieve economies of scale, the average size of industrial firms has decreased since the late 1960s, and subcontracting constitutes an ever greater portion of most producers’ costs.16 Outsourcing has become a major strategy to leverage internal technical capabilities and to tap the rapid response and innovative capabilities of small enterprises. Richard Leibhaber, chief strategy and technology officer at MCI, commented:

MCI constantly seeks to grow by finding and developing associations with small companies having interesting services they can hang onto the MCI network. Although we employ only about 1,000 professional technical personnel internally, 19,000 such personnel work directly for us through contracts. . . . Now we do about 60 percent of our software development work internally, but we manage [in detail] the other 40 percent in contractors’ hands. We do all the specification, process rating, operational procedures, and system testing inside our company. We design the system. We control the process. Then we let others do what they can do best.17

Boston Consulting Group, which has studied more than 100 major companies doing extensive outsourcing, has concluded that most western companies outsource primarily to save on overhead or short-term costs.18 The result is a piecemeal approach that “results in patches of overcapacity scattered at random throughout the company’s operation. . . . [These companies] end up with large numbers of subcontractors, which are more costly to manage than in-house operations that are individually less efficient.”19 Worse still, the buying companies, by not providing adequate monitoring and technical backup, often lose their grip on key competencies they may need in the future. The Japanese, by contrast, outsource primarily to improve the efficiency and quality of their own processes, focus on a very few sources, build close interdependent relationships, and hold on tightly to high value-added activities that are crucial to quality. For those systems they contract out, Japanese companies advise closely on manufacturing and cooperate in process and product R&D on the suppliers’ premises.

Strategic Risks

Outsourcing complete or partial activities creates great opportunities but also new types of risks. Management’s main strategic concerns are (1) loss of critical skills or developing the wrong skills, (2) loss of cross-functional skills, and (3) loss of control over a supplier.

Loss of critical skills or developing the wrong skills.

Unfortunately, many U.S. companies outsourced manufacture of what, at the time, seemed to be only minor components, like semiconductor chips or a bicycle frame, and taught suppliers how to build them to needed quality standards. Later these companies found their suppliers were unable or unwilling to supply them as required. By then, the buying company had lost the skills it needed to reenter manufacture and could not prevent its suppliers from either assisting competitors or entering downstream markets on their own. In some cases, by outsourcing a key component, the company lost its own strategic flexibility to introduce new designs when it wanted, rather than when the vendor permitted a change. For example, few manufacturers can afford to design a new laser-printer engine to obtain a slight timing edge, rather than wait for Canon (with its 84 percent market share in such engines) to move.20 The activity share that Canon has in the design function for this field or that Matsushita now has in drives for CD players gives each company such an overwhelming competitive advantage that it can control other characteristics of its industry, limiting the strategic options of others. The dual strategy framework we propose prevents such bypassing and helps managers explicitly address both needed long-term competencies and strategic vulnerabilities before embarking on outsourcing.

Loss of cross-functional skills.

The interactions among skilled people in different functional activities often develop unexpected new insights or solutions. Companies fear outsourcing will make such cross-functional serendipity less likely. However, if the company consciously ensures that its remaining employees interact constantly and closely with its outsourced experts, its employees’ knowledge base can be much higher than if production were in-house, and the creativity benefits can be even greater. For example, companies using Texas Instrument’s or Intel’s design capabilities can have these suppliers’ designers — with their much greater technical expertise and access to support technologies — codesign chips in-house with their own design teams during development. In such circumstances, the buyer’s employees are in contact with much more skilled integrated circuit people than the firm could possibly have itself.

In a number of industries studied, two-thirds of all innovation occurred at the customer-supplier interface.21 By definition, outsourcing increases the buyer’s own participation (as the customer) in such interfaces. Consequently, if managed properly, the practice often can increase total innovation potentials substantially (through leveraging multiple supplier relationships).

However, having outsourced expertise at many different locations may make close cross-functional teamwork more difficult. To guard against this, in entering long-term outsourcing relationships that may involve future innovation, many managers specify that an outsource partner’s personnel may be “seconded” to the buying company for special development projects. They then ensure that close personal relationships are developed between the supplier companies and their own technical personnel at the bench and operating levels. Contractual prearrangements are usually necessary to ensure that critical personnel from the outsource partner are available when needed. But the buying company must be close enough to its partner to evaluate and name the specific people it wants. Otherwise the provision may be useless when needed.

Loss of control over a supplier.

Real problems can occur when the supplier’s priorities do not match the buyer’s. The most successful outsourcers find it absolutely essential to have both close personal contact and rapport at the floor level and political clout and understanding with the supplier’s top management. For this reason, Nike both has full-time “production expatriates” on its suppliers’ premises and frequently brings the suppliers’ top people to its Beaverton, Oregon, headquarters to exchange details about future capabilities and prospects. When conflicts occur, both the supplier’s CEO and key operating personnel can be pressured directly to break the logjam. Even then, serious difficulties can occur if the buyer does not have sufficient market power relative to the seller. Some buying companies go to the extreme of owning key pieces of equipment the seller uses to make the components they are purchasing. If priorities conflict too badly, the buyer can remove its equipment and shut down the seller’s whole line. These buyers say that such arrangements “ensure we can get the seller’s attention when we need it.”

Nevertheless, unless the buyer’s core competency is a true block to the marketplace, some suppliers, after building up their expertise with the buyer’s support, will attempt to bypass the buyer directly in the marketplace, as Giant Manufacturing of Taiwan, a supplier of bicycle frames, did to Schwinn. Alternatively, the seller may learn as much as possible from the buyer and its engineering groups and then attempt to resell this knowledge in different product configurations to the buyer’s competitors, as Toshiba did with submarine propeller technology. Careful definition, limitation, and implementation of means to remedy such external conflicts are critical in any but the most routine outsourcing arrangements. Companies that outsource extensively have generally found satisfactory legal and operational ways to deal with the problem — and are often willing to share useful techniques with those outside their industry.

New Management Approaches

Most large companies have very sophisticated techniques for the traditional purchasing of parts, subassemblies, supplies, equipment, construction, or standard services. And models from the natural resources, real estate/construction, and finance/insurance industries — where joint ventures have been common for years — can provide useful guides for more complex partnering relationships. In addition to seeking out these experiences, the main managerial adjustments for most companies are those needed for coping with the increased scale, diversity, and service-oriented nature of the activities potentially outsourced. These center on: (1) a much more professional and highly trained purchasing and contract management group (as compared with the lowly purchasing groups of the past); and (2) a greatly enhanced logistics-information system (to track and evaluate vendors, coordinate transportation activities, and manage service transactions and materials movements from the vendors’ hands to the customers’). There is vast electronic document interchange (EDI) and materials requirements planning (MRP) literature on such logistics management for products and components.

Now, similar concepts are needed for the management of knowledge and service-based activities. A number of companies are establishing direct computer connections between their service suppliers and the top managers controlling that function, as Apple has done with its consulting and public relations groups. It is increasingly easier to implement software interfaces that allow continuous electronic monitoring and executive interactions for the design, financial, advertising, public relations, R&D, real estate, or personnel-search activities, as well as manufacturing, being performed at remote locations. To manage more extended outsourcing effectively, contracting and logistics activities generally need to be elevated to corporate strategic levels. So should the development of the much more sophisticated knowledge-based systems needed to capture and analyze essential details about the company’s own internal processes and those of vendors. Most companies’ systems need improving in this respect, but some interesting developments are under way.

For example, a consortium headed by Digital Equipment, Ford, Texas Instruments, US West, Carnegie Group, and Alcorp is developing a next-generation software tool called Initiative for Managing Knowledge Assets (IMKA). Built around the proven knowledge-based systems of DEC and TI, IMKA uses many features found in object-oriented programs that allow collection and comparison of knowledge from a variety of different end nodes, inside and outside the company. For example, it can compare each supplier plant throughout the world for its capability to meet a given subsystem’s circuit performance, manufacturing, design, interconnection, weight, cost, or power requirement parameters — for any of 100,000 different objects — against the capabilities of other possible supplier plants. In milliseconds, it can coordinate and check the production dynamics necessary to ensure that parts are produced in optimum locations at lowest cost and to specification throughout the world.

Many companies fear they may not be able to maintain sufficient knowledge internally to manage their specialist suppliers, a real problem if not attacked systematically. Successful outsourcers upgrade both their top management talent and their information systems for this purpose. When they move aggressively, many companies have found that they actually improve their knowledge bases through strategic outsourcing, as Ford did with its best-in-class program. By actively riding circuit on the best outside suppliers and experts, they obtain more stimulation and insights than any insider group could possibly offer, unless that group represents the core competence of the company.

Further, when executives continuously interact with the very best talent in the world, not just the best in the next office, they are considerably more likely to stay at the top of their professions. As a side benefit of outsourcing, they can pressure internal supply groups to compete with the best external companies, question subordinates more knowledgeably, and keep internal groups more competitive.

Conclusion

Most companies can substantially leverage their resources through strategic outsourcing by: (1) developing a few well-selected core competencies of significance to customers and in which the company can be best-in-world; (2) focusing investment and management attention on them; and (3) strategically outsourcing many other activities where it cannot be or need not be best. There are always some inherent risks in outsourcing, but there are also risks and costs of insourcing. When approached within a genuinely strategic framework, using the variety of outsourcing options available and analyzing the strategic issues developed here, companies can overcome many of the costs and risks. When intelligently combined, core competency and extensive outsourcing strategies provide improved returns on capital, lowered risk, greater flexibility, and better responsiveness to customer needs at lower costs.