The Outsourcing Compulsion

The conventional wisdom in government, academia and much of industry is that companies are choosing to close their costly domestic operations in favor of better prospects and profits in other countries. While it is certainly true that U.S. companies are being pulled overseas by the allure of potential profits and cheap labor, the vast majority are also being pushed overseas by something that is much more proximate to the U.S. domestic industrial structure than the desire for new markets, lower labor costs or greater efficiencies in sourcing: the United States’ dysfunctional distribution system. And, although its impact is ubiquitous, the clear connection of this force to the surge in U.S. outsourcing has gone largely unnoticed.

It is not corporate avarice that is driving a good deal of manufacturing out of the United States. Nor is it the desire for the cheapest price on the part of consumers. What is forcing thousands of companies to close U.S. operations and lay off workers is an imbalance in the sales and distribution model that has evolved over the past four decades. Distribution has been turned on its head as distributors have wrested control of the strategic prerogatives of manufacturers in order to capture a disproportionate share of the value of the supplying company’s products. The megadistributors end up profiting at the expense of their vendors, and manufacturers earn little or nothing on the sale of their own products. As a result of this phenomenon, U.S. companies have compulsively embraced offshoring not so much as a result of their internally generated goals and objectives, but rather as a necessary response to the demands of sheer corporate survival.

Back in the Day

Prior to World War II, producers sought to control every aspect of the goods that rolled out of their factories. Manufacturers viscerally understood that it was blood, sweat, investment and risk taking that brought their creations to the public. Industrialists purposefully exerted as much control as possible over the distribution and sale of their products. By exercising power over downstream value chain activities, manufacturers carefully safeguarded their own interests.

The industrial structure that emerged during the second half of the 19th century has been variously characterized as hierarchical capitalism, managerial capitalism or internalization. Here, vertically integrated companies created large production facilities that could take advantage of scale and scope while at the same time developing marketing, distribution and purchasing networks for specific products. Manufacturers integrated forward into sales and distribution as they achieved a product volume that was sufficient to overcome cost advantages previously enjoyed by wholesalers and other intermediaries. Producers developed their own distribution capabilities, including sales, installation, service, the provision of credit and other ancillaries appropriate to particular product offerings. The ability to control distribution allowed companies to monitor and understand their markets and customers and helped them to create economies of scale. As a result, distribution became the most valuable way for the 20th century’s new industrial giants to gain and hold market share.

Companies that offered products with few if any intangible ancillaries (such as service, installation or credit) continued to work through wholesalers, but only for the purpose of the physical distribution of their products. For example, food and chemical companies, such as Procter & Gamble Co. and Colgate-Palmolive-Peet Co., fielded their own sales forces while utilizing wholesalers as essentially shipping agents. By the end of the 1920s, companies that manufactured branded packaged goods expanded into international markets and into related product lines based largely on their marketing and distributional capabilities.

While almost all efforts directed toward marketing and distribution by U.S. manufacturers extended only to wholesaling rather than retailing, companies organized their operations so that they could reach customers directly. For example, newly developed malting processes in the 1880s improved quality and speed in the brewing of beer. Combined with new temperature-controlled tank cars, this allowed what had been essentially local breweries to extend their reach nationally. By 1894, Pabst Brewing Co. had 30 branches throughout the United States that warehoused, marketed and distributed its beer. While the company used wholesalers in some markets, most sales resulted directly from these branch offices. National Cash Register, Eastman Kodak and the then Remington Typewriter Co. were among a select number of producers that created networks of retail stores in U.S. cities.

From the earliest days of the second industrial revolution, manufacturers were in charge of the distribution and sale of their products. While seldom acting as retailers, U.S. industrialists used vertical integration coupled with the abilit y to const r ain the operational boundaries of middlemen and shop owners to that of logistics and product delivery. This resulted in an industrial structure in which powerful manufacturers were able to capture the lion’s share of the economic value that their products created.

Strategy as Blunder

In the early 1970s, manufacturers permitted outsiders (distributors) who did not have a vested stake in their companies to control more and more sales and distribution activities. Producers were responding to the exhortations of management theorists who preached a doctrine of business transformation that emphasized resources, capabilities, innovation, technology and operational effectiveness. Companies that had once been in control of all aspects of product development, sales and service were slowly convinced by leading business thinkers to focus exclusively on “core competencies” and get rid of everything else. Consequently, big companies began to divest themselves of activities that were not perceived as “value adding” and to embrace operational paradigms that emphasized total quality management, materials requirement planning, just-in-time inventory control and lean manufacturing.

Eventually, these efforts paid off, and company boundaries underwent dramatic changes. Companies that had previously exercised power over their value chains now were outsourcing almost everything they could except those activities that they considered to be unique to their bases of sustainable competitive advantage. Feeling rising pressure from perceived higher-quality Japanese companies, U.S. manufacturers ended up spinning off not only business functions unrelated to their core resources and competencies but also valuable distribution and sales capabilities.

Consider what happened to Goodyear Tire & Rubber Co. In the late 1980s, Goodyear, then the largest tire company in the world, underwent an organization-wide change effort to adopt the principles of total quality management. Like thousands of other companies that embraced TQM, Good-year’s operations, logistics, procurement and research and development were retooled with the goal of making “defect-free” products. Sales and distribution, which had always been the linchpin of Goodyear’s success, were relegated to a secondary status because TQM focused almost exclusively on the manufacturing process. Inevitably, cracks began to form between the manufacturing people and individuals working in sales and distribution.

Resources to support the highly successful existing U.S. dealer network, which had taken nearly a century to build and perfect, were reallocated to operations. With less to work with, Goodyear had little choice but to cannibalize its existing distribution arrangement. Wholesalers were turned into dealers and vice versa. Multiple sales outlets began to appear in towns where there had been one or two exclusive Goodyear dealers for years. Consequently, Goodyear’s control over the sale and distribution of its products began to erode.

Although Goodyear started using alternate distribution channels in the 1970s, the shift away from its dealer network accelerated dramatically in the early 1990s when the company introduced its tires to Sears, Roebuck and Co. and Wal-Mart Stores Inc. As a direct result, the company went from having a global network of loyal and faithful dealers and strong brand loyalty to becoming the manufacturer of a commodity that could be purchased at an ever-growing number of outlets for a lower price.

For the consumers of Goodyear’s products, this was a boon. Customers suddenly could have Wrangler or American Eagle tires mounted on their cars while they shopped at the mall or purchased dry goods at big box stores. Retailers also benefited. Unlike in the old system, the new retail outlets were not exclusive dealers. They placed Goodyear tires on their shelves next to competing brands and, as a result, could offer more choice to their customers. The prices of Goodyear tires to consumers fell precipitously. With a larger number of outlets now competing for the same customer base, price wars became inevitable.

The only loser in the long run was Goodyear — and its workers. A slow degeneration of the company began. Unable to raise its prices through a compromised distribution network in which the lowest prices never seemed low enough, Goodyear was faced with the inevitable: the removal of costly manufacturing centers within the United States. Over the next several years the company would close nearly a dozen U.S. plants in favor of cheaper labor overseas. This was done in order to compensate for losses resulting from the company’s ill-conceived dissolution of its dealer network. Not surprisingly, in an effort to improve its financial position, Good-year executives recently announced that they plan to reduce North American production of private label, low profit tires by a third this year.

The New System

Recognizing the transformation of the new American manufacturing approach was the genius of Sam Walton. He and a raft of imitators stepped in to fill the power vacuum that the strategy gurus had helped to create. The result was the formation of massive distributors who drove the sale and distribution of manufacturers’ products in the United States. Today, the vast majority of consumer products are sold, distributed and controlled by entities other than the actual manufacturers.

Thousands of U.S. manufacturers have little or no control over the distribution and sale of products in their home market. They do not even have control over the price they can charge for their products. This is evidenced by mandates from megadistributors imposing yearly price reductions on manufactured goods while simultaneously insisting that suppliers maintain the same high standards of quality and service.

The ability of Wal-Mart to squeeze its suppliers is legendary — and no wonder, with a 30% share of the U.S. market for household staples such as toothpaste, shampoo and paper products and roughly 20% of all CD, DVD and video sales. Its vendors have no choice but to toe the line. Such market power allows the megadistributor to home in on every aspect of a supplier’s operation: which products get developed, what they’re made of, and how to price them.

In 2001, consumer products manufacturer Newell Rubbermaid Inc. finally bent to the overwhelming pressure of Wal-Mart — its biggest U.S. customer — to cut its Rubbermaid plastics prices drastically. At the same time as a new contract for future business was being announced between the two companies, Rubbermaid’s Wooster, Ohio, plant was closed. The company began to make significant manufacturing layoffs, and many of those jobs relocated to China.

Wal-Mart is not the only company that has gained strategic advantage as a result of the “core capability thinking” of U.S. manufacturers. Consider Home Depot Inc.’s dealings with American Standard Companies Inc., which employs thousands of people at dozens of factories around the world, including a few holdouts in the United States and Canada. This company sells more than $700 million in bath and kitchen products to Home Depot each year. But here’s the problem: American Standard makes little or no money selling these products to Home Depot. Because of the distributor’s size, American Standard has few other viable distribution channels in which to place its bath and kitchen products in the United States. The only other possibility is Lowe’s Companies Inc., the second largest megadistributor in the do-it-yourself market. Home Depot knows this all too well and every year pays less for the same products from American Standard than the year before. Given the circumstances, how long will it be before the remaining few Canadian and U.S. plants are closed and relocated?

Another example is that of aluminum production giant Alcoa Inc., which is in the process of reconfiguring all of its North American production facilities. It has been forced to relocate many of its operations to China and Russia because DaimlerChrysler Corp., after nearly 10 years of research and development, decided that it would pay over 40% less for the wheels that it had been sourcing from Alcoa Wheel Products. As a result, thousands of U.S. jobs have been lost, factories will be closed, and technology and machinery will be exported from the United States to help operate the new plant in Shanghai, China.

The companies described above are not exceptions to the rule; they are merely a few of the most visible examples. In home electronics, medical equipment, chemicals, do-it-yourself and nearly every other industry imaginable in the United States megadistributors have emerged to dominate the sale and distribution of most products.

The Outsourcing Compulsion

Presently, far too many U.S. manufacturers view out-sourcing overseas as their only option when it comes to “growing” their business. They are locked out of opportunities at home because of the abnormal relationships they possess with megadistributors that not only control the delivery of their products to consumers but also wield tremendous power over their internal processes. Cut off from the ability to control distribution and sales, these manufacturers can only grow by cutting costs at the other end of the value chain. They must chase the cheapest in terms of their inputs, particularly labor, in order to generate adequate margins and maintain shareholder value.

Equally debilitating is the fact that many manufacturers that feel compelled to relocate some or all of their operations offshore may not accurately assess the inherent risks in doing business in less developed countries. In China, for example, an overwhelmed infrastructure, competition for scarcer and scarcer resources, a government that frequently protects its own interests over those of foreign companies and an impending currency correction are critical elements that manufacturers often do not, or seemingly cannot, consider. Such factors should be heavily weighed when looking at overseas locations. However, the perils of doing business in emerging markets are often glossed over as the demands of the megadistributors compel manufacturers to embrace what appears to be their only strategic option.

The Way Out

There are steps that manufacturers can take to wean themselves from the ensnarement of dysfunctional “partnerships” with the megadistributors. The first step is to recognize that there is something intrinsically wrong about an industrial system in which control over so much of American manufacturing is exercised from the sales floor. The “everyday low price” mentality is a perversion of the marketing concept, because price is the only consumer need that is considered to be important by the megadistributors and, by extension, their manufacturing “partners.” Degrading working conditions, the outsourcing of jobs and the cheapening of product quality should not be the norm in American business.

Having recognized the scope of the problem, and having resolved to change course, managers must determine to reassert control over the products that their companies produce. Control over distribution must become the strategic operational imperative. In order to achieve such control, it may or may not be necessary for companies to abandon their current distributors. It may be possible to continue pushing product through the Wal-Marts and Targets of the world. However, manufacturers must abandon the “tail-wagging-the-dog” mentality that they now mistake for standard operating procedure. A number of companies that have retained control over their distribution strategies and focused on product and/or service quality — such as Avon, Harley-Davidson, Starbucks, Sherwin-Williams, Dell and Caterpillar — have revenues, profits, returns on assets and returns on equity that are above their industry averages. All companies should learn from the actions that these companies and others have taken.

First, explore new channels of distribution. In order to break the addiction of mass-market merchandising, business people must research other possible channel strategies. Direct marketing has proven to be a highly effective way of circumventing the distributor colonization. David Oreck, founder of the Oreck Corp., which is headquartered in New Orleans, Louisiana, sells his vacuum cleaners through licensed resellers, direct mail, company-owned outlets, and online. According to Oreck, “Any manufacturer who does not control distribution, will eventually be controlled by the distribution channel.” The Sherwin-Williams Co., headquartered in Cleveland, Ohio, manufactures paint and related products and employs over 25,000 people. In contrast to most of its competitors, it has maintained control over its sales and distribution by selling its products through over 2,600 company-owned stores located primarily in North America. Sherwin-Williams is a well-above-average performer in the industry. Perhaps the most famous example of control over distribution is the computer manufacturer Dell Inc. The company became an industry giant by bypassing typical distribution channels and dealing directly with consumers.

Next, do not create and sell commodities. Instead of creating a trimmed-down product that is perceived as a commodity by potential customers, re-create the product so that buyers are willing to pay a higher price. This can be accomplished in a number of ways. First, product quality has become so poor as a result of the megadistributors that first-mover advantage should accrue to companies that create and promote quality as a key product attribute. Second, mass distribution has eroded service across a range of products that are greatly enhanced by knowledgeable customer service. Starbucks Corp. not only produces a high-quality product but also sells an experience. This is accomplished with a work force that has been trained to educate and entertain customers with the ins and outs of Guatemala Antigua and Colombia Nariño Supremo coffees. Starbucks reinvented an entire industry and was able to do so in a mature business with high barriers to entry.

Finally, realize that bigger is not better. The allure of attractive revenue forecasts based on enormous sales volumes has proved an enticing elixir for companies ready to throw off the burden of distribution in favor of the easy arms of mass marketing. Building a business (including distribution and sales) brick by brick is hard work. But mass marketing, with its loss of control over distribution, is a risky venture. The desire to get rich quick leaves many companies vulnerable to much bigger and much more determined“partners.” Strategies like direct marketing ultimately allow manufacturers to build the kinds of relationships that are driven by the best things about their products and services.

FOR THE FORESEEABLE FUTURE, the likelihood that U.S. manufacturers will regain control over the sale and distribution of their products at home is minimal. The megadistributors are clearly in control. Opportunity for manufacturers to regain control over the sale and distribution of their products ironically exists in developing countries overseas.

In high-growth emerging markets around the world, manufacturers still possess the ability to directly influence what happens to their products once they enter the distribution chain. True, the Wal-Marts and Home Depots are trying to make their mark in Mexico, China and Eastern Europe, but they and other megadistributors have yet to become entrenched in such markets. The window of opportunity is open for manufacturers to shape and mold how their products are distributed there. In the meantime, circumstances at home will keep the out-sourcing compulsion churning for years to come.