Trading Places: Why Outsourcing May Destroy your Business

As last quarter profit reports continue to pour in, an interesting trend emerges in the high tech industries and most notably in the handset phone segment: Long time American and European leaders like Motorola and Nokia are trailing in sales growth their Asian counterparts like Samsung Electronics. What makes this "changing places" trend interesting is that many of these Asian companies have been contract manufacturers of their American and European counterparts. First, they performed assembly operation for them. Then they performed component manufacturing. And eventually they performed everything, from product development, to manufacturing, and after sale services. In short, by outsourcing every piece of their business, American and European companies they gave it away to formidable competitors they created. Is this a good strategy? Hardly.

Economists are almost unanimous: Outsourcing is a good business strategy. It improves efficiency, cuts costs, speeds up product development, and allows companies to focus on their "core competencies."

And for the most part, they are right. Outsourcing has helped American companies deal with the destructive forces of globalization, that is; the intensification of competition and the price and profit erosion associated with it. For some companies, outsourcing has made the difference between staying in business and going out of business. But, as with every other business strategy, outsourcing has its own limitations and "unintended consequences" that if not addressed, can turn it into a bad business strategy.

Outsourcing is easy to be replicated by the competition; it leads to fragmentation and disintegration of the product supply chain, inviting new competitors into the industry. It also nurtures corporate complacency; and it undermines a company's relations with its labor, customers, and the domestic and local community.

Outsourcing is easy to be replicated, and therefore, it is not a source of sustainable competitive advantage. Outsourcing provides certain competitive advantages to early-movers--that is, to companies that adapt it first, but it isn't proprietary. It cannot be patented, preventing others from adapting it. For example, if outsourcing hardware manufacturing provides IBM a cost advantage, it al so does for its competitors, such as HP, Dell Computers, and Sun Microsystems that will follow suit. If outsourcing call centers cut costs for American Express, it also does for its credit card competitors. This means that outsourcing works only as long as some industry members have yet to adapt it. Once this happens, outsourcing is no longer a source of competitive advantage.

Outsourcing leads to the fragmentation and disintegration of the product supply chain, inviting new competitors into the industry, and undermining pricing power and profitability. Outsourcing of manufacturing, for instance, is feasible only if it can be separated from other supply chain activities: product development, branding, marketing, distribution, and after sales services. The same is true when it comes to outsourcing marketing or distribution and so on. This means that as more and more activities are outsourced, the supply chain turns from a single integrated process performed within the boundaries of traditional corporations to a fragmented and disintegrated process, a collection of separate and disjoint activities, performed across several independent subcontractors. And although such a fragmentation and disintegration of the value chain offers corporations a number of well publicized advantages, it has an unintended consequence: it makes entry of new competitors to the industry easier, intensifying competition, shortening product cycles, and squeezing return on invested capital.

To understand how this works, let us imagine a perfectly fragmented and disintegrated TV-supply chain: every activity from the new TV-concept development, to design, manufacturing, marketing, and so on can be performed by independent subcontractors. This means that any company that has no capabilities in making and selling TVs can enter the TV industry, as long as it comes up with the sufficient capital to pay the subcontractors handling the different value chain activities. The problem, though, is that once the product hits the market, nothing prevents another company from doing exactly the same thing, and then another, and another, until the TV industry becomes crowded with companies pitting against each other in a cut throat competition that eliminates industry profitability. What seemed to be a good strategy for each company in the beginning turned into a bad strategy for everyone at the end. By carrying outsourcing to the extreme, industry members open the door widely to competition, reversing whatever outsourcing's early positive effects, and then some.

But what if outsourcing isn't carried that far? What if companies outsource only their "non-core activities," and retain their "core

activities"-- the things they can do best inhouse? Certainly this strategy cuts costs and improves product quality, but it has another unintended consequence: it nurtures corporate complacency. By focusing on things that they can do best, company managers become complacent with their achievements, they think that what is a best product for their customers today will be the best product tomorrow. Corporate complacency, in turn, leads into corporate blindness, the failure of management to see that their markets reach saturation or is undermined by alternative products.

Outsourcing's unintended consequences for companies and industries that adapt it are not confined to the intensification of competition and corporate complacency. They extend to the relations of these companies with one of their partners--labor. If each and every activity of the product supply chain is gradually farmed out, what binds labor with management and stockholders? If company engineers and marketers who develop new product ideas can sense that their jobs will eventually be farmed out, why should they be loyal to the company? Wouldn't it be better to part from the company and pursue their own product supply chain by farming out the development, the manufacturing and so on, to outsourcing companies themselves?

Outsourcing unintended consequences extend to company relations with another partner--the customer. If each and every activity is outsourced, customers may feel betrayed. If I hire Sears or Home Depot to make certain improvements in my house because they have a reputation for reliable services, I would feel betrayed if I get services from strangers hired by the said companies, especially if they perform a sloppy job. And I would feel even more betrayed if I end up discussing my medical or financial records with some stranger in an overseas call center.

Outsourcing undermines relations with a third company partner--the domestic and local community. By shifting production and jobs overseas, outsourcing has a devastated impact on both levels that often unleash tidal ideological and political waves that may reverse all the gains from outsourcing, and then some. Let's not forget that people who live in these communities are not just workers, they are customers and citizens, too. As customers, they may end up boycotting the products of corporations shifting production from one location to another, just for the sake of profits. As citizens, people may end up supporting legislation that increases the cost of doing business in their community.

In short, what seems to be trendy in business strategy isn't always a good strategy. If carried to the extreme, outsourcing turns corporations into opportunistic institutions, without a vision in a collision course with its most valuable partners, labor, customers, and the community.

True, in a competitive world, it is hard to swim like a salmon against the current. Yet the salmons that swim hard always make it to their destination.