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8.2 To Outsource or Not to Outsource

Few companies, especially ones with a global presence, are self-sufficient in all of the activities that make up their value chain. Growing global competitive pressures force companies to focus on those activities they judge as critical to their success and excel at—core capabilities in which they have a distinct competitive advantage—and that can be leveraged across geographies and lines of business. Which activities should be kept in house and which ones can effectively be outsourced depends on a host of factors, most prominently the nature of the company’s core strategy and dominant value discipline. [1]

In principle, every functional or value-adding activity, from research to manufacturing to customer service, is a candidate for outsourcing. It is hard to imagine, however, that operationally excellent companies would consider outsourcing activities that are critical to the efficacy of their supply chain. Similarly, companies operating with a customer-intimate business model should be reluctant to outsource customer-service-related functions, while product leaders should nurture their capacity to innovate. That is why Toyota made continuous investments in its production system as it globalized its operations, Procter & Gamble focused on strengthening its world-class innovation and marketing capabilities as it expanded abroad, and Wal-Mart continued to refine its supply-chain management capabilities.

Firms tend to concentrate their investments in global value chain activities that contribute directly to their competitive advantage and, at the same time, help the company retain the right amount of strategic flexibility. Making such decisions is a formidable challenge—capabilities that may seem unrelated at first glance can turn out to be critical for creating an essential advantage when they are combined. As an example, consider the case of a leading consumer packaged-goods company that created strong embedded capabilities in sales. Its smaller brands showed up on retailers’ shelves far more regularly than comparable brands from competitors. It was also known for the efficacy of its short-term R&D in rapidly bringing product variations to market. These capabilities are worth investing in separately, but, together, they add up to a substantial advantage over competitors, especially in introducing new products.

Outsourcing and offshoring of component manufacturing and support services can offer compelling strategic and financial advantages including lower costs, greater flexibility, enhanced expertise, greater discipline, and the freedom to focus on core business activities.

Lower Costs

Savings may result from lower inherent, structural, systemic, or realized costs. A detailed analysis of each of these cost categories can identify the potential sources of advantage. For example, larger suppliers may capture greater scale benefits than the internal organization. The risk is that efficiency gains lead to lower quality or reliability. Offshoring typically offers significant infrastructure and labor cost advantages over traditional outsourcing. In addition, many offshoring providers have established very large-scale operations that are not economically possible for domestic providers.

Greater Flexibility

Using an outside supplier can sometimes add flexibility to a company such that it can rapidly adjust the scale and scope of production at low cost. As we have learned from the Japanese keiretsu and Korean chaebol conglomerates, networks of organizations can often adjust to demand more easily than fully integrated organizations.

Enhanced Expertise

Some suppliers may have proprietary access to technology or other intellectual property advantages that a firm cannot access by itself. This technology may improve operational reliability, productivity, efficiency, or long-term total costs and production. The significant scale of today’s offshore manufacturers, in particular, allows them to invest in technology that may be cost prohibitive for domestic providers.

Greater Discipline

Separation of purchasers and providers can assist with transparency and accountability in identifying true costs and benefits of certain activities. This can enable transactions under market-based contracts where the focus is on output rather than input. At the same time, competition among suppliers creates choice for purchasers and encourages the adoption of innovative work practices.

Focus on Core Activities

The ability to focus frees up resources internally to concentrate on those activities at which the company has distinctive capability and scale, experience, or differentiation to yield economic benefits. In other words, focus allows a company to concentrate on creating relative advantage to maximize total value and allows others to produce supportive goods and services.

While outsourcing is largely about scale and the ability to provide services at a more competitive cost, offshoring is primarily driven by the dramatic wage-cost differentials that exist between developed and developing nations. However, cost should not be the only consideration in making offshoring decisions; other relevant factors include the quality and reliability of labor continuous process improvements, environment, and infrastructure. Political stability and broad economic and legal frameworks should also be taken into account. In reality, even very significant labor cost differentials between countries cannot be the sole driver of offshoring decisions. Companies need to be assured of quality and reliability in the services they are outsourcing. This is the same whether services are outsourced domestically or offshore.

[1] Special report on outsourcing (2006, January).

8.3 The Growth in Knowledge-Based Outsourcing

In the last 20 years companies have outsourced many activities, including manufacturing, back-office functions, information technology (IT) services, and customer support. Now the focus is shifting to more knowledge-intensive areas, such as product development, R&D, engineering, and analytical services. [1] For example, as noted above, pharmaceutical companies depend on a steady pipeline of new products from R&D. The competitive pressures on these firms to bring out new products at an ever rapid pace to meet market needs are increasing. With it, the pressures on the R&D function are increasing. In order to alleviate the pressure, firms have to either increase R&D budgets or find ways to utilize the resources in a more productive way. There are situations when a firm should consider outsourcing some of its R&D work to contract research organizations or universities, for example, when (a) in-house new product design is ineffective or too slow, (b) the company is plagued by consistent project time and cost overruns, (c) loss of key talent has slowed new product development, (d) there is a need for an immediate competitive response, or (e) when problems of quality or yield reduce R&D effectiveness.

The growth in knowledge-based outsourcing is mainly driven by cost imperatives, but, increasingly, shortages of talent in home markets and the growing availability of skills in nations such as India, China, and Russia play a role. A second driver behind the growth in knowledge-based outsourcing is the increasing “commoditization” of standard business processes and IT services, depressing margins on such activities for outsourcers. This has further encouraged service providers to switch to other activities for which profits are potentially greater—including “innovation services” such as new product development (NPD), R&D, and engineering. According to Booz & Company, there has been 95% growth in the provision of such capabilities since the millennium. [2] At the same time, providers of standardized services have come to recognize that they need to focus on efficiency and more seamless client integration if they are to continue making sufficient returns. By contrast, innovation services, including everything from prototype design to credit analysis, are more complex and client-specific, and therefore are more likely to command a premium.

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

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

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

Minicase: Outsourcing of R&D in the Pharmaceutical Industry [3]

To cut costs and speed development, Eli Lilly outsources a substantial portion of its R&D—including clinical trials—to countries such as India and China. Lilly is not the only pharmaceutical company that has relocated R&D operations to the developing world; Pfizer tests drugs in Russia, and AstraZeneca conducts clinical trials in China. The main driver is rising development costs, estimated at some $1.1 billion per drug—including expenses on all the products that do not make it to the market—and expected to increase to $1.5 billion by 2010.

More recently, Lilly and other drug makers have begun to expand their R&D efforts in India and China to include clinical trials. These are the late-stage experiments to prove a drug can be used on humans. These tests are enormously expensive; Lilly estimates that each Phase III test costs at least $50 million a year. To reduce costs, Lilly plans to move 20% to 30% of this testing in the next few years. While cost reduction is the main reason for the migration, this migration is made possible by the investments these nations have made in the necessary research labs, hospitals, and professional staffs to conduct studies that meet the stringent regulations of the U.S. Food & Drug Administration or drug regulators in the European Union.

While these outsourcing initiatives are extremely successful, it is unlikely that Lilly will move its entire R&D portfolio abroad. It will likely keep a number of centers of excellence in the United States, renowned for their path-breaking research in cancer and heart disease, to maintain its leadership in these areas and to keep a research presence in the country. Another reason that prevents pharmaceutical companies from outsourcing all of its research is that they may not be able to sell their newest products in countries like India and China because patients cannot afford them or because of worries about patent protection.
[1] Myers and Cheung (2008, Summer).

[2] Bliss, Muelleer, Pfitzmann, and Shorter (2007).

[3] Special report on outsourcing (2006, January).

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