Sourcing & Shifting
On the perils of the slimming organization
Friends,
I hope that you and yours are well on this, the last of February, Friday morning.
Over the past year – yes, that is right, our continuously growing community has officially had its first birthday – we have dug into a number of strategic frameworks and models that in their various ways have promoted the idea that companies should focus on what they do best. Regardless of whether their creators argued for an external-internal view, internal-external view or a mix of both, outsourcing has thus always been a part (either explicitly or implicitly) of the strategic conversation.
But if we do focus on what we do best, should we let others handle all the rest? Where does one draw the line?
The questions are as pertinent as they are justified. As we know, the nuance of practice is rarely addressed properly in generalized theses, and theoretical reasoning often falls down upon first contact with reality as a result.
Outsourcing, going by its evident popularity, does not appear to suffer from this issue. But appearances may be deceiving. Today, we are therefore going to look into whether the concept holds up to scrutiny – and what conclusions relevant to strategy that we can draw based on our findings.
Whatcha talkin’ bout, Willis?
At its most basic, the portmanteau of ‘outside’ and ‘sourcing’ is rather self-explanatory; one goes outside the organization to source a service provided or good created. It stands in direct contrast to insourcing, which conversely means to simply assign a project to a person, team or department within the company. Most everyone agrees on this. So far, so good.
However, confusion sometimes arises when things are moved either in or out. In order to understand why this is, we have to take a short (I promise) trip back in history.
Although the term outsourcing seemingly originated in the 1980s, the concept can be traced back to Ronald Coase, who in The Nature of the Firm (1937) discussed what might constitute the boundaries of a company. By comparing the costs of internal supply of a good or service with that of the equivalent market price, he argued, managers could get a measure of the efficiency of production (this, as it happens, also laid the foundation of modern transaction cost economics).
Admittedly, that is not to say that the endeavor did not exist earlier. During the industrial revolution, US textile companies, for example, would habitually source raw materials from India and have them processed in Scotland. But it was not until after Coase – and in particular the last quarter of the 20th century – that outsourcing really became a trend.
Until then, the model organization had very much been a vertically integrated behemoth governed under the mantra of ‘owning, managing and controlling’. As one might expect, this eventually led to calls for diversification so as to take advantage of economies of scale and, indeed, they also echoed throughout the 1950s and 1960s.
But then came the increasingly globalized markets of the 1970s and 1980s, and the management structures of old were suddenly revealed to be far too large and rigid for the new context. In search of greater agility and efficiency, many companies shifted to a narrower focus on core competencies (no doubt inspired by thinkers such as Prahalad and Hamel). This, of course, meant unavoidable conversations about what should stay and what should go. Even though ‘outside sourcing’ literally means to find or acquire a source outside, the process took on the meaning of externalizing existing functions.
This interpretation made sense at the time, but has proven to no longer be sufficient. As demand for outside capabilities increased, supply followed suit – and the internet has made access to it a non-issue. In today’s highly interconnected markets, it is entirely possible to obtain almost any capability from an external agent at any point in a company’s lifecycle. Movement is hardly a prerequisite.
Consequently, for the purposes of clarity, I will in the following refer to sourcing from set relationships as insourcing and outsourcing, whereas movement will be called either in-shifting or out-shifting, as per the obligatory 2x2 below.
It is a point that goes beyond mere linguistics though, to be fair. While sourcing and shifting share similarities, they are also different in terms of strategic scope, at least as a rule. Having an outside party provide even an integral function (e.g., an advertising agency that relies on a production company to make commercials) is undoubtedly another matter than building it for oneself via M&A, recruitment or training. Likewise, relying on existing employees is business as usual, whereas externalizing their jobs is anything but.
Back to today
The present-day arguments for outsourcing and out-shifting are broadly the same as the historical ones. Large companies still frequently realize that they lack agility and resilience (often amusingly verbalized in nonsensical terms of having to ‘behave like a startup’). Relying on an external party, whether by a preceding shift of not, can create cost savings, enable an improved focus on key strategic issues, and provide access to specialized technology and expertise, among many benefits.
But subcontracting is hardly reserved for the incumbents. On the contrary, small companies that do not yet have the funds to recruit or train to acquire particular know-how may afford to obtain it from those that already possess it, and outsourcing production can circumvent traditional barriers to market entry (e.g., by using others’ factories instead of building one’s own).
Or so the story typically goes. The public narrative around outsourcing is very much driven by those who stand to gain most from it – and that can be a lot. Taking on subcontracts is, if the stars align, a low risk-high reward affair; the more crucial the function, the likelier is it that free help will be provided by the outsourcing company (this is especially true in manufacturing). As much as suppliers can fail, it is very much in the outsourcing company’s interest to keep that from happening. This asymmetrical power-size dynamic is partly the reason why Michael Porter named suppliers as one of the potential threats in the five forces model.
Wisely, more and more companies are building resilience through multi-sourcing strategies (with interchangeable providers) and thereby mitigating some of the risks involved. But most anything positive that can come out of outsourcing or out-shifting may also have the opposite effect. Cost savings can become unrealized, hidden costs can materialize, the company can become less flexible, the outsourcing partner can turn out to be far less qualified than originally thought, power can shift to the supplier, IPs and profit mechanisms can become lost along with reputation, customers or opportunities, employee morale can deteriorate, and so on. The list, as they say, goes on.
There are as many horror stories concerning subcontracting as there are success stories. Boeing, for example, nearly went under as a result of out-shifting; instead of reducing the 787’s development time and cost, it managed the opposite. As then-CEO Jim Albaugh put it, the company ‘spent a lot more money in trying to recover’ than they ‘ever would have spent’ if they had tried to keep key technologies in-house.
In a brilliant internal report, one of the company’s aerospace engineers, Dr. L. J. Hart-Smith, went into more detail. His extremely well-argued conclusion was that it was not possible to make more and more profit out of less and less product; not only was the work out-shifted, but the profits were too. He also emphasized the dangers of sub-optimum solutions in which individual costs were minimized in isolation, a point that echoes recurring arguments in this newsletter about the interconnectedness of organizations.
What to do
The strategic debate between insourcing, in-shifting, outsourcing and out-shifting is a lot less binary than often portrayed, featuring a fractured body of academic research where one can cherrypick conclusions and a practical narrative skewed by those that do. The only viable conclusion one can reach is consequently that, as always, it all comes down to context.
Unfortunately, this requires a more profound and in-depth analysis than provided by some of the almost cartoonish frameworks currently making the rounds. You may want to ask yourself, for example:
Is there a clear strategic purpose for the exercise? There is nothing more effective when it comes to reducing costs than ensuring that it is done correctly the first time.
How close is the function to the center of the overall strategy? Some losses may prevent you from making another bet.
Are you acting in context or isolation? Try to identify broader organizational implications of your actions.
What is the time horizon? A short-term gain may be easily identified as a long-term risk.
How will you measure impact? Metrics can be gamed and fail to represent reality.
Does the decision increase or decrease the potential for human error? Some skills are transferrable and may even be automated, others are not.
Will there still be enough cash flow generating work done in-house to create room for innovation and new product development? Remember that companies need both robustness and resilience.
But above all else, to paraphrase a line from Hart-Smith, always listen more to your employees than to any outside commentator or business consultant who has never run your kind of business (and yes, that includes yours truly). Whether they argue for insourcing, in-shifting, outsourcing or out-shifting, if their advice changes every year, it cannot possibly be correct.
Next week, we are going to cover another topic requested by a subscriber: customer acquisition vs retention.
Until then, I wish you the loveliest of weekends. And stay safe.
Onwards and upwards,
JP