“Strategic outsourcing” is not an oxymoron

The term “strategic outsourcing” may sound like an oxymoron since the central dogma of outsourcing calls for companies to sequester strategic capabilities in-house and only source non-core activities from 3rd parties.  The situation becomes more complex in a dynamic context since what may be deemed a core competency today may become peripheral tomorrow. One key strategic consideration in outsourcing is to recognize and anticipate the underlying industry structural trends (consumer, technology, macro-economic) that can sway value chain capabilities from its current strategic role to a more peripheral role down the horizon or vice versa.

The key benefits of outsourcing stem from 3rd party’s ability to pool cross-firm volume and experience to achieve economies of scale (e.g. 3PL warehousing for CPGs; credit assessment for credit card companies) and economies of scope (e.g. product bundling in contract sale force).  However structural barriers can prevent capabilities from realizing scale benefits. For example, manufacturing in the food sector and early stage R&D in the pharma sector a are capabilities with structural barriers. As such, a third party “supply market” is slow to develop and companies must continue to pursue  in-house options on these “strategic” competencies.  Broadly, 4 key structural barriers can prevent an outsourcing option from materializing:

1. Process non-modularity: the ease of decomposing key activities and processes into sub-components for outsourcing. For example software testing is amenable to divide and conquer due to standardized, object oriented architecture. In contrast, early stage drug discovery is less modular since conducting biochemical experiments require tacit knowledge locked in the minds of the scientists.
2. Long capital payback: the capital investment intensity and risk required to establish 3rd party capacity. To illustrate, building microelectronics fabrication plants required a huge capital investment barrier that  initially prevented a 3rd party outsourcing supply market from developing.  It took a massive government subsidy and investment program in the 60′s/70′s in Singapore and Taiwan to finally catalyze the development of a global contract manufacturing market for the electronics industry.
3. Regional or fragmented consumer needs: A highly fragmented set of consumer needs or consumption pattern may limit the benefits from economies of scale and scope. For example, advertising in the used car sales industry enjoys modest economies of scale, compare to say marketing household consumer products, as most customers still search and shop for used cars using localized media.
4. IP appropriation risk: The ease by which differentiated assets or know-how can be protected through patents and other IP mechanisms if they are exposed to 3^rd parties. For example, outsourcing i-Phone manufacturing has low appropriation risk due to a strong thicket of technology patents. Outsourcing sales force for med-device has strong appropriation concerns since key physician (customer) relationships are typically with sales reps and not the parent institution.

Executives faced with making  decisions on the future direction of their firm must assess and anticipate trends (e.g. disruptive technologies, regulatory policies, changing or new customer needs) along the above four structural drivers that can alter the existing outsourcing vs. captive equation. The future scope and direction of the firm depends on it.