The term “strategic outsourcing” may sound like an oxymoron. Traditional dogma of outsourcing calls for companies to sequester strategic capabilities in-house and only source non-core or commoditized capabilities from 3rd parties. The situation becomes more complex in a dynamic market context since (i) what may be deemed a core competency today may become peripheral tomorrow and (ii) firms may increasingly find a deficit of in-house critical capabilities and know-how as they react to new markets and consumer changes. One key implication is that outsourcing must recognize and anticipate the underlying industry structural trends (consumer, technology, macro-economic) that can unexpectedly change a firm’s value chain capabilities landscape.
The key benefits of outsourcing stem from 3rd party’s ability to pool cross-firm economies of scale. For example, 3PL warehousing for CPGs, credit assessment for credit card companies, customer contact center operations, etc.. Outsourcing also unlock economies of scope. For example, interior fabs for automobile, smart phone assemblies for TV manufacturers, etc.. However structural barriers can prevent capabilities from realizing scale and scope benefits. Manufacturing in the food sector and early stage R&D in the pharma sector are capabilities with large structural barriers. As such, a third party “supply market” is slow to develop and companies must continue to pursue in-house options. Broadly, 4 key structural barriers can prevent an outsourcing option from materializing:
4 Drivers of Strategic Outsourcing
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 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 capex barrier that initially prevents 3rd party outsourcing supply market entry. It took massive government investment programs in the 60’s/70’s in Singapore and Taiwan to 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 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 3rd parties. For example, outsourcing iPhone 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 relationships are typically with sales reps.
Executives must assess and anticipate emerging technology, market and regulatory trends along the above four structural drivers. Strategic outsourcing is not an oxymoron The future competitiveness of their firm depends on it.
See related article on how CPG companies are increasing relying on external eco-systems in driving innovation.