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Time to talk sense about outsourcing

Knowledge@Wharton says the political firestorm around Gregory Mankiw's comments obscures a new reality in the economy.

Time to talk sense about outsourcing
From Knowledge@Wharton
Special to CNET News.com
February 28, 2004, 6:00 AM PST

Gregory Mankiw, who heads the White House Council of Economic Advisors, ignited a firestorm of debate this month, when he said outsourcing of U.S. jobs is probably a good thing in the long run.

As tends to happen with hot-button issues in presidential election years, sensible discussion of this question was soon drowned in an uproar of political posturing. John Kerry and John Edwards--who are seeking the Democratic nomination to take on George W. Bush in November--denounced the government's so-called conspiracy to ship jobs overseas.

Politics apart, the reality is that outsourcing is as old as the corporation.
Even Dennis Hastert, the Republican speaker of the House, criticized Mankiw. In the past few days, other respected economists--such as Columbia University's Jagdish Bhagwati--have come under fire when they tried to explain the economic rationale behind outsourcing.

Politics apart, the reality is that outsourcing is as old as the corporation. One business arranges with another to make a widget or provide a certain service that it cannot do itself--or does not wish to do--so that it can focus on the parts of the business it does best. The sourcing arrangement is normally seamless, and it matters little to end-use customers who have been paid to perform the outsourced work.

Flash forward to today, though, and it becomes clear that the phenomenon of outsourcing has taken on a whole new dimension that companies even a decade or two ago would find astonishing. Experts at Wharton and the Boston Consulting Group say outsourcing is no longer a tactical option that can help a company save a few dollars here and there. Rather, it has emerged as a strategic necessity in an era when opportunities offered by "low-cost countries" such as China, India or Mexico abound. Indeed, these experts say the sourcing juggernaut will continue to move forward, despite occasional missteps and retrenchment, and will transform national economies in both the developed and developing worlds in the process.

"It's the classic 'make vs. buy' question," says Morris Cohen, professor of manufacturing and logistics at Wharton. "Do I make something internally or buy it in the marketplace, and how do I add value most effectively? This is a problem that's been studied in economics and management for decades. This is not a new issue, and it's not one that will ever go away."

What has changed, Cohen said, is that more companies are engaged in more outsourcing than before; and they are doing it in novel ways. "The idea of moving things offshore and outside the boundary of the firm--more of that has been happening around processes you would never have thought possible. Having somebody in India answer calls--who would have ever thought of that?"

More than cutting costs
Hal Sirkin, senior vice president and director in BCG's Chicago office and head of the company's global operations practice, emphasizes that "leveraging low-cost countries" is not only about reducing costs. "It cuts across a number of dimensions. It doesn't mean your total cost will be cheaper, if you can find someone who can make something cheaper," Sirkin said. "Having a long supply chain is not as cheap (as a short one). You can't look at leveraging low-cost countries as just finding the purest lowest-cost widget. It affects so much of your business and your customers. You have to take a holistic view."

Ravi Aron, a professor of operations and information management at Wharton, emphasizes the same point. In a new paper, "Rightsourcing Services: Make, Migrate or Outsource?" Aron describes how his field research has determined that for a company to reap dividends beyond operational efficiencies, it is imperative that senior management view sourcing strategically and not as an operational decision.

"Rightsourcing initiatives that have cost savings as their principal intent do not yield strategic gains easily. Considerable rearchitecting of the relationship is needed before strategic gains can be captured," according to the paper.

Senior executives who treat outsourcing primarily as a cost-cutting maneuver will usually not commit to the major organizational change often required to produce important strategic benefits. Typical benefits of outsourcing include superior service customization, premium prices for superior service, buyer lock-in, getting to market faster, compression of the product development cycle and increased market share through competitive pricing.

Jim Hemerling, vice president and director in the Shanghai office of BCG, says the shift of manufacturing and service operations to other nations "is more about leveraging low-cost countries than outsourcing, per se. "Increasingly, it's appropriate to define it more broadly than sourcing a physical material component or product," Hemerling said. "There's a need to think about it so that it includes product development, research and development--a set of knowledge-related and people-related services and activities in addition to the sourcing of things. Just as there's cost saving in sourcing things, there are savings in sourcing knowledge and talent."

Cohen agrees that, by sourcing, companies can achieve much more than cost savings. "One of the strategic advantages of sourcing is knowledge of technology, access to better processes or efficiencies, or learning about more efficient management procedures. Another company might be a specialist in making types of precision components. By outsourcing, you gain access to that superior knowledge and capability. There are also companies that outsource for capacity. They know how to make a product but don't have capacity, or they don't want to invest in how to make it."

Saving money may not be the only reason for a corporation to cast a strategic eye on low-cost countries, but it is a major impetus. Hemerling notes that the savings can be as high as 50 percent. Much of the savings is driven by lower-wage rates. But other factors also come into play: lower costs for equipment, tooling, raw materials and real estate, as well as government incentives.

Companies in some sectors--apparel, footwear and consumer electronics--were among the earliest to shift many of their operations to low-cost countries, according to BCG research. Nike, for instance, decided a long time ago that its core competency was marketing high-end sneakers, not making them. Other sectors, such as electrical equipment, household appliances and computer equipment, are among the fast-growing segments that are penetrating low-cost countries today. But migration to low-cost countries has only just begun for companies in many other industries, including measuring and controlling devices, heating and ventilation equipment, fabricated metal products and motor vehicle parts.

Along the sourcing continuum
Companies, as well as individual business units within companies, differ sharply in how advanced they are in taking advantage of low-cost countries. BCG, which has analyzed outsourcing trends in 11 low-cost countries--Brazil, China, the Czech Republic, Hungary, India, Indonesia, Malaysia, Mexico, Poland, Russia and Thailand--divides companies into five categories.

• Some are merely testing the water. These companies recognize that outsourcing is important. They may even outsource some basic commodities--but only on a trial basis. There may be incremental benefits from this cautious approach, but no real competitive advantage is gained.

• Other companies have advanced to the point where they are purchasing components or complete products. Big retailers like America's Wal-Mart Stores and France's Carrefour, for example, purchase billions of dollars of goods from China each year. One advantage of such purchases is, of course, reduced costs. Another is that the buyers gain knowledge from working with particular suppliers. But these advantages can be easily lost, because competitors can readily imitate them.

• Some companies find themselves further along the continuum in that they have developed comprehensive sourcing. By 2006, Motorola aims to have made $10 billion in accumulated purchases from China and to be producing $10 billion a year in goods there. By that same year, Motorola also wants to have made investments totaling $10 billion inside China, including the construction of a global research and development center and the hiring of 5,000 researchers. This kind of comprehensive sourcing, which involves much more than mere procurement, produces a real competitive edge. Companies can design and make products with higher value added; at the same time, they can reduce their dependence on imports from higher-cost countries and speed up product development cycles.

• Still other companies have reached the stage where they have adopted an integrated sourcing strategy. Major auto manufacturers, for example, once viewed countries like China primarily as places to make cars for sale domestically. Today, however, car makers see these countries not just as an important market or a principal supply base for goods sold elsewhere--but as both.

An integrated strategy is required so that each business line can outsource components for products that will be exported and produce goods to be sold in the domestic market. Companies that have reached this stage are reaping major benefits. An integrated approach produces a variety of advantages not easily copied by competitors, such as being able to use plants to realize true economies of scale and broadening the opportunity to increase sales.

• Furthest along the sourcing spectrum, BCG says, are those companies, thus far few in number, that recognize that they must capture a global advantage. They recognize that if they manage their business across multiple low-cost countries, they can achieve more growth at all levels: local, regional and global. For example, Toyota outsources vehicle subassemblies from many Asian countries, allowing it to keep costs low and achieve just-in-time delivery.

Capturing global advantage--achieving the lowest costs while making use of the best people and practices--is the holy grail of leveraging low-cost countries. It is hard to achieve, but it is also difficult for competitors to replicate.

To capture global advantage, "you need to think about where you can best source competitive advantage," Hemerling notes. "And you have to do that in a dynamic sense so that you can constantly update your knowledge as to what to source, from where, to (know) the risks from any one country and to balance the exposure of risk in any one country."

How do companies move toward the goal of achieving global advantage? BCG has identified three steps: Companies must analyze opportunities and determine what should be sourced, establish an infrastructure to support the sourcing operation and overcome barriers to sourcing.

"We argue that the biggest component is building the sourcing capability," Hemerling explains. "This involves a set of processes, policies, skills, data and supplier relationships. Within each one of those categories, there are things to think about. With policies, say, you have to define the specific policies of how you operate in each country--human rights, legal issues and integrity--and the management of an enormous amount of information."

He adds that one of the major stumbling blocks to leveraging low-cost countries is not the availability of low-cost suppliers or labor but rather barriers within the organization doing the sourcing.

"If you think about a large company with multiple businesses--its functions and procurement are often decentralized down to the business unit and factory level. The organizational complexity of trying to orchestrate things across a global company is really quite extraordinary. To bring together the information and individuals required to make the decisions of where to relocate production and sourcing is a fairly staggering task."

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All materials copyright ? 2003 of the Wharton School of the University of Pennsylvania.

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