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Outsourcing May Lead to Failure, Professor Says


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In tough economic times, many companies slash staff and turn to outsourcing, yet that strategy may doom their products; and in good times, as with Toyota, losing control over critical components can contribute to failure, according to Lyda Bigelow, business-strategy professor in the University of Utah's David Eccles School of Business.

The latest study by Bigelow and her team on the importance of vertical integration—or the in-house manufacture of products—appears in the current issue of the journal Organizational Science. Bigelow and co-author Nicholas Argyres of Washington University analyzed product performance in more than 100 U.S. auto manufacturers during the years 1917 through 1931, in order to study the industry's shift from innovation to production efficiency. At that time, there were many more manufacturers than there are today, Bigelow says.

In a previous study, Bigelow found that companies were more likely to fail when they outsourced components critical to their competitive position.

"Across the board, we find statistically significant increases in the failure rate for firms that don't consider transaction costs in their outsourcing decisions," she says. "Firms need to look beyond production costs to other costs such as poor quality, delivery delays and risk of price increases by suppliers."

Their work from the previous study shows that failure rate (either firm bankruptcy or liquidation) increased between 5 percent and 70 percent more than companies that did not outsource, depending on the risk associated with making technological changes, the product type and the company's market share.

"This is a critical strategic choice that firms make," Bigelow says. "Companies need to retain adequate control over specialized components that differentiate their products or have unique interdependencies, or they are more likely to fail to survive."

According to Bigelow, the current economic environment is similar to the period that her team studied in that it is highly competitive and is forcing firms to focus on reducing costs while maintaining value to customers.

"Two modern examples with outsourcing problems are Toyota and Boeing," says Bigelow.

For Toyota, those specialized components were the electrical system and the accelerator. Since October 2009, the company has recalled nearly 8.5 million vehicles due to problems with floor mat interference and a sticky accelerator pedal, and some have said that its design shift to an electronic throttle control is problematic. And, the company recently announced the recall of another 412,000 cars for steering problems.

In Toyota's case, the team's research suggests that outsourcing amid its strategy of accelerated growth may have led to the company's current woes.

"In this situation, it's no surprise when things break down," Bigelow says. "In 2004 and 2005, Toyota's premier goal was to overtake GM. This desire for rapid expansion, combined with an increased level of complexity in its auto designs, left Toyota with few supply options, as generating an in-house infrastructure to accommodate the increased production would've taken years."

Consequently, the company had to increase its reliance on suppliers who often had weaker incentives to maintain and improve quality, she explains.

For Boeing, the interconnections among the Dreamliner airplane's wings, fuselage, engines and software are crucial. In a bid to reduce production costs and increase support for the aircraft among foreign nations, Boeing outsourced more of this plane than any other in its history, or approximately 70 percent, Bigelow says.

"The increase in outsourcing may have reduced the costs of some components, but this cost has been more than offset by increased re-design costs and expensive delays," she says. "Boeing has indicated that it will rein in outsourcing on the next version of the Dreamliner, acknowledging that the unique aspects of this aircraft production process favor vertical integration over outsourcing."

For other companies, success or failure might hinge factors such as poor customer service, leading to a loss of business.

Throughout the U.S. auto industry's history, the decision to outsource has usually been made for financial reasons, Bigelow says. While the manufacturing process always requires some reliance on suppliers, in any industry success or failure can hinge on what components companies choose to outsource.

In their paper, Bigelow and Argyres examine a watershed event in the auto industry: the emergence of a dominant design for cars. Once automakers knew what buyers wanted and expected from them, Bigelow says, their ability to efficiently deliver a quality product became vital. This shift took place in the 1923-1924 model year when the dominant design was characterized by an all-steel, enclosed body with the steering wheel on the left and a gas-propulsion engine.

"The nature of competition shifted," Bigelow says. "Firms that continued to come up with innovative ways to design vehicles were penalized, because the market no longer valued that kind of radical innovation. What it valued was greater reliability and durability, and a lower price."

One success story was the Pennsylvania-based Biddle Motor Car Co., which specialized in sports cars and luxury vehicles. In spite of its reputation at the time as a vanity project by the company's affluent owner, Biddle outlasted many contemporaries thanks to its decision to produce many specialized parts in-house.

"As it turned out, he knew enough to keep the company running longer than anyone ever expected," Bigelow says.

Their research helps prove the transaction-cost-economics theory of Oliver E. Williamson, professor emeritus at the University of California, Berkeley, who won the 2009 Nobel Prize in economics. Williamson theorized that in a producer/supplier relationship, the more highly specialized a component, the greater the level of risk to both parties, if it is outsourced. Bigelow studied with Williamson at Berkeley.

Measuring firm performance as survival, Bigelow and Argyres found that companies that make vertical-integration decisions consistent with the logic of transaction-cost economics survive longer than those that do not.

Although studies of other industries—computer hardware and software manufacturers, pharmaceutical companies and hospitals, for example—have looked at the impact of vertical integration on specific outcomes, such as customer satisfaction or the transfer of knowledge, Bigelow and Argyres' study is one of the few that links outsourcing to firm performance.

While the importance of a good product and good business strategy can't be overlooked, in both the past and present, "the firms that do the best are the ones who make these judicious sourcing decisions," Bigelow says.


 

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