Strategic Outsourcing

The opposite of integration (a firm’s growth, in number of businesses) is outsourcing value-creation activities to subcontractors. In recent years there has been a clear move among many enterprises to outsource non-core or non-strategic activities. Any function can be outsourced, if it is not critical to a firm’s success (is not one of its distinctive competencies).

Outsourcing begins with a identification of a firm’s distinctive competencies–these will continue to be performed within the company. All other activities are then reviewed to see whether they can be performed more effectively and efficiently by independent suppliers. If they can, these activities are outsourced to those suppliers. The relationships between the company and those suppliers are then often structured as long-term contractual relationships.

Strategic Outsourcing

The term virtual corporation has been coined to describe companies that have pursued extensive strategic outsourcing.

Advantages of Strategic Outsourcing

There are several advantages of strategic outsourcing.

  1. First, by outsourcing a non-core activity to a supplier who is more efficient at performing that particular activity, the company may reduce its own cost structure, enhancing its cost leadership strategy. Suppliers may be more efficient due to economies of scale or learning effects and low-cost location.
  2. By outsourcing a non-core value-creation activity to a supplier that has a distinctive competency in that particular activity, the company may be able to better differentiate its final product.
  3. A third advantage of strategic outsourcing is that it allows the company to remove distractions, focusing more resources on strengthening its distinctive competencies.

Risks of Strategic Outsourcing

There are also some risks associated with strategic outsourcing.

  1. There is a risk of holdup, or becoming too dependent on an outsourced activity. This risk can be reduced by outsourcing from several companies at once, using a parallel sourcing policy. Another way to manage this risk is simply to signal to the subcontractors the company’s willingness to choose a different provider when the contract is up for renewal.
  2. A further drawback of outsourcing is the potential for loss of control of scheduling. This problem is intensified by a long supply chain, unpredictable demand, and outsourcing to a number of competing companies, rather than just one.
  3. Another concern is the potential for a loss of important competitive information. This risk can be managed by ensuring good communication between the subcontractor and the company.

Case Study on Failed Strategic Outsourcing: Cisco’s $2 Billion Blunder

Cisco, the largest supplier of Internet hardware such as routers and switches, performs R&D, marketing, and supply chain management within the organization, and outsources all other functions, including manufacturing. Cisco claimed that the firm benefited by not investing in capital-intensive manufacturing facilities and by not maintaining any inventory. The supply chain was a four-level pyramid, with Cisco at the peak and hundreds of suppliers of commodity inputs at the base. But when demand started to fall in 2001, Cisco found that its system couldn’t adapt quickly enough, and the company had to write off $2.2 billion in unusable inventory. This occurred because customers overbooked in the high-demand periods, and then at each level of the pyramid, buyers overbooked, magnifying the extent of the problem. Cisco’s outsourcing system distanced the company from its suppliers, with a disastrous loss of communication capability. Since the write down, Cisco has implemented a web site for industry-wide supply chain management that allows firms at all stages of the supply chain to stay in touch with the true level of demand.

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