One of the most fundamental strategic decisions every company faces is which activities should be conducted in-house and which should be outsourced from various partners and suppliers. Such span of ownership, or vertical integration, decisions ultimately define the very essence of the firm’s business model and determine whom it considers its customers, suppliers, competitors, and partners. Moreover, these decisions can have a profound impact on competitive performance.
Unfortunately, managers attempting to develop vertical integration strategies must negotiate their way through advice that seems to change with the times. In the mid-1980s, Business week warned of the dire consequences that would result from extensive outsourcing and even coined the pejorative term hollow corporation to describe companies that possessed no manufacturing capabilities of their own. The effect on innovation could be huge.
The relevant is not whether vertical integration is a good strategy in general, or whether outsourcing is better, but under what conditions should an organization vertically integrate and under what conditions should it outsource? We introduce a frame work to help one identify the circumstances under which different decisions about outsourcing and vertical integration can create a strategic advantage.
Historically, many US industries were characterized by a high degree of vertical integration. A pillar of Henry Ford’s original system was integration from the production of wood and steel through final auto assembly. IBM was vertically integrated for much of its history, designing and producing its own components and writing its own software. Over the past decade, however, there has been a clear trend toward outsourcing and vertical disintegration. Ford and General Motors have both spun off major chunks of their parts divisions. Whereas electronics companies once designed and manufactured most to their components and systems in-house. Whereas pharmaceutical companies historically conducted most of their R&D in their own labs, a growing share of their R&D budgets is now spent on alliances with new biotechnology firms, and clinical trials are routinely sub-contracted to specialists such as quintiles or Covance. A web of alliances characterizes the business models of the vast majority of companies competing in the telecommunications space.
Some observers regard these trends as clear indications of the superiority of extensive outsourcing and of focusing on a narrow set of core competences. Vertical integration is deemed to be too costly, inflexible and distracting for companies competing in fast paced environments. In particular manufacturing is often cited as a nonstrategic activity that can and should be outsourced. Increasingly, moreover, companies are outsourcing services and high tech activities such as R&D, product design, accounting software and information systems management. Recent research and case studies also have tended to focus on the benefits of outsourcing. For example, a study of product development in the automobile industry found that a portion of Japanese automobile companies’ advantages in engineering productivity could be traced to their more effective use of suppliers in the product development cycle. Japanese automobile manufacturers have tended, on average, to be less vertically integrated than their American and European competitors. Moreover, they typically encourage their suppliers to take on greater responsibilities for the design and development or components and subsystems. In their attempts to become more cost competitive, and flexible, US automobile companies have followed these foreign competitors’ lead by outsourcing a far greater percentage of their component design and manufacturing needs. Dell Computer the most consistently profitable personal computer maker over the past ten years neither, designs nor manufacturers any of the internal components that go into its machines, focusing strictly on basic design, configuration, assembly, and distribution. Yet, it has crafted an enormously well- coordinated set of linkages with its suppliers that provide it unmatched flexibility in that industry.
By focusing its resources and attention on a narrow set of activities or competences, an organization should be able to perform them better than an organization that spreads itself more broadly/. In addition, outsourcing enables a company to take advantage of suppliers’ lower factor costs (particularly wages) and thereby harness the power of market forces to drive down costs and /or improve quality. Or, it might simply exploit supplier’s willingness to accept a lower rate of profitability and/or return on assets than its own shareholders demand.