startegic outsourceing

48 THE McKINSEY QUARTERLY 1995 NUMBER 1

MAKE VERSUS BUY

James Brian Quinn isBuchanan Professor of Management at theAmos Tuck School ofBusiness Administration,Dartmouth College.Frederick G. Hilmer is Dean of the AustralianGraduate School ofManagement, Universityof New South Wales. This article is reprinted by permission of thepublisher from the Sloan Management Review, Summer 1994.Copyright © 1994 SloanManagement ReviewAssociation. All rightsreserved.

1 For notes, see page 70.

James Brian Quinn • Frederick G Hilmer

TWO NEW STRATEGIC approaches, whenproperly combined, allow managers toleverage their companies’ skills and

resources well beyond levels available withother strategies:

• Concentrate the firm’s own resources on a set of “core competencies” where it canachieve definable preeminence and provideunique value for customers.1

• Strategically outsource other activities – in-cluding many traditionally considered integralto any company – for which the firm has neithera critical strategic need nor special capabilities.2

The benefits of successfully combining the twoapproaches are significant. Managers leveragetheir company’s resources in four ways.

First, they maximize returns on internalresources by concentrating investments andenergies on what the enterprise does best.Second, well-developed core competenciesprovide formidable barriers against presentand future competitors that seek to expandinto the company’s areas of interest, thusfacilitating and protecting the strategic ad-vantages of market share. Third, perhaps thegreatest leverage of all is the full utilization ofexternal suppliers’ investments, innovations,and specialized professional capabilities that

By assessing the relative costs and risks of making or buying, companies can leverage their skills and resources for increased profitability

Strategic

THE McKINSEY QUARTERLY 1995 NUMBER 1 49

would be prohibitively expensive or even impossible to duplicate internally.Fourth, in rapidly changing marketplaces and technological situations, thisjoint strategy decreases risks, shortens cycle times, lowers investments, andcreates better responsiveness to customer needs.

Two examples from our studies of Australian and US companies illustrateour point:

• Nike, Inc. is the largest supplier of athletic shoes in the world. Yet itoutsources 100 percent of its shoe production and manufactures only key technical components of its Nike Air system. Athletic footwear istechnology- and fashion-intensive, requiring high flexibility at both the production and marketing levels. Nike creates maximum value byconcentrating on preproduction (research and development) and post-production activities (marketing, distribution, and sales), linked togetherby perhaps the best marketing information system in the industry.

Using a carefully developed, on-site “expatriate” program to coordinate itsforeign-based suppliers, Nike even outsourced the advertising componentof its marketing program to Wieden & Kennedy, whose creative eƒfortsdrove Nike to the top of the product recognition scale. Nike grew at acompounded 20 percent growth rate and earned a 31 percent ROE for itsshareholders through most of the past decade.

• Knowing it could not be the best at making chips, boxes, monitors, cables, keyboards, and the like for its explosively successful Apple II, Apple Computer outsourced 70 percent of its manufacturing costs andcomponents. Instead of building internal bureaucracies where it had nounique skills, Apple outsourced critical items like design (to Frogdesign),printers (to Tokyo Electric), and even key elements of marketing (to RegisMcKenna, which achieved a “$100 million image” for Apple when it hadonly a few employees and about $1 million to spend).

Reprinted from theSloan ManagementReviewoutsourcing

Apple focused its internal resources on its own Apple DOS (disk operatingsystem) and the supporting macro soƒtware to give Apple products theirunique look and feel. Its open architecture policy stimulated independentdevelopers to write the much-needed soƒtware that gave the Apple II’scustomers uniquely high functionality. Apple thus avoided unnecessary

investments, benefited from its vendors’R&D and technical expertise, kept itselfflexible to adopt new technologies as theybecame available, and leveraged its limitedcapital resources to a huge extent. Operatingwith an extremely flat organization, Appleenjoyed three times the capital turnover and

the highest market value versus fixed investment ratio among majorcomputer producers throughout the 1980s.3

How can managers combine core competency concepts and strategicoutsourcing for maximum eƒfectiveness? To achieve benefits like Nike’s orApple’s requires careful attention to several diƒficult issues, each of whichwe discuss in turn:

1. What exactly is a “core competency”? Unfortunately, most of theliterature on this subject is tautological – “core” equals “key” or “critical”or “fundamental.” How can managers analytically select and develop thecore competencies that will provide the firm’s uniqueness, competitive edge,and basis of value creation for the future?

2. Granting that the competencies defining the firm and its essentialreasons for existence should be kept in-house, should all else be out-sourced? In most cases, common sense and theory suggest a clear “no.”How then can managers determine strategically, rather than in a short-term or ad hoc fashion, which activities to maintain internally and whichto outsource?

3. How can managers assess the relative risks and benefits of outsourcingin particular situations? And how can they contain critical risks – especiallythe potential loss of crucial skills or control over the company’s futuredirections – when outsourcing is desirable?

Core competency strategies

The basic ideas behind core competencies and strategic outsourcing havebeen well supported by research extending over a twenty-year period.4 In1974, Rumelt noted that neither of the then-favored strategies – unrelateddiversification or vertical integration – yielded consistently high returns.5Since then, other carefully structured research has indicated the eƒfectiveness

STRATEGIC OUTSOURCING


How can managers combine core competency concepts

and strategic outsourcing formaximum eƒfectiveness?

of disaggregation strategies in many industries.6 Noting the failures of many conglomerates in the 1960s and 1970s, both financial theorists andinvestors began to support more focused company concepts. Generally thismeant “sticking to your knitting” by cutting back to fewer product lines.Unfortunately, this also meant a concomitant increase in the systematic riskthese narrower markets represented.

However, some analysts noticed that many highly successful Japanese and American companies had very wide product lines, yet were neitherconglomerates nor truly vertically integrated.7 Japanese companies, likeSony, Mitsubishi, Matsushita, or Yamaha, had extremely diverse productoƒferings, as did 3M or Hewlett-Packard in the United States. Yet they were not conglomerates in the normal sense. They were termed “relatedconglomerates,” redeploying certain key skills from market to market.8

At the same time, these companies also contracted out significant supportactivities. Although frequently considered vertically integrated, the Japaneseauto industry, for example, was structured around “mother companies” thatprimarily performed design and assembly, with a number of independentsuppliers and alliance partners – without ownership bonds to the mothercompanies – feeding into them.9 Many other Japanese hi-tech companies,particularly the more innovative ones like Sony and Honda, usedcomparable strategies leveraging a few core skills against multiple marketsthrough extensive outsourcing.

The term “core competency strategies” was later used to describe theseand other less diversified strategies developed around a central set ofcorporate skills.10 However, there has been little theory or consistency in the literature about what “core” reallymeans. Consequently, many executives havebeen understandably confused about thetopic. They need not be if they think interms of the specific skills the company hasor must have to create unique value forcustomers. However, their analyses must gowell beyond looking at traditional product or functional strategies to thefundamentals of what the company can do better than anyone else.11

For example, aƒter some diƒficult times, it was easy enough for a beercompany like Foster’s to decide that it should not be in the finance, forestproducts, and pastoral businesses into which it had diversified. It has nowdivested these peripheral businesses and is concentrating on beer. However,even within this concept, Foster’s true competencies are in brewing andmarketing beer. Many of its distribution, transportation, and can productionactivities, for example, might actually be more eƒfectively contracted out.



Managers need to think in terms of the specific skills thecompany must have to createunique value for customers

Within individual functions like production, Foster’s could further extendits competitive advantage by outsourcing selected activities – such asmaintenance or computing – where it has no unique capabilities.

The essence of core competenciesWhat then is really “core”? And why? The concept requires that managersthink much more carefully about which of the firm’s activities really do –or could – create unique value and which activities managers could moreeƒfectively buy externally. Careful study of both successful and unsuccessfulcorporate examples suggests that eƒfective core competencies are:

1. Skill or knowledge sets, not products or functions. Executives need to lookbeyond the company’s products to the intellectual skills or managementsystems that actually create a maintainable competitive edge. Products,even those with valuable legal protection, can be too easily back-engineered, duplicated, or replaced by substitutes. Nor is a competencytypically one of the traditional functions such as production, engi-neering, sales, or finance, around which organizations were formed in the past. Instead, competencies tend to be sets of skills that cut acrosstraditional functions.

This interaction allows the organization consistently to perform an activitybetter than functional competitors and continually to improve on theactivity as markets, technology, and competition evolve. Competencies thusinvolve activities such as product or service design, technology creation,customer service, or logistics that tend to be based on knowledge rather

than on ownership of assets or intellectualproperty per se. Knowledge-based activitiesgenerate most of the value in services andmanufacturing.

In services, which account for 79 percent ofall jobs and 76 percent of all value-added inthe United States, intellectual inputs create

virtually all of the value-added. Banking, financial services, advertising,consulting, accounting, retailing, wholesaling, education, entertainment,communications, and health care are clear examples. In manufacturing,knowledge-based activities – like R&D, product design, process design,logistics, marketing research, marketing, advertising, distribution, andcustomer service – also dominate the value-added chain of most companies(see Exhibit 1).

2. Flexible, long-term platforms – capable of adaptation or evolution. Toomany companies try to focus on the narrow areas where they currentlyexcel, usually on some product-oriented skills. The real challenge is to



Competencies involve activitiesthat tend to be based on

knowledge rather than onownership of assets or

intellectual property per se

consciously build dominating skillsin areas that the customer willcontinue to value over time, asMotorola is doing with its focus on“superior quality, portable com-munications.” The uniqueness ofToys “R” Us lies in its powerfulinformation and distribution systemsfor toys, and that of State StreetBoston in its advanced informationand management systems for largecustodial accounts.

Problems occur when managerschoose to concentrate too narrowlyon products (as computer companiesdid on hardware) or too inflexibly onformats and skills that no longermatch customer needs (as FotoMatand numerous department storesdid). Flexible skill sets and constant,conscious reassessment of trends are hallmarks of successful corecompetency strategies.

3. Limited in number. Most com-panies target two or three (not oneand rarely more than five) activitiesin the value chain most critical tofuture success. For example, 3Mconcentrates on four critical tech-nologies in great depth and supportsthese with a peerless innovationsystem. As work becomes more com-plex, and the opportunities to excelin many detailed activities proliferate, managers find they cannot be bestat every activity in the value chain. As they go beyond three to five activitiesor skill sets, they are unable to match the performance of their more focusedcompetitors or suppliers.

Each skill set requires intensity and management dedication that cannottolerate dilution. It is hard to imagine Microsoƒt’s top managers taking theirenthusiasm and skills in soƒtware into, say, chip design or even large-scaletraining in soƒtware usage. And if they did, what would be the cost of theirloss of attention on soƒtware development?



Exhibit 1

Make or buy?

Potential cost reduction

Potential provider

High ($)

Potential value gain

Low ($)

Cost Value

BenchmarkInternal

AMEX

Andersen

Banc One

DEC

EDS

IBM

When to outsource

Potential cost reduction

Potential provider

High ($)

Potential value gain

Low ($)

Cost Value

Benchmark

Internal

Company A

Company B

Company C

When to insource

Leg

al

Pub

lic r

elat

ion

s

Acc

ou

nti

ng

Pers

on

nel

Reg

ula

tory

aff

airs

Dat

a ce

nte

r

Bas

ic r

esea

rch

Mai

nte

nan

ce

Fin

ance

Log

isti

cs

Ap

plie

d r

esea

rch

Pro

cess

des

ign

Pro

du

ct d

esig

n

Plan

t en

gin

eeri

ng

War

eho

usi

ng

Man

ufa

ctu

rin

g

Qu

alit

y co

ntr

ol

Mar

ket

rese

arch

Mar

keti

ng

Ad

vert

isin

g

Sale

s

Dis

trib

uti

on

Rep

air

Serv

ice

Corporate staff services

Example

Value chain services

Example

4. Unique sources of leverage in the value chain. Eƒfective strategies seekout places where there are market imperfections or knowledge gaps that the company is uniquely qualified to fill and where investments in intellectual resources can be highly leveraged. Raychem and Intelconcentrate on depth in design and on highly specialized test-feedbacksystems supporting carefully selected knowledge-based products – not onvolume production of standardized products – to jump over the experiencecurve advantages of their larger competitors. Morgan Stanley, through itsTAPS system, and Bear Stearns, through its integrated bond-tradingprograms, have developed in-depth knowledge bases creating uniqueintellectual advantages and profitability in their highly competitive markets.

5. Areas where the company can dominate. Companies consistently makemore money than their competitors only if they can perform some activities – which are important to customers – more eƒfectively thananyone else. True focus in strategy means the capacity to bring more powerto bear on a selected sector than any competitor can. Once, this meantowning and managing all the elements in the value chain supporting aspecific product or service in a selected market position. Today, however,some outside supplier, by specializing in the specific skills and tech-nologies underlying a single element in the value chain, can become more

proficient at that activity than virtually anycompany spreading its eƒforts over thewhole value chain.

In essence, each company is in competitionwith all potential suppliers of each activityin its value chain. Hence, it must benchmark

its selected core competencies against all other potential suppliers of thatactivity and continue to build these core capabilities until it is demonstrablybest. Thus the basic nature of strategic analysis changes from an industryanalysis perspective to a horizontal analysis of capabilities across allpotential providers of an activity, regardless of which industry the providermight be in (see Exhibit 1).

6. Elements important to customers in the long run. At least one of the firm’score competencies should normally relate directly to understanding andserving its customers – that is, the right half of the value chain in Exhibit 1.Hi-tech companies with the world’s best state-of-the-art technology oƒtenfail when they ignore this caveat. On the other hand, Merck matches itssuperb basic research with a prescription drug marketing knowhow that isequally outstanding.

By aggressively analyzing its customers’ value chains, a company can oƒtenidentify where it can specialize and provide an activity at lower cost or more



True focus in strategy means the capacity to bring more

power to bear on a selectedsector than any competitor can

eƒfectively to the customer. Such analyses have created whole newindustries, like the specialized mortgage broker, syndication, secondarymarket, transaction-processing, escrow, title search, and insurancebusinesses that have now taken over these risks and functions for banksand have disaggregated the entire mortgage industry.

7. Embedded in the organization’s systems. Maintainable competenciescannot depend on one or two talented stars – such as Steven Jobs andStephen Wozniak at Apple or Herbert Boyer and Arthur D. Riggs atGenentech – whose departure could destroy a company’s success. Instead,the firm must convert these competencies into a corporate reputation orculture that outlives the stars. Especially when a strategy is heavilydependent on creativity, personal dedication, and initiative or on attractingtop-flight professionals, core competencies must be captured within thecompany’s systems – broadly defined to include its values, organizationstructures, and management systems.

Such competencies might include recruiting (McKinsey, Goldman Sachs),training (McDonald’s, Disney), marketing (Procter & Gamble, Hallmark),innovation (Sony, 3M), motivation systems (ServiceMaster), or control ofremote and diverse operating sites within a common framework andphilosophy (Exxon, CRA, Inc.). These systems are oƒten at the heart ofconsistent superior performance; in many cases, a firm’s systems becomeits core competencies.12

Preeminence: The key strategic barrierFor its selected core competencies, the company must ensure that itmaintains absolute preeminence. It may also need to surround these corecompetencies with defensive positions, both upstream and downstream. In

some cases, it may have to performsome activities where it is not best-in-world, just to keep existing orpotential competitors from learning,taking over, eroding, or bypassingelements of its special competencies.In fact, managers should consciously

develop these core competencies to block competitors strategically andavoid outsourcing them or giving suppliers access to the critical knowledgebases or skills that underpin them.

Honda, for example, does all its engine R&D in-house and makes all thecritical parts for its small motor design core competency in closelycontrolled facilities in Japan. It will consider outsourcing any othernoncritical elements in its products, but builds a careful strategic blockaround this most essential element for all its businesses.13



For its selected corecompetencies, the company

must ensure that it maintainsabsolute preeminence

Most important, as a company’s preeminence in selected fields grows, itsknowledge-based core competencies become ever harder to overtake.Knowledge bases tend to grow exponentially in value with investment andexperience. Intellectual leadership tends to attract the most talented people,

who then work on and solve the mostinteresting problems. The combination inturn creates higher returns and attracts thenext round of outstanding talent. In additionto the examples we have already cited,organizations as diverse as Bechtel, AT&TBell Labs, Microsoƒt, Boeing, Intel, Merck,

Genentech, McKinsey, Arthur Andersen, Sony, Nike, Nintendo, BankersTrust, and Mayo Clinic have found this to be true.

Some executives regard core activities as those the company is continuouslyengaged in, while peripheral activities are those that are intermittent andtherefore can be outsourced. From a strategic outsourcing viewpoint,however, core competencies are the activities that oƒfer long-term compet-itive advantage and thus must be rigidly controlled and protected. Peripheralactivities are those not critical to the company’s competitive edge.

Strategic outsourcing

If supplier markets were totally reliable and eƒficient, rational companieswould outsource everything except those special activities in which theycould achieve a unique competitive edge, that is, their core competencies.Unfortunately, most supplier markets are imperfect and do entail some risksfor both buyer and seller with respect to price, quality, time, or other key

dimensions. Moreover, outsourcing entails uniquetransaction costs – searching, contracting, control-ling, and recontracting – that at times may exceedthe transaction costs of having the activity directlyunder management’s in-house control.

To address these diƒficulties, managers must answerthree key questions about any activity consideredfor outsourcing. First, what is the potential forobtaining competitive advantage in this activity,taking account of transaction costs? Second, whatis the potential vulnerability that could arise from market failure if the activity is outsourced?Conceptually, these two factors can be arrayed

in a simple matrix (see Exhibit 2). Third, what can we do to alleviate our vulnerability by structuring arrangements with suppliers to aƒfordappropriate controls yet provide for necessary flexibilities in demand?



Intellectual leadership tends toattract the most talented people,

who then work on and solve the most interesting problems

Exhibit 2

Competitive advantage versus strategic vulnerability

Pote

nti

al f

or

com

pet

itiv

e ed

ge

Low control needed (buy off the shelf)

Moderate control needed (special venture or contract arrangements)

Strategic control (produce internally)

Degree of strategic vulnerability

The two extremes in Exhibit 2 are relatively straightforward. When thepotential for both competitive edge and strategic vulnerability is high, thecompany needs a high degree of control, usually entailing productioninternally or through joint ownership arrangements or tight long-termcontracts (explicit or implicit).

Marks & Spencer, for example, is famous for its network of tied suppliers,which create the unique brands and styles that underpin the retailer’svalue reputation. Spot suppliers would be too unreliable and unlikely to meet the demanding standards that are Marks & Spencer’s uniqueconsumer franchise. Hence, close control of product quality, design,technology, and equipment through contracts and even financial supportis essential.

The opposite case is perhaps oƒfice cleaning, where little competitive edgeis usually possible and there is an active and deep market of supplier firms.In between, there is a continuous range of activities requiring diƒferentdegrees of control and strategic flexibility.

At each intervening point, the question is not just whether to make or buy,but how to implement a desired balance between independence andincentives for the supplier versus control and security for the buyer. Mostcompanies will benefit by extending outsourcing first in less critical areas,or in parts of activities, like payroll, rather than all of accounting. As theygain experience, they may increase profitopportunities greatly by outsourcing morecritical activities to noncompeting firms thatcan perform them more eƒfectively.

In a few cases, more complex alliances withcompetitors may be essential to garnerspecialized skills that cannot be obtained inother ways. At each level, the company must isolate and rigorously controlstrategically critical relationships between its suppliers and its customers.

Competitive edgeThe key strategic issue in insourcing versus outsourcing is whether acompany can achieve a maintainable competitive edge by performing anactivity internally – usually cheaper, better, in a more timely fashion, orwith some unique capability – on a continuing basis. If one or more of thesedimensions is critical to the customer and if the company can perform thatfunction uniquely well, the activity should be kept in-house. Manycompanies unfortunately assume that because they have historicallyperformed an activity internally, or because it seems integral to theirbusiness, the activity should be insourced. However, on closer investigation



The question is how toimplement a balance betweenindependence and incentives for the supplier versus control

and security for the buyer

and with careful benchmarking, a company’s internal capabilities may turnout to be significantly below those of best-in-world suppliers.

Ford Motor Company, for example, found that many of its internalsuppliers’ quality practices and costs were nowhere near those of externalsuppliers when it began its famous “best in class” worldwide benchmarkingstudies on 400 subassemblies for the new Taurus-Sable line. A New Yorkbank with extensive worldwide operations investigated why its FederalExpress costs were soaring and found that its internal mail department took

two days more than Federal Express to get aletter or package from the third floor to thefortieth floor of its building.

In interviews about benchmarking with top operating managers in both service andmanufacturing companies, we frequently

encountered some paraphrase of “We thought we were the best in the world at many activities. But when we benchmarked against the bestexternal suppliers, we found we were not even up to the worst of thebenchmarking cases.”

Transaction costsIn all calculations, analysts must include internal transaction costs as wellas those associated with external sourcing. If the company is to producethe item or service internally on a long-term basis, it must back up itsdecision with continuing R&D, personnel development, and infrastructureinvestments that at least match those of the best external supplier;otherwise, it will lose its competitive edge over time. Managers oƒten tendto overlook such backup costs, as well as the losses from laggard innovationand unresponsiveness of internalgroups that know they have aguaranteed market.

Finally, there are the headquartersand support costs of constantlymanaging the insourced activity. Oneof the great gains of outsourcing is the decrease in executive time spentmanaging peripheral activities – freeing top management to focus more onthe core of its business.

Various studies have shown that when these internal transaction costs arethoroughly analyzed, they can be extremely high.14 Since it is easier toidentify the explicit transaction costs of dealing with external suppliers,these generally tend to be included in analyses. Harder-to-identify internaltransaction costs, however, are oƒten not included, thus biasing results.



“We thought we were the best in the world, but we found wewere not even up to the worst of the benchmarking cases”

One of the great gains ofoutsourcing is freeing top

management to focus more on the core of its business

VulnerabilityWhen there are many suppliers (with adequate but not dominating scale) and mature market standards and terms, a potential buyer is unlikelyto be more eƒficient than the best available supplier. If, on the other hand,there is not suƒficient depth in the market, overly powerful suppliers canhold the company ransom. Conversely, if the number of suppliers is limitedor individual suppliers are too weak, they may be unable to supplyinnovative products or services as well as a much larger buyer could byperforming the activity in-house. While the activity or product might notbe one of its core competencies, the company might nevertheless benefitby producing internally rather than undertaking the training, investment,and codesign expenses necessary to bring weak suppliers up to neededperformance levels.

Another form of vulnerability is the lack of information available in themarketplace or from individual suppliers; for example, a supplier maysecretly expect labor disruptions or raw material problems, but hide theseconcerns until it is too late for the customerto go elsewhere. A related problem occurswhen a supplier has unique informationcapabilities: for example, large wholesalersor retailers, market research firms, soƒtwarecompanies, or legal specialists may haveinformation or fact-gathering systems thatwould be impossible for the buyer or any other single supplier to reproduceeƒficiently. Such suppliers may be able to charge what are essentiallymonopoly prices, but purchasing from them could still be less costly thanreproducing the service internally. In other cases, there may be manycapable suppliers (for example, in R&D or soƒtware), but the costs ofadequately monitoring progress on the suppliers’ premises might makeoutsourcing prohibitive.

Sometimes the whole structure of information in an industry will militatefor or against outsourcing. Computing, for example, was largely kept in-house in its early years because the information available to a buyer ofcomputing services and its ability to make judgments about such serviceswere very diƒferent for the buying company (which knew very little) thanfor the supplier (which had excellent information). Many buyers lacked thecompetency either to assess or to monitor sellers, and feared loss of vitalinformation. A company can outsource computing more easily today, in partbecause buyers’ computer, technical management, and soƒtware knowhoware suƒficient to make informed judgments about external suppliers.

In addition to information anomalies, Stuckey and White note three typesof “asset specificity” that commonly create market imperfections, calling



Sometimes the whole structure of information inan industry will militate for

or against outsourcing

for controlled sourcing solutions rather than relying on eƒficient markets.15

These are: (1) site specificity, where sellers have located costly fixed assetsin close proximity to the buyer, thus minimizing transport and inventorycosts for a single supplier; (2) technical specificity, where one or both partiesmust invest in equipment that can be used only by the parties in conjunctionwith each other and has low value in alternative uses; and (3) human capitalspecificity, where employees must develop in-depth skills that are specific toa particular buyer or customer relationship.

Stuckey and White explain the outsourcing implications of information and specificity problems in the case of a bauxite mine and an aluminarefiner. Refineries are usually located close to mines because of the highcost of transporting bauxite, relative to its value. Refineries in turn are tunedto process the narrow set of physical properties associated with theparticular mine’s bauxite.

Diƒferent and highly specialized skills and assets are needed for refiningversus mining. Access to information further compounds problems; if anindependent mine expects a strike, it is unlikely to share that informationwith its customers, unless there are strong incentives. As a result, the alu-minum industry has moved toward vertical integration or strong bilateraljoint ventures, as opposed to open outsourcing of bauxite supplies – despitethe apparent presence of a commodity product and many suppliers andsellers. In this case, issues of both competitive advantage and potentialmarket failure dictate a higher degree of sourcing control.

Degree of sourcing controlIn deciding on a sourcing strategy for a particular segment of their business,managers have a wide range of control options (see Exhibits 3 and 4 for the most basic). Where there is high potential both for vulnerability and for competitive edge, tight control is indicated (as in the bauxite case). At the opposite end is, say, oƒfice cleaning. Between these extremes areopportunities for developing special incentives or more complex oversightcontracts to balance intermediate levels of vulnerability against moremoderate prospects for competitive edge. Nike’s multi-tier strategy oƒfers aninteresting example (see boxed insert on page 62).

The practice and law ofstrategic alliances are rapidlydeveloping new ways to dealwith common control issues– by establishing specifiedprocedures that permit di-rect involvement in limitedstages of a partner’s activities,



Exhibit 3

Range of outsourcing options

Self Partnership

Controlled Not controlled

Long term Short term

Make Buyversus

without incurring either the costs ofownership arrangements or the lossof control inherent in arm’s-lengthtransactions. As they work their way through the available options,managers should ask themselves aseries of strategic questions:

1. Do we really want to produce thegoods or service internally in thelong run? If we do, are we willing to make the back-up investmentsnecessary to sustain a best-in-worldposition? Is it critical to defendingour core competency? If not…

2. Can we license technology or buy knowhow that will let us be best on acontinuing basis? If not…

3. Can we buy the item as an oƒf-the-shelf product or service from a best-in-world supplier? Is this a viable long-term option as volume andcomplexity grow? If not…

4. Can we establish a joint development project with a knowledgeablesupplier that will ultimately give us the capability to be best at this activity?If not…

5. Can we enter into a long-term development or purchase agreement thatgives us a secure source of supply and a proprietary interest in knowledgeor other property of vital interest to us and the supplier? If not…

6. Can we acquire and manage a best-in-world supplier to advantage? If not, can we set up a joint venture or partnership that avoids the short-comings we see in each of the above? If so…

7. Can we establish controls and incentives that reduce total transactioncosts below those of producing internally?

Flexibility versus controlWithin this framework, there is a constant tradeoƒf between flexibility andcontrol. One of the main purposes of outsourcing is to have the supplierassume certain classes of investment and risk, such as demand variability.To optimize costs, the buying company may want to maintain its internalcapacity at relatively constant levels despite highly fluctuating salesdemands. Under these circumstances, it needs a surge strategy.



Exhibit 4

Potential contract relationships

Co

ntr

ol n

eed

Short-term contract

Call option

Long-term contract

Retainer

Joint development

Partial ownership

Full ownership

Flexibility need


Nike, Inc. has a three-tier strategy of“production partners.”

Developed partners produce Nike’s latestand most expensive “statement products,”which can absorb higher production costs.These companies usually produce lowervolumes, codevelop products, and coinvest in new technologies.

Volume producers are above-average in size (making 70,000 to 85,000 units a day,compared to 20,000 to 25,000 units fordeveloped partners). They generally produce a specific type of footwear (say, basketballshoes) and are vertically integrated. Nike doesno development work with them becauseeach company may produce for seven or eightother buyers to keep up its volume. AlthoughNike tries very hard to stabilize volumes for its developed partners, volume partners areexpected to handle most surges in volumethemselves.

Developing sources are attractive primarilybecause of their low labor costs and theircapacity to diversify assembly locations. Allproduce exclusively for Nike, which has astrong “tutelage” program to develop theminto higher-level suppliers. To help both

parties, Nike tries to link developing sources(through joint ventures) with its developedpartners. The latter assist by providingtraining, helping to finance some operations,and moving some of their own labor-intensiveactivities to these units.

In addition to its first tier of assembly units,Nike supports a complex network of second-tier suppliers for materials, components, andsubassemblies. In Nike’s third tier, some of themore specialized and technical components –for example, patented features like the NikeAirsole® are made in supplier companies that Nike totally controls. Nike manages itsexternal suppliers through its “expatriate”program. Nike expatriates become permanentpersonnel in each factory producing Nikefootwear, functioning as liaisons withcorporate R&D, headquarters, and worldwidequality assurance and product developmentefforts. Nike’s own R&D group participates indesign, its corporately owned componentfactories give it a second window onproduction, and its corporate offices constantlyscan new suppliers for better techniques.

NIKE’S MULTI-TIER PARTNER STRATEGY

McDonald’s, for example, with $8 billion in sales and 10.1 percent growthper year, needs to call in part-time and casual workers to handle extensivedaily variations yet also be able to select its future permanent or managerialpersonnel from these people. IBM has had the opposite problem; since itscore demand has been declining, the company has had to lay oƒf employees.Yet it needs surge capacity for: (1) quick access to some former employees’basic skills; (2) available production capacity without the costs of supportingfacilities full time; and (3) the ability to exploit strong outside parties’specialized capabilities through temporary consortia – for example, inapplications soƒtware, microprocessors, network development, or factoryautomation.

Strategically, McDonald’s has created a pool of people available on “calloptions,” while IBM – through spinouts of factories with baseloadcommitments to IBM, guaranteed consulting employment for key people,flexible joint ventures, and strategic alliances – has created “put options”to handle surge needs as it downsizes and tries to turn around its business.

There is a full spectrum of outsourcing arrangements, depending on thecompany’s control and flexibility needs (see Exhibit 4). The issue is lesswhether to make or buy an activity than it is how to structure internal versus external sourcing on an optimal basis. Companies are outsourcing much more of what used to be considered either integral elements of theirvalue chains or necessary staƒf activities. Because of greater complexity, higher specialization, and new technological capabilities, outside suppliers can now perform many such activities atlower cost and with higher value-added thana fully integrated company can.

In some cases, new production technologieshave moved manufacturing economies ofscale toward the supplier. In others, servicetechnologies have lowered transaction costssubstantially, making it possible to specify, transport, store, and coordinateinputs from external sources so inexpensively that the balance of benefitshas shiƒted from insourcing to outsourcing. In certain specialized niches,outside companies have grown to such size and sophistication that theyhave developed economies of scale, scope, and knowledge intensity soformidable that neither smaller nor more integrated producers caneƒfectively compete with them (for example, ADP Services in payroll, andServiceMaster in maintenance). To the extent that knowledge of a specificactivity is more important than knowledge of the end product itself,specialized suppliers can oƒten produce higher value-added at lower costfor that activity than almost any integrated company.

Strategic benefits versus risks

Too oƒten companies look at outsourcing as a means to lower only short-term direct costs. However, through strategic outsourcing, companies can lower their long-term capital investments and leverage their keycompetencies significantly, as Apple and Nike have done. They can also forcemany types of risk and unwanted management problems onto suppliers.

Gallo, the largest producer and distributor of wines in the United States,outsources most of its grapes, pushing the risks of weather, land prices, andlabor problems onto its suppliers.

Argyle Diamonds, one of the world’s largest diamond producers, outsourcesvirtually all aspects of its operation except the crucial steps of separation andsorting of diamonds. It contracts all its huge earth-moving operations (toavoid capital and labor risks), its housing and food services for workers (toavoid confrontations on nonoperating issues), and much of its distribution(to De Beers to protect prices, to finance inventories, and to avoid the



Outside suppliers can nowperform many activities at lower cost and with higher value-added than a fullyintegrated company can

complications of worldwide distribution). By outsourcing to best-in-class suppliers in each case, it further ensures the quality and image of its operations.

Important strategic benefitsStrategically, outsourcing can provide the buyer with greater flexibility,especially in the purchase of rapidly developing new technologies, fashiongoods, or the myriad components of complex systems. It reduces thecompany’s design-cycle times as multiple best-in-class suppliers worksimultaneously on individual components of a system. Each supplier canboth have more personnel depth and sophisticated technical knowledgeabout its specific area and support more specialized facilities for higherquality than the coordinating (buyer) company could possibly achieve alone.

In the same vein, strategic outsourcing spreads the company’s risk forcomponent and technology developments across a number of suppliers.The company does not have to undertake the full failure risks of allcomponent R&D programs or invest in and constantly update prod-uction capabilities for each component system. Further, the buyer is notlimited to its own innovative capabilities; it can tap into a stream of new

product and process ideas and qualityimprovement potentials it could not possiblygenerate itself.

In the world’s advanced economies,increased aƒfluence has forced much greaterattention on new product ideas, quality

details, and customization. Because small specialized suppliers oƒten oƒfergreater responsiveness, and new technologies have reduced the size neededto achieve economies of scale, the average size of industrial firms hasdecreased since the late 1960s, and subcontracting constitutes an evergreater portion of most producers’ costs.16 Outsourcing has become a majorstrategy to leverage internal technical capabilities and to tap the rapidresponse and innovative capabilities of small enterprises. RichardLeibhaber, chief strategy and technology oƒficer at MCI, commented:

MCI constantly seeks to grow by finding and developing associations withsmall companies having interesting services they can hang onto the MCInetwork. Although we employ only about 1,000 professional technicalpersonnel internally, 19,000 such personnel work directly for us throughcontracts… Now we do about 60 percent of our soƒtware development workinternally, but we manage [in detail] the other 40 percent in contractors’hands. We do all the specification, process rating, operational procedures,and system testing inside our company. We design the system. We controlthe process. Then we let others do what they can do best.17



Outsourcing has become a major strategy to tap the rapid

response and innovativecapabilities of small enterprises

Boston Consulting Group, which has studied more than a hundred majorcompanies doing extensive outsourcing, has concluded that most Westerncompanies outsource primarily to save on overhead or short-term costs.18

The result is a piecemeal approach that “results in patches of overcapacityscattered at random throughout the company’s operation… [Thesecompanies] end up with largenumbers of subcontractors, whichare more costly to manage than in-house operations that are individ-

ually less eƒficient.”19 Worse still, the buying companies, by not providingadequate monitoring and technical backup, oƒten lose their grip on keycompetencies they may need in the future.

The Japanese, by contrast, outsource primarily to improve the eƒficiencyand quality of their own processes, focus on a very few sources, build closeinterdependent relationships, and hold on tightly to high value-addedactivities that are crucial to quality. For those systems they contract out,Japanese companies advise closely on manufacturing and cooperate inprocess and product R&D on the suppliers’ premises.

Strategic risksOutsourcing complete or partial activities creates great opportunities butalso new types of risks. Management’s main strategic concerns are:

1. Loss of critical skills or developing the wrong skills. Unfortunately, manyUS companies outsourced manufacture of what at the time seemed to be only minor components, like semiconductor chips or bicycle frames, and taught suppliers how to build them to needed quality standards. Later, thesecompanies found their suppliers were unableor unwilling to supply them as required. Bythen, they had lost the skills they needed toreenter manufacture and could not preventtheir suppliers from either assisting com-petitors or entering downstream markets on their own. In some cases, byoutsourcing a key component, companies lost their own strategic flexibilityto introduce new designs when they wanted, rather than when vendorspermitted a change.

Few manufacturers, for example, can aƒford to design a new laser-printerengine to obtain a slight timing edge, rather than wait for Canon (with its84 percent market share in such engines) to move.20 The activity share thatCanon has in the design function for this field, or that Matsushita now hasin drives for CD players, gives each company such an overwhelming



Western companies outsourceprimarily to save on overhead

or short-term costs…

…The Japanese outsourceprimarily to improve theeƒficiency and quality of

their own processes

competitive advantage that it can control other characteristics of itsindustry, limiting the strategic options of others. The dual strategyframework we propose prevents such bypassing and helps managersexplicitly address both needed long-term competencies and strategicvulnerabilities before embarking on outsourcing.

2. Loss of cross-functional skills. The interactions among skilled people indiƒferent functional activities oƒten develop unexpected new insights orsolutions. Companies fear outsourcing will make such cross-functionalserendipity less likely. However, if the company consciously ensures that itsremaining employees interact constantly and closely with its outsourcedexperts, its employees’ knowledge base can be much higher than ifproduction were in-house, and the creativity benefits can be even greater.

Companies using Texas Instruments’ or Intel’s design capabilities, forexample, can have these suppliers’ designers – with their much greatertechnical expertise and access to support technologies – codesign chips in-house with their own design teams during development. In such

circumstances, the buyer’s employees are incontact with much more skilled integratedcircuit people than the firm could possiblypossess itself.

In a number of industries studied, two-thirds of all innovation occurred at the

customer/supplier interface.21 By definition, outsourcing increases the buyer’s own participation (as the customer) in such interfaces.Consequently, if managed properly, the practice can oƒten increase totalinnovation potential substantially through leveraging multiple supplierrelationships.

However, having outsourced expertise at many diƒferent locations maymake close cross-functional teamwork more diƒficult. To guard against this,in entering long-term outsourcing relationships that may involve futureinnovation, many managers specify that an outsource partner’s personnelmay be “seconded” to the buying company for special development projects.They then ensure that close personal relationships are developed betweenthe supplier companies and their own technical personnel at the bench andoperating levels.

Contractual prearrangements are usually necessary to ensure that criticalpersonnel from the outsource partner are available when needed. But thebuying company must be close enough to its partner to evaluate and namethe specific people it wants; otherwise the provision may be useless whenit is needed.



Outsourcing can oƒten increasetotal innovation potential

substantially through leveragingmultiple supplier relationships

3. Loss of control over a supplier. Real problems can occur when thesupplier’s priorities do not match the buyer’s. The most successful out-sourcers find it absolutely essential to have both close personal contact and rapport at the floor level and political clout and understanding withthe supplier’s top management. For this reason, Nike both has full-time“production expatriates” on its suppliers’ premises and frequently bringsthe suppliers’ top people to its Beaverton, Oregon headquarters to exchangedetails about future capabilities and prospects. When conflicts occur, both the supplier’s CEO and key operatingpersonnel can be pressured directly to breakthe logjam.

Even then, serious diƒficulties can occur ifthe buyer does not have suƒficient marketpower relative to the seller. Some buyingcompanies go to the extreme of owning keypieces of equipment the seller uses to make the components they arepurchasing. If priorities conflict too badly, the buyer can remove itsequipment and shut down the seller’s whole line. These buyers say that sucharrangements “ensure we can get the seller’s attention when we need it.”

Nevertheless, unless the buyer’s core competency is a true block to themarketplace, some suppliers, aƒter building up their expertise with thebuyer’s support, will attempt to bypass the buyer directly in themarketplace, as Giant Manufacturing of Taiwan, a supplier of bicycleframes, did to Schwinn. Alternatively, the seller may learn as much aspossible from the buyer and its engineering groups and then attempt toresell this knowledge in diƒferent product configurations to the buyer’s

competitors, as Toshiba did withsubmarine propeller technology.

Careful definition, limitation, andimplementation of means to remedysuch external conflicts are critical in any but the most routine out-sourcing arrangements. Companies

that outsource extensively have generally found satisfactory legal andoperational ways to deal with the problem – and are oƒten willing to shareuseful techniques with those outside their industry.

New management approachesMost large companies have very sophisticated techniques for the traditionalpurchasing of parts, subassemblies, supplies, equipment, construction, orstandard services. And models from the natural resources, real estate/construction, and finance/insurance industries – where joint ventures have



Some suppliers, aƒter building up their expertise with the

buyer’s support, will attempt to bypass the buyer directly

in the marketplace

Careful implementation of means to remedy externalconflicts are critical in any

but the most routine outsourcing arrangements

been common for years – can provide useful guides for more complexpartnering relationships. In addition to seeking out these experiences, themain managerial adjustments for most companies are those needed forcoping with the increased scale, diversity, and service-oriented nature ofthe activities potentially outsourced.

These center on: (1) a much more professional and highly trained purchasingand contract management group (as compared with the lowly purchasinggroups of the past); and (2) a greatly enhanced logistics information system(to track and evaluate vendors, coordinate transportation activities, andmanage service transactions and materials movements from the vendors’hands to the customers’). There is vast electronic document interchange

(EDI) and materials requirements planning(MRP) literature on such logistics manage-ment for products and components.

Now, similar concepts are needed for themanagement of knowledge and service-based activities. A number of companies areestablishing direct computer connections

between their service suppliers and the top managers controlling thatfunction, as Apple has done with its consulting and public relations groups.It is increasingly easy to implement soƒtware interfaces that allow contin-uous electronic monitoring and executive interactions for the design,financial, advertising, public relations, R&D, real estate, or personnel-searchactivities, as well as manufacturing, being performed at remote locations.

To manage more extended outsourcing eƒfectively, contracting and logisticsactivities generally need to be elevated to corporate strategic levels. Soshould the development of the much more sophisticated knowledge-basedsystems needed to capture and analyze essential details about the company’sown internal processes and those of vendors. Most companies’ systemsneed improving in this respect, but some interesting developments areunder way.

A consortium headed by Digital Equipment, Ford, Texas Instruments, USWest, Carnegie Group, and Alcorp is developing a next-generation soƒtwaretool called Initiative for Managing Knowledge Assets (IMKA). Built around the proven knowledge-based systems of Digital and TI, IMKA usesmany features found in object-oriented programs that allow collection andcomparison of knowledge from a variety of diƒferent end nodes, inside andoutside the company. For example, it can compare each supplier plantthroughout the world for its capability to meet a given subsystem’s circuitperformance, manufacturing, design, interconnection, weight, cost, or powerrequirement parameters – for any of 100,000 diƒferent objects – against



To manage more extendedoutsourcing eƒfectively,

contracting and logisticsactivities need to be elevated to corporate strategic levels

the capabilities of other possible supplier plants. In milliseconds, it cancoordinate and check the production dynamics necessary to ensure thatparts are produced in optimum locations at lowest cost and to specificationthroughout the world.

Many companies fear they may not be able to maintain suƒficient knowledgeinternally to manage their specialist suppliers, a real problem if not attackedsystematically. Most successful outsourcersupgrade both their top management talentand their information systems for this pur-pose. When they move aggressively, manycompanies have found that they actuallyimprove their knowledge bases throughstrategic outsourcing, as Ford did with itsbest-in-class program. By actively ridingcircuit on the best outside suppliers and experts, they obtain morestimulation and insights than any insider group could possibly oƒfer, unlessthat group represented the core competency of the company.

Further, when executives continuously interact with the very best talent inthe world, not just the best in the next oƒfice, they are considerably morelikely to stay at the top of their professions. As a side benefit of outsourcing,they can pressure internal supply groups to compete with the best externalcompanies, question subordinates more knowledgeably, and keep internalgroups more competitive.

Most companies can substantially leverage their resources through strategicoutsourcing by: (1) developing a few well-selected core competencies ofsignificance to customers and in which the company can be best-in-world;(2) focusing investment and management attention on them; and (3)strategically outsourcing many other activities where it cannot or need notbe best.

There are always some inherent risks in outsourcing, but there are also risksand costs associated with insourcing. When approached within a genuinelystrategic framework, using the variety of outsourcing options available, andanalyzing the strategic issues developed here, companies can overcomemany of the costs and risks. When intelligently combined, core competencyand extensive outsourcing strategies provide improved returns on capital,lowered risk, greater flexibility, and better responsiveness to customer needsat lower cost.



When they move aggressively,many companies have found

that they actually improve theirknowledge bases through

strategic outsourcing

NOTESThe authors gratefully acknowledge the research support of McKinsey & Company; NovaCare,Inc.; Marsh & McLennan; William M. Mercer Companies; Arthur Andersen & Co.; andAmerican Express on various aspects of this project.

1 J. B. Quinn, T. L. Doorley, and P. C. Paquette, “Technology in services: Rethinking strategicfocus,” Sloan Management Review, Winter 1990, pp. 79–87.

2 J. B. Quinn, “Leveraging knowledge and service-based strategies through outsourcing,” inIntelligent Enterprise, Free Press, New York, 1992, pp. 71–97.

3 M. Moritz, The Little Kingdom: The Private Story of Apple Computer, Morrow, New York, 1984;and W. Davidson, “Apple Computer Inc.,” University of Virginia, Charlottesville, DardenResearch Foundation, Case UVA-BP219, 1984.

4 R. Coase, “The nature of the firm,” Economica, November 1937, pp. 386–405; and O.Williamson, Markets and Hierarchies, Analysis and Antitrust Implications, Free Press, NewYork, 1975.

5 R. Rumelt, Strategy, Structure and Economic Performance, Harvard University Press,Cambridge, Massachusetts, 1974.

6 R. D’Aveni and A. Illinich, “Complex patterns of vertical integration in the forest productsindustry,” Academy of Management Journal, Vol. 35, 1992, pp. 596–625; P. Y. Batteyri, “Theconcept of impartition policies: A diƒferent approach to vertical integration strategies,”Strategic Management Journal, Vol. 9, 1988, pp. 507–20.

7 G. J. Maloney, “The choice of organizational form…,” Strategic Management Journal, Vol. 3,1992, pp. 559–84; R. Miles and C. Snow, “Organizations, new concepts and new forms,”California Management Review, Spring 1986, pp. 62–73.

8 Rumelt, Strategy, Structure and Economic Performance.9 W. Davidson, The Amazing Race, Winning the Technorivalry with Japan, John Wiley, New York,

1983.10 C. Prahalad and G. Hamel, “The core competence of the corporation,” Harvard Business

Review, May–June 1990, pp. 79–91.11 J. B. Quinn, T. L. Doorley, and P. C. Paquette, “Beyond products: Service-based strategies,”

Harvard Business Review, March–April 1990, pp. 58–68.12 D. Turner and M. Crawford, “Managing current and future competitive performance: The

role of competence,” University of New South Wales, Australian Graduate School ofManagement, Center for Corporate Change, Kensington, 1992.

13 H. Mintzberg and J. B. Quinn, “Honda Motor Co.,” The Strategy Process, Prentice Hall,Englewood Cliƒfs, New Jersey, 1993, pp. 140–55.

14 R. D’Aveni and D. Ravenscraƒt, “Economics of integration versus bureaucracy costs: Doesvertical integration improve performance?” Academy of Management Journal, Vol. 37, Number5, 1994, pp. 1167–1206; and H. Mintzberg, The Nature of Managerial Work, Harper & Row,New York, 1973.

15 J. Stuckey and D. White, “When and when not to vertically integrate,” Sloan ManagementReview, Spring 1993, pp. 71–83.

16 “The incredible shrinking company,” The Economist, 15 December 1990, pp. 65–6; and“Costing the factory of the future,” The Economist, 3 March 1990, pp. 61–2.

17 Interview with J. B. Quinn, March 1992.18 “Manufacturing: The ins and outs of outing,” The Economist, 31 August 1991, pp. 54, 56.19 M. F. Blaxill and T. M. Hout, “The fallacy of the overhead quick fix,” Harvard Business

Review, July–August 1991, pp. 93–101.20 R. Reich, “Who is us?,” Harvard Business Review, January–February 1990, pp. 53–64.21 E. von Hippel, The Sources of Innovation, Oxford University Press, New York, 1988.



startegic outsourceing

Business

australian

sloan management

harvard business

maintainable

strategic

selected core

fully integrated

corporate