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Strategic: Make Versus Buy
Strategic: Make Versus Buy
Strategic: Make Versus Buy
Strategic
By assessing the relative costs and risks of
making or buying, companies can leverage their
skills and resources for increased profitability
approaches, when
T
WO NEW STRATEGIC
properly combined, allow managers to
leverage their companies’ skills and
resources well beyond levels available with
other strategies:
• Nike, Inc. is the largest supplier of athletic shoes in the world. Yet it
outsources 100 percent of its shoe production and manufactures only
key technical components of its Nike Air system. Athletic footwear is
technology- and fashion-intensive, requiring high flexibility at both
the production and marketing levels. Nike creates maximum value by
concentrating on preproduction (research and development) and post-
production activities (marketing, distribution, and sales), linked together
by perhaps the best marketing information system in the industry.
Apple focused its internal resources on its own Apple DOS (disk operating
system) and the supporting macro soƒtware to give Apple products their
unique look and feel. Its open architecture policy stimulated independent
developers to write the much-needed soƒtware that gave the Apple II’s
customers uniquely high functionality. Apple thus avoided unnecessary
investments, benefited from its vendors’
R&D and technical expertise, kept itself
How can managers combine
flexible to adopt new technologies as they
core competency concepts
became available, and leveraged its limited
and strategic outsourcing for
capital resources to a huge extent. Operating
maximum eƒfectiveness?
with an extremely flat organization, Apple
enjoyed three times the capital turnover and
the highest market value versus fixed investment ratio among major
computer producers throughout the 1980s.3
2. Granting that the competencies defining the firm and its essential
reasons 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 which
to outsource?
3. How can managers assess the relative risks and benefits of outsourcing
in particular situations? And how can they contain critical risks – especially
the potential loss of crucial skills or control over the company’s future
directions – when outsourcing is desirable?
At the same time, these companies also contracted out significant support
activities. Although frequently considered vertically integrated, the Japanese
auto industry, for example, was structured around “mother companies” that
primarily performed design and assembly, with a number of independent
suppliers and alliance partners – without ownership bonds to the mother
companies – feeding into them.9 Many other Japanese hi-tech companies,
particularly the more innovative ones like Sony and Honda, used
comparable strategies leveraging a few core skills against multiple markets
through extensive outsourcing.
The term “core competency strategies” was later used to describe these
and other less diversified strategies developed around a central set of
corporate skills.10 However, there has been little theory or consistency
in the literature about what “core” really
means. Consequently, many executives have
Managers need to think in
been understandably confused about the
terms of the specific skills the
topic. They need not be if they think in
company must have to create
terms of the specific skills the company has
unique value for customers
or must have to create unique value for
customers. However, their analyses must go
well beyond looking at traditional product or functional strategies to the
fundamentals of what the company can do better than anyone else.11
For example, aƒter some diƒficult times, it was easy enough for a beer
company like Foster’s to decide that it should not be in the finance, forest
products, and pastoral businesses into which it had diversified. It has now
divested these peripheral businesses and is concentrating on beer. However,
even within this concept, Foster’s true competencies are in brewing and
marketing beer. Many of its distribution, transportation, and can production
activities, for example, might actually be more eƒfectively contracted out.
Exhibit 1
consciously build dominating skills
Make or buy?
in areas that the customer will
When to outsource
continue to value over time, as
Corporate staff services
Motorola is doing with its focus on
Regulatory affairs
“superior quality, portable com-
Public relations
Basic research
Maintenance
munications.” The uniqueness of
Data center
Accounting
Personnel
Toys “R” Us lies in its powerful
Finance
Legal
information and distribution systems
for toys, and that of State Street
Example
Boston in its advanced information
and management systems for large Potential
provider
Potential
cost reduction
Potential
value gain
custodial accounts. Cost Value
Internal
Benchmark
Low ($) High ($)
Problems occur when managers AMEX
choose to concentrate too narrowly Andersen
on products (as computer companies Banc One
did on hardware) or too inflexibly on DEC
Market research
Warehousing
competency strategies.
Distribution
Advertising
Marketing
Logistics
Service
Repair
Sales
Each skill set requires intensity and management dedication that cannot
tolerate dilution. It is hard to imagine Microsoƒt’s top managers taking their
enthusiasm and skills in soƒtware into, say, chip design or even large-scale
training in soƒtware usage. And if they did, what would be the cost of their
loss of attention on soƒtware development?
6. Elements important to customers in the long run. At least one of the firm’s
core competencies should normally relate directly to understanding and
serving 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 oƒten
fail when they ignore this caveat. On the other hand, Merck matches its
superb basic research with a prescription drug marketing knowhow that is
equally outstanding.
Honda, for example, does all its engine R&D in-house and makes all the
critical parts for its small motor design core competency in closely
controlled facilities in Japan. It will consider outsourcing any other
noncritical elements in its products, but builds a careful strategic block
around this most essential element for all its businesses.13
Strategic outsourcing
If supplier markets were totally reliable and eƒficient, rational companies
would outsource everything except those special activities in which they
could achieve a unique competitive edge, that is, their core competencies.
Unfortunately, most supplier markets are imperfect and do entail some risks
for both buyer and seller with respect to price, quality, time, or other key
Exhibit 2
dimensions. Moreover, outsourcing entails unique
Competitive advantage versus
transaction costs – searching, contracting, control-
strategic vulnerability ling, and recontracting – that at times may exceed
Strategic
the transaction costs of having the activity directly
Potential for competitive edge
Marks & Spencer, for example, is famous for its network of tied suppliers,
which create the unique brands and styles that underpin the retailer’s
value reputation. Spot suppliers would be too unreliable and unlikely
to meet the demanding standards that are Marks & Spencer’s unique
consumer franchise. Hence, close control of product quality, design,
technology, and equipment through contracts and even financial support
is essential.
The opposite case is perhaps oƒfice cleaning, where little competitive edge
is usually possible and there is an active and deep market of supplier firms.
In between, there is a continuous range of activities requiring diƒferent
degrees 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 and
incentives for the supplier versus control and security for the buyer. Most
companies will benefit by extending outsourcing first in less critical areas,
or in parts of activities, like payroll, rather than all of accounting. As they
gain experience, they may increase profit
opportunities greatly by outsourcing more
The question is how to
critical activities to noncompeting firms that
implement a balance between
can perform them more eƒfectively.
independence and incentives
for the supplier versus control
In a few cases, more complex alliances with
and security for the buyer
competitors may be essential to garner
specialized skills that cannot be obtained in
other ways. At each level, the company must isolate and rigorously control
strategically critical relationships between its suppliers and its customers.
Competitive edge
The key strategic issue in insourcing versus outsourcing is whether a
company can achieve a maintainable competitive edge by performing an
activity internally – usually cheaper, better, in a more timely fashion, or
with some unique capability – on a continuing basis. If one or more of these
dimensions is critical to the customer and if the company can perform that
function uniquely well, the activity should be kept in-house. Many
companies unfortunately assume that because they have historically
performed an activity internally, or because it seems integral to their
business, the activity should be insourced. However, on closer investigation
Ford Motor Company, for example, found that many of its internal
suppliers’ quality practices and costs were nowhere near those of external
suppliers when it began its famous “best in class” worldwide benchmarking
studies on 400 subassemblies for the new Taurus-Sable line. A New York
bank with extensive worldwide operations investigated why its Federal
Express costs were soaring and found that its internal mail department took
two days more than Federal Express to get a
letter or package from the third floor to the
“We thought we were the best
fortieth floor of its building.
in the world, but we found we
were not even up to the worst
In interviews about benchmarking with
of the benchmarking cases”
top operating managers in both service and
manufacturing 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 best
external suppliers, we found we were not even up to the worst of the
benchmarking cases.”
Transaction costs
In all calculations, analysts must include internal transaction costs as well
as those associated with external sourcing. If the company is to produce
the item or service internally on a long-term basis, it must back up its
decision with continuing R&D, personnel development, and infrastructure
investments that at least match those of the best external supplier;
otherwise, it will lose its competitive edge over time. Managers oƒten tend
to overlook such backup costs, as well as the losses from laggard innovation
and unresponsiveness of internal
groups that know they have a
One of the great gains of
guaranteed market.
outsourcing is freeing top
management to focus more
Finally, there are the headquarters
on the core of its business
and support costs of constantly
managing the insourced activity. One
of the great gains of outsourcing is the decrease in executive time spent
managing peripheral activities – freeing top management to focus more on
the core of its business.
Various studies have shown that when these internal transaction costs are
thoroughly analyzed, they can be extremely high.14 Since it is easier to
identify the explicit transaction costs of dealing with external suppliers,
these generally tend to be included in analyses. Harder-to-identify internal
transaction costs, however, are oƒten not included, thus biasing results.
Vulnerability
When there are many suppliers (with adequate but not dominating
scale) and mature market standards and terms, a potential buyer is unlikely
to be more eƒficient than the best available supplier. If, on the other hand,
there is not suƒficient depth in the market, overly powerful suppliers can
hold the company ransom. Conversely, if the number of suppliers is limited
or individual suppliers are too weak, they may be unable to supply
innovative products or services as well as a much larger buyer could by
performing the activity in-house. While the activity or product might not
be one of its core competencies, the company might nevertheless benefit
by producing internally rather than undertaking the training, investment,
and codesign expenses necessary to bring weak suppliers up to needed
performance levels.
Diƒferent and highly specialized skills and assets are needed for refining
versus mining. Access to information further compounds problems; if an
independent mine expects a strike, it is unlikely to share that information
with its customers, unless there are strong incentives. As a result, the alu-
minum industry has moved toward vertical integration or strong bilateral
joint ventures, as opposed to open outsourcing of bauxite supplies – despite
the apparent presence of a commodity product and many suppliers and
sellers. In this case, issues of both competitive advantage and potential
market failure dictate a higher degree of sourcing control.
Degree of sourcing control
In 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 are
opportunities for developing special incentives or more complex oversight
contracts to balance intermediate levels of vulnerability against more
moderate prospects for competitive edge. Nike’s multi-tier strategy oƒfers an
interesting example (see boxed insert on page 62).
Exhibit 3
The practice and law of
Range of outsourcing options
strategic alliances are rapidly
Make versus Buy developing new ways to deal
with common control issues
Self Partnership Long term Short term – by establishing specified
procedures that permit di-
Controlled Not controlled rect involvement in limited
stages of a partner’s activities,
development
Retainer
Long-term
1. Do we really want to produce the
contract goods or service internally in the
Call option long run? If we do, are we willing
Short-term
to make the back-up investments
contract necessary to sustain a best-in-world
position? Is it critical to defending
Flexibility need
our core competency? If not…
McDonald’s, for example, with $8 billion in sales and 10.1 percent growth
per year, needs to call in part-time and casual workers to handle extensive
daily variations yet also be able to select its future permanent or managerial
personnel from these people. IBM has had the opposite problem; since its
core 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 supporting
facilities full time; and (3) the ability to exploit strong outside parties’
specialized capabilities through temporary consortia – for example, in
applications soƒtware, microprocessors, network development, or factory
automation.
Gallo, the largest producer and distributor of wines in the United States,
outsources most of its grapes, pushing the risks of weather, land prices, and
labor problems onto its suppliers.
In the same vein, strategic outsourcing spreads the company’s risk for
component and technology developments across a number of suppliers.
The company does not have to undertake the full failure risks of all
component R&D programs or invest in and constantly update prod-
uction capabilities for each component system. Further, the buyer is not
limited to its own innovative capabilities; it can tap into a stream of new
product and process ideas and quality
improvement potentials it could not possibly
Outsourcing has become a
generate itself.
major strategy to tap the rapid
response and innovative
In the world’s advanced economies,
capabilities of small enterprises
increased aƒfluence has forced much greater
attention on new product ideas, quality
details, and customization. Because small specialized suppliers oƒten oƒfer
greater responsiveness, and new technologies have reduced the size needed
to achieve economies of scale, the average size of industrial firms has
decreased since the late 1960s, and subcontracting constitutes an ever
greater portion of most producers’ costs.16 Outsourcing has become a major
strategy to leverage internal technical capabilities and to tap the rapid
response and innovative capabilities of small enterprises. Richard
Leibhaber, chief strategy and technology oƒficer at MCI, commented:
Boston Consulting Group, which has studied more than a hundred major
companies doing extensive outsourcing, has concluded that most Western
companies outsource primarily to save on overhead or short-term costs.18
The result is a piecemeal approach that “results in patches of overcapacity
scattered at random throughout
the company’s operation… [These
Western companies outsource
companies] end up with large
primarily to save on overhead
numbers of subcontractors, which
or short-term costs…
are more costly to manage than in-
house operations that are individ-
ually less eƒficient.”19 Worse still, the buying companies, by not providing
adequate monitoring and technical backup, oƒten lose their grip on key
competencies they may need in the future.
3. Loss of control over a supplier. Real problems can occur when the
supplier’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 with
the supplier’s top management. For this reason, Nike both has full-time
“production expatriates” on its suppliers’ premises and frequently brings
the suppliers’ top people to its Beaverton, Oregon headquarters to exchange
details about future capabilities and prospects. When conflicts occur,
both the supplier’s CEO and key operating
personnel can be pressured directly to break
Some suppliers, aƒter building
the logjam.
up their expertise with the
buyer’s support, will attempt
Even then, serious diƒficulties can occur if
to bypass the buyer directly
the buyer does not have suƒficient market
in the marketplace
power relative to the seller. Some buying
companies go to the extreme of owning key
pieces of equipment the seller uses to make the components they are
purchasing. If priorities conflict too badly, the buyer can remove its
equipment and shut down the seller’s whole line. These buyers say that such
arrangements “ensure we can get the seller’s attention when we need it.”
been common for years – can provide useful guides for more complex
partnering relationships. In addition to seeking out these experiences, the
main managerial adjustments for most companies are those needed for
coping with the increased scale, diversity, and service-oriented nature of
the activities potentially outsourced.
These center on: (1) a much more professional and highly trained purchasing
and contract management group (as compared with the lowly purchasing
groups of the past); and (2) a greatly enhanced logistics information system
(to track and evaluate vendors, coordinate transportation activities, and
manage 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-
To manage more extended
ment for products and components.
outsourcing eƒfectively,
contracting and logistics
Now, similar concepts are needed for the
activities need to be elevated
management of knowledge and service-
to corporate strategic levels
based activities. A number of companies are
establishing direct computer connections
between their service suppliers and the top managers controlling that
function, 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-search
activities, as well as manufacturing, being performed at remote locations.
Many companies fear they may not be able to maintain suƒficient knowledge
internally to manage their specialist suppliers, a real problem if not attacked
systematically. Most successful outsourcers
upgrade both their top management talent
When they move aggressively,
and their information systems for this pur-
many companies have found
pose. When they move aggressively, many
that they actually improve their
companies have found that they actually
knowledge bases through
improve their knowledge bases through
strategic outsourcing
strategic outsourcing, as Ford did with its
best-in-class program. By actively riding
circuit on the best outside suppliers and experts, they obtain more
stimulation and insights than any insider group could possibly oƒfer, unless
that group represented the core competency of the company.
Further, when executives continuously interact with the very best talent in
the world, not just the best in the next oƒfice, they are considerably more
likely 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 external
companies, question subordinates more knowledgeably, and keep internal
groups more competitive.
There are always some inherent risks in outsourcing, but there are also risks
and costs associated with insourcing. When approached within a genuinely
strategic framework, using the variety of outsourcing options available, and
analyzing the strategic issues developed here, companies can overcome
many of the costs and risks. When intelligently combined, core competency
and extensive outsourcing strategies provide improved returns on capital,
lowered risk, greater flexibility, and better responsiveness to customer needs
at lower cost.
NOTES
The authors gratefully acknowledge the research support of McKinsey & Company; NovaCare,
Inc.; Marsh & McLennan; William M. Mercer Companies; Arthur Andersen & Co.; and
American Express on various aspects of this project.