In-House or Outsource in a Supply Chain?

The decision to outsource is based on the growth in supply chain surplus provided by the third party and the increase in risk incurred by using a third party. A firm should consider outsourcing if the growth in surplus is large with a small increase in risk. Performing the function in-house is preferable if the growth in surplus is small or the increase in risk is large.

1. How Do Third Parties increase the Supply Chain Surplus?

Third parties increase the supply chain surplus if they either increase value for the customer or decrease the supply chain cost relative to a firm performing the task in-house. Third parties can increase the supply chain surplus effectively if they are able to aggregate supply chain assets or flows to a higher level than a firm itself can. Here, we discuss various mechanisms that third par­ties can use to grow the surplus.

  1. Capacity aggregation. A third party can increase the supply chain surplus by aggre­gating demand across multiple firms and gaining production economies of scale that no single firm can on its own. This is the most common reason for outsourcing production in a supply chain. One of the reasons that all smartphone manufacturers outsource glass manufacturing for their screens is that the third parties achieve manufacturing economies that no single smartphone manufacturer can on its own. The growth in surplus from outsourcing is highest when the needs of the firm are significantly lower than the volumes required to gain economies of scale. A good example in this context is Magna Steyr, a third party that has taken over assembly of automobiles for several manufacturers. Magna Steyr designs flexible assembly lines that can build up to five different vehicle types on a single line. This flexible capacity allows the company to produce a variety of low volume cars economically. In 2013, Magna Steyr assembled the G class for Mer­cedes, the RCZ for Peugeot, and the Mini Countryman and Mini Paceman for BMW in the same plant. In each case, the models had relatively low demand volume. Each firm would not have gained sufficient economies of scale for assembling its model. By combining all of them in a single flexible plant, Magna Steyr grew the surplus relative to each firm assembling its own cars. A third party is unlikely to increase the surplus through capacity aggregation if the volume requirements of a firm are large and stable. This is substantiated by the fact that no auto manu­facturer outsources production of its best-selling cars to a third party.
  2. Inventory aggregation. A third party can increase the supply chain surplus by aggre­gating inventories across a large number of customers. W.W. Grainger and McMaster-Carr are MRO suppliers that provide value primarily by aggregating inventory for hundreds of thousands of customers. Aggregation allows them to significantly lower overall uncertainty and improve economies of scale in purchasing and transportation. As a result, these MRO distributors carry significantly less safety and cycle inventory than would be required if each customer decided to carry inventory of MRO products on its own. Another example of inventory aggregation is pro­vided by Brightstar, a distributor that facilitates postponement for cell phones. These phones are manufactured in the Far East and shipped to the Brightstar warehouse in Miami, where software and accessories are added as customer orders arrive from South America. High product variety and many small customers allow Brightstar to increase the supply chain surplus through inven­tory aggregation and postponement. The third party performing inventory aggregation adds most to the supply chain surplus when demand from customers is fragmented and uncertain. When demand is large and predictable, an intermediary adds little to the surplus by holding inventory. The consolidation of retailing and the resulting scale and predictability of demand for large retailers explain why distributors play a much smaller role in the United States than in develop­ing countries.
  1. Transportation aggregation by transportation intermediaries. A third party may increase the surplus by aggregating the transportation function to a higher level than any shipper can on its own. UPS, FedEx, and a host of LTL carriers are examples of transportation interme­diaries that increase the supply chain surplus by aggregating transportation across a variety of shippers. The value provided in each case is driven by the inherent economies of scale in trans­portation. When shippers want to send small quantities, the transportation intermediary aggre­gates shipments across multiple shippers, thus lowering the cost of each shipment below what could be achieved by the shipper alone. A transportation intermediary increases the supply chain surplus when shippers are sending packages or LTL quantities to customers that are geographi­cally distributed. A transportation intermediary can also grow the surplus for TL shipping by aggregating across multiple firms having unbalanced transportation flows, with the quantity coming into a region being very different from the quantity leaving the region. An excellent example of a transportation intermediary increasing the supply chain surplus is provided by a pilot program involving Chrysler and Ford. Exel, a third-party logistics (3PL) provider, operated a dedicated fleet for the distribution of spare parts for Chrysler. In tests in Michigan and Mexico, Ford added its own truck parts for delivery on the same fleet. Given the relatively low density of dealers in Northern Michigan and Mexico (outside Mexico City), the aggregation provided by Exel was a benefit for both Ford and Chrysler. A transportation intermediary is likely to add the least to the supply chain surplus for a company such as Walmart, for which shipment sizes are large and the company achieves aggregation across the many retail stores that it owns. The only possibility for a transportation intermediary in such a setting would be to obtain better backhauls than Walmart does.
  2. Transportation aggregation by storage intermediaries. A third party that stores inventory can also increase the supply chain surplus by aggregating inbound and outbound transportation. Storage intermediaries such as W.W. Grainger and McMaster-Carr stock prod­ucts from more than a thousand manufacturers each and sell to hundreds of thousands of cus­tomers. On the inbound side, they are able to aggregate shipments from several manufacturers onto a single truck. This results in a lower transportation cost than could be achieved by each manufacturer independently. On the outbound side, they aggregate packages for customers at a common destination, resulting in a significantly lower transportation cost than can be achieved if each supplier shipped to each customer separately. For example, the Chicago dis­tribution center for Grainger fills separate trucks with packages destined for each adjacent state. As soon as a truck destined for Michigan (for instance) is filled, it is sent to the UPS sorting facility in Michigan. This level of aggregation cannot be achieved by individual suppli­ers or customers. Thus, the storage of goods by Grainger and McMaster-Carr increases the supply chain surplus by aggregating inbound and outbound transportation. A similar service is provided by distributors in countries such as India. Given the small size of retail outlets, a distributor aggregates delivery for several manufacturers, significantly lowering the outbound transportation cost. This form of aggregation is most effective if the intermediary stocks prod­ucts from many suppliers and serves many customers, each ordering in small quantities. This form of aggregation becomes less effective as the scale of shipment from a supplier to cus­tomer grows. This is seen in the decreased use of distributors by U.S. supermarket chains. The supermarkets typically get full trucks delivered to their DCs or stores and do not need distribu­tors for further aggregation.
  3. Warehousing aggregation. A third party may increase the supply chain surplus by aggregating warehousing needs over several firms. The growth in surplus is achieved in terms of lower real estate costs and lower processing costs within the warehouse. Savings through ware­housing aggregation arise if a firm’s warehousing needs are small or if its needs fluctuate over time. In either case, the intermediary with the warehouse can exploit economies of scale in ware­house construction and operation by aggregating across multiple customers. An example is Saf- express, a third-party logistics provider in India. Safexpress owns warehouses distributed throughout the country that are used by many of its customers. Most of its customers do not have warehousing needs that are large enough to justify a warehouse of their own in each region. Warehousing aggregation by an intermediary adds a lot to the surplus for small suppliers and for companies that are starting out in a geographic location. Warehousing aggregation is unlikely to add much to the surplus for a large supplier or customer whose warehousing needs are large and relatively stable over time. The warehousing needs of Walmart, Amazon, and Grainger are suf­ficiently large and stable to justify their own warehouses, and a third party is unlikely to increase the surplus.
  4. Procurement aggregation. A third party increases the supply chain surplus if it aggregates procurement for many small players and facilitates economies of scale in ordering, production, and inbound transportation. Procurement aggregation is most effective across many small buyers. Small retailers in India purchase goods from distributors that aggregate buying from manufacturers. Procurement aggregation is not likely to be a big factor with a few large customers. For example, Walmart has sufficient scale that it manages its own procurement. It sees no value added in procuring through a third party.
  5. Information aggregation. A third party may increase the surplus by aggregating information to a higher level than can be achieved by a firm performing the function in-house. All retailers aggregate information on products from many manufacturers in a single location. This information aggregation reduces search costs for customers. eBags is an example of an online retailer that primarily provides information aggregation. eBags holds little inventory but is a single point of display for information on bags from many manufacturers. By aggregating product information, eBags significantly reduces search costs for the online customer. Relative to eBags, if each manufacturer set up its own website and online store, search costs for the cus­tomer would be higher, and each manufacturer would have to invest in the information infra­structure. Thus, eBags increases the supply chain surplus through information aggregation by making search cheaper and reducing investment in information technology. Two other examples of companies using information aggregation are W.W. Grainger and McMaster-Carr. Both pro­vide product catalogs and detailed websites. This simplifies search by the customer and aggre­gates product information for more than a thousand manufacturers. Another excellent example of information aggregation is provided by the various online sites, such as Freight Zone and Echo Global Logistics, that bring together shippers and truckers looking for shipments. Information aggregation reduces search costs and allows better matching of truckers and shipments. Informa­tion aggregation increases the surplus if both buyers and sellers are fragmented and buying is sporadic. Information aggregation is not likely to be a big factor for a car manufacturer that regu­larly buys steel from a single supplier.
  6. Receivables aggregation. A third party may increase the supply chain surplus if it can aggregate the receivables risk to a higher level than the firm or it has a lower collection cost than the firm. Brightstar, for example, was a distributor for Motorola in most Latin American countries other than Brazil. Cell phones in the area are sold through many small, independently owned retail outlets. Collecting receivables from each retail outlet is an expensive proposition for a manufac­turer. Given that a retailer buys from many manufacturers, the power of each manufacturer to col­lect is also reduced. Brightstar, as a distributor, was able to aggregate collection across all manufacturers that it served, reducing the collection cost. By aggregating collection to a greater extent than any one manufacturer can, Brightstar also lowered the default risk. Reduced collection cost and risk allowed Brightstar to increase the supply chain surplus relative to having this activity performed by manufacturers. The same is true with distributors in India that often distribute for a large number of manufacturers to the same retailer. Given their ability to aggregate across many manufacturers and small retailers, distributors in India typically take responsibility for managing receivables from the retailers. Receivables aggregation is likely to increase the supply chain sur­plus if retail outlets are small and numerous and each outlet stocks products from many manufac­turers that are all served by the same distributor. Such a scenario is more likely in developing countries where retailing is fragmented. It is less likely in developed countries, such as the United States and most Western European countries, where retailing is consolidated.
  1. Relationship aggregation. An intermediary can increase the supply chain surplus by decreasing the number of relationships required between multiple buyers and sellers. Without an intermediary, connecting a thousand sellers to a million buyers requires a billion relationships. The presence of an intermediary lowers the number of relationships required to just over a mil­lion. Most retailers and MRO distributors such as W.W. Grainger improve supply chain surplus through relationship aggregation. Relationship aggregation increases the supply chain surplus by increasing the size of each transaction and decreasing their number. Relationship aggregation is most effective when many buyers sporadically purchase small amounts at a time, but each order often has products from multiple suppliers. Thus, Grainger can increase the surplus by being a relationship aggregator for MRO products. A third party, however, does not increase the surplus by being a relationship aggregator between a few buyers and sellers for which the relationships are longer term and large. For example, Covisint failed to become a relationship aggregator in the automotive industry, especially for direct materials.
  2. Lower costs and higher quality. A third party can increase the supply chain surplus if it provides lower cost or higher quality relative to the firm. If these benefits come from special­ization and learning, they are likely to be sustainable over the longer term. A specialized third party that is further along the learning curve for some supply chain activity is likely to maintain its advantage over the long term. A common scenario, however, is one in which the third party has a low-cost location that the firm does not have. In such a situation, lower labor and overhead costs are temporary reasons for outsourcing, because if the wage differential is persistent and the third party offers none of the other advantages discussed earlier, it is best for the firm to maintain ownership and offshore production to the low-cost location.

Key Point

A third party may be able to provide a sustainable growth of the surplus by aggregating to a higher level than the firm itself. The growth in surplus comes from aggregating capacity, inventory, inbound or out­bound transportation, warehousing, procurement, information, receivables, or relationships to a level that the firm cannot achieve on its own. A growth in surplus may also occur if the third party has lower costs or higher quality because of specialization or learning.

2. Factors influencing Growth of Surplus by a Third Party

Three important factors affect the increase in surplus that a third party provides: scale, uncer­tainty, and the specificity of assets. If the scale is large, it is likely that sufficient economies of scale are achieved internal to the firm itself. In this case, it is unlikely that a third party can achieve further scale economies and increase the surplus. Walmart has sufficient scale in terms of its transportation needs that it achieves economies of scale on trucking by itself. Going to a third party would not increase the surplus and would result in some loss of control. In contrast, if a firm’s needs do not provide sufficient economies of scale, the third party can increase the surplus by a large amount. Even though Grainger has a large number of outbound packages, given their geographical dispersion, it would not be able to achieve economies of scale for door-to-door delivery. A third-party package carrier adds to the surplus in this case.

The second important factor is the uncertainty of a firm’s needs. If the needs are predict­able, the increase in surplus from a third party is limited, especially if the firm has sufficient scale. In contrast, if the firm’s needs are highly variable over time, the third party can increase the surplus through aggregation with other customers. For example, Grainger has predictable needs in terms of warehouse space required. Given sufficient scale, it owns and operates its own distri­bution centers. In contrast, most firms have very uncertain demand for MRO products. They prefer not to hold these items in stock and use Grainger as an intermediary.

Finally, the growth in surplus is influenced by the specificity of assets required by the third party. If the assets required are specific to a firm and cannot be used for others, a third party is unlikely to increase the surplus because all it does is move the assets from one firm to another. The third party has no opportunity to aggregate across other customers. For example, if a distributor holds inventory that is specific to a customer, the distributor is unable to aggregate it to a higher level than the customer. The presence of the distributor does not increase the surplus in this case. Similarly, if a third-party logistics provider manages a warehouse exclusively for a single firm, it has few opportunities to increase the surplus unless it can aggregate the use of management or information systems across other warehouses. In contrast, if assets (inventory or warehouses, in the previous examples) are less specific and can be used across multiple firms, a third party can increase the surplus by aggregating uncertainty across multiple customers or improving economies of scale.

One instance in which a firm may outsource to a third party even when none of the men­tioned factors suggests outsourcing is shortage of capital or a third party with a much lower cost of capital. In either of these scenarios, the third party can grow the surplus by bringing lower-cost capital to the supply chain. This discussion on how and when a third party can increase the sup­ply chain surplus is summarized in Table 15-1.

3. Risks of Using a Third Party

Firms must evaluate the following risks when they move any function to a third party:

  1. The process is broken. The biggest problems arise when a firm outsources supply chain functions simply because it has lost control of the process. Keep in mind that introducing a third party into a broken supply chain process only makes it worse and harder to control. The first step should be to get the process under control, then do a cost-benefit analysis, and only then decide on outsourcing.
  2. Underestimation of the cost of coordination. A common mistake when outsourcing is to underestimate the effort required to coordinate activities across multiple entities perform­ing supply chain tasks. This is especially true if a firm plans to outsource specific supply chain functions to different third parties. Outsourcing functions to many third parties is feasible (and can be very effective) if the firm views being a coordinator as one of its core strengths. A good example of a strong coordinator is Cisco. However, even Cisco ran into trouble in the early 2000s and was left with a great deal of surplus inventory because of coordination problems. Another example of coordination causing problems occurred between Nike and i2 Technologies in 2000. Nike blamed its loss of $100 million on inventory management glitches that it attrib­uted to the supply chain planning software from i2; i2, in turn, blamed the problems on Nike’s execution of the software. Clearly, insufficient coordination between the two firms played a role in this failure.
  3. Reduced customer/supplier contact. A firm may lose customer/supplier contact by introducing an intermediary. The loss of customer contact is particularly significant for firms that sell directly to consumers but decide to use a third party to either collect incoming orders or deliver outgoing product. A good example is Boise Cascade, which outsourced all its outbound distribution to third parties. This led to a significant loss of customer contact. Boise Cascade decided to bring outbound delivery for customers located close to its distribution centers in­house. Given the high density of customers around its distribution centers, the additional gain in surplus that a third party could provide was minimal, whereas the gain from improved customer contact was significant. Boise Cascade did not bring distribution beyond this point in-house because the gain in surplus provided by a third party was significant.
  4. Loss of internal capability and growth in third-party power. A firm may choose to keep a supply chain function in-house if outsourcing will significantly increase the third party’s power. An example can be found in the electronics industry. Companies such as HP and Motor­ola have moved most of their manufacturing to contract manufacturers but are reluctant to move either procurement or design, even though contract manufacturers have developed both capabili­ties. Given the commonality of components, it can be argued that a contract manufacturer can achieve a higher level of aggregation in procurement as well as design assets. HP and Motorola, however, are reluctant to move procurement to contract manufacturers because the potential loss in power is large, whereas the aggregation gains are small given the relatively large size of both firms. Keeping part of a supply chain function in-house is also important if a complete loss of capability significantly strengthens the third party’s bargaining position. The in-house capability then serves as an option that can be exercised when the need arises. The option also limits how much of the supply chain surplus the third party can keep for itself.
  5. Leakage of sensitive data and information. Using a third party requires a firm to share demand information and, in some cases, intellectual property. If the third party also serves competitors, leakage is always a danger. Firms have often insisted on firewalls within the third party, but a firewall increases the specificity of assets, limiting the growth in surplus that the third party can provide. When leakage is an issue, especially with regard to intellectual property, firms often choose to keep the function in-house.
  6. Ineffective contracts. Contracts with performance metrics that distort the third par­ty’s incentives often significantly reduce any gains from outsourcing. For example, cost-plus pricing of third-party services presents incentive problems even if the third party opens its books. This form of pricing eliminates incentives for the third party to innovate further to reduce costs. The onus for improvement falls back on the firm. Another example occurs when firms require suppliers or distributors to maintain a certain number of days of inventory as part of the contract. Such a contract reduces the third party’s incentive to take actions that reduce inventories. In such a situation, it is better for the firm to contract on a desired service level and leave the third party more freedom with regard to the amount of inventory. The third party then has an incentive to work on reducing the inventory required to provide a given level of service.
  7. Loss of supply chain visibility. Introducing third parties reduces the visibility of sup­ply chain operations, making it harder for the firm to respond quickly to local customer and market demands. This loss of visibility can be particularly harmful for long supply chains.
  8. Negative reputational impact. In many instances, actions regarding labor or the envi­ronment taken by the third party can have a significant negative impact on the reputation of the firm. Nike has had difficulty with several of its suppliers regarding labor practices and the envi­ronment. In 2008, Nike produced its first supply chain report on suppliers in China and reported several questionable labor practices, including underage workers, unpaid wages, and falsified documents. The reputational loss from actions by a supplier can be particularly damaging to firms like Nike with strong brands.

4. Strategic Factors in Sourcing

Besides economic factors and risks, strategic factors must be accounted for when making sourc­ing decisions.

  1. Support the business strategy. Harley-Davidson illustrates the importance of linking business strategy to the make or buy decision. To maintain its strong “Made in America” brand image, the company manufactures mostly in the United States even though cheaper components may be found overseas. An even more extreme example is Brunello Cucinelli, a successful Ital­ian luxury brand. The company positions itself as providing outstanding artisanal Italian manu­facturing and a culture of “ethical capitalism.” To support this strategy, the company has focused much of its production at Solomeo, a medieval hamlet in Umbria, Italy. At Solomeo, the com­pany has built what the founder calls a “humanistic factory” where “employees are treated as preciously as the clothes they create.”
  2. Improve firm focus. In today’s complex world, it is impossible for a firm to do every­thing. A lack of focus because a firm is doing everything in-house can be a major problem. Among the required activities, a firm must identify those that are core and provide a strategic advantage. Outsourcing all other activities helps improve focus and, thus, performance. A good example of increased outsourcing comes from the automotive industry. At one time, most auto manufacturers produced many of their components in-house. With the increasing complexity of an automobile, however, companies outsource most of their parts today, focusing instead on design, assembly, and coordination.

Source: Chopra Sunil, Meindl Peter (2014), Supply Chain Management: Strategy, Planning, and Operation, Pearson; 6th edition.

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