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Evaluation of Outsourcing*

In recent years, the outsourcing decision has gone beyond manufacturing physical products, to service activities. For example, many U.S. based companies have outsourced their customer call centers to India.

However, not always is outsourcing better. At times, producing in house is better. This is especially the case when the following benefits can be obtained.

Lower costs : If the firm is more efficient in producing the product

Facilitating specialized investments: Specialized assets are those whose value is contingent on a particular relationship. For example, manufacturing in uniquely designed systems require investments in equipment which can only be used for this purpose. In this case, if there is lack of trust between the two parties, it may be unable to persuade any independent supplier to manufacture them.

Protecting proprietary technology: If this involves producing a product containing superior features, proprietary technology can give the firm a competitive advantage.

Accumulation of dynamic capabilities: Dynamic capabilities are the skills that become more valuable over time, through learning. Thereby, firms that outsource activities to gain a short term cost advantage may miss out on the opportunity to build important capabilities in that activity. Thereby, firms should not outsource if those activities are potentially important for the long term competitive advantage.

Improving scheduling: Planning, coordination and scheduling of processes is easier with in house production. For international businesses that source worldwide, scheduling problems are exacerbated by the time and distance between the firm and its suppliers.

However, outsourcing would be better in certain cases. Thsi is mainly due to the following benefits of buying.

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Strategic Flexibility: When operating internationally, changes in exchange rates and trade barriers can alter the attractiveness of supply sources. In this case, having flexibility to switch orders between suppliers as circumstances dictate is good. This is why most firms source the same products from suppliers based in two countries primarily, as a hedge against adverse movements in factor costs, exchange rates, etc.

Also, when the optimal location for manufacturing a product is beset by political risks, it is better to source products from independent suppliers. However, maintaining strategic flexibility has its downside. If a supplier perceives that a firm might change suppliers in response to exchange rates, trade barriers or political circumstances, then the supplier might not be willing to make investments in specialized plants and equipment.

Lower costs: When producing in house, the organization’s scope increases. This results in an increase in organizational complexity which can raise a firm’s cost structure. This increase in cost structure happens due to the following reasons.

  1. Greater number of sub units in an organization- With greater number of sub units, there will be more problems coordinating and controlling the units. This will require top management to process large amounts of information about sub unit activities.
  2. Lack of incentive to reduce costs- Vertically integrated firms may lack incentive to lower costs because of captive customers in the firm.
  3. Determination of proper transfer pricing is tough- Deciding the appropriate prices for goods transferred to subunits within the firm is a challenge in any firm.

Offsets: Outsourcing some manufacturing to independent suppliers based in other countries may help the firm to capture more orders from that country. For example, U.S. has repetitively urged Japanese automobile companies to purchase more component parts from U.S. suppliers to partially offset the large volume of automobile exports from Japan to U.S.

However, some international businesses have attempted to reap benefits of vertical integration without the above problems, by entering strategic alliances with essential suppliers.

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For example, Kodak and Canon under which Canon built photocopiers for sale by Kodak.

Microsoft and Flextronics in which Flextronics built Xbox for Microsoft.

Such strategic alliances build trust between the firm and its suppliers. This kind of arrangement betweent he firm and its parts uppliers was pioneered in Japan by large auto companies like Toyota. However, if a firm enters into long term alliances, this may limit strategic flexibility by the commitments it makes to its alliance partners.

Thus, both producing in house and outsourcing is not favorable at all times.

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