Outsourcing Strategy in U.S. Manufacturing: Benefits and Risks

Introduction

An increase in market competition, the decision to lower production costs, and shortened time to market are the driving forces that lead a large number of manufacturing companies to adopt outsourcing policies. Outsourcing is the management practice of allowing third-party external providers to take up non-core activities of an organization, enabling firms to focus on their core businesses. In the contemporary global business environment, firms are required to produce innovative products and develop new strategies to increase profitability; outsourcing has become a business technique that firms employ to remain competitive. Thus, outsourcing helps manufacturing companies lower costs and remain competitive in a fiercely competitive business environment. However, there is an ongoing debate that the outsourcing decision can be detrimental to an organization's competitive advantage.

The objective of this essay is to explore the benefits and shortcomings of outsourcing for manufacturing companies.

Benefits of Outsourcing for Manufacturing Companies

The goal of lowering production costs is one of the major factors that leads U.S. manufacturing companies to adopt outsourcing policies. Outsourcing assists manufacturing companies in reducing costs and competing in the global environment. It enables firms to focus on core activities because those core functions give them a clear leadership position and deliver greater value to customers at lower costs. Dabhilkar et al. argue that outsourcing high volumes of materials to suppliers assists firms in lowering fixed costs, because higher capacity utilization of machinery and plant space will be reduced (146). Moreover, the outsourcing decision assists manufacturing companies in lowering variable costs when entrusting higher volumes of materials to a third party. When firms design the same type of materials for different customers, it leads to cheaper sourcing costs. For example, "engineering/design capability for outsourced parts can lead to lower variable costs" (Dabhilkar et al. 146). When a firm outsources the design of a large volume of materials to a third-party company, it is able to reduce variable costs by enjoying economies of scale. A company that outsources its operations to low-wage countries, for instance, will enjoy a reduction in variable costs.

Outsourcing can also assist firms in gaining power over suppliers. Porter argues that pressure from suppliers can force firms to increase product prices and lower the quality of final products (1). When there are few suppliers in an industry, their bargaining power is high; conversely, when a large number of suppliers are available, supplier power is relatively low. However, when firms have established good relationships with third-party materials providers and have developed expertise in negotiating with suppliers, they build the capability to exert power over those suppliers. As Dabhilkar et al. point out, "purchasing capability for outsourced parts can lead to lower variable costs by using buying power to get pre-specified components for several customers at lower cost" (146).

Additionally, manufacturing companies are able to improve supplier relationships because firm–supplier interaction increases the likelihood of leveraging operating capabilities. Firms and suppliers can, for example, share production systems, co-plan, and develop a common framework for cost reduction — a strategy that improves delivery performance and product pricing. Outsourcing also assists firms in focusing on product differentiation to produce superior products. Long-term strategic collaboration with a third-party company helps firms "to create distinct competence in the market" (Dabhilkar et al. 147).

Risks and Shortcomings of Outsourcing

Despite the benefits that firms can derive from outsourcing, the decision to outsource carries real risks. Rob Dekkers uses the theory of transaction cost economics to explain the shortcomings of outsourcing decisions. According to transaction cost economics, a firm and its third-party provider are required to draw up a contract agreement to finalize the outsourcing arrangement. During the course of negotiation, one party may possess more information about the contract than the other, leading to information asymmetry. Information asymmetry refers to a situation in which one party in a contract negotiation has more information than the other. If the third-party provider has more information than the firm, this imbalance leads to uncertainty in demand, moral hazard, asset specificity, and opportunistic behavior. When a vendor possesses more information than the buyer, for instance, the vendor may mandate the buyer to transfer specific or high-value assets as a condition of the arrangement. Transferring a high-valued asset to a vendor when signing an outsourcing contract creates significant risk, particularly in outsourcing arrangements that involve technical skills.

In the contemporary manufacturing environment, an increasing number of companies are outsourcing IT functions to third-party providers. The goal of IT outsourcing is to utilize the most competent IT professionals to develop the best products. However, asset specificity can occur during the outsourcing contract when vendors instruct firms to transfer their IT assets in order to perform their functions effectively. In such circumstances, the contract deal can become risky: instead of deriving benefits from outsourcing, firms may incur losses. An outsourcing contract that involves transferring IT assets to the vendor can create security vulnerabilities. Moreover, a poorly structured outsourcing contract can lead to operational problems and threats to information confidentiality. The absence of data integrity can jeopardize organizational efficiency and undermine effective business decision-making. Loss of competency is another shortcoming: when firms entrust part of their business activities to service providers, they lose competency in that area because they rely entirely on vendors to deliver the services. Some vendors may be unreliable, causing firms to lose business reputation and incur financial losses.

While outsourcing contract agreements may have loopholes, business organizations continue to use outsourcing as a strategy to lower costs and gain competitive market advantages. The decision to focus on core competencies is the major factor that keeps firms committed to outsourcing. Nicholas O'Regan and Gerhard Kling point out that the benefits of outsourcing outweigh the shortcomings. Many small and medium enterprises (SMEs), for example, face challenges in controlling costs and therefore need to adopt current business models to remain viable. Moreover, SMEs often lack the capacity to address market demands — such as developing innovative new products — making external assistance the only practical option.

Works Cited

Dabhilkar, Mandar, Lars Bengtsson, Robin v. Haartman, and Par Ahlstrom. "Collaboration or Supplier Selection? Determining Factors of the Performance Improvement When Outsourcing Manufacturing." Journal of Purchasing & Supply Management, vol. 15, 2009, pp. 143–53.

Dekkers, Rob. "Impact of Strategic Decision-Making for Outsourcing on Managing to Manufacture." International Journal of Operations & Production Management, vol. 31, no. 9, 2001, pp. 935–965.

Dyer, Jeffrey H., and Nile W. Hatch. "Using Supplier Networks to Learn Faster." MIT Sloan Management Review, vol. 45, no. 3, pp. 57–63.

O'Regan, Nicholas, and Gerhard Kling. "Technology Outsourcing in Manufacturing Small- and Medium-Sized Firms: Another Competitive Resource?" R&D Management, vol. 41, no. 1, 2011, pp. 92–105.

Porter, Michael E. "The Five Competitive Forces That Shape Strategy." Harvard Business Review, 2008, pp. 86–104.