Vertical integration squelches 'siren song' of outsourcing

ICM Controls

In Greek mythology, the Sirens were sea deities who lived in various locations, all of them surrounded by cliffs and rocks. Seamen who sailed near them were decoyed with the Sirens’ enchanting music to shipwreck on the rocky coast. Now, the term “siren song” refers to an appeal that is hard to resist but that, if heeded, will lead to a bad result.

Photo 1. ICM Controls’ facilities in North Syracuse, N.Y.

While certainly less dramatic, a strong case can be made that the modern-day business equivalent of the siren song is outsourcing. While this widespread practice does hold some alluring benefits, it is also fraught with economic dangers that, if the song is followed with total commitment, can cause a company to crash, commercially speaking.

Without question, the most melodious note in the outsourcing symphony is low cost. Goods manufactured offshore, by and large, tend to cost less to produce, mainly because of the availability of cheap labor. This low cost can subsequently be turned into increased profit for the manufacturing company or passed on with a reduced price to the customer.

But with outsourcing comes the inevitable problem, the most egregious of which is product quality. Maintaining oversight of a manufacturing operation thousands of miles away can be a challenging, if not impossible, task. Quality is exceptionally difficult to preserve in burgeoning markets. Consider the scenario in China, which is rapidly becoming an outsourced manufacturing giant. Despite the low cost of producing goods there, there have also been extreme issues revolving around quality, in particular the products containing unsafe levels of lead. Manufacturers in China are experiencing intense pressure to keep costs low at a time when the country is experiencing a rising inflation rate in excess of 11 percent, a currency that is undervalued by as much as 20 percent, and widespread labor shortages; as a result, many of them become susceptible to taking shortcuts that turn into quality trouble – or worse.

The importance of quality – in any industry but particularly in heating, ventilation, air conditioning and refrigeration (HVACR) – cannot be overstated. For proof, one need look no further than a study recently conducted by Air Conditioning, Heating and Refrigeration News asking HVACR industry contractors to name the factors that are most important when selecting and purchasing thermostats. Product reliability and product quality were cited as the top two reasons by a wide margin (98 percent and 97 percent listed them as important, respectively); price was a distant seventh.

These results mirror findings from an ongoing survey conducted by ICM Controls, a leading manufacturer of electronic controls for the HVACR industry for more than 20 years. Contractors in the study overwhelmingly rate product quality as the most important criteria in the product selection process by a nearly 2:1 ratio over the second rated criteria, ease of use. Price ranks next to last, just ahead of product availability.

But product quality is just the tip of the proverbial iceberg. Companies that rely heavily on an outsourcing strategy are traditionally not as quick to adapt to a changing marketplace. In a large percentage of outsourcing situations, a company will literally flood the market with a product, trying to realize economies of scale and mass distribution. Yet this approach invariably hampers the company’s ability to react quickly to market fluctuations, including huge swings in market demand. And if demand swings severely downward, the company is stuck with one or more offshore warehouses full of product that is “all dressed up with no place to go.”

Another sour note of outsourcing is the lack of familiarity with the outsourcer. If you outsource, you don’t truly know who your supplier is. You are, essentially, in business with a facility about which you are not totally familiar, exposing yourself to the risk of a classic “bait and switch” scenario in which you’re never quite sure who’s fulfilling your order. Additionally, not knowing the supplier means that you are potentially giving away your ideas and technology to a competitor and training others to do so, so there is a significant competitive risk involved.

“The worst-case scenario in an outsourcing situation is that you are giving away all your know-how and proprietary concepts and possibly developing a global competitor,” said Ron Kadah, president of ICM Controls. “In a few years, when you start to lose market share to that competitor, there will be no mystery as to how it happened.”

Humming a Different Tune
The siren song of outsourcing is a powerful one. The way to resist it, along with its pitfalls, is to follow a different song that, while not as alluring in the short term, holds far greater promise for long-term success. That name of that song is vertical integration.

What is the practice of vertical integration? Basically, it is an approach whereby a company positions itself as a one-stop manufacturing source, from “soup to nuts.” By having all production, research and development, and sales functions in-house, the company can exert tighter control over the entire supply chain while maintaining the flexibility to create customized solutions. It also allows for the ability to adapt to changes in the marketplace, both economic and technological, and to remain globally competitive from both a price and product standpoint.

Conversely, when a company elects to travel the outsourcing route, its supply chain is no longer guaranteed.

“If you’re not the big fish in the supply chain, you risk not having your own product available to you when you need it,” said Kadah. “You may not be able to get an important order, for example, because a more influential customer just placed an order 10 times bigger than yours, thereby maxing out resources. Whose order do you think will get done first?”

ICM Controls is a prime example of the vertical integration philosophy. The company does everything from fabricate its own print circuit boards (a task many companies will not undertake), to creating its own molding on plastics cases, to doing its own wiring, its own assemblies, and so on. At ICM Controls, vertical integration is a two-fold process: internal and external. The company provides all of the products and solutions – off-the-shelf and customized, for aftermarket and OEM applications – that companies might need externally, but it does it all internally.

Embracing the rationale and the ultimate benefits of vertical integration is easy. What’s not as easy is how a company undertakes the task of implementing this approach on an enterprise-wide basis. Adopting a vertical integration methodology essentially requires five elements:

Commitment: Vertical integration requires 100 percent commitment, often problematic given the plethora of market pressures. It’s not an approach that can be effective when implemented only halfway. Creating a company that does everything in-house means exactly that – the company must do, with very few exceptions, everything. Naturally, every company does some outsourcing; even ICM still outsources small components that go in the circuit boards, but that’s a drop in the bucket compared to the percentage of parts produced in-house.

Financial resources: Vertical integration requires a company to continue to re-invest in itself, especially in its processes and equipment. Frankly, it requires significant investment in a company’s entire infrastructure, a commitment that not every company is fiscally equipped to make and/or willing to adhere to. 

Time: It won’t happen overnight. Bringing all of your processes and procedures in-house will first mean severing your outsourcing ties, then creating in-house capabilities where they don’t yet exist. This will take time, sometimes years.

Balance: Of course, a company needs to be able to capture business when it’s presented on a silver platter, which may involve veering slightly off course from the main business philosophy for the short-term. Ultimately, a fine balance is required; walking a straight line to financial success is a near impossibility. Being flexible enough to take advantage of immediate opportunities when they arise, but without straying permanently from the main path, is the key.

Visionary management: This approach also requires progressive thinking, as well as the insight to clearly understand that in the end, it is the more sound approach, economically speaking. Forward-thinking ownership knows that lopping money off the bottom line to re-invest can lead to some sleepless nights, but it pays back in the long run.

Benefits Galore
It’s a complicated process, at times fiscally painful, but the benefits cannot be challenged. As it has with ICM, vertical integration not only helps a company exercise much firmer quality control, it also allows for faster times to market with prototypes, with product releases, and with enhancements. From a cost-effectiveness standpoint, by being able to build on demand, a company can keep overhead low and reduce inventory costs. What’s more, companies can adapt faster to market changes: because they’re building on demand, a slowdown in the economy means they can slow down as well. If technology changes, the company can change and bring a new product to market faster, taking advantage of new-mover initiatives. Products can also be improved and enhanced “on the fly,” a critical aspect of customer retention.

While developing high-quality products for the marketplace is critical, it is necessary to take the entire supply chain into account. In the HVAC industry, this means considering the needs of the contractors who will be specifying your product, the installers who will be working directly with them, and the end users. Listening to and responding to the requirements of one group while ignoring those of another is a recipe for disaster: imagine developing a product that end users love but that contractors hate to install.

An ancillary benefit of ICM’s vertical integration approach is the chance to create products entirely in the United States. Many companies are eager to buy American-made products but they often associate American business with high cost. This perception may be true in terms of the actual cost of manufacture, when one accounts for the higher cost of U.S. labor, the expense associated with worker benefits, and the need for many products to meet strict government regulations. Still, the visionary customer will understand the hidden costs: poor quality product, shipping costs and, in extreme cases, the cost of litigation if a defective product should result in injury or worse.

Is outsourcing wrong? Hardly. It is one way of doing business that can certainly work, if the accompanying problems and issues are anticipated and proactively addressed. Still, ICM Controls believes that vertical integration holds far more promise for commercial success over the long haul. That should be sweet music to everyone’s ears.

Photo 2. Inside ICM Controls’ plant in New York.