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In tough economic times, many companies slash staff and turn to outsourcing, yet that strategy may doom their products, And, in good times, as with Toyota, losing control over critical components can contribute to failure, according to study led by Lyda Bigelow, business-strategy professor in the University of Utah’s David Eccles School of Business.
Her team found that companies were more likely to fail when they outsourced components critical to their competitive position.
“Across the board, we find statistically significant increases in the failure rate for firms that don’t consider transaction costs in their outsourcing decisions,” she said. “Firms need to look beyond production costs to other costs such as poor quality, delivery delays and risk of price increases by suppliers.”
Their work shows that failure rate (either firm bankruptcy or liquidation) increased between 5 percent and 70 percent more than companies that did not outsource, depending on the risk associated with making technological changes, the product type and the company’s market share.
“This is a critical strategic choice that firms make,” Bigelow said. “Companies need to retain adequate control over specialized components that differentiate their products or have unique interdependencies, or they are more likely to fail to survive.”
This study on the importance of vertical integration – or the in-house manufacture of products – appears in the August issue of the journal Organizational Science. Bigelow and co-author Nicholas Argyres of Washington University analyzed product performance in more than 100 U.S. auto manufacturers during the years 1917 through 1931, in order to study the industry’s shift from innovation to production efficiency. At that time, there were many more manufacturers than there are today, Bigelow said.
“Indeed, the kind of empirical study we conducted would be impossible in today’s industry because there aren't enough data points – auto companies – in the United States,” she said.
According to Bigelow, the current economic environment is similar to the period they studied in that it is highly competitive and is forcing firms to focus on reducing costs while maintaining value to customers.
Two modern examples with outsourcing problems are Toyota and Boeing.
For Toyota, those specialized components were the electrical system and the accelerator. Since October 2009, the company has recalled nearly 8.5 million vehicles due to problems with floor mat interference and a sticky accelerator pedal, and some have said that its design shift to an electronic throttle control is problematic. And, the company recently announced the recall of another 412,000 cars for steering problems.
In Toyota’s case, their research suggests that outsourcing amid its strategy of accelerated growth may have led to the company’s current woes.
“In this situation, it’s no surprise when things break down,” Bigelow said. “In 2004 and 2005, Toyota’s premier goal was to overtake GM. This desire for rapid expansion, combined with an increased level of complexity in its auto designs, left Toyota with few supply options, as generating an in-house infrastructure to accommodate the increased production would’ve taken years.”
Consequently, the company had to increase its reliance on suppliers who often had weaker incentives to maintain and improve quality, she explained.
For Boeing, the interconnections among the Dreamliner’s wings, fuselage, engines and software are crucially important. In a bid to reduce production costs and increase support for the aircraft among foreign nations, Boeing outsourced more of this plane than any other in its history, approximately 70 percent, Bigelow said.
“The increase in outsourcing may have reduced the costs of some components, but this cost has been more than offset by increased re-design costs and expensive delays,” she continued. “Boeing has indicated that it will rein in outsourcing on the next version of the Dreamliner, acknowledging that the unique aspects of this aircraft production process favor vertical integration over outsourcing.”
For other companies, success or failure might hinge factors such as poor customer service, leading to a loss of business.
Throughout the U.S. auto industry’s history, the decision to outsource has usually been made for financial reasons, Bigelow said. While the manufacturing process always requires some reliance on suppliers, in any industry success or failure can hinge on what components companies choose to outsource.
In their paper. Bigelow and Argyres examine a watershed event in the auto industry: the emergence of a dominant design for cars. Once automakers knew what buyers wanted and expected from them, Bigelow said, their ability to efficiently deliver a quality product became vital. This shift took place in the 1923-1924 model year when the dominant design was characterized by an all-steel, enclosed body with the steering wheel on the left and a gas-propulsion engine.
“The nature of competition shifted,” she said. “Firms that continued to come up with innovative ways to design vehicles were penalized, because the market no longer valued that kind of radical innovation. What it valued was greater reliability and durability, and a lower price.”
One success story was the Pennsylvania-based Biddle Motor Car Company, which specialized in sports cars and luxury vehicles. In spite of its reputation at the time as a vanity project by the company’s affluent owner, Biddle outlasted many contemporaries thanks to its decision to produce many specialized parts in-house.
“As it turned out, he knew enough to keep the company running longer than anyone ever expected,” Bigelow said.
Their research helps prove the transaction-cost-economics theory of Oliver E. Williamson, professor emeritus of the University of California, Berkeley, who won the 2009 Nobel Prize in economics. Williamson theorized that in a producer/supplier relationship, the more highly specialized a component, the greater the level of risk to both parties, if it is outsourced. Bigelow studied with Williamson at Berkeley.
Measuring firm performance as survival, Bigelow and Argyres found that companies that make vertical-integration decisions consistent with the logic of transaction-cost economics survive longer than those that do not.
Although studies of other industries – computer hardware and software manufacturers, pharmaceutical companies and hospitals, for example – have looked at the impact of vertical integration on specific outcomes, such as customer satisfaction or the transfer of knowledge, Bigelow and Argyres’ study is one of the few that links outsourcing to firm performance.
While the importance of a good product and good business strategy can’t be overlooked, in both the past and present, “the firms that do the best are the ones who make these judicious sourcing decisions,” Bigelow said.
About the authors
Lyda Bigelow is an assistant professor of strategy and a David Eccles Emerging Scholar in the Department of Management at the University of Utah’s David Eccles School of Business. She received her MBA from Wharton and her Ph.D. from the University of California, Berkeley. Her research focuses on firms’ ability to survive, expand and adapt to changes, based on their strategic choices. Her work has appeared in the Strategic Management Journal, Journal of Economic Behavior and Organization and Management Science. She is a member of the Editorial Board of the Strategic Management Journal and is a reviewer for Administrative Science Quarterly, Organization Science and other journals.
Nicholas Argyres is a professor at the Olin Business School at Washington University in St. Louis, Mo. His research focuses on topics in organizational strategy, such as organizational boundaries, contracting and inter-organizational relationships, internal organization structure, technology and organization and organizational dissent.
About the David Eccles School of Business
With emphasis on interdisciplinary education and experiential learning, the David Eccles School of Business has programs in entrepreneurship, technology innovation and venture capital management. It launched the country’s largest student-run venture capital fund with $18.3 million, and the Association of University Technology Officers ranks the school first in the country in taking university-generated technology to market.
Founded in 1917, the school has the first accredited MBA program in the Intermountain West. Some 3,500 students are enrolled in its undergraduate, graduate and executive degree programs as well as joint MBA programs in architecture, law and health administration. Ranked by The Wall Street Journal among the world’s top 100 business schools, it is located in Salt Lake City, Utah.