Outsourcing May Lead to Failure in Tough Times and in Good, Shows University of Utah Research

SALT LAKE CITY, Aug. 4 /PRNewswire/ -- In tough 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 a study led by Lyda Bigelow, strategy professor in the University of Utah's David Eccles School of Business, that appears in the August issue of the journal Organizational Science.

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."

One of their previous studies shows that failure rate increased between 5% and 70%, depending on the risk associated with making technological changes, product type and company market share.  

In the latest study on vertical integration – or the in-house manufacture of products, Bigelow and co-author Nicholas Argyres of Washington University analyzed performance in more than 100 U.S. auto companies from 1917 through 1931, to examine the industry's shift from innovation to production efficiency. At that time, there were many more manufacturers than there are today.

Today's economic environment is similar in that it is highly competitive and forces firms to focus on reducing costs while maintaining value to customers, Bigelow said.

Two modern examples with outsourcing problems are Toyota and Boeing.

"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."

For Toyota, those components were the electrical system and the accelerator. For Boeing, the attachment of the Dreamliner's wing to the fuselage was crucial. For other companies, success or failure might hinge on something such as customer service.

For Toyota, 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 increased complexity in its designs, left Toyota with few supply options, as generating an in-house infrastructure to accommodate increased production would've taken years."

Consequently, Toyota had to increase exposure among suppliers who often had weaker incentives to maintain and improve quality.

Bigelow and Argyres examined a watershed event in the auto industry: the emergence of a dominant design for cars. Once automakers knew what buyers wanted and expected, their ability to efficiently deliver a quality product became vital.

"The nature of competition shifted," she said. "Firms that continued to develop 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 as a vanity project by its affluent owner, it outlasted many contemporaries because it produced 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 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.

Although studies in other industries – computer hardware and software manufacturers, pharmaceutical companies and hospitals, for example – have examined the impact of vertical integration, Bigelow and Argyres' study is one of the few that link outsourcing to performance.

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SOURCE University of Utah's David Eccles School of Business