Why Do Companies Outsource - Essay Example

Running Head: essay Nike of the of the of the Introduction The pace at which the world is converging to become a global village is astounding. Advances in transportation, information technology, and the economic policy adopted by most of the governments have ensured that there are lesser restrictions on the flow of capital and labour than there were a few decades back. All these factors help explain the rise of truly multinational companies, whose products sell in all corners of globe and which belong to no particular country. Similarly, the rules of business have changed greatly during these years. In the 1960s, manufacturing was the predominant business activity. Manufacturing was the life blood of a nation’s economy. This is not the case anymore. Although the productivity of the manufacturing sector in United Kingdom, and elsewhere, has improved, the share of manufacturing in the Gross Domestic Product (GDP) of the countries of the developed world has declined (OECD 2009). In the United Kingdom, for instance, the share of manufacturing has come down from nearly 22% in 2000 to 16% in 2007 (OECD 2009). One of the most important reasons for this loss in the share of manufacturing sector is the emergence of Asian and other third world countries as a provider of cheap labour where the transnational companies could shift their manufacturing units and continue manufacturing their products at a fraction of the cost of what it would have had, had they continued to manufacture it in the developing world. The multinationals have become adept at exploiting each and every opportunity to reduce the costs of their products by shifting their production base from one low cost centre to another low cost centre. This has resulted in increasing profits for the companies, and in some cases, lower prices for the end customer. On the other hand, globalization has also lead to problems for the transnational organizations. They have received negative publicity over the alleged ill treatment of the workers at their low cost manufacturing centres, and for using the natural resources of the countries they are operating in and spreading pollution there. Why do companies outsource? The transnational corporations try to adapt themselves to the changing landscape of business in many different ways. Their responses have ranged from outsourcing a part of their business to acquiring strategic business partners abroad. The advantages offered by moving the manufacturing units offshore are not only related to cost, but also to quality, risk mitigation and the ability to concentrate on the core areas of business. The biggest and most easily recognizable advantage gained by outsourcing is the cost advantage. Producing the product at a location which has low cost of labour reduces the cost to the multinational organization or gives better product at the same cost. The founders of Nike, Phil Knight and Bill Bower man recognized the competitive advantage to be gained from outsourcing at an early stage. In 1960, they saw that low priced, high quality Japanese products had begun to take over the US market in consumer electronics. Adidas and other leading footwear manufacturers, on the other hand, were still manufacturing their products in high cost locations like USA and Germany. Knight and Bower man figured out that they could undersell the competition by importing the low cost Japanese footwear. They tied up with Onitsuka Tiger of Japan first, and later with Nippon Rubber and Nihon Koyo later (Locke 2008). Even later, when due to inflationary pressures and oil crisis, Japan started to become a costlier option, Nike shifted its manufacturing base to Taiwan, Thailand, and South Korea. This decision was also influenced by the steps taken by the South Korean government to develop Korea’s footwear manufacturing industry. It also opened a couple of plants in the United States to develop a high quality and reliable source to satiate the domestic market which was growing at an unprecedented rate. As costs continued to rise in the United States, Nike closed down both the plants and became totally dependent on Asia for its supplies. In 1982, Nike sourced 86% of its supplies from Taiwan and South Korea (International Sourcing in Athletic Footwear: Nike and Reebok n.d.). When even Taiwan and South Korea developed and became costly, Nike opened up manufacturing centres in Indonesia and Vietnam. There were nearly 500,000 people associated in the manufacturing of Nike shoes (Duesen 1998). Only 20, 00 people worldwide are direct employees of Nike. All along, Nike continued to expand its product ranges and continued to move into different segments as and when it recognized and opportunity in that segment (Nike 2007). This was possible only because Nike decided to concentrate on its core competency which was the design of the footwear and the accompanying advertising campaign. Starting from the legendary ‘swoosh’ to the ‘Air Jordan’ campaign, the company has been known for its advertising. Similarly, Nike has brought a lot of new innovations in the design of footwear. It would be safe to say that had Nike also manufactured the footwear instead of subcontracting the manufacturing, they would not have been able to innovate so consistently. Moreover, they would not have been able to tap into the latent desires of their customers had they been kept busy by the manufacturing. This fact was realized by many leading multinationals during the 70s and the 80s. They found out that manufacturing was not the activity which provided the maximum value add to the organization. Therefore, they focussed on research and development, design and other such activities which added the maximum value to the product. So, not only in the footwear industry, but also in many other industries like chemicals, drugs and tyres, transnational organizations began to concentrate on activities like research and development and getting patents while subcontracting or outsourcing their manufacturing to a contractor in a low cost centre which was generally in the developing world. This model also depends upon the product being manufactured. For example, it would be difficult to produce a car at a location which is far away from the place where the demand for the car is because the shipping costs involved would nullify all the advantages gained by producing the car in a relatively cheap location. Also, producing in a different country may lead the organization vulnerable to protectionist tariffs being imposed by one or the other government. For example, Japanese auto-manufacturers realized this fact during the 80s, when the shipping costs combined with the taxes imposed by United States on the imported vehicles, forced Toyota, Nissan and Honda to start producing in the United States. Subcontracting the production to two or more contractors is also a form of risk mitigation practiced by many firms. This protects them from, among other things, political risk and currency risk. For example, if one of the countries where the product is manufactured becomes embroiled in domestic riots and the multinational is unable to source from that country, it can look forward to receiving the product from the other country’s contractor. This can prevent the total shutdown of the multinational organization’s business. Many firms also outsource to restructure their costs. Outsourcing can balance the operating cost to fixed cost ratio, known as operating leverage by reducing the fixed costs (since most of the fixed costs are associated with manufacturing) and by making the variable costs more predictable. Two other factors which promote outsourcing are the reduction in time to market and an access to the best of the breed trade practices. As the contractor is generally much more experienced in the field than the company which is outsourcing, they are much more likely to have best practices and can significantly reduce the time to market of a new product. Strategies for Outsourcing Even when companies take the strategic decision to outsource their production, they have to decide on the details. The details include what parts of the production process to outsource, how many outsourcing partners to involve, who those partners should be and what should be the criterion on which to decide those partners. Most of the organizations decide to outsource the entire part of their production process. But they do not outsource everything to the same contractor. Also, within the partners chosen for outsourcing, there are preferred partners. Finally, the criterion used to decide upon the choice of contractor depends on many things and not just the cost. Many organizations trust only some contractors with the design/ prototype of a product which they are yet to bring to market. Also, if the product involves high technology which is not yet in public domain, the organization would be reluctant to share it with the contractor. The concept of preferred contractor comes into picture at this stage. Preferred contractors are those contractors, with whom the transnational organization has had long and fruitful relationship. Generally, when the existing manufacturing centre becomes too costly, it is transformed into a low level design centre which also performs hand holding role for the newer manufacturing centres. Thus, they move up in the value chain and instead of mass manufacturing, they also help out the contracting company in converting the design to prototype or in preparing the specifications to be passed to the manufacturing centre. Nike called these preferred partners as developed partners. Nike had a three tier structure of its partners. At the top were the developed partners, who produced the latest and most innovative shoes for Nike. The second rung was of Volume Producers, who manufactured a specific variety of footwear in huge volumes. They were less flexible than the developed partners but they were more cost effective. Lastly, there were the developing sources, which were the cheapest but required a lot of hand holding from developed partners and volume producers. Nike maintained strong linkages with its developed partners because it depended on them in two ways – one for their expertise and flexibility, and other for the wealth of experience they had. Negatives of Outsourcing Like any coins with two faces, outsourcing is a potential source for many problems as well. They include real problems as well as perceived problems. Some of the problems which have been faced in the real world by the multinational organizations which have outsourced their production are lack of quality, low productivity, bad publicity, low morale in the workforce, and not getting the desired business transformation. Lack of quality is a major point which all the organizations which want to outsource consider. This lack of quality is both perceived and real. There may be situations where the contractor is plainly incompetent to perform properly the work given. But, in some cases, there has been a tendency to attribute the failure of the outsourcing initiative to the lack of quality when the culprit was the lack of clarity at the uppermost levels of management. In manufacturing, quality is easy to measure and the contract can be made in such way that the penalties imposed on the contractor for not meeting the prescribed quality standard would be huge. Also, if adequate care is taken to transfer the knowhow of production to the contractor, there are lesser chances of quality issues being found out. Generally, the most important reason for the lack of quality is the lack of support from the outsourcing company to the contractor. Instead of improving the productivity really, some companies fall into the trap of measuring the productivity by money spent on each worker. They do not take into the account the fact that in a developed country, the plant would be highly mechanized and would require lesser number of people. Thus, sometimes companies sacrifice their long term gains, which they can achieve by investing in technology, for the short term gain, obtained by hiring more labour which are cheaper. This is harmful for the company in the long run. Indeed, firms need to maintain a healthy balance between present savings and investing for the future. Many companies, Nike included, have come under the scanner of human rights group who have often complained that the labourers who work in the facilities under the contractors are subject to inhuman working condition, physical, mental and sexual abuse. In addition, they are paid very poorly. Their wages are below subsistence levels in many cases. These factories have been compared to the sweatshops which operated in pre war Britain. Nike has also been accused of using child labour in Pakistan for manufacturing soccer balls. At first, Nike denied having any knowledge of these facts. Then it tried to ignore the criticisms saying that since the factories were run by contractors, they were not responsible for the abuses taking place inside them. Later Nike took corrective action to remedy the situation by increasing the daily wage above the legal minimum wage. Nike also states that it now has a thorough procedure to check the contractor’s behaviour. Nike’s expatriate workers visit the factories at least once every week to see if everything is in order (Nike 2007). Despite all these efforts, Nike continues to get negative publicity because of the working conditions in the factories of its contractors. However there have been other controversies as well where Nike has been criticized for its particular products hurting the sentiments of a religious community. One such incident happened in 1996, when a particular design on its shoe carried the name of Islamic god i.e. Allah. But Nike soon withdrew all such footwear products from the market around the globe and apologized to Muslim community for this blunder. Conclusions No organization which wants to succeed can afford to waste its limited resources on activities which are non-core to its business. Each organization should concentrate on its core competence, according to the Principle of Core Competence given by Gary Hamel and C K Prahalad. Increasingly, the core competence of the multinational firms is not manufacturing but some other activity which can provide more value add to the organization. In Nike’s case, it is design of the athletic footwear and the branding of Nike. The firm concentrated on its core competencies and performed really well. And this is the model which most of the other transnational companies have adopted or will have to adopt in order to survive. Ricardo’s theory of competitive advantage states that each party should do the task it is good at and then trade would leave everybody better off. Presently, the multinational firms are better at handling activities like Research and Development, branding, innovation etc. On the other hand, the developing world is not far behind them in manufacturing. Hence, the competitive advantage of the big transnational firms lies in their ability to innovate, while the competitive advantage of the developing world is in providing cheap labour. This is the division of labour which would lead to most economic allocation of resources. Slowly and slowly, the companies from developing nation would become large and the prosperity brought about by the trade would help the developing nations come at par with the developed world. Then, we can truly have transnational organizations which can call the world their home. References Duesen, Steven van. The Manufacturing Practices of the Footwear Industry: Nike vs. the Competitors. 1998. http://www.unc.edu/~andrewsr/ints092/vandu.html (accessed May 3, 2010). International Sourcing in Athletic Footwear: Nike and Reebok. HBS Case # 9-394-189 Locke, Richar M. MIT Working Paper The Promise and Perils of Globalization. 2008. http://web.mit.edu/ipc/publications/pdf/02-007.pdf (accessed May 3, 2010). Nike. "Corporate Responsibility Report." 2007. OECD. Statistical Country Profiles 2009. 2009. http://stats.oecd.org/viewhtml.aspx?queryname=18174&querytype=view&lang=en (accessed May 3, 2010). Read More