Vertical Integration and Outsourcing

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Dangers of Outsourcing
While outsourcing has its advantages, it also has its dangers. There are two major dangers of outsourcing: a loss
of capabilities (particularly the capability to innovate) and a lack of control over critical assets or activities.
Dell’s experience of outsourcing the majority of components, supply chain management, and final assembly of
its computers is instructive. Although Dell’s outsourcing strategy lowered its asset base and increased its profits
in the short run, it also resulted in Dell having fewer capabilities to innovate and create competitive advantage
in the future. Dell’s market value soared to a high of $103 billion in 2005, but at the beginning of 2012, Dell’s
market value had dropped to $26 billion. One reason for Dell’s fall is the emergence of new, low-cost PC
makers such as ASUS—a competitor that Dell helped create (see Strategy in Practice: How to Prevent a
Subcontractor from Becoming a Competitor). However, and perhaps more importantly, Dell has had a difficult
time designing and building differentiated PCs, laptops, and tablets to compete effectively with Apple. More
vertically integrated than Dell, Apple makes much of the software that runs its products as well as some of the
key components. By having a larger portfolio of capabilities, Apple is better able to innovate and create new
products. Outsourcing can also be dangerous because it can lead to a loss of capabilities to do new things.
In addition to leading to a loss of innovation capabilities, outsourcing can lead to a loss of control as suppliers
that provide key inputs gain bargaining power. To illustrate, when IBM first launched a micro-computer—the
PC—it decided to outsource two of the key components of the computer: the microprocessor (to Intel) and the
operating system (to Microsoft). The microprocessor was the single most expensive component of the PC, and
the DOS operating system was the software that users had to learn in order to navigate the computer. IBM
believed that if the PC turned out to be successful, it would eventually make its own microprocessors and create
its own operating system.
Strategy in Practice How to Prevent a Subcontractor from Becoming a
Competitor
Companies that outsource face a substantial challenge. They must make sure that they don’t end up creating a
competitor—which was essentially what Dell did by outsourcing so much to ASUS. What steps can companies
take to prevent this from happening?
1.
Build barriers to imitation. One of the most important things a company can do to prevent a supplier from
becoming a competitor is to build barriers to imitation. As described in Chapter 2, a barrier to entry prevents
new entrants from easily entering a particular industry. A barrier to imitation is something that prevents
other companies from imitating what a particular company can do.
To illustrate, Nike outsources the manufacturing of its athletic shoes to subcontractors—so they know how
to make Nike-quality shoes. Why don’t these suppliers enter the athletic footwear business and compete
with Nike? The answer is that Nike has built a number of barriers to imitation that make reproduction of
their footwear difficult. The first barrier is brand. Nike’s brand is so well known that a no-name brand would
have a hard time competing, even if it is good quality. But beyond that, Nike’s shoes go through annual
design changes. This means suppliers would soon be developing shoes using “old” design technology. Of
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Vertical Integration and Outsourcing 5/14/18, 12:28 PM
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course, Nike also writes contracts with suppliers that prohibit them from making shoes based on Nike’s
designs or intellectual property. These practices all make it difficult for suppliers to become a competitor to
Nike.
2.Limit knowledge of the full product. Another way to stop a supplier from becoming a competitor is by
preventing the supplier from knowing everything about making a product. Some companies will outsource
some of the components of a product to suppliers but will manufacture one or more key components
internally and manage final assembly of the product internally. That way, no one supplier has all of the
knowledge necessary to easily produce a competing product.
3.Take an equity stake in the supplier. A final way to prevent a supplier from becoming a competitor—or
from becoming too powerful—is by taking an equity stake in the supplier. For example, when IBM
launched its PC, back in the early 1980s, it could have looked at its key suppliers—for example, Intel and
Microsoft—and decided to take an equity stake in those suppliers. If IBM had taken an equity stake in Intel
and Microsoft it would have given itself more control over their activities. Moreover, IBM would have at
least been rewarded for helping Intel and Microsoft grow and become powerful suppliers in the industry.
Imagine how much more successful IBM would be today if it had only thought to take a 40 percent equity
stake in Intel and Microsoft—something it could have easily done when it launched the first IBM PC.
As it turned out, IBM PCs were very successful, and so the company decided to make its own microprocessors
and operating systems. However, Intel launched the “Intel Inside” campaign, telling customers that the
microprocessor was the “heart” of the computer and alerting customers to look for “Intel Inside.” As a result,
IBM was not successful at getting customers to buy IBM PCs that didn’t have Intel chips in them. In fact, in the
halls of IBM’s headquarters, some of the executives were heard asking the question: “Who let Intel Inside?”
Many believed that IBM should have purchased Intel early on or should have launched the first PC with an
IBM-built microprocessor because it was a key input that the company should have controlled. IBM had traded
speed to market (flexibility) for control of a critical input.
In similar fashion, IBM decided that it no longer wanted to rely on Microsoft for the operating system, so it
launched its own OS/2 operating system and tried to get customers to switch. Microsoft responded with its
Windows 3 operating system. IBM’s customers were so well acquainted with Microsoft’s operating system that
they didn’t want to switch to OS/2. IBM eventually abandoned OS/2 in 2004. At the end, IBM had outsourced
the two key components that it later realized it wanted to control. Without making its own operating system or
microprocessor, IBM had few options for differentiating its PCs. IBM eventually sold off its PC division to
Chinese firm Lenovo in 2004. IBM and Dell’s experiences provide a cautionary tale for companies that choose
to outsource.
Concept Check 7.5
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