Outsourcing: Make vs Buy

• The "make versus buy" decision refers to a firm's choice between

performing activities internally or outsourcing them to an independent
firm.
• This strategic decision involves determining which activities to handle in-
house and which to outsource, selecting appropriate partners for
outsourced tasks, and defining the nature of the relationship with those
partners. The relationship can either be transactional or based on long-
term partnership.
Make Versus Buy: The Strategic Approach
• The supply chain consists of multiple firms involved in transforming
goods from raw materials to the final product reaching the end
customer. The "make versus buy" decision, analyzed from the
perspective of the focal firm in the supply chain, evaluates whether
each activity should be performed internally or outsourced.
• Using Michael Porter's value chain framework, activities are divided
into primary (e.g., logistics, operations, sales) and support activities
(e.g., procurement, technology development, HR).
• The decision to outsource requires selecting suppliers and
determining the relationship type.
• Historically, firms preferred internal operations unless outsourcing
was strongly justified, but now many, like Dell, advocate for
outsourcing to avoid unnecessary costs and inefficiencies.
• The decision-making process has evolved from a rigid, vertically
integrated model to a more flexible, strategic approach, requiring a
balanced managerial logic to determine the best approach for each
activity.
Identifying Core Processes
• Identifying core processes is a critical decision for a firm. If driven
solely by short-term gains like balance sheet re-engineering or
improved returns, it can jeopardize long-term sustainability and turn
the firm into a hollow corporation.
• To truly excel, firms must focus on becoming the best in the world in
their core areas, not just match industry standards. This requires
significant investment in people, equipment, and R&D, which also
helps attract top talent.
• Some companies have outsourced areas like IT, realizing they can't
compete for the best talent in that field. The first step is to distinguish
between core and non-core activities, keeping certain core activities
in-house while ensuring effective management of outsourced critical
functions. Core processes can be identified through two routes: the
business process route and the product architecture route.
The Business Process Route
• For any firm, three key business processes are customer relationship,
product innovation, and supply chain management. These processes
can be separated, and a firm may outsource two of them.
• Some experts suggest that a firm should focus on building core
capabilities in at least one of these areas.
• For example, HP and pharmaceutical companies focus on product
innovation, Nike and Benetton focus on customer relationships, and
companies like Wal-Mart and Dell excel in supply chain management.
• Within core processes, firms can outsource non-essential activities,
such as warehousing or transportation in supply chain management.
• Microsoft, for instance, focuses on customer relationship
management and software design as core processes, while
outsourcing design and manufacturing.
• Bharti Airtel focuses on customer relationship management and
outsources network management. The core processes retained by a
firm must be strategically important, giving the firm bargaining power
within its supply chain.
• If a firm doesn't control key processes, it can lose power, as seen with
IBM in the PC industry, where it lost influence to Intel and Microsoft
despite its strategic position.
The Product Architecture Route
• The product architecture approach guides make-or-buy decisions by
classifying sub-systems and components as strategic or non-strategic.
Strategic sub-systems involve rapidly evolving technologies, specialized
skills, and significant product performance impact. These should be kept
in-house to maintain differentiation, while non-strategic sub-systems are
outsourced.
• At the component level, firms retain components where they have or can
develop technological leadership, while outsourcing those where suppliers
have a clear lead, often treating them as strategic partners. Examples
include Tata Motors outsourcing diesel engines to Fiat and Cummins
outsourcing pistons.
• Even when outsourcing, companies must retain architectural
knowledge—the expertise needed to translate customer needs into
system specifications. Firms that outsource too much without
maintaining core expertise risk becoming hollow corporations, losing
competitiveness (e.g., Webvan’s failure due to poor supply chain
understanding).
• companies must balance in-house development and outsourcing
while safeguarding critical architectural knowledge to sustain
competitive advantage.
Market Versus Hierarchy
• The make versus buy decision, also known as the market versus hierarchy
decision, involves choosing whether to produce components in-house or
procure them externally. Making in-house provides control but lacks
economies of scale and may lead to higher agency costs due to
inefficiencies and lack of motivation for innovation.
• Buying externally allows for economies of scale, supplier competition, and
innovation incentives but incurs transaction costs for coordination and
control.
• The decision-making process involves evaluating economies of scale,
agency costs, and transaction costs. Initially, the focus is on a strict make-
or-buy scenario, but later, intermediate relationship models between firms
are considered.
Economies of Scale

• Firms that specialize in producing inputs can typically achieve greater

economies of scale compared to vertically integrated firms, which
produce solely for their internal needs. A vertically integrated firm
faces limited demand, while an external supplier can aggregate the
demands of many buyers, benefiting from significant economies of
scale. These economies of scale can be realized in both manufacturing
and logistics activities.
• Spreading Fixed Costs:
When a firm increases production volume, it can spread fixed costs (such as
setup costs, truck costs, or manufacturing unit setup) across a larger number of
units. For example, the cost of operating a truck or setting up a manufacturing
facility remains relatively fixed, regardless of the amount produced. A firm
producing larger volumes can thus reduce the per-unit cost of operations.
• Adopting Efficient Technologies:
Higher production volumes allow firms to invest in capital-intensive
technologies that lower both fixed and variable costs per unit. For instance, in
the semiconductor industry, using more advanced technology that processes
larger wafers can significantly increase output per wafer, reducing the cost per
chip. Similarly, a transport company using a larger truck can transport more
goods at a lower cost per ton than using smaller trucks.
• Pooling of Buffer Capacities and Inventories:
Firms that operate in-house must keep large inventories and buffer capacities
to handle demand fluctuations. External suppliers, however, can pool these
uncertainties across multiple customers, requiring less inventory and buffer
capacity. By handling varying demand profiles from different customers (e.g.,
transporting goods for different companies on the same trip), suppliers can
better utilize their resources and reduce costs.
• Learning Curve Effect:
As production accumulates over time, workers and management improve
efficiency, leading to a decrease in the average cost of production. In many
industries, cumulative production causes costs to drop by 10-20% every time
output doubles, as firms gain experience and streamline their processes.
Agency Cost
• Bharti previously managed customer billing operations through its internal IT
department, raising the question of how to align the interests of the IT and marketing
departments.
• This issue, known as the agency problem, involves the IT department (agent) and the
marketing department (principal). A similar issue arises with a firm's internal transport
department. In hierarchical firms, there is more control, but less motivation for internal
suppliers to innovate and reduce costs.
• This lack of motivation and the cost of coordination are termed agency costs. Internal
divisions often face challenges in acting in the firm's best interests, and without market
competition, it's difficult for management to assess performance and profitability, as
divisions are treated as cost centers and are insulated from competitive pressures.
Transaction Cost
• Transaction costs refer to the costs involved in using market
mechanisms, which can be avoided by bringing activities inside the
firm. These costs include:
1. Search and Information Costs: The costs of finding and evaluating
the right supplier.
2. Bargaining and Contracting Costs: The costs of negotiating terms
and preparing contracts to ensure suppliers deliver as agreed.
3. Policing and Enforcement Costs: The costs of monitoring suppliers to
ensure they follow contract terms, and the potential legal costs if
enforcement is necessary.
4. Loss of Control Costs: Using market mechanisms may lead to
underinvestment in specific assets, poor coordination, and the risk of
strategic information leakage, which could harm the firm in the long run.
• The loss of control is a significant component of transaction costs,
particularly in market exchanges, as perfect contracts and enforcement are
not feasible in the real world.
Incomplete Contracts
• In theory, it is possible to write a complete contract covering all
contingencies in a transaction, but in practice, it is impossible due to
several reasons:
1. Bounded Rationality: Managers have limited capacity to process all
information, making it difficult to foresee every possible scenario, such as
regulatory changes or market conditions.
2. Difficulties in Specifying or Measuring Performance: Some services or
product qualities are hard to define or measure in contracts, like the
quality of consultancy services or pharmaceuticals, leading to challenges
in ensuring performance.
1. Asymmetry of Information: At the time of contract writing, one
party may have more relevant information, such as about future
technologies or market changes, which can lead to opportunistic
behavior.
• Additionally, in countries with weak legal systems, enforcing contracts
can be difficult, making incomplete contracts more common. As a
result, the supplier's reputation becomes crucial, as firms with strong
reputations are less likely to act opportunistically. However, these
firms may charge a premium, which is reflected in transaction costs.
• The inability to create a complete contract increases transaction
costs, leading to issues like:
• Relationship-specific assets
• Poor coordination in the supply chain
• Leakage of strategic information impacting supply chain
performance.
 Integrative Framework
of Market Versus Hierarchy
• To address the make versus buy decision, a firm must consider both benefits and costs,
including transaction costs and risks of losing control in market exchanges.
• If the costs of internal control and poor economies of scale are lower than market
transaction costs, the firm should choose to make.
• However, if market exchange is more cost-effective, the firm should buy. Understanding
true agency and transaction costs requires in-depth business knowledge.
• While most garment firms outsource, companies like Zara and Benetton prefer internal
manufacturing to maintain control and responsiveness to market trends.
• The make-versus-buy decision is not always clear-cut, as it exists on a spectrum rather
than as a binary choice.
Designing Distribution Network
• Designing a distribution network is a crucial part of logistics and
supply chain management. It involves determining the most efficient
and cost-effective way to move goods from manufacturers or
suppliers to end customers or retail locations.
• The network design process takes into account factors like
transportation, warehouse placement, inventory management, and
customer service levels.
Factors influencing distribution

• Several factors influence the design, efficiency, and performance of a

distribution network. These factors can vary depending on the
industry, geographic location, customer needs, and other external
conditions.
key factors that affect distribution:
1. Customer Demand
• Geographical Distribution: The location and spread of your customer
base directly affect where distribution centers and warehouses need
to be placed. If customers are spread across a large area, you might
need more regional distribution centers (DCs).
• Order Frequency & Volume: Understanding how frequently
customers order and the typical order size helps you plan inventory
and shipping strategies. High-volume, frequent orders require more
streamlined operations.
2. Transportation Costs and Infrastructure
• Transportation Mode: The choice of transportation (road, rail, air,
sea) impacts distribution costs and delivery times. Air and sea
transport are generally faster but more expensive, while rail and road
may offer lower costs but longer delivery times.
• Route Planning: Efficient routing can reduce transportation costs and
improve service times. Optimization software can help to identify the
most cost-effective and time-efficient routes.
• Infrastructure Availability: Availability of roads, ports, airports, and
railways influences where you can place distribution centers. Regions
with advanced infrastructure might offer lower transportation costs.
3. Warehouse and Inventory Management
• Inventory Control Systems: Effective warehouse management systems
(WMS) help in the accurate tracking and management of inventory. A more
advanced WMS allows for better order fulfillment and minimizes errors,
reducing costs and improving customer satisfaction.
• Warehouse Location: Proximity to customer locations, raw materials, and
transportation hubs can impact the efficiency of the network. Locating
warehouses near high-demand areas reduces transportation time and
costs.
• Inventory Levels: Balancing between inventory levels and demand is
essential. Too much inventory increases holding costs, while too little can
lead to stockouts and poor customer service.
4. Cost Structure
• Fixed and Variable Costs: Fixed costs (e.g., rent for warehouses) and
variable costs (e.g., fuel, wages) both influence network design.
Understanding this helps you strike a balance between cost-efficiency
and service level.
• Total Distribution Costs: This includes warehousing, transportation,
inventory holding, and labor costs. A company must balance the costs
of maintaining large inventory levels with the benefits of faster
delivery times.
5. Market Dynamics and Competition
• Competitive Pressure: The distribution network needs to be efficient
to maintain competitive advantage. If competitors have faster or
more cost-effective delivery networks, you might need to invest in
improving your system.
• Globalization and Outsourcing: As businesses expand internationally,
they may outsource parts of their distribution or use third-party
logistics (3PL) providers to handle some of the network activities.
Distribution Network Design Option

• When designing a distribution network, there are several options to

choose from, each with its advantages and trade-offs. The optimal
design depends on the size of the business, the market,
transportation costs, customer service expectations, and other factors
we've discussed. Below are the most common distribution network
design options, each suited for different business models and goals.
• Managers must make two key decisions when designing a distribution
network:

1. Will product be delivered to the customer location or picked up from a

prearranged site?

2. Will product flow through an intermediary (or intermediate location)?

Based on the firm’s industry and the answers to these two questions, one of
six distinct distribution network designs may be used to move products from
factory to customer
1. Manufacturer storage with direct shipping
2. Manufacturer storage with direct shipping and in-transit merge
3. Distributor storage with carrier delivery
4. Distributor storage with last-mile delivery
5. Manufacturer/distributor storage with customer pickup
6. Retail storage with customer pickup
Manufacturer storage with Direct shipping
• In this option products are shipped directly from the manufacturer to the
customer, bypassing the retailer. This options is also referred as ‘Drop
Shipping.’
• The retailer does not carry inventory, and information flows from the
customer through the retailer to the manufacturer.
• This model centralizes inventories at the manufacturer, enabling better
product availability with lower inventory levels.
• However, the benefit of aggregation depends on the manufacturer's ability
to allocate inventory across retailers as needed, rather than assigning fixed
portions to each retailer.
Manufacturer storage with Direct shipping and
in-Transit Merge
• In-transit merge combines products from different locations into a single
delivery to the customer, unlike pure drop-shipping, where each product is
shipped directly from its manufacturer.
• Used by companies like Dell, in-transit merge involves a package carrier
picking up items from different factories and merging them at a hub before
delivering to the customer.
• This model allows inventory aggregation and postponement of
customization, benefiting high-value products with unpredictable demand.
While it requires more coordination, in-transit merge reduces
transportation costs compared to drop-shipping by consolidating
deliveries.
Distributor storage with Carrier Delivery
• In distributor storage, inventory is held by distributors or retailers in intermediate
warehouses, rather than at manufacturer factories, with package carriers transporting
products to customers.
• Companies like Amazon and W.W. Grainger use this model alongside drop-shipping.
While distributor storage requires higher inventory levels due to a loss of aggregation, it
suits products with moderate demand.
• These companies stock fast-moving items in their warehouses and keep slower-moving
ones further upstream.
• This approach can incorporate product differentiation, but requires assembly capabilities.
Compared to retail networks, distributor storage requires less inventory, and Amazon's
warehouses turned inventory faster than Barnes & Noble's retail network.
Distributor storage with last-Mile Delivery
• Last-mile delivery involves the distributor or retailer delivering products
directly to the customer's home, instead of using a package carrier.
• Companies like Blinkit, Instamart, and Zepto use this model in the grocery
industry, and it is also common in the automotive spare parts industry.
• In this sector, OEMs store spare parts at local distribution centers, which
deliver parts to dealers multiple times a day. Unlike package carrier
delivery, last-mile delivery requires the distributor’s warehouse to be closer
to customers, leading to the need for more warehouses due to the limited
delivery radius.
 Manufacturer or Distributor storage with
Customer pickup
• In this model, inventory is stored at the manufacturer or distributor
warehouse, but customers place orders online or by phone and pick up
their merchandise at designated pickup points.
• The products are shipped to these locations as needed. Examples include
7dream.com, Otoriyose-bin by Seven-Eleven Japan, and Tesco in the UK,
which allow customers to collect their online orders from specific stores.
• Amazon’s locker service is another example, as is W.W. Grainger, where
customers can pick up orders at retail outlets. Some items are stored at the
pickup locations, while others come from a central warehouse.
•
Retail storage with Customer pickup
• In this traditional supply chain model, inventory is stored locally at retail stores.
Customers can either walk into the store or place orders online and pick up their
purchases at the store.
• Companies like Walmart and Tesco offer multiple order placement options. While
local storage increases inventory costs due to the lack of aggregation, it has
minimal impact on fast-moving products.
• Walmart and W.W. Grainger keep fast-moving items at stores, while slower-
moving ones are stocked centrally. Transportation costs are lower since
inexpensive transport methods can be used for store replenishment. However,
facility costs are higher due to the need for many local locations, and a strong
information infrastructure is necessary for tracking online orders.
Distribution Network in Practice
1. Ownership Structure Impact: The way a distribution network is owned
affects its performance as much as its physical design. A manufacturer-
controlled network ensures efficiency, while independent distributors
prioritize their own interests, requiring careful coordination to optimize
the supply chain.
2. Adaptability of Distribution Networks: Distribution networks must evolve
with changing technologies. Companies like Blockbuster and Borders
failed to adapt to the rise of the Internet, whereas Walmart successfully
integrated online strategies with physical stores to remain competitive.
• For example, Blockbuster in the movie rental business and Borders in
the bookselling business had great success with a network of retail
stores. Their inability to adapt to the arrival of the Internet, however,
allowed competitors such as Amazon and Netflix to gain market share
at their expense. If either Blockbuster or Borders had adapted to take
advantage of the Internet to create a tailored distribution network, it
can be argued that they could have continued their dominance.
3. Customer Preferences and Product Type: The preferred distribution
system depends on product price, commoditization, and criticality.
High-value, specialized products justify exclusive distribution, while
commoditized goods are best sold through general retailers.
4. Integrating Online and Physical Networks: Companies should merge
their online and physical supply chains for efficiency. Examples include
Tesco’s hybrid model and Walmart’s strategy of using stores for online
order pickups, optimizing inventory management and customer
convenience.
Factors affecting the network design decision
Strategic Factors
• A firm's competitive strategy greatly influences its supply chain
network design.
• Companies focused on cost leadership often choose low-cost
locations for manufacturing, even if distant from their markets, as
seen with Foxconn and Flextronics in China. On the other hand,
companies emphasizing responsiveness prioritize proximity to
markets, even if it means higher costs.
• For example, Zara, despite higher costs in Spain and Portugal, locates
production there to quickly adapt to fashion trends, contributing to
its success as a major apparel retailer.
Technological factors:
• influence network design decisions based on production technology
characteristics.
• When production technology benefits from economies of scale, a few
high-capacity locations are optimal, such as in semiconductor
manufacturing, where large investments are made in a few facilities
due to low transportation costs.
• In contrast, if facilities have lower fixed costs, companies prefer many
local facilities to reduce transportation costs. For example, Coca-Cola
operates numerous bottling plants globally, each serving local
markets to minimize transportation expenses.
Macroeconomic Factors
• Macroeconomic factors include taxes, tariffs, exchange rates, and shipping
costs that are not internal to an individual firm.

• As global trade has increased, macroeconomic factors have had a

significant influence on the success or failure of supply chain networks.

• Thus, it is imperative that firms take these factors into account when
making network design decisions.
Tariff and Incentives
• Tariffs and tax incentives play a key role in location decisions within a
supply chain. High tariffs often lead companies to either avoid serving a
local market or establish manufacturing plants in that market to avoid
paying duties, which results in more production locations with lower
capacity.
• However, as tariffs have decreased due to global agreements like NAFTA,
the EU, and Mercosur, companies have consolidated their production and
distribution facilities. Tax incentives, which are reductions in tariffs or taxes
offered by governments to attract businesses, can also influence location
choices.
• For example, BMW built a factory in Spartanburg, South Carolina, due to
tax incentives.
• Developing countries often create free trade zones to encourage
foreign investment by relaxing tariffs for production aimed at export,
as seen in China with the Guangzhou free trade zone. Some countries
also offer tax incentives based on factors like workforce training and
benefits.
• Additionally, tariffs may vary based on product technology, as in
China's case, where high-tech products enjoy waived tariffs,
encouraging companies like Motorola to set up manufacturing plants
there.
Political Factors
• Political factors significantly impact location decisions, with
companies preferring to establish facilities in politically stable
countries where business regulations and ownership rights are clearly
defined. Political risk, though difficult to quantify, can be assessed
using tools like the Global Political Risk Index (GPRI), which is
provided by the Eurasia Group.
• The GPRI evaluates a country's ability to handle crises across four
categories: government, society, security, and economy. This helps
companies assess the political stability of emerging markets before
investing.