Can Smaller Companies Outsource Strategically?

Some companies (both large and small) are going beyond outsourcing commodities to outsourcing core/strategic parts. It makes sense for smaller firms with scarce resources to outsource commodities. A commodity by definition is something for which several suppliers exist As a result of competition, someone else can do it better, faster, and cheaper. However, data also shows that outsourcing core parts can be done effectively if companies take a strategic approach and look beyond short-term considerations. For example, some companies use techniques such as co-location and long-term contracts. Smaller companies in particular should establish joint ownership of all design and manufacturing capabilities developed during the outsourcing partnership. There was a time when the school of thought was that every company needed a core competency and should focus all of its scarce resources on developing that competency. Having a core competency implied you could do something better, faster, and cheaper than anyone else and everyone came to you for it. However, it appears that strategic outsourcing to outsourcing companies can in itself be developed into a core competency, especially for smaller companies that have fewer resources to begin with.

The Core

With core parts there might only be one, two, or three suppliers to choose from. After all, a few or no suppliers to choose from is what defines a core part. Also, if it is core, chances are you need to go with one supplier because using more than one might be too complicated and sensitive. Companies, especially smaller ones, should resist the temptation of using competitive bidding when they outsource core parts. Why? One, how do you use competitive bidding if there are only one or two suppliers to choose from? You cannot. Have you heard about the government awarding multibillion dollar contracts to suppliers with no bids? People often ask why don’t they use competitive bidding to get the best price. It is often because there is only one supplier that can give the government everything they need and want.

Also, with core parts, price is usually not the most important evaluation criterion. Everyone of course cares about price. But how much does a smaller firm know about price with something as complicated as a core part? It is not a commodity like a widget. The buying organization should establish cost target goals and reward the supplier if they exceed those goals. Usually, strategic outsourcing of core parts is about performance (e.g., quality, service, and flexibility). Smaller firms should use negotiation to find a supplier for core parts. Smaller firms should use inexperienced junior buyers for competitive bidding of commodities. However, smaller firms need to tap into the experience and skills sets of senior buyers that can negotiate the terms and conditions of a contract with suppliers for strategic parts.

Commodities and core parts can both be outsourced, but the techniques used for outsourcing require careful evaluation, especially for a smaller company. Larger companies might have the resources to regroup if they ineffectively outsource something strategic, but smaller companies might be more at risk because of a lack of resources to play catch-up. For example, decades ago, IBM wanted to outsource the operating system and microprocessor for its personal computers and it was all about driving down costs. IBM failed to recognize that these two components of a PC were strategic and that perhaps cost was not the major driver. IBM quickly outsourced these parts to Microsoft and Intel. These two suppliers proceeded to widen their margins in the PC market as companies like IBM failed to establish joint ownership of design capabilities. IBM was large enough to regroup from these outsourcing decisions, but, smaller firms are under pressure to widen margins with limited resources. One way to get there is through strategic sourcing and that includes commodities.

For example, do not assume that you are getting the best price and cannot do better because it is a commodity. You might outsource steel pipes to a distributor and only pay $1.00 per piece because that distributor buys steel pipes from the mill in bulk. It would cost you $1.20 if you bought directly from the steel mill. That is strategic sourcing, but it never stops. Raw material costs for all types of mills have been escalating at very rapid rates and these mills refuse to sell products at a loss and go out of business. They are better managed today and have surcharges for cost increases that are out of their control such as raw materials. If the steel mill has a 15% surcharge that is passed on to the distributor and the distributor marks up that 15%, then your new cost will exceed $1.15.

Finding outsourcing companies for strategic sourcing would have addressed this issue with the distributor upfront and required that you only pay an increased amount above the $1.00, which is exactly the rate of the surcharge. In other words, you pay the 15% surcharge, but you don’t let the distributor mark up the 15%. You could also shop around for mills that are more efficient and have a smaller surcharge or use a different distributor. Even commodities can be managed strategically and this might be required for smaller companies as they look for ways to widen margins with fewer resources.

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