Special four-article report on strategic outsourcing

Outsourcing strategies: opportunities and

risks
Brian Leavy

Brian Leavy is AIB Professor of

Strategic Management at Dublin
City University Business School
and a contributing editor of
Strategy & Leadership
(brian.leavy@dcu.ie). He has
published three books Strategy
and Leadership (co-authored with
David Wilson); Strategy and
General Management (co-edited
with James S. Walsh); and Key
Processes in Strategy.

characteristic of corporate strategy in developed countries in the last 20 years has been
an increasing interest in outsourcing as a potential source of competitiveness and value
creation. The earliest outsourcing strategies were largely driven by the desire to lower
costs in the face of intensifying global competition, typically by moving low-skilled, laborintensive, activities offshore to South-East Asia and other low cost locations. In more recent
years, there has been a growing awareness of the potential of outsourcing to support a range of
strategies beyond that of lower cost.
Corporate strategists may not be fully familiar with four of the most promising opportunities for
using outsourcing strategies focus, scale without mass, disruptive innovation, and strategic
repositioning. While assessing the potential of these opportunities in specic corporate
situations, strategists also need to look at two of the most signicant associated risks the risk
of losing skills that could be key to competing in the future, and the risk of turning to outsourcing
at the wrong stage in an industry's evolution. My goal is to widen managers' views of the
strategic alternatives that outsourcing can be used to support, while making managers aware of
the main risks to be weighed in the balance.

Four promising outsourcing strategies

Focus Nike and Dell
In intensely competitive environments, many companies see outsourcing as a way to hire ``best
in class'' companies to perform routine business functions and then focus corporate resources
on key activities in their value chain where the impact will be felt the most by the customer. This
is the strategy that has helped Nike to capture and sustain leadership in the athletic footwear
and apparel industry for most of the last three decades.
Nike's business started as a company of athletes selling imported performance Japanese
shoes to other athletes, and by the end of its rst decade in 1972, sales had reached just $2

strategists may not be fully familiar with four

`` Corporate
of the most promising opportunities for using
outsourcing strategies focus, scale without mass,
disruptive innovation, and strategic repositioning.

''

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VOL. 32 NO. 6 2004, pp. 20-25, Emerald Group Publishing Limited, ISSN 1087-8572

DOI 10.1108/10878570410568875

million. Despite the relatively slow growth of these early years, the founders continued to
experiment with new performance designs and prototypes, based on their intimate knowledge
of the market. By the end of their rst decade they had already developed the core
competencies in brand building and design that were soon to become the foundation for Nike's
rapid growth. The company decided to focus primarily on these activities and outsource most of
its production and much of its sales and distribution. As a consequence, by the end of its
second decade Nike sales had rocketed to $700 million, with gross margins running at nearly
40 percent. Even before the notion of focused outsourcing was generally understood, Nike had
demonstrated the potential power of such a strategy. It continues to do so today, retaining a 39
percent share of the $7.8 billion US market for branded athletic footwear, and doing so in the
face of very determined competition.
The strategy of focusing corporate resources mainly on those activities where clear
differentiation can be developed and outsourcing much of the rest, has also served many
other companies well. The key often lies in knowing which of the main value drivers to
concentrate on customer intimacy, product leadership or operational excellence. All three are
key to delivering value to customers, but the organizational capabilities and cultures that
promote them are not the same, and often tend to pull in different directions[1]. So, for example,
Nike has tended to focus on primarily on product leadership and Dell on operational excellence
and customer relationship management, and both rely on the competencies of others to help
them deliver value in other areas. The appeal of such a strategy continues to widen, even into
some of the most traditional sectors. Today, for example, many newspapers now tend to
concentrate mainly on the customer relationship area, outsourcing much of their content and
most of their printing and distribution.
Scaling without mass Nokia and Nortel
Another attractive feature of outsourcing is that it offers companies the opportunity to grow in
market presence without a corresponding expansion in organizational size or bureaucracy.
Strategic outsourcing can help a rapidly growing company avoid a premature internal transition
from its informal entrepreneurial phase to a more bureaucratic mode of operation. In this way,
outsourcing allows rms to retain their entrepreneurial speed and agility, which they would
otherwise sacrice in order to become efcient as they greatly expanded.
# 2004 Robert M. Randall

This is one of the primary benets that companies like Nike, opting initially for a focused strategy
with extensive outsourcing, tend to enjoy from the outset. For example, over the 1978-82
period, during the steepest phase in Nike's early growth, revenue scaled up nearly ten-fold from
$71 million to $690 million, while the employee population grew from 720 to 3,600, just half the
growth rate of revenue. In fact, Nike continued to retain many of the characteristics of an
entrepreneurial rm until it was almost a $1 billion company. It was not until it reached billionaire
status that the lack of formal management systems became a serious impediment to the
company's further development.
However, the prospect of being able to scale up without a pro-rata increase in organizational
mass and complexity is an attractive reason to consider outsourcing at any stage in a
company's development, not just at start-up. For example, in early 2000, when employee
numbers at Nokia were increasing at the rate of 1,000 per month, and approaching the 60,000
mark, CEO Jorma Ollila decided to outsource a signicant portion of its production in both its
network equipment and mobile handset businesses in order to help slow down the growth in
number of employees without impeding the company's momentum in the marketplace. It was a
strategy that helped cushion the effects of a subsequent downturn, but the main consideration
was the fear that too-rapid growth would dilute the Nokia spirit and undermine organizational
coherence. At the time, Nokia was widely known as one of the least bureaucratic of global
corporations, and Ollila embraced outsourcing to keep it that way.
For another large corporate example, at Nortel Networks in 1999 management recognized they
were on the cusp of a ``once-in-a-lifetime'' market shift, with the opportunity to double their
company's revenue from $20 billion to $40 billion within 24 months, if they could get their
business model right. They also realized that they could not hope to avail themselves of this
opportunity by remaining a traditional manufacturer. The realization produced a managerial

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mantra ``Why do companies fail? They fail because their processes don't scale.'' This insight
led the Nortel management team to conclude that ``we'd never be a $40B company with
our existing processes'' as Frank Dunn, the company's chief nancial ofcer later recalled. At
the time, the company's return on invested capital was running at just about half that of market
leader, Cisco. Over the 1999-2001 period, Nortel divested 15 manufacturing sites and
transferred 9,000 employees to contract manufacturers such as Solectron and Sanmina. This
was part of a wider move towards a more customer-centric strategy, outsourcing production
while creating in-house supply chain management teams for each major customer. The entire
system was dedicated to improving end-to-end fulllment using Internet-enabled resource
management systems[2].
Disruptive innovation IKEA, Canon and Ryanair
Outsourcing is a key element in many of the most impressive examples of disruptive innovation
to date. Typical examples include IKEA's entry into furniture retailing, Canon's into the
photocopying market, and Ryanair's into the European airline industry. The primary aim of most
disruptive innovation is to create a whole new segment at a price point well below the bottom of
the current market and then to dominate this segment as it grows. This usually requires the
development of an innovative business model capable of producing overall returns at least as
good as those of the leading incumbents, but doing it at signicantly lower cost through much
higher asset productivity[3]. IKEA, Canon and Ryanair were all late entrants into their respective
industries, but all succeeded in building substantial market positions through such a strategy,
and outsourcing was a common element in the development of a distinctive lower-cost/higherasset-productivity formula in all three cases.
At the time of IKEA's founding in the early 1950s, the European furniture industry was highly
fragmented geographically. National department stores established exclusive relationships with
local manufacturers to allow them to offer distinctive product lines, reective of local tastes and
traditions. Quality new furniture was typically priced beyond the reach of all but the relatively
prosperous, and most young people setting out to furnish their rst home had to rely on the
second hand market or hand-me-downs from parents. Ingvar Kamprad, and his company
IKEA, set out to ``democratize'' this marketplace by bringing quality new furniture within reach
of the many, not just the few. IKEA developed a range of simple, elegant, ``modern'' designs,
using light-colored quality woods. This appealed to young customers of all nations. The key to
delivering such attractive furniture at prices well below prevailing norms was designing for
manufacturability and transportability, not just consumer appeal. IKEA revolutionized the
European furniture industry with a novel ``production-oriented retailing'' business model, the
competitiveness of which depended not only the careful outsourcing of production, but also on
``outsourcing'' nal assembly and delivery to the customers themselves. The ``productionoriented retailing'' principle remains fundamental to the IKEA business model as the company
continues to expand internationally, and, no matter how strong the pull at the retail end, the
company will only enter new lines of furniture that t with its production-oriented economics.
Outsourcing has been a prominent feature in the business models of other classic disruptive
innovators over the years, not just IKEA. For example, in the case of Canon, outsourcing has
always been a major element in the company's strategy in the copier market, with 80 percent of
product assembled from purchased parts and only drums and toner manufactured in-house.
Outsourcing is also prominent in the business model of Ryanair, the disruptive innovator in the
European airline industry (the self-styled ``Southwest Airlines of Europe''), where the company
contracts out most of its aircraft handling, heavy maintenance and baggage handling as part of
its strategy to avoid complexity, keep cost down and maintain productivity at levels well above
industry norms.
Strategic repositioning IBM
Strategic repositioning is rarely easy, especially when you are a long-time industry leader like
IBM. Yet, one of the biggest strategic bets that Lou Gerstner made as part of the turnaround at
IBM in the mid-1990s was that services, not technology, would be the major growth area going
forward, particularly in the corporate computing market. As he saw it then: ``If customers were
going to look to an integrator to help them envision, design, and build end-to-end solutions,

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of the most important are the risk of losing skills

`` Two
key to competing for the future and the risk of making
the outsourcing move at the least suitable time in an
industry's evolution.

''

then the companies playing that role would exert tremendous inuence over the full range
of technology decisions from architecture and applications to hardware and software
choices[4].'' Traditionally IBM's strategy had always stressed service as a distinguishing feature
of its value proposition, but this was service tied to products. What Gerstner had in mind was
consultancy and solutions integration services as a major business driver in its own right. In
1992, services was a $9.2 billion business at IBM within ten years IBM Global Services had
grown into a $30 billion business, employing half the corporation's human resources. Recently,
IBM has intensied its commitment to this strategic repositioning, as part of CEO Sam
Palmisano's e-business ``on-demand'' vision.
Outsourcing is central to IBM's repositioning both as a driver and an enabler. Under the new
strategy IBM has become both an extensive provider of outsourcing services to others as part of
its offering as a solutions integrator (primarily in the IT area), while at the same time becoming a
more extensive user of outsourcing services itself (primarily in the product area from contract
manufacturers). For example, IBM's own IT outsourcing services is now one of the main
revenue drivers in the company's new e-business on demand strategy and one that generated
$13 billion in the European market alone in 2002. Further back its value chain, IBM's decision to
outsource a growing share of its own production is helping it accelerate its ongoing migration to
a services-led model and recongure its resources to support this strategy. Within the last two
years the company has entered into a $5 billion outsourcing contract with Sanmina-SCI
Corporation to manufacture its NetVista line of desktop computers, later expanded to include a
signicant portion of its low- to mid-range server and workstation lines, along with some
distribution and fulllment activities. Substantial transfers of assets and overheads have been
involved in both of these deals, which the company sees as allowing it to ``leverage the skills of
the industry where it makes sense to improve our costs, and focus our own investments on
areas that deliver the highest value to our customers[5].''

The risks of outsourcing

Outsourcing also increases certain strategic risks. Two of the most important are the risk of
losing skills key to competing for the future and the risk of making the outsourcing move at the
least suitable time in an industry's evolution.
Mortgaging the future: losing key skills and capabilities
Companies can often be attracted to outsourcing as a means to relieve intensifying competitive
pressure. However, if they fail to consider the long-term implications, they may unwittingly
mortgage their future opportunities for short-term advantage. For example, not too many years
ago Eastman Kodak executives made a decision to exit the camcorder business because the
investment challenge at the time looked too steep to stay in the game. Years later, however,
they came to recognize that the skills and knowledge they would have developed in the
manufacture of the major sub-components could have been used to support a wider range of
applications of the core technologies beyond the consumer market into medical imaging
and other areas. In a similar way, Bulova was slow to see the wider applications that the
manufacturing skills developed in the area of miniature turning fork technology might have
beyond the watch market, an insight not lost on Citizen. In contrast, Canon chose to take a
longer view and remain in the semiconductor business following its failure to make the hopedfor impact in the calculator market, a decision that in time would leave it well positioned to play
in the ofce products market when electronic imaging later emerged as a key technology.
Like prematurely exiting a market, hasty and near-sighted outsourcing may result in the loss or
unintended transfer of critical learning opportunities, as happened to General Electric in its

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outsourcing arrangement with Samsung in the microwave market. In the early 1980s General
Electric was still investing heavily in its own manufacturing capability in Columbia, Maryland
when it decided to outsource the production of some of its models at the small to medium end
of the market to Samsung, then just a modest enterprise little known outside of Korea. The initial
contract was for just 15,000 units. However, GE quickly found itself on a steep dependence
spiral that ultimately saw it ceding most of the investment and skills development initiative in
microwave production to its outsourcer within just two years. For Samsung, the arrangement
allowed it to scale up its production and engineering to levels that would not have been possible
without access to GE's American consumers. This one small outsourcing contract set the stage
for Samsung's emergence as a global powerhouse in consumer appliances[6]. The lesson from
this and similar examples is that it pays to be mindful that strategic capabilities are rarely
synonymous with discrete functions like engineering or production but tend to be deeply
embedded in the collective know-how that reects their integration[7]. That is why many
extensive outsourcers like Nike still wish to retain some manufacturing activity and closely tie it
to engineering and marketing in order to preserve the multifunctional capabilities they see as
key to their future success.
Choosing to outsource at the wrong time in a market's evolution
Strategists also need to know when in an industry's evolution and where along its value chain
the economics favor outsourcing. They also need to be aware how this tends to change over
time, particularly in technology markets. According to disruptive innovation authority, Clayton
Christensen, the critical transition is when the market changes from the stage where most
customers continue to desire more functionality than is currently offered to the point where the
majority of customers come to see themselves as being
over-served with features. This is the juncture at which
the product rapidly becomes a commodity and where
the primary basis of competition shifts to aspects of the
value proposition beyond technology such as price,
speed, convenience and customization.
In the PC market, for example, it is widely recognized
today that IBM outsourced too early because of its
anxiety to slow down the progress of Apple Computer,
and in doing so allowed the initiative at the featuresdriven stage of the market's evolution to ow mainly to
Intel and Microsoft. Later, when the personal computer
became a commodity, the market favored the business
model of Dell, which focused largely on customer
relationship management and efcient fulllment and
used extensive outsourcing. Indeed, in migrating its
model to other segments, Dell's success continues to rely on recognizing when a market's
evolution has progressed beyond the features-led, technology-driven stage. To date, it has
managed to get this right in the personal computer and mid-range server markets. It now
believes the time is more than ripe to apply its model to ink-jet printers, where market leader
Hewlett Packard continues to place its bets on its superior technological capabilities and on
proprietary features. When deciding whether to make such a wager, it is important for
managers to recognize that core competence, as understood in many businesses, can be ``a
dangerously inward-looking notion.'' Managers are much more likely to win their bet if they
understand that competitiveness ``is far more about doing what customers value than what you
think you are good at[8].'' Knowing the difference is one of the secrets to getting the timing of
outsourcing strategy right, as the following insight from a senior supply chain executive at
Hewlett Packard makes clear:

# 2004 Robert M. Randall

``How do you spot early that you are losing your protected differentiation with the
customer in terms of product, process or performance? Every company likes to believe
that it has a superior product. It takes skill to recognize that others are catching up. In the
inkjet printer market we always have to ask ourselves are we still producing products that
the customer values on an ongoing basis? Are things going horizontal? Sooner or later,

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as a strategy has the potential to drive

`` Outsourcing
competitiveness and value creation in many ways
beyond the narrow goal of cost reduction alone.
''
you get to a point of diminishing returns where the market no longer fully values say an
improvement in speed from 25 to 30 pages per minute or where the next improvement in
photo quality resolution reaches the point where only a measuring instrument will detect
it. When further improvements have a negligible impact on the customer, in terms of
perceived value, you are not too far from being commoditized or horizontalized. How do
you then operate in a different mode? How do you transition to a different model? This is
when outsourcing tends to become a serious option for a business to consider[9].''

Know your options and consider the timing and risk

Outsourcing as a strategy has the potential to drive competitiveness and value creation in many
ways beyond the narrow goal of cost reduction alone. Achieving greater focus, scaling without
mass, fuelling disruptive innovation and enabling strategic repositioning are just four of the many
promising options that outsourcing as a strategy can offer and support. However, managers
considering any such outsourcing options will always need to ask themselves whether the
timing is right and also what strategic skills and capabilities they might be putting at risk.

Notes
1. For a full discussion of these value drivers see Treacy, M. and Wiersema, F. (1993), ``Customer intimacy
and other value disciplines'', Harvard Business Review, January-February, pp. 84-93. For a closer look
at the inherent tensions among them, see also Hagel, J. and Singer, M. (1999), ``Unbundling the
corporation'', Harvard Business Review, March-April, pp. 133-41.
2. For more on the Nortel case see Fisher, L.M. (2001), ``From vertical to virtual: how Nortel's supplier
alliances extend the enterprise'', Strategy + Business, Quarter 1.
3. The term disruptive innovation is used here in the sense dened by Clay Christensen see Christensen,
C.M. and Raynor, M.E. (2003), The Innovator's Solution, Harvard Business School Press, Boston, MA.
4. Quote from Gerstner, L.V. (2003), Who Says Elephants Can't Dance? HarperBusiness, New York, NY.
5. Bob Moffat, general manager of IBM's Personal & Printing Systems Group quoted in an IBM press
release, ``IBM signs agreement with Sanmina-SCI to manufacture its NetVista desktop PCs in US and
Europe'', January 8 2002.
6. For more on the GE/Samsung case see Magaziner, I.C. and Patinkin, M. (1989), ``Fast heat: how Korea
won the microwave war'', Harvard Business Review, January-February, pp. 83-91. For more examples
of the risk of losing key skills and learning opportunities, see Lei, D. and Slocum, J.W. (1992), ``Global
strategy, competence-building and strategic alliances'', California Management Review, Fall, pp. 81-97.
7. For more on the embedded and integrated nature of core competencies see Prahalad, C.K., Fahey, L.
and Randall, R.M. (2001), ``Creating and leveraging core competencies'', in Fahey, L. and Randall, R.M.
(Eds), The Portable MBA in Strategy, 2nd ed, Wiley, New York, NY, pp. 236-52.
8. For more on this risk, see Christensen, C.M. and Raynor, M.E. (2003), The Innovator's Solution, Harvard
Business School Press, Boston, MA (especially chapters 5 and 6 the quote comes from Chapter 6).
9. Maurice O'Connell, Materials Director of Hewlett Packard's inkjet printer business, in conversation with
the author at the HP plant in Dublin, July 2nd, 2004.

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