How Outsourcing Can Destroy a Company

In making outsourcing decisions, Clayton Christensen recommends that companies focus on: (1) what capabilities (resources, processes, and priorities) they need to keep in-house in order to succeed in the future; and (2) the type of work subcontracting suppliers will try to do later on. See "How Will You Measure Your Life?" and list of Christensen sources on Concepts page. Subcontractors making cheap, outsourced components don't want to stay at the low end of the market -- they want more sophisticated, profitable product work as they move upstream in search of better margins. As a low end subcontractor moves upstream and acquires new capabilities, it often displaces the company it formerly worked for. The original outsourcing company creates its own demise at the hands of a more cost efficient low end competitor (that formerly served as a subcontracting supplier).

Christensen notes that Dell outsourced its way to mediocrity by subcontracting more and more work to component suppliers like Asus. As a result Dell gradually lost its capabilities, while Asus gained new capabilities and eventually started making Asus-branded computers. Dell ended up just stamping its brand name on computers designed and made by its subcontractors, losing its ability to create innovative new products. Outsourcing: (1) retarded Dell’s ability to create compelling new products; and (2) hampered meaningful sustaining improvements to Dell’s existing products.

Consistent with Christensen's recommendations, Apple seems aware of the need to protect its future by keeping key technologies and capabilities in-house. The following quote from Steve Jobs is revealing: "One of our biggest insights [years ago] was that we didn't want to get into any business where we didn't own or control the primary technology because you'll get your head handed to you." Tim Cook has said the same thing. And Cook's expertise in supply chain management gives him the ability to create a unique supply chain where Apple avoids outsourcing too much. Apple keeps the following key technologies or capabilities in-house: industrial design, hardware and software engineering, mobile chip design and engineering, fingerprint authentication, Siri, and retail sales and service. Apple also maintains ownership or exclusive control of certain key manufacturing equipment/processes (through agreements with companies like GT Advanced, which is producing sapphire for Apple). 

Outsourcing is great for a company’s return on net assets, since it reduces the net assets denominator, but it can destroy the capabilities needed to make: (1) meaningful product improvements; and (2) innovative new products. The outsourcing company gives up control of its destiny: lacking in-house capabilities, an outsourcing final assembler is at the mercy of the supplier's ability to continue making meaningful innovations at the component level. 

If component suppliers can't continue making meaningful improvements, the outsourcing company’s business is vulnerable to more integrated companies with strong in-house capabilities. These integrated companies are better positioned to improve existing products and come up with new products. And that's exactly what’s happening right now with Apple taking more and more business from traditional PC makers. Intel and Microsoft are no longer making meaningful improvements to key PC components, leaving PC makers like HP and Dell vulnerable to integrated companies like Apple. 

Integrated companies are well-positioned to create innovative, affordable new products that disrupt overserving modular products. The conventional wisdom is that modular companies sell more affordable products. Dell, HP, and Asus sell standardized, modular PC's at very affordable prices. Outsourcing has caused a modular, price-focused "race to the bottom" in the PC market. Yet an integrated company — Apple — created the iPad. And the simpler, more affordable iPad has disrupted modular PC's, which overserve many users. 

Somewhat ironically, integrated companies may be best at creating disruptive, affordable products for new and low end markets, since outsourcing causes modular manufacturers to lose the capabilities needed to create this type of offering. When a modular, snap-together product starts to overserve, the final assembler/manufacturer lacks the capabilities needed to do anything about it. In this situation, an integrated company can swoop in and design, engineer, and manufacture an affordable alternative that isn’t overserving, and that squarely addresses the job that needs done.

And this is a big, long term problem for modular assemblers/manufacturers. At some point meaningful innovation at the outsourced component level dries up. Component suppliers start making improvements that aren’t meaningful, resulting in a final product with overserving product attributes. This leaves the modular final assembler vulnerable to integrated competitors with strong in-house capabilities. These integrated competitors are well-positioned to create affordable new products that: (1) don’t overserve; (2) squarely address a job that needs done; and (3) appeal to new and low end markets, thereby disrupting modular, overserving alternatives.

The author owns stock shares of Apple.