Richer Sourcing

Richer Sourcing

          
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Richer Sourcing

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    This article is the first in a series of Perspectives on network capital and transaction costs.

    Outsourcing is generally seen as a means to lower cost. But this is only half the story. The other half is about collaborative innovation. Companies therefore need two quite different modes of outsourcing. A failure to segment supplier relations accordingly results in a massive loss of competitive advantage.

    The underlying logic is embedded in the economics of information. There is a nearuniversal tradeoff between richness and reach. Richness is variously the amount, quality, specificity, recency, or trustworthiness of the information shared in a transaction; and reach is the number of people or entities involved. Typically, we can transact with lots of richness if we are willing to give up reach (a conversation) or with lots of reach if we are willing to give up richness (a newspaper ad). But we cannot have both at once.

    The richness-reach tradeoff is embedded in methods of transaction. Markets enable comparatively high-reach/low-richness transactions—hierarchies, the converse. In the past decade, technology has displaced the trade-off, but primarily for low-richness transactions: e-mail, Web publishing, electronic payments, and—prospectively—Web services. By favoring reach over richness, technology has favored markets over hierarchies, thus inserting market mechanisms into previously vertically integrated hierarchies and thereby shifting the boundaries of the corporation. (See Exhibit 1.)

    Sourcing strategy reflects these general principles. Insourcing enables richness—of collaboration among colleagues with shared goals, common reporting relationships, and the ability to negotiate mutual expectations in a context of shared tacit knowledge and trust. But constrained, thereby, within the boundaries of the corporation. Outsourcing gives you reach—to the most innovative and lowestcost specialists in the world. But constrained, thereby, within the narrow nexus of negotiated product specs and legal contracts. The make-versus-buy choice is thus a tradeoff between richness and reach. By favoring reach in general, technology has favored outsourcing in particular.

    Low-richness transactions are fine when the goal is cost reduction: just write the spec, put it out to tender, find the lowest-cost global supplier, keep the contract term short, and rebid whenever a cheaper source becomes available. Fine for commodity businesses. Fine for commodity inputs into noncommodity businesses. But overdo it, and you make your business into a commodity business. Remember IBM’s decision to outsource the PC operating system? That put Microsoft on the map. Innovation, adaptability, variety, and qualitybeyond-spec are the ways most companies earn superior returns. Relentless outsourcing must undermine those capabilities. That’s the stuff that has to be kept in-house. Right?

    Wrong.

    Consider Toyota. Toyota emphasizes product variety and quality-beyond-spec far more than do its U.S. competitors. Its spectacular success with the hybrid Prius demonstrates a level of innovation and adaptability beyond anything achieved by Detroit. It is moving away from the “commodity” end of automobile manufacturing, as it must because of the strength of the yen. Yet whereas U.S. OEMs outsource less than half of their component costs, Toyota outsources nearly threequarters!

    Achieving Richness and Reach

    The resolution of the paradox is that Toyota outsources through a method of transaction that achieves both richness and reach: the richness of in-house collaboration and reach to a wide range of globally competitive suppliers. The elements of this method are

    • Long-term, open-ended relationships that commit both sides to mutual dependence but leave open many specifics

    • Execution across the companies of a common work discipline, characterized by pervasive, quantified, and granular experimentation

    • Development of a rich language, common to the entire supply chain, through which experimental results are communicated

    • Investment in mechanisms to ensure the rapid dissemination of detailed learning—broadcast, small group, and hub and spoke—all based on pervasive IT

    • Open sharing across the supply chain that treats process knowledge as common intellectual property while product knowledge remains largely proprietary

    • A mutual understanding that the benefits of productivity gains will be shared equitably over the long term, and an acceptance that competitors may be incidental beneficiaries

    This approach, applied consistently over a long period, generates trust, shared “semantics” (mental frameworks, vocabulary), and shared knowledge: forms of capital embedded in the network itself. Applied internally, it enables richer collaboration among coworkers. Applied externally, it allows elements of the supply chain to combine resources in whatever patterns make sense, unconstrained by corporate boundaries or contractual commitments. This focus on network capital accommodates both the flexibility of markets and the close collaboration and low transaction costs of hierarchies. This is not the Toyota Production System as conventionally understood (kanban, kaizen), though the latter is in many ways a manifestation of this managerial method. And it is not specific to Japan: Toyota operates the same way in Kentucky and Ontario, and Nissan operates quite differently in Japan.

    The benefits of this approach are striking. Jeffrey H. Dyer, author of Collaborative Advantage: Winning Through Extended Enterprise Supplier Networks, estimates that Toyota’s procurement costs are about one-third those of the average U.S. manufacturer. And whereas Toyota’s suppliers have matched the productivity gains of Toyota itself (and Detroit has also matched those gains, albeit from a lower base), Detroit’s suppliers have achieved negligible productivity improvements. (See Exhibit 2.) In Detroit’s world, the low-richness nexus of arm’s length procurement has destroyed the capacity of the network to share learning. Affecting half the cost structure, this cumulative loss far outweighs the one-shot gains from aggressive price negotiation.

    A Systematic Approach

    There is still a richness-reach tradeoff, of course. Toyota cannot deal with thousands of suppliers this way, only hundreds. But the resulting supply chain—neither traditional market nor traditional hierarchy—achieves a new combination of richness and reach. It displaces the traditional tradeoff in that higherrichness zone where it must be displaced if new technologies and new organizational forms are to offer an escape from the relentless drive to commoditization. (For a comparison of the alternative sourcing strategies used by Toyota and Detroit, see Exhibit 3.)

    The analysis required to adopt a networkcapital strategy is rarely performed systematically. It comprises the following elements:

    • Map the network of productive interactions by individuals and teams within and across organizational boundaries. “Richness” is embedded in the patterns of human networks, in the connections among activities, people, teams, modules, or functions. Information technology,
      for the first time, makes such mapping cheap and accurate. Network analysis makes the richness-reach tradeoff specific and quantifiable: it tells you, by activity, the value of richness.

    • Benchmark the capabilities of alternative suppliers, both inside and out, current and potential. This is a conventional analysis (usually the only one done—hence the bias toward 0utsourcing). It tells you the value of reach.

    • Segment the collaboration patterns by balancing the values of richness and reach. This approach would yield three types: those best supported by hierarchy (insourcing), by shared network capital (relationship outsourcing), and by markets (commodity outsourcing). But the strategic analysis, as always, is merely preliminary. Implementation requires building networks and building network capital in entirely new ways. But that is another story.



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