Outsourcing: Menace or Gold Mine?

By Robert W. Bradford

The Menace

For almost a decade, gurus have been telling us that outsourcing is one of the next major trends. Many skeptics filed those predictions in the same place where all of the bright, glittering promises about the "new economy" were stored. As with most predictions, there was an element of truth to the outsourcing one - as we are now discovering.

The basic drivers of outsourcing behavior can be summed up in six ideas about how people behave when they buy things:

  1. Everyone wants to have low costs.
  2. Some companies also want to get low prices, while others want high prices.
  3. Everyone wants to get greater value when they buy.
  4. Everyone wants better service and faster delivery.
  5. Everyone wants more technical and logistical support.
  6. No one believes they will get more value without a strong reason to believe it.

These six facts define much of the dynamic that is causing many US companies - large and small - to seek sources outside the US for things they previously bought solely in the US. They also defined the dynamic that made Japanese suppliers attractive in the 1980s. It's my opinion that, in fact, the economy will be driven, more or less, by the same dynamics 100 years from now. The difficult part in all this is to understand how YOUR business will function in this system, and how it - and your position within it - will change over time.

To begin with, we have to understand that there are some critical disconnects that are creating inefficiencies in the economy today. The most critical (in my opinion) are:

  1. The difference between perceived value and actual value.
  2. The abuse of consumers and suppliers by powerful companies (leverage).
  3. The glut of unrefined data available to consumer and business decision makers.

The first two items alone have led consumers to a (largely just) belief that most products and services in their lives will be barely adequate, and that they will have little ability to affect this by their behavior. The growth of the internet as a way of learning about and combating this trend has been largely eclipsed by the third item: there is just too much data out there for any but the most fanatical (or those with too much time on their hands).

Interestingly, in the 1980s the increased availability of information led a large number of consumers to change their buying behaviors to seek products and services of higher quality. Today, however, the assumption is that "quality" (however ill-defined) is a given and the only remaining quantifiable assessment of value, where you will find differentiation, is price. The fact that much of the real value in products and services lies in non-quantifiable areas (for example, a Jaguar looks more elegant than a Chevette) is often overlooked for one simple reason: your perception of it often cannot be trusted until after you have purchased the product or service.

Understanding Value Added

Ultimately, companies can be broken down into Class A and Class B. In my mind, a Class B company is one that takes a number of inputs, combines them, and sells them for a small profit. This kind of company can last a long time, but is never very profitable. Class A companies, by contrast, produce products and services that have a much higher value than the inputs. Sometimes this is a temporary situation - for example, when a product is protected by a patent that will expire - and sometimes it is made permanent by continuous improvement. The permanent Class A status is what all of us would like - and, because it is so desirable, it is also difficult and expensive to attain. To understand how to get there, let's take a look at situations that lead to temporary Class A status.

1. Cost advantages

Cost advantages are one of the most temporary reasons a company can create more value than competitors. As a general rule, cost advantages can be situational - such as those caused by currency shifts - or systemic - such as those enjoyed by Wal-Mart or Southwest Airlines due to their unique operating practices. Situational cost advantages come for a variety of reasons: location, relationships, contracts, legal protections, tax advantages, and workforce composition, just to name a few. Almost all of these are subject to change, and, in fact, many cannot be greatly influenced by most management teams. Consider a petroleum-related company that gains a cost advantage by building a plant right across the street from a large refinery. Clearly, transportation costs to and from the refinery will be minimized, leading to competitive advantage. In the long term, however, there is no guarantee this advantage will continue. The refinery could shut down or refuse to do business with you, for example, or a competitor could move in nearby.

It's pretty clear that the greatest competitive threats posed by globalization fall into this situational category. In other words, buyers are moving their business from one country to another because they see cost advantages in doing so, given the current currency, labor and tax rates (as well as other advantages offered by some countries, such as lax environmental laws). All of these are subject to change and easy to copy, however, so companies that are seeking Class A status on the basis of these advantages are in for a bitter disappointment.

By contrast, systemic cost advantages can be of a more permanent nature. The key challenge here is to assure that the operating practices that lead to the systemic advantage are at the core of the company's operating philosophy over long periods of time. Compromises that take focus away from maintaining systemic cost advantages ultimately create opportunities for other competitors to beat you at your own game. For example, while K-Mart was trying to improve their profitability by increasing margins and appeal to upscale customers, Wal-Mart managed to out-manage them at the core business of mass discounting.

2. Technology

Technology is a wonderful source of value. When you first develop a new technology, you are very likely the only company in the world able to offer that particular value to your customers. At that point, the sale process is simply an "evangelical" one - you merely have to convert the buyer to seeing the value in your technology, and then the sale is almost automatic. Unfortunately, competitors react - sometimes swiftly - to these kinds of incursions into their market share. If your technology gets a customer to switch to you, you can bet that your competitors will attempt to do one of four things:

  1. Convince customers that your technology isn't worth it.
  2. Copy your technology.
  3. Counter the increased value of your technology by lowering prices.
  4. Come up with their own technology that offers similar value.

The net effect of these behaviors is a kind of "leap-frog" game in markets where technology has a major impact on market share: first one company leads, and then it is surpassed by another. The struggles between major players in computer CPUs and graphics hardware are good examples of this kind of leap-frogging competition. Unfortunately, while this is great for consumers, it seldom leads any of the players involved to permanent Class A status.

3. Proprietary Information or Networks

This one is a little tricky. Basically, some companies have great abilities to create value because of information they have accumulated or networks they have built. Naturally, the more difficult it is to replicate these, the more value they create. For example, the major cable TV companies had a tremendous ability to deliver broadband internet access to American homes because they already had cable laid to those locations, as well as billing relationships. On the information side, Dun and Bradstreet has a strong ability to deliver value to customers based upon their huge credit-reporting database. The long-term maintenance of these proprietary networks and information is critical to the success of the companies that create value with them. As a source of permanent advantage, these can work very well, as long as a competitor does not find a quick, inexpensive way to replicate the networks or information.

4. Quality and service

I put these two items together because they are facets of the same concept: tactical execution or operational excellence. Often, things that seem inconsequential to you drive customer perceptions of quality and service -the salesperson may remember your customers' birthdays, or you may use slightly more expensive raw materials in your manufacturing, for example. As customers, however, many of us will prefer a given product or service precisely because these elements fit our concept of value. Often the cost of the added value is very small in proportion to the perception of value created in the customer's mind. In other cases, such as manufacturing quality, there is a much more difficult relationship between cost and value. As a general rule, the value of quality and service are at their greatest when they help to distinguish between the competing players. If all companies in a market have very similar levels of quality or service, there is less perceived value in those levels.

5. Branding and reputation

Branding and reputation are a bit like the goose that laid the golden egg: they are fantastic sources of value, but there is great temptation to kill the goose in an effort to get more eggs. Basically, branding and reputation only become useful after customers have learned to trust a company for creating value. This can be driven by a history for service, quality, technology or low prices, but it is always driven by history. At first, these might seem like a license to print money, and they are - in the short term. Unfortunately, both brand and reputation come at a cost of time and effort, and will degrade if they are not supported by continuing effort over time.

It should be clear from the above examples of value creation that low-cost overseas competition is very attractive to our customers because it creates value. It should also be apparent that this value is somewhat one-dimensional, because it is based almost completely on cost advantages.

Finding the Gold Mine

Here is the key to using value creation to meet the threat of outsourcing: if you have no clear advantage - or if your customers do not value the advantage you have - you are indeed threatened, as your only viable defense is to cut your prices. This will mean sharpening your axe and cutting costs in very real, painful ways, if you are to maintain margins that are even close to those you enjoy currently. I cannot overemphasize this: if you have no value creation advantage, you must do this, and do it as quickly and efficiently as you can. On the other hand, if you have a clear advantage in value creation, you probably have a less painful strategic task ahead of you. This involves four basic steps:

1. Make sure you understand your value creation advantage.

This is critical. If you mis-identify the advantage, or over-rate your own abilities, you can end up worse off than you are today.

2. Identify those customers that place significant value on that advantage and focus your efforts on that part of the market.

Some customers will choose to buy from you when offered attractive alternatives - even lower prices. One of the most important roles salespeople overlook in their selling process is understanding exactly why those customers buy from you anyway. It is a key marketing function to aggregate that information into groupings of customers. I've found it useful to think of customers in three groups: Those who will obviously buy from you; those who might buy from you; and those who will obviously not buy from you, based on your advantages.

3. If you have the resources, seek to convert customers who do not value your advantage into ones who do.

If you can afford to market specifically to the "might buy" group - in order to raise their awareness of the value that you specifically create - this can be a good source of future growth in your market. Be aware that any competitor that creates value in a similar way will be able to come along for a free ride when you do this!

4. If you have a strategic need for the volume represented by customers who do not value your advantage, you must either:

  1. Develop an advantage that those customers do value.
  2. Outsource to someone who can provide that advantage.

This last bit is a very difficult situation - and one reason why I always have some preference for strategies that steer companies away from volume dependence. Strategically, if you must have the volume, you have no choice but to court customers who don't find your company a particularly compelling source of value. Choice (a) - developing a new strategic advantage - is inevitably difficult, and expensive, and choosing the wrong advantage can be disastrous. Many companies have chosen the outsourcing route for this reason - it's cheaper, and less risky. But choice (b), outsourcing for a critical strategic advantage, is probably not a permanent solution - and in fact, may only be a way of staving off the inevitable.

The end result of this is that proper strategic assessment and well-planned risk-taking are critical alternatives to outsourcing for many companies that are currently facing strategic threats from global competition. Future issues of Compass Points will include articles about how to tackle some of the steps above, as well as ways that you can test your understanding of your current position to make better informed choices for your company's future.

Robert Bradford is President of Center for Simplified Strategic Planning, Inc. He can be reached via e-mail at

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