scm integration
TRANSCRIPT
Supply Chain Integration: Putting Humpty-Dumpty Back Together Again1
Geoffrey G. Parker
Tulane University Freeman School of Business
New Orleans LA 70118 504.865.5472
Edward G. Anderson Jr.University of Texas
McCombs School of Business Austin TX 78712
512.471.6394 [email protected]
We propose integration and learning as appropriate lenses through which to view supply chain design decisions. As background, we discuss the challenges already posed by product outsourcing, and future challenges likely to arise as design outsourcing becomes more common. We describe outsourcing traps which are decisions that improve a firm’s short-run cost position but fail to take integration issues into account and lead to a long-run cost penalty. We present supply chain design for integration, discussing key factors in building integration capability. We then describe the change in supply-chain management toward supply-chain integration, finding that as large firms disaggregate into linked chains of focused firms specializing in distinct areas, those focused firms paradoxically require more highly-skilled generalists, "supply-chain integrators," capable of coordinating product development, marketing, production, and logistics within and across organizational boundaries. Finally, we call for systematic study of integration and learning in supply chain design.
August 4, 2000
To Appear as a Chapter in the Book:
Future Directions in Supply Chain and Technology Management
This book is to be published in conjunction with the
Frank Batten Young Scholars Forum in Operations and Information Technology Management College of William and Mary, Williamsburg, VA
June 30-July 1, 2000
1 The authors would like to thank Tonya Boone and Ram Ganeshan for organizing the Batten Conference. We would also like to thank Mary Ann Anderson, who made numerous contributions to the intellectual content of this paper.
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1 Introduction
“How do we manage the networks of suppliers we are building in order to be
competitive?” In our fieldwork on the management of supply-chains, we have heard this
question at every firm we have visited. As they have vertically disaggregated in the
product domain at an often blinding pace, these firms sense that their existing models of
supplier management are inadequate, yet they have no clear idea of what might work
better. Even as firms are still experimenting with their product supply chain decisions,
they face a new challenge: how to think about design outsourcing.
In this chapter, we suggest that a key organizing principle behind supply chain decisions
should be learning and integration. When viewed through the learning and integration
lens, we can make rational choices about what products should be made internally and
what design capabilities should be retained in-house. These decisions are intimately
related to product design choices and indeed product design and supply chain design
should be concurrent, as a number of authors have suggested (Nevins and Whitney 1989),
(Fine and Whitney 1995), (Fine 1998). However, we go beyond this earlier work to
describe when retaining integration capabilities might be particularly important.
The period from 1980-2000 saw a dramatic re-organization of industry in the United
States and much of the world toward a tiered system of industrial production, modeled
after the system Toyota developed in the 1960s and 1970s. The Toyota system has been
much-studied and is well documented in (Womack, Jones et al. 1990) and (Clark and
Fujimoto 1991) and in many other sources. Supplier firms such as Solectron and SCI
have experienced tremendous growth rates as brand-name firms have concluded that
marketing, distribution, and product design are where their talents lay. More recently,
firms have re-considered the distribution function, turning third-party logistics into an
industry with twenty percent growth rates. We suspect that the product development and
design function is the next area likely to see increasing outsourcing activity.
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1.1 Design for Supply Chain Integration
A key feature of the economy for the past century has been that the wealth of
technological knowledge is increasing at an exponential rate. This has led to the
subdivision of technologists into ever-finer specialties creating management problems for
large companies that no longer are capable of monitoring and rewarding their
technologists effectively (Zenger 1994). This problem is often referred to as a
“diseconomies of scale in R&D.” However, two recent trends in the past decade, the rise
of information infrastructural capabilities and the breaking down of regional trade
barriers, have radically reduced the costs of geographic distance on knowledge
collaboration (Fine, Gilboy, and Parker 1995). Thus, we speculate that there is again a
return of R&D economies of scale, albeit for groups based on more narrow
specializations and greater geographical distribution than before. This leads, however, to
what we call the “Humpty-Dumpty” problem. Any technical design or development
work of the future is likely to incorporate many more firms than 5 years ago or even
today, each of which will have a different set of corporate cultures and beliefs. But once
technical development is broken into perhaps a dozen or more pieces, how are all the
King’s (or OEM’s) product planners going to put them back together again into a product
that satisfies customer requirements? Maintaining product coherence, let alone quality,
across the supply chain will become an ever more difficult and important proposition as
the number of supply chain members increases. Hence, in the future, one key to product
quality will be how effectively a supply chain integrates individual firms’ development
projects into a coherent whole. In this paper, we speculate on two themes. First, how
does a firm integrate all of the pieces of a “humpty-dumpty” project back into a coherent
whole? Second, as a key lever to answering the first question, exactly what sort of sizes
and parts should a firm break up the “humpty-dumpty” of a product development project
into in the first place? By examining these two questions, we hope to provide a key to
successful product development in the future.
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2 Background and Motivation
2.1 Product outsourcing has happened
As noted above, outsourcing in the product domain is a well-established practice. Very
few firms remain vertically integrated, and those that do are likely to be reconsidering
their supply chain design in the near future.
At Japanese automobile firms, outsourcing became common during the 1970s (Clark and
Fujimoto 1991; Womack, et al. 1990). However, outsourcing really did not hit most U.S.
firms head-on until the beginning of the 1990s. Now, there is a tidal wave of outsourcing
as firms scrutinize their operations and keep in-house only what is core. And—as we
shall see in the HP study—the “new” outsourcing is much more radical than the
traditional Japanese keiretsu model in both its extent and continual reconfiguration. As a
result, supplier firms are surfacing in all domains and industries. Sturgeon (1997) calls
this new model of “brand-name” firm/contract-manufacturer firm partnership a “turnkey
production network” and documents its emergence in the electronics industry. For
example, it is now possible to purchase a hard-drive service in which the supplier firm
delivers a certain amount of storage (usually measured in terabytes) and performs
maintenance and backups (Parker 1999b). This relieves firms of a large asset. The hard-
drive service has been particularly popular with web-based start-up firms who want to
avoid large capital outlays but require a high level of service. A similar situation has
evolved in the shipping industry with the emergence of “third-party-” and even “fourth-
party-logistics” providers. With annual industry growth rates of twenty percent, these
firms are taking control of companies’ docks, inventory control systems, and, in some
cases, inventory itself (Alden 1999). A close look at any industry would likely reveal
similar breakups of vertically integrated organizations and the formation of firms that
provide non-core products and services (non-core to the customer firms). Our goal is to
better understand how to work with these new suppliers to ensure successful integration
of their activities into a coherent final product or service. We are also concerned with
understanding and mitigating transaction costs as non-core activities are performed by
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suppliers (Williamson 1975). One key source of transaction costs, product integration, is
especially important in industries with short product or process life-cycles in which
suppliers are often changed, requirements are unclear, and the incentives to achieve
coordination have not been specifically addressed.
In answer to these problems, the Japanese keiretsu model is illuminating but insufficient.
In the paradigmatic keiretsu, the assembly firm still designs the core components that
form a product’s technological center-of-gravity (Prahalad and Hamel 1990). However,
as (Parker and Anderson 2000) learned in their study of Hewlett-Packard, some of the
new disaggregated firms seem to outsource everything except product integration. Thus,
disaggregated firms must “design” products without having any traditional design—i.e.
component—capabilities to leverage. In contrast, keiretsu assembly firms typically
outsource the design of non-core components only to suppliers with whom they have
decades-long relationships. These conditions foster an atmosphere of well-understood
mutual expectations enabling efficient and precise problem resolution (Fujimoto 1994).
However, disaggregated firms do not have the luxury to spend twenty years developing
good supplier relationships. One of the challenges firms face as they assemble a virtual
organization is how to ensure that products are specified, designed and built coherently,
even though many individual firms may be responsible for pieces of a product, and, as we
discuss in the next sub-section, the design of a product.
2.2 Design outsourcing is coming
We believe that design outsourcing is likely to increase, as firms again examine their
corporate structures for areas in which to reduce cost. The design services business is
experiencing high rates of growth as firms take advantage of design outsourcing
(Wiederhold 2000). In the past, firms have retained design in-house, arguing that this
was their core competence, as they outsourced production. However, firms are now
asking whether all of design can possibly be a core competence, and if not, then what
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pieces should be sub-contracted to a supplier of design services, and what should be
retained internally.
Given that much production is outsourced, and that design outsourcing could become a
substantial trend, we now discuss some of the possible pitfalls from failing to take
integration into account.
3 Outsourcing Traps
This section draws substantially from material first developed in (Anderson and Parker
2000) and later in (Anderson and Anderson Forthcoming). As we have discussed above,
since the 1990s, there has been a tidal wave of firms outsourcing all or part of their
products and services. The two remaining domestic automakers have recently broken off
their multi-billion-dollar component businesses to focus on their core design and
assembly operations. Many personal computer manufacturers, such as Hewlett-Packard,
are farming out their notebook computer products to manufacturers in Taiwan. In the
software industry, the rise of contract software designers in the “three I’s”—India,
Ireland, and Israel—represents a prominent trend. Some firms—such as those who
outsource their logistics decisions to “fourth-party” logistics providers— have even gone
so far as to outsource the very decision of whether or not to outsource. Why are so many
companies taking this dramatic step? The benefits of this new business model include
lower parts or service costs, lower investment, and less financial risk if expected sales
volumes do not materialize. But outsourcing has hidden drawbacks that may take several
years to emerge. Ultimately, these “outsourcing traps” may actually increase a firm’s
cost structure, reduce its products’ competitiveness, or in the worst case, lead to the
emergence of new competitors.
As the vertically integrated firm of yesteryear transforms itself into the virtually
integrated supply chain of today, it evolves from a firm that produces all of its final
products’ subcomponents and services internally into a firm that buys all of its
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subcomponents and services from a network —or supply chain — of independent
supplier companies. But how does it manage this transformation without falling into an
outsourcing trap? Research shows that the design of a company’s supply chain is of
decisive importance. Fine (1998) argues that supply chain design may be a business’s
most important competency and that deciding which components to make and which to
buy profoundly influences long-term corporate survival. We suggest in our research that
one key to making wise sourcing decisions is to understand the short- and long-term
trade-offs that outsourcing entails.
Although the outsourcing issue has been extensively examined in the academic literature,
most of this work has focused on topics such as the economies of scale available through
outsourcing. We are aware of few resources that examine the outsourcing issue from a
systems perspective, taking into account the intricate relationships, time delays, and
feedback processes that relying on an outside vendor sets into motion. But companies
that fail to apply this level of analysis to the decision-making process may encounter a
series of traps that could seriously undermine their competitive position.
3.1 Common Outsourcing Traps
As part of our research, we have developed a system dynamics simulation model that has
identified several circumstances in which an organization may experience short-term
gains from outsourcing followed by devastating—and unexpected—long-term
consequences. We call these “outsourcing traps.” Three of the more interesting traps
are:
1. A firm loses its market dominance when its supplier acquires its propriety
technology and diffuses it to its competitors.
2. A firm relies too heavily on a single supplier, which weakens its ability to negotiate favorable purchase agreements.
3. A firm outsources a component to a vendor to reduce costs only to encounter
higher expenses or reduced functionality when assembling the final product.
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We examine each of these dynamics in more detail below.
3.2 Making Life Easy for the Competitor (or Maybe Creating One)
One possible consequence of outsourcing is that a competitor may gain access to critical
technology through a common supplier, either directly through purchasing it, or
indirectly as the supplier’s engineers move to projects with other companies bringing the
knowledge gained from working with the original firm. If the competitor then uses the
information to duplicate or improve the original product, it may erode the first company’s
market position. The classic example of this dynamic occurred when IBM was
developing its new personal computers (PCs) in the early 1980’s. The company made
what turned out to be a fateful decision to outsource production of the PC’s
microprocessor to Intel and development of its operating system to Microsoft. Little did
IBM know that by doing so, it was opening the door for direct competitors such as
Compaq and Dell to purchase directly the two components of the PC most difficult to
duplicate (Carroll 1993). Today, IBM is only the third-largest maker in an industry that it
helped to create. Furthermore, the majority of profits in IBM’s PC business come not
from manufacturing the “box” but rather from “servicing” it by providing buyers with
maintenance and technical support. Hence, its ability to generate profits rests not on its
capability to design and manufacture products efficiently, but rather the capability to
keep these products up and running for their clients at all times. The logical progression
of this trend would be for IBM to give up producing boxes, and instead provide services
for those made by other firms.
Enterprise-wide integrated software packages such as SAP provide another example.
While they often improve operational performance for many firms, they also remove any
chance for a company to obtain a sustainable strategic advantage through advanced
information systems. Furthermore, once the information systems group of a corporation
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is disbanded, a firm may lose its capability to create new technological advantages and
become utterly dependent on the supplier for innovation.
Another twist on this situation may occur as the supplier grows more efficient at making
the component and learns more about the component’s functionality. Eventually, it may
become sufficiently skilled at manufacturing the entire product to become a direct
competitor. U.S. consumer electronics firms followed this path in the 1960s and 1970s
when they outsourced production of televisions and other electronics to Japanese
suppliers (Dertouzos, Lester et al. 1989). Ultimately, as domestic suppliers failed to
develop their own capabilities, they fell further and further behind their own vendors. The
suppliers eventually began to sell products under their own names—including Sony,
Panasonic, and Mitsubishi—driving U.S. manufacturers such as Zenith and General
Electric out of business. Today’s U.S. electronics and software companies may be
repeating the same mistakes, as they increasingly outsource design activities to
international suppliers.
3.3 Held Hostage by Your Supplier
A common but subtle outsourcing trap occurs when a supplier holds a firm hostage. If a
firm—or an industry—becomes too reliant on a particular vendor or set of vendors,
power may shift to the supplier, allowing it to reap most of the profits. This dynamic is
really just an extension of the problem illustrated earlier in the example of the IBM PC.
Little did IBM know that the PC assembly industry would become primarily a
commodity business as the functionality that differentiated performance migrated from
the assembled circuit board into the purchased semiconductor chips and software. When
IBM outsourced the bulk of the PC’s intellectual property to the software and
semiconductor houses, they gave up a great deal of power in the supply chain. Intel and
Microsoft could sell to any of a number of circuit board manufacturers that could readily
duplicate IBM’s design, but IBM could only purchase Intel-compatible processors from
Intel and Windows-compatible operating systems from Microsoft. This gave Intel and
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Microsoft something of a monopolist’s power and enabled them to capture the bulk of the
supply chain’s profits (Carroll 1993).
IBM tried to buck this trend by developing OS/2, its own operating system, in the late
1980s. It was arguably a better operating system than Windows, however, customers
wouldn’t buy OS/2because the majority of software applications available at the time
functioned only on Windows. Furthermore, because Windows had many more users than
OS/2, Windows customers could much more easily trade documents or software with
other users than could OS/2 customers. In the end, the OS/2 system didn’t offer enough
new features to convince users to overcome these standardization benefits (Carroll 1993).
Because of the difficulties in competing with Microsoft or Intel, many PC firms are
instead trying to expand beyond the unprofitable PC business today by following IBM’s
move into providing services to PC users, which offers more comfortable margins.
Others are giving up in another way by outsourcing as much of their production as
possible to Asian contract manufacturers with lower personnel costs.
Another possible adverse consequence to outsourcing is that a company may lose the
ability to intelligently purchase components—and the suppliers may take advantage of
this ignorance and price them at a premium. An executive at a top PC manufacturer
recently stated that his firm found completely outsourcing a product to be undesirable
(Anderson 2000). He said that, when the company first outsourced its computer
manufacturing, it could do so efficiently. However, after three years, the technology had
changed sufficiently that internal people no longer knew enough about the product to
determine whether a contract bid was sufficiently competitive—especially because they
suspected their vendors of engaging in price collusion and price gouging in certain areas.
The suppliers had the PC company in a difficult position, because they knew that the firm
could no longer make the product themselves and that they had even lost the ability to
determine the cost of the products they were buying.
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The danger of falling into this trap is especially acute for companies that outsource a
component to one supplier for a long period of time. Lack of expertise within the
original company about creating the component leads to increased in-house
manufacturing costs, which makes outsourcing even more attractive. This reinforcing
dynamic can prove costly if the firm ever desires to make the part again, because as time
passes and the knowledge of how to make the component diminishes, it can become
prohibitively expensive to reverse the outsourcing decision. If the firm determines in the
future that this component is vital to the performance of the product, it may need to invest
to bring the knowledge back in-house. However, this penalty may be necessary to regain
some bargaining leverage with suppliers.
3.4 Outsourcing’s Impact on Systems Integration
A related problem to having enough information to effectively negotiate with suppliers is
the need for a firm to know enough about its components to effectively integrate them
into coherent products. As stated earlier, a common reason why a firm outsources is that
it can purchase a component from a supplier for much less than the firm can make it
itself. In (Anderson and Parker 2000), the authors develop a model of sourcing that
incorporates learning effects. We draw on this source for Figures 1-3 below.
Figure 1 below illustrates the point about the need to mind integration by showing three
cost curves: integration cost, component cost, and total cost. At time t=10, the firm
changes from internal component production to 100% component outsourcing in order to
take advantage of a supplier’s lower component cost position.
Figure 1 - OEM switches from 100% internal component production to 100% purchasing of component at t = 10
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Component Costs in Dollars vs. Time
100
75
50
25
0
0 5 10 15 20 25 30 35 40 45 50year
Component Make/Buy CostSystem Integration CostTotal Product Cost
At first, total product costs are lower. In fact, component acquisition costs continue to
decline in the short run because the additional manufacturing volume at the supplier will
drive its production costs even lower than they were at the time of outsourcing. However,
because internal component production has ceased, the OEM is no longer learning about
those aspects of the component that are crucial to integrating it effectively into the
product. Thus, with time, the integration knowledge stock deteriorates from obsolescence
that causes the integration cost to begin to creep upward. After about five years (for
these parameter values), the total product cost is equal to the cost before the decision to
outsource was made. After this time, increased integration costs exceed the component
cost savings, causing the total product cost to climb even more. Thus, while outsourcing
provided excellent short-run returns, it proved to have long-run drawbacks. Furthermore,
if the OEM decides to re-insource once again, it will no longer have the in-house
manufacturing experience it had at the time of the outsourcing decision, and will have to
climb the learning curve yet again before returning to the lower total product costs.
Hence, the OEM has been caught in the outsourcing trap of seductive low initial supplier
acquisition costs, and will find a return back to its prior cost levels to be quite painful.
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General Motors and Ford may have fallen into this trap when they decided to spin off
their component divisions. The two new companies, Delphi and Visteon, are busily
expanding their customer base beyond their parent corporations. As they do so, the risk
of another automaker gaining access to once-proprietary technology grows. GM and
Ford’s knowledge of the components may also become obsolete, leaving them helpless to
make innovations in component performance and unable to effectively integrate
electronic components with the rest of the system.
We suspect that this was the main reason behind Toyota’s re-insourcing of electronics
components. Auto companies may be most vulnerable to potential integration cost
penalties in the area of automotive electronics, which has become the decisive factor in
advancing car comfort, safety, and performance. Toyota may be acting to avoid this trap
by bringing its automotive electronics back in-house after 45 years , even though its
supplier, Denso, is the world leader in cost and quality (Hansen Report 1994). It has
made this move just as U.S. manufacturers are divesting themselves of this same
capability. Without understanding electronics, we believe it will be more difficult to
develop a competitive automotive product than in previous years.
Figure 2 illustrates the cost hurdle that a firm must overcome if it wants to insource
components after a long period of outsourcing component production.
Figure 2 - OEM switches from 100% purchasing of components to 100% internal component production at t = 10
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Component Costs in Dollars vs. Time
100
75
50
25
0
0 5 10 15 20 25 30 35 40 45 50
year
Component Make/Buy Cost
System Integration Cost
Total Product Cost
At time t=10, a firm that was outsourcing all component production begins to
manufacture the component internally. At first, the firm’s costs increase due to higher
component costs. However, for products with high integration costs (as in this example),
integration costs could fall enough in the long run to offset the higher component cost.
In another from another industry, the second-largest software company in the world,
SAP, a German provider of enterprise-wide integrated software packages, experienced
serious implementation problems with many of its North American clients. These
software packages, often known as enterprise resource planning programs (or ERPs),
integrate all the information processing activities in a firm, from purchasing and
manufacturing, to order fulfillment and accounting. SAP ultimately traced its difficulties
to its outsourcing of implementation to third-party consultants. Because SAP didn’t
participate in the implementation process directly, the company didn’t gain knowledge to
feed back into product improvements. Many of these problems have lessened since SAP
began to join its alliance partners in actual implementation projects.
Manufacturing a component or performing a service can thus give a firm a decisive edge
in knowing how to integrate it effectively into the final product. For example, many of
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Microsoft’s detractors claim that Microsoft uses its in-depth knowledge of the Windows
operating system to give it an edge over its competitors in designing the features of its
applications software. If this is true, then splitting Microsoft into an operating systems
company and an applications software company, as mandated by court order, may have a
hidden cost to the consumer. The new applications company may become less familiar
with Windows as the operating systems changes with time and their former Microsoft
employees turn over, leading it to design products that exploit Windows’ capabilities less
effectively. In a related phenomenon, (Parker and Van Alstyne 2000) have modeled the
potential benefit to consumers when firms are allowed to take advantage of products that
exhibit cross-market externalities by setting one price to zero.
3.5 Overcoming Outsourcing Traps
How does a firm overcome these outsourcing traps? One way is to avoid outsourcing
altogether. This approach may be necessary for firms concerned about the leakage of
proprietary knowledge through a supplier. If the company still wants to pursue
outsourcing, it may need to have vendors sign binding nondisclosure agreements.
However, even the best of these will only slow, not stop, the diffusion of knowledge.
Personnel cannot be permanently kept from transferring between projects from different
clients. And, even if transfers could be stopped, as long as the supplier is reaping some
benefit from selling to more than one customer, there will necessarily be some
information leakage between the groups supplying each customer. On the other hand,
complete insourcing may not be an option. Making components in-house will avoid the
supplier-hostage and systems-integration traps; however, it can also put a firm at a
serious competitive disadvantage by raising the cost of acquiring components or services.
There is at least one possible way to avoid this dilemma and obtain both the low
component cost of outsourcing and the low risks and integration costs of insourcing. In
many instances, by making just a small percentage of the component (or one of a number
of similar components) in-house, a firm can reduce the average cost to make or buy a
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component while maintaining adequate knowledge to keep many outsourcing risks and
integration penalties under control. A similar strategy can be pursued when outsourcing
services. The success of this strategy depends on a number of variables, but clearly of the
utmost importance are the fixed costs associated with the component or service. If high
fixed costs need to be duplicated at both the firm and its suppliers, then pursuing this
partial outsourcing strategy may not be feasible. Figure 3 demonstrates the partial
outsourcing strategy. In this figure, only total costs are plotted for three different
strategies: total component outsourcing, total component insourcing, and 90% component
outsourcing.
Figure 3 - OEM maintains 100% internal component production or switches to 90% or 100% purchasing of component at t = 10
Total Product Cost in Dollars vs. Time
90
85
80
75
70
0 5 10 15 20 25 30 35 40 45 50year
No Outsourcing90% OutsourcingComplete Outsourcing
For these parameter values, a firm that pursues total component outsourcing gets into an
outsourcing trap, as described above. However, the firm that pursues 90% outsourcing
gains most of the benefit of lower component costs while keeping integration costs low
enough to gain a total cost advantage.
This is essentially the policy we suspect that Toyota has pursued with Denso. It is
probable that Toyota can never produce electronics control systems more cheaply than
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Denso. So it lets Denso produce most of them; thus keeping average parts costs down.
However, by designing and manufacturing some electronics in-house, Toyota can gain
enough knowledge to utilize the full potential inherent in electronics control systems
when designing new automobiles. It also helps prevent a “Denso inside” strategy
paralleling Intel’s branding of the personal computer industry. A similar strategy can be
pursued when outsourcing services. Franchisors that maintain company-owned stores are
classic examples of using partial outsourcing to give “a firm direct knowledge of
operations issues and allows it to test and implement marketing strategies franchisees
may not be able to do at their stores” (Tikoo 1996). For example, in 1988 Dunkin’
Donuts operated only 2% of its 1500 locations itself. However, it specifically used its
company-operated sites to pilot all of its new distribution and marketing programs before
asking franchisees to adopt them (Kauffmann 1988). Hence, partial outsourcing is a
powerful tool in many economic endeavors to gain outsourcing cost benefits while
maintaining insourcing’s innovation and integration benefits.
The success of the partial outsourcing strategy depends on a number of variables
including economies of scale, the pace of technological change, and the modularity of
components. But most important are the fixed costs associated with the component or
service. If high fixed costs need to be duplicated at both the firm and its suppliers, then
pursuing this partial outsourcing strategy may not be feasible. For example silicon wafer
fabs, which make semiconductor chips, cost several billion dollars and are unsuitable for
low-volume production. Unless a semiconductor company has a tremendous number of
components, partial outsourcing in this industry is unlikely to be cost-effective. On the
other hand, in the software design industry, the majority of fixed costs, such as providing
high-end computers and internet access, are accrued per programmer. Hence,
maintaining a small fraction of programming activities in-house is unlikely to duplicate
fixed costs at the supplier.
There are other possible solutions to the outsourcing dilemma as well. For example, a
firm can lower its integration costs by hiring and training people with certain specific
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systems-integration skills, such as systems engineering. If employees can carefully design
a product so that its component interfaces are well defined and well understood, then
many thorny integration problems may be avoided. For example, products that are
designed to use “snap-in” components are usually much easier to assemble into a final
product than those requiring parts to be screwed into place. Hewlett-Packard has pursued
this approach in tandem with increased outsourcing over the past five years. HP’s
notebook division has seen a tenfold increase in its revenue and a significant
improvement in profitability since it began outsourcing production of its notebook
computers in 1997 (Parker and Anderson 2000). In Section 5, we discuss the human
resource strategy of employing supply chain integrators whose job is to work to ensure
product and service integrity.
3.6 Could the IBM PC’s Fate Have Been Avoided?
This section looked at just a few of the difficulties that can result from a decision to
outsource. The outsourcing traps highlight how a seemingly simple decision to have a
vendor produce a component or service can have devastating effects on a company’s
future well-being. By examining the dynamics behind outsourcing, companies can
identify potential traps and make better decisions about outsourcing than they might have
otherwise.
By building the concept of integration into dynamic models, we can look beyond the
short-term benefits achieved by outsourcing and analyze the long-term consequences,
including what effects these decisions may have on future economic and market
positions. We can be almost certain that IBM’s management did not envision the future
that it created when it chose to farm out its microprocessor to Intel and its operating
system to Microsoft. Perhaps the fate of IBM in the personal computing market and the
structure of the entire industry would have been different if they could have used the
tools that system dynamics and systems thinking offer.
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In the next section, we consider issues of supplier relationships that affect a supplier’s
willingness to invest in the firm-specific technologies necessary to pursue high-
performance integrated product design strategies.
4 Supply Chain Design for Integration-Contracting Issues
This section draws substantially from material originally presented in (Parker 1998). As
firms work to design their supply chains, they must build relationships with providers of
goods, technology, and skills, both within and outside company boundaries. In this work,
think of a supply chain as a chain of skills or capabilities superimposed on a chain of
organizations (Fine 1996, 1998). This section focuses on skill development, taking as
given that the types and strengths of capabilities in the chain are key determinants of
supply chain performance.
The question for firms is how to contract for a coherent sequence of projects that satisfies
the need to compete successfully in today’s marketplace and builds a set of desired
capabilities to enable competition in tomorrow’s marketplace. Supplier capabilities do
not remain static over time, but instead constantly evolve as unused capabilities shrink
and new capabilities are created (Leonard-Barton 1992). Contracting firms must take
into account that suppliers will evaluate business opportunities in part by assessing how
projects will improve market opportunities outside the existing relationship. The tension
is that buyer firms may prefer projects that add little value to a supplier's outside
opportunities, but create substantial value within the firm/supplier relationship. The work
presented in this section attempts to establish some of the building blocks for
understanding the strategic implications of projects between customers and suppliers that
involve learning.
20
4.1 Key factors in building integration-enabling capabilities
The negotiation between firms and suppliers over which projects to undertake and how to
distribute rewards takes place in a complex setting that includes but is not limited to the
following:
Firm technology
A major factor that both parties will take into account is the type of technology employed
by the firm with which the supplier (firm or individual) must integrate in order to produce
the desired output. If the firm employs very specialized technologies, the supplier (if it
hasn’t already) will have to acquire the ability to work with this technology. To the
extent that the technology is unique, the supplier cannot use the capabilities with other
firms, and suppliers will take this into account before agreeing to develop the capability.
Suppliers might fear that they will be locked in to a specific technology and that once
locked in, they might lose negotiating leverage with the customer firm. Conversely, a
firm that pursues specialized designs with high integration requirements might fear
supplier hold-up as described in Section 4.
Rate of technological change
The rate of technological change is a factor that affects the willingness of suppliers to
adopt unique capabilities. For example, suppliers to a coal-fired electric generating plant
can be confident that the capabilities they develop will likely be useful over the (thirty-to-
forty-year) lifetime of the plant. However, the capabilities of suppliers to a consumer
electronics firm may obsolesce in a very short time period of years to months. Planning
to make capability investments in a rapidly changing environment requires the parties to
make the additional calculation of how long the capability is expected to be relevant. The
terminology “slow clockspeed” and “fast clockspeed” is used to describe industries that
are innovating slowly versus those which are innovating rapidly (Fine, 1998).
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Incentives
We assume that supply chain partners act in their own self-interest. That is, suppliers
cannot be compelled to undertake projects that are not in their interest. It is assumed that
suppliers always have the option to make (potentially unobserved) capability investments
in more general technologies if the customer firm does not offer a sufficiently broad set
of project choices. Firms must therefore offer incentives to suppliers if they wish
suppliers to risk getting locked in to highly unique technologies.
4.2 Supply chain design matters: IBM example
As noted in the section above on outsourcing traps, IBM’s supply chain design decision
for the personal computer product line launched in the early 1980s provides an example
of the importance of the supplier decisions companies make early in product
introductions. At the time, no one had a believable prediction for how large the market
for personal computers was going to become. “Heavy Iron,” the large mainframe
computers upon which IBM was built remained supreme.
Supply chain decision allowed quick entry
IBM tasked Microsoft with the development of the operating system and assigned
microprocessor production to Intel. This division of responsibility allowed IBM to gain
quick access to the market. The product design and distribution activities carried out by
IBM provided the most value added early in the industry life-cycle. However, as other
competitors entered the market over time, product designs became standardized and
additional distribution channels were developed. IBM was no longer able to earn
substantial profits on the basis of these activities.
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Supply chain partners appropriate the profit
Fast forward to 2000 and the environment is far different. Both Microsoft and Intel are
among the world’s most valuable companies, as measured by market capitalization. As
discussed earlier, the design and sale of personal computer boxes became a commodity
business, while the majority of industry profit is made further up the supply chain in
microprocessors and operating systems; a recent report said that Intel and Microsoft
together earn fully half of the total profits earned in the personal computer industry.2
Other firms learned to use Intel/Microsoft output.
Early in the personal computer industry life-cycle, there was a very limited market for
Intel and Microsoft output, so IBM could appropriate industry profits. However, other
firms developed the capability to manufacture PCs using Intel and Microsoft output. In
this way, the capabilities developed by Intel and Microsoft became general to the industry
instead of specific to IBM.
Could IBM have done anything differently when it was designing the supply system for
the personal computer to capture more of the value created by the capabilities developed
along the supply chain? Was there a way of thinking about the supply chain and how the
locus of relative value could shift, which might have led IBM to make different decisions
about control over personal computer components? Should (could?) IBM have attempted
to bind supply chain members to technologies controlled by IBM as opposed to opening
the architecture for component by component competition (see Farrell, Monroe et al.
(1998))? It is unlikely that the industry would have grown nearly so rapidly if IBM had
adopted a closed architecture (as Apple did), forcing Intel and Microsoft to remain
captive suppliers. So, any answers to the questions above must take into account the
desire to create a large and growing market, while at the same time attempting to earn
profits from participating in this market.
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4.3 Supplier Incentive Designs
Parker (1998) developed models of capability development for suppliers under different
sharing regimes. The general problem being considered was how to provide incentives
for suppliers to develop highly specific technologies while reducing the hold-up problems
discussed in (Williamson 1975) and many follow-on studies.
Figure 4 – Output and payments for two technologies
yt |Proprietary technology
yt | General technology
rt | General Capability
rt | Proprietary Capability
t
Output, Payments
In the figure above, there are two output (yt) curves, and two reservation payment (rt)
curves are shown for two technology and capability emphases, general and proprietary.
In this example, the firm’s proprietary technology joined with a supplier that has invested
it creates more output than a general technology. Conversely, when the supplier invests
in general capabilities, other firms place a higher valuation on the supplier’s capabilities
than if it invests in more firm-specific capabilities. This means that the distance between
output and reservation wages in the proprietary case is larger than the distance between
output and reservation wages in the general case. If the purchasing firm chooses to share
none of this distance, then a rational supplier firm will act only to raise it own reservation
payments, but not to improve output and would therefore choose to invest only in general
capabilities. Such capabilities would be unlikely to lead to successful joint buyer-
supplier product development efforts if the design is for a highly integrated product.
Parker (1998) models how much a buying firm must employ profit-sharing in order to
induce suppliers to invest in proprietary technologies. In survey results from technical
professionals, Parker finds that firms that employ highly-sought-after technologies must
24
offer substantially higher sharing contracts than those (such as space flight systems) that
employ technologies of relatively little value elsewhere.
This example leads us to consider the issue of how to train and reward people for supply
chain integration roles.
5 Human Resource Issues – Supply Chain Integrators
This section draws heavily from (Parker and Anderson 2000). Our story about the new
role of the supply-chain integrator is developed from four sources. (1) We drew upon a
substantial set of background interviews through our participation in a research project
with Professor Charles Fine and Dr. Daniel Whitney of the Massachusetts Institute of
Technology, during which we visited many firms (including the Chrysler Corporation
[now Daimler-Chrysler], the Ford Motor Company, General Motors, Cincinnati
Milacron, Bihler USA, Detroit Center Tool, Progressive Tool, Giddings and Lewis,
Leblond-Makino, NipponDenso [now Denso], Toyota, Applied Materials, Intel, and
others) over the period 1993 to 1996. These visits were part of the supporting research
for an investigation of the development of corporate technology supply-chains (Whitney
1993; Fine and Whitney 1995; Fine 1998). (2) In 1997 and 1998, we were introduced to
the changing role of the supply-chain manager through a series of 19 open-ended
interviews at Hewlett-Packard. Between October and December 1999, we followed up
with five additional interviews at Hewlett-Packard. We augmented this knowledge base
with interviews at BridgePoint (a semiconductor firm), an automotive firm, and an office
of the Department of Defense. (3) We made use of articles from the popular business
press to delineate a contrast between industry practice in the early 1980s and today, and
to add further support to our case study information. (4) Finally, we utilized our own
experience as engineers and project managers at General Motors (Anderson 1985-1987),
Ford Motor Company (Anderson 1988-1993), and General Electric (Parker 1985-1990).
We turned to our former industrial colleagues in these three firms to help clarify issues
we observed in our case and archival data.
25
From these information sources, we have come to believe that there is a job, the supply-
chain integrator, that has become critical to the vertically-disaggregated firm’s success
and growth. This new job differs radically from those found in traditional supply-
management organizations, which have focused primarily on issues of cost, delivery, and
inventory control. In the era of large, vertically integrated firms purchasing well-
specified components, these issues were of paramount importance. As we have argued
above, firms have been disaggregating their operations as they cease to perform non-core
activities in-house (Fung and Magretta 1998), (Scouras 1996). More and more, firms are
purchasing sub-assemblies for final assembly into complete products to be shipped to
customers, leaving detailed engineering and design work to the suppliers. In order to
successfully manage this new “virtually-integrated” supply base, some firms have created
the position of supply-chain integrator. A number of former mid-level managers, many
of whom may have been victims of corporate downsizing only two years ago, have found
a new career as individual contributors managing the interaction of supplier firms. Even
as firms are reducing head-count and becoming more focused, the people responsible for
direct interaction with the suppliers are finding their jobs to be richer and more complex
than ever before.
So, how does a disaggregated firm stitch together its suppliers into one virtually-
integrated firm? One partial answer to the issue may be to employ supply-chain
integrators on both sides of a customer/supplier relationship. By providing the necessary
translation, coordination, and negotiation between supply-chain members, these highly-
skilled integrators act as the glue to bind together the virtually-integrated firm into a
coherent, effective reality. But how does a firm employ them, what skills do these people
need, and how does a disaggregated firm find the people possessing them?
Based on case studies presented in (Parker and Anderson 2000), we develop a list of
desirable supply-chain integrator capabilities. We note that in many cases firms are using
26
veteran employees who learned their skills in large, vertically-integrated manufacturing
firms.
We suggest that the supply-chain integrator’s primary purpose is to translate knowledge
and mediate requirements across the supply-chain to maintain product integrity. In our
case studies, two main themes emerge. From the notebook case described earlier we see
one firm emphasizing people-skills and managerial competence (Parker and Anderson
1999). We needed a whole new group of people. [These new supply-chain managers] need people-management skills, such as objectives setting and planning and exploiting people’s strengths and setting up plans to improve their weaknesses. The supply-chain managers also need negotiation skills. Half of the people…were managers [in their former positions]. Third party partners [in Taiwan] are more complicated to manage than HP people. They are 16 hours ahead of us. It’s a lot like having first-shift supervisors managing second shift people. Being really good at setting plans and objectives is more crucial. It’s a better more interesting problem. You need to be a better manager than before. Contingency plans need to be set in place. They’re forced not to micromanage. They need to know information technology systems and how they fit together. This is needed to stitch together the systems at HP and the suppliers. They need a cursory understanding of what tools are out there and what’s available. It’s also clearly helpful if they understand logistics, but maybe more emphasis is necessary on the people side.
In contrast, one domestic automotive firm has stressed a technological solution to the
problem of managing the supplier base. This firm is emphasizing systems engineering
skills—the ability to make technical trade-offs. A manager at the firm said the following
(Anderson and Parker 1999a): Our strategy is to leverage systems engineering capability. We’ve won awards for integration…but it’s in pockets. What are our core competencies? What do we need to do to develop people? We’re trying to manage complexity. Systems engineering tools look like the best for the job. We’re not wedded to [them]; if a better methodology comes along, we’ll adopt it.
One explanation for the difference in the two approaches is that automobiles are vastly
more complex products than notebook computers. Indeed, the instrument panels in some
27
higher-end automobiles incorporate specialized laptop-type computers as subsystems to
provide navigation and other information services to drivers and passengers. Despite the
emphasis on systems engineering at one automobile firm, we believe that this firm
requires at least the same skills in its supply-chain integration function as the notebook
computer firm. Combining these approaches, we develop a set of skills for the supply-
chain integration role. This set includes:
1. Product development, including system decomposition and interface specification as well as project management. This also includes that portion of marketing science required to translate customer requirements faithfully into a product concept and maintaining its integrity over time (see Iansiti and Clark, 1994 for a fuller description of product integrity).
2. The “soft” people skills necessary to mediate and resolve conflicts successfully.
3. The ability to evaluate business decisions on a cost and strategic basis.
4. The ability to make trade-offs at the sub-system level to improve system level
performance. 5. Operations management, particularly logistics and process analysis.
6. A good working knowledge of information technology capabilities.
Several comments are necessary on the list above. The integrator clearly must
understand product development, including system decomposition and the translation of
customer needs into product requirements. This is, of course, true for any firm.
However, the disaggregated supply chain makes special demands. One is the multiplicity
of firm world-views, expectations, and assumptions. In this mixed and ambiguous
milieu, a clear articulation of product vision is of the utmost importance in aligning firms
to a common purpose. Also crucial is decomposing a product to minimize potential inter-
firm design problems because, as we will discuss shortly, resolving problems across firm
boundaries is extremely difficult. Thus, a deep understanding of product design is
necessary to clearly delineate the “virtually-integrated” firm’s target, define a path
towards it, and removing as many obstacles as possible along the way.
28
But, inevitably such obstacles will arise. Thus, the integrator must also be a skilled
practitioner of “soft” people skills. This requirement may appear unimportant if there is
only one integrator purchasing all of a project’s outsourced goods and services.
However, as demonstrated in the case of the semiconductor manufacturing chain, the
supply-chain integrator may not reside in the same company that purchases the final
product. Thus, at that firm, there is automatically a complex relationship cutting across
two organizational boundaries (chip supplier � testing, packaging, and integration �
customer firm � end customer). And even if only one integrator is purchasing the
services, the buyer’s coercive power is essentially restricted to threatening withdrawal of
business from the supplier. While such power can be effective, it is also crude and likely
to work only in stable environments with well-known requirements and multiple potential
replacements for the affected supplier. Something else must replace the fine-grained
coercive power of a product manager in an integrated firm with organizational
connections to supplier engineers. What is necessary, then, are the skills of persuasion
and mediation. When requirements are not all that clear and product life-cycles short, the
integrator’s goal is to tease out the joint solutions with the supplier firms in order to
faithfully maintain the original product vision. This suggests that the relationship with
suppliers is not a zero-sum game with players negotiating over a fixed-size reward, but
instead an effort to create the highest joint reward. An integrator’s ability to engender
mutual trust with suppliers is critical to facilitating this type of joint problem-solving
(Currall and Judge 1995), (Zaheer, McEvily et al. 1998). It also suggests how necessary
it is for the integrator to translate imperfect requirements from the technical and
institutional context in one firm to another. For without such inter-firm translation,
miscommunications will lead inevitably to either inter-firm conflict or a sub-optimal
product (Nonaka 1991). Hence, translation as well as mediation and negotiation are the
primary tools with which the supply-chain integrator must organize the supply-chain.
The complementary abilities to evaluate business cases and system trade-offs are
necessary to guide the integrator in solving the inevitable product development and
sourcing problems in such a way as to maximize customer value and firm profit.
29
Integrators need not know how to evaluate all the problems themselves; knowing all the
possible technological ramifications of every possible problem as well as being expert in
project management and soft people skills would require a superhuman. The solution
favored by many is to hire specialized technical experts to advise front-line integrators
when they must handle especially challenging technical problems. For instance, HP’s
notebook division employs several such troubleshooters with deep technical expertise in
miniaturization. According to a manager in the notebook division, most of these experts
“were small hardware designers at HP for a long time. People who designed calculators
in the 70s and palmtops” (Parker and Anderson 1999). The Department of Defense
employs companies such as Aerospace Corporation to fill a similar role by providing
Ph.D. experts in fields such as load dynamics to provide technical evaluation support for
their project managers on an as-needed basis (Anderson and Parker 1999b). Thus, while
it is imperative that integrators have the general skills of an MBA and systems engineer,
they need not know all the technical fields with which they interact in depth.
The integrator must also understand the core concepts of operations management such as
process analysis quite well. For the more esoteric aspects of specific areas such as
logistics, they can request technical assistance from an operations research group.
Without a good understanding of the possibilities inherent in operations management,
however, they will not know what questions to ask suppliers or which possible solutions
to evaluate. Finally, a basic knowledge of the possibilities inherent in modern
information technology is also necessary to the integrator. This may surprise the reader
(as it did the authors!). Increasingly, however, the requirement for a basic knowledge of
information technology appears to be true not only for supply-chain integrators, but for
operations managers in general. Sturgeon (1997) noted that “electronics firms are using
information technology to communicate across the firm boundary….” One of the authors
(Anderson) supervised five MBA operations group-internship projects (at four separate
firms) in the 1999-2000 academic year. Each project required a significant information
technology component; this prevalence was not true even two years ago. Again, the
actual information technology applications can be developed by specialists, but a
30
knowledge of what supply chain strategies information technology can and cannot enable
is essential.
The care and feeding of supply chain integrators
Having defined the skill set necessary for supply-chain integrators, we must address how
to develop and maintain them. Parker and Anderson (2000) discusses some possible
options to formally educate supply-chain integrators. However, for the foreseeable
future, firms will obtain integrators in one of two ways. The first method described by
firms such as Hewlett-Packard that are currently building integration capabilities is to
hire older engineers and managers who have held multiple positions in product design
and manufacturing over ten to twenty years. While this is a quick and efficient method, it
may become less viable as the vertically integrated firms which created these veterans in
the first place disaggregate. The other option available to firms is to create integrators
through internal training. This training will necessarily be demanding and lengthy,
including in all likelihood both a period of formal training and a following period of on-
the-job learning. Once firms obtain a number of experienced integrators, they may be
able to reduce this training period by mentoring less-experienced colleagues. However,
even with a veteran core of experience integrators, managing these sorts of in-house
training programs is quite difficult because of the dynamic trade-offs involved,
particularly if there is market growth (Anderson 2000) or cyclicality (Anderson 1999).
For example, during upswings in demand, should integrators best spend their time
integrating new products or training new integrators? During downswings, should
integrators be fired knowing that they will be difficult to replace during the next
upswing? Anderson, Fine, and Parker (forthcoming) explore similar issues in skill
retention issues in the machine tool industry in the face of industry cyclicality. Further,
all of these problems are exacerbated when planning policies for product design staffs
must be integrated across a supply chain (Anderson and Morrice 2000). The results of all
these papers suggest that such programs and people must be treated as expensive, long-
term investment programs. Many firms may be naturally reluctant to bear the costs of
such training programs. As discussed earlier, however, the ability to effectively integrate
31
supply-chains is becoming increasingly more critical, makes the expense of setting up
such training programs unavoidable. And given the lead time required to build up this
capability, the earlier that firms begin to develop this capability, the sooner they will be
able to exploit their new disaggregated business models most effectively.
6 Conclusion
We have argued that designing supply chains with an eye toward managing learning and
integration along the supply chain will provide substantial advantage to firms that can
manage these difficult tasks well. As motivation, we note that product outsourcing has
led to a number of challenges for managers. As firms have disaggregated their supply
chains to take advantage of cost savings offered by supplier organizations, firms become
susceptible to the “humpty dumpty” problem. They must somehow ensure that products
remain tightly integrated even though their design is broken up into a dozen pieces or
more. One response, as described above, is to design products that have well-defined
sub-systems (modular architecture) and hence need little integration. Another response is
to hire special integrators whose job it is to ensure product integrity over a disaggregated
supply chain. The need for such personnel is likely to increase if firms begin to
outsource substantial portions of their product design. However, creating such a
workforce may be initially quite problematic.
There are other downsides to the vertically integrated firm. In particular, there are many
outsourcing traps that snare firms in low quality, high-cost product solutions. What
makes outsourcing traps difficult for firms to avoid is that near-term decisions that offer
component cost savings are the very decisions that, in the long run, can increase
integration costs, and possibly increase total product cost. Finally, there are substantial
contracting issues that firms must confront if they wish to develop proprietary
technologies jointly with their suppliers.
32
We firmly believe that integration will become the key issue for firms as they design their
physical and technology supply chains in the future. Because there is little literature
examining how learning, integration, and outsourcing mutually interact, we call for a
systematic study of their relationship to improve supply chain design. This study can
teach us how to fully exploit the advantages of product and design outsourcing without
suffering the possibly devastating consequences of poor outsourcing decisions.
33
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