Strategic Outsourcing for Sustainable Competitive Advantages: Case studies of Multi-National Corporations (MNCs) in China

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1 Strategic Outsourcing for Sustainable Competitive Advantages: Case studies of Multi-National Corporations (MNCs) in China Mingu Kang Ph.D. Student,School of Management, Zhejiang University, P.R. China Xiaobo Wu Professor of Management, Vice Dean, School of Management, Director, National Institute for Innovation Management, Zhejiang University, P.R. China Paul Hong Professor, Information Operations and Technology Management, College of Business Administration, University of Toledo, Toledo, OH, 43606, USA Abstract Increasingly, with rapid wealth growth of emerging global economies, the basis of competitive advantage is changing from internal capacities to network capabilities. What matters is not a company ownership of hard assets but rather its ability to fully utilize them to capture the worldwide business opportunities. In this highly competitive global environment, outsourcing is approached not as a functional value extension but strategic priority practice for achieving sustainable competitive advantage. This paper presents a research model that describes strategic outsourcing practices for sustainable competitive advantages in Chinese context. Case studies include global firms from Switzerland, Korea and USA that have been operating in China for more than seven years successfully. This paper discusses how each firm maintains clear and disciplined strategic focus in achieving desired business outcomes. Case studies of these firms in China may provide better understanding on how to implement successful outsourcing practices in the Chinese market. Key Words: Strategic Outsourcing; Emerging Global Economies; Sustainable Competitive Advantages; Case Studies of MNCs in China 1. Introduction With rapid growth of economics over the past two decades, China has significant size of middle and upper class of consumers affording huge domestic market. Besides, China also offers cost-effective manufacturing opportunities and innovative outsourcing capabilities for multi-national corporations (MNCs) through its vast network of socio-technological resources. Figure 1 and Figure 2 show the rapid growth of GDP and FDI. The average annual GDP growth rate of China for the past seven years is 9.9%. Chinese share of global GDP was only 6% of in 1990, but with rapid economic growth, its share of global GDP has grown 15% of in ,000 GDP(RMB, billion) Growth Rate 12% 80 FDI(USD, billion) Growth Rate 16% 25,000 20,000 15,000 10,000 5,000 10% 8% 6% 4% 2% % 12% 10% 8% 6% 4% 2% 0% % % Figure 1: GDP Growth of China( ) Figure 2: FDI Growth of China( ) Source: National Bureau of Statistics of China 1

2 With continuous expansion of privately-held firms and massive inflows of foreign direct investment, China have sustained such high rate of economic growth. Such rapid economic growth in China enabled an impressive expansion of middle class which in turn contributes to the social stability and the formation of huge consumer market (Zhang Jing, 2007). According to Chinese Brand Strategy Association, the potential size of affluent consumers that purchase high brand products is 160 millions that is about 13% of the total population. This suggests that China has the third largest consumer market in the world which is next to Japan and USA. Ernst & Young Survey Report predicts that by 2010, brand-conscious consumers will increase up to 250 millions and by 2015, China is expected to have the second largest consumer market in the world. While the growing consumer market in China gives multi-national corporations expanding business opportunities, other environmental factors also make Chinese market challenging and risky as well. Recently, RMB(Chinese currency) value is rising. Changes in labor laws and tax regulations affect firm s profit level. Rapidly evolving competitive landscape in China requires new capabilities for global companies in China. And MNCs in China are facing intense competition with other lots of global companies and Chinese local innovative companies(wu, Xu et al. 2004; Wu, Ma et al. 2006). So, simply low cost based manufacturing or outsourcing arrangements are not adequate in ensuring sustainable competitive advantages. Considering these opportunities and risks, the purpose of this paper is to provide an useful framework for analyzing the outsourcing practices for sustainable competitive advantages in Chinese context. Three case details provide implications on the role of strategic outsourcing to sustainable comparative advantages in Chinese market. 2. Research Background Outsourcing Benefits and Risks Increasingly, with rapid wealth growth of emerging global economies, the basis of competitive advantage is changing from internal capacities to network capabilities (Zander 1999; Mudambi 2002; McEvily and Marcus 2005). In this highly competitive global environment, outsourcing is more than a tool for functional value extension but strategic priority practice. Outsourcing may reduce operation costs and free up asset(harland, Knight et al. 2005). In the early 1980s, companies started outsourcing non-core activities to suppliers for the purpose of securing specialized expertise and lower costs. Firms have moved their internal manufacturing and operations to lower cost countries to seek competitive advantage. Reasons for such outsourcing practices include low cost strategy, proximity to foreign markets and easy access to innovative capabilities. In recent years, outsourcing is associated with attaining firm s competitive advantages. Through outsourcing, firms can access to external technologies and increase operational flexibility and concentrate more on core business activities and innovative new projects. Outsourcing benefits include lower cost, more investment on core competencies, flexibility, reduction assets and complementary capabilities. While outsourcing is associated with various benefits, it can also be a serious risky factor (Bahli and Rivard 2003). Examples of outsourcing risks are interface within activities, loss of competitive base, opportunistic behavior, rising transaction and coordination costs, limited learning and innovation and higher procurement costs in relation to the fluctuating currency exchange rates (Kotabe, Mol et al. 2008). According to the latest Bain Survey, 77% of their research sample companies have outsourcing policy and yet more half of the companies do not achieve the expected benefits 2

3 from outsourcing. If firms only focus on achieving short-term benefits of outsourcing without considering these risk factors, they may fail to access original goals of outsourcing. Firms need to carefully consider balancing the benefits and risks to maximize the outsourcing effects on their long-term competitive advantages(rothaermel, Hitt et al. 2006). In this sense, firm s approach to outsourcing is becoming increasingly strategic (Gottfredson, Puryear et al. 2005; Hoecht and Trott 2006). Strategic Outsourcing For the meaningful analysis of outsourcing various theoretical insights are helpful. Transaction Cost Theory (TCT) originates from economic perspective and Resource Based View (RBV) is heavily applied in strategic management. Loh(Loh 1994) investigates the consideration of various cost factors (e.g., bargaining, influence, administrative and management, agency and decision-making costs) that are critical for an outsourcing decision. Transaction costs are often disregarded because of the difficulty in quantifying the costs. Firms need to consider both the production and transaction costs in relation to outsourcing(lacity, Willcocks et al. 1995). Other unexpected hidden costs are related to activities such as contractual amendment, unexpected transition and management, lock-in and disputes and litigations (Bahli and Rivard 2003). In addition to the production costs, firms pay close attention to the potential increase in all other transaction-related costs(qu and Brocklehurst 2003). Resource-Based View argues that a firm has the ability to achieve and sustain competitive advantage if it possess resources that are valuable, rare, imperfectly imitable and nonsubstitutable(barney 1991). Not all resources are strategically relevant within an organization. The goal of an organization is to ensure it has access to and control of valuable resources by developing and securing all the relevant resources either internally or externally(das and Teng 2000). If a firm possesses critical resources that have strategic value, it is better to retain the activity in-house. On the contrary, if the strategic value of target activities is low and no internal resources are available to perform such activities, it is beneficial for the company to outsource them(roy and Aubert 2001). For the sustainable competitive advantages firms are forced to rely on a multitude of outside suppliers for parts, software, knowhow and sales and in doing so gain access to valuable resources and external capabilities(langlois 1990). In view of the above mentioned relevant theories, we have adapted Kraljic s purchasing portfolio for our analysis of outsourcing strategy(kraljic 1983). In 1983, Kraljic introduced portfolio approach for the use in purchasing and supply management. Karjic s model classifies all the purchased materials in terms of profit impacts and supply risks. By assessing the company s situation in terms of these two variables, purchasing executives may determine the overall strategic supply position and accordingly exploit its purchasing power and reduce the overall risk associated with purchasing decisions (Kraljic 1983). This purchasing portfolio model is a useful tool for the analysis of outsourcing decisions because of close linkage between purchasing and outsourcing (Caniëls and Gelderman 2005). Atkearney Survey(2005) indicates a plausible causal link between the level of procurement involvement in the outsourcing process and the degree of success achieved. Nearly 80 percent of survey respondents say that their procurement organizations have a high level of involvement in the strategic outsourcing processes. About two-thirds of the respondents suggest that procurement has a high level of involvement in the outsourcing strategy planning processes. In light of close relationship of purchasing with outsourcing we have derived strategic outsourcing matrix out of Kraljic s portfolio model. Our analysis focuses on the efficient allocation of limited resources to improve the management ability and maximize outsourcing benefits. Figure 3 shows strategic outsourcing matrix. We modified Kraljic s purchasing 3

4 portfolio for strategic outsourcing matrix and classified a firm's products, services and purchased products on the basis of two dimensions: profit impact and outsourcing risk. The profit impacts are defined in terms of the cost reduction, volume of activity, market opportunity and customer effect. The outsourcing risks may be assessed in terms of technical complexity, uniqueness of business process, business risk and entry level. Using these two parameters, executives may consider carefully their business activities, products and components for the effective outsourcing decisions. In a situation where the profit impacts are high and the outsourcing risks are low, firms would be advised to develop expansion strategy to penetrate and expand their market shares. If profit impacts and outsourcing risks are high, firms need to make strategic partnership with outsourcing partners very carefully, or vertically control these items for long term market share. In the case of low profit impacts and low outsourcing risks, firms may pursue business approaches that focus on efficiencies and seek economies of scale in production and sales. Where the outsourcing risks are high and profit impacts are low, In this case, firms may try to source alternate partners for assuring supply. Profit Impact High Low Low Leverage items : Exploit market penetration and expansion of market with high level outsourcing. Non-critical items : Ensure efficient cost strategy for economies of scale Source : Modified from Kraljic, 1983 Outsourcing Risk High Strategic items : Insourcing for competitiveness Seek strategic partnership for longterm market position. Bottleneck Items : Close partnership for assuring supply Sourcing alternate partner 3. Case illustration Figure 3: Strategic Outsourcing Matrix Case 1: E-Land Established in 1980, E-Land is a leading group of fashion retailer in Korea. E-Land has successfully marketed mid-level casual brand in Korea. From the beginning its key functional strategy was efficient production through outsourcing and marketing through franchise style promotion. Its corporate priority has consistently maintained the core competencies in terms of strategic planning, merchandising and design. In 1994 E-Land started its marketing effort in China. Different from its Korean marketing position, the Chinese strategy was to premium brand strategy. The entire production was done through outsourcing in China. The typical problems for global firms that do outsourcing in China are trust issues in terms of quality and delivery. To resolve these problems E-Land manage contracts with their outsourcing suppliers in strictly tested contract terms, conduct post-purchase follow-up and adopt systematic evaluations. E-Land ensures high quality production management of suppliers by utilizing internal production and quality control teams. In this way E-Land adopts high level of outsourcing strategy and achieved high volume flexibility without huge investment of production lines and human resources. E-land focused on distribution and design capability. Different E-Land Korea s franchising system, E-Land China vertically integrated distribution function. Currently, E-Land has introduced 15 different brands of products, including about 7,500 new items a year. Its operation network extends to 100 cities and 500 department stores in China. It covered all main cities and main department stores. In 2007, E-Land s sales volume was more USD 300million, It s growth rate is more 100% than

5 Case 2: Swatch Swatch was originally intended to re-capture market share lost by Swiss manufacturers during the aggressive growth of Japanese companies such as Seiko. As core capabilities, Swatch focused on new style design, manufacturing efficiency and brand power. Now, Swatch is the largest watch maker in the world. Based on it s 157 processing facilities in Switzerland, it has successfully marketed 20 different brands in the global market over the years. Swatch group penetrated Chinese market in With its high vertical control of the production in Switzerland, it penetrated Chinese market with efficient managing and distribution strategy. Swatch entrusts import, tax, consulting and human resource management to highly specialize Chinese local firms. By utilizing their expert knowledge and relational competencies, Swath enhanced productivity (e.g., cost reduction) and excellent risk management for changing market conditions. Swatch has successfully made contracts with the largest Chinese wholesale distributors and utilized the existing well-established national distribution networks. In this way, Swatch has achieved rapid business growth while building brand images among Chinese growing middle and upper class consumers. Swatch launched 15 different brands in China, targeting all market segments, from low-end to high end brads. Sales volume in China became the second largest among the global sales amounts of Swath Group during the short period. Case 3: AULT Ault has grown as a vertically integrated firm that handles product development, production and marketing of AC-DC Converter in USA. With its rapidly losing its competitiveness with high cost of manufacturing in USA, in 1987 Ault built its first factory in Korea. Ault s USA corporate functions focused on strategic management, marketing and product development. It also streamlined its organizational structures to be flexible and efficient. After operating Ault Korea, it strengthened its cost competitiveness through better management of purchasing and production functions. In 1990s, it started manufacturing operations in a city nearby Beijing China. In Shanghai it formed a corporation for marketing management and product development. In its early stage of operations, Ault China focused on assembly process to reduce manufacturing costs. Most of raw materials was supplied in Completely Knock Down(CKD) form by Ault Korea. Assembling process for cost reducing by CKD led to serious problems in Ault China operation. Ault has produced multiple lines of products with more 5,000 components parts list. Naturally, it experienced material shortages and long delivery problems. Supply chain issues between Ault Korea and Ault China were quite frequent and serious. It s a big bottleneck for satisfying customer need with on time delivery. In 2001, Ault started sourcing alternate vendors in shanghai area and during the 1 year effort they set up 100% purchasing system in Ault China. In result, Ault secured its cost competitiveness (10% cost down) and established speed delivery system. Ault China has vertically controlled some critical parts(e.g., plastic case, transformer) and they decided moving these production operations to external partners to focus on end product manufacturing. Besides, Ault China decided outsourcing it s non-core end products(e.g., linear power suppliers) from the most competitive GuangDong area AC-DC manufacturers. They supplied linear power supplier to Ault with high quality and more low cost. In this way, Ault China has changed it s supply chain system. Since it s non-core businesses were handed over to external supplier partners, Ault China focused on manufacturing high end Switching Mode Power Suppliers(SMPS). Ault could survive in extremely competitive industry with its constant adaptations to changing according to market reality. In this way, Ault has enhanced its core competitiveness through sustained strategic development and persistent innovation. 5

6 4. Findings As shown in the above cases, multi-national corporations (MNCs) are successful through strategic outsourcing practices in generating consistently high level of profits in the Chinese market. However, outsourcing has serious negative impacts on business too. The key for strategic outsourcing is to employ appropriate strategy which carefully considers profit potential and risk factors. Low Outsourcing Risk High High Profit Impact Low Leverage Items E: Production by outsourcing S: Distribution by outsourcing high level outsourcing S: Outsourcing Import, Tax, HR for efficiency A: Linear Adapter - > outsourcing for low cost and high quality Non Critical Items Race to the Top Focus on Distribution R&D Brand Race to the Bottom Strategic Items E: Market Distribution : insourcing in China S: Production : insourcing in Swiss A: High end SMPS: in house Transformer, Case: insourcing -> outsourcing with strategic partnership low level outsourcing A: Raw materials: Shortage, long delivery -> Sourcing alternate suppliers in China Bottleneck Items Figure 4: Application of Strategic Outsourcing Matrix Figure 4 shows application of strategic outsourcing matrix. It has four different patterns leverage, strategic, non-critical and bottle-neck items. E, S and A refers to E Land, Swatch and Ault respectively. The horizontal axis shows two continuum of risk factor(left-low, righthigh). The vertical axis is about two profit impact(up-high, down-low). The horizontal level is about the degree of outsourcing (either low or high). The vertical level is about the strategic direction either race to the top or race to the bottom. Our case examples show different strategic outsourcing choices and business outcomes. First, Case companies focused on brand management, R&D and distribution as their core business. For the leverage items, E Land & Swatch outsourced production and distribution functions with high level of outsourcing and they successfully penetrated Chinese market and exploited the growing buying power. For the strategic items, firms vertically controlled the items in house for long term Chinese market. If the strategic items are purchasing items, they made strategic relationship with suppliers. For the non-critical items, Swatch outsourced the importing business processes for efficiency. Ault mostly outsourced low end linear adapters which were marketed mainly in USA and EU market, not Chinese market. Fourth, for the bottleneck items, Ault has not adopted purchasing function, so it is the big bottleneck item in China. Ault instead sourced alternate suppliers in China and enhanced cost and delivery competitiveness. In this way, bottleneck items become leverage items. 6

7 As shown above, these case examples indicate high level of outsourcing at the leverage and non critical items. Case companies not only reduced cost but also enhanced their core business outcomes by utilizing high level of outsourcing at these items. Because of low outsourcing risks at these categories, companies could exploit buying power and access the external capabilities for competitive advantage. In contrast, low level of outsourcing is applied for strategic and bottleneck items. Case companies maintained their core business and critical items within for sustainable competitive advantage. In the case of outsourcing critical items, they outsourced these items to the close strategic partnership with external suppliers. Case companies also rapidly expand Chinese market and race to the top by determining appropriate level of outsourcing for their leverage and strategic items. Ault China do not keep simple assembly production line and the low end production, but instead it has upgraded the production facilities to high end production in response to the changing market demand. E- Land has launched premium brands in China, quite different from their medium brand strategy in Korea. E-Land has outsourced production activities and internally integrated its value added activities in the areas of design and distribution) to implement its rapid market expansion strategy in China. At these leverage and strategic items, top executives decisions on the appropriate level of outsourcing and insouricng really matter for sustainable competitive advantages. Masaaki Kotabe and Mol (2008) argued that the outsourcing-performance relationship takes on an inverted-u shape which suggests an optimal degree of outsourcing. The extremely high degree of outsourcing may result in external relational inefficiency, technological dependence and high transaction costs(kotabe, Mol et al. 2008). The MNCs in China face many challenges for successful outsourcing execution. Therefore, MNCs rather formulate their long-term outsourcing strategy and clearly understand what particular factors affect the optimal outsourcing level for sustainable competitive advantage. Kotabe and Mol (2008) argued that e-commerce may change the optimal point of outsourcing level. We find core capabilities (e.g., e-commerce) of any companies may also impact the optimal point of outsourcing level. So, the first step for outsourcing is to identify the firms core of core business(gottfredson, Puryear et al. 2005). Then, Firms have to make decision for outsourcing items and outsourcing levels, considering strategic outsourcing matrix to maximize the competitive advantage. 5. Discussion and Conclusion This paper provides an outsourcing typology in Chinese business contexts with the particular focus on strategic outsourcing. We present a strategic outsourcing matrix which is useful to analyze the patterns of outsourcing in China. This paper indicates strategic outsourcing approach may improve firms to achieve substantial market growth in China. Since business environment in China is becoming more challenging and difficult, more firms require to compete beyond low costs and cost reduction measures in manufacturing. MNCs in China consistently enhance their core capabilities while balancing the needs for the outsourcing and insourcing for their sustainable competitive advantages. The realistic option for the MNCs in China is to move toward high premium value goods, services and industries. MNCs should seek to compete with emerging economies in a race to the top (leverage items & strategic items) rather than in a race to the bottom (bottle neck items & non critical items). References A.T.Kearney, Inc. (2005). "Outsourcing Strategically for Sustainable Competitive Advantage" Bahli, B. and S. Rivard (2003). "The information technology outsourcing risk: a transaction cost and agency theory-based perspective." Journal of Information Technology 18(3):

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