Another argument for producing all or part of a product in-house is that production cost savings result because it makes planning, coordination, and scheduling of adjacent processes easier.30 This is particularly important in firms with just-in-time inventory systems (discussed later in the chapter). In the 1920s, for example, Ford profited from tight coordination and scheduling made possible by backward vertical integration into steel foundries, iron ore shipping, and mining. Deliveries at Ford’s foundries on the Great Lakes were coordinated so well that ore was turned into engine blocks within 24 hours. This substantially reduced Ford’s production costs by eliminating the need to hold excessive ore inventories.
For international businesses that source worldwide, scheduling problems can be exacerbated by the time and distance between the firm and its suppliers. This is true whether the firms use their own subunits as suppliers or use independent suppliers. However, ownership of upstream production facilities is not the issue here. By using information technology, firms can attain tight coordination between different stages in the production process.
THE ADVANTAGES OF BUY
Buying component parts, or an entire product, from independent suppliers can give the firm greater flexibility, can help drive down the firm’s cost structure, and may help the firm capture orders from international customers.
The great advantage of buying component parts, or even an entire product, from independent suppliers is that the firm can maintain its flexibility, switching orders between suppliers as circumstances dictate. This is particularly important internationally, where changes in exchange rates and trade barriers can alter the attractiveness of supply sources. One year, Hong Kong might offer the lowest cost for a particular component; the next year, Mexico may have the lowest cost. Many firms source the same products from suppliers based in two countries primarily as a hedge against adverse movements in factor costs, exchange rates, and the like.
Sourcing products from independent suppliers can also be advantageous when the optimal location for manufacturing a product is beset by political risks. Under such circumstances, foreign direct investment to establish a component manufacturing operation in that country would expose the firm to political risks. The firm can avoid many of these risks by buying from an independent supplier in that country, thereby maintaining the flexibility to switch sourcing to another country if a war, revolution, or other political change alters that country’s attractiveness as a supply source.
However, maintaining strategic flexibility has its downside. If a supplier perceives the firm will change suppliers in response to changes in exchange rates, trade barriers, or general political circumstances, that supplier might not be willing to make investments in specialized plants and equipment that would ultimately benefit the firm.
Although making a product or component part in-house—vertical integration—is often undertaken to lower costs, it may have the opposite effect. When this is the case, outsourcing may lower the firm’s cost structure. Making all or part of a product in-house increases an organization’s scope, and the resulting increase in organizational complexity can raise a firm’s cost structure. There are three reasons for this.
First, the greater the number of subunits in an organization, the more problems coordinating and controlling those units. Coordinating and controlling subunits require top management to process large amounts of information about subunit activities. The greater the number of subunits, the more information top management must process and the harder it is to do well. Theoretically, when the firm becomes involved in too many activities, headquarters management will be unable to effectively control all of them, and the resulting inefficiencies will more than offset any advantages derived from vertical integration.31 This can be particularly serious in an international business, where the problem of controlling subunits is exacerbated by distance and differences in time, language, and culture.
Second, the firm that vertically integrates into component part manufacture may find that because its internal suppliers have a captive customer in the firm, they lack an incentive to reduce costs. The fact that they do not have to compete for orders with other suppliers may result in high operating costs. The managers of the supply operation may be tempted to pass on cost increases to other parts of the firm in the form of higher transfer prices, rather than looking for ways to reduce those costs.
Third, vertically integrated firms have to determine appropriate prices for goods transferred to subunits within the firm. This is a challenge in any firm, but it is even more complex in international businesses. Different tax regimes, exchange rate movements, and headquarters’ ignorance about local conditions all increase the complexity of transfer pricing decisions. This complexity enhances internal suppliers’ ability to manipulate transfer prices to their advantage, passing cost increases downstream rather than looking for ways to reduce costs.
The firm that buys its components from independent suppliers can avoid all these problems and the associated costs. The firm that sources from independent suppliers has fewer subunits to control. The incentive problems that occur with internal suppliers do not arise when independent suppliers are used. Independent suppliers know they must continue to be efficient if they are to win business from the firm. Also, because independent suppliers’ prices are set by market forces, the transfer pricing problem does not exist. In sum, the bureaucratic inefficiencies and resulting costs that can arise when firms vertically integrate backward and produce their own components are avoided by buying component parts from independent suppliers.
Another reason for outsourcing some manufacturing to independent suppliers based in other countries is that it may help the firm capture more orders from that country. Offsets are common in the commercial aerospace industry. For example, before Air India places a large order with Boeing, the Indian government might ask Boeing to push some subcontracting work toward Indian manufacturers. This is not unusual in international business. Representatives of the U.S. government have repeatedly urged Japanese automobile companies to purchase more component parts from U.S. suppliers to partially offset the large volume of automobile exports from Japan to the United States.