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The danger of outsourcing everything that is not your core competency

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This is a great story told by Clayton Christensen at a lecture entitled “Business Model Innovation”

Here is the get – “This is a very common phenomenon.  It is how the Indian IT companies are hollowing out the inside of their customers.  They started out just doing the bare bones simple code, and they just keep integrating more and more forward, taking more and more of the value-added until it is really not a, it is almost a, it is not clear whether the IT departments are outsourcing to TCS and Infosys or whether Infosys and TCS are outsourcing the brand from their customers”

Now there is another kind of disruption that occurs that is rooted in the gospel that we should always outsource everything that is not our core competence.  I’d like to just walk you through an interaction between a supplier and a customer that is typical of this interaction in many different industries.  So I am just going to describe this as an interaction between Compaq, a late, great computer manufacturer, and Flextronics, one of its suppliers.  But I’ll just use these as representatives of Dell and Asus Tech and a bunch of other interactions.

So Flextronics starts out making the simplest of the circuit boards inside of a Compaq computer, piddly little Singapore-based company.  They came to Compaq then with an interesting value proposition.  It was, “You know we’ve been doing a good job on the little boards, why don’t you let us do the mother board because circuit manufacturing isn’t your core competence, and if you give it to us we could fabricate those for 20% lower cost.”

Well Compaq’s analysts looked at it and realized, “Gosh, they could.  And if we gave the mother board to them, not only could we drop cost by 20%, but we could get all the circuit manufacturing assets off the balance sheet,” because it was very capital-intensive.

So they shoveled that over.  Compaq’s revenues were unaffected but their profits improved, it felt good to get out of the mother board.  Flextronics’ revenues improved and its profits improved.  It felt great to get into the mother board.

Then Flextronics came back.  “You know we’ve been doing the mother board for you, come to think of it, that is really the guts of the computer.  Why should you have to bother to assemble the rest of the stupid computer because assembly is not your core competence.  Let us do it.  We could do it for 20% lower cost.”

And Compaq’s analysts looked at it and realized, “Gosh they could.  And if we gave assembly to them, not only could we drop costs but we could get all the other manufacturing assets off of our balance sheet.”  So they shoveled that over.

Compaq’s revenues were unaffected but their profits improved.  It felt good to get out of assembly.  Flextronics’ revenues and profits improved, it felt good to get into assembly.

Then Flextronics came back.  “You know we’ve been assembling your computers for a while, doing a good job.  Come to think of it, you shouldn’t have to bother to manage the supply chain, dealing with the component suppliers, working out all these logistics headaches, shipping your dumb computers to your stupid customers.  And logistics isn’t your core competence.  Let us take on the supply chain.  We could reduce the cost by 20%.”

And Compaq’s analysts looked at it and realized, “Gosh, they could.  And if we gave the supply chain to them, not only could we drop costs even further, but we could get all the current assets off the balance sheet.”  And so they shoveled that over.

Compaq’s revenues were unaffected but their profits improved again, especially return on assets, because they’ve got no assets.  And Wall Street loves asset-like companies.  Flextronics’ revenues improved and their profits improved because they are getting into value-added services.  And Wall Street loves value-added services.  It felt good to get out of the supply chain and good to get into the supply chain.

Then Flextronics came back.  “You know we’ve been managing the supply chain for a while.  Come to think of it, you shouldn’t have to bother to design your dumb computers, because design really is little more than component selection and we’ve got all those relationships.  Why don’t you let us design your computers?  We could do it for 20% less cost.”

Compaq’s analysts looked at it and realized, “Gosh, they could.  And if we gave design to them, we could fire all of our engineers, drop our costs even lower because our core competence in the end really is our brand.”  So they shoveled that over.

Compaq’s revenues were unaffected but their profits improved.  Flextronics’ revenues and profits improved.

Then Flextronics came back one more time, but this time they did not go to Compaq, they went to Best Buy.  “You know here we are, one of the world’s best manufacturers and designers of the world’s best computers.  Come to think of it, you know those brands Hewlett-Packard and Compaq and Dell on your shelves, you don’t need to stock those brands.  We’ll give you our brand, your brand, any brand at 20% lower cost.”

And bingo, one company is here, another one takes its place.  And just like the mini mill story, you notice I was able to tell this story without using the words “stupid manager” once.  Because Compaq did everything that good managers are taught to do, focus on what they believe are their core competencies, outsource the lowest value added of the activities they are performing if there is somebody who could do it better.  And yet when this happens you create again that same asymmetry of motivation that one company is motivated to flee from the very market that the other company is motivated to attack, until ultimately the outsourcer liquidates its business model to its customers.

This is a very common phenomenon.  It is how the Indian IT companies are hollowing out the inside of their customers.  They started out just doing the bare bones simple code, and they just keep integrating more and more forward, taking more and more of the value-added until it is really not a, it is almost a, it is not clear whether the IT departments are outsourcing to TCS and Infosys or whether Infosys and TCS are outsourcing the brand from their customers

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Written by frrl

March 24, 2010 at 5:00 am

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