[MUSIC] Sourcing relationships follow in a continuum between a transactional market exchange on the one extreme, and vertical integration on the other. Insourcing means that the supply relationship is internal. Outsourcing refers to having an external party supply the activity. Let's discuss the relative advantages of each. What are the benefits of transactional outsourcing? The simplest form of external sourcing uses a transactional market exchange and is more commonly known as purchasing procurement. While it technically represents the simplest and most extreme form of outsourcing, purchasing often refers to the practical sourcing of off-the-shelf good source services using an arm's length relationship. The benefit of outsourcing through arm's length relationships or by using the market include one, operational and strategic focus, competencies. Outsourcing some activities allows the firm to solely focus on those activities at which it excels. Tailor Toys is the developer of PowerUp, a device and an app that turns your very own paper airplane into a smartphone-controlled flying machine, does not deal with the production of its controllers. The firm can then focus on the development of the product and the marketing effort. Two, cost and risk pooling efficiencies; sizing and location. External specialists may have greater economies of scale and scope, they may also enjoy risk pooling by serving many other customers in market segments. When outsourcing is combined with off-shoring, additional cost efficiencies may accumulate. Three, operational and financial flexibility which relates to timing type and risk. Outsourcing reduces capital commitments, such as fixed assets, thereby liberating the balance sheets. If structured correctly, outsourcing allows capacity to scale up and down quickly, and flexibly among products, thus mitigating demand risks. Boeing outsource the production, but also the entire development of the components of its dreamliner with the idea of sharing financial risk with many players. Four, access to the latest technologies and innovations. Few companies have the scale and the resources to stay updated with all the latest technologies. Outsourcing can give access to proprietary technology or other intellectual property. Access to state-of-the-art technologies was also one of the primary reasons for Boeing's outsourcing plan. Five, market competition enhances efficiency and incentives for improvement. If there are several potential suppliers, the firm has choices and gains more insights into true costs. In contrast, insourcing creates an internal monopoly that may be reluctant to change. Thus, it may provide lower quality service and higher costs than those of external parties that must compete for business. At the same time, there are arguments in favor of vertical integration. One: control, size, timing and type. By supplying an activity internally, the firm controls the delivered volumes, quality and speed to market. In contrast, outsourcers may become hostage to suppliers who may gradually raise prices or reduce quality of service especially when they have capacity shortages. Recently, Swatches' parent company announced that it would no longer provide unfinished watch movements to competitors and that they better start investing themselves into movement manufacturing. Aligned incentives promote optimal investments, size and technology integration. If the supply technology's specific to one user, external suppliers will have little incentive to invest, because such investments are susceptible to exposed expropriation. Suppliers also typically invest less than what is optimal for the entire value chain, even without asset specificity, simply because they only gain a part of the total margin. Vertical integration aligns incentives and removes two problems known as the holder problem and double marginalization. Fashion houses such as Gucci and LV, Mitch attempted to acquire suppliers of tanned leather. By acquiring suppliers, luxury goods purveyors hope to get more control over raw material goods. Prices of calf hides have soared in recent years due to Europe's falling veal consumption. Calves are slaughtered primarily as the source of veal, and skins are by-product. With fewer calves slaughtered to meet shrinking demand for veal, the supply of skins available for luxury leather goods is also diminished. Three, operational and transaction cost efficiency, which concerns the location and technology. Vertical integration may be more efficient than incurring the transaction and coordination cost of dealing with the suppliers. Interaction costs include managing the relationship, and monitoring, and coordinating the exchange of information, goods, and services. By joining sequential processes and eliminating hand-offs for transportation, internal processing may be cheaper than buying from external parties. Four, learning by doing. And five, protection of proprietary assets, technology, and other intellectual property. One example that touches on many of these aspects is Voltaic Systems. Voltaic Systems is a portable power company based in Brooklyn, New York. A drained phone in the middle of Spain led the founder to design the first solar backpack. The firm has more than a dozen manufacturing partners in China, who produce a range of components, such as the solar panels, fabric shells, batteries, and cables. The parts for those components come from all over the world, including the U.S., which provides the solar panel coding, and Germany, which provides the solar cells, mostly from Bosch. While the components are all outsourced, the firm decided to do the final assembly in the U.S. in their own warehouses. Why? On its webpage the firm writes that the initial reason was that is was cheaper. The US puts a 17% tariff on all bags brought into the country. If we attached a solar panel and battery to that bag and imported the entire thing, we'd be spending a lot on duties for every bag. It was simply less expensive to assemble the bag here than the cost of assembly plus duties. However, since then the firm realized many other advantages. The ability to manage inventory and pool risk of stocking out of a specific product was improved since the firm did not stock only finished goods. The firm has also better control on the quality of the product, with the ability to do a final inspection of the components before they are being assembled. And finally, the ability to control part of the process allowed the firm to innovate and offer newer products by combining the sub-assemblies into new product lines. [MUSIC]
