Supply Chain Frontiers issue #59
A key sourcing decision, and a central issue in supply chain design, is which core activities can be outsourced and which ones need to be kept in-house. The choice can be especially difficult in industries where consumers are extremely sensitive to product quality. A research project at the Malaysia Institute for Supply Chain Innovation (MISI) developed a framework that helps companies make this type of sourcing decision, and applied the model in a case study of the infant nutrition industry.
The work was carried out by Amit Kumar and Sunil Kumar Injeti for their MIT Malaysia Master of Science in Supply Chain Management thesis. Dr. Javad Feizabadi, Director of MISI’s PhD program, supervised the thesis.
In addition to being highly sensitive to product quality and consumer perceptions, the infant nutrition market is dynamic. Companies are under constant pressure to innovate and introduce new products, while maintaining profitability.
The researchers initially set out to define which factors influence outsourcing decisions. Economists and organizational scientists have identified multiple factors that enterprises should take into account when choosing between outsourcing and insourcing. In economics the process is known as a market-hierarchy decision and in organizational science it is referred to as a make-or-buy decision.
A literature search identified 12 factors that can affect these choices. For example, if a company possesses proprietary technology, it tends not to outsource activities directly related to that technology. On the other hand, the tendency to outsource is higher where there is a strong legal environment to protect the firm’s interests. Other factors that sway the decision include alignment with business growth plans, process architecture, and product quality.
The mix of factors depends to a significant degree on the industry concerned. In the auto industry product complexity (defined as the number of subcomponents, the interaction between components and the degree of component novelty) is a key determinant. In this industry the likelihood of sourcing a component in-house increases with its complexity. Industries that market simpler products require different approaches to supply chain design.
The MISI researchers developed a number of hypotheses concerning the association between each decision-influencing factor and the level of outsourcing/insourcing. Regression models, based on data from a number of sources including industry executives, were developed to test the hypotheses. The research looked at several value chain activities, including a semi-finished manufacturing process, a finished manufacturing process, product and process R&D, and quality assurance.
It was found that product quality is the most important determinant for infant nutrition businesses when weighing the merits of outsourcing and insourcing. After further analysis, the researchers categorized the factors in three classes based on the strength of association with the level of outsourcing. The first group of factors has the strongest impact on the outsourcing level, the second and third groups have moderate and weak influences respectively.
These groups of factors are:
- First: product quality, core competency, alignment with business strategy and process architecture.
- Second: tacit knowledge, dependency risk and asset specificity.
- Third: legal environment, IP, proprietary technology and financial health of the company.
A key conclusion is that product quality is critically important in determining whether a firm should outsource or insource specific value chain activities, in industries where consumers are sensitive to quality standards.
The finding might seem obvious, but managers can be prone to paying too much attention to financial considerations when looking to outsource key production activities. Companies in the infant nutrition business can pay a high price if product quality is overshadowed by financial performance when making these decisions.
Another finding is that the factor “skills level of people” has the strongest influence on achieving the desired product quality. Maintaining high quality standards takes more than sourcing the best ingredients; it starts with the culture of the company.
The researchers hope that the decision-making framework they have developed will help companies to make better outsourcing decisions, particularly where no models or platforms exist to support the process. Also, two key elements of supply chain/value chain management are system design and order fulfillment. Companies that fail to pay particular attention to their decisions in these areas and how they configure solutions, can negatively impact market performance.
For more information on the thesis Strategic Sourcing Decision in Infant Nutrition Industry, contact Dr. Javad Feizabadi (jfeizabadi@misi.edu.my).