Introduction

Objective

Scope

Methodology

The course of action during the project

Theoretical framework

Small companies

How is a small business defined?

The importance of a strong small business community to the nation

The characteristics of small corporations

The strategic planning process in small business

The notion of outsourcing

The driving forces behind outsourcing

The process of outsourcing

The two steps in focus

Strategic aspects of outsourcing to low-cost-countries

Establish a presence in a foreign market

Risk of intellectual property losses

React to the action of competitors

Introduce competition to domestic suppliers

Innovation and geographical distance

Cultural distance

The Marketing Mix – the tactical marketing tools

Product quality

Product brand

Pricing strategy and costs

Place - marketing and logistics

Economic aspects of outsourcing to Low-cost-countries

Total cost of ownership (TCO)

Lead times

Effects on current supplier relations

Increased demands on the purchasing departmen

Financial risk

Socio-Political risks

Currency risks

Dependence on supplier

A conceptual model

Empirical findings and comparative analysis

Conclusion

References

Introduction

During the past few years purchasing and supply chain management as a discipline has changed considerably in many companies. Moving away from their traditional, operational roles, purchasing- and supply managers are assuming more strategic roles in their organizations (Van Weele 2002). Considering that organizations today are much more dependent on suppliers – purchasing share in the total turnover typically ranges from 50-90 % - this is not so strange. In addition, today the globalization of trade and the Internet enlarge a purchaser’s choice set. Changing customers preferences require a broader and faster supplier selection. These developments strongly urge for a more systematic and transparent approach to purchasing decision-making, especially regarding the area of supplier selection (De Boer et al 2000).

Decades ago western companies began to manufacture physical goods in offshore locations with the low wages as the primary driver. Despite the cost of transporting the goods, it was cheaper to make them there, then to keep the factory onshore. With the rise of cheap and reliable global communications and the emergence of skilled labor force in many developing countries, remote outsourcing has become real in most industries (Daruvala 2003). The rise of outsourcing manufacturing, R&D and service operations from high-cost countries (HCCs) to low-cost countries (LCCs) are well under way and accelerating fast. No major industry will be immune. In industry after industry, globalization is redrawing the playing field and creating new winners and losers (Adler et al 2004).

However, even though companies are starting to realize that the competitive advantages to be gained from global sourcing are huge, they are also discovering that the process is complex. The bottom-line economic advantages to be gained in various regions are not always easy to assess or compare. Many kinds of risk need to be taken into account, from operational, monetary and intellectual property risk to geopolitical risk (Adler et al 2004). A rapport from the consulting firm BoozAllenHamilton shows that one third of the Swedish companies fail their outsourcing initiatives. The problems are said to arise already during planning, because the firms don’t consider the consequences of outsourcing enough before executing the plans (Mattsson 2002).


If the problems and complexity of global sourcing are significant for the large companies, the challenge is even greater for the small and medium size enterprises (SMEs). Effective purchasing needs resources and capital, which is rarely the case in SMEs. In one study the results shows that just 19 % of small firms have a purchasing function and 65 % view purchasing as not important. Another important issue is that smaller firms often are the minority partner within the supply chain, limiting their possibilities to negotiate (Quayle 2002).

Handling the globalization of business seems to be the most challenging task the western business world will face during this decade. Up till now, the classic Swedish industrial base of producing machinery has been relatively mildly affected. This is about to change. A rapport, written by the Boston Consulting Group (Adler et al 2004), indicates that industrial metal products and machine shops will be the next wave of global outsourcing. LCCs penetration of these products is still relatively low but accelerating quickly – in some cases by more then 15 % per year. Companies in these sectors face the greatest opportunities but also the greatest threats, because much of their business will face new cost competition. Establishing a method for handling these new issues will be absolutely critical if these companies are to maintain their competitive positions.

In general, this research intends to construct a model, which considers the special conditions of SMEs and brings out all aspects of outsourcing production of machinery to low-cost countries.

Objective

The major objective of this paper is to construct a generic model for SMEs, able to perform a comparative evaluation between outsourcing to a Swedish supplier and one situated in a low-cost country. The evaluation should include both economical and strategic aspects of the action. The generic research question thereby becomes:

What are the economic and strategic consequences and risks that a small company has to consider, when outsourcing production to low-cost countries?

Scope

Since the research question is very wide, this project had to be limited in a number of ways:

  • The model will be constructed from the perspective of a specific case company.
  • The case firm belongs to the sector of forest machinery.
  • The strategic analysis is based in a Marketing perspective.

Methodology

Two common types of research projects, which can be undertaken as a basis for a thesis at the master’s level, are empirical and conceptual projects (Hackley, 2003).

A conceptual project is based mainly on existing sources of information: literature, academic papers and published economic data. The main part of the project thereby becomes an extended critical review of the available literature around a particular set of problems. Normally the review spots gaps of knowledge in a particular area, in order to make suggestions about needed future research. The conceptual project can also induce a conceptual model from the literature review, relating different theories for summarizing particular relationships (Hackley, 2003).

In opposite, an empirical project utilizes first-hand information gathered by the research student. The primary data, collected through interviews or surveys, is placed in the context of the literature and the analyzed for insights and findings (Hackley, 2003).

This project will try to combine elements of both conceptual and empirical approaches. The first part of the project will be to construct a conceptual model from the literature review. This model will then be compared with the findings from first-hand interviews with experienced practitioners within the machinery industry.

The course of action during the project

  1. Choosing the topic
  2. Studying the literature within the chosen topic
  3. Choosing a specific area of interest
  4. Choosing the methodology for the project
  5. Constructing a conceptual model from the literature review
  6. Making qualitative interviews
  7. Formulating the major findings
  8. Making a comparative analysis with the conceptual model
  9. Refining the conceptual model according to the empirical findings

Theoretical framework

First this chapter consists of a brief summary of the special conditions that signifies small companies. Then the notion of outsourcing and the driving force behind it will be discussed. This background will be followed by a presentation of a generic model of the process of outsourcing. The two steps in the model that handle the strategic and cost analysis, will be further developed into a conceptual model with the aid of a vide variety of theories relevant to the objective of the project. After that, the chapter will conclude with more detailed presentations of the different consequences and risks that have been identified in the literature review.

Small companies

This part of the theoretical framework tries to clarify what a small corporation is and its characteristics.

How is a small business defined?

Today, the dominant basis for classifying the size of the firm is the number of employees. The primary reason is that this measurement, in contradiction to the monetary based ones, is not influenced by inflation and changes in prices. This simplifies comparisons over time (Bohman and Boter, 1984). Within this thesis, the definitions drawn up by the European Union will be used (Lundström et al, 1994):

  • Microenterprises – firms that employs 0-9 people.
  • Small enterprises – corporations that employs 10-99 people.
  • Medium-sized enterprises – ranges between 100-499 people.
  • Large enterprises – employs more then 500 people.

This means that the companies included in the purpose of this paper, called SMEs, employs a staff that ranges from 0-499 people.

The importance of a strong small business community to the nation

The existence of a strong, healthy small business community has always been recognized as the best way to preserve competition in a capitalistic society. They prevent the monopolistic control of any industries and thus assure the population of the benefits of competition through better prices and quality products (Steinhoff & Burgess, 1986).

In Sweden, this image has been partly replaced by a view that instead recognises the SMEs as a necessary complement to the large corporations. This complementary role divides into two different branches: partly as a supplier of components to the large industrial firms and partly as a manufacturer of products omitted by the large corporations (Bohman and Boter, 1984).

The characteristics of small corporations

The SMEs relationship to the environment is often characterised by a geographical concentration. Both the customers and the suppliers tend to be located close, local and regional. This implies that the share of the total market often is relatively small, since the SMEs do not have the same prerequisites of dominance. Many smaller firms choose a small market niche, and can thereby acquire the profile and competence needed to dominate a specific segment (Bohman and Boter, 1984).

The structure of the customers can indicate an important aspect of the environment of the smaller businesses; if the turn-over is limited to a few numbers of clients, the loss of one customer could mean a financial crisis. This dependence to the environment is also valid when discussing suppliers and their deliveries. However, this dependence does not have to be negative, since an intimate relationship can cause a foundry of stability that facilitates the development of the company (Bohman and Boter, 1984).

A direct consequence from this common dependence is a greater limitation in strategic choices, due to their lack of resources. Instead the primary strategy of the SMEs will be adaptation; they compensate their weak power towards their environment with flexible actions (Bohman and Boter, 1984).

When it comes to organisational structure, it is often characterised by lack of hierarchy and specialized workforce. Instead the owner-manager (usually the same individual) has a dominant role as responsible for a lot of functions, and the employees often have a variety of tasks demanding multi-skilled personal. A limited administrative system also means that the distance between management and personal is small, implying that the flexibility is higher there in large corporations due to the high amount of informal communication (Bohman and Boter, 1984).

As mentioned earlier, the resources available for change and adaptation is restricted. This could be one of the main reasons that small firms generally are local/regionally oriented. A small business thereby has fewer possibilities to market their products abroad, due to limitations in administrative and lingual resources (Bohman and Boter, 1984).

Another important issue for the SMEs is the identification and handling of risks. Every firm operates with daily risks and the total costs may be much greater for large firms, but they are relatively more important for small firms. The small firm is characteristically less able to absorb losses from risks, making it essential for all small firms to understand the risks to which it is subjected (Steinhoff & Burgess, 1986).

Thus, the generic SME characteristics are:

  • High level of external dependence, both with customers and suppliers.
  • Limited resources of time, money and competence.
  • High flexibility; fast adaptation to new conditions.
  • The owner-manager often has a dominant role.
  • Normally has a strong local/regional orientation.
  • Generally more vulnerable for risks
  • Often a component supplier or specializes in a market niche.

The strategic planning process in small business

All these characteristics of the small firms affect the possibilities for strategic planning and evaluation. Thereby the starting-point for creating a planning process in a small company will be the external environment and the size of the internal resources (Bohman and Boter, 1984).

The conclusion of this part of the theoretical framework thus becomes that the SMEs has a set of distinct characteristics, compared to larger companies. Furthermore, these characteristics create limitations for the generic model that is the main objective of the thesis. In the second half of the theoretical framework, the implications of these characteristics when outsourcing will be further analyzed.

The notion of outsourcing

There are several definitions of outsourcing circulating in literature and media. In this essay outsourcing is defined as “when a company hires an external supplier to perform services previously done in-house” (Asplund 2002). This means that outsourcing differs both from purchasing products never manufactured and selling businesses no longer needed. However, this definition does not give any clues to why a firm would make the decision to outsource. To understand the logic behind outsourcing, one must grasp the underlying driving forces.

The driving forces behind outsourcing

The reasoning behind outsourcing is largely based on the concept of Porter’s value-chain(Asplund 2002). The value-chain is an attempt to explain the total value of a company, made up of all the activities creating value and a profit margin (Figure XX). According to the model a company consists of a number of primary activities related to actual production and various supportive activities. Both the primary and the supportive activities can contribute to the competitive advantage by adding value to the product.

Porter means that all companies should analyze the value it creates for its customers. The value is calculated as the company’s total income; the product price multiplied with the annual sales. If the value exceeds the total costs for delivering the product to the customer the company is profitable (Porter 1985).

FIGURXX

This implies that a company’s competitive advantage, or the creation of value,often lies in certain parts of its value-chain. Thereby the primary motive to outsource often is a will to focus on these strategically important parts, also known as core competence, and use best-practice suppliers to perform other activities distant from its core. The suppliers enhances the execution of the distant activities (either with better quality or lower costs), thereby increasing the value for the final customer (Asplund 2002).

The Porter value-chain model is widely accepted and its impact on corporate strategy has been immense. As all models that have the ambition of being generic, the model has received some criticism. The main issue is whether or not Porter has made to many simplifications and disregarded the problemswith implementing the strategies (Holm 2002). And no doubt about it, executing an outsourcing strategy is a costly and time-consuming process, demanding the outmost attention from upper management. All the departments will be effected by the decision, not just the one being outsourced. Naturally the process and its effects will differ depending on the outsourcing object and the firm (for example the size). However, all firms realizing an outsourcing strategy has to carry out the same major generic steps.

The process of outsourcing

A first step towards dividing the process of outsourcing into actual activities, is to separate between the transaction part and the transition part. The transactional part is similar to a regular purchase, including selection of supplier and negotiating of the contract. Once the contract is signed the transitional part takes over, involving the actual move of resources and employees (Wasner 1999). However, this distinction overlooks the fact that outsourcing is more then a regular purchase. When a company decides to outsource, this will have a vast number of consequences for the future structure of the company. In the model formulated by Greaver (1999), the emphasis on analyzing both the strategic consequences and the costs is more adequate. According to Greaver, all companies considering outsourcing should follow a seven step path (se figure XX):

FIGURTEXTOCHRITA MARKERING AV 2 OCH 3

  1. Plan initiative - The initial step, after deciding to further exploit the possibilities with outsourcing, should be the formation of a project group responsible for the initiative. This group should contain representatives from all the relevant departments. After planning the project, including important goals and dates, the group should revise what outsourcing competence the firm possesses. This will be aid the firm in deciding what sort of external aid needed during the process.
  1. Analyze strategic consequences – To be able to control the effects of outsourcing during implementation, the project group needs to understand the consequences it will have for the company’s generic strategies. The answers to these questions are received by relating the outsourcing to the present and expected future structures, core competencies, costs, abilities and competitive advantages
  1. Analyze costs – By using an activity-based cost analysis the project group can clarify which activities that can be outsourced. Then a future cost analysis should be made, where both the remaining internal costs and the new external costs are calculated. In this step actual make/buy decision is made.
  1. Supplier selection - Now is the time for the project group to formulate the list of criteria for qualifying suppliers based on the outsourcing needs. Potential suppliers are identified and an RFP (Request For Proposal) is sent with: grounds for outsourcing, specification of the service, qualifications requested from supplier and assessment methods. Once the proposals arrive they should be evaluated and compared with the organizations expectations. Naturally references should be checked and on-site visitations made. Then a short-list is made with the two-three most interesting suppliers. These make formal presentations, which will be the basis for the actual choice.
  1. Negotiating the contract – When it’s time to finish the agreement the project group needs to clarify a negotiation strategy. In the final contract the following areas should be included: the service levels, the transition terms, management and control, price-model and terms in case of a termination.
  1. Transition resources – During the transition process the management of human resources is of the outmost significance. The focus should be on communication and compensation, since the treatment of these employees leaving the company will have a great impact on acceptance of future outsourcing.
  1. Managing relations – Once the supplier has taken control of the outsourcing object, the needed management changes. The key to a successful relationship is having the same view on controlling performance, evaluating results and solving problems. However, the foundation of the collaboration should always be mutual trust.

The objective with this research implies that thethesis will focus on steps two and three: the analysis of strategic consequences, costs and abilities.