Chapter 30
Supply Chains, Outsourcing, and Innovation

Supply chains are as simple and as complex as chicken and egg problems. To have your breakfast you have to get the egg from the chicken and then get the egg into your skillet. That is a simple supply chain. Of course, you must have gotten your skillet from somewhere, which had to get the raw materials that were combined to make your skillet. Then your heating source, probably a stove had to come from somewhere and that fuel used to heat the skillet likely got mined and transported. As you take apart the components involved in your breakfast, the supply chain has become more complex. Supply chains have been critical to business forever. During the nineteenth century, pioneering industrialist Andrew Carnegie saw the benefits of combining and controlling an integrated supply chain of coal, railroads, and steel production. Supply chains have evolved dramatically and are now global. They add value, flexibility, and risk to the modern corporation.

In the making of a product, a supply chain is the process that takes raw materials, organizes them and assembles them into a final product that is then packaged and marketed and moved out to the end customer. While it is usually associated with manufacturing, it could be applied to intellectual properties too. For example, you could have people that develop a concept for a customer order system, then software coders that prepare the code to make the system operate, a separate team that prepares the end user interfaces and legal and accounting teams that make sure the information on the system is processed right. Supply chains can get quite complex and the construction and management of efficient supply chains has become its own field of study.

In many cases when an organization is vertically integrated a large portion of a suply chain may be managed within the company. When part or all of a product or service comes from another organization it could be considered outsourcing. Sometimes that outsourcing can be from local third party vendors or it can come from another region or country. When it involves a company using products and services from outside its home country it is often called off-shoring. Off-shoring can be more controversial politically.

Use of outside supply chains, outsourcing and offshoring can allow companies to tap into the most cost effective and efficient methods of production, but require detailed logistics, vigilance, careful design and quality controls. Increasingly there are start-ups, younger companies and innovative incumbents that run a large portion of their company operations using outsourcing. This can allow a business start-up to require less capital, be formed quickly and, if necessary, change strategy rapidly. Even the physical logistics of the supply chain can be outsourced all the way to having the mail delivered in your office. There are consequences to consider for the investor, for example a heavy use of outsourcing can result in a company’s primary value being in the form of intellectual property, rather than more tangible assets.

The evolution and exploitation of the supply chain does not necessarily mean that the supply chain has to go global; but it often does and global value chains have helped to drive global trade. Apple’s innovatively designed products that have impacted music, communications, social inter-action, business, education and language have utilized the global value added supply chain for many years. In a much cited research paper in 2008, Jason Dedrick, and others, analyzed the supply chain for Apple’s iPod and some other computer products. The study tracked a staggering number of countries from which Apple sourced low cost components that included items to run the screens, video, memory, processing and other functions of the iPod93 that were eventually assembled in China.

There have been numerous innovations in logistics that have increased confidence in using complex supply chains. Additionally, the development of the concepts inspired by just in time manufacturing (JIT) have further increased the willingness of companies to utilize outsourcing. Improvements in logistics have tapped into developments in everything from fuel efficiency to better satellite technology. Logistics have benefitted due to better, package tracking, routing, transportation, energy efficiency, computerization of manufacturing specifications, and customer-vendor communication that have allowed supply chains to be more flexible and precise. JIT has shown companies the benefits of running with little to no inventory and the financial benefits of lower working capital needs. This allows companies to be more flexible in their offerings and can allow for more customer specific requests. There are now specialized third party vendors that allow an innovative corporation to outsource almost all of its logistical and production needs and have just the right amount of inventory in place to fill current orders.

Federal Express (FedEx) was a major innovator in the field of logistics. FedEx was founded by Fredrick Smith. As a teenager Mr. Smith became a pilot. While studying economics at Yale he wrote a paper about delivery logistics. However, before he got to see if his theories worked he served two combat tours as a United States marine in the Vietnam War. After he was discharged he raised money and started a delivery company, effectively competing with the United States Postal Service (USPS). According to Mr. Smith, one of the key changes that allowed his company to revolutionize the logistics industry was the government’s deregulation of the air cargo industry. This allowed more flexibility in air routes and for overnight competition with the USPS. Mr. Smith realized that there was greater efficiency in delivering everything to one central hub and routing the packages to their destinations from there. However, it did not stop at the hub and spoke innovations, as he wrote in 2015, “Innovation is the holy grail of both businesses and consumers around the world.”94 His company had the first global tracking network for shipments, the first system for customers to electronically request pickups, the first to use barcodes in ground transportation, and the first to have internet package tracking available for customers. FedEx is now one of the most successful logistics companies in the world. Third party logistics firms like DHL, FedEx, Li & Fung, and United Parcel Service (UPS) can all effectively run all the logistics at a company. These companies operate around the globe. This allows a company to focus management and capital on other parts of the business.

Improved logistics have allowed supply chains to be less dependent on proximity and this has led strategies like JIT to expand and be able to use the best priced and best quality components from around the world. Just in time, manufacturing has also helped to innovate outsourcing supply chain management. The Japanese car company Toyota has been credited with truly exploiting the benefits of JIT. Taiichi Ohno has received much of the credit for championing this strategy. He was born in Manchuria to Japanese parents and moved back to Japan and spent his career at Toyota. He started off working in their textile machinery company and moved to the automotive operation in 1943. He was tasked with making his division more efficient. He constantly studied inventory levels and questioned the existing manufacturing methods. In his efforts to eliminate waste, inventory costs, and space he developed the JIT system. This involved careful tagging of each part used in manufacturing and studying the manufacture and delivery time for each piece of the final product. The system allowed Toyota to wait for a customer order before manufacturing and then once the specs for the order were in it would have all the parts for that order arrive just ahead of when they were needed for manufacturing.95 As the advantages of JIT became apparent, and because of Toyota’s success, the focus on more efficient supply chains increased throughout the business world. Computer driven technologies have allowed for more precise specifications of parts. Better communication, precise computerized manufacturing specifications, package tracking, and labeling of products has made JIT more accessible to a variety of industries. Manufacturing with the use of 3-D cameras should also enhance the ability for JIT to be more widly used.

These developments in logistics and JIT have increased the benefits of outsourcing many of the components in the manufacturing process. Outsourcing has become a modern day version of the classical economist David Ricardo’s theory of comparative advantage. Mr. Ricardo’s famous example was where he suggested that even though both Portugal and England could produce port and good linen cloth, the world would be more efficient, and enjoy port more, if the Portuguese stuck to the port and the English focused on the textiles. A modern analogy is a company that just focused on axles for cars should do a better job making an axle than a car company that made seventy-five different car parts, although the axle company may be more at risk given its high level of specialization. This system allows the central final product company in a supply chain to be more flexible, use less working capital and be able to respond better to demand changes. It should also free management to be more forward looking. A car company’s management might be more willing to look at cutting edge opportunities in something like designing a flying car if they do not have to rationalize how much they had spent on an axle factory or tire inventory. They will not care as much that the axle company spent the money. A move to a flying car will likely hurt the specialized axle company, but may allow the car manufacturer to adjust more quickly to fend off a rival upstart. The supply chain is often thought of in terms of physical products. This is not always the case; there is an increasing use of outsourcing in less physically tangible products and services. This can include everything from research and development to product testing, design, legal work, and coding.

Increased use of supply chains and outsourcing is not without risk. Problems can erupt, such as the delays and electrical problems that occurred in the production of Boeing’s Dreamliner airplane due to the use of subcontractors in the supply chain that were used for many of the components and that did not meet Boeing’s specs. There are also scandals such as with Menu Foods, a pet food company that appeared to have included contaminated wheat in its food from a manufacturing partner in China. Companies like Nike and Apple have also faced scandals over some of their parts suppliers following inhumane employment practices. Interruptions from natural disasters like an earthquake or flood can create significant moral dilemmas for the end customers about switching suppliers when the affected country or region may be in need of revenue. A high use of supply chains also can make a company much more sensitive to transportation costs, rising fuel costs or transportation shortages can suddenly become nightmares to the smooth operation of a business. All these issues present problems involving loss of control for companies that have tapped into outsourcing and need to be factored in to an investment assessment.

The supply chain and outsourcing evolution changes the value and need for inventory and working capital. Also, if specialized suppliers are building cutting edge manufacturing plants with the latest technology it decreases the value of the invested capital that other operators may have in their older plants. Supply chains increase the amount and value of intellectual property, such as manufacturing specifications, supply chain design, and contracts. The value of the intellectual property and the barriers to entry they may present are difficult to truly value in financial statements. The specialized nature of these types of assets may make them more difficult to monetize if the company becomes distressed. This can all change the value of comparing capital expenditures and other business investment over various time periods and may make it more difficult to compare two businesses that compete but have chosen very different business models if one has chosen to vertically integrate and one to outsource.

The use of diverse supply chains and JIT can be a great help to a company’s profitability and flexibility, but it also allows new entrants to come in to a market with less capital. Companies can be more flexible and may have the ability to rapidly change parts, adjust business design, and be more responsive to customer needs. However, the outsourcing company may have less control over its business. On the opposite side of the ledger the companies within the supply chain typically will develop specialization and perhaps a more narrow focus, which may make them more susceptible to revenue disruption.