Outsourcing in the Automotive Industry

Keywords: outsourcing automotive industry, automotive outsourcing

The global automotive industry continues to grow worldwide at about 2.5% annually, driven by increasing car ownership in the developing economies. In the mature economies, including the UK, growth is much lower or even absent (NGAIT, 2008). Because of market proximity and local content restrictions imposed by the Governments of many developing nations who wish to encourage the establishment of local automotive sectors, the vast majority of new manufacturing capacity in the last 6 years to support this growth has been in the BRIC countries and within the EU, in Eastern Europe. Lower labour costs in these developing automotive economies have also stimulated a shift of production eastwards, but this has to date mainly affected the automotive supply base and less so vehicle assembly sites.

The UK automotive industry has transformed itself in the last decade from a sector with turbulent labour relations and a poor reputation for quality and productivity to one that is fully competitive. Independent external reliability surveys put UK built cars at the top of the rankings, and productivity and labour relations are among the best in the world.

Until the impact of the global financial crisis, the industry was profitable and self-sustaining in Europe and in the UK. Technology and modern management practices have transformed the shop floor environment, and product technology embraces lightweight materials, cutting edge design analysis and visualisation tools and the extensive use of integrated electronic systems to extend digital control to most functions of the car. The climate change agenda is accelerating technological change at an unprecedented rate, and the industry in Europe and the UK has embraced the CO2 challenge and is investing heavily in people and technology to provide innovative solutions while continuing to offer exciting, safe and satisfying products that people want to buy. In 2008, 1.65 million vehicles and 3 million engines were built in the UK, by a diverse range of manufacturers in car, commercial vehicle, off-road and premium vehicle sectors. The vehicle production levels (until the present recession began) were relatively stable for some years, but employment has been declining as productivity improved and there has been severe ‘hollowing out’ of the supply chain. This is important because about 75% of the value of material in a new vehicle is added by the supply chain (NGAIT, 2008).

Literature review:

Manufacturing outsourcing continuum:

There is much debate in the management literature on defining outsourcing (Gilley and Rasheed, 2000; Harland et al., 2005). The definitions of outsourcing relevant to supply chain management emerge from these elements:

Outsourcing implies a business relationship between two parties: the outsourcing subject (also called the principal or the client) who makes the decision of whether to outsource or not; and an external outsourcing firm (Arnold, 2000).

The objects of outsourcing are general business processes or processes’ results which might be outsourced (Arnold, 2000; Kimura, 2002). This can include core (e.g. manufacturing, marketing, R&D) as well as support (e.g. maintenance, accounting, IT, logistics) processes (Gilley et al., 2004).

Outsourcing is not simply a purchasing decision. While all firms purchase elements of their operations, outsourcing is less common and represents the fundamental decision to reject the internalization of an activity (Gilley and Rasheed, 2000). Thus, outsourcing occurs in two situations. First, is when the client outsources objects that were originally sourced internally, resulting from a vertical disintegration decision (Gilley and Rasheed, 2000). Second, when the client sources objects that, although they have not been completed in-house in the past, are within the client’s capabilities and hence could have been sourced internally notwithstanding the decision to go outside (Gilley and Rasheed, 2000; Van Mieghem, 1999).

The outsourced objects are specific to the client. That is, the outsourced activities are performed according to a plan, specification, form, or design, of varying detail, provided by the client (Kimura, 2002; Van Mieghem, 1999; Webster et al., 1997). Hence, a firm buying an off-the-shelf, standardized component or a supplier’s proprietary part is not considered outsourcing, because no customization is performed for the buyer.

The client may outsource all or part of a process or process result (Gilley et al., 2004). For example, the outsourcing of manufacturing processes may take the form of a part, component, or a finished product (Harland et al., 2005).

Manufacturing outsourcing:

Throughout the 1990s a remarkable increase of outsourcing activities by firms has been observed. It has been hypothesized that this increase results from the decline in transaction costs in connection with the intensified use of information technology (Abraham and Taylor, 1996). Today, activities that used to be performed in-house (e.g. auditing, maintenance, repair, transportation, janitorial and legal services) are usually outsourced to firms in the business service sector. Consequently, outsourcing has contributed significantly to the growth of business-related services during the last decade (Fixler and Siegel, 1999). Moreover, manufacturing firms are outsourcing not only services but also internal production. One prominent example is the automotive industry, where some large car manufacturers only perform the final assemblage of major parts whose production is outsourced to external suppliers. Since this type of outsourcing quite often occurs at an international level, it is also closely entwined with the globalization process (Feenstra and Hanson, 1996).

Various aspects of the trend to outsource have been discussed in the academic literature. A large literature starting with the seminal paper by Coase (1937) and papers by Grossman and Hart (1986), Bolton and Whinston (1993) and Grossman and Helpman (2002) examines theoretically a firm’s decision of whether to produce in-house or to outsource. At the heart of this literature are issues concerned with transaction costs and, in particular, incomplete contracts leading to either vertical integration or specialisation. Lyons (1995) provides an empirical application to evaluate the importance of transaction costs theory for firms’ outsourcing decisions.

The trade related aspects of outsourcing have also attracted increasing attention in the literature. Trade theoretic models such as Deardorff (2001), Jones and Kierzkowski (2001) and Kohler (2001) examine the effects of trade in “fragmented products” on countries’ patterns of specialisation and resulting implications for factor prices. On the empirical side recent papers by Feenstra and Hanson (1996, 1999) and Gorg et al. (2001) have analysed the effect of international outsourcing (or fragmentation) on relative wages and labour demand using industry level data for the US and UK respectively. In line with traditional HOS trade theory these papers find that international outsourcing (moving low skill intensive production to low skill abundant countries) leads to increased demand and increases in the wage premium for high skilled workers in the US and UK. Egger and Egger (2001) investigate the effect of outsourcing on the productivity of low skilled labour in the EU using industry level data. They find that increases in outsourcing have a negative effect on low skilled labour productivity in the short run, but a positive effect in the long run.

Drivers of manufacturing outsourcing:

There have been several studies that have examined the motivations for and benefits of outsourcing. Abraham and Taylor (1996) identified three reasons for outsourcing:

1. Savings on wage and benefit payments,
2. Transfer of demand uncertainty to the outside contractor
3. Access to specialized skills and inputs that the organization cannot itself possess.

Kakabadse and Kakabadse (2000) report that the main reasons for outsourcing are:

Economic: greater specialization in the provision of services, as outsourcing allows economies of scale and the longevity of demand for the activity;

Quality: access to skills, the competency and focus of potential suppliers and geographical coverage is increased; and

Innovation: improvements in quality through innovation, and the development of new service products, can lead to new demands.

Bendor-Samuel (1998) also asserts that outsourcing provides certain power that is not available within an organization’s internal departments. This power can have many dimensions: economies of scale, process expertise, access to capital, access to expensive technology, etc. The combination of these dimensions creates the cost savings inherent in outsourcing, because the outsourcing supplier (the organization specializing in a particular business function) has the economy of scale, the expertise and the capital investments in leading technology to perform the same tasks more efficiently and effectively than the internal departments of the outsourcing ‘buyer’ .

Another possible benefit is that outsourcing provides companies with greater capacity for flexibility, especially in the purchase of rapidly developing new technologies, fashion goods, or the myriad components of complex systems (Carlson, 1989; Harrison, 1994). Companies can buy technology from a supplier that would be too expensive to replicate internally. A network of suppliers could provide an organization with the ability to adjust the scale and scope of their production capability upward or downward, at a lower cost, in response to changing demand conditions and at a rapid rate. As such, outsourcing claims to provide greater flexibility than the vertically integrated organization (Carlson, 1989; Harrison, 1994; Domberger, 1998). Furthermore, outsourcing can decrease the product/process design cycle time, if the client uses multiple best-in-class suppliers, who work simultaneously on individual components of the process (Quinn and Hilmer, 1994).

Issues in manufacturing outsourcing:

The case against outsourcing is based on arguments such as loss of management control, reduction in flexibility and increased costs. For instance, competitive outsourcing requires a high standard of supplier management to avoid the pitfalls of transferring critical functionality, or becoming too dependent on a supplier for day-today performance of vital business functions. In addition, outsourcing can generate new risks, such as the loss of critical skills, developing the wrong skills, the loss of cross-functional skills, and the loss of control over suppliers (Domberger, 1998; Quinn and Hilmer, 1994). The possible loss of flexibility is connected to the typical long-term contractual relationship that is formed as part of an outsourcing agreement, and that during the contract term, the customer’s business, the available technology, and the competitive and regulatory environment may change dramatically. Thus, this inflexibility is mostly linked to an unyielding and inappropriate contract. Although outsourcing is undertaken by many organizations to control or reduce costs, there is some evidence that it does not decrease costs as expected, and in some cases, costs increase. For instance, when an item is outsourced, the assumption is that the supplier’s costs and required contribution is less and will continue to be less than the cost of internal provision. A survey based on 1000 managers worldwide by the PA Consulting Group (PACG) revealed that only 5% of organizations gained ”high” levels of economic benefit from outsourcing (PA ConsultingGroup (PACG), 1996) and that 39% of organizations admitted ”mediocre” economic benefit. Also, as outsourcing leads to a re-definition of organizational boundaries and, by implication, structural adjustments involving human resources, these changes incur social as well as financial costs. Although the social costs are transitory and can be mitigated by facilitating the adjustments through the re-training and redeployment of staff within the organization, their transfer to the supplier organization and ensuing redundancy payouts can still be considerable (Domberger, 1998; Hall and Domberger, 1995). Also, outsourcing can lead to industrial disputes between employers and employees, which in turn can damage morale, trust and productivity.

Experts maintain that global supply chains are more difficult to manage than domestic supply chains (Dornier et al., 1998; Wood et al., 2002; MacCarthy and Atthirawong, 2003). Substantial geographical distances in these global situations not only increase transportation costs, but complicate decisions because of inventory cost tradeoffs due to increased lead-time in the supply chain. Different local cultures, languages, and practices diminish the effectiveness of business processes such as demand forecasting and material planning. Similarly, infrastructural deficiencies in developing countries in transportation and telecommunications, as well as inadequate worker skills, supplier availability, supplier quality, equipment and technology provide challenges normally not experienced in developed countries. These difficulties inhibit the degree to which a global supply chain provides a competitive advantage.

Cost benefits of manufacturing outsourcing:

In the absence of transaction costs, a firm will decide to outsource when the market price for an outsourced activity is lower than internal marginal cost for that activity (Fixler and Siegel, 1999). It is an unresolved empirical issue whether outsourcing actually has a positive influence on a firm’s performance as is expected a priori. Some case studies have reported that firms tend to underestimate the transaction costs associated with outsourcing. For instance, it has been documented that some firm have again ‘in-sourced’ activities that were previously performed by external firms, because they were dissatisfied with the quality or because they have underestimated the amount of asset specific investments (Benson, 1999; Gornig and Ring, 2000; Young and Macneil, 2000). A few studies have analysed the impact of outsourcing on firm efficiency (Heshmati, 2002). Although efficiency is certainly an important aspect of firm performance, it neglects the product market performance of firms. For instance, even if efficiency of firms remains unchanged after outsourcing of internal production, higher quality of intermediate inputs might result in higher quality of final products and hence higher sales and higher margins. The lack of empirical studies on the link between outsourcing and firm performance might be also due to a limited availability of suitable micro data for analysing this subject.

Theoretical considerations for manufacturing outsourcing:

In theory, efficient firms will allocate their resources within the value chain to those activities that give them a comparative advantage (Shank and Govindarajan, 1992). Other activities that do not offer such advantages will be outsourced to external suppliers. When firms engage in outsourcing, they assess the productivity of their in-house service functions and decide to outsource if others can provide comparable services cheaper. Basically, when firms outsource activities and functions related to producing their products and services, they move towards a business strategy based on ‘core competencies’, a set of ‘skills and knowledge’ that helps maintain their competitive advantage in serving customers (Porter, 1985; Sharpe, 1997). Thus outsourcing is expected to imply cost savings relative to internal production or internal service functions. This will be the case if outside suppliers benefit from specialized knowledge and/or economies of scale (Heshmati, 2002).

However, recent work by Grossman and Helpman (2002) shows that the choice between continued internal production or an outsourcing decision means taking into consideration more than just production cost differences. According to transaction cost economics, outsourcing is desirable only when transaction costs incurring from asset specificity, incomplete contracting and search efforts are lower than the production cost advantage (Williamson, 1971). In addition, the attractiveness of outsourcing to a certain producer may well depend on how many firms can potentially provide the inputs it needs. As mentioned above, some case studies have also reported that benefits from outsourcing are quite often not derived immediately and that managers tend to overestimate the resulting benefits and underestimate the involved transaction costs (Benson, 1999; Gornig and Ring, 2000; Young and Macneil, 2000).

Earlier works:

Wasner (1999) presents a state-of-the-art view on the outsourcing process by combining a thorough literature review with two independent case studies of the Swedish aircraft industry (Saab AB) and the electronics industry (Ericsson Radio Systems AB and one key supplier Swedform Metall AB). The first case concentrates on outsourcing of aircraft sub-systems and subsequent in-sourcing of related software activities, whereas the second case deals with outsourcing of radio base station production. However, he argues that the process of carrying out the transfer of an activity from being internally controlled to becoming externally managed is equally difficult because of interdependencies at the operational level. The effects of outsourcing are far reaching in terms of physical, temporal and organisational reach. Physically, because there is an inherent complication of losing control as an activity is turned over to an external supplier. Temporally, because it is difficult to estimate how conditions will change over time. Organisationally, because outsourcing involves converting decisions at the strategic level into actions at the operational level and transferring functions from one organisation to another.