Integrated or best-of-breed outsourcing?
AN ECONOMIC ANALYSIS BY THORSTEN WINKELMANN, PRESIDENT HEALTHCARE
These days, outsourcing (contract) logistics activities is an obvious choice when designing and optimizing supply chains. This is particularly true of companies that are not attached to an existing infrastructure. While in the past it was usually companies based outside of Europe – in particular the US, Japan, and South Korea – today, outsourcing logistics is theoretically and practically a viable option for all companies.
The traditional reasons for outsourcing logistics include realizing scale effects, labor cost benefits, using the service provider’s function-specific expertise and related innovation capacity, and concentrating management activities on core competencies. The first outsourcing wave that began in the early 1990s was driven mainly by labor cost benefits, while the motive behind the second wave was predominantly the desire to take advantage of the service provider’s technical and management expertise. Industry is currently experiencing a third outsourcing wave, and this is all about outsourcing integrated process chains and whole geographic networks to service providers, rather than isolated activities such as warehousing in one country. This raises the question of the economics behind this trend, and why such economics are coming into effect at this point in time.
In 1972, the British economist G. B. Richardson outlined very clearly the criteria by which activities within a company should be carried out or, alternatively, they should be outsourced and then coordinated accordingly via the market or intercompany collaborations*.
[*G. B. Richardson, The Organisation of Industry, in: The Economic Journal, Vol. 82, No. 327 (Sep., 1972), pp. 883-896]
In addition to the affinity of capabilities, which – to simplify – can be compared to similar expertise and in terms of the result with scale effects, i.e. the traditional reasons for outsourcing mentioned above, he also emphasizes the complementarity of activities. A high level of complementarity exists when there are a number of interfaces between two activities, and complex and frequently recurring coordination processes are required or make good commercial sense, or high one- or two-way dependencies exist, in particular as a result of specific investments.
Outsourcing integrated process chains
After that theoretical explanation of the economics, we must now ask what its practical relevance may be for outsourcing logistics. To illustrate this relevance, the first step is to list the activities that can be outsourced, going beyond warehousing as a core activity of distribution contract logistics:
- Warehousing (as a core, and therefore anchor, activity)
- Order and Cash Management
- Field Inventory Management
- Quality Assurance
- Reporting and Business Intelligence
- Manufacturing, Postponement
- Returns and Repair activities
- IT (in accordance with the respective activities)
How the supply chains and their coordination structures actually look is determined to a great extent by the client’s outsourcing decisions. The clients – most of whom are industrial companies, brand companies, and verticalized retailers – usually only perform the above-listed activities to meet their own needs, and can by definition only achieve scaling benefits to a limited degree as a result. As a rule, these companies have no edge in terms of expertise in the respective disciplines, nor can they maintain or develop it.* Outsourcing the individual activities therefore makes sense unless there are significant complementarities and interfaces with other activities within the client company, for example between sales and order management.
If, on the basis of these analyses, a company decides to outsource several of the above-listed activities, they must then choose whether to opt for best-in-breed outsourcing for each individual function and award contracts to the best supplier in each area, or outsource whole integrated process chains to a single service provider, as corresponding complementarities also exist between the individual activities. Customer and article master data is required in almost all activities; orders become consignments, consignments become transports; inventories can be better optimized if all the storage locations including the inventories at the place of consumption are known and this information is integrated into the production management including postponement. The list of examples could be extended, fleshed out and specified in greater detail.
*That, however, does not necessarily apply in cases where the client only outsources peripheral activities and otherwise works inhouse.
The economic advantage of outsourcing integrated process chains to a partner comes from the fact that a suitably set up service provider carries out the relevant activities in a standardized way. Interfaces must be set up only once, costs are reduced.”
Best-in-breed offers the advantage of optimal value for money for the respective outsourced service. However, this approach involves a number of company-wide interfaces, which – depending on the complementarity of the activities – bring about varying levels of additional management complexity and therefore costs. An additional aspect to consider, one that is often even more important, is that the complexity that can thereby arise could lead to frictions, a need for high levels of multilateral coordination, different interests and priorities, unclear responsibilities, and ultimately delayed action and reaction in a competitive environment, and this sometimes gets out of control.
Outsourcing integrated process chains avoids this complexity. The economic advantage of contracting whole process chains comes from the fact that a suitably set up service provider carries out the relevant activities in a standardized way in accordance with the modular principle, and establishes interfaces between these activities once and once only, and can thereby achieve significant economies of scale. Through the standardized modular approach, each client receives a highly individualized service, which in turn improves the cost effectiveness of outsourcing, and thereby encourages the practice of contracting services out. This then leads to even higher economies of scale, from which everyone involved benefits. It may sound paradoxical, but individualization makes the scale effects possible.
When deciding between best-in-breed and integrated outsourcing, the main issue to consider is the relative advantages of optimal individual activities and the additional cost of the company-wide coordination of activities. This clearly means that there is no such thing as an optimal solution that applies to all cases. Rather, the question that must be asked is in which situation each approach would be suitable. Speaking generally, it can be argued that best-in-breed outsourcing tends to be more suited in more static environments in which cost efficiency is normally a decisive competitive factor because over time, the cost of company-wide coordination can be optimized where the requirements are clearly defined and relatively stable. Most importantly, however, intersections between activities can, once established, pay off over a long period of time.
In contrast, outsourcing integrated process chains is better in dynamic markets that are unfamiliar to the client, for example when
- new sales channels are tapped (direct sales, e-commerce),
- new products with their own sales-channel requirements are introduced,
- new geographic markets are opened up (market entry by Asian or American companies in Europe),
- acquired companies are integrated, or
- existing distribution and logistics networks are transformed.
Ultimately, this is about reducing the complexity from the client’s point of view, and this is reflected firstly in speed advantages and secondly in the use of the service provider’s expertise in relevant projects, and the management of a major subproject in the client’s overall project. Against this backdrop, it is clear that outsourcing integrated process chains is currently gaining in importance for the pharmaceutical and medical technology sector, for example. New, personalized (in the broadest sense) medicine, direct sales, and the regionalization of logistics structures in Europe moving away from national logistics solutions are all important keywords in the field.
Outsourcing whole regional networks to a strategic partner
Alongside the issue of outsourcing integrated process chains, another dimension involving a similar question reveals itself through the regionalization of logistics structures: Is it better to opt for a best-in-breed service provider in every country or to award the contract for a whole region such as Europe to one strategic partner? In essence, when it comes to the regionalization of logistics structures it is a matter of optimizing the supply chain and associated inventories, availability, and costs for the whole region, rather than by each individual country. This can result in relying solely on central warehouses, on hub & spoke centers, or on several fully integrated warehouses in the region. Central warehousing concepts in particular can be effectively combined with field inventory management concepts such as consignment stocks and forward stocking locations in order to combine inventories in their entirety with the highest possible levels of product availability.
In cases where there are several warehouses in the region and possibly also field inventory management concepts, a key factor in the decision regarding whether to use a local best-in-breed provider or to outsource the whole network to one strategic partner is the potential economies of scale that can be achieved in functions that extend across national borders and company locations. Specifically, this involves IT, the management of the customer-supplier relationship in particular also with regard to the regular performance-indicator-based management of the business (reporting), and quality management in the healthcare sector. However, it is not all about cost degression in these functions, but also transparency, for example in inventories and sales figures by sales channel, as well as about speed, reliability, and security (compliance).
As a rule, when outsourcing the whole network to a strategic partner, it is an obvious choice to also outsource the non-warehousing activities for a whole region to one partner. However, if doing so, it is important to bear in mind that when it comes to functions such as order and cash management, local best-in-breed providers may have a better understanding of the national market and business practices than multinational service providers. In addition to designing the supply chain activities – e.g. central vs. local order management – it is then important to consider whether the economies of scale in central functions and other central governance aspects outbalance the best-in-breed advantages offered by local providers. Ultimately, it is also important how quickly a strategic partner can acquire the local expertise and thereby close the gap as far as possible.
Conclusion and future prospects: The role of new technologies
The third outsourcing wave in logistics is currently being driven by new, direct sales channels, innovative and complex products, M&A activity on the client side, intelligent and digitalized systems in logistics and supply chains including the associated investments, and increasingly complex governance and compliance requirements. As part of this trend, increasingly integrated process chains and whole regional networks are outsourced to a strategic partner.
It is not yet possible to say whether and to what extent new technologies such as the cloud computing and services facilitated by it, blockchain, and uberization will affect supply chain and coordination structures in logistics over the long term. On the one hand they make it possible to efficiently handle interfaces, which would speak more in favor of best-in-breed concepts in the long term; on the other hand, however, the technologies must first be introduced and adapted, which in the short and medium term points to a strategic partnership with an integrated service provider who takes over the work.