Off-shoring evolves

When is it best to outsource? How does the strength of your rivals affect your decision? How do you balance the downsides of less product differentiation and increased market competition?

Operations professor Lauren Xiaoyuan Lu grew up in Nanjing, a historic city in China that was home to electronics plants that provided manufacturing services for global corporations.

In completing her doctorate, she delved into the impact of off-shoring in global manufacturing networks and global supply chain management. Most recently, she explores the relatively new practice of design outsourcing in “Design Outsourcing in a Differentiated Product Market: The Role of Bargaining and Scope Economies.”

She and Qi Feng of the University of Texas wrote the paper, which received first prize in the 2009 Junior Faculty Interest Group paper competition from the Institute for Operations Research and the Management Sciences (INFORMS), the world’s largest professional society for professionals in the field of operations research, management science and business analytics.

“Outsourcing nowadays is not limited to manufacturing; it expands to more value-added activities, such as design,” Lu said. “This study is the first step in understanding a new business model and the managerial issues surrounding it.”

Original equipment manufacturers (OEMs) use outsourcing to lower costs. They purchase off-the-shelf products that are fully designed and manufactured by original design manufacturers (ODMs).

For example, Dell or Hewlett-Packard (OEMs) buy laptops supplied by Quanta Computer (an ODM), a company in Taiwan. Quanta designs, develops and manufactures laptops and sells them to Dell or HP, which in turn sell the laptops under their own brand names to consumers.

Quanta supplied 33 percent of the world’s total production of notebook PCs in 2007. By outsourcing to Quanta, Dell and HP do not have to spend money on in-house research and development. Quanta takes on that task and does so efficiently by amortizing the cost over its many OEM clients.

ODMs typically create a separate division for each OEM client. To design and manufacture generic equipment cost effectively, ODMs pool their resources from among the various divisions to reap the benefits of scale and scope economies, which leads to some overlap similarities in the products produced for each OEM. From consumers’ perspective, there isn’t much difference between the products sold by one brand over another. With little to distinguish their products from their competitors’ models, OEMs become increasingly competitive.

“Price premium comes from product differentiation,” Lu said. “When products become more homogeneous, OEMs have little basis to charge more, because a product’s unique features are what consumers will pay more for.”

Concern among OEMs that design outsourcing might dilute product differentiation and intensify market competition raises an interesting managerial question: Would OEMs become reluctant to outsource design because of ODMs’ resource pooling practices?

Lu wanted to determine when it was most advantageous to outsource (and lose some product differentiation) as opposed to designing a product in-house (and gain unique features but spend time, money and human capital to do so). Using a design sourcing game, she explored the strength of bargaining power of the OEM in relation to the ODM and the OEM’s rivals when negotiating an outsourcing contract. She analyzed the OEMs’ equilibrium sourcing decisions under various scenarios.

Her research showed that an OEM is more likely to outsource design when the OEM’s rival had strong bargaining power compared to the ODM. Lu calls it the subtle effect of bargaining.

By providing the design as well as the manufacturing service, the ODM climbs the value chain. It can charge more per unit because it holds the intellectual property and offers more than a supplier responsible only for manufacturing. And it gains some bargaining power vis-à-vis the OEM.

Ultimately, the bargaining power of OEMs relative to their ODM supplier affects their profit margin, which in turn determines their design outsourcing decision. Outsourcing allows OEMs to keep costs low, and it is most attractive for them to outsource when their profit margin is thin.

When two competing OEMs both have strong bargaining power, both can negotiate a relatively low price from the ODM. But that only drives the intensity of the competition between the rival OEMs, and both sell their product for a low price. It makes sense for OEMs to outsource design in this scenario because the OEMs can save on design costs.

If one OEM has strong bargaining power and its rival does not, the strong OEM could price the weak one out of the market. The weak OEM is driven to outsource to save costs and remain competitive. The strong OEM has the flexibility to keep the design process in-house, thus being able to incorporate some unique features that would allow it to raise the price. If the strong OEM were to outsource in this situation, it would lose some of its bargaining power by shifting the control of the product design and the associated intellectual property to the ODM.

This business model that shifts the control of product design and intellectual property to the suppliers raises an important managerial question: How would design decisions change when product design is outsourced to an ODM?

An OEM might benefit from being weak in bargaining with an ODM. A decrease in an OEM’s bargaining power increases the price charged by an ODM, which in turn softens the price competition between rival OEMs and increases the overall profit of the supply chain. Moreover, as the OEM’s bargaining power decreases, the ODM has an incentive to design more differentiated products. Thus, shifting bargaining power to ODM suppliers can be used by OEMs as a lever to exert some control over the design of an outsourced product.

“Design outsourcing is relatively new in practice and even newer in the academic literature,” Lu said. “We want to do more to understand its strategic implications and managerial issues.”

Key take-aways

• Outsourcing design to ODMs (original design manufacturers) raises concerns among OEMs (original equipment manufacturers) about a decline in product differentiation that would intensify competition.
• When both OEM rivals have strong bargaining power with an ODM, outsourcing is in the best interest of both OEMs. When there is a bargaining-power disparity between OEMs, the weaker rival gains more from outsourcing.
• Shifting bargaining power to ODM suppliers can be used by OEMs as a lever to exert more control over the design of an outsourced product.

Lauren Xiaoyuan Lu is associate professor of operations at UNC Kenan-Flagler.