[MUSIC] We next suggest a framework for making the decision of what relationship to engage in. The starting point, identify the activity and its requirements. Any sourcing strategy, including an outsourcing decision, must first identify the activity or process under consideration, its requirements, and potential qualified suppliers. This necessitates a clear specification of the scope of activities in the value chain, design, production, distribution, service, that is being considered. Clearly defining what we require from the activities is equally important. Requirements take various forms depending on activity under consideration. For example, when an airline analyzes the option of outsourcing its call center, it must consider the quality of the service in terms of time, responsiveness, and the range and depth of questions that can be answered. Step one, is outsourcing feasible? To verify whether outsourcing is even an option, consider the supply market and the political and larger consequences of outsourcing. Outsourcing is only feasible if a financially stable supply base is available, consisting of at least one supplier with the necessary capabilities. This is the case for sure in textile manufacturing. In contrast, when Harley-Davidson considered expanding capacity in 1995, they did not have the option of outsourcing the chrome plating of motorcycle metal parts. There was a lack of suppliers that could chrome at the necessary jewelry, quality and volume. Feasibility should also consider governmental regulations and potential non-market customer responses to outsourcing. For example, Defense Department contractors are under stringent requirements that may not allow outsourcing to foreign companies. >> Step two, is outsourcing necessary? Limited financial and operational means and capabilities may preclude performing the activity in-house and instead necessitate outsourcing. Limited resources are often a binding constraint for small companies. For most startups if actual production is required, the financial means do not allow the company to build its own facility, necessitating using contract manufacturers. Third step, is outsourcing in line with strategic priorities and risks? Competitive strategy clearly defines the so-called core activities, that are critical to the business, that differentiate the company from competitors and that provide a competitive advantage. A company tries to perform its core activities better than rivals do. Core activities are typically performed internally. Non-core activities are all other activities where a firm only wants to be competitive with rivals. Consequently, they are candidates for outsourcing. >> Step four, is outsourcing desirable, given our value proposition? If outsourcing is an option, the next step is to question whether it would be more desirable than insourcing. The answer should consider both qualitative fit with a value proposition, how we prioritize cost, quality time, and variety, and, economic attractiveness. For example, given that design direct timeliness and almost continuous style changes are necessary to execute Zara's value proposition of fashion items, the company can only outsource textile manufacturing to local, well-coordinated suppliers. For reasonably stable items such as T-shirts, however, offshore outsourcing to Asia is in line with a value proposition of both Zara and, say, the Gap. If outsourcing is qualitatively aligned with the priorities, the question is whether its total cost is less than insourcing in the long term. This requires estimating the net present value of total costs. Sometimes insourcing yields a simpler, faster, or more efficient operational flow. Such that even in non-core activity is still better insourced. >> Step five, can we contract and manage suppliers and ongoing risk? If outsourcing has survived the first four tests, the final test is whether we can align incentives in the bilateral relationship. Often, but not always, this involves contracting, and whether we have the capability to manage the relationship over time at a tolerable risk. The ability to specify detailed contracts to outsource an activity greatly depends on the underlying product and process architecture. As the activity becomes more complex and develops more interactions with other activities in the network, it becomes harder to detail all the contingencies, and the cost of coordination and changes rises. Economists call this incomplete contracting. Products and services that are composed of modules with enumerable and quantifiable interfaces are easier to outsource than those with countless and almost inseparable interactions. The ability to contract and the extent of outsourcing, therefore, is strongly dependent on product and process technology. In the following video, we will turn our attention to an important tool that addresses question four, the total landed cost. [MUSIC]
