Henry Ford, who once said that history is bunk, is himself undergoing an historic debunking. Not Ford the individual, but Ford the apostle of the idea that companies must be vertically integrated to maximize efficiency.
The legendary automaker once made in-house virtually everything that went into the car. In the last few years, U.S. business has been moving in the opposite direction. Companies are scurrying to "disintegrate"-that is, shed their so-called noncore operations. And as they do so, they are poised to release enormous amounts of stock market value-value that a few may be nimble enough to capture for themselves.
It is surprising how much delayering is required to arrive at a company's bedrock competitive raison d'etre. For a shoe company like Nike, it means abandoning nearly all manufacturing. Nike does not itself make a single complete shoe; it basically designs and markets. For a beer company like Boston Brewing (Sam Adams beer), it means not producing a drop of beer. Boston Brewing also confines itself largely to designing and marketing.
For a credit card company like First USA, it means not processing a single transaction. You guessed it-another marketer. And for an auto company like Ford, it means being treasonous to the tenets of the founder: Currently, 87% of the automaker's expense dollar goes to outside suppliers.
What is behind this relentless peeling of the corporate artichoke, popularly known as outsourcing? At bottom, it is the simple fact that different goods and services require different inputs of resources and talent, and the various economic actors inevitably sport different endowments of these required resources and talents. In many cases, these different endowments equate to absolute cost advantages in production; in others, to relative advantages.
From the viewpoint of economic rationality, the distinction is irrelevant. It makes sense for me to outsource those tasks at which I am absolutely worse than others at performing, while retaining those at which I am absolutely better. But the basis for outsourcing also exists if I am twice as good as others at some jobs, but only 1.3 times as good as them at others. Then it pays me to concentrate on the former and buy what I am only 30% better at, provided I can devote the resources freed up by outsourcing to doing more of what I do relatively best.
While never challenged as the basis for wealth maximization in either domestic or international trade, the laws of absolute and relative advantage have frequently been flouted. Corporations have remained scofflaws for one or more of three major reasons: lack of information (outsourcers could not readily identify actual or potential suppliers of needed goods and services); barriers to trade (outsourcers could not count on uninterrupted supplies); and, perhaps most important, an overdeveloped corporate "edifice complex" (CEOs often confused size with strength, and boards of directors nourished this confusion by compensating top executives primarily according to the amount of assets under their direct management).
Fortunately, advances in information technology, the progressive liberalization of trade, and the pressure of increasingly sophisticated investor populations are making it impossible for managers to ignore the value-generating potential of outsourcing.
This value takes two forms: one simple and straightforward and the other less so. In the first instance, a company that outsources to a more efficient supplier quite obviously cuts expenses. For example, when General Motors outsourced its information technology to Electronic Data Systems, it trimmed its information technology costs, which probably contributed a fillip to its stock price.
But the real surge in value came from understanding that what worked at GM would work elsewhere. Possessed of GM's business, EDS acquired the credibility with which to pursue the business of other companies at a time when these were keenly interested in rationalizing their ballooning information technology costs. EDS became so successful at doing this that when it was sold by GM in 1996 it fetched a price of $28 billion, which was about 70% of the entire market value of GM at that time. In other words, GM found a company with the requisite smarts, endowed it with both operational scale and cachet at a critical time, and then harvested a capital gain nearly as great as the value of its bread-and-butter operations.
Although GM was shrewd enough to see EDS' potential and share in it by maintaining an ownership position, other outsourcers have not always been that clever. A few years ago when the credit card companies began outsourcing their processing, a prescient few might have made arrangements, by means of joint venturing with their suppliers, to participate in the growth they were helping to foster. None did. As a result, each card company realized only individual cost savings rather than a portion of the value of those savings being achieved by the industry as a whole.
The same opportunities now exist for vanward companies in a variety of industries, especially other financial services businesses and retailing.
Consider, for example, what might happen if banks outsourced their telephone call services-both inbound and outbound. These burgeoning activities are costly and, on the whole, poorly conducted. The situation cries out for a linkage between a few large banks and some professional telemarketers. The banks have scale but little skill; the telemarketers have skill but little scale. Combine the two and one can trim costs not only for those banks initially involved but for most of the industry. Call it a new form of correspondent banking, one in which large banks through the intermediary of a good telemarketer provide cost savings instead of clearing services for smaller banks and receive dividends instead of balances in compensation.
Once again, there is a premium for agility. Today, bankers are debating the wisdom of outsourcing their call centers, much as, in the '70s, automakers debated the outsourcing of electronic-components production. Tomorrow, there will be no debate on the call center issue in banking, just as there is now no debate on the electronic components question in the auto industry. These outsourcing steps are just too logical. Those bankers who understand history and the fact that their brethren have no real choice will rush to identify and invest in the appropriate telemarketer, thereby snaring a goodly portion of the future industrywide savings.
As similar deals are made in other industries, American business gravitates closer to axiomatic integrity. We are taught in school that the whole is greater than the sum of its parts. But in business the converse has long prevailed, which is why the stock market always seems to punish concentrators and reward de-concentrators.
Barriers to market efficiency have led companies to enter or remain in many businesses in which they did not belong, becoming the corporate analogue of "closed economies." As these barriers fall, companies, like countries, will become more open and hence more profitable. Those who can speed the transition to openness stand to gain hugely.