When outsourcing does not make sense

As engineer who had worked at McDonnell-Douglas, Dr. Hart-Smith saw that extensive outsourcing enabled the company's suppliers to keep all the profits. When he went to work for Boeing, he warned them that when you outsource parts of your product, you also outsource your profits.  [You should read his complete memo, especially his suggestions at the very end. These should be required reading for any executive at any technology company].

There's a parable that illustrates what Boeing was doing: the idea of a man making his living picking pennies in front of a steam roller. Day after day, he collects a tidy amount of change, and thinks that it's the easiest money ever. But strategically, it's stupid, because that steam-roller is going to crush him one of those days. In other words, you need to price in risk, especially long-tailed risk. Boeing could only see the small cost savings they were achieving by outsourcing their parts, but failed to see the risks of technology leaking out, the loss of maintenance income (the highly profitable business of spare parts went to Boeing's suppliers, not Boeing, for example) and of the fact that Boeing couldn't survive without those suppliers: whenever any of the suppliers went bankrupt, Boeing had to bail them out anyway.

Now, Boeing admits that it made a mistake:
"We gave work to people that had never really done this kind of technology before, and then we didn't provide the oversight that was necessary," Jim Albaugh, the company's commercial aviation chief, told business students at Seattle University last month. "In hindsight, we spent a lot more money in trying to recover than we ever would have spent if we tried to keep many of the key technologies closer to Boeing. The pendulum swung too far."
Outsource payroll, maybe. But if you are a technology company, you don't outsource engineering. Hopefully, Boeing has learned its lesson, but probably at the expense of making it possible for a competitor to rise out of those suppliers. But will other companies avoid making that same kind of mistake -- already, you see many Android phones coming out of former outsourcees.

And yet, the parable of the fellow picking pennies in front of a steam roller carries a warning for the way we have organized our economy. If you pay executives according to short-term profitability, they will fall for such strategic blunders all the time -- chances are that by the time the steamroller hits, they'll have collected their millions and retired. Perhaps, the age of the public company is over.  Facebook may have the right idea, remaining in private hands.


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