Offshore outsourcing has become an important strategy to lower production costs among Western firms. The importance of outsourcing is manifested by its sheer volume. According to the United Nations 2011 World Investment Report, contract manufacturing and service activities, undertaken mostly in developing countries, generated $1.1–1.3 trillion sales in 2010.
This practice however has some risks. One of those is the phenomenon of value chain climbing – suppliers in emerging markets can develop capabilities by supplying, with aspirations to compete with the buyers in the product market. And this competition often occurs in the more lucrative part of the global value chain controlled by the buyer, according to new research by University of Michigan strategy professor Brian Wu and Zhixi Wan, assistant professor at the University of Oregon.
As a result of close interactions with the buyer, the supplier can develop technological and marketing capabilities that are necessary to compete in the product market but are difficult to develop independently. Despite buyers’ efforts to prevent the suppliers’ capability development, outsourcing facilitated the transformation of many suppliers into direct competitors across a variety of industries such as electronics, garments, pharmaceuticals, and IT.
One prominent example of this transformation is HTC of Taiwan. Beginning as a contract cell phone manufacturer in the 1990s, HTC entered the smartphone market with its own brand in 2002, and was once among the top five smartphone brands in the world.
"It's a very dynamic situation, and any reaction to value climbing has to be considered in a full context—in the industry, your situation and the supplier's situation," Wu said. He explains that automatic responses are to either dump the supplier or accommodate by paying more, but that those responses don’t take into account the risks of each action or market conditions.
Their study shows a third way that's often more optimal—building a sort of apprentice-type relationship with a supplier. In that case, the supplier accepts lower margins early in the relationship while being allowed to learn design and marketing know-how.
This gives the buyer time to design the next generation of the product. At that point, both supplier and buyer can decide if it's worth it to continue the relationship.
"Our model shows that it's not a question of whether to dump or accommodate, but when," Wu said. "What are the market conditions, and what is the right time?"
The full picture of risk often isn't considered when reacting to a supplier becoming a competitor. Dumping the supplier means either making the components in-house—politically popular but expensive when done hastily—and finding new suppliers, which is also expensive with an uncertain outcome.
But the future also is uncertain for suppliers who wish to enter the market with their own products. It's a risky move, and more will fail than succeed.
"It's costly to climb up the value chain, and there's no guarantee of a payoff," Wu said. "It's like any other entrepreneurial activity in that most of them will fail. If you can pay them enough, maybe they won't take that risk. But you have to measure that against your own business interests."