Answer 1. Companies outsource production of their products for the following reasons: Lack of technical expertise, or expert labor in certain operations; reduce manufacturing costs due to the availability of cheap labor; make less investments in expensive equipment, staff and IT systems; optimize resource utilization and free up management time from outsourced routine supporting activities to focus on its core competencies; and when domestic manufacturing capacity is reached.
Outsourcing is a good strategy for the following situations: Tasks that require specific manufacturing equipment and technical expertise can be outsourced to vendors who specialize in these fields to produce goods faster and of better quality. Outsourcing the supporting processes enables the firm to concentrate on its core business processes. Outsourcing also helps in risk sharing since the outsourced vendor is a specialist who can mitigate risks better. Outsourcing also helps a firm to decrease its operating risk by not completely relying on domestic suppliers; and reduces lead times in case of domestic supply shortage. Sometimes government in the foreign country provides incentives for foreign investment. Companies can sometimes access restricted market to sell their goods only if they purchase certain goods or services from the foreign country. Outsourcing helps a firm to increase its ability to operate 24 hours per day. A firm that sources from abroad may be able to exploit local competitive advantages such as cheap labor, skilled personnel, and technical experts. Outsourcing also enables firms to tap in to a knowledge base for better innovation. Outsourcing enables companies to generate better revenue recognition and provides them an added competitive differentiator.
Outsourcing is not a good strategy in the following situations: The risk to expose confidential data is high such as outsourcing HR, payroll and recruitment services. Risk of exposing intellectual property increases which can lead to illegal copying, trademark or patent infringement and production of knock-offs if the barriers of entry are low. Outsourcing firms sometimes lose control of the business processes outsourced. Loss of quality control increases returns of goods. The outsourced vendor can provide sluggish response times coupled with slow issue resolutions. The lead time can be longer and more variable. Outsourcing can lead to problems such as stretched delivery time frames, greater transit times, poor quality of goods, inappropriate categorization of responsibilities, non-receipt of goods, and outsourced vendor’s lack of focus on the outsourcing firm’s customers. The logistics infrastructure in the foreign country can be poor. International transportation is more complicated than domestic ones and involves many intermediaries like banks, insurance companies, freight forwarders, governments of both the countries. Packing should also be excellent as the risk of damage is greater in international transportation. There can be issues pertaining to lingual accent variation and cultural diversity. Although outsourcing most of the times is cost-effective at times the hidden costs involved in signing a contract across international boundaries may pose a serious threat. Hidden costs include unstable currency rate fluctuation, custom clearance, unstable political and economic condition, and social and labor issues. The risk of outsourcing increases when the outsourced vendor sub-contracts some of the outsourced activities and manages the sub-contracted work poorly. Outsourcing abroad can increase unemployment in home country and reduce customer buying power and also result in bad reputation for the outsourcing firm. Thus, a firm should outsource only if the returns outweigh the risks.
Answer 2. In 2004, a major internal crisis drew Lego near bankruptcy and Lego made net losses of DKK888million and DKK1.8 million in 2003 and 2004 respectively. Sales had plummeted by 30 to 40%. The main reason for these losses was Lego had lost confidence and focus on its core product “Lego brick” and Lego diversified its portfolio by entering new areas of business such as clothing, theme parks, television and computer games. This portfolio diversification further complicated the already complex business operations and caused Lego to lose focus on its core competencies. New products were delivering less profit and added more complexity to the supply chain as each new product required a range of unique bricks. Lego sets had grown much more elaborate and complex. Although such intricacy and attention to detail reflected the firm’s culture of craftsmanship, it also reflected its disregard for the costs of innovation. The carefree creativity and attitude of the company designers to design new toys without factoring in the price of materials or the costs of production was not sustainable in the current global toy market, where cost pressures were a constant concern. Furthermore, the Lego Group did not align its supply chain with the strategy of introducing new products. Only 30 products generated 80 percent of sales, while a significant number of the stock keeping units (SKUs) were items that Lego no longer needed for its manufacturing process and the number of SKUs increased every year which increased the inventory costs. The inventory piling was also the result of significant forecast errors, seasonal demand fluctuations and customers’ expectation of short delivery time. The increased number of Lego components also required greater investment in molds and molding equipment. The Lego Group had an astounding number of suppliers; more than 11,000 in all and the number of suppliers increased over the years, as product developers sought new materials and procurement staff did not follow standard procurement compliance procedures. Ordering so many specialized products at irregular intervals from a large number of vendors reduced the bargaining power of LEGO and LEGO could not leverage the company’s scale in dealing with suppliers. The production facilities were located in high-cost countries such as Denmark, Switzerland, and the United States which put the firm at a cost disadvantage. The Lego Group’s supply chain was flexible and customized even to meet the needs of its smallest retailers. Without clearly defined service policies, the company spent a disproportionate amount of time and effort serving small retailers, which drove up the costs of distribution, increased demand forecast unpredictability and increased the complexity of the supply chain. The unfavorable change in the currency exchange rate of key markets made things worse.
Outsourcing would not increase profitability as Lego had a very complicated supply chain and outsourcing would not reduce but increase the complexity of Lego production and organization. Outsourcing would make it difficult for Lego group to control the outsourced vendor’s global and complex production facilities. Lego group lacked documentation of production processes and structures which made production knowledge transfer between the outsourced vendor and Lego at a quicker pace difficult. Lego group also lacked standardization of mindsets, operations, planning processes and production that could help in reducing complexity in Lego sets; improve demand forecast accuracy; and result in a smooth and flexible supply chain. It was difficult for Lego to find a partner who could provide flexible and market responsive business solutions. Lego management also had little prior experience on outsourcing. Lego Group needed to analyze and look closely at its supply chain and production processes; try to glue all its operations workflow together; and optimize every cost driver to provide just-in-time delivery to the retailers. Any outsourced vendor would not be able to help Lego group understand its own business processes. Lego was expecting the outsourced vendors to know more about its operations than itself. Moreover, building bricks was Lego group’s core competency and outsourcing this core competency was not a good idea. Outsourcing isn’t always the best solution for cutting costs and reducing complexities, it can complicate matters instead of simplifying them.
Answer 3. Lego should have taken time to understand its own processes and structures and optimized them before its partnership with Flextronics. It took a long time for Lego group to realize that its misaligned and antique supply chain was the real source of problem. Many years before its partnership with Flextronics, Lego group should have taken a war-room approach and introduced Sales and Operation Planning (S&OP) process to monitor and coordinate sales, production and product development areas. S&OP process would have helped Lego group glue all operations work-flows together, create transparency, increase supply chain efficiencies, help in resolving issues, reduce redundancies and cost, and help in understanding its own business processes. This would speed up training Flextronics on Lego’s operations. Documentation of work processes, communication lines and interfaces between production activities is indispensable for the coordination, transparency and control of global operations. It helps in identifying the strength and weakness of the production network and optimizes the production network. If Lego group had the documentation in place before the partnership, it would have been possible to transfer the production knowledge to Flextronics at a rapid pace. Lego group should have taken standardization initiatives many years before the partnership with Flextronics. Standardization of mindsets, operations, planning processes and production would have reduced the complexity in Lego sets; reduced number of new elements needed in Lego sets; improved demand forecast accuracy and resulted in a smooth and flexible supply chain. The demand forecast accuracy would help in aligning with Flextronics’ stable and predictable operations business model. Lego should have developed standard KPIs to compare operations between in-house production facilities and Flextronics’ production facilities. LEGO should have had a monitoring and inspection system that would identify weakness and issues and resolve them as soon as they arise. Lego group’s core competence of building bricks was characterized by worker’s knowledge and highly specialized machines. The bricks were strategic asset and that outsourcing of production of bricks did not constitute the most appropriate setup. The high accuracy rate in building bricks was an important source of competitive advantage and by outsourcing manufacturing of bricks, Lego group lost control over this accuracy rate. LEGO could have taken care of the principal-agent problem by basing Flextronics’ pay-off on LEGO’s profit. LEGO could have an ERP system that would standardize and speed up production process; improve inventory planning; reduce costs; improve global supply chain management; and improve collaboration with Flextronics. LEGO aimed at reducing the in-house production capacity from 95% to 20% and the transition phase of the production from LEGO to Flextronics was characterized by extreme speed. LEGO could have improved its partnership success by outsourcing less production capacity to Flextronics at the beginning. LEGO group could have later increased the outsourced production capacity after monitoring the success of Flextronics in the beginning phase.