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November 20, 2017
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Manufacturing

The case for front-end vertical integration

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Companies that outsource manufacturing can better control process, product quality, flexibility, and delivery if they have a higher degree of integration with their suppliers. In some cases, it may make sense to bring some manufacturing in-house. A technique called "Krajlic's matrix" facilitates that decision.

Promising delivery to a customer on a certain date is fraught with risks and uncertainty. Because current business practice is to outsource as much as possible, many companies now are outsourcing much of their manufacturing work. In this operating environment, sellers may never see the product at all; they only need to know that it has been shipped to a customer. In short, many brand owners have become contract managers with little hands-on involvement with their products.

For many companies, this approach to manufacturing can be problematic. There is less certainty that a collection of suppliers will be able to provide everything needed, on time and at the quality level required, so that customers' expectations can be met with complete assurance. The reputation of the company whose name appears on a product is on the line and is often at risk.

Article Figures
[Figure 1] Kraljic's supply matrix
[Figure 1] Kraljic's supply matrix Enlarge this image
[Figure 2] Kraljic's supply matrix, 21st century model
[Figure 2] Kraljic's supply matrix, 21st century model Enlarge this image

Rather then rely entirely on suppliers that may not be able to meet those requirements, companies can reduce risk by taking more control of production through "front-end vertical integration." True vertical integration would have all processes performed in-house. While that may not be practical, doing as much work in-house as possible at the "front end"—for example, building as many subassemblies as possible—can strike the right balance between outsourcing and in-house control, thus minimizing supply-related risk. A method known as "Kraljic's matrix" can guide managers in determining whether and which items or components should be manufactured in-house.

Rethinking reasons for outsourcing
At the individual part-number level within a bill of materials (BOM), there have been many good reasons to outsource. These reasons historically have included, but are not limited to, the following:

  • Cost savings
  • Manufacturing is not a core competency
  • Lack of technical skills to develop or make an item
  • Lack of capacity
  • Minimization of inventory
  • Avoidance of risk of technical errors
  • Insufficient staff to process orders

Each of these reasons for outsourcing can often be justified in the myopic view and occasionally in the long-range view. When analyzed in detail, however, many of these once-valid reasons break down in today's business environment.

The cost savings associated with outsourcing overseas (most often to China), while once significant in the short term, is not as great as it once was. Chinese companies' manufacturing successes have created a middle class that now requires higher pay and benefits. Add to that the cost of establishing and managing the contracts with external suppliers, plus the increasing transportation costs and lead times, and the overall cost advantage of outsourced manufacturing has shrunk, or in some cases disappeared.

Core competency issues are strategic decisions. When small volumes of products and components are required, and preparing to manufacture the product in-house would be extremely expensive, it probably does make sense to leave it to the experts. However, if significant volumes would be involved, then it would be worthwhile to at least look at what it would take to do that work in-house.

Lack of technical skills ties in with core competency issues. Whether or not an organization should possess certain skills is a strategic decision. If company leadership decides that those skills are necessary, then they can be developed internally. Indeed, developing manufacturing competency could be just the challenge the bright young engineer with a fresh Master's of Business Administration (MBA) degree needs. And if management is afraid of taking on that risk, then the easy route would be to find someone externally who has the necessary knowledge.

As for lack of capacity, it's easy to say that a production facility can't take on any more work, but often a shop is not actually at maximum capacity. Are there three shifts working, and is all production equipment being used? A "mothballed" production machine may still have value and capacity, which is why it has been kept in storage.

The lean, build-to-order inventory mentality says that the supplier takes on the inventory risk, and that manufacturers should carry little or no inventory. But when a customer order does arrive and there is insufficient stock to fill it, those who go too far in minimizing inventory may end up paying more for the expedited supply of small quantities.

Delegating the technical risk to a supplier appears to absolve the brand owner of responsibility. It gives management someone to blame if a product doesn't live up to the promises made to the customer. But technical risk is part of being creative and standing behind one's product, and the seller should accept that responsibility.

Outsourcing has encouraged companies to keep their staffs lean, but that can be risky. Few companies, for instance, recognize the consequences of failing to have enough staff to enable timely and competent order processing. In addition to poor customer service, these can include the need to assume the risk of late delivery or to expedite shipments. It is clearly worthwhile to locate or train suitable talent to handle this critical function.

Advantages of in-house production
A re-examination of the reasons for outsourcing goes hand-in-hand with careful consideration of the potential benefits of manufacturing in-house. Doing at least some manufacturing work internally has some clear advantages. Those include, but are not limited to, the following:

  • Control of the processes
  • Quality assurance
  • Avoidance of unreliable or unsuitable suppliers
  • Avoidance of shipping and handling costs of large subassemblies
  • Protection of proprietary designs
  • Potential for new business-unit startup

Control of all aspects of the process of creating subassemblies includes all production costs, scheduling, and engineering changes. Being able to "touch" these aspects of production in a matter of seconds and directly engage with them in person provides tremendous power over the operation. The need to navigate bureaucracies, time delays in modifying contracts, and contract-enforcement issues are all significantly reduced when parts of production are in-house.

In-house production assures quality in the manufacturing and assembly processes. Because every assembly can be tested on-site before moving to the next stage of production, quality issues can be addressed immediately and solutions in place in minutes, rather than weeks or months, as is often the case with outside suppliers. Surprise problems in final testing and inspection are minimized or eliminated.

In-house manufacturing eliminates some of the quality issues that have been associated with outsourced manufacturing in recent years. Problems have increased as suppliers have felt the constraints of the economic downturn and have reduced staffing, often to the detriment of their customers. Overseas suppliers have also been affected to varying degrees, which are often unknown until bad product arrives on the receiving dock. Some previously reliable suppliers are taking shortcuts or failing in other ways. And product-safety issues such as contamination and lead paint continue to generate news headlines.

In-house production also minimizes transportation costs. Shipping large subassemblies is much more expensive than shipping the piece parts. As fuel costs have risen, the cost difference has only increased. And with ocean carriers managing their fuel costs by reducing vessel speeds on most trade lanes, product lead times have also increased, often to unacceptable limits.

Companies are better able to protect their intellectual capital if they manufacture products themselves. The easiest way to lose protection for a proprietary design is to outsource its manufacture. Because of the lack of patent-protection practices in many countries where overseas suppliers are located, a prized invention or a product's uniqueness can be lost, or at least diluted. Inferior copies are often produced and sold, which can harm the original developer's sales and reputation.

Building subassemblies in-house not only supports the company's local suppliers, but it may also lead to an opportunity to supply another company in a different business niche. The in-house operation could itself become a supplier for a nearby domestic manufacturer, opening up a new line of business and bringing in additional revenue.

Kraljic's matrix
Once managers have re-examined their companies' historical reasons for outsourcing and considered the potential benefits of manufacturing their own products, the question then becomes: How can they determine whether products should indeed be manufactured in-house, and if so, which ones? A method known as Kraljic's matrix offers an effective guide to making those decisions.

In a 1983 Harvard Business Review article, the consultant Peter Kraljic posited a risk/profit matrix for use by purchasing managers.1 He divided purchased goods into four categories based on their relative risk and profit impact, as shown in simplified form in Figure 1.

High profit/high risk items deserve the most attention because they typically are the most costly, and they would have the greatest impact on profits and the ability to serve customers if there were an interruption in the flow of available supply. These items represent the "performance core" of the item being manufactured and are classified as strategic items. An automobile engine is one example of a product that fits this category.

Low profit/high risk items deserve attention to the extent that they do not have such a strategic impact on the end product, but they do prevent the product from being completed. These items are often custom-made and are readily available if suppliers are given enough advance warning of expected demand. The lack of some of these items would delay production, but by themselves, they add little profitability to the finished item. They are considered bottleneck items. The exhaust system for an automobile would be included in this category.

High profit/low risk items are absolutely necessary to complete a product and ideally are available on short notice from established suppliers. Delivery terms can usually be established on a "call forward" basis from the suppliers, based on projected annual demand. (In a call-forward scenario, the supplier produces and maintains the inventory, and the buyer places orders for delivery in small lots as needed.) They are classified as leverage items. Automobile glass or seats would fit this category.

Low risk/low profit items are necessary to complete a product but are readily available, low-cost, and are not customized for the product. These parts, which usually are acquired in bulk quantities, are classified as non-critical items. Common hardware and welding rods used in automobile production are typical of this category.

Given today's lean inventory and outsourcing practices, all but the non-critical items are subject to some degree of risk of being unavailable when needed. Outsourcing can occur at every level of production, and with each additional level the risk increases.

A 21st-century approach
The uncertainty of today's business environment makes it an appropriate time for companies to embrace the old adage, "If you want it done right, do it yourself." They can do this sensibly by exercising Kraljic's matrix, adapted for 21st-century business conditions, as shown in Figure 2.

Beginning with strategic items, a manufacturer's most trusted partner should be itself. It should acquire the capability to make these items in-house. Buying the supplier would provide immediate capability and permit the supplier to carry on production for other customers while allowing the buyer to reap the benefits of the new addition's success. Or, if the talent is available, the company could create the required capability in-house, tailored to its own needs. This approach, too, often leads to the creation of a new business unit. (For a real-life example, see the sidebar "Allen Organ hits the right notes on production.") Regardless of which path is chosen, the result is control of all aspects of the most critical subassemblies.

Moving next to the bottleneck items, the certain way to ensure available supply is, again, to produce it in-house. Cost control will be the biggest challenge for these items, because they may produce little profit. Acquiring or creating capability is a possibility, but cost-effectiveness will be the immediate concern. Another strategy would be to invest in the supplier, becoming a part owner with a seat on the board of directors, so as to ensure the manufacturer's interests are locked in with the supplier's overall business strategy.

Leverage items must be handled in much the same way as bottleneck items, but because they represent a greater cost and profit exposure than bottleneck items do, the company must have a stronger voice as a board member, and there must be a stronger commitment by the supplier to always make the items available when needed. (For an example of a manufacturer that followed this strategy, see "Neways invests for success.")

Non-critical items are usually classified as "C" items (lowest category of annual cost-volume) by inventory managers. Manufacturing resource planning (MRP) or enterprise resource planning (ERP) information systems can manage these items and warn of supply problems well before they occur. Since these are common, low-cost items that usually are purchased in bulk and typically are available from a variety of sources, it makes sense to establish relationships with more than one supplier. This will allow buyers to always have a "warm base" of several suppliers that are producing those items at moderate rates and are able to respond to surges in demand for these fast movers.

Once all of these actions are under way, it will become apparent that some should apply to more than one class of item. For example, it might be worthwhile to establish a warm base for bottleneck items as well as for non-critical items.

While outsourcing may make economic sense for many companies and allow them to capitalize on their core competencies, vertical integration challenges a manufacturer to create competencies and take control of the firm's future. What this article proposes is that companies take more ownership of front-end processes, a strategy often referred to as "backward vertical integration." I prefer to call it "front-end vertical integration," because controlling more of the processes allows companies to properly prioritize and sequence activities within the assembly processes.

Moving toward front-end integration
A good way to get started on the path to front-end vertical integration is to escalate the approval of an order for an outsourced assembly to a top-level executive, such as the chief operating officer or chief logistics/supply chain officer. That is the level at which the "why?" questions (such as: "Why are we outsourcing this activity?" and "Why are we missing out on the benefits of in-house production?") must be asked. The point is to prompt decision makers to recognize that the conditions that had justified outsourcing in the past have changed dramatically, and that earlier decisions to outsource may have been rendered obsolete by the developments of the past few years.

If the company is to carry out a front-end vertical integration strategy, it will need unwavering support at the highest levels: from the chief executive officer, chief operating officer, chief logistics/supply chain/procurement officer, and chief financial officer. Everyone involved in the decision will have to recognize the strategic importance of innovation. In addition, engineering talent must be available to develop processes and create solutions to problems.

Companies that travel this road will encounter challenges. A big concern will be the shortage of qualified engineers and skilled labor. Working closely with academic institutions and technical schools will enhance the availability of skills needed by local manufacturers. Moreover, companies may need to build their own skill base through structured, in-house training.

The nature of the procurement organization will change, and there will be many more stock-keeping units (SKUs) or part numbers to deal with. However, these items will have a lower monetary value and will require less individual management and attention, since many of them will be the non-critical items that can be handled in a routine manner by the MRP and ERP systems.

Active participation in trade and professional organizations can be very helpful because these groups promote innovation and sharing of ideas for improvements in processes, quality, inventory management, delivery, and many other aspects of the supply chain. In addition, providers of the MRP and ERP systems enable sharing of ideas for improvement and problem-solving methods through their user groups.

If these actions appear aggressive, it is because they are meant to be. Restoring a company's domestic manufacturing capability will not be easy. But analyzing front-end actions and following the scheme laid out here will allow its leadership to set both priorities and order for the most effective actions.

With this front-end approach, a manufacturer makes the most effective use of Kraljic's matrix by redefining it and taking more responsibility for what goes through the company's production facilities. For this to be effective, the manufacturer must control all of the inputs to the processes.

And indeed, more control is within reach, allowing much more positive and precise influence over business developments. The benefits will be better control, service, quality, and flexibility, all achieved while rebuilding domestic manufacturing capacity and creating real jobs in local communities.

Note:
1. Peter Kraljic, "Purchasing must become supply management," Harvard Business Review (September/October 1983) Vol. 61, Issue 5: 109-117.

Robert Bugge is an Instructor in the Marketing and Supply Chain Management Department of the Richard J. Fox School of Business at Temple University.

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