On outsourcing and vertical integration

There is an interesting pattern happening in the business world at the moment.  It's the outsourcing of everything.  And it's interesting because there are leaders, followers, and my conclusion from watching what's happening is that this outsourcing shift is more than an outsourcing movement, it's actually a shift in intellectual capital from one sector to another.

I'm not sure when this started, but in my mind the current batch of outsourcing picked up steam in the 1990s with IT outsourcing.  As technology was a newer thing to companies they thought it might be easier to hire experts rather than develop their own in-house capabilities.

Of course outsourcing isn't new, companies have always relied on vendors to help them in their business.  Not every company that delivers parts owns a trucking or rail fleet.  Completely vertical integration isn't possible, and isn't necessary, but that's not what I want to talk about.

What's happening is a technical outsourcing on steroids.  Because companies were comfortable outsourcing initial IT support, or systems there has always been a comfort level to other types of technical outsourcing.

Executives have an idea that it's much easier to outsource an accounting system, rather than host their own customized accounting system.  Or to outsource sales verses building an in-house staff.  The rallying cry is "we don't want to be involved in things that aren't our core competency."

Of course that makes sense.  If a business is the best in the world at manufacturing widgets why would they want to get bogged down in the logistics of distributing those widgets to the world?  Or why would they want to waste time hiring people to manage facilities, or run a phone system?  Instead they should focus all of their energy on manufacturing widgets and let others do the rest.

The problem is most companies don't really have a core competency.  If you take a deep dive into a businesses' operations you'll find there really isn't much of a secret sauce.  It's just a group of people working together in a unique way to provide a solution.  And if you begin to abstract the pieces away like lego blocks you start to realize there isn't anything at the center that can't be replicated elsewhere.  The exception to a generalization like this would be companies that own infrastructure, or prized real estate that is truly one of a kind.

What's happened is these outsourced vendors begin to understand their client's business better than themselves.  And the vendor starts to think "why don't we just bolt on a few front office features too?"  Then suddenly the back office vendor becomes a vertically integrated company that is competing with their clients and doing it better than they could do it themselves.

In effect many companies have leadership teams that have bought into this outsourcing mentality so deeply that they're slowly disassembling their own companies and transferring their knowledge and skills to their vendors.  And those vendors are realizing that with their knowledge and expertise that they can replicate what their clients are doing better.

It's fascinating that the competitive advantage Carnegie had with his steel was that he fully integrated operations.  He owned coal mines, owned the path to the coaling and coking plants and eventually steel.  The great innovation was the fully assembly line from coal to steel was physically located in close proximity eliminating the distributed logistics gap that existed at the time.  It was an enormous factory made up of many smaller operations all lining the same river.

The end result of this outsourcing transformation is this "new economy" that we're experiencing.  Old main-line companies are willingly disassembling their businesses and re-incarnating as portions of multiple tech companies.

The implications of this are far ranging and wide, and I'm not sure this process can be stopped.  It's the pattern of the Innovators Dilemma on a much larger macro scale.


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