The Dire Consequence Of Outsourcing -- IBM's Fall To Lenovo

Editor's Note: This article is by Shih-Fen S. Chen ([email protected]) -- an International Marketing professor in Brandeis University's International Business School. His study that establishes the role of outsourcing in international technology transfer will appear in the Journal of International Business Studies.

IBM's decision to put its PC business for sale is another sad day for American corporate history. After long ago outsourcing the development and manufacturing of the product it helped create, IBM is not even interested in carrying the personal computer any more. Following the footsteps of RCA, Schwinn, and the like, another iconic U.S. brand is falling into foreign hands.

The buyer of IBM's PC division is its subcontractor Lenovo, China's leading computer maker. In April 2004, a similar deal was cut between RCA and TCL, the largest TV set maker in China, who had been the subcontractor of RCA for years. Is the acquisition of a hollowed-out U.S. business by its foreign subcontractor a coincidence in both cases? If not, something must be terribly wrong with outsourcing.

The opportunity of outsourcing emerges when products developed and consumed in the U.S. can be more cheaply made in a foreign country. Outsourcing, nonetheless, is not the only means to exploit low production costs abroad. To begin with, U.S. firms can invest directly in offshore production and send back the output for sale at home. The main obstacle to direct investment is the difficulties of managing production facilities in foreign lands. To avoid the burden of cross-border operations, U.S. firms can instead license proprietary know-how to foreign manufacturers by collecting a royalty fee to recover their development expenditures. Accordingly, licensing is often used to serve the host market rather than outsource foreign-made products for sale at home.

Outsourcing finds a role to play when investment and licensing have both failed to organize offshore production. In a typical sourcing arrangement called original equipment manufacturing (OEM), U.S. firms can transfer all necessary design and production knowledge to subcontractors and then buy back the output for resale at home. At the first look, OEM is a perfect structure of offshore sourcing. It allows U.S. firms to enjoy low factor prices overseas without the hassles of managing their own production facilities. By taking back the finished products, they can transfer all technologies to subcontractors for free, thus eliminating the contracting problems in licensing. The beauty of outsourcing is that the parties can each perform the function(s) that they are good at - U.S. firms control development and marketing; foreign subcontractors take on manufacturing.

Critics of outsourcing focus mainly on the loss of production jobs to low-wage countries, which is a non-issue in the eyes of free trade advocates. The debate, however, misses a hidden danger in outsourcing, that is, free, complete and thorough flows of technologies to subcontractors. For subcontracting to work U.S. firms must disclose all technical information to foreign manufacturers, as incomplete knowledge transfer will harm the quality of the bought-back products. For the same reason, they must also provide full and continuous technical support to assure that their subcontractors always keep quality above a given level. Unlike the case of licensing, U.S. firms can no longer withhold tacit information from foreign manufacturers to prolong their technological leadership.

Outsourcing, indeed, provides an excellent platform for foreign subcontractors to absorb advanced technologies. After closing its Chicago plant in 1981, Schwinn sent equipment and engineers to Taiwan and thereafter outsourced millions of bicycles from its supplier Giant. Only six years into this alliance, Giant was able to introduce the world's first mass-produced carbon fiber bicycle frame. In 2001, its non-resonance suspension system won the "Bike of the Year" award from the Mountain Biking magazine. Giant now sells such innovative products under its own brand in more than 50 nations, charging a premium over its former technology mentor.

Without attempting to regain technological leadership, U.S. firms further farm out product development to subcontractors, making the bad situation even worse. Through a new sourcing mechanism called original design manufacturing (ODM), Giant develops and assembles bicycles for its western clients without receiving any technical assistance from them. Taiwanese laptop makers such as Asustek, Mitac, and Quanta also provide similar services for Apple, Dell, and HP.

Given the losses of both technology lead and production edge, U.S. firms still can leverage their brand power to rein in subcontractors. But this option is available only to those who enjoy enormous consumer loyalty, such as Apple, Nike, or Levi's. Others lacking a strong brand face harsh competition that sometimes can be shielded only through bankruptcy protection. This was exactly what happened to Schwinn, which pedaled into Chapter 11 twice in 1993 and 2001.

To avoid the unavoidable, RCA and IBM offered to sell their business to subcontractors, trying to squeeze a few more miles from their empty tank. Ironically, the most valuable asset in such hollowed-out companies is their brand name, which foreign acquirers can use to fool those consumers who preach and practice "Buy America" to keep jobs at home.

In the pursuit for quick profits from outsourcing, US firms seem slow to realize that they are losing technologies to subcontractors, and the dissipation of technology edge is accelerating. It took 65 years for RCA to fall into Chinese hands (from its introduction of television in 1939), but IBM needed only 23 years to hollow out its PC business (it made the first PC in 1981).

It is naive to believe that U.S. firms can maintain their global dominance by delegating the dirty work of managing factories to subcontractors. To halt the technology bleeding, they must deploy foot soldiers to set up production around the globe, just like what Japanese and German manufacturers have been doing all along. If the current trend of outsourcing is allowed to go on, the victim list will get even longer. The next one to fall could well be Boeing, Motorola, Oracle, H&R Block, or anyone in our imagination.

Shih-Fen S. Chen ([email protected]) is an International Marketing professor in Brandeis University's International Business School. His study that establishes the role of outsourcing in international technology transfer will appear in the Journal of International Business Studies.