Outsourcing – A Cautionary Tale

Why is this important? Let me put this in concrete, or simplistic terms, for you. Lets start off with 5 companies that all make widgets. We will call them A, B, C, D, and E. A, B, and C have most of the widget market while D and E are niche players who provide customized widgets.

A decides to outsource their widgets to (using Dilbert’s fictional country) Elbonia. A’s profit margin soars initially and this causes B and C to go seeking an outsourcing partner in Elbonia too, because labor is cheap there. Meanwhile A is having quality control issues and starts losing market share to B and C. This causes A to drop its prices to regain that market share. The price drop puts even more pressure on B and C to also outsource to Elbonia.

However, as part of the deal A made with the Elbonian company we will call Uno, the proprietary knowledge and intellectual property on widgets has been turned over to Uno who is now making and selling widgets for the Elbonian market. Uno continues to use the local market as a test bed to refine its processes to create the cheapest widgets possible.

C is the second to ink a deal with an Elbonian company to make their widgets with Dos. Dos follows suit and starts making and selling widgets in the Elbonian market, competing with Uno. B, who had previously held a large market share in Elbonia, is now really feeling the pinch of outsourcing so they ink a deal with Uno and hand over their intellectual property to Uno as well.

Uno uses the combined IP to create super-widgets and starts crushing Dos in the local market, eventually buying Dos. C has no idea that Dos has been acquired and Uno now combines the IP from C into its super-widgets. Uno is now marketing its super- widgets world wide under the brands of A, B, and C. Uno is declared an Elbonian champion company and gets special treatment from the Elbonian government including reduced taxes, special government controlled labor rates, and exports shipped outside Elbonia not only do not pay export taxes but frequently get subsidies to cover the import duties imposed by any country on Elbonia’s strategic market list.

Now that the market is flooded with cheap super-widgets, almost no one wants to use customized widgets. D and E who were formally making customized widgets have the choice to either outsource or exist the widget market. E refocuses from widgets to whatitzs and watches as its formerly profitable widget division continues to shrink as more and more customers starts switching to Uno’s super widgets.

D decides to outsource to the slightly more expensive Mordor (a nod to Tolkien) and retain its IP. D acquires the widget division of E and combines the two operations to gain some sort of economies of scope and scale. Now, however, D finds itself continually fighting against knock off custom widgets being shipped from a variety of suppliers in Mordor. Many of these are substandard and the packaging directs customer complaints and warranty issues to D’s help line.

D litigates and wins but has difficulty recovering damages or even just the legal fees from the companies in Mordor. D’s brand eventually becomes so diluted by these knock offs that no one wants to buy D’s products. D finally shuts its doors and the Mordor companies continue to flood the market with knock offs of D’s products.

In the meantime, companies A, B, and C are just a former shadow of themselves while Uno is definitely driving production, feature set, and all aspects of the super-widgets. Uno eventually acquires A, B, and C for a fraction of their original value. The Elbonia government is also working to manipulate their currency on the world market to keep Elbonian exports cheap for the list of the targeted markets. The Elbonian government also uses diplomatic processes and trade agreements to keep the flood of cheap Elbonian goods flowing into the targeted countries.

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