Could that most ephemeral of all industries, Hollywood’s film-making business, hold messages about scope and structure for even the most sober of operations? It is an industry whose complexity most of us do not fully appre- ciate. In American writer F. Scott Fitzgerald’s unfinished novel The Last Tycoon, the narrator of the story, Cecelia Brady, said, ‘You can take Hollywood for granted like I did, or you can dismiss it with the contempt we reserve for what we don’t understand . . . not half a dozen men have ever been able to keep the whole equation of [making] pictures in their heads’.2 The ‘equation’ involves balancing the artistic crea- tivity and fashion awareness necessary to create a market for its products, with the efficiency and tight operations practices that get films made and distributed on time. But although the form of the equation remains the same, the way its elements relate to each other has changed pro- foundly. The typical Hollywood studio once did everything itself. It employed everyone from the carpenters, who
made the stage, through to the film stars. The film star Cary Grant (one of the biggest in his day) was as much of an employee as the chauffeur who drove him to the
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Why is it important to consider the whole supply network?
What is undeniable is that supply network issues, and the operations’ positions in them, have a significant effect on their strategic performance. In addition, there are other reasons why it is important to stand back and look at the whole (or a large part) of a supply network rather than an individual operation.
It helps an understanding of competitiveness
Immediate customers and immediate suppliers, quite understandably, are the main concern for companies. Yet sometimes they need to look beyond these immediate contacts to understand why customers and suppliers act as they do. Any operation has only two options if it wants to understand its ultimate customers’ needs. It can rely on all the intermediate customers and customers’ customers, and so on, that separate it from its end customers, or it can take respon- sibility for looking beyond its immediate customers and suppliers itself. Simply relying only on one’s immediate network is arguably putting too much faith in someone else’s judgement of things that are central to an organisation’s own competitive health.
It helps identify significant links in the network
Not everyone in a supply network has the same degree of influence over the performance of the network as a whole. Some operations contribute more to the performance objectives that are valued by end customers. So an analysis of networks needs an understanding of the downstream and the upstream operations that contribute most to end-customer service.
For example, the important end customers for domestic plumbing parts and appliances are the installers and service companies that deal directly with consumers. They are supplied by
‘stock holders’ who must have all parts in stock and deliver them fast. Suppliers of parts to the stock holders can best contribute to their end customers’ competitiveness partly by offering a short delivery lead time but mainly through dependable delivery. The key players in this example are the stock holders. The best way of winning end-customer business in this case is to give the stock holder prompt delivery, which helps keep costs down while providing high availa- bility of parts.
It helps focus on long-term issues
There are times when circumstances render parts of a supply network weaker than its adjacent links. High-street music stores, for example, have been largely displaced by music streaming and downloading services. A long-term supply network view would involve examining tech- nology and market changes constantly to see how each operation in the supply network might be affected.
OPERATIONS PRINCIPLE A supply network perspective helps to make sense of competitive, relationship and longer-term operations issues.
studio, though his contract was probably more restrictive.
The finished products were rolls of film that had to be mass produced and physically distributed to the cinemas of the world. No longer. Studios now deal almost exclusively in ideas. They buy and sell concepts, they arrange finance, they cut marketing deals and, above all, they manage the
virtual network of creative and not-so-creative talent that goes into a film’s production. The ability to put together teams of self-employed film stars and the small technical specialist operations that provide technical support has become a key skill. It is a world that is less easy for the studios, and even streaming services, to control.
4.1 Diagnostic question: Does the operation understand its place in its supply network? ■ 123
Scope and structure
The scope and structure of an operation’s supply network are strongly related (which is why we treat them together). For example, suppose that a company that runs a shopping mall is dissat- isfied with the service it is receiving from its supplier of security services. Also suppose that it is considering three alternatives. Option 1 is to switch suppliers and award the security contract to a different security services supplier. Option 2 is to accept an offer from the company that supplies cleaning services to supply both security and cleaning services. Option 3 is to take over responsibility for security itself, hiring its own security staff who would be put on the mall’s payroll. These options are illustrated in Figure 4.3. The first of these options changes neither the structure nor the scope of this part of the supply network. The shopping mall still has three suppliers and is doing exactly what it did before. All that has changed is that security services are now being provided by another (hopefully better) supplier. However, option 2 changes the structure of the supply network (the mall now has only two suppliers, the combined cleaning and security supplier, and the maintenance supplier), but not the scope of what the mall does (it does exactly what it did before). Option 3 changes both the structure of the network (again, the mall has only two suppliers; cleaning and maintenance services) and the scope of what the mall does (it now also takes on responsibility for security itself).
A further point to make is that both scope and structure decisions actually comprise a num- ber of other ‘constituent’ decisions.
The scope of an operation’s activities within the network is determined by two decisions:
1. The extent and nature of the operation’s vertical integration.
2. The nature and degree of outsourcing it engages in.
The structure of an operation’s supply network is determined by three sets of decisions:
1. How the network should be configured.
2. The long-term capacity decision – what physical capacity each part of the network should have.
3. The location decision – where each part of the network should be located.
Note, however, that all of these decisions rely on forecasts of future demand, which the supplement to this chapter explores in more detail.
Shopping mall Security
services Security services Cleaning services Maintenance
services
Security services Cleaning
services Shopping
mall Maintenance
services
Security services Cleaning
services Shopping
mall Maintenance
services
Structure – same as before Scope – same as before
Structure – changed
Scope – same as before Structure – changed Scope – changed Option 1
Replace the security services supplier
Option 2 Accept offer from cleaning services supplier to provide
security services also
Option 3 Mall to take on responsibility for providing
its own security services
Figure 4.3 Three options for a shopping mall’s supply network
Source: From Slack, N. Operations Management, 8e, © 2016 Pearson Education Limited, UK.
4.2 Diagnostic question: How vertically integrated should the operation’s network be?
The scope of an operation’s supply network determines to what extent an operation does things itself and the extent to which it will rely on other operations to do things for it. This is often referred to as ‘vertical integration’ when it is ownership of whole operations that are being decided, or ‘outsourcing’ when individual activities are being considered. We will look at the ‘outsourcing’ decision in the next section. Vertical integration is the extent to which an organisation owns the network of which it is a part. It usually involves an organisation assessing the wisdom of acquiring suppliers or customers. And different companies, even in the same industry, can make very different decisions over how much and where in the network they want to be. Figure 4.4 illustrates the (simplified) supply network for the wind turbine power generation industry. Original equipment manufacturers (OEMs) assemble the wind turbine nacelles (the nacelle houses the generator and gearbox). Towers and blades are often built to the OEM’s specifications, either in-house or by outside suppliers. Installing wind turbines involves assembling the nacelle, tower and blades on site, erecting the tower and connecting to the electricity network. The extent of vertical integration varies by company and compo- nent. The three companies illustrated in Figure 4.4 have all chosen different vertical integration strategies. Company A is primarily a nacelle designer and manufacturer that also makes the parts. Company B is primarily an installer that also makes the tower and blades (but buys in the nacelle itself). Company C is primarily an operator that generates electricity and also designs and assembles the nacelles as well as installing the whole tower (but it outsources the manu- facture of the nacelle parts, tower and blades).
Design Manufacture nacelle parts
Assemble
nacelle Install Operate
Manufacture tower/blades Company A
Parts of the supply chain owned by each company Design Manufacture
nacelle parts
Assemble
nacelle Install Operate
Manufacture tower/blades Company B
Design Tower
Blades
Nacelle details
Manufacture
nacelle parts Assemble
nacelle Install Operate
Manufacture tower/blades Company C
Figure 4.4 Three companies operating in the wind power generation industry with different vertical integration positions
Source: From Slack, N. Operations Management, 8e, © 2016 Pearson Education Limited, UK.
4.2 Diagnostic question: How vertically integrated should the operation’s network be? ■ 125 Generally, an organisation’s vertical integration strategy can be defined in terms of:
• The direction of any integration – does it expand by buying one of its suppliers (backward or ‘upstream’ vertical integration) or should it expand by buying one of its customers (for- ward or ‘downstream’ vertical integration)? Backward vertical integration, by allowing an organisation to take control of its suppliers, is often used either to gain cost advantages or to prevent competitors gaining control of important suppliers. Forward vertical integration, on the other hand, takes an organisation closer to its markets and allows more freedom for an organisation to make contact directly with its customers, and possibly sell complementary products and services.
• The extent of the process span of integration – some organisations deliberately choose not to integrate far, if at all, from their original part of the network. Alternatively, some organi-
sations choose to become very vertically integrated.
• The balance among the vertically integrated stages – this is not strictly about the ownership of the network. It refers to the amount of capacity at each stage in the network that is devoted to supplying the next stage. So a totally balanced network relationship is one where one stage produces only for the next stage in the network and totally satisfies its requirements.
Advantages and disadvantages of vertical integration
The decision as to whether to vertically integrate in a particular set of circumstances is largely a matter of a business balancing the following advantages and disadvantages as they apply to them.
Perceived advantages of vertical integration
Although extensive vertical integration is no longer as popular as it once was, there are still companies who find it advantageous to own several sequential stages of their supply network.
Indeed, very few companies are anywhere close to ‘virtual’, with no vertical integration of stages whatsoever. What then are the reasons why companies still choose to vertically inte- grate? Most justifications for vertical integration fall under four categories. These are:
1. It secures dependable access to supply or markets – the most fundamental reasons for engaging in some vertical integration are that it can give a more secure supply or bring a business closer to its customers. One reason why the oil companies, who sell gasoline, are also engaged in extracting it is to ensure long-term supply. In some cases, there may not even be sufficient capacity in the supply market to satisfy the company. It therefore has little alternative but to supply itself. Downstream vertical integration can give a firm greater control over its market positioning. For example, Apple has always adopted a supply network model where both its hardware and at least some of its software are ‘designed’ in-house, by Apple.
2. It may reduce costs – the most common argument here is that ‘we can do it cheaper than our supplier’s price’. Such statements are often made by comparing the marginal direct cost incurred by a company in doing something itself against the price it is paying to buy the product or service from a supplier. But costs savings should also take into account start-up and learning costs. A more straightforward case can be made when there are technical advantages of integration. For example, producing aluminium kitchen foil involves rolling it to the required thickness and then ‘slitting’ it into the finished widths. Performing both activ- ities in-house saves the loading and unloading activity and the transportation to another operation. Vertical integration also reduces the ‘transaction costs’ of dealing with suppliers OPERATIONS PRINCIPLE
Vertical integration is the extent to which an organisation owns the network of which it is a part.
It is defined by the direction, extent and balance of integration.
and customers. Transaction costs are expenses, other than price, which are incurred in the process of buying and selling, such as searching for and selecting suppliers, setting up moni- toring arrangements, negotiating contracts and so on. If transaction costs can be lowered to the point where the purchase price plus transaction costs is less than the internal cost, there is little justification for the vertical integration of the activity.
3. It may help to improve product or service quality – sometimes vertical integration can be used to secure specialist or technological advantage by preventing product and service knowledge getting into the hands of competitors. The exact specialist advantage may be anything from the ‘secret ingredient’ in fizzy drinks through to a complex technological pro- cess. In either case the argument is the same: ‘this process gives us the key identifying factor for our products and services, so vertical integration therefore is necessary to the survival of product or service uniqueness’.
4. It helps in understanding other activities in the supply network – some companies, even those who are famous for their rejection of traditional vertical integration, do choose to own some parts of the supply network other than what they regard as core. For exam- ple, McDonald’s, the restaurant chain, although largely franchising its retail operations, does own some retail outlets. How else, it argues, could it understand its retail operations so well?
Perceived disadvantages of vertical integration
The arguments against vertical integration tend to cluster around a number of observed disad- vantages for those companies that have practised vertical integration extensively. These are:
1. It creates an internal monopoly – operations, it is argued, will only change when they see a pressing need to do so. Internal supply is less subject to the normal competitive forces that keep operations motivated to improve. If an external supplier serves its customers well, it will make higher profits; if not, it will suffer. Such incentives and sanctions do not apply to the same extent if the supplying operation is part of the same company.
2. You can’t exploit economies of scale – any activity that is vertically integrated within an organisation is probably also carried out elsewhere in the industry. But the effort it puts into the process will be a relatively small part of the sum total of that activity within the industry.
Specialist suppliers who can serve more than one customer are likely to have volumes larger than any of their customers could achieve by doing things for themselves. This allows spe- cialist suppliers to reap some of the cost benefits of economies of scale, which can be passed on in terms of lower prices to their customers.
3. It results in loss of flexibility – heavily vertically integrated companies, by definition, do most things themselves. This means that a high proportion of their costs will be fixed costs.
They have, after all, invested heavily in the capacity that allows them to do most things in-house. A high level of fixed costs relative to variable costs means that any reduction in the total volume of activity can easily move the economics of the operation close to, or below, its break-even point.
4. It cuts you off from innovation – vertical integration means investing in the processes and technologies necessary to produce products and services in-house. But, as soon as that investment is made, the company has an inherent interest in maintaining it. Abandoning such investments can be both economically and emotionally difficult. The temptation is always to wait until any new technology is clearly established before admitting that one’s own is obsolete. This may lead to a tendency to lag in the adoption of new technologies and ideas.
4.3 Diagnostic question: How do operations decide what to do in-house and what to outsource? ■ 127
5. It distracts you from core activities (loss of focus) – the final, and arguably most powerful, case against vertical integration concerns any organisation’s ability to be technically com- petent at a very wide range of activities. All companies have things that they need to be good at. And it is far easier to be exceptionally good at something if the company focuses exclusively on it, rather than being distracted by many other things. Vertical integration, by definition, means doing more things, which can distract from the (few) particularly impor- tant things.
4.3 Diagnostic question: How do operations decide what to do in-house and what to outsource?
Theoretically, the ‘vertical integration’ decision and the ‘outsourcing’ decision are almost the same thing. The difference between them is one of scale. Vertical integration is a term that is usually (but not always) applied to whole operations. So, buying a supplier because you want to deny their products to a competitor, or selling the part of your business that services your products to a specialist servicing company that can do the job better, are vertical integration decisions. Outsourcing usually applies to smaller sets of activities that have previously been performed in-house. Deciding to ask a specialist laboratory to perform some quality tests that your own quality control department used to do, or having your call (contact) centre taken over and run by a larger call-centre company, are both outsourcing decisions.
Outsourcing is also known as the ‘do-or-buy’ decision, and has become an important issue for most businesses. This is because, although most companies have always outsourced some of their activities, a larger proportion of direct activities are now bought from suppliers. Also, many indirect and administrative processes are now outsourced. This is often referred to as business process outsourcing (BPO). Financial service companies, in particular, outsource some of their more routine back-office processes. In a similar way, many processes within the human resource function, from simple payroll services through to more complex training and develop- ment processes, are outsourced to specialist companies. The processes may still be physically located where they were before, but the outsourcing service provider manages the staff and technology. The reason for doing this is often primarily to reduce costs. However, there can sometimes also be significant gains in the quality and flexibility of service offered.
Making the outsourcing decision
Outsourcing is rarely a simple decision. Operations in different circumstances with different objectives are likely to make different decisions. Yet the question itself is relatively simple, even if the decision is not: ‘Is it in-house or outsourced supply in a particular set of circumstances that gives the company the appropriate performance objectives that it requires to compete more effectively in its markets?’ For example, if the main performance objectives for an operation are dependable delivery and meeting short-term changes in customers’ delivery requirements, the key question should be: ‘How does in-house or outsourcing give better dependability and delivery flexibility performance?’ This means judging two sets of opposing factors – those that give the potential to improve perfor- mance, and those that work against this potential being realised. Table 4.1 summarises some arguments for in-house supply versus outsourcing in terms of each performance objective.
OPERATIONS PRINCIPLE Assessing the advisability of outsourcing should include how it impacts on relevant performance objectives.