In the past twenty years, outsourcing has become a necessary part of manufacturing strategies (Chen, Ishikawa & Yu, 2004; Sachs, Yang & Zhang, 2000). For example, in the study of companies in the USA, Ettlie and Sethuraman (2002) found that fifty per cent or more of the value of components and services of durable manufactured products were outsourced to developing countries. Similarly, outsourcing is also one of the major industry trends in Australia (Benson & Littler, 2002). As manufacturing contracting is important in the field of manufacturing strategies, there are major concerns regarding the strategies for decisions between vertical integration and outsourcing, what and where to outsource, with whom to collaborate, how to manage outsourcing operations, and how to solve problems and identify business success factors (Anderson & Parker, 2002; Young, 2000).
2.2.1 Manufacturing structure
In deciding manufacturing strategies that provide optimal performance, there exist available choices of structures of vertical integration, strategic alliances and arms- length. In order to understand the operations of long-term outsourcing contracts and to pursue the subject of this study, this literature review focuses on the outsourcing relationship of strategic alliances.
2.2.2 The disadvantages of vertical integration and the movement to outsourcing
Vertical integration or outsourcing decisions may be influenced by factors such as the capabilities and resources of purchasing companies (for example, companies in Australia), coordination requirements between purchasing and supply companies,
management control, and related risks. Many organisations find that there are increasingly high fixed costs associated with a traditional vertical integration structure in manufacturing (Humphreys, McIvor & Huang, 2002). Vertical integration is less flexible when fixed production lines have to be changed to suit new market conditions, and that this structure detracts from successful competition in the new global environment. Due to fixed production facilities, companies may also lack the ability to utilise new technologies and waste much time on non-core tasks. Organisations in developed countries therefore increasingly shift their manufacturing structures from vertical integration to outsourcing, ranging from components and partial production to finished products or entire production (Baden-Fuller, Targett & Hunt, 2000; Leavy, 2001).
2.2.3 Advantages and disadvantages of outsourcing
Outsourcing as a manufacturing strategy can improve supply chains in ways such as saving on production costs, leaner production lines, and concentration on core activities and competencies. The improved international trade environment provides good opportunities that make offshore outsourcing available to companies in Australia. Many companies have experienced the benefits of outsourcing manufacturing to China (Ettlie & Sethuraman, 2002; Gilley, Greer & Rasheed, 2004). However, although outsourcing provides many advantages, not every product is suited to this solution and there are many risks and problems associated with this practice (Liu & Roos, 2006). For example, when an outsourced product requires highly specific components and technologies, or when the environment in the host country is uncertain, the products are less likely to be outsourced (Ellram et al., 2008). In the case of outsourcing to China, generally labour intensive products are more suitable than products that require high technology and capital (Li et al., 2007). The quality of products and the protection of intellectual property are also major concerns when sending production tasks overseas (Bidanda, Arisoy & Shuman, 2006; Kennedy & Clark, 2006).
Frohlich and Westbrook (2001) further point out that vertical integration and outsourcing, or a combination of these two, has both benefits and risks. Some companies choose vertical integration to retain control and maintain consistency in 2.2.4 Choice of vertical integration or outsourcing
production, and others choose outsourcing mainly to reduce production costs. For example, when the choice is for full vertical integration, owners have high levels of control and information access in operations and logistics management. When the choice is arms-length short-term transactions, there is no common ownership between parties, so that management control and information access between business parties are restricted to operating on trust, business relationships and legally enforceable contracts.
2.2.5 International trade and outsourcing
Comparative advantages of production occur when the manufacturing capability and production efficiency in one country has absolute advantage over another. When each side restructures its production, both sides can achieve net benefits. For example, China has many low-cost and low-skilled labourers, and Australia has technologies and capital, so if Australian companies outsource their labour intensive products and services to China, both sides can benefit (Feenstra & Hanson, 1996; Rexha & Miyamoto, 2000). Lower production costs and product prices in developing countries thus become the main reason for huge increases in offshore outsourcing. With over 3000 Australian companies doing business in China in 2009, the products outsourced to China include many labour intensive products such as TCF, toys, shoes, as well as some high technology products such as traffic control systems and medical devices (Austrade, 2010).
2.2.6 Outsourcing strategies
A common strategy is that in attempting to have the correct outsourcing strategies pertinent to the level of production to outsource, purchasing companies should preferably only outsource peripheral components (Langfield-Smith et al., 2000; Li et al., 2007). In addition, only activities that are not critical to main strategic competencies of company maintenance and growth should be outsourced (Ellram et al., 2008; Gilley et al., 2004). That is, companies in developed countries should mainly focus on outsourcing their non-core, low technology, labour intensive components and products to a developing country such as China (Garner, 2004). Similarly, Gilley et al., (2004) explain that a Transaction Cost Economic perspective suggests that operations that do not belong to firm-specific areas are more likely to be outsourced. A resource-based perspective argues that operations
that are not critical to core competencies of the purchasing companies should be outsourced.
Activities critical to business performance through innovation and rejuvenation policies that are designed to create competitive advantage and future growth need to remain in-house in order to retain high technology, capital intensive and core production. In addition, when assets that are more specific are required to support an activity, the firm is less likely to outsource that activity. For these reasons, many Australian companies choose to avoid core component outsourcing; that is, retaining the core parts of design and production at their own sites rather than sending them to China where the technology is not highly developed enough to cope with quality and innovation requirements, and there is insufficient protection of intellectual property rights (Baden-Fuller et al., 2000).