BRIAN KANTOR: With outsourcing, less can well be more

Much notice is being given to the disruption of supply chains by lockdowns and war in Ukraine. With hindsight, producing more of the essential components in-house or holding larger inventories to avoid relying on just-in -time delivery, would have been a superior, less costly, choice.

But few firms are fully integrated. Steel mills are likely to outsource supplies of coking coal and the gold mines their sources of power for obvious reasons — outsourcing is expected to be cheaper.

A continuous comparison will be made of the expected costs of insourcing or outsourcing all the different operations that lead to the final delivery of any product or service. Such decisions help determine the optimum size and scope of any enterprise. Less can well be more for shareholders.

All firms are defined by some mixture of in-house activity and goods and services contracted for. Even the accounting and human resource function may be outsourced to specialist service providers as easily as the company canteen. Decisions to outsource may hopefully mean a better focus on what are properly understood to be the essential ingredients for any thriving business.

The objective should be to be realistic and prescient about how best to release the key competencies that make the firm competitive and are its essential reason for being. Strategic decisions to insource, making the firm larger and less specialised, or outsource — making it smaller and more specialised — cannot be outsourced.

Technological change alters the optimum size of any firm. That the decision to outsource the IT function to the computer cloud is seen as the right decision now would not have been feasible 20 years ago. Then firms with heavy data collection and processing demands would have had no choice but to invest in mainframes and tinker with legacy systems with large in-house IT departments. That may be difficult for some to abandon.

The operators in the cloud can reduce the danger of excess or deficient computing capacity by attracting a well-diversified customer base. The market share gains of one customer can offset the losses of another competing with it, so adding to the predictability of demand for an outsourced service or component. Such a pooling of business risks can be a great driver of economies of scale and allow the concentrator to offer competitive terms to a more specialised operation.

A similar explanation fits the component manufacturers that supply a variety of competing assemblers of appliances or automobiles whose core capabilities may be in the design and marketing of their badges — not in in-house manufacture. Every entrant into the burgeoning electric vehicle industry is having to answer this important question — how much of our production could or should we outsource?

The answer Tesla provided — producing its own batteries in its own large factories with substantial fixed overhead costs — may no longer best serve the purpose. The enhanced scale of the specialist provider may also facilitate R&D on a scale that any in-house department could not justify and could leave the integrated firm behind in the development of intellectual property, which can be hired on reasonable terms from the inventors.

Firms no longer have to run their own warehousing and distribution systems. The delivery of goods produced is increasingly outsourced to specialist logistic providers that can deliver more cheaply or conveniently to a variety of customers than a firm running its own trucks and warehouses. They can fill the return legs. Sales online to a global market have been made possible not only by the internet but by outsourcing delivery to the specialised courier.

These opportunities to outsource essential inputs in production or service provision are a huge boon to the entrepreneurs whose barrier to entry was traditionally limited access to capital — understandably given their unknown potential. By outsourcing — staying lean and capital light and highly focused — the start-up’s plans to compete become more viable.

Good for them and their customers, and especially good for the economy that hosts them.

• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.