Apple, Outsourcing, And Taking Back The Factory Floor

| About: Apple Inc. (AAPL)

In what China-based business sustainability expert Richard Brubaker calls “the best piece to date on just how rotten Apple's (NASDAQ:AAPL) supply chain is,” Charles Duhigg and David Barboza of The New York Times have actually done more than that. They have written a piece that underscores the ethical risks implicit in both outsourcing and offshoring.

Control is the Issue

You could argue that this story and the reception it is getting is a function, in part, of the end of the Steve Jobs Reality Distortion Field, or, as I overheard someone say the other day in reference to Apple, “the King is Dead, the Gloves are Off.” That may be true, in part, but I think that this story is the harbinger of a wider issue plaguing the global manufacturing sector, and the challenges Apple is facing with its suppliers are simply the most visible examples.

The problem goes deeper than the conflict implicit in asking a supplier to give you the best price AND to manage its business in a way that increases its costs. The mater of working conditions is part of a bigger question about the value and importance of control over the means of production. (Don’t worry, I’m not about to go off on a Marxist tangent here. Bear with me.)

I started my career managing the output of 30-odd factories and suppliers in greater China making furniture, jewelry boxes, and small gift items for a medium-sized US importer. I learned a hell of a lot from that job, but the lesson that has stuck with me throughout my career is that you cannot change what you cannot control. We like to think that a customer like Apple would, by virtue of the size of its business, be able to strong arm its suppliers into complying with its codes of behavior, or even “incentivize” a supplier to go along by raising prices.

In reality, it is nowhere near that easy. Any customer, even one the size of Apple, exerts influence over how a supplier is run, but not control. A customer can exact some concessions from a supplier on factors outside of product features and quality, but at some point, any self-respecting factory owner is going to push back and say “you may buy from me, you may be my biggest customer, but you don’t own me. I’ll give in to you on some things, but beyond that, you need to let me run my own business.”

Outsourcing and Reputation

As long as governments, NGOs, unions, activist shareholders, and bloggers aren’t looking over the customer’s shoulder, as long as the supplier is compelled to operate according to strict occupational health and safety regulations, or as long as the customer’s customers don’t care, that is an acceptable arrangement. But if the supplier operates in an environment that rewards risking health and safety, has the world watching them online, or has an activist bunch of end-users, the risks of outsourcing grows until it lands the customer and supplier in the hot water that Foxconn and Apple find themselves in today.

Barring an incident that disrupts production, the costs to Apple of its supply chain problems are in goodwill and reputation. Apple, arguably, has amassed enough goodwill and reputation to be able to afford to pay such costs for a while at least. The rest of us must live in a world where we must guard our goodwill and reputation as the corporate crown jewels, spending both with care and amassing more if possible. Indeed, if we replace “Apple” in the NYT story with Nokia, Dell, or Samsung, the report would have very real and unpleasant ramifications for any of those companies.

Apple notwithstanding, we are leaving the age when spin, messaging, great products, and generous corporate philanthropy are enough to pave over corporate practices that governments, shareholders, and consumers find objectionable. We are entering an age where the Spin Gap, the difference between a company’s reputation and the reality of its behavior, is closing, and approaching a time when behavior and reputation are essentially the same thing.

Beyond Goodwill

I tend to harp on reputation and goodwill first because these assets, always important, have become both more important and more fleeting when bad news travels at the speed of Twitter. But the problems with outsourcing and the loss of control over production goes beyond the risk to reputation posed by supplier misbehavior.

We in the west have forgotten that much of the value of our companies create happens in production. The stock market rewards companies for outsourcing their production because of a short-term focus on cost savings and on superficial measures like return on capital. But investors ignore – because they cannot see or measure – the implicit value of keeping production in house.

But, as The Economist pointed out in a superb editorial comparing the fortunes of bankrupt Kodak (EKDKQ.PK) with those of prospering Fujifilm (OTCPK:FUJIY):

It is easy to think that companies can compete by outsourcing production and focus on developing and marketing. But many innovations bubble up from the factory floor. Even Apple, a master in outsourcing and orchestrating manufacturing, has in-house expertise and occasionally acquires certain technologies. Today, as debates rage in America over the degree to which returns on capital exceed those from actual business operations, and the relative merits of employment in manufacturing versus the services sector, the history of Kodak is more relevant than ever.

The point about innovations on the factory floor deserves some amplification. Apart from the product innovations that come from the factory floor, innovations in the production process itself can become a huge source of competitive advantage. Ford, Toyota, Hewlett-Packard, and Dell are just four companies that built their success to a great degree on innovations in the production processes.

Owning production is a hard sell to a lot of American business, not just because of Wall Street’s expectations, but because so few young Americans learn production or operations management anymore, preferring courses in finance and marketing in the hopes of getting a job in an office. That does not take away from The Economist’s point. You start outsourcing, and not only do you lose control, you mortgage your future for near-term returns.

There is no shortage of companies who, consciously or otherwise, defend their future by hanging onto their factories. Two examples off the top of my head are Boeing (NYSE:BA) and Intel (NASDAQ:INTC). Boeing got so good at manufacturing that it was able to cut an entire time-consuming step – full-size mockups – out of the development process, going straight from computer model to production on the 777 jetliner. When the company tried to go the “design and market” route with the new 787 dreamliner, they got hit with a three-year delay on their critical 787 program and, until they took back production from several contractors, they were on the verge of sacrificing expertise in a critical new skill area: manufacturing all-composite aircraft components.

Intel has always been a leader in manufacturing processes, being first in the industry to try new, expensive, and often risky technologies, working out the kinks, and sustaining leadership as a result of that expertise. Even today, Intel outsources little: the company continues to build, own, and operate manufacturing incredibly expensive manufacturing facilities – from chip fabricators to pack-and-test assembly lines – because the company understands that there is more to their business than design and marketing.

And the idea of outsourcing would be anathema to Mercedes-Benz, Fender Guitars, Microsoft (NASDAQ:MSFT), or most companies in the service industries. In all of those cases, keeping the production close is either an important part of the value delivered or the very source of company’s differentiation.

The Vote of History

Outsourcing has saved its share of companies and returned its share of profits. But the persistent challenges encountered in its execution by one of the smartest and healthiest companies in the world is a warning: short-term expedients do not create long-term winners. Those of us who love Apple and the products it makes and who understand the nature of its relationship with its suppliers (and their own ambitions) make us worry that the company is forgetting a key source of its uniqueness.

The upshot of the above is simple: two years from now even Apple could find its reputation savaged by the perfect storm of one bad product, one down quarter, and a mishap caused by a factory it did not control; or fifteen years from now it could follow Bethlehem Steel, General Motors, and Kodak into the ignominy of Chapter 11. Either would be the ultimate result of depending on somebody else’s factory for the production of Apple devices.

What is true for Apple applies doubly for the rest of us. The factory floor matters. It’s time to take it back.

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