Reduce Outsourcing to Address Supply Chain Sustainability

Building sustainability into complex global supply chains is tough. In response, some firms are choosing to bring production in-house instead of outsourcing.

Firms increasingly see practices in their supply chains as part of their sustainability or CSR efforts. They expect suppliers to treat workers fairly and to implement environmental practices. But these goals can be difficult to achieve in the complex world of multi-tiered global supply chains.

As a result, companies committed to sustainability are increasingly shifting away from outsourcing and instead choosing vertical integration. Vertical integration means combining in one company stages of production normally operated by separate companies.

This approach reverses global supply chain strategies. It means bringing operations in-house, and sometimes making the value chain extremely local. Here’s an example:

In 2015, the Swedish furniture giant IKEA purchased a forest in Romania. For the first time IKEA would manage its own forest operations. The company explained that owning and operating forests would help it secure long-term access to sustainably managed wood.

Previously, IKEA had looked to suppliers for sustainable materials. For wood, the company relied on certification (purchasing products approved by the Forest Stewardship Council) and supplier audits.  These strategies hadn’t saved the company from problems with unsustainable timber sourcing, though.

By purchasing the Romanian forest, IKEA gained direct control over at least some of its materials.  The company envisioned a tight value chain, planning to use some of the wood from the forest to locally make furniture for the IKEA store in Bucharest.

My colleagues Rajat Panwar (Appalachian State University) and Jorge Tarzijan (Pontificia Universidad Catolica) and I studied this shift toward vertical integration by looking at a multi-industry dataset of 278 S&P 500 member firms over the 2002-2014 period. We measured firms’ CSR performance by using ESG scores from the Thomson Reuters ASSET4 database and measured vertical integration through the firms’ valued-added to sales ratio.[1]

We found that CSR-focused companies have lower average levels of outsourcing and higher average levels of vertical integration. Once firms move beyond their industry’s average CSR performance, there’s an average 3% increase in their level of vertical integration. For S&P 500 corporations, this commitment can translate into several billion dollars.

Our research design can’t definitively say the direction of the relationship. There might be a virtuous circle, with high CSR performance requiring more vertical integration, which leads to high CSR performance in the future. We believe it’s likely that supply-chain monitoring costs and risks have become so high that companies that care about CSR performance are choosing to increase the proportion of their activities they conduct in-house.

In this rest of this article, we describe the pros and cons of vertical integration and one additional path to better supply chain CSR. Specifically, our research shows that companies with collaborative, trust-based relationships with their suppliers may be able to maintain their global supply chains and still achieve CSR.

Why companies shift to vertical integration

Firms can gain significant economic and competitive advantages from global outsourcing. But as firms’ responsibility toward society and the environment increasingly extend across their supply chain, they face the challenge of implementing sustainable supply-chain CSR.

That’s not easy. Take the 2013 Rana Plaza episode involving the collapse of an eight-story building in Bangladesh’s capital city, killing approximately 1,130 people and injuring thousands more. Global fashion brands such as J.C. Penney and Walmart that outsouced their production there faced reputational harm as they were held responsible for unsafe working conditions.

Most global companies struggle with monitoring these kind of supply chains risks. In a survey of 1700 global firms, only 19% reported confidence in their knowledge of the actions of their supply chain members. Traditional tools like audits are often ineffective, subject to bias and vested interests.

So, a growing number of firms say their commitments to supply-chain CSR have led them to vertically integrate their operations. Examples include:

  • Ferrero, the global confectionery company, in 2014 acquired Turkey’s largest hazelnut exporter Oltan in order to guarantee the quality of an essential raw material in many of its products, such as Nutella. Ferrero executives stated that “this acquisition will foster Ferrero’s corporate social responsibility engagement on sustainable agricultural practices.”

  • Symrise, the fragrance and flavoring manufacturer, vertically integrated its vanilla production in Madagascar in 2019 in order to “to safely source natural high-quality vanilla, providing full traceability of the vanilla beans and their related flavors, (…) and to improve local partner farmers living conditions.”

The vertical integration trend might get an added boost after COVID. As my co-author Rajat Panwar argues in a recent California Management Review article, the pandemic has shown the vulnerability of global supply chains to public health risks, as well as more traditional CSR concerns.

Vertical integration can pose its own challenges

Yet higher levels of vertical integration are not a cure-all for supply-chain CSR challenges. Vertical integration can create its own problems for a firm, because monitoring internal activities can also become a complex and tedious task. Firms might not perform that monitoring due to financial or technical limitations.

For example: companies that shift to vertical integration should be prepared to manage a larger payroll of employees and attend to their training and development needs. Just as suppliers need training in sustainability issues, so do employees.

When bringing supply chain activities in-house, companies also need the technical competence to uphold environmental standards within their operations. Mastering diverse environmental standards and processes can be complicated.

Because of these limitations, even firms with the highest CSR standards will need to outsource some activities. As your company decides what to outsource, prioritize areas where:

  • The difference in costs highly favors the use of external suppliers (e.g., because of required technical capabilities)

  • It’s easier to monitor the suppliers´ CSR engagement than it is to build your firm’s in-house monitoring capacity

  • Monitoring is less essential because either the activity is not core to the firm or the suppliers have a record of CSR engagement.

If your supply chains stays global, build close relationships

For companies that don’t want to increase vertical integration, there may be another path. Our study suggests that firms that are able to foster collaborative, trust-based relationships with their suppliers are less likely to reduce outsourcing. These relationships generally involve setting joint goals, adopting mutually acceptable CSR standards, training their personnel, and developing logistical processes.

Companies that take this approach deepen social relations across the supply chain, promoting information exchange and commitment to mutual problem-solving, and facilitating adaptation for long-term and effective sourcing relationships. Working so closely with suppliers can overcome the challenges of a global supply chain.

Companies must be both vigilant and trusting: strengthening monitoring mechanisms on one hand, and relationships on the other. With this approach, companies may be able to achieve the benefits of global outsourcing while achieving high CSR performance.

These two strategies can achieve improved supply chain CSR

To return to IKEA: In recent years, the company seems to have pursued both vertical integration and close supplier relationships. As of 2020, IKEA owns 613,000 acres of land across Europe and America, pledging to “manage our forests sustainably while at the same time meeting our business objectives.” Meanwhile, the company’s approach with suppliers emphasizes long-term, high-volume relationships; for example, providing suppliers with financing, hands-on training and support from dedicated sustainability teams.

Companies today know that sourcing decisions are not just about economic criteria. Concern about broader societal issues, reflected in CSR performance, also shapes sourcing strategies. We hope that our research helps companies find a ‘win-win’ between their strategic priorities and their societal obligations.

Read the Article

Murcia, M.J., Panwar, R., & Tarzijan, J. 2020. Socially responsible firms outsource less. Business & Society.

[1] A note on methods: We measured vertical integration vs. outsourcing) by using companies’ valued-added to sales ratio. The ratio represents the proportion of value generated by the focal firm relative to total sales value, which is generated by both the focal firm and all of its upstream suppliers.

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Author

  • Maria Jose (Majo) Murcia

     Maria Jose (Majo) Murcia is an Assistant Professor at IAE Business School and Facultad de Ciencias Empresariales, Universidad Austral, Argentina. She is also a Visiting Professor at University of British Columbia, Canada. She majored in Economics at Universidad de Buenos Aires (cum Laude), received an MBA degree from IAE Business School, Austral University (Summa cum Laude), and earned a doctorate from University of British Columbia, Canada. She conducts research in the broad fields of strategy and sustainable business management, which she has published in such journals as Business & Society, Journal of Business Ethics, Management Learning, among others.

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