Decision Sciences C 2007, The Author Volume 38 Number 1 Journal compilation C 2007, Decision Sciences Institute February 2007 Strategic Outsourcing Decisions for Manufacturers that Produce Partially Substitutable Products in a Quantity-Setting ∗ Duopoly Situation Tiaojun Xiao School of Management Science and Engineering, Nanjing University, Nanjing, Jiangsu 210093, P. R. China, e-mail: [email protected] Yusen Xia† Robinson College of Business, Georgia State University, Atlanta, GA 30303, e-mail: [email protected] G. Peter Zhang Robinson College of Business, Georgia State University, Atlanta, GA 30303, e-mail: [email protected] ABSTRACT This article examines production and outsourcing decisions for two manufacturers that produce partially substitutable products and play a strategic game with quantity com- petition. When both manufacturers outsource key components to the same upstream supplier, their products become more substitutable due to the increased commonality of the products. In addition, outsourcing may create better consumer perception about the product if the manufacturers choose reputable suppliers with better brand or quality. We explicitly model the substitutability change and the brand/quality effect and provide conditions under which the manufacturers should outsource the components to a sup- plier. We present the subgame perfect Nash equilibriums for the situation in which there is only one supplier and the case in which two suppliers compete with each other in the upstream supply chain. Numerical examples are presented to illustrate the findings. Subject Areas: Common Components, Game Theory, Outsourcing Strategy, Product Substitutability, and Supply Chain Management. INTRODUCTION With globalization and competitive pressure on specialization, outsourcing has be- come prevalent in many industries. As one Business Week editorial commented, ∗We would like to thank the referees, the associate editor, and the editor for their many helpful suggestions and insightful comments, which have significantly improved the content and presentation of the article. The first author’s research is supported in part by the NSFC under grant 70301014 and 70671055; and the fund for Study on the Evolution of Complex Economic System at Innovation Center of Economic Transition and Development of Nanjing University of the Ministry of Education, China. †Corresponding author. 81 82 Strategic Outsourcing Decisions for Manufacturers “What were once considered core competencies for high tech and other compa- nies are now becoming inexpensive global commodities. Chip design, mechanical and electrical engineering, testing, software writing, and high-tech manufacturing are heading to India, China, Eastern Europe” (Business Week, 2005, p. 124). For example, in the aerospace industry, Boeing outsources to numerous manufacturers the production of more than 34,000 components to be assembled into its 747 pas- senger aircraft (Shy & Stenbacka, 2003). In the computer industry, manufacturers such as Dell, Hewlett-Packard, Toshiba, and Lenovo purchase almost all of the components for their products from suppliers all over the world. Outsourcing al- lows these companies to focus their resources on the design and marketing of their products. A direct consequence of outsourcing is that products from different compa- nies in the same industry share many common components, making those products less differentiated from the consumer’s perspective. For instance, the desktop com- puters produced by different manufacturers such as Dell and Hewlett-Packard are highly substitutable in the retail market. One of the key components in computers is the central processing unit (CPU), which is supplied predominantly by Intel and AMD. From the consumer’s point of view, computers that share the same brand CPU are more substitutable than those with CPUs made by different manufactur- ers. Generally speaking, common components in competing products affect their substitutability, and the larger the number of key common components there are, the more substitutable the products will become. Outsourcing also has two other notable effects. The first is double marginal- ization, which occurs when upstream suppliers and downstream manufacturers independently engage in noncompetitive pricing, that is, they independently mark up the product’s price above their marginal costs. As a result, manufacturers are sub- ject to less intense price competition (Iyer, 1998), and the supply chain has a lower combined profit than it would if the firms were vertically integrated (Spengler, 1950; Tirole, 1988). Second, outsourcing may increase the consumer’s positive perception about the product if manufacturers choose reputable suppliers with bet- ter brand or quality (Ramdas, Fisher, & Ulrich, 2003). For example, when Apple Computer announced the plan to adopt Intel’s chips, the decision was viewed very positively by the market (Clark, Wingfield, & Bulkeley, 2005). In this article, we study the outsourcing decision of two manufacturers that produce partially substitutable products and play a strategic game with quantity competition. For key components, the manufacturers can either keep the production in house (insourcing) or outsource to suppliers. If they both choose to outsource to the same supplier, the substitutability of the end products increases. We explicitly model the change of the substitutability as well as the brand/quality effect when a core component is outsourced to a supplier. The main conclusion of this article is that the manufacturers should outsource the key components if the change of the substitutability due to outsourcing is relatively small and if the brand-quality effect outweighs the double marginalization effect. Otherwise, they should keep the production in house. In the sections that follow, we review the related literature, describe the basic model, and then investigate the subgame perfect equilibrium for two conditions, (i) only one supplier in the upstream supply chain and (ii) two competing suppliers. Xiao, Xia, and Zhang 83 After providing numerical examples for additional insights, we conclude with a summary and directions for future research. LITERATURE REVIEW This research is closely related to the literature of outsourcing, product common- ality, and channel structure. There are strategic as well as tactical/operational rea- sons for outsourcing. From the strategic point of view, Cachon and Harker (2002) find that firms may be better off outsourcing when the production cost exhibits economies of scale. Shy and Stenbacka (2003) believe that competition in the fi- nal product market affects a firm’s outsourcing decision. They investigate how the degree of competition changes the incentive to outsource key components. Kim (2003) shows how the investment capability of a contract manufacturer affects the outsourcing decision. Gilbert, Xia, and Yu (2006) show that strategic outsourcing can mitigate downstream manufacturers’ overinvestment in the reduction of production costs. Although both our study and Gilbert et al. (2006) consider two manufacturers and one supplier in the base model, there are several key differences. First, while Gilbert et al. (2006) focus on the role of outsourcing in dampening cost-based competi- tion between two competing manufacturers, our focus is on the effect of product substitutability and the supplier’s brand/quality on the manufacturer’s outsourcing decision. Second, Gilbert et al. (2006) assume that the product substitutability is constant and the supplier and manufacturers have the same production cost. In our article, we explicitly consider the change of product substitutability as well as different production costs. Third, our findings complement those of Gilbert et al. (2006). For example, Gilbert et al. (2006) conjecture that the supplier would never want to induce an asymmetric equilibrium. We find, however, that under certain conditions, the supplier can either attract both manufacturers to outsource or sell only to one manufacturer, that is, induce an asymmetric equilibrium. From the tactical or operational point of view, outsourcing plays a role in cost reduction, production smoothing, and leadtime reduction. Van Mieghem (1999) studies a stochastic two-stage game with recourse between a manufacturer and its subcontractor, where both firms invest in production capacities. He characterizes the relationship between outsourcing and pricing flexibility. Kamien and Li (1990) illustrate the production smoothing effect of outsourcing. Yang, Qi, and Xia (2005) study the outsourcing quantity for a multiperiod production and inventory system with Markovian capacity and random demand. Our study is also related to research on component commonality and con- sumer perception. Ramdas et al. (2003) investigate how to select components to manage product portfolios. While their research assumes that sharing of compo- nents does not significantly affect consumers’ perceptions about product differen- tiation, our model specifically considers the impact of outsourcing on consumer perception change. Robertson and Ulrich (1998) discuss the advantage of a plat- form approach for product design and suggest that it is necessary to make a trade- off between distinctiveness and commonality. Desai, Kekre, Radhakrishnan, and Srinivasan (2001) study the consumer perception issue with common components and explore whether to use common components for two products when there are 84 Strategic Outsourcing Decisions for Manufacturers two segments of consumers with different quality