Is Outsourcing Really to Blame for the Dreamliner Fiasco? Our Faculty Discusses
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Jan 23, 2013

Is Outsourcing Really to Blame for the Dreamliner Fiasco? Our Faculty Discusses

By Jessica Love

Last week one overheated; the week before one caught fire. Concerns about the Boeing 787's lithium-ion batteries eventually led safety regulators to ground the entire fleet.

As the days pass, it appears increasingly unlikely that this current round of malfunctions will prove to be mere “teething problems" for the new line of jets. This has prompted a number of analysts to question Boeing’s decision to outsource so many key components. So is outsourcing really responsible for the technical problems now hounding the aircraft? Kellogg faculty members Thomas Hubbard, David Dranove, Craig Garthwaite, Meghan Busse, and Marty Lariviere discuss how Boeing might--or might not--have avoided its current predicament.

Thomas Hubbard

Thomas Hubbard
Thomas Hubbard, Elinor and H. Wendell Hobbs Professor of Management

Boeing’s much-heralded 787 (“the Dreamliner”) has been grounded pending various investigations of technical problems, including electrical fires related to the plane’s lithium batteries.  In contrast to its production of previous planes, Boeing had outsourced a fairly high percentage of this plane’s pieces (instead of producing most of the plane’s subassemblies internally).  This difference is leading some analysts to attribute these problems to the decision to outsource.

Whether to produce an input internally or buy it from another company is a key strategic decision for many companies. Modern strategic thinking that draws from the economics of organization emphasizes the same point made by Mick Jagger and Keith Richards in 1969.

You can’t. Always get. What you wah-hant.

Businessmen have long known this, of course. But the traditional wisdom was that this applied when you subcontract, not when you do it yourself. And this wisdom has strong intellectual roots. The economist Ronald Coase won a Nobel Prize in part for his 1937 analysis of firms’ decisions about whether to produce internally or subcontract. In his analysis, Coase assumed that in internal procurement, production is coordinated “by fiat”--that is, people do what their boss tells them. And so CEOs never suffer from the problem that Mick and Keith identify when their firm produces its own inputs, or at least they never suffer from this problem because incentives fail.

The more modern thinking about procurement emphasizes that this problem appears--albeit in different forms--both when a firm procures internally and when it subcontracts. The problem of getting procurement incentives right does not disappear when you produce internally rather than subcontract; it just changes. Firms struggle to get their subcontractors to produce what they want at low cost; they also struggle to get their own divisions to do so.

This thinking emphasizes that incentives do differ when procurement is internal rather than subcontracted. But there are fundamental reasons for this--for example, one reason is that subcontractors have final say on how their assets are used, but the managers of internal procurement divisions do not. When the procurement is simple--and it is easy to write and enforce an agreement that specifies exactly what the firm wants and when it wants it--this difference is meaningless; the firm will tend to get what it wants when it wants it regardless. But when procurement is more complex--when what the firm wants and when is harder to specify exactly or can change due to unforeseen contingencies, this difference matters.

And this can tend to make subcontracting good on the cost front, but internal procurement better when adaptation (for example, in the form of change orders) to unforeseen circumstances is likely.

So getting back to Boeing. Is there a direct connection between its problems and its decision to subcontract a major share of its production of the Dreamliner?  Maybe.  There are several possibilities. One obvious possibility is that the subcontractors may have produced subassemblies that were of low quality in dimensions that Boeing could not describe in its agreements.  Another is that the subcontractors might have not coordinated the design or function of their subassemblies with other subassemblies well. We will surely learn what the specific failures were as time passes.

But before we attribute these to the decision to subcontract, we have to remember that Mick and Keith’s point bears on internal procurement as well. Why exactly would quality have been higher if Boeing had produced these subassemblies internally? Why exactly would coordination have improved? Automakers struggle with quality and coordination problems with their internal divisions, and it is reasonable to think that Boeing would have too. It is certainly possible that the Dreamliner’s current problems are derived from its design--it relies far more on electrical systems than Boeing’s previous planes--and that these problems would have been just as significant (and worse on the cost front) had Boeing sourced more subassemblies internally.

Managers--including many CEOs--grapple with very subtle problems when making procurement decisions for complex inputs. The first thing they often recognize when they do so is the problem that Mick and Keith posed. Success comes when they land where Mick and Keith ultimately did: if you try sometimes, you just might find you get what you need. The roots of this success come in learning about the strengths and weaknesses of internal procurement and subcontracting for key inputs, and modern strategic thinking provides a useful lens for doing so.

David Dranove

David Dranove
David Dranove, Walter J. McNerney Professor of Health Industry Management and Professor of Management & Strategy

The saga of the 787 reminds me of research by our former colleagues Sharon Novak and Scott Stern, who studied the manufacturing at Volvo. They found that the various electronics components could not be developed in isolation, yet such was often the case when parts were outsourced. Simply put, contracts cannot assure that independent trading partners always do what is best for overall production.  Economists call this the coordination problem, and Boeing seems to be suffering from this problem in spades.

Craig Garthwaite

Craig Garthwaite
Craig Garthwaite, Assistant Professor of Management & Strategy

I think that David and Tom have made some really good points already. There are a few things that I would add to Tom’s points about the design of the plane being a potential source of the problem. An important point to realize when we talk about the Dreamliner is that this was not the first time Boeing had a large portion of a plane manufactured by another firm. Boeing has long subcontracted out the production of parts in what they describe as a “build to print” system, i.e. Boeing provides a detailed set of design plans that the subcontracting firm is supposed to follow exactly. With the Dreamliner, Boeing moved to a “build to performance” procurement process where they provide basic guidelines for how the part should operate and then rely on the sub-contractor to design the part. I think this is the strategic decision that exposes them to the coordination problem that David describes.

In reality, the recent problems with the Dreamliner are just a continuation of a long running saga for Boeing, much of which is the result of choosing to outsource the design and the manufacturing of several large subassemblies on this model. This model has suffered at least six different delays in delivery and Boeing has had to offer millions of dollars in concessions to its airline customers. These delays have been directly related to coordinating production amongst their various suppliers, and—with many of their suppliers being unable to meet the technical demands of the new “build to performance” model—have even resulted in Boeing having to acquire some of these suppliers and return to making various parts of the plane internally. (Perhaps this is “what they need,” to use Tom’s parlance).

The response of Boeing to this story is going to be both interesting and informative. One concern that was expressed by Boeing’s machinists union when the firm moved to the “design to performance” model for the Dreamliner was that Boeing would have increased difficulty addressing the problems that would emerge as the models entered service. Specifically, the union was worried about knowledge of the design being owned by suppliers who may or may not be in the business in the future.

Beyond this concern, there is a worry about having to coordinate such a large number of designers from these supplier firms in order to respond to the incident. This is becoming clearer as the complexity of the battery problem grows. While this was a fairly self-serving argument made by the union, that does not mean it is without merit. This will be the first big test of this change in Boeing’s sourcing strategy—how well can the firm react to the various problems that have emerged with the Dreamliner? Will they be able to quickly figure out both what is going wrong and how to fix the problem? While I don’t think that we know whether this event was “caused” by outsourcing, it is clear that the current situation, in terms of Boeing’s ability to respond, is an additional cost of the decision to outsource design in the way that Boeing has, and must be weighed against projected “savings” from this strategic choice.

Meghan Busse

Meghan Busse
Meghan Busse, Associate Professor of Management & Strategy

My colleagues have summarized nicely the trade-offs Boeing made by outsourcing so much of the design of the 787. I want to point out another aspect of the 787s recent problems that have to do with Boeing’s strategy.

Aircraft manufacturing can be a difficult industry to make profits in, for many of the reasons Michael Porter would outline in a Five Forces analysis (referring back to our last conversation). Designing an airplane requires big development costs, which a manufacturer will find difficult to recoup if it sells airplanes at their marginal cost of production. However, there are a lot of factors that can make price rivalry aggressive: aircraft orders are large and infrequent; demand for aircraft is cyclical, which makes orders hard to come by in recessions; and airlines are skilled at playing Boeing and Airbus off of one another to get large concessions as a condition of buying.

All of these factors are compounded greatly if the aircraft that Boeing and Airbus offer are fairly similar, i.e. if they can fly a similar number of passengers a similar distance at a similar cost. This has been true for many of Boeing’s and Airbus’s aircraft: the 737 and the A319/320, the 777 and the A340, etc. Part of the tragedy for Boeing is that the Dreamliner was an attempt to create an aircraft that was fundamentally different from anything offered by Airbus, and thereby avoid the aggressive price rivalry that Boeing and Airbus have found themselves locked in.

The 787 is designed to carry a moderate number of passengers (around 250) over long distances. The key advantage of this is that it would make it economically possible for an airline to offer direct flights between cities that are not international hubs: for example, a direct flight between Boston and Tokyo, saving passengers a connection in New York or San Francisco. Airbus’s newest major offering, the A380, was designed to carry a very large number of passengers (500-600 or more) in a double-decker configuration. This is a plane designed for flying between exactly the international hubs that the 787 allows passengers to avoid. Each having a plane that is ideal for a different kind of route is much better for both firms than having planes that compete head-to-head.

All the signs suggested that the 787 was a compelling offer for airlines. The number of pending orders mostly held steady or increased for the 787, despite years of delays in the delivery timetable. While the 787’s problems will presumably be resolved, and quickly if Boeing is lucky, this is an unfortunate interruption of the momentum of what was a very innovative—and potentially very successful—product strategy.

Craig Garthwaite

I just wanted to follow up on Meghan’s points about the strategic considerations of the Dreamliner, because I think there is an important competitive strategy point related to this particular outsourcing decision that we haven’t fully touched on yet. As Meghan explains, both Boeing’s move to the Dreamliner and Airbus’ move to A380 as their premier planes introduced some much needed differentiation in this industry. This might result in greater profits for each firm. However, as Boeing attempted to increase their profits by decreasing rivalry, their outsourcing decisions increased the added value (or uniqueness) of their suppliers and decreased the barriers to entry for their competitors. This should negatively impact Boeing’s profits in the future.

Both of these changes are the result of suppliers now possessing more knowledge about designing, rather than just manufacturing, the complicated parts of one of the world’s most sophisticated commercial aircraft. Previously, this knowledge primarily remained within Boeing, and the company was therefore freer to outsource to a wider set of suppliers.  This is less true when your suppliers are responsible for a greater share of the design responsibilities.They are more critical and unique than before, and they can therefore capture more value.

Furthermore, now that these suppliers possess the human capital necessary for designing these parts, they are better able to assist new entrants in working down the learning curve that confronts any new firm in the aircraft manufacturing industry. This even works directly against some of the beneficial learning curve costs that Boeing created by moving to a plane that was made of over 50 percent composite materials! One of these potential entrants is the Commercial Aircraft Corporation of China—which has clearly announced its intention to be a major player in this sector. We have already seen General Electric announce a joint venture with a Chinese firm, where the firms will share technology that was used in the Dreamliner to make the C919.

I think the Dreamliner demonstrates the inherent difficulty of successful competitive strategy beyond the important trade-offs that Tom discusses.  Boeing’s attempts to address one threat to profitability created several others. This is one reason, among many, that we currently use this example as a case study in the core strategy course for MBAs at Kellogg in a variety of our degree-granting programs. It provides a contemporary, real-world example of the important strategic decisions made by firms operating in an increasingly global economy.

Marty Lariviere

Thomas Hubbard
Marty Lariviere,John L. and Helen Kellogg Professor of Managerial Economics & Decision Sciences

An interesting aspect of Boeing’s current problems is that it affects a component that Boeing could not have produced in-house. Unlike fuselage or wing components, batteries in general, and lithium-ion batteries in particular, have never been made by Boeing. This is a technology that has never been used in a plane before. Even if Boeing had approached designing the Dreamliner with the intention of doing the same amount of design and manufacturing in-house as it had done on past projects, it would still be dependent on an outside battery supplier—certainly for manufacturing and quite likely for technical guidance on how to integrate the batteries into the overall electrical system of the plane. Said another way, Boeing’s approach to outsourcing on the Dreamliner project has created a whole set of issues; I am just not sure that the battery issue could have been avoided with a less aggressive approach.

David Dranove

While Boeing could not easily make its own batteries, it should have assessed the extent to which the batteries would be a “plug and play” component that did not interact with other components, or one whose success depended on component integration.  If the latter, then Boeing would have been well-advised to in-source some of the key components to assure better integration.  This is how Boeing used to operate. Outsourcing to market experts has its dangers when component integration is critical.  In this case, Boeing may even find that it would have been cheaper to obtain battery expertise in-house, as there is a nontrivial chance that the 787 never again takes off.

Photo credit: Wikipedia Commons

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