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These days, devising an outsourcing strategy involves a host of challenges and opportunities. Between deglobalization and pandemic-induced supply chain issues, the 20^th century practice of moving manufacturing to wherever labor was cheapest is paying smaller and smaller dividends. As the value proposition of cost-cutting diminishes, a different rationale for outsourcing—one based upon maximizing synergies—is gaining traction.

Developments on the supplier side are fueling the change. “Firms that were historically only doing manufacturing have realized they can get a bigger margin, a bigger piece of the pie if they are doing more of the activity and knowledge work,” said Cheryl Druehl, associate professor of operations management and associate dean for faculty at Mason. She mentions how Ford Motor Company reaped unexpected profits in 2009 that were attributed to to co-develop electric vehicles. Her recently published paper in IEEE Transactions on Engineering Management (co-authored by Gal Raz and Hubert Pun of Western University) lays out a model to help managers think about how to outsource in this new world.

The model includes four options for the focal firm, or “buyer:” doing everything in-house, outsourcing only manufacturing, outsourcing both manufacturing and product innovation, or co-development of the product between buyer and supplier.

Replicating the wholesale price contracts that are most commonly used in practice, the model calculates how prices, costs and the firms’ respective capabilities combine to shape the synergies of various types of outsourcing relationships. For example, having one company (whether buyer or supplier) handle both design and manufacturing creates positive synergies. For example, designs can be altered for ease of manufacturing at scale.

However, when a supplier’s cost of product innovation is lower than that of the buyer, the resulting design changes produce benefits to product quality that increase ��customer demand—especially when buyer and seller can pool expertise and resources in a co-development scenario. On the other hand, in any collaboration there can be a multitude of costs, ranging from coordination issues to free riding. These constitute a counter-current of negative synergy that needs to be measured alongside the positive to formulate a final outsourcing decision.

In any model like this, the extremes are self-explanatory. Suppliers with a very high cost of product innovation—in other words, those that cannot innovate or lack necessary specialization—are fit for manufacturing but not design On the flip-side, if a supplier can accomplish the sort of innovation that the buyer requires much more cheaply than the buyer itself, it’s an obvious choice for both manufacturing and design. If the supplier can do neither manufacturing nor product innovation at significantly lower cost, the buyer should move everything in-house.

But the surprise in Druehl’s analysis is in the moderate outcomes. Once the supplier’s product innovation costs rise above dirt-cheap levels, the incentives to co-develop are more compelling for both supplier and buyer. Compared to design outsourcing, the supplier’s costs for co-development are lower, on the principle that many hands make lighter work. Additionally, co-development increases the overall amount of effort devoted to an innovation project (again, because two parties are contributing instead of one), which drives product quality and thus consumer demand even higher. This, too, benefits both firms. “We found that co-development (with outsourced manufacturing) was optimal for situations when the supplier had relatively intermediate costs of the process and product innovation,” the researchers write.

Of course, this assumes negative synergies are kept to a manageable degree. Each escalation of collaboration-related costs makes co-development a less attractive option for buyers and suppliers, as it erodes the quality-enhancing impact of innovation.

Druehl says that her research takes on special relevance in light of ongoing disruptions to the global supply chain. In the United States, calls to are growing louder. But the outsourcing movement in the U.S. has left a huge skills deficit in the labor market. “If we don’t have anyone who knows how to weld anymore, it’s not like we’re going to immediately be able to open a welding shop…And we saw that, ten or 15 years ago, when the appliance companies brought a lot of stuff back from China, they did a lot of redesigns and took out a lot of the labor,” Druehl said.

The positive synergies involved in double-or-nothing outsourcing can be powerful. But an obvious implication of Druehl’s paper is that as companies rethink their outsourcing strategy, they should keep in mind the potential for co-development solutions to set in motion a virtuous cycle that improves outcomes for buyers, suppliers and consumers alike.

Lest you think the paper exaggerates co-development’s social and economic strengths, Druehl argues that, if anything, the opposite is the case. “One of the big benefits of doing an activity is learning. When you collaborate, then we have some chance of both firms learning, which could have positive impacts. And we don’t capture that specifically in the model, but it’s an interesting thing to think about.”

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