Boeing Learns a Lesson In Theory of the Firm – Outsourcing Isn’t Always Profitable

Boeing is learning a hard lesson in what micro-economists call the “theory of the firm”.  Theory of the firm is the branch of econ that explores the question of “why do corporations exist?” and “why do they vary in size?”.  First, from the LA Times (much more at the linked article itself):

The airliner is billions of dollars over budget and about three years late. Much of the blame belongs to the company’s farming out work to suppliers around the nation and in foreign countries…

Case in point: Boeing Co. and its 787 Dreamliner.
The next-generation airliner is billions of dollars over budget and about three years late; the first paying passengers won’t be boarding until this fall, if then. Some of the delay stems from the plane’s advances in design, engineering and material, which made it harder to build. A two-month machinists strike in 2008 didn’t help.

But much of the blame belongs to the company’s quantum leap in farming out the design and manufacture of crucial components to suppliers around the nation and in foreign countries such as Italy, Sweden, China, and South Korea. Boeing’s dream was to save money. The reality is that it would have been cheaper to keep a lot of this work in-house…

Paul Krugman summarizes the relationship to some modern theory of the firm writings:

Oliver Williamson shared the 2009 Nobel mainly because of his work on a question that may seem obvious, but is much less so once you think about it: why are there so many big companies? Why not just rely on markets to coordinate activity among individuals or small firms? Why, in effect, do we have a lot of fairly large command-and-control economies embedded in our market system?

Williamson answered this in terms of the difficulties of writing complete contracts; when the tasks that need to be done are complex, so that you can’t fully specify what people should do in advance, there can be a lot of slippage and strategic behavior if you rely on market incentives; in such cases it can be better to do these things in-house, so that you can simply tell people to do something a particular way or to change their behavior.

In Boeing’s case, they outsourced far too much, only to find that they were getting parts that didn’t do what they were supposed to — and also to find that the subcontractors were seizing a lot of the rents. They discovered, in effect, that there are times when it’s better to rely on central planning than to leave things up to the market.

Obviously this isn’t always true. There’s a tradeoff. But that’s the point — and it’s this tradeoff that determines how big firms should be. Boeing has now provided a clear motivating example. Their loss, the economics profession’s gain.

Paul Walker at Anti-Dismal offers a more complete explanation of Williamson’s ideas.  And, of course, Williamson’s books, unlike many by Nobel-winning economists, are actually rather readable by non-economists.

 

The more things change…

From a Republican Vice-Presidential candidate:

Too much cannot be said against the men of wealth who  sacrifice everything to getting wealth. There is not in  the world a more ignoble character than the mere  money-getting American, insensible to every duty,  regardless of every principle, bent only on amassing a  fortune, and putting his fortune only to the basest  uses —whether these uses be to speculate in stocks and  wreck railroads himself, or to allow his son to lead a  life of foolish and expensive idleness and gross  debauchery, or to purchase some scoundrel of high social position, foreign or native, for his daughter. Such  a man is only the more dangerous if he occasionally  does some deed like founding a college or endowing a  church, which makes those good people who are also  foolish forget his real iniquity. These men are equally  careless of the working men, whom they oppress, and  of the State, whose existence they imperil. There are  not very many of them, but there is a very great number  of men who approach more or less closely to the type,  and, just in so far as they do so approach, they are  curses to the country.

The candidate, BTW, was Theodore Roosevelt, later President of the US.  It seems that the “men of great wealth” often continue to behave as badly today as they did 115 years ago when Teddy wrote/spoke this.  On the other hand, the party of Roosevelt has sure changed.  TR would be cast-out of today’s Republican party as some sort of “socialist” that wants “class warfare”.  Source here. (h/t Brad Delong)

The Way to Maximize Corporate Profits is not to try to Maximize Profits

From Naked Capitalism (Yves Smith) (emphases are mine):

the blind pursuit of “maximizing shareholder value” is not all it is cracked up to be:

The recent productivity report received much attention. But I did not see anyone point out that the spread between nonfarm corporate prices and unit labor cost was 5.25%, the widest spread on record.

This spread is the single most important variable driving corporate profit margins and implies that you should expect major positive earnings surprises.

Yves here. Translation: employers are continuing to squeeze down on workers to improve their margins. And the US has been pursuing that strategy for some time, of shifting the composition of GDP growth away from increases in worker incomes (via hiring and/or paying them more) to increases in corporate profits. The shift was dramatic in the last supposed expansion; it was called a “jobless recovery” for good reason. In every previous postwar growth period, the labor share of GDP growth was never less than 55% and had averaged not much less than 60%. In the pre-crisis expansion, it plunged to 29%.

Before some readers contend that this pattern is inherent to the “maximizing shareholder value,” let’s start with one consideration: strategies that focus on that goal actually do less well than ones that pursue broader aims. John Kay notes in a 2004 Financial Times article (sadly, no longer available on line):

Paradoxical as it sounds, goals are more likely to be achieved when pursued indirectly. So the most profitable companies are not the most profit -oriented, and the happiest people are not those who make happiness their main aim. The name of this idea? Obliquity….

Obliquity is characteristic of systems that are complex, imperfectly understood, and
change their nature as we engage with them…..

Obliquity is equally relevant to our businesses and our bodies, to the management of our lives and our national economies. We do not maximise shareholder value or the length of our lives, our happiness or the gross national product, for the simple but fundamental reason that we do not know how to and never will. No one will ever be buried with the epitaph “He maximised shareholder value”. Not just because it is a less than inspiring objective, but because even with hindsight there is no way of recognising whether the objective has been achieved.

For most of the 20th century, ICI was Britain’s largest and most successful manufacturing company. In 1987, ICI described its business purpose thus: “ICI aims to be the world’s leading chemical company, serving customers internationally through the innovative and responsible application of chemistry and related science. “Through achievement of our aim, we will enhance the wealth and well-being of our shareholders, our employees, our customers and the communities which we serve and in which we operate.”….

In 1991, Hanson, the predatory UK conglomerate that had successfully acquired and reorganised sluggish British manufacturing businesses such as Ever Ready and Imperial Tobacco, bought a modest stake in ICI. While the threat to the company’s independence did not last long, the effects were galvanising. ICI restructured its operations and floated the pharmaceutical division as a separate business, Zeneca. The rump business of ICI declared a new mission statement: “Our objective is to maximise value for our shareholders by focusing on businesses where we have market leadership, a technological edge and a world competitive cost base.”….

ICI made the opposite shift – from a grand vision of the responsible application of chemistry to a narrow concentration on established, successful activities. The aim of bringing benefit to a wide range of stakeholders was replaced by the specific objective of creating shareholder value from narrowly focused operations. The company translated this into an operational strategy by disposing of the company’s interests in bulk chemicals to acquire a niche group of speciality businesses: ICI, once the main supplier of chemical products to one third of the world, was reinvented as a smells company.

The outcome was not successful in any terms, including those of creating shareholder value. The share price peaked in 1998, soon after the new strategy was announced. The decline since then has been relentless. After two successive dividend cuts the company was ejected in early 2003 from the FTSE 100 index, the transition from industrial giant to mid-cap corporation had taken only 12 years…..

Obliquity gives rise to the profit -seeking paradox: the most profitable companies are not the most profit -oriented. ICI and Boeing illustrate how a greater focus on shareholder returns was self -defeating in its own narrow terms. Comparisons of the same companies over time are mirrored in contrasts between different companies in the same industries. In their 2002 book, Built to Last: Successful Habits of Visionary Companies, Jim Collins and Jerry Porras compared outstanding companies with adequate but less remarkable companies with similar operations….

Collins and Porras….found the same result in each case: the company that put more emphasis on profit in its declaration of objectives was the less profitable in its financial statements.

Yves again. Simple-minded profit seeking is not what it is cracked up to be. And worse, squeezing worker wages to not simply preserve, but increase profits, is destructive on an economy-wide level (note the rising gap between wages and prices disproves the canard that the wage pressure is necessary to preserve competitiveness).

US business used to operate with the idea that the returns resulting from productivity gains would be shared by workers and the company; that notion now seems as dead as the dodo. But not allowing workers to participate in improvements in corporate returns blunts overall economic growth. Companies are fattening their current bottom lines at the expense of future top line growth. But in our current climate, this strategy looks just dandy….until government stimulus starts to be withdrawn.

Save the Whales! Abolish Patents!

Well, actually it likely wouldn’t save the whales. But, abolishing patents would likely re-invigorate the economy, revive competition, lower costs (particularly healthcare costs), and speed up innovation.

Levine and Boldrin help lay out the case against patents in this piece.  An excerpt ( I recommend following the link):

Abolishing so-called intellectual “property” (IP) won’t solve all social ills — and it certainly won’t save the whales. But it would be a big step in the right direction for solving a range of problems from the high cost of health care, to innovating our way out of the current recession. In a series of posts with my co-author Michele Boldrin, we’ll tackle these issues one at a time.

….

With the exception of Japan, the rest of the world spends only about 60-70% of what we spend for prescription drugs. The European countries’ average is 60%, with some countries at around 55%.That means that simply paying what the rest of the world pays would reduce our health care bill by at least 4% – that is about 0.7% of national GDP, or roughly $100 billion.

via David K. Levine: Save the Whales! Abolish Patents!.

Also, it’s worthwhile to go to their blog at

Angry Bear explains how US businesses failed in the late 20th century

Angry Bear explains how mistaken thinking in the US business community from 1960’s onward set the stage for the loss of world-wide economic and technology leadership in many industries.

A fable: The Guitar Player who sold his gear or, Bruce Henderson vs. Gordon Moore ~ Angry Bear.

I spent much of my career from the late 70’s through 2000 as a corporate planner and strategy consultant.  It gave me a ring-side seat to the mind-battles described in this “fable”.  I have to agree with the author of the fable.  US business leaders blew it.  They fell in love with the finance gin-game:  buy businesses, milk ‘em, sell’em a few years later.   True builders of value and pioneers of innovation and infrastructure lost out because they couldn’t put a faith in an unknown future into spreadsheets.