Tuesday, April 21, 2020

Outsourcing Reduces Productivity

Salim Furth provides yet more evidence of falling productivity in What’s Behind Falling Productivity: The Census May Hold the Answer:
Records kept since 1940 tell a contrasting story: even as the census has introduced labor-saving technologies, it has required more, not fewer, workers. The efficiency of census-taking appears to have declined over time as it has for most of the economy.
Below the fold, some commentary.

Furth's post takes off from Census Technology, Politics, and Institutional Change, 1790-2020 by Steven Ruggles and Diana L. Magnuson. An extract from their abstract:
The case study of the census reflects the critical and shifting role of the state and the private sector in the development of technology. For most of the twentieth century, Census Bureau administrators resisted private-sector intrusion into data capture and processing operations, but beginning in the mid-1990s, the Census Bureau increasingly turned to outside vendors from the private sector for data capture and processing. This privatization led to rapidly escalating costs, reduced productivity, near catastrophic failures of the 2000 and 2010 censuses, and high risks for the 2020 census.
Their account of the history of in-house Census Bureau technology is fascinating. In the early 1900s the Census Bureau purchased equipment; these contracts led eventually to IBM and Unisys. Then:
For most of the twentieth century, however, Census Bureau administrators adamantly resisted private-sector intrusion into data capture and processing operations. Beginning in 1907, the Census Bureau maintained its own machine shop that designed and manufactured data processing equipment, in direct competition with machinery produced by the private sector. For nine decades the Census Bureau was able to maintain bureaucratic autonomy, doing all data capture and processing in-house, mainly using purpose-built equipment engineered and manufactured by Census Bureau staff. As Carpenter has shown, similar bureaucratic autonomy occurred across a variety of federal agencies where mid-level staff developed unique capabilities that enabled them to resist political pressures.
The Clinton administration put an end to all that:
Census Bureau autonomy ended abruptly in the 1990s. Ideological shifts of the late 20th century redefined the role of government. Under pressure from the Clinton administration, the Census Bureau privatized data capture. In 1996 the Census Bureau closed the machine shop and began to outsource Census data capture operations to private vendors. Privatization led to rapidly escalating costs, reduced productivity, and near catastrophic failures of the 2000 and 2010 censuses. As we approach the 2020 Census, the risk of a major failure in data capture and processing is palpable.
The authors' account of the disastrous outsourcing of the 2000 and 2010 censuses is a standout even among the dismal history of government IT contracts and gouging by defense contractors. Here is the 2000 version:
the cost for the Lockheed Martin contract jumped from $49 million to $220 million, and the contract to TRW went from $188 million to $314 million.
These increased costs were easy to predict:
There were many unanticipated costs. The contractors did not consult with the Census Bureau personnel who had institutional knowledge and experience processing millions of paper forms. The Bureau’s lack of experience with contractors led to inefficiencies. Requirements were poorly documented, resulting in frequent changes. There were major philosophical differences between the contractors and the Bureau, especially in the area of quality assurance. Misunderstanding led to change orders, which increased costs.
It wasn't merely higher costs, it was lower quality:
The digital imaging and OCR systems did not work as well as anticipated. The scanning machines were far slower than the FOSDIC machines they replaced. It took approximately thirty-five of the new Kodak machines to do the work of a single FOSDIC machine, so the number of scanning machines grew dramatically. The 1990 census used twenty-one FOSDIC machines, which DCS 2000 replaced with 162 Kodak Digital Science Scanner 9500 machines. Despite the increased number of machines, overall data capture throughput declined by some 75%.
The 2010 version was much worse. Lockheed Martin failed to deliver their $500 million system in time for it to be used, but that was small potatoes compared to:
The handheld device contract with the Harris Corporation was an even greater disaster. The software did not function correctly, the work fell behind schedule, and the projected cost more than doubled to $1.3 billion. In 2008 the Census Bureau abruptly canceled the plan to use the handheld devices for non-response follow-up and reverted to entirely paper-based processing. The last-minute change further increased the cost of the 2010 census by up to three billion dollars, making the Harris debacle one of the most expensive failed software systems in history.
In June last year's The Risks Of Outsourcing I discussed Why public sector outsourcing is less efficient than Soviet central planning by Abby Innes of the London School of Economics . She points to the inevitable information asymmetry that places the buyer of outsourcing at a disadvantage:
The following market failures are rife in public service markets: high barriers to entry leave public service markets dominated by monopoly or oligopoly firms which render the provider relatively immune from the self–correcting mechanisms of market competition; uncertainty and complexities in contractual requirements create huge information asymmetries between buyer and seller; relationship–specific investments encourage the producer to exploit the loss of bargaining power entailed by sunk costs (i.e. ‘hold-up’ problems); and finally, negative spillovers, that is to say, damaging external effects not reflected in the original price of the transaction are particularly problematic given systemic interdependencies, for example between NHS and social care systems.
These problems aren't specific to the public sector, Boeing was warned about them in a 2001 internal report OUT-SOURCED PROFITS –THE CORNERSTONE OF SUCCESSFUL SUBCONTRACTING by L. J. Hart-Smith:
The point is made that not only is the work out-sourced; all of the profits associated with the work are out-sourced, too. The history of the former Douglas Aircraft Company is cited as a clear indication of what these policies have done – and as a warning of what more may be done. The subcontractors on the DC-10 made all of the profits; the prime manufacturer absorbed all of the over-runs.
The report fell on deaf ears, as Mike Collins discussed in The Boeing Supply Chain Model:
On January 29, 2003, Boeing decided to design an all-new airplane made out of composites. They called it the 787 and the design idea was to make the plane light and fuel-efficient, to be a long range airplane. The dream for this aircraft was to move manufacturing to its Tier 1 suppliers who would coordinate with Tier 2 and 3 suppliers, and all Boeing would have to do was assemble the parts and save a whole bunch of time, effort, and money.
August 2009 -- Boeing announces a $2.5 billion charge to third quarter earnings and pushes deliveries to the 4th quarter of 2010 – 2 years later than the original schedule.
Undeterred, the financial wizards in charge of Boeing continued outsourcing and have ended up facing COVID-19 with all three of their business segments in dire straits. In New document reveals significant fall from grace for Boeing’s space program, Eric Berger writes:
Much has been made of Boeing's difficulties in aviation, most notably with the 737 Max. This airplane has been grounded for a year after two crashes that killed 346 people between them, collectively making for the worst air disaster since September 11, 2001.

Then there are the issues with the company's KC-146 Pegasus tanker program, which is $3 billion over budget, three years behind schedule, and beset by technical issues. Most recently, in March, the Air Force revealed that it had upgraded chronic leaks in the aircraft's fuel system to a Category I deficiency. This is a problem for an aircraft that is supposed to perform aerial refueling.

Since December, the company's space issues have also become more widely known following the failure of the company's Starliner capsule to successfully carry out a test flight to the International Space Station.
But a new document released by NASA reveals the broader scope of Boeing's apparent decline in spaceflight dominance.
Boeing's massive stock buybacks mean it can't survive without a massive taxpayer bailout which, being "too big to fail", it will get. But even a huge bailout can't fix the fundamental mistake in the past. In 797. The Plane That Never Was, Patrick Smith writes about low aerospace productivity and the future of the mid-size market segment:
Indeed, we might not see an all-new design from Boeing or Airbus for the next 30 years. one factor is the incredible amount of time it takes nowadays for a plane to move from the planning stages to commercial service. How things have changed. Fifty years ago, the 747 went from an idea on the back of a napkin to an actual, flying aircraft, in two years. Today, just building a derivative from an existing model can take twice that long. And that’s what we’ll continue seeing: more derivatives. Boeing has been milking the 737 since 1965. The A320 debuted in 1988. One can easily see the 777, 787, A330 and A350 tracking similar evolutions. We won’t have a new model because they take too long and they’re too damn expensive, and also because there won’t be a need for one: derivatives will have all the possible ranges and seating combinations covered for the foreseeable future. The 797 was the one remaining niche crying out for a new plane. Boeing chose to ignore it; Airbus threw a patch on it. And off we go.
Given the likely decrease in demand for air travel in the wake of COVID-19, the mid-size segment is probably critical:
Airbus has stepped in with the A321-XLR, a stretched, longer-range, souped-up version of the baseline A320. A 757 knockoff, it kind of, almost, sort-of-but-not-really does the job. A downer, I know, but that’s as close as we’re going to get.

Airbus will sell a thousand XLRs, mark my words. For carriers it’s the only option. And Boeing will be left looking dumber than it does already.
Productivity is the ratio of outputs to inputs. It is easy for companies or institutions to believe that by outsourcing, replacing internal opex and capex by payments to suppliers, they will get the same output for less input. But experience tends to show that in most cases the result is less output for more input. The Gadarene rush to outsource may be a major contributor to the notorious decay of productivity (See Scott Alexander's Considerations on Cost Disease for many examples).


Michael Nielsen said...

Nice overview. Certainly, it seems that ideologically-driven outsourcing is often a bad idea.

That said, there's plenty of examples where outsourcing seems to provide a competitive advantage, by allowing firms to specialize. My impression is that AMD is much less vertically integrated than Intel (eg, they don't do their own manufacturing0, and this has helped them specialize and obtain an edge in the things they do focus on.

I'm certainly not an expert on microprocessors, and the last example may be mistaken. Still, there are plenty of industries where outsourcing seems to have happened for sound division-of-labour-and-specialization reasons, not on unsound ideological grounds.

David. said...

Michael, you raise a good point. Although AMD originally owned fabs, they did so in collaboration with IBM and Motorola. Finally they spun their fabs out as Global Foundaries. Even before that they were also using TSMC and Samsung. So they weren't always a fabless company but they were never a company like Intel whose fabs were their core strategy.

I know more about Nvidia, clearly one of the most successful fabless companies of all time. Part of the reason I became employee #4 was that Jensen Huang's goal in starting Nvidia was to rethink the relationship between a fabless company and its fab on a win-win basis. He knew how to do this because he'd been on the fab side of the deal at LSI Logic. History shows that he was on to something.

Outsourcing a function that used to be a core capability, as with the Census Bureau, is very different from designing a company to use outside suppliers from the start.

Blissex2 said...

Interesting stories, but they wholly miss the point, consider the example of a dairy farm in two cases:

* It initially produces $1,000,000 of milk, at the cost of $900,000 of feed etc., leaving the farmer who owns it with $100,000 as gross income.
* Then the farmer decides to feed the cattle a smaller quantity of lower quality feed that costs $750.000, and output falls to $900.0000. The farmer is left with $150,0000.

From the point of view of the farmer even if output has fallen by 10%, "productivity" has jumped by 50% (physical productive has improved from 11% to 20%). The point of view of the cattle does not matter, the farm is run for the benefit of its owner, not that of farm machinery or the cattle, that are just costs.

Anti-union consultants have driven a lot of strategic decisions of corporations, for example they point out that:

* Large plants on a single site run by one organization are a breeding ground for union infections, because they both make organizing a lot easier and they hand workers effective veto over the use of a single large amount of capital.it is much better to divide-and-conquer, by splitting corporate operations into many smaller parts, geographically or at least organizationally separated.

* Outsourcing to some domestic or foreign locations ("offshoring") can be done to countries where unions and strikes are either outlawed or tightly controlled by their (often very sensitive to cash "incentives") governments.

The owners and managers of corporations are not interested in physical productivity, but in dollar productivity, that is how much they can take; it can well happen that lower physical productivity, for example because of using long supply chains or less skilled labour and poorer infrastructure, increases their dollar takings, by increasing their share of a smaller and less efficiently produced output.

Blissex2 said...

«That said, there's plenty of examples where outsourcing seems to provide a competitive advantage, by allowing firms to specialize.»

That is a really stupid argument: what prevents a company from having a team of specialists running their "core competence" by having other functions integrated within it? There are things called "divisions" to provide separate environments for separate activities.

Suppose that there is a car company and the argument for outsourcing its marketing department is that otherwise the car-making main part of the company cannot just hire car-making specialists but risks putting marketers in charge of car-making. That's obviously ridiculous.

The substantive reasons to replace open-ended top-down relationships with fixed-term, peer-peer contracts can only be two: there is a temporary need for that activity, or when there are no conflicts of interests or they are easy to check, between supplier and customer, so that the customer does not need to be in charge of the supplier.

In companies engaged in large complex production processes those conditions rarely happen. Consider Apple and the manufacturer of Apple products: in practice their relationship is long term and very intimate, and the real relationship is a bit like that of McDonalds and their franchisers, where the franchisers or Apple's OEMs are nearly just figureheads.