The virtualization of the American corporation proceeds apace. Inform the gods of re-engineering and outsourcing that another convert has been won. Two weeks ago, Sara Lee Corp., the venerable manufacturer of baked goods, Jimmy Dean sausages, Hanes T-shirts, Kiwi shoe polish, Brylcreem and, yes, the Wonderbra, announced that it would be divesting itself of its manufacturing operations to become a company whose main business was the marketing of its brands. Others could make the products. Sara Lee just wanted to make them popular.
Investors' reaction to the announcement was immediate and positive, unsurprising since the decision fit nicely with current thinking on the importance of leanness and farming out production. Underlying Sara Lee CEO John Bryan's avid embrace of what he called "de-verticalization" was a confused combination of reasonable assumptions, misplaced analogies, and an overwhelming desire to cater to Wall Street's desires--all packaged with the obligatory rhetorical appeal to the demands of the market.
In thinking about "de-verticalization" the most obvious risk is succumbing to nostalgia for the days when companies "actually made something." When Henry Ford first constructed the mammoth River Rouge and Highland Park complexes, where automobiles were essentially built from scratch, those factories seemed to many to be symbols of the exaltation of efficiency over all other goals. Now, with the onset of outsourcing, globalization, and the virtual corporation, those old factories have acquired a patina of humanist authenticity they could not have had in their own time. (Assembly-line work, after all, was seen as replacing the "real" production of skilled laborers.)
Nostalgia, though, tends not to be very useful in understanding either the past or the present. Bryan's rhetorical question--"What is a product and what makes a product?"--is a good one. In Sara Lee's case, the product is not just the physical snack cake or shoe polish. The product is that cake with the Sara Lee name attached or the shoe polish with Kiwi on the cover. And if what Sara Lee can do best is make those products more desirable by making those names more desirable, it's hard to argue that anyone would be better off with the company pursuing the Fordist dream. The idea of comparative advantage applies to companies and individuals as well as to nations.
For all that, however, there's a lot of smoke being blown about Sara Lee's restructuring in particular and about the supposed evils of vertical integration in general. Press accounts invariably suggested that Sara Lee's divestment of manufacturing operations would free cash "currently tied up in low-margin activities." "Slaughtering hogs and running knitting machines are businesses of yesterday. And they have low returns," Bryan said of those operations. But it only makes sense to speak of low returns and low margins if you're making products to sell to others.
Sara Lee doesn't run knitting machines to sell fabric to other companies. It runs them to supply the fabric it uses in its own products. And in theory, it should be able to make that fabric for itself for less than it would cost to buy it from a third party, because there will be no profit margin built into the price. The margins are higher, not lower, than they will be after the knitting machines are sold. That was one of the crucial appeals of vertical integration: It cut out the middleman. It's possible, of course, that a company that specializes in making fabric will be able to do it more efficiently, so that even with the markup Sara Lee will still come out ahead. But Sara Lee is the third-largest textile producer in the United States. It seems safe to assume that, by now, it's figured out how to knit efficiently.
Vertical integration does mean that you need to invest heavily in fixed assets and then keep investing in upkeep and upgrades. If you can avoid those costs and still make the products you want at a reasonable price, you're ahead of the game--which is why Coke makes syrup and not bottles and Nike contracts out all its manufacturing to hungry Third World workers. (If the ethics of outsourcing abroad bother you, read Slate's "In Praise of Cheap Labor," by Paul Krugman.) But vertical integration also offers major benefits. It keeps you from having to haggle with suppliers over prices, gives you total supervision over quality, and allows you to control production. One of the key impetuses for General Motors' push for vertical integration, for example, was its perennial struggle with Fisher Body, a major supplier who kept holding up GM for price increases. Once GM acquired Fisher, the problems stopped.
Today, of course, it's hard to find anyone who will defend vertical integration. But that's essentially the product of two factors, neither of which has anything to do with vertical integration per se. The first is American business's newfound assurance that competition is the necessary progenitor of efficiency. Since vertical integration replaces the market with the firm--that is, the company makes the product instead of allowing others to bid for the chance to make it--it must be a mistake, for we know the market's decisions are always right. The second, more important, factor is the experience of the U.S. auto industry in the late 1970s and early 1980s. Since the Big Three automakers' move toward more outsourcing and less in-house parts production has coincided with their return to profitability, it has seemed logical to pronounce vertical integration an idea whose time came and went.
T he problem with this logic is that the auto industry abandoned vertical integration for one reason: labor costs. The Big Three didn't give up on it because of just-in-time manufacturing or Japanese business models or a desire to focus on the brand. They did it because they didn't want to pay union wages when they didn't have to. Outsourcing parts production means that instead of paying a United Auto Workers member $45 an hour in wages and benefits, Chrysler can buy parts from a nonunion firm paying its workers $14 an hour. Even with the supplier's profit built in, Chrysler's still getting a bargain. But it's hard to see how this lesson applies to industries or companies--like Sara Lee--that aren't dealing with the UAW or the United Steelworkers.
The really disconcerting thing about Bryan's decision, though, is that it seems so blatantly to be more about gaining the favor of Wall Street than about improving the performance of the company. Sara Lee has been a terrific bottom-line company for the last three years, but its stock price has not risen as sharply as its competitors'. In his post-announcement interviews, Bryan was blunt about how much this bothered him. "It is increasingly obvious," he said, "that the investment community does not like asset-intensive companies."
What the investment community does like is short-term measures designed to boost share prices. So all the money from the sales of the manufacturing operations, $3 billion, is going to a share buyback program, which is to say that instead of being used to create new wealth, it will simply be redistributed from the company to investors. That's not redeploying assets to take advantage of what Sara Lee does best. It's redeploying assets to boost the stock price.
At this point, of course, that kind of maneuver should come as no surprise, since companies now seem to spend as much time looking at the stock ticker as at their production lines. But there is, nonetheless, something melancholic about it, and this is where the lament about companies actually making products has real resonance. To give up on River Rouge in order to build your brand is one thing. But to give up on River Rouge to buy back shares? That's something else entirely.