December 5, 2016

Lego: Outsourcing vs Insourcing

For this post, I am sharing with you the individual paper that I wrote for my Global Operations and Supply Chain Management class in IE Business School. The instruction from the professor was  "to scan the recent press, to select a news message and prepare a written analysis and interpretation of what had happened".

What follows is the paper on Lego that I wrote. Happy reading!

Who doesn't love Lego?

For close to 70 years, Lego experienced steady growth. In 1998, the company started losing money due to a series of unsuccessful diversification efforts (apparel, theme parks and video games to name a few). By 2003, sales had dropped by 35 percent in the US and 29 percent worldwide, culminating a year later in the biggest loss in the company’s history: £217 million.[1] This prompted the company to embark on a restructuring program, one that would see: 1) Kjeld Kirk Kristiansen, grandson of the man who invented the iconic Lego block, step down as CEO and be replaced by Jorgen Vig Knudstorp; 2) Lego selling off parts of the business that it deemed to be non-essential to the core product including properties in the US, South Korea and Australia, its four Legoland amusement parks, and its videogames development division; and 3) Lego deciding to offshore and outsource majority of its production to Flextronics, a large Singaporean electronics manufacturing services provider.

The third item, which was announced in June 2006, was deemed by Lego to be the “last major step in our process of restructuring of the group’s supply chain.”[2] The outsourcing was seen at the time by Lego as a step to improve competitiveness through cost reduction: “In the course of the last decade, competition on the toy market has, however, intensified considerably, and the need for cost reductions has increased in order to ensure future profitability.”[3] However, just two years later, on July 2008, it was announced that Lego would end the partnership and bring back production in-house. The partnership was considered valuable but complicated by Iqbal Padda, Lego’s Executive Vice President for Global Supply Chain:

We have had an intensive and very valuable cooperation with Flextronics on the relocation of major parts of our production. As expected this transition has been complicated but, throughout the process we have maintained our high quality level. Jointly we have now come to the conclusion that it is more optimal for the LEGO Group to manage the global manufacturing set up ourselves.”[4]

This surprising turn of events would appear to show that Lego was too hasty in its initial decision to outsource production. What could have promoted this turnaround within Lego and what lessons can be learned from this piece of news?

Looking deeper at the situation, the decision to outsource was actually the last step in the process to restructure Lego’s supply chain. Lego actually were facing several problems including: 1) majority of its production centers were located in high-cost countries; 2) having a complex product portfolio; 3) poor in-house supply chain that had problems in sourcing, manufacturing and distribution.

To me, the main problem of Lego appeared to be that it had not evolved its supply chain to match with the times. In the past, the toy industry was much simpler. There was less competition for the attention (and dollars) of kids, toy retailing was focused on smaller toy stores instead of larger chains and discount stores and Lego products were simpler and less complex. As competition grew in the form of more kinds of toys and also other non-traditional toys like video games, Lego ventured into creating more product lines and more complex playsets, including venturing into licensing of highly seasonal characters like Star Wars. However, Lego did not adapt its supply chain and its lead engineers and designers continued to add more and more product components to its production lines. This meant that Lego had to invest heavily in creating more molds and as more and more components entered the chain, it became more and more difficult to forecast demand. This resulted in Lego keeping more and more stock, which quickly became a costly and unprofitable exercise.

Lego also dealt with a lot of suppliers, more than 11,000 in all.[5] There was very few procurement procedures in place which meant engineers each used their own preferred set of suppliers whenever new products or projects were being developed. The same problem existed in manufacturing where each production team operated like an independent toy shop. This independent spirit was borne by Lego’s desire to push for more innovation. However, it made it difficult to leverage Lego’s size and enjoy economies of scale.

Lego was also ill equipped to properly handle the shift from retailing at small toy stores to larger chains like Walmart and Toys R Us. With decentralized distribution and poor forecasting in place, Lego could not properly fill orders with these large retailers and eventually lost space to competitors who could meet the stricter and shorter lead times required. Lego had also always kept to the principle of keeping its manufacturing centers close to its main markets. While other toy manufacturers had begun outsourcing manufacturing to Asia, especially to China, Lego had resisted for this strategic reason. This, however, meant higher fixed costs and higher capital requirements for expansion.  

To address these problems, Lego tightened control of several elements of the supply chain. They began by limiting the number of new components that entered the production process. This was done mainly by challenging engineers and designers to look for creative ways to reuse existing components. The goal was to eventually reduce the number of new components being produced. Also, a program was put into place to make sourcing of materials more strategic. The roster of suppliers was narrowed resulting in the stabilization of prices.

Lego also looked to standardize and improve their distribution. Where in the past, they were very flexible even towards the smaller retailers (for instance they allowed orders that consisted of less than a full carton which resulted in labor intensive “pick packing” at distribution centers), now they had put into place stricter rules on the level of servicing that retailers got with the greatest focus being given to only the largest retailers. This helped to drive down cost of distribution and provided a more reliable overview of demand. With the reduced complexity, it helped relieve some pressure from the supply chain. Distribution was also centralized, for instance, Lego’s five European distribution facilities (scattered across Germany, France and Denmark) were centralized in Prague. The operation was also outsourced to DHL.

On the manufacturing front, Lego looked to shift production facilities from Denmark and Switzerland, to lower cost countries. However, Lego wanted to maintain proximity to their main markets of Europe and the United States. As such, European manufacturing was moved to Czech Republic and Hungary, while US manufacturing was moved from Enfield (USA) to Mexico.
This lay the ground work for the final step: outsourcing production. Flextronics was selected as a partner and over the next few months, control of the manufacturing facilities was handed over to them. However, Lego still wanted to retain control over two essential parts, molding and packing which was retained in Billund, Denmark. The goal of outsourcing was for Lego to be able to reduce costs and at the same time learn from Flextronics expertise in reducing complexity and improving organization in general.

On paper, the partnership should have worked. It had worked well for other toy manufacturers. Why did Lego terminate the partnership? One reason is that Flextronics was a company that specialized in producing more functional products. Its supply chains were geared more towards achieving maximum efficiency and economies of scale. This was not very well suited for the toy industry where products were highly innovative and seasonal. Toy seasonality skewed heavily towards the peak holiday period with products only having a lifespan of 16 to 18 months. Demand also fluctuated heavily. Lego needed a supply chain partner that had expertise in being flexible and market-responsive which was not exactly what Flextronics were capable of.

Another reason is that it was much more difficult to shift competencies to Flextronics than previously expected. Flextronics had a lot of expertise as a manufacturer of electronics, but little as a manufacturer of toys. The great demands brought about by increased competition and the changing landscape put a great deal of pressure to make the transition speedy and hassle free, something that did not happen.

Lastly, all of this happened within the same period as the toy recalls that were occurring at rivals such as Mattel. Although Lego had deliberately avoided China for strategic reasons, outsourcing of production meant relinquishing control. As we have seen at Mattel, even the most reliable and trustworthy of partners can let you down. Theoretically, retaining control would also enable Lego to become much more flexible and adaptable to market changes. Information would also flow freely since there would be no fear of information and designs being leaked to competitors.

Looking at Lego’s annual report for 2007 sheds some more light as to why the partnership did not work: “In the course of 2006 and 2007, the outsourcing turned out to be more cost-consuming and more complicated than anticipated at the adoption of the plan. This is seen in, for example, a higher need for IT integration between the parties than expected.”[6] Taking the statement into account, it becomes more apparent to me that the outsourcing activity was done without properly taking into account the greater company strategy. It appears that outsourcing was done mainly for the cost-savings it would generate. When this did not materialize or meet expectations, Lego quickly decided to return manufacturing into the fold.

I think Lego is a peculiar case where insourcing manufacturing made more sense than outsourcing it. It has to do with the strategic fit that insourcing had with Lego’s fine-tuned and improved supply chain and the overall business culture that pushed for creativity and innovation. Lego believed that insourcing would prove to be much more flexible and responsive to Lego’s innovative product line. It would also afford Lego more control over the process which meant greater efficiency. Although insourcing may not be the right answer for other companies, the lessons learned from Lego’s situation, particularly how they were able to learn from their mistakes and turn around the business by adapting their supply chain to the changing landscape, are lessons that can and should be applied elsewhere.

[1] Delingpole, James. “When Lego Lost Its Head”. Daily Mail. 18 December 2009. Last accessed on 14 July 2014.
[2] Olson, Parmy. “Billionaire’s Lego Farms Out To Flextronics”. Forbes. 20 June 2006. Last accessed on 14 July 2014.
[3] Lego Annual Report 2006.
[4] Lego Corporate Website. 1 July 2008. Last accessed on 15 July 2014.
[5] Oliver, Keith. “Rebuilding Lego, Brick by Brick”. Strategy + Business. 29 August 2007. Last accessed 14 July 2014.
[6] Lego Annual Report 2007.