The DisneyPixar relationship dynamics:Lessons for outsourcing vs. vertical integration

Jerome Barthelemy

Organizational Dynamics (2011) 40, 4348

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The choice between outsourcing and vertical integration is acrucial decision for many firms. However, there is no standardframework for making firm boundary decisions. Thus, it isoften unclear for managers whether they should outsource orintegrate an activity.

An in-depth reviewof the academic literature suggests thatthreedifferentapproaches canhelpmanagersmake successfulfirm boundary decisions. First, the opportunism approach isbased on the assumption that suppliers may behave opportu-nistically towards their clients. Vertical integration is away forclients to respond to such a threat. Second, the competitiveadvantage approach suggests that it is vital for firms topossess the resources and capabilities that offer the potentialfor competitive advantage. Outsourcing can be used to accessall other resources and capabilities. Third, the flexibilityapproach considers the uncertainty associatedwith an activ-ity. The greater the uncertainty, the better off firms are to useflexible arrangements such as outsourcing.

While the three approaches are often used in isolation,only a simultaneous consideration of the opportunismapproach, the competitive advantage approach and theflexibility approach can capture the full richness of firmboundary decisions. This paper proposes a framework thatcombines the three approaches. The operational nature ofthe framework is demonstrated by applying it to a symboliccase: the relationship between Disney and Pixar in 3D ani-mated films.

In 1991, Disney decided to outsource the production of 3Danimated films to Pixar, while focusing on their marketing anddistribution. Between 1995 and 2005, the films resulting fromthe DisneyPixar partnership generated over $3 billion in boxoffice takings worldwide. Over 150 million home videos(cassette tapes and DVDs) and countless articles of tie-inmerchandising were also sold in a relationship that SteveJobs, Pixars CEO, described as one of themost successful inHollywood history. In 2006, Disney eventually bought itspartner for $7.4 billion.

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Why did Disney first decide to outsource and subsequentlyto integrate the production of 3D animated films? Whichapproach played the most important role. Is the frameworksufficient to account for all firm boundary decisions, or shouldother factors be taken into account?

OUTSOURCING VS. VERTICAL INTEGRATION:A FRAMEWORK

As pointed out above, an extensive review of the academicliterature suggests that three approaches can be used toexplain firm boundary decisions: the opportunism approach,the competitive advantage approach and the flexibilityapproach. In this section, each approach is described ingreater detail. Their main recommendations are summarizedin Table 1.

The Opportunism Approach

The most important contribution of the opportunismapproach is that it takes into consideration potential oppor-tunistic behaviors that may arise during a clientsupplierrelationship. Some suppliers are not just self-interested, butalso opportunistic. For instance, they may make promisesknowing well that they will break them in an instant, shouldthe benefits from breaking them exceed the costs.

According to the opportunism approach, suppliers are par-ticularly likely to behave opportunistically in small numberssituations. The smaller the number of suppliers, the moredependent are clients on their suppliers. Suppliers may thentake advantage of their clients dependence to behave oppor-tunistically. In that case, it is recommended to use verticalintegration rather than outsourcing. Arcelor Mittal is theworlds largest steelmaker. Over the past year, the companyhas bought several iron ore mines. The underlying rationale isstraightforward. There are only three major suppliers for iron

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http://dx.doi.org/10.1016/j.orgdyn.2010.10.002http://dx.doi.org/10.1016/j.orgdyn.2010.10.002

Table 1 Outsourcing vs. vertical integration: a framework.

Main recommendations

Opportunism approach Use vertical integration when the threat of supplier opportunism is highUse outsourcing otherwise

Competitive advantage approach Use vertical integration when resources and capabilities offer potentialfor competitive advantageUse outsourcing otherwise

Flexibility approach Use outsourcing when the uncertainty surrounding an activity is highUse vertical integration otherwise

44 J. Barthelemy

ore worldwide. As Arcelor Mittal expects the demand for steelto increase, its objective is to become less dependent onsuppliers. Indeed, suppliers may take advantage of risingdemand and tighter supply to increase their prices.

While a small numbers bargaining situation may existfrom the start, it is important to note that it can also emergein the course of a relationship when the client: (1) transfersspecific resources to its supplier, and (2) makes relation-specific investments (i.e., investments that cannot be rede-ployed outside the relationship without losing a large pro-portion of their value). For instance, Lego, the Danish firmthat commercializes the famous building blocks, outsourcedmost of its manufacturing activity in 2006. Hundreds ofinjection molding and packing machines were transferredto its suppliers factories in Mexico and Hungary. In 2008, Legodecided to bring manufacturing back in-house. Because themachines used to produce and pack the building blocks arespecific, outsourcing led to a small numbers bargainingsituation. In addition, the specificity of the machines pre-vented the supplier from reaping significant economies ofscale by using them for other clients.

The Competitive Advantage Approach

According to the competitive advantage approach, perfor-mance differences between firms are essentially a reflectionof differences in terms of resources and capabilities. Ingeneral, four conditions must be met for resources andcapabilities to generate a competitive advantage. Theymust: (1) create value, (2) be rare, (3) be difficult forcompetitors to imitate, and (4) be difficult to replace byother resources and capabilities.

The competitive advantage approach has clear implicationsfor outsourcing vs. vertical integration decisions. On the onehand, firms must absolutely possess the resources and capabil-ities that can provide them with a competitive advantage.Firms that outsource activities with high strategic value aredoomed to become hollow corporations (and eventuallyfail). On the other hand, firms may use outsourcing to accessresources and capabilities that do not offer the potential forcompetitiveadvantage.Anadditionaladvantageofoutsourcingactivities with limited strategic value is that it frees financialresources for integrating activities with high strategic value.

Because design capabilities are crucial in notebook com-puters and consumer electronics, Apple performs this activityin-house. Manufacturing capabilities are less likely to gen-erate a competitive advantage in this industry. Therefore,Apple outsources the manufacturing of products such asnotebooks, iPod or iPhone to outside suppliers. Interestingly,

the case of Apple can be contrasted with that of the Spanishchain of fashion stores Zara. In fast fashion, the ability tomanufacture (and distribute) new items as quickly as possibleis key to competitive advantage. Therefore, Zara is verticallyintegrated into the production (and distribution) of fastfashion items. On the other hand, Zara outsources theproduction of basic items that are more price-sensitive thantime-sensitive to low-cost Asian suppliers.

The Flexibility Approach

Compared with the other two approaches, the main contri-bution of the flexibility approach is its emphasis on the role ofuncertainty in outsourcing vs. vertical integration decisions.

According to the flexibility approach, the higher theuncertainty associated with a particular activity, the betteroff a firm is to enter into a flexible arrangement such asoutsourcing. On the one hand, it is often preferable to letsuppliers make investments that may quickly become obso-lete. For instance, the rapid development in IT outsourcingsince the early-1990s can largely be explained by the reluc-tance ofmany firms to invest in equipment whose durability isby no means guaranteed. On the other hand, it is oftenpreferable to have suppliers bear the cost of investmentswhose market outcomes are difficult to predict. This reason-ing helps explain why many pharmaceutical firms outsourcetheir biotechnology research and development (R&D) tospecialized firms instead of focusing on a limited numberof in-house research projects.

The history of Hollywood film studios clearly shows howoutsourcing can be used to deal with uncertainty. In the 1930sand the 1940s, cinema attendance was strong, and customerpreferences were stable. Because studios could easily predictwhich stars, directors and film genres would be popular, theyused to sign exclusive long-term contracts with stars. Moregenerally, major studies were vertically integrated into theproduction and even the distribution of movies. With theadvent of television in the 1950s, cinema attendancedeclined, and customer preferences became increasinglyunpredictable. As a result, Hollywood studios started bring-ing together stars, directors and crews on a project basisinstead of hiring them on a permanent basis. This highlyflexible Hollywood system is still in use today.

THE DISNEYPIXAR RELATIONSHIP IN 3DANIMATED FILMS

In the early-1990s, Disney was a highly diversified firm withtheme parks, TV chann