Networked Organizations:

A Strategic Cost Management Perspective

Gianni Lorenzoni
Department of Management
University of Bologna
Piazza Scaravilli, 1
40126 Bologna Italy
e-mail: gianni.lorenzoni@unibo.it
John K. Shank
The Amos Tuck School
Dartmouth College
Hanover, New Hampshire, 03755 USA
e-mail: john.shank@dartmouth.edu
and
The Olin Graduate School of Management
Babson College
Babson Park, Massachusetts, 02157 USA
e-mail: shank@babson.edu
Riccardo Silvi
Department of Management
University of Bologna
Piazzale della Vittoria, 15
47100 Forli, Italy
e-mail: riccardo.silvi@unibo.it
Keywords: Strategic Cost Management, Network, Transaction Cost, Cost Driver, Value Chain,
Strategic Management, Motorbike Industry
JEL Classification: M40, D23, L10, L14, L62,

BABSON WORKING PAPER SERIES No. 99 109 NB

6th Draft
July 21, 1999

Electronic copy available at: http://ssrn.com/abstract=1012643

Abstract
Networked organizations are receiving increasing attention in the management literature because
of their perceived success in terms of fast growth, increased flexibility and efficiency of
operations, lower overhead costs, and effective competitive positioning. For all firms, the choice
of which activities to perform internally and which to outsource is a critical issue. Cost
information can play a fundamental role in the decision about how much market and how
much hierarchy. Indeed, outsourcing is, basically, a cost and benefits evaluation.
Management accounting and strategic management studies have, so far, not addressed this
perspective explicitly. Management accounting is too internally focused on the costs of the firm
rather than the entire supply chain. The strategic management perspective, on the contrary,
focuses its attention on the supply chain, but only deals very generally with those transaction
costs which emerge in using the market. Both approaches fall short in providing a well
articulated financial rationale for which activities should be outsourced and which should be
entrusted to the market. Neither approach does much to help managers understand where value
is created in the value chain, the costs of the activities involved or their cost drivers.
Strategic cost management (SCM) studies provide a useful cost analysis framework which is too
often missing in the strategic decision making process. Competitive analysis, value or supply
chain mapping, and cost driver analysis are, in particular, the tools of SCM. The aim of this
paper is to apply SMC to the theory of networked organizations. In this paper we will use SCM
to explain the Italian motor bike industry where both vertically integrated and network
organizations exist. In particular, we will try to interpret different firms performance by
comparing their value chains and their positions along the value system. The financial impact of
the complexity involved in these different organization models and its impact on profitability and
competitive position is our main theme.

Electronic copy available at: http://ssrn.com/abstract=1012643

Introduction
Strategic alliances and partnerships have grown considerably in recent years. Managed
relationships along the supply chain have become a central element of strategy for many
organizations in a wide range of industrial contexts (Mowery, 1988; Nohria and Eccles, 1992;
Gulati, 1995; Beamish and Killing, 1997). Several rationales for more partnering have been
offered:

achieving production efficiency (Womack et. al., 1990),

sharing R&D risks (Westney, 1988),

gaining access to new markets and skills (Kogut, 1988),

reducing the time to market in the development of new products (Clark and Fujimoto, 1991)
and,

searching for new technological opportunities (Hagedoorn, 1993).

It has been reported that networked firms have experienced lower overhead costs, enhanced
responsiveness and flexibility, and greater efficiency of operations (Lorenzoni and Baden Fuller,
1995). Furthermore, from the single-firm perspective, alliances and partnerships have created
new strategic options, induced new rules of the game, and enabled new complementary resource
combination (Kogut, 1991).
From the initial emphasis on joint ventures, a wider spectrum of forms of network
alliances has emerged. One form is licensing or outsourcing strategies which transform the
firms value chain to reduce the assets required and the number of traditional functional activities
performed inside the organization. This can lead to a very different configuration of the
corporate boundaries. Alliances and partnerships create leverage in strategic maneuvering,

shaping the so-called intelligent firm (Quinn, 1992) or the strategic center (Lorenzoni and
Baden Fuller, 1995).
From an organizational point of view, new configurations such as the network form are
complementary to alliances and partnerships. Networks can be considered an intermediate
course between pure markets and pure hierarchy (Williamson, 1975). Or, they can be seen
as a distinctive architecture with special outcomes and mechanisms (Powell, 1990).
In networked organization design the key choice is which activities to perform internally
and which to entrust to the network (Khanna, 1998). The choice can free resources to focus on
core competencies that foster the firms competitive advantages. Cost information should play a
fundamental role in evaluating this choice. How much market and how much hierarchy is,
essentially, a cost-benefit trade off. Management accounting and strategic management studies
to date have not provided much explicit financial analysis for this trade off. Conventional
management accounting is mainly focused internally and on the short run. It ignores long-run
costs related to the management activities involved in make or buy decisions and the resulting
linkages with customers and suppliers. The strategic management perspective, on the contrary,
focuses its attention on the general concept of transaction costs which emerge in using markets.
If transaction costs exceed the benefits of the outsourcing, the hierarchy option is preferred
(Williamson, 1975).
Neither of these cost analysis approaches explain fully which activities should be
outsourced and which entrusted to the market. Neither recognizes the cost of all activities along
the supply chain involved in the decision. Moreover, neither helps managers understand where
value is created in the value chain, what the costs of the related activities are, or what cost drivers
are at work. Strategic cost management (SCM) uses cost information to develop strategies to

acquire or sustain competitive advantage (Shank and Govindarajan, 1993). Strategic cost
management (SCM) studies illustrate a more comprehensive cost analysis framework to improve
the effectiveness of the decision making process. In SCMs framework, managers should
explicitly consider the firms competitive positioning, the value creation process all along the
value chain, the full cost of the related activities, and the interrelated impact of specific cost
drivers.
This paper explores how SCM concepts could help firms more fully evaluate the benefits
of a networked organization while mitigating the negative effects of outsourcing. SMC tries to
allow managers to understand where customer value is created in internal activities and relate
this to the strategic issues of the overall supply chain for the business (Silvi, McNair, and
Polutnik, 1999).
After reviewing more carefully the traditional approaches to studying the financial impact
of outsourcing, this paper will introduce SCM for designing networked organizations. We will
use SCM to explore the Italian motorbike industry where both integrated and network-like
organizations exist. In particular, we will try to interpret three firms overall financial
performance by comparing their value chains and their positioning within the overall customer
value creation system.

Cost analysis in networked organization: two approaches

Cost information should play a fundamental role in the placement of the boundaries of the firm.
Indeed, cost estimation for the resources employed and for the related benefits should shape how
managers make decisions about the rational level of vertical integration for their firms.
Typically, however, make or buy decisions are framed in managerial accounting from a short-

run, differential cost perspective. In contrast, the strategic management literature frames such
decisions in terms of transaction costs. This latter approach really includes very little
accounting, while the former includes very little strategy. We will argue here that they are not
really alternative viewpoints but rather potentially reinforcing partial lenses. We support the
view that the two approaches can and must be joined (Johnson and Kaplan, 1987; Johnson,
1992).
Transaction cost analysis
Transaction cost economics (TCE) defines the rational boundaries of a firm in terms of the tradeoff between production costs and the costs associated with maintaining the relationships
necessary to acquire the resource in an external exchange. Williamson (1975) developed this
approach, drawing upon the institutional economics studies of Coase (1937). A transaction is
defined as the transfer of a good or a service between two technologically separated activities.
Williamson (1985) holds that such exchanges can produce increased costs, relative to internal
acquisition, because of delays, lack of communication, transactor conflicts, malfunctions or other
maladjustments. With the purpose of avoiding such transactions costs, firms set up governance
structures with planning, coordination and control functions. However, these structures,
themselves, also cause resource consumption and thus costs.
Transaction costs are the costs related to managing supplier and buyer activities across
external exchanges. As noted by Williamson (1985), such activities occur both ex ante in
searching, learning, and negotiating or safeguarding agreements, and ex post in organizing,
managing and monitoring the resulting relationship. The cost of transacting may become higher
than the production cost savings because of increases in opportunistic behavior, bounded

rationality, uncertainty, transactor conflicts or asset specificity. Firms then tend to prefer the
integrated organization over the market transaction.
Integrated organization, indeed, can provide numerous benefits: controllability of the
actors, better attenuation of conflicts, or more effective communications (Williamson, 1986).
But, many people today believe that the market supports powerful incentives and limits
bureaucratic distortions more efficiently than the internal organization. The market can also
aggregate several demands, yielding economies of scale or scope (Williamson, 1985). For
further theoretical literature on vertical integration see DAveni and Ravenscraft (1994),
DAveni and Ilintich (1992), Harrigan (1983), Hennart (1988), or Quinn et al. (1990).
In particular, Williamson (1985) argues that asset specificity, the existence of recurrent
patterns of transactions and market uncertainty are three factors which most significantly define
the level of transaction costs. Further analysis of the relationships between increasing asset
specificity, degree of interdependence and transaction cost are in Alchian and Demsetz (1972),
Klein, Crawford, and Alchian (1978), Scott (1981) and Thompson (1967). When these factors
are relevant, market failure and vertical integration tend to emerge. Either the supplier moves
downstream to its customer or the customer moves upstream to its supplier, or both.
Williamsons framework clearly provides the conceptually relevant approach to
understanding the organizations cost of using the market. In this respect, it explains why we
observe so many different organizational forms. It is certainly helpful in explaining the
widespread existence of vertical integration in mature settings such as the automotive or
petroleum industries.
But, in attempting to apply TCE concepts in practice, difficulties and complications are
encountered. First, economies of scale or learning or scope yield cost savings that can play a

major role in the analysis (Walker, 1988). Also, the cost of transacting is only one element of
the overall cost of purchasing (Demsetz, 1993). Furthermore, although vertical integration
decreases transaction costs, it also entails bureaucratic costs of its own related to the
management of the internal transactions. DAveni and Ravenscraft (1994) cite empirical
evidence showing that vertical integration lowered such costs as selling administration, or R&D,
but increased production costs. Other evidence on this phenomenon is provided by Coase
(1937), Williamson (1975), Hill and Hoskisson (1987), Jones and Hill (1988), Mahoney (1992),
and Perrow (1986). Internal complexity can also dramatically increase internal costs (Berliner
and Brimson, 1988; Morrow, 1992; Shank and Govindarajan, 1993).
In an operational sense, transaction costs are also very difficult to estimate (Williamson,
1985; Demsetz, 1993). For instance, it is conceptually difficult to separate transaction costs from
internal management costs in a sales or purchasing activity. Transaction costs are more than just
those related to the drafting or monitoring of the agreement. Dyer (1997) used the cost of the
purchasing function, as an empirical proxy for the level of transaction costs, but this is
conceptually weak. Transaction costs most appropriately are opportunity costs reflecting the risk
the firm bears to run the business with other parties when asset specificity, uncertainty, and risk
of opportunism are high, adjusted for the total benefits of the market option (Demsetz, 1993).
Conceptually, vertical integration should occur only in the presence of increasing asset
specificity, frequently recurring transactions and high supply/demand uncertainty. Otherwise,
the market still remains the right way of doing business effectively.
After the fact, the framework explains observed results. Before the fact, the framework is
just not intended to be a practical calculus.

Management accounting approach

The management accounting approach to outsourcing is basically the make or buy problem
tool set. The analysis is carried out by comparing the short-run differential costs and benefits of
the different make or buy options (Atkinson, et al. 1997; Horngren, et al. 1997; Shillinglaw,
1982). Even though this approach, in principle, takes into consideration all the economic
aspects of the decision, in practice the analysis tends to be rather narrow. There are at least two
reasons. First is the typical assumption that the relevant time frame is the short run where the
management support costs are considered fixed and thus irrelevant for the choice (Horngren, et
al., 1997). The second reason is that accounting systems typically do not provide explicit cost
information related to the activities that would emerge or disappear with the decision (Anthony
and Welsch, 1977). Recently, management accounting has become more cognizant of these
management systems costs through the activity based costing approach (Atkinson, Banker,
Kaplan, and Young, 1997; Kaplan and Cooper, 1998; Horngren, Foster, and Datar, 1997; Shank
and Govindarajan, 1993). Activity based costing (ABC) suggests focusing cost analysis on the
activities required to produce a product or support a customer.
In principle, to emphasize the transaction costs issues, ABC could be linked to Porters
value chain framework, in which the firm is defined as a set of interdependent activities aimed at
developing, producing, selling, delivering, and servicing products. This would facilitate a
broader conception of the costs and benefits associated with make or buy decisions. In
particular, it could allow managers to better estimate the cost of ownership (Carr and Ittner,
1992; Kaplan and Atkinson, 1989; Kaplan and Cooper, 1998). Cost of ownership would include
not only the purchase price, but also those costs related to purchasing activities (ordering,
receiving, incoming inspection. . . ), holding activities (storage, cost of capital, obsolescence. . .),

poor quality issues (rejections, re-receiving, scrap, rework,, repackaging. . .), or delivery failures
(expediting, premium transportation, lost sales owing to late deliveries . . .). Cost of ownership
is obviously dramatically higher than purchase price alone.
For example, Texas Instruments (Carr and Ittner, 1992), discovered that the cost of
ownership of an integrated circuit increased from $2.50 to $4.76 because of poor quality.
Another survey (Ask and Laseter, 1998) found that in selected commodities like office supplies,
fabrication equipment and copy machines, total cost of ownership was, respectively, 50%, 100%,
and 200% higher than the purchase price. Clearly, ABC is a necessary augmentation to the
traditional management accounting conception of the make/buy decision, but the result is still too
heavily internally focused to catch the full richness of the context.
Two Traditional Approaches: Recapping the Shortcomings
Both the TCE and the management accounting approaches to the make/buy decision provide
very relevant insights. But, from a strategic perspective they both must be considered only as
starting points for the analysis. First, internal hierarchy does not represent the only way to
mitigate transaction costs. A large number of studies have focused on networked organizations
(Dyer, 1996 and 1997; Lorenzoni and Baden Fuller, 1995; Lorenzoni and Lipparini, 1999;
Larson, 1992; Gulati, 1995; Ring, 1996). Others have focused on supply chain management
(Boykin et al. 1997; Ellram and Feitzinger, 1997; Tagoe and Innes, 1998; Stuart, 1997). Still
others have emphasized the lean enterprise (Womack and Jones, 1996; Cooper, 1995). All
these studies show that stable relationships and process alignment along the value chain can
reduce transaction costs even when asset specificity, market uncertainty or recurrent transactions
are high. In other words, many approaches exist to monitor and contain transaction costs without
going all the way to internal hierarchies.

10

Moreover, the underlying logic of static TCE analysis does not fully encompass such
strategic effects of inter-firm relationships as the integration of capabilities. And, it ignores such
issues as learning costs (Ring, 1996). The static nature of transaction cost economics is not
appropriate for understanding learning and innovative processes when knowledge is broadly
distributed and the locus of innovation lies within a network of inter-organizational relationships
(Zajac and Olsen, 1993).
Furthermore, the explanatory power of TCE is limited when changes in organizational
boundaries are possible in choosing the most efficient organizational form. The static
assumptions of TCE based on short-term, dyadic linkages, is not appropriate when studying what
transforms a combination of separate firms into a durable network with large-scale reliance on
inter-firm collaboration.
The management accounting approach, even if it does consider both the costs and
benefits of both the emerging and disappearing activities, is quite often focused on the short run
and thus does not analyze the strategic implications of the decision. Decisions that are
supposedly neutral to long-run issues might well change strategic positioning. They may also
affect, unconsciously, the organizational relationships within or among the transacting firms.
The traditional management accounting information system is still too focused on an internal
perspective. The internal value-added framework starts too late and stops too soon in the overall
supply chain. As a consequence, it misses the opportunities for exploiting new linkages with the
firms customers and suppliers. Attempting to maximize internal value-added also often creates
unnecessary constraints on those external entities contracting with the firm (Rackham et. al.,
1996).

11

Indeed, a large part of a firms costs are due to its way of functioning with its customers
and suppliers. As well, the costs of these supply chain partners are influenced by the focal firms
way of doing business with them. Pratt & Whitney (P&W) discovered that activities by its raw
ingots suppliers to produce ultrapure metals were duplicated at great cost downstream by the
forging mills who converted the ingots into near-net shapes suitable for machining. In addition,
the initial ingots (titanium or nickel) were ten times the weight of the machined parts eventually
fashioned from them. Ninety percent of costly metals was being scrapped because the initial
ingot was poured in a massive size to achieve a cost effective melt. Finally, P&W was
ordering several different ingotsat great costin order to meet precise technical requirements
for each jet engine. Upon investigation, it was determined that these requirements varied only
marginally between engine families and could be easily standardized. As a result of this study,
P&W eliminated many activities along the supply chain with dramatic cost savings. P&W had
been operating inefficiently for many years, simply because each player along the value chain
(ingots, forgings, machine shop, and final assembly) had never fully explained their activities to
each other. Each management group was accustomed to looking carefully at an issue from its
own perspective, not that of the entire value system.
Finally, both traditional approaches fail to explicitly consider the customer value, if any,
which results from costs incurred along the supply chain. Coase (1937) argued that as
hierarchies expand, managers too often fail to emphasize those factors of production with the
greatest impact on customer value. His point is still very valid today. Notable exceptions
include Nike, a nine-billion revenues and high margin firm, which wisely focused its attention
and resources on marketing and R&D rather than manufacturing. A competitor, Converse,
invested in manufacturing resources, detracting from its marketing and design prominence. The

12

more typical story is exemplified in large petroleum firms or forest products firms which overinvest in basic manufacturing capacity and consistently earn negative economic profits in
downstream converting operations (Shank, Spiegel and Escher, 1998). In recent years, such
Italian firms as Natuzzi in furniture, Luxottica in eyewear, and Aprilia in motorbikes have
benefited from effective deployment of corporate resources only in value-creating functions.
The Strategic Cost Management Perspective
Strategic Cost Management (SCM) is the view that cost analysis and cost management must be
tackled broadly with explicit focus on the firms strategic positioning, its overall value chain, and
the full set of cost drivers for the firm (Shank and Govindarajan, 1989, 1993).
Strategic Positioning. For sustained profitability, any firm must be explicit about how it will
compete. Competitive advantage in the marketplace (Porter, 1985) ultimately derives from
providing better customer value for equivalent cost (differentiation) or equivalent customer value
for lower cost (low cost). Occasionally, in a few market niches, a company may achieve both
cost leadership and superior value simultaneously, for awhile. Examples include IBM in PCs in
1986 or Intel in integrated circuits in 1992. In general, shareholder value derives more clearly
from differentiation, since the benefits of low cost are passed more often to customers than to
shareholders.
Value chain analysis. The Value Chain framework sees any business as a linked progression of
value-creating activities, from basic raw material purchases through to end-use customers. Each
link in the chain is strategically relevant. Where in the chain is value generated and where
destroyed? More broadly, each industry is also a linked chain with comparable issues about
value creation and destruction at each stage (Shank, et. al., 1998). In carefully analyzing its
internal value chain and the industry chain of which it is a part, a firm might discover that

13

economic profits are earned in the downstream activities, such as distribution or customer service
or financing, but not upstream in basic manufacturing. In such a case, any incremented resource
allocation upstream would require very strong justification. Many businesses today are showing,
for instance, that value is moving downstream in the chain (Slywotzky, 1996). General Electric
and Coca Cola have experienced the benefits of moving downstream (Slywotzky and Morrison,
1997). In the U.S. auto industry, a very high percentage of overall margins is in after-market
services such as leasing, insurance, rentals, and warranty repairs. New car dealers and auto
manufacturing show low profit (Gadiesh and Gilbert, 1998). But, at a deeper level, value chain
analysis allows managers to better understand their activities in relation to their core
competencies and to customer value. Many firms have discovered that activities are duplicated
such that streamlining the chain can reduce costs and enhance the value provided to their
customers (Hergert and Morris, 1989; Normann and Ramirez, 1994; Porter, 1985; Rackham, et
al., 1996; Womack and Jones, 1996).
Cost driver analysis. In SCMs framework, competitive advantage and effective supply chain
management presume a good understanding of the causal factors which drive cost incurrence.
Costs, indeed, are caused by many interrelated factors. Some factors are implicit in the firms
choices about its underlying economic structure (structural cost drivers). They include strategic
choices concerning: scale (size of investment to be made in manufacturing, R&D, marketing
areas), scope (degree of vertical integration), experience (number of times the firm has already
done what it is doing again), technology (type of process technologies used at each step of the
firms value chain) and complexity (product or service line breadth). Structural cost components
can be managed (up or down), but only by changing the fundamental economic elements of how
the business competes. Such changes are far from easy to implement. Also, in general,

14

structural factors are not monotonically scaled. That is, one can have too much scale, or
complexity, as well as too little. This makes optimization very tricky.
Costs also are driven by the firms ability to execute successfully within its given
structure (executional drivers). In particular, executional cost drivers include work force
involvement (commitment to improvement), total quality management (Kaizen and zero defects),
capacity utilization, plant layout, product configuration, and linkages with customers and
suppliers. In general, executional cost drivers are monotonically scaled, so that more is always
better (Riley, 1987). Lower costs can be achieved either through redesigning the firms value
chain, reassessing the coherence of current activities compared with the customers business
requirements, reconfiguring the structural business model, or better executing within that model.
In a recent study, one Italian agricultural machinery firm discovered that more than 50% of its
activity costs (manufacturing, logistics, purchasing, inventory, ) were driven by ineffective
product configurations (Shank and Silvi, 1999). An increasing variety of components and parts
and low commitment to design for manufacturability and assembly adversely affected day-today performance as well as resource allocation. A major portion of these activities were nonvalue-added, or worse, pure waste (McNair, 1994). Reduced product configuration complexity,
with concern for manufacturing issues, achieved dramatic profitability recovery.
SCM and the networked organization
We believe that effective management of networked organizations requires effective cost
management. The strategy literature as noted above, presents only the transaction costs
framework to frame the make/buy choices. As noted here, this TCE framework is conceptually
solid, but limited in its practical implications. The management accounting literature as noted
above presents only the incremental cost-benefit framework for make/buy choices. As noted

15

here, this framework, is limited in its practical implications, even when augmented with the ABC
lens.
We believe that SCMs framework can better support the analysis necessary for
appropriate strategic choices about structuring the network. Indeed, in a defined strategic
context where the ways to reach a competitive edge are defined value chain mapping
combined with activity analysis and cost driver analysis can significantly increase the
effectiveness of managements actions. SCM is a necessary supplement to either or both of the
traditional approaches to the theoretical issues.
Value chain mapping is necessary to identify where value is created along the activities
performed in the chain. Managers who want to develop effective networked strategies must
focus their scarce resources on value enhancing activities. Partners should be entrusted with
everything else. As we will show below, the most successful Italian motorbike firms are mainly
focused on design, assembly, and marketing activities, using a network of suppliers to provide
components.
Effective networked strategies require appropriate cost driver analysis too. Structural
cost drivers, such as economies of scope or scale can be managed through partnerships.
Executional cost drivers related to customer and supplier linkages can be managed through better
information exchange and process alignment. Electronic data interchange (EDI), for instance,
can dramatically reduce management systems costs and other transaction costs by eliminating
redundant and non-value adding activities. Co-design and co-engineering are planning and
manufacturing issues that can reduce logistics and inventory costs, as well as manufacturing
costs for all players along the chain (Clark and Fujimoto, 1991; Urban and Hauser, 1993;
Womack and Jones, 1996). In particular, design for manufacturing, for quality, and for assembly

16

can affect those executional cost drivers related to the cost of quality, unused capacity and
product configuration.
The Italian motorbike industry: A SCM perspective
In this section we will use the Italian motorbike industry to illustrate how an SCM perspective
can be used to understand where and why both integrated and networked organizations exist. In
particular, we will try to interpret the financial performance of three players by showing how
their positioning along the industry value chain differs. In addition, we will look at one cost
driver, complexity, across the three different organization models to see how it impacts
profitability and competitive position.
Methodology. The illustrative study here is based on externally available information. Previous
studies on this industry by Lorenzoni and Lipparini (1997) and Lipparini (1999) defined the
strategic context in terms of players and related suppliers.1 Based on their work, we developed
the preliminary value chains. We then interviewed two distributors and a retailer to estimate the
overall, extended value system. For three dissimilar players, we used externally available
financial reports to estimate profitability and complexity ratios (number of employees in relation
to operating cost). The results presented are based on averages across 28 financial reports. We
are certainly aware of the possible shortcomings here induced by this rough methodology,
especially when each company spans several businesses with different markets and customers.
But, for our purpose here, the results are revealing enough to demonstrate how the methodology
might be extended using a richer data base.
The industry. In recent years, the Italian motorbike industry has experienced a renaissance.
Some reasons include improvements in ease of driving, increased traffic jams and parking

17

difficulties with cars, and new legislation promoting replacement of existing old motorbikes by
giving the customer a contribution to the cost of a replacement purchase (Bersani law).
In Italy in 1997, unit sales were about 648,000, about 22% higher than in 1996. Of this
total, about 74% were manufactured in Italy.2 Italy represents about 50% of the European
market. In 1997 European sales were about one million units. Since 1994, the rate of growth in
Europe has averaged 16% for bikes less than 50 cc of displacement and 27% for bikes above 50
cc.3
In Italy, the players include domestic firms such as Piaggio, Aprilia, Malaguti, Italjet,
Benelli and Atala, and worldwide competitors such as Honda, Yamaha, Suzuki, Kymco, MBK or
Peugeot. Italian players range in revenue from a few billion lira to more than one thousand
billion. Young companies like Aprilia (927 billion in 97) and Malaguti (278 billion in 97) have
grown at dizzying rates with good profitability (see Exhibit 1). The yearly rates of growth of
revenues between 94 and 97 were 40% for Aprilia4 and 31% for Malaguti. ROI and ROS
average rates were respectively 13.1% and 5.3% for Aprilia and 41.8% and 19.5% for Malaguti.
This contrasts with very poor results for Piaggio, a much larger and more established firm with
worldwide revenue of 1,835 billion lira, but negative profitability and declining market share
(from 47% in 94 for small bikes to 33% in 97).5 The two newer players experienced high
product innovation, wider customer choice, shorter time to market, and quicker delivery. Use of
networking relationships led not only to superior profitability performance, but also to lower
financial intensity and operating leverage.
SCM A comparative value chain perspective
1

The authors acknowledge Prof. A Lipparini for his support given during this phase of the research.
Source: ANCMA (Italian Cycle, Motorcycle and Fittings Manufacturers Association).
3
Source: estimation from Piaggio Financial Reports.
4
Revenues include also the sales of larger motorcycles.
2

18

A partial explanation for the dramatically different performance for Piaggio, Aprilia and
Malaguti can be found in their different value chains. As shown in Exhibit 2, Aprilia and
Malaguti are mainly outsourced firms. Aprilia, for instance, does mainly development, assembly
and marketing.6 Malaguti, indeed, does only assembly and marketing. These two firms both
partnered with their suppliers for the purchase of engines, brake systems and frames. Moreover,
in 1997, Aprilia launched a logistics outsourcing program with a small firm, located in the same
area, which will handle most in- and outbound logistics and pre-assembly and storage of
components and final products. Piaggio, on the contrary, is largely integrated. Most of the
engine, electrical, and frame components are produced internally within the group. Piaggio owns
most stages of its value chain.
This evidence clearly supports the assertion that the choice of which activities to perform
within the firm and which to entrust to network partners or the market can significantly affect
performance. A key theme of SCM is to understand the value created in the different stages of
the value chain to better inform the dialogue about what to outsource. Accordingly, we broke
this industry into the following stages: manufacturing of frames, engines, brakes, shock
absorbers, electrical systems, mufflers, plastic components, lights and mirror components,
wheels and tires; logistics, assembly, marketing and selling, distribution, and retailing. We also
looked at research and development and the support functions of IT, Finance, and HR. By using
supplier companies financial report information, we estimated the profitability of each
manufacturing stage as shown in Exhibit 3. In the case of Piaggio, producing engines, and
electrical systems seems to be a correct choice. Frames manufacturing and management of

Source: Piaggio Financial Reports.

In 1997, R&D expenses were about 37 billion lira (4% on sales) with 150 employees (Source: Aprilia 1997
Financial Report). In 1997 Piaggio invested about 56 billion in R&D which is roughly 3% of sales (Source:
Piaggio Financial Reports).
6

19

logistics were unprofitable activities. Unused capacity and increased management complexity
are serious impediments to profitability in Piaggio. With networking, these locked-in resources
could be directed to other, value-capturing activities. On the other hand, Aprilia and Malaguti
focused their attention on a smaller number of activities and outsourced those where they could
not reach economies of scale. They preferred to manage the overall system using network
partners.
Extending the analysis downstream in the business system (see Exhibit 4) shows, again,
the three firms with different strategies and different results. Piaggio and Aprilia, for instance,
have the same distribution pattern. They sell to a distributor who then sells to customers through
retailers. Margins are different. Piaggios distributors who reach budgeted volumes earn an
average margin of 16.8%. Piaggios distributors charge dealers a commission for promotion
activities and for catalogues. Retailers earn about a 10% margin. The distributor provides
assistance with selling, purchasing, storage, and delivery. In the two distributors we visited, we
counted 16 and 28 people. Spare parts and bikes have a low turnover because of the delivery
time which ranges from two to three months. Although Aprilia uses the same distribution
system, it allows higher margins to the distributor and to the retailers. Moreover it does not
charge for catalogues or promotions. On the contrary, it provides a small promotion budget for
the distributor. Furthermore, Aprilia assists its distributors and retailers in educating the final
customers about post-sale services. Again, distributor profitability depends on achieved volumes
and on the mix between direct and indirect sales.
Malaguti chose a different system. It is mainly focused on a large number of small
distributors who sell direct to end-users and earn high margins with fast deliveries and small
budgets. This option tends to enhance the distributor profitability because it does not entail an

20

infrastructure of warehouse space, people, and large inventory. Looking at the extended value
system, it emerges that the two virtual firms not only create value for their suppliers and endcustomers, but also for the distribution agents along the supply chain.
Networking and complexity costs. Working through the market in Williamsons framework
entails increasing transaction costs, whereas performing the activities internally increases
complexity and management costs. We tried to measure in our sample the magnitude of both
consequences in terms of numbers of employees per activity. We estimated complexity by
dividing the number of employees by operating cost and by activity cost (operating cost less
purchases of raw materials, parts and components). Exhibit 4 shows the results. Clearly, the
more integrated the firm, the higher the number of employees that are needed to manage the
activities and the resources. In the case of aggregate activity costs, the ratio moves from 6.6 for
Piaggio to 5.2 for Aprilia and 3.1 for Malaguti. The same trend emerged in considering total
operating cost (respectively 3.3, 1.5, 1) and white collar employees.7 These results highlight
that using the market does reduce complexity costs as well as the level of resources (manpower,
space, services, capital) dedicated to non-value creating activities.
A dynamic situation. The application of SCM concepts highlights the impact of different value
chain configurations among competing firms. This picture is not static however. Piaggio, for
instance, has started a project to improve profitability through outsourcing certain aspects of
frames. Moreover, in 1997 they sold to Mitsuba and Nissho Iwai a 50% interest in FACIND, a
firm of the Piaggio Group dealing with electric and electronic components. In 1998, Piaggio
announced a partnership with TNT Traco for spare parts logistics. They also launched an EDI

In the case of the ratio of white-collar employees to activity cost, Aprilia showed the highest result. A possible
explanation is that it employed many people in R&D, and that the financial reports include the racing team activity.

21

pilot project with distributors to streamline the order entry process. Furthermore, they split their
business into two divisions: Engines and Vehicles. The Engines division is intended to operate
as a business and sell products to other competitors to enhance efficiency and utilize unused
capacity.
Also, Aprilia in 1998 announced a project for the production of ecologically designed
engines8 to enhance its worldwide competitive position. This fact seems in contrast with
networking. But, looking at the value analysis we performed, this investment is directed to a
profitable stage of the chain (21.4% ROI and 12.9% ROS). In this new venture, Aprilia will
have to face the cost of inexperience, lack of scale economies, and significant unused capacity.
These problems will absorb resources and cause waste and negative customer value. Aprilia is
certainly aware of these issues, but sees competitive advantage in spite of them.

Conclusion
In this paper we proposed SCM as a tool for better understanding the financial implications of
networked organizations. In particular, in the field study presented, we confirmed that
networked organizations tend to create value not only for the focal firms, but also for their
partners along the extended value chain. The research also confirmed that in networked
organizations, complexity is lower than in an integrated firm. The relationships, stable or not,
with suppliers reduce transactions and management costs and also tend to reduce the level of
slack resources which cause waste, delays and overall inefficiency. As shown, SCM can help
managers in understanding the dynamics of value creation and delivery, the factors which affect
profitability, and the key value chain stages where management efforts should be focused.

The plant will be located in the Republic of San Marino.

22

Cost analysis that is solidly embedded in the strategic context can be a richer element of
the outsourcing dialogue than is possible when using either of the two more traditional cost
frameworks, TCE or accounting-based make/buy. Using network strategic cost management,
companies can improve the effectiveness of their decision making and increase the quality of the
strategic planning process.

23

EXHIBIT 1
Piaggio, Aprilia and Malaguti: Some key performance measures
Piaggio

Aprilia

Malaguti

1,835
6,297

927
1,491

278
200

Rate of growth
(yearly average rate 94-97)
Revenues
Employees

1%
-5%

40%
49%

31%
11%

Profitability
(yearly average rate 94-97)
ROI (on operations)
ROS

-3.8%
-2.8%

13.1%
5.3%

41.8%
19.5%

-334
45%

0.6
15%

1.0
23%

1.5

1.0

0.02

Size
Revenues 1997 (billions of Italian liras)
Employees

Flexibility
Operating leverage (94 vs. 97)
Net assets on revenues (yearly average)
Financial position
Financial debt to equity ratio
(yearly average)

24

EXHIBIT 2
Piaggio, Aprilia and Malaguti: the value chains

EXHIBIT 3
Profitability per manufacturing phase (1997)

25

EXHIBIT 4
Comparative aggregate profitability across the industry value chains

EXHIBIT 5
The complexity (cost in billions of lit)
Piaggio
6.6
1.1
0.6
3.3

Employees/activity cost
White collars/activity cost
White collars/operating cost
Employees/operating cost

26

Aprilia
5.2
1.9
0.5
1.5

Malaguti
3.1
1.0
0.3
1.0

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