procuremetn & outsourcing strategies

8/7/2019 procuremetn & outsourcing strategies

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Outsourcing & Procurement

StrategiesSource: Simchi-Levi, Chapter 7


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Introduction

` In the 90s outsourcing was the focus of manyindustrial manufacturers

` Everything from procurement to production to

manufacturing were outsourced

` There was a huge pressure on organization to

increase profits

` One easy way to increase profit is by reducing

costs through outsourcing


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Procurement and Outsourcing

Strategies

` Outsourcing benefits and risks` Through 90s, Strategic outsourcing was used as a tool to

rapidly cut costs

` Outsourcing the manufacturing of key components

` Recent study of 8 major contract equipment manufacturers(CEMs)

` Aggregate revenue quadrupled between 1996 and 2000 while capital

expenditure grew 11-fold


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Motivations for outsourcing

` Motivations for outsourcing

` Economies of scale

Reduce manufacturing costs through aggregation of orders

from different buyers

Economies of scale in both purchasing and manufacturing

` Risk pooling

Outsourcing allow buyers to transfer demand uncertainty to

the CEM

Advantage: CEMs can aggregate demand from many buyers

and can reduce uncertainty through risk-pooling CEMs can reduce component inventory level while

maintaining or even increasing service levels


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` Reduce capital investment

CEMs handle demand uncertainty and capital

investments

Investment is shared between many CEM

customers

` Focus on core competency

Buyer is able to focus on core strengths (i.e.,

specific talent, skills, and knowledge thatdifferentiates the company from its competitors

and gives it a competitive advantage)


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` Increased flexibility

3 issues

The ability to better react to changing

customer demand

The ability to use the suppliers technical

knowledge to speedup product development

cycle time

The ability to gain access to new technologyand innovation


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Risks associated with outsourcing

` Loss of competitive knowledge

Outsourcing critical components may open up

opportunities for competitors

Companies loss the ability to introduce new

designs based on own agenda rather than

suppliers agenda

May hinder the development of new insights,

innovations, and solutions that typically requirecross-functional teamwork


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Strategies

` Risks associated with outsourcing` Conflicting objectives-lot size

Good times: demand is high, conflict resolved by buyerwilling to long-term commitment for minimum quantity

Bad times: demand is low, long-term commitments canhave huge financial risks for buyers

` Conflicting objectives-design problems

Buyers want flexibility so that design problems aresolved as quickly as possible

Suppliers focus on cost reduction which usually meansslow responsiveness to design changes


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Examples of Outsourcing Problems

IBM

` PC market entry in 1981

` Outsourced many components to get to marketquickly

` 40% market share by 1985 beating Apple as the top

PC manufacturer` Other competitors like Compaq used the same

suppliers

` IBM tried to regain market by introducing the PS/2

line with the OS/2 system` Suppliers and competitors did not follow` IBM market share shrunk to 8% in 1995

` Behind Compaqs 10% leading share

` Led to eventual sale ofPC business to Lenovo


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Strategies

` A framework for buy/make decisions

` How can the firm decide which components to

manufacture (make) and which components to

outsource (buy)?

` Firms should focus on core competencies

` How does a firm identify

what is in the core, and therefore should be

made internally? What is outside the core, and therefore should

be purchased outside?


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Strategies


` The reasons for outsourcing fall under 2 major

categories

` Dependency on capacity

The firm has the knowledge and the skills

required

` Dependency on knowledge

The firm does not have the people, skills, andknowledge required and uses outsourcing to

gain access to these capabilities


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Strategies

` A framework for buy/make decisions` Example, Toyota

` They have knowledge and skill to produce enginesproduce 100% of engines internally

` For transmissions, they depend on suppliers capacities(70% of components are outsourced)

` Vehicle electronic systems designed and produced bysuppliers

Dependency on both capacity and knowledge

` Toyota varies outsourcing depending on the strategic roleof the components and subsystems

The more strategically important the component, thesmaller the dependency on knowledge and capacity


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Strategies

` A framework for buy/make decisions` Integral products vs. modular products

` Modular products can be made by combining different

components

Components are independent of each other Components are interchangeable

Standard interfaces are used

A component can be designed or upgraded with little

or no regard to other components Customer preference determines the product

configuration


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Strategies

` A framework for buy/make decisions` Integral products vs. modular products

` Integral products are products made up from componentswhose functionalities are tightly related

Integral products are not made from off-the-shelfcomponents

Integral products are designed as a system by taking atop-down design approach

Integral products are evaluated based on system

performance, not based on component performance Components in integral products perform multiple

functions


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Strategies

` A framework for buy/make decisions` Integral products vs. modular product

` Very few products are either modular or integral

Highly modular products

Personal computers

Highly integral products

Airplanes

` The buy/make decision should consider both modular and

integral products, and the firms dependency onknowledge and capacity


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Strategies

` Modular products:` Capturing knowledge is important

` Having production capacity in-house is less critical

If a company has the knowledge, outsourcing the

manufacturing process provides an opportunity toreduce cost

If the firm has neither knowledge nor capacity,

outsourcing may be a risky strategy

Knowledge developed by the supplier may betransferred to a competitors product


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Strategies

` Integral products:` Capturing both knowledge and capacity is important if

possible

If the firm has both knowledge and capacity, production

should be performed in-house If the firm doesnt have both knowledge and capacity, it

may be in the wrong business!!!


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Strategies


A Framework for Make/Buy Decisions

Product Dependency onknowledge and

capacity

Independent forknowledge, dependency

for capacity

Independent forknowledge and

capacity

Modular Outsourcing is risky Outsourcing is an

opportunity

Opportunity to reduce

cost through outsourcing

Integral Outsourcing is very

risky

Outsourcing is an option Keep production in-

house


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Hierarchical Model to Decide

Whether to Outsource or Not

` Customer Importance` How important is the component to the customer?

` What is the impact of the component on customer experience?

` Does the component affect customer choice?

`

Component Clockspeed` How fast does the components technology change relative to other

components in the system?

` Competitive Position` Does the firm have a competitive advantage producing this

component?

` Capable Suppliers` How many capable suppliers exist?

` Architecture` How modular or integral is this element to the overall architecture

of the system?


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Examples of Decisions

Criteria Example 1 Example 2 Example 3 Example 4

Customer

Importance

Important Not important Important Important

Clockspeed High Slow High Slow

Competitive

Position

Competitive

Advantage

No advantage No advantage No advantage

Capable

Suppliers

X X Key variable to

decide

strategy

Architecture X X Key variable to

decide

strategyDECISION Inhouse Outsource Inhouse,

Acquire

supplier,

Partnership

Outsource

with modular;

Inhouse or

joint

development

with integral.


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Procurement Strategies

` Impact of procurement on business performance` 2005 profit margins for Pfizer (24%), Dell (5%),Boeing

(2.8%).

` Reducing procurement cost by exactly 1% of revenue

would have translated directly into bottom line, i.e.,net profit.

` To achieve the same impact on net profit throughhigher sales` Pfizer would need to increase its revenue by 4.17 (0.01/0.24)

%` Dell by 20% and Boeing by 35.7%

` The smaller the profit margins, the more important itis to focus on reducing procurement costs.


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Appropriate Strategy

`

Depends on:` type of products the firm is purchasing

` level of risk

` uncertainty involved

` Issues:` How can the firm develop an effective purchasing strategy?

` What are the capabilities needed for a successfulprocurement function?

` What are the drivers of effective procurement strategies?

` How can the firm ensure continuous supply of materialwithout increasing its risks?


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Kraljics Supply Matrix

` Firms supply strategy should depend on two dimensions` profit impact

` Volume purchased/ percentage of total purchased cost/impact on product quality or business growth

` supply risk

` Availability/number of suppliers/competitive demand/make-or-buy opportunities/ storage risks/ substitutionopportunities


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` Top right quadrant:` Strategic items where supply risk and impact on profit are

high

` Highest impact on customer experience

` Price is a large portion of the system cost

` Typically have a single supplier` Focus on long-term partnerships with suppliers

` Bottom right quadrant` Items with high impact on profit

` L

ow supply risk (leverage items)` Many suppliers

` Small percentage of cost savings will have a large impact onbottom line

` Focus on cost reduction by competition betweensuppliers


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`

Top left quadrant:` High supply risk but low profit impact items.

` Bottleneck components

` Do not contribute a large portion of the product cost

` Suppliers have power position

` Ensure continuous supply, even possibly at a premium cost` Focus on long-term contracts or by carrying stock

(or both)

` Bottom left quadrant:` Non-critical items

` Simplify and automate the procurement process as much aspossible

` Use a decentralized procurement policy with no formalrequisition and approval process


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Supplier Footprint

` Supply Strategies have changed over the years` American automotive manufacturers

` 1980s: Suppliers either in the US or in Germany.

` 1990s: Suppliers in Mexico, Spain, and Portugal.

` 2000s: Suppliers in China

` High-tech industry` 1980s: Sourcing in the US

` 1990s: Singapore and Malaysia

` 2000s: Taiwan and mainland China

` Challenge:` Framework that helps organizations determine the appropriate

supplier footprint.

` Strategy should depend on the type of product or componentpurchased


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Fishers Functional vs. Innovative

Products

Functional Products Innovative Products

Product clockspeed Slow Fast

Demand Characteristics Predictable Unpredictable

Profit Margin Low High

Product Variety Low High

Average forecast error at thetime production is committed Low High

Average stockout rate Low High


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Supply Chain Strategy

` Functional Products` Diapers, soup, milk, tiers

` Appropriate supply chain strategy for functional products ispush

` Focus: efficiency, cost reduction, and supply chain planning.

` Innovative products` Fashion items, cosmetics, or high tech products

` Appropriate supply chain strategy is pull

` Focus: high profit margins, fast clockspeed, and

unpredictable demand, responsiveness, maximizing servicelevel, order fulfillment


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Procurement Strategy for the Two

Types

` Functional Products` Focus should be on minimizing total landed cost

` unit cost

` transportation cost

` inventory holding cost

` handling cost` duties and taxation

` cost of financing

` Sourcing from low-cost countries,

` Innovative Products` Focus should be on reducing lead times and on supply flexibility.` Sourcing close to the market area

` Short lead time may be achieved using air shipments


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E-Procurement


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E-Procurement

` Mid to late 90s:B2B automation was considered atrend that would have a profound impact on supplychain performance.

` 1998-2000:` Multiple e-markets established in various industries

` Promised:` increased market reach for both buyers and suppliers

` reduced procurement costs

` paperless transactions

` Processing cost per order proposed to be reduced to$5/order from as high as $150/order


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E-Procurement

` In mid 90s manufacturers were looking tooutsource their procurement functions` Recognized that procurement process is highly complex,

requires significant expertise, and is very costly

` Business-to-business (B2B) transactions represent a largeportion of the economy (much larger than business-to-customer (B2C))

The B2B marketplace is highly fragmented, with a largenumber of suppliers competing and offering similar

products


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E-Procurement

` Both fragmented marketplace provides both opportunitiesand challenges

` Procurement costs can be significantly reduced

` To achieve these lower costs, buyers need significant

expertise in the procurement process Which many dont have

` Initial offerings: independent e-marketplaces with either a

vertical-industry focus or a horizontal-business-process or

functional focus


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E-Procurement

` Value proposition offered to buyers by e-markets` Serving as an intermediary between buyers and suppliers

` Identifying saving opportunities

` Increasing the number of suppliers involved in the bidding

event` Identifying, quantifying, and supporting suppliers

` Conducting the bidding event


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E-Procurement

` Between 1996-1999, the focus was on reducingprocurement cost

` Depending on the industry, e-markets were reported toreduce procurement cost by a few percentage points to asmuch as 40% and, on average, about 15%

This business model is appropriate when buyers arefocused on the spot market and long-term relationshipsare not important

If long-term relationships are important, selecting asupplier based on on-line bidding may be risky


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E-Procurement

` Problem: The value proposition for the supplier was not asclear

` E-markets allowed small suppliers to expand markethorizon

` E-markets allowed suppliers to access spot markets

These markets allow suppliers to reduce marketing andsales costs and thus increase their ability to compete onprice

` e-markets allow suppliers to better utilize their availablecapacities and inventories


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E-Procurement

` Problem: The value proposition for the supplier was not asclear

` Its not clear that many suppliers fell comfortable

competing on price alone

Suppliers, especially those with name recognition, mayresist selling their services through e-markets


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E-Procurement`

How do e-markets generate revenue?` Initially: markets charged a transaction fee paid byeither the buyer, the supplier, or both Fees were typically a percentage of the price paid

by the buyer (1 to 5%)` Problems with transaction fees

1. Sellers resist paying a fee to the company whosemain objective was to reduce the purchase price2. The revenue model needs to be flexible enough so

that transaction fees are charged to the party thatis more motivated to make the deal If demand is much larger than supply, buyers

are more motivated then sellers, therefore thefee should be paid by the buyer3. Buyers also resist paying a fee in addition to

purchase price


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E-Procurement

` Many exchanges have changed the way they charge theirclients

` 2 other types of charge mechanisms have been used

` Licensing fee

The market maker licenses its software so that thecompany can automate the access to the

marketplace

` Subscription fee

The marketplace charges a membership fee that

depends on the size of the company, the number

of employees who use the system, and the number

of purchase orders


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E-Procurement

` E-market value proposition` Initially the focus was on market reach for buyers and

sellers as well as lower purchase costs

` Now, 4 types of markets

` Value-added independent (public) e-markets` Private e-markets

` Consortia-based e-markets

` Content-based e-market


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E-Procurement

` Now, 4 types of markets` Value-added independent (public) e-markets

Additional services such as inventory management,

supply chain planning, and financial services

Instill.comfocuses on food service industry Provides value by offering not only procurement

services but also forecasting, collaboration, and

replenishment tools


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E-Procurement

` Private e-markets Example, Dell Computers, Sun Microsystems, Wal-Mart,

and IBM, etc

Companies dont use e-market to force suppliers to

compete on price E-market is viewed as a way to improve supply chain

collaboration by providing demand information and

production data to their suppliers

Other companies use private e-markets to consolidate

their purchasing power across the entire corporation


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E-Procurement

` Consortia-based e-markets Very similar to public e-markets except that they are

established by a number of companies within the same

industry

Examples Convisintautomotive industry

Exostaraerospace industry

Trade-Rangeroil industry

Converge and E2Openelectronic industry


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E-Procurement

` Consortia-based e-markets The objective:

To aggregate activities and use the buying power of

consortia members

To provide suppliers with a standard system thatsupports all the consortias buyers

allows suppliers to reduce cost and become more

efficient


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E-Procurement

` Content-based e-market 2 types of markets

1. Focuses on maintenance, repair, and operations

(MRO) goods

2.Focuses on industry-specific products

The e-market integrates catalogs from many

industrial suppliers

Provides effective tools for searching and

comparing suppliers products


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E-Procurement

` e-ProcurementPrivate and Public Marketplaces

Privatemarketplace Public/consortia marketplace

Owner A single buyer Independent owner or a group of companies from thesame industry

Objectives 1. Share proprietary data includingproduct design, demandforecast, and production plans

2. Allows for logistics and supplychain collaboration

1. Buying and selling commodities by focusing onprice

2. Finding new suppliers3. Buying and selling excess inventory and

capacity

Participants Selected group of suppliers Open market

Buyer cost Building and maintaining the site 1. Subscription fee

2. Licensing fee

3. Transaction fee

Supplier cost No fee 1. Transaction fee

2. Subscription fee

Main problems 1. Initial investment

2. Data nor malization anduploading

1. Recent collapse of many marketplaces

2. Objections by referred suppliers because ofprice focus

3. Sharing of proprietary information

4. Data nor malization and uploading


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E-Procurement

` The boundaries between the different types of e-marketsare blurred

` Many consortia-based e-markets provide content-

based services

`

Some consortia-based e-marketplaces provideservices similar to those provided by private

exchanges


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A framework for e-Procurement

` E-markets allow buyers to increase market reach, bettercollaborate with suppliers, and remove inefficiencies from their

SCs

` It is unclear if a firm should build a private marketplace, use

independent markets, or participate in consortia-based

markets


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A framework for e-Procurement`

Different types of goods purchased by firms` Strategic components

Components that are part of the finished goods and arenot only industry specific but also company specific

Usually integral products

`

Commodity products Products that can be purchased from a variety of

vendors and whose price is determined by marketforces

Usually modular components that go directly into thefinished product

Also includes commodities that do not go directly intothe finished product (e.g., electricity)


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`

Indirect materials Often referred to as maintenance, repair, and operations

(MRO) Include components that are not part of the finished

product or manufacturing process, but are essential forthe business e.g., lighting, janitorial supplies, office supplies,

fasteners, and generators


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` The procurement strategy depends on the type of productand the level of risk

` Risk is associated with

` Uncertain demand

Inventory risk

` Volatile market price

Price risk

` Component availability

Shortage risk with an impact on the firms ability to

satisfy customer demand


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` To illustrate various types of risks, consider a commodityproduct

` Can be purchased either in the open market through on-line auctions or through the use of long-term contracts

Long-term contracts guarantee a certain level of supply,

but may be risky if realized demand is either lower orhigher then the demand forecast

If demand is lower than forecastbuyer facesinventory holding costs

If demand is higher than forecastbuyer faces either

shortage risk or price risk Price risk means that additional components need to

be purchased in the open market at times ofshortagetypically at higher prices

If components are not available in the open market

then shortage risk!!


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` Indirect material` Risk associated with indirect materials is usually low and

therefore the focus is on using content-based hubs

Firms should use MRO hubs that specialize in unifying

catalogs from many suppliers


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` Strategic components` High-risk components that can be purchased from a small

number of suppliers

Private or consortia-based e-marketplaces are

appropriate Focus is on a marketplace that allows for better

collaboration with the suppliers

Marketplace provides the supplier with real-time

demand information as well as the buyers production

plans


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` Strategic components` The decision to establish a private marketplace or to use a

consortia-based e-market depends on

Transaction volume

Number of suppliers

Cost to build and maintain a private site

Importance of protecting proprietary business practices

Technology and product life cycle

The shorter the technology and product life cycle, the

closer the required collaboration with key suppliers A private exchange is better for this type of

relationship

Allows buyers and suppliers to cut design cost anddevelopment cycle time


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` Commodity products` Most challenging product category

Product often goes directly into finished goods

Risk is high

There are a variety of potential options to choose from

Selecting from many suppliers offering long-term,sometimes flexible contracts, and/or using spotmarket for short-term purchasing

High risk

Focus should be both on price and risk management

Use portfolio approach


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A framework for e-Procurement`

Commodity products` Portfolio approach

Focus on the appropriate trade-off between riskand cost

` To implement a portfolio approach the firm shoulduse a combination of1. Long-term contracts

Both firms commit to a certain volume and thesupplier guarantees a level of supply for acertain price

Base commitment level


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2.Flexible, or option, contracts The buyer prepays a relatively small fraction of

the product price up front The supplier satisfies demand up to a certain

level (a.k.a., the option level) If the buyer doesnt exercise the option, the

initial payment is lost The buyer can purchase any amount up to the

option level, by paying an additional price The total price paid by the buyer for each unit

is higher than the unit price in a long-term

contract


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Spot purchasing Buyers look for additional supply in the openmarket

Firm should use an independent e-market toselect supplier

Focus is on using the marketplace to find new

suppliers and on forcing competition betweensuppliers to reduce product price


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` How does the portfolio approach address risk?` If demand is much higher than anticipated and the

base commitment level plus the option level do not

provide enough protection, the firm must use the

spot market for additional supply

In the spot market prices are typically high due to

shortages

` The buyer select a trade-off level between price risk,

shortage risk, and inventory risk by selecting the level

of long-term commitments and option levels


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` How does the portfolio approach address risk?` Example,

For same option level, the higher the initial

contract commitment, the smaller the price risk

but the higher the inventory risk taken by buyers

The smaller the level of the base commitment, the

higher the price and shortage risks due to the

likelihood of using the spot market

For the same level of base commitment, the higher

the option level, the higher the risk assumed bythe supplier since the buyer may exercise only a

small fraction of the option level


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Risk Trade-Off in Portfolio Contracts

Option

level

High Inventory risk (supplier) N/A*

Low

Price and shortage risks

(buyer)

Inventory risk (buyer)

Low High

Base commitment level

procuremetn & outsourcing strategies

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