Chapter 9

Procurement and Outsourcing Strategies

McGraw-Hill/Irwin Copyright 2008 by The McGraw-Hill Companies, Inc. All rights reserved.

9.1 Introduction
Outsourcing components have increased progressively over the years Some industries have been outsourcing for an extended time

Fashion Industry (Nike) (all manufacturing outsourced) Electronics Industry

Cisco

(major suppliers across the world) Apple (over 70% of components outsourced)

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Not Just Manufacturing but Product Design, Too

Taiwanese companies now design and manufacture most laptop sold around the world Brands such as Hewlett-Packard and PalmOne collaborate with Asian suppliers on the design of their PDAs.

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Questions/Issues with Outsourcing

Why do many technology companies outsource manufacturing, and even innovation, to Asian manufacturers? What are the risks involved? Should outsourcing strategies depend on product characteristics, such as product clockspeed, and if so how?

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Discussion Points

Buy/make decision process

Advantages and the risks with outsourcing Framework for optimizing buy/make decisions. Framework for identifying the appropriate procurement strategy Linkage of procurement strategy to outsourcing strategy. Independent (public), private, and consortium-based e-marketplaces. New developments mean higher opportunities and greater challenges faced by many buyers

Effective procurement strategies

The procurement process

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9.2 Outsourcing Benefits and Risks Benefits

Economies of scale

Aggregation of multiple orders reduces costs, both in purchasing and in manufacturing Demand uncertainty transferred to the suppliers Suppliers reduce uncertainty through the risk-pooling effect

Risk pooling

Reduce capital investment

Capital investment transferred to suppliers. Suppliers higher investment shared between customers.
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Outsourcing Benefits

Focus on core competency

Buyer can focus on its core strength Allows buyer to differentiate from its competitors The ability to better react to changes in customer demand The ability to use the suppliers technical knowledge to accelerate product development cycle time The ability to gain access to new technologies and innovation. Critical in certain industries:

Increased flexibility

High tech where technologies change very frequently Fashion where products have a short life cycle

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Outsourcing Risks Loss of Competitive Knowledge

Outsourcing critical components to suppliers may open up opportunities for competitors Outsourcing implies that companies lose their ability to introduce new designs based on their own agenda rather than the suppliers agenda Outsourcing the manufacturing of various components to different suppliers may prevent the development of new insights, innovations, and solutions that typically require crossfunctional teamwork

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Outsourcing Risks Conflicting Objectives

Demand Issues

In a good economy
Demand is high Conflict can be addressed by buyers who are willing to make long-term commitments to purchase minimum quantities specified by a contract

In a slow economy
Significant decline in demand Long-term commitments entail huge financial risks for the buyers

Product design issues

Buyers insist on flexibility

would like to solve design problems as fast as possible implies slow responsiveness to design changes.
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Suppliers focus on cost reduction

Examples of Outsourcing Problems IBM

PC market entry in 1981 Outsourced many components to get to market quickly 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 of PC business to Lenovo
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Examples of Outsourcing Problems Cisco

2000 problem:

Forced to announce a $2.2 billion write-down for obsolete inventory 8,500 employees were laid off.

Significant reduction in demand for telecommunication infrastructure Problem in its virtual global manufacturing network

Long supply lead time for key components Would have impacted delivery to customers Cisco carried component inventory which were ordered long in advance of the downturn. Competition on limited supplier capacities

Long-term contracts with its suppliers

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9.3 Framework for Make/Buy Decisions

How can the firm decide on which component to manufacture and which to outsource? Focus on core competencies

How can the firm identify what is in the core? What is outside the core?

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Two Main Reasons for Outsourcing

Dependency on capacity
Firm has the knowledge and the skills required to produce the component For various reasons decides to outsource

Dependency on knowledge
Firm does not have the people, skills, and knowledge required to produce the component Outsources in order to have access to these capabilities.

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Outsourcing Decisions at Toyota

About 30% of components in-sourced Engines:

Company has knowledge and capacity 100% of engines are produced internally Company has the knowledge Designs all the components Depends on its suppliers capacities 70 % of the components outsourced Designed and produced by Toyotas suppliers. Company has dependency on both capacity and knowledge

Transmissions

Vehicle electronic systems

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Outsourcing Decisions at Toyota

Toyota seems to vary its outsourcing practice depending on the strategic role of the components and subsystems

The more strategically important the component, the smaller the dependency on knowledge or capacity.

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Product Architectures

Modular product

Made by combining different components Components are independent of each other Components are interchangeable Standard interfaces are used Customer preference determines the product configuration. Made up from components whose functionalities are tightly related. = Not made from off-the-shelf components. Designed as a system by taking a top-down design approach. Evaluated on system performance, not on component performance Components perform multiple functions.
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Integral product

A Framework for Make/Buy Decisions

Product Dependency on knowledge and capacity Outsourcing is risky Independent for knowledge, dependent for capacity Outsourcing is an opportunity Independent for knowledge and capacity Opportunity to reduce cost through outsourcing Keep production internal Modular

Integral

Outsourcing is very risky

Outsourcing is an option

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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? How fast does the components technology change relative to other components in the system? Does the firm have a competitive advantage producing this component? How many capable suppliers exist? How modular or integral is this element to the overall architecture of the system?
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Component Clockspeed

Competitive Position

Capable Suppliers

Architecture

Examples of Decisions
Criteria Example 1 Example 2 Example 3 Example 4

Customer Importance
Clockspeed Competitive Position Capable Suppliers Architecture

Important
High Competitive Advantage X

Not important
Slow No advantage X

Important
High No advantage Key variable to decide strategy

Important
Slow No advantage

Key variable to decide strategy Inhouse, Acquire supplier, Partnership Outsource with modular; Inhouse or joint development with integral.
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DECISION

Inhouse

Outsource

9.4 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 through higher 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 it is 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 How can the firm develop an effective purchasing strategy? What are the capabilities needed for a successful procurement function? What are the drivers of effective procurement strategies? How can the firm ensure continuous supply of material without increasing its risks?
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Issues:

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/ substitution opportunities

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Kraljics Supply Matrix

FIGURE 9-4: Kraljics supply matrix

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Kraljics Supply Matrix

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 Items with high impact on profit Low supply risk (leverage items) Many suppliers Small percentage of cost savings will have a large impact on bottom line Focus on cost reduction by competition between suppliers
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Bottom right quadrant

Kraljics Supply Matrix

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) Non-critical items Simplify and automate the procurement process as much as possible Use a decentralized procurement policy with no formal requisition and approval process
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Bottom left quadrant:

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 1980s: Sourcing in the US 1990s: Singapore and Malaysia 2000s: Taiwan and mainland China

High-tech industry

Challenge:

Framework that helps organizations determine the appropriate supplier footprint. Strategy should depend on the type of product or component purchased
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Fishers Functional vs. Innovative Products

Functional Products Innovative Products Product clockspeed Demand Characteristics Slow Predictable Fast Unpredictable

Profit Margin Product Variety Average forecast error at the time production is committed

Low Low Low

High High 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 is push Focus: efficiency, cost reduction, and supply chain planning. Fashion items, cosmetics, or high tech products Appropriate supply chain strategy is pull Focus: high profit margins, fast clockspeed, and unpredictable demand, responsiveness, maximizing service level, order fulfillment

Innovative products

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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, e.g., mainland China and Taiwan is appropriate

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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Sourcing Strategy for Components

Fishers framework focuses on finished goods and demand side Kraljics framework focuses on supply side Combine Fishers and Kraljics frameworks to derive sourcing strategy

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Integrated Framework
Component forecast accuracy Component supply risk Component financial impact Component clockspeed

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Component Forecast Accuracy

Not necessarily the same forecast accuracy as for finished goods

Risk pooling concept implies higher accuracy for components

Sourcing strategy may be minimizing total landed costs, lead time reduction, or increasing flexibility.

Cost-based sourcing strategy

High component forecast accuracy/Low supply risk/High financial impact/Slow is appropriate.

Low component forecast accuracy/High financial risk/Fast clockspeed Low component forecast accuracy/High financial risk/Fast clockspeed/High supply risk
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Lead time reduction strategy

Flexibility and lead time strategy

HPs Portfolio Strategy

Exponential growth in demand for Flash memory resulted in high demand uncertainty Uncertain price and supply Significant financial and supply risk. Commitment to purchase large amount of inventory

huge financial risk through obsolescence cost.

both supply risk and financial risk

Not have enough supply to meet demand

purchasing from the spot market during shortage periods yield to premium payments

HPs solution: the portfolio strategy

Combined fixed commitment, option contracts, and spot purchasing

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Qualitative Approach to Sourcing Strategy

FIGURE 9-5: A qualitative approach for evaluating component sourcing strategy

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9.5 E-Procurement

Mid to late 90s: B2B automation was considered a trend that would have a profound impact on supply chain 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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Business Environment in the 1990s

Many manufacturers desperately looking to outsource their procurement functions. Procurement process highly complex, significant expertise required and expensive B2B transactions an enormous portion of the economy (much larger B2B marketplace highly fragmented

a large number of suppliers competing in the same marketplace offering similar products. Lowered procurement costs (Suppliers) Significant expertise in procurement process absent (Buyers)
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Opportunities and challenges

Opportunities for the Marketplaces

Initial offerings of independent emarketplaces

Either a vertical-industry focus or a horizontalbusiness-process or a functional focus. Companies offered:

expertise

in the procurement process ability to force competition between a large number of suppliers.

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Value Proposition to Buyers

Serving as an intermediary between buyers and suppliers. Identifying saving opportunities. Increasing the number of suppliers involved in the bidding event. Identifying, qualifying, and supporting suppliers. Conducting the bidding event.

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The Result
Reduction in procurement costs from 1540% Buyers focused on the spot market or on leverage component Long term relationships with suppliers not important Value proposition to suppliers not clear

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Benefits of e-markets to Suppliers

Relatively small suppliers could expand their market horizon Allows suppliers to access spot markets. Advantageous in:

Fragmented markets Reducing marketing and sales costs Increasing ability to compete on price.

Allows suppliers to better utilize their available capacities and inventories.

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Issues of the Benefits

Do the benefits compensate for a reduction in revenue?

Average 15%, sometimes as high as 40%.

Many suppliers may not feel comfortable competing on price alone. Suppliers, especially those with brandname recognition, may resist selling their services through e-markets.

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What about the e-markets Themselves?

Revenue generation through transaction costs

Typically 1-5% of price paid by buyer

Transaction fees pose serious challenges to the market maker:

Sellers resist paying a fee to the company whose main objective is to reduce the purchase price. Revenue model needs to be flexible enough so that transaction fees are charged to the party that is more motivated to secure the engagement. Buyers also resist paying a fee in addition to the purchase price.

Low barriers to entry created a fragmented industry

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Fragmented e-markets in the Chemical Industry

About 30 e-markets
CheMatch, e-Chemicals, ChemB2B.com, ChemCross, OneChem, ChemicalDesk, ChemRound, Chemdex Low margins and inability to build scale resulted in a major shake-up of this industry

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Challenges Lead to Evolution of the e-markets

Changes in the way clients are charged

Licensing fee
software

vendor licenses its software so that the company can automate the access to the marketplace

Subscription fee
marketplace

charges a membership fee Fee 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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Challenges Lead to Evolution of the e-markets

Modification of value proposition

Initial proposition was market reach Changed through creation of four types of markets.

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Value-Added Independent Public eMarkets

Expanded value proposition by offering additional services:

inventory management supply chain planning financial services

Instill.com focuses on the food service industry

Examples:

Provides an infrastructure that links together operators Additional services like forecasting, collaboration, and replenishment tools. Offers buyers access to a large number of independent fresh fish auctions. Provide visibility on price from many European ports Provide information on product quality
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Pefa.com services the European fresh fish market

Private e-markets

Many companies have established their own private e-markets Key activities:

to run reverse auctions on-line supplier negotiation. Subway restaurant franchise

Examples:

16,000 members in over 70 countries Allows the different restaurants to purchase from over 100 suppliers. Implemented supplier negotiation software Allows firm to conduct bids, negotiate and select an effective procurement strategy.
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Motorola

Consortia-Based e-markets

Similar to public e-markets Established by a number of companies within the same industry. Examples:

Covisint in the automotive industry Exostar in the aerospace industry Trade-Ranger in the oil industry Converge and E2Open in the electronic industry.

Provides suppliers with a standard system that supports all the consortias buyers Some of the consortia have exited the auction business

Focus on technology that enables business collaboration between trading partners (Examples: Covisint and E2Open)
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Content-Based e-markets

Two types of markets

Maintenance, repair, operations (MRO) goods Industry-specific products. Achieved by integrating catalogs from many industrial suppliers. Unify suppliers catalogs Provide effective tools for searching and comparing suppliers products. Aspect Development (now part of i2) offers electronics parts catalogs that integrate with CAD systems.

Focus on content

Example:

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SUMMARY

Outsourcing has both benefits and risks Buy/make decisions should depend on:

Whether a particular component is modular or integral Whether or not a firm has the expertise and capacity to manufacture a particular component or product. Variety of criteria including customer importance, technology clockspeed, competitive position, number of suppliers, and product architecture.

Procurement strategies vary from component to component

Four categories of components, strategic, leverage, bottleneck and non-critical items

Four categories important in selecting suppliers: component forecast accuracy, clockspeed, supply risk, and financial impact.
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