Dr. Prashant GuptaProcurement and Outsourcing Strategies

S. Chopra / Demand Planning

Purchasing / Procurement / SourcingProcurement:Procurement refers to a process of obtaining all goods, services, capacities and knowledge from external sources which are necessary for running, maintaining, and managing a firms primary and support activities at the most favorable conditions. Procurement Management:Procurement Management is a strategic process for development of a sound purchasing set up and an effective supply base so as to achieve supply chain productivity.

Acquisition of goods & servicesActivitiesHelp decide whether to make or buyIdentify sources of supplySelect suppliers & negotiate contractsControl vendor performanceImportanceMajor cost centerAffects quality of final productPurchasing

Objectives of the Purchasing FunctionHelp identify the products and services that can be best obtained externally; and

Develop, evaluate, and determine the best supplier, price, and delivery for those products and services.

Purchasing Costs as a Percent of SalesAll industryAutomobileFoodLumber (Furniture)PaperPetroleumTransportation52%61%60%61%55%74%63%IndustryPercent of Sales

Benefits of Effective Sourcing DecisionsBetter economies of scale can be achieved if orders are aggregated.More efficient procurement transactions can significantly reduce the overall cost of purchasing.Design collaboration can result in products that are easier to manufacture and distribute, resulting in lower overall costs.Good procurement processes can facilitate coordination with suppliers improving forecasting and planning.Appropriate supplier contracts can allow for the sharing of risk.Firms can achieve a lower purchase price by increasing competition through the use of auctions.

Sourcing in a Supply ChainSourcing Processes include:1. Supplier Assessment & Scoring 2. Supplier Selection and Contract Negotiation3. Design Collaboration4. Procurement5. Sourcing Planning and Analysis

1.Supplier Assessment and Scoring Supplier performance should be compared on the basis of the suppliers impact on total cost.There are several other factors besides purchase price that influence total cost.

1.1 Supplier Assessment FactorsReplenishment Lead TimeOn-Time PerformanceSupply FlexibilityDelivery Frequency / Minimum Lot SizeSupply QualityInbound Transportation CostPricing TermsInformation Coordination CapabilityDesign Collaboration CapabilityExchange Rates, Taxes, DutiesSupplier Viability

2. Supplier Selection and ContractsObjectives:To increase firms and supply chain profit.To discourage information distortion.To offer incentives to the supplier to improve performance.Selection Mechanisms:Off-line Competitive BidsDirect negotiationsReverse Auctions

Supplier Selection and Contracts (Contd.)Contracts for Product Availability and Supply Chain ProfitsBuyback ContractsRevenue-Sharing ContractsQuantity Flexibility ContractsContracts to Coordinate Supply Chain CostsContracts to Increase Agent EffortContracts to Induce Performance Improvement

2.1 Contracts for Product Availability and Supply Chain ProfitsMany shortcomings in supply chain performance occur because the buyer and supplier are separate organizations and each tries to optimize its own profit.Total supply chain profits might, therefore, be lower than the profits if the supply chain coordinated actions are taken to have a common objective of maximizing total supply chain profits.Double marginalization results in suboptimal order quantity.An approach to dealing with this problem is to design a contract that encourages a buyer to purchase more and increases the level of product availability.The supplier must share in some of the buyers demand uncertainty.

Risk Trade-Off in Portfolio Contracts

High Option Level for BuyerInventory Risk(Supplier)N / A*Low Option Level for Buyer Price and Shortage Risks (Buyer)Inventory Risk(Buyer)Low Base Commitment Level by BuyerHigh Base Commitment Level by Buyer

3. Design Collaboration50-70 percent of spending at a manufacturer is through procurement.80 percent of the cost of a purchased part is fixed in the design phase.Design collaboration with suppliers can result in reduced cost, improved quality, and decreased time to market.Important to employ design for logistics, design for manufacturability.Manufacturers must become effective design coordinators throughout the supply chain.

3.1 Design for LogisticsReduces transportation, handling, and inventory costs during distribution by taking appropriate actions during design.Packages to be designed to suit expected order sizes from the retailers and end consumers. It reduces need to break open a pack to fulfill an order.Packaging to be kept as compact as possible.Designed to ensure easy stacking.Design product for postponement and mass customization.

3.2 Mass CustomizationMass customization is designing a product such that inventory can be carried in a form that aggregates across multiple end products.The customization occurs along a combination of the following three categories: -Modular-Adjustable -Dimensional

3.2 Types of Mass CustomizationModular Customization: PC assembly at Dell.

Adjustable Customization: Washing machine that can automatically select from among different cycles. All inventory is thus maintained as a single product.

Dimensional Customization: Cutting frame tubing for a bicycle to fit the body size of the customer at National Bicycle.

3.3 Design for ManufacturabilityPart commonalityEliminating right-hand and left-hand partsDesigning symmetrical partsCombining partsUsing catalog parts rather than designing a new partDesigning parts to provide access for other parts and tools.

4. The Procurement ProcessThe process in which the supplier sends product in response to orders placed by the buyer.

Goal is to enable orders to be placed and delivered on schedule at the lowest possible overall cost.

Two main categories of purchased goods:Direct materials: Components used to make finished goods.Indirect materials: Goods used to support the operations of a firm.

Differences between Direct and Indirect Materials

AspectsDirect MaterialsIndirect MaterialsUseProduction Maintenance, Repair, and Support Operations (MRO)AccountingCost of goods soldSG&A (Selling, General and Administrative)Impact on productionAny delay will delay productionLess direct impactProcessing cost relative to value of transactionLowHighNumber of transactionsLowHigh

Differences between Procurement for Primary and Support Activities

AspectsProcurement for Primary ActivitiesProcurement for Support ActivitiesProduct AssortmentLimited to largeVery LargeNumber of SuppliersLimited, TransparentVery LargePurchasing TurnoverVery Large, ConsiderableLimitedNumber of Purchase OrdersConsiderableVery LargeAverage Order SizeHighSmallControlDepends on type of production planningLimited, forecast-related or project-related planningDecision Making UnitEngineering, Manufacturing specialists dominantFragmented, varies with product or service

The Procurement ProcessFocus for direct materials should be on improving coordination and visibility between the manufacturer and the supplier.e.g. e-Hub initiative at Cisco providing synchronized planning and end-to-end supply chain visibility.Focus for indirect materials should be on decreasing the transaction cost for each order.Procurement process for both direct and indirect materials should consolidate orders, wherever possible, by product and supplier to take advantage of economies of scale and quantity discounts.

5. Sourcing Planning and AnalysisA firm should periodically analyze its procurement spending and supplier performance and use this analysis as an input for future sourcing decisions.Procurement spending should be analyzed by part and supplier to ensure appropriate economies of scale.Supplier performance analysis should be used to build a portfolio of suppliers with complementary strengths.Cheaper but lower performing suppliers should be used to supply base demand.Higher performing but more expensive suppliers should be used to buffer against variation in demand and supply from the other source.

Procurement StrategiesImpact 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 salesPfizer 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.

Appropriate Procurement StrategyDepends on: Type of products the firm is purchasing Level of riskUncertainty involved Issues: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?

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 growthSupply Risk:Availability/number of suppliers / competitive demand / make-or-buy opportunities / storage risks / substitution opportunities

Kraljics Supply Matrix Kraljics Supply Matrix

Kraljics Supply MatrixTop right quadrant: Strategic items where supply risk and impact on profit are highHighest impact on customer experiencePrice is a large portion of the system costTypically have a single supplier Focus on long-term partnerships with suppliersBottom right quadrantItems with high impact on profitLow supply risk (leverage items)Many suppliersSmall percentage of cost savings will have a large impact on bottom line Focus on cost reduction by competition between suppliers

Kraljics Supply MatrixTop left quadrant: High supply risk but low profit impact items. Bottleneck componentsDo not contribute a large portion of the product cost Suppliers have power position Ensure continuous supply, even possibly at a premium costFocus on long-term contracts or by carrying stock (or both)Bottom left quadrant: Non-critical itemsSimplify and automate the procurement process as much as possibleUse a decentralized procurement policy with no formal requisition and approval process

Supplier FootprintSupply Strategies have changed over the yearsAmerican automotive manufacturers1980s: Suppliers either in the US or in Germany. 1990s: Suppliers in Mexico, Spain, and Portugal. 2000s: Suppliers in ChinaHigh-tech industry1980s: Sourcing in the US1990s: Singapore and Malaysia2000s: Taiwan and mainland ChinaChallenge: Framework that helps organizations determine the appropriate supplier footprint. Strategy should depend on the type of product or component purchased.

Fishers Functional vs. Innovative Products

Functional ProductsInnovative ProductsProduct clockspeedSlowFastDemand CharacteristicsPredictableUnpredictableProfit MarginLowHighProduct VarietyLowHighAverage forecast error at the time production is committedLowHighAverage stockout rateLowHigh

Supply Chain StrategyFunctional ProductsDiapers, soup, milk, tiersAppropriate supply chain strategy for functional products is pushFocus: efficiency, cost reduction, and supply chain planning.Innovative productsFashion items, cosmetics, or high tech products Appropriate supply chain strategy is pullFocus: high profit margins, fast clock-speed, and unpredictable demand, responsiveness, maximizing service level, order fulfillment

Procurement Strategy for the Two TypesFunctional ProductsFocus should be on minimizing total landed costunit cost transportation costinventory holding costhandling costduties and taxationcost of financingSourcing from low-cost countries, e.g., mainland China and Taiwan is appropriateInnovative ProductsFocus should be on reducing lead times and on supply flexibility. Sourcing close to the market areaShort lead time may be achieved using air shipments

Sourcing Strategy for ComponentsFishers Framework focuses on finished goods and demand sideKraljics Framework focuses on supply sideCombine Fishers and Kraljics Frameworks to derive sourcing strategy

Integrated FrameworkComponent Forecast Accuracy Component Supply RiskComponent Financial ImpactComponent Clock-speed

Component Sourcing StrategyNot necessarily the same forecast accuracy as for finished goods.Risk pooling concept implies higher accuracy for componentsSourcing strategy may be minimizing total landed costs, lead time reduction, or increasing flexibility. Cost-based sourcing strategyHigh component forecast accuracy/Low supply risk/High financial impact/Slow clock-speed. Lead time reduction strategyLow component forecast accuracy/High financial risk/Fast clock-speedFlexibility and lead time strategy Low component forecast accuracy/High financial risk/Fast clock-speed/High supply risk

Qualitative Approach to Sourcing StrategyA Qualitative Approach for Evaluating Component Sourcing Strategy

HPs Portfolio StrategyExponential growth in demand for Flash memory resulted in high demand uncertaintyUncertain price and supply. Significant financial and supply risk. Commitment to purchase large amount of inventoryhuge financial risk through obsolescence cost. Not have enough supply to meet demandboth supply risk and financial risk.purchasing from the spot market during shortage periods yield to premium payments.HPs solution: the portfolio strategyCombined fixed commitment, option contracts, and spot purchasing

OutsourcingOutsourcing refers to delegation or assignment of certain non-core activities of a corporate enterprise to outside agencies or firms with the objective to be performed in superior manner than performed internally.

Outsourcing TrendsOutsourcing components have increased progressively over the years.Some industries have been outsourcing for a long time.Fashion Industry (Nike) (all manufacturing outsourced)Electronics IndustryCisco (major suppliers across the world)Apple (over 70% of components outsourced)

Outsourcing Trends (Contd.)Taiwanese companies now design and manufacture most laptops sold around the world.Brands such as Hewlett-Packard and PalmOne collaborate with Asian suppliers on the design of their PDAs (A personal digital assistant , also known as a handheld PC, or personal data assistant, is a mobile device that functions as a personal information manager).

Questions / Issues with OutsourcingWhy 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 clock-speed, and if so, how?

Outsourcing Benefits and RisksBenefitsEconomies of scaleAggregation of multiple orders reduces costs, both in purchasing and in manufacturing.Risk poolingDemand uncertainty transferred to the suppliers.Suppliers reduce uncertainty through the risk-pooling effect.Reduce capital investmentCapital investment transferred to suppliers. Suppliers higher investment shared between customers.

Outsourcing BenefitsFocus on core competencyBuyer can focus on its core strength.Allows buyer to differentiate from its competitors. Increased flexibilityThe 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: High tech where technologies change very frequentlyFashion where products have a short life cycle

Outsourcing Risks Loss of Competitive KnowledgeOutsourcing 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 it depends more on the suppliers agenda. Outsourcing manufacturing of various components to different suppliers may prevent development of new insights, innovations, and solutions that typically require cross-functional teamwork .

Outsourcing RisksConflicting ObjectivesDemand IssuesIn a good economyDemand is highConflict can be addressed by buyers who are willing to make long-term commitments to purchase minimum quantities specified by a contractIn a slow economySignificant decline in demandLong-term commitments entail huge financial risks for the buyers. Product design issues Buyers insist on flexibilitywould like to solve design problems as fast as possible.Suppliers focus on cost reduction implies slow responsiveness to design changes.

Examples of Outsourcing Problems-IBMPC 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 systemSuppliers and competitors did not follow.IBM market share shrank to 8% in 1995Behind Compaqs 10% leading shareLed to eventual sale of PC business to Lenovo

Examples of Outsourcing Problems- Cisco2000 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.Problems 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

Strategic Dimensions to OutsourcingIdentifying self Core CompetencyOutsourcing Activities PortfolioEvaluating Competency of Potential Outsourcing Partners

Identifying Core CompetencyCore Competency is collective learning in an organization to coordinate diverse production skills and to integrate multiple streams of technologies to give the organization a unique advantage over its competitors by delivering superior value to customers.

Outsourcing Activities Portfolio

Nature of ActivityPrimarySecondaryStrategic Characteristics of ActivityNon-CorePrimary Non-Core ActivitiesSecondary Non-Core ActivitiesCorePrimary Core ActivitiesSecondary Core Activities

Outsourcing Activities Portfolio

Type of ActivityActivitiesPrimary CoreProduction, Product Design, Production Planning and Scheduling, Marketing, and Customer ServicesSecondary CoreLogistics, Human Resources, MaintenancePrimary Non-CoreInformation Technology, Finance and Accounting, Sales, and ProcurementSecondary Non-CoreReal Estate, Food Service, Landscaping

Product ArchitectureIntegral ProductsModular Products

Integral ProductsMade from components whose functionalities are tightly related.Not made from off-the-shelf componentsDesigned as a system taking a top-down design approachEvaluated based on system performance, not based on component performanceComponents in integral products perform multiple functions

Modular ProductsMade by combining different components.Components are independent of each otherComponents are interchangeableStandard interfaces are usedA component can be designed or upgraded with little or no regard to other componentsCustomer preference determines the product configuration

Two Main Reasons for OutsourcingDependency on CapacityFirm has the knowledge and the skills required to produce the component. For various reasons decides to outsource.Dependency on KnowledgeFirm does not have the people, skills, and knowledge required to produce the component. Outsources in order to have access to these capabilities.

Framework for Make / Buy Decisions

Dependency / Product Dependency on knowledge and capacityIndependent for knowledge, dependency for capacityIndependent for knowledge and capacityModularOutsourcing is riskyOutsourcing is an opportunityOpportunity to reduce cost through outsourcingIntegralOutsourcing is very riskyOutsourcing is an optionKeep production internal

Make/Buy ConsiderationsLower production costUnsuitable suppliersAssure adequate supplyUtilize surplus labor and make a marginal contributionObtain desired quantityRemove supplier collusionObtain a unique item that would entail a prohibitive commitment from the supplierMaintain organizational talentProtect proprietary design or qualityIncrease/maintain size of company

Lower acquisition costPreserve supplier commitmentObtain technical or management abilityInadequate capacityReduce inventory costsEnsure flexibility and alternate source of supplyReciprocityItem is protected by patent or trade secretFrees management to deal with its primary business Reasons for Making Reasons for Buying

Outsourcing Decisions at ToyotaAbout 30% of components in-sourcedEngines:Company has knowledge and capacity100% of engines are produced internallyTransmissionsCompany has the knowledge Designs all the components Depends on its suppliers capacities70 % of the components outsourcedVehicle electronic systemsDesigned and produced by Toyotas suppliers. Company has dependency on both capacity and knowledge

Outsourcing Decisions at ToyotaToyota seems to vary its outsourcing practice depending on the strategic role of the components and subsystemsThe more strategically important the component, the smaller the dependency on knowledge or capacity.

**161917***************************23