OPER3208-001 Supply Chain Management

1. OPER3208-001Supply Chain Management Fall 2006 Instructor: Prof. Setzler

2. Simchi-Levi, Chapter 7

3. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • Introduction • In the 90s outsourcing was the focus of many industrial 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

4. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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

5. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • Outsourcing benefits and risks • Motivations for outsourcing • Economies of scale • Risk pooling • Reduce capital investment • Focus on core competency • Increased flexibility • Risks associated with outsourcing • Loss of competitive knowledge • Conflicting objectives

6. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • Outsourcing benefits and risks • Risks associated with outsourcing • Conflicting objectives-lot size • Good times: demand is high, conflict resolved by buyer willing to long-term commitment for minimum quantity • Bad times: demand is low, long-term commitments can have huge financial risks for buyers • Conflicting objectives-design problems • Buyers want flexibility so that design problems are solved as quickly as possible • Suppliers focus on cost reduction which usually means slow responsiveness to design changes

7. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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?

8. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions • 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, and knowledge required and uses outsourcing to gain access to these capabilities

9. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions • Example, Toyota • They have knowledge and skill to produce engines—produce 100% of engines internally • For transmissions, they depend on suppliers’ capacities (70% of components are outsourced) • Vehicle electronic systems designed and produced by suppliers • Dependency on both capacity and knowledge • Toyota varies outsourcing depending on the strategic role of the components and subsystems • The more strategically important the component, the smaller the dependency on knowledge and capacity

10. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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

11. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions • Integral products vs. modular products • Integral products are products made up from components whose functionalities are tightly related • Integral products are not made from off-the-shelf components • Integral products are designed as a system by taking a top-down design approach • Integral products are evaluated based on system performance, not based on component performance • Components in integral products perform multiple functions

12. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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 firm’s dependency on knowledge and capacity

13. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions • 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 to reduce cost • If the firm has neither knowledge nor capacity, outsourcing may be a risky strategy • Knowledge developed by the supplier may be transferred to a competitor’s product

14. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions • 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 doesn’t have both knowledge and capacity, it may be in the wrong business!!!

15. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for buy/make decisions

16. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Between 1998 and 2000 hundreds of e-markets were established in dozens of industries • Increased market reach for both buyers and suppliers • Reduced procurement costs • Paperless transactions • Promise: e-procurement software would automate requisitioning process and reduce processing costs per order from as high as $15 per order to as low as $5 per order

17. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • In mid 90s manufacturers were looking to outsource their procurement functions • Recognized that procurement process is highly complex, requires significant expertise, and is very costly • Business-to-business (B2B) transactions represent a large portion of the economy (much larger than business-to-customer (B2C)) • The B2B marketplace is highly fragmented, with a large number of suppliers competing and offering similar products

18. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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

19. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Between 1996-1999, the focus was on reducing procurement cost • Depending on the industry, e-markets were reported to reduce procurement cost by a few percentage points to as much as 40% and, on average, about 15% • This business model is appropriate when buyers are focused on the spot market and long-term relationships are not important • If long-term relationships are important, selecting a supplier based on on-line bidding may be risky

20. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Problem: The value proposition for the supplier was not as clear • E-markets allowed small suppliers to expand market horizon • E-markets allowed suppliers to access spot markets • These markets allow suppliers to reduce marketing and sales costs and thus increase their ability to compete on price • e-markets allow suppliers to better utilize their available capacities and inventories

21. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Problem: The value proposition for the supplier was not as clear • It’s not clear that many suppliers fell comfortable competing on price alone • Suppliers, especially those with name recognition, may resist selling their services through e-markets

22. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Question: How do e-markets generate revenue? • Initially: markets charged a transaction fee paid by either 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 • Sellers resist paying a fee to the company whose main objective was to reduce the purchase price • The revenue model needs to be flexible enough so that transaction fees are charged to the party that is more motivated to make the deal • If demand is much larger than supply, buyers are more motivated then sellers, therefore the fee should be paid by the buyer • Buyers also resist paying a fee in addition to purchase price

23. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Many exchanges have changed the way they charge their clients • 2 other types of charge mechanisms have been used • Licensing fee • The market maker licenses its software so that the company 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

24. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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

25. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • 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.com—focuses on food service industry • Provides value by offering not only procurement services but also forecasting, collaboration, and replenishment tools

26. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Now, 4 types of markets • Private e-markets • Example, Dell Computers, Sun Microsystems, Wal-Mart, and IBM, etc • Companies don’t 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

27. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Now, 4 types of markets • 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 • Convisint—automotive industry • Exostar—aerospace industry • Trade-Ranger—oil industry • Converge and E2Open—electronic industry

28. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Now, 4 types of markets • Consortia-based e-markets • The objective: • To aggregate activities and use the buying power of consortia members • To provide suppliers with a standard system that supports all the consortia’s buyers • allows suppliers to reduce cost and become more efficient

29. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement • Now, 4 types of markets • Content-based e-market • 2 types of markets • Focuses on maintenance, repair, and operations (MRO) goods • Focuses on industry-specific products • The e-market integrates catalogs from many industrial suppliers • Provides effective tools for searching and comparing supplier’s products

30. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • e-Procurement

31. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • Different types of goods purchased by firms • Strategic components • Components that are part of the finished goods and are not 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 market forces • Usually modular components that go directly into the finished product • Also includes commodities that do not go directly into the finished product (e.g., electricity) • 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 for the business • e.g., lighting, janitorial supplies, office supplies, fasteners, and generators

32. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • The procurement strategy depends on the type of product and 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 firm’s ability to satisfy customer demand

33. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • To illustrate various types of risks, consider a commodity product • 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 or higher then the demand forecast • If demand is lower than forecast—buyer faces inventory holding costs • If demand is higher than forecast—buyer faces either shortage risk or price risk • Price risk means that additional components need to be purchased in the open market at times of shortage—typically at higher prices • If components are not available in the open market—then shortage risk!!

34. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • 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

35. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • 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 buyer’s production plans

36. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • 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 spot market for short-term purchasing • High risk • Focus should be both on price and risk management • Use portfolio approach

37. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • Commodity products • Portfolio approach • Focus on the appropriate trade-off between risk and cost • To implement a portfolio approach the firm should use a combination of • Long-term contracts • Both firms commit to a certain volume and the supplier guarantees a level of supply for a certain price • Base commitment level • 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 doesn’t 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 • Spot purchasing • Buyers look for additional supply in the open market • Firm should use an independent e-market to select supplier • Focus is on using the marketplace to find new suppliers and on forcing competition between suppliers to reduce product price

38. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • 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

39. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement • 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 by the supplier since the buyer may exercise only a small fraction of the option level

40. Chapter 7: Procurement and Outsourcing Strategies (Simchi-Levi) • A framework for e-Procurement