Procurement and Outsourcing

1. Procurement and Outsourcing Phil Kaminskykaminsky@ieor.berkeley.edu David Simchi-Levi Philip Kaminsky Edith Simchi-Levi

2. Lecture Outline 1) FreeMarkets Online 2) B2B Strategies 3) B2B Pitfalls 4) Outsourcing

3. FreeMarkets Online • FreeMarkets is an online market making firm that enabled industrial buyers to link up with their potential suppliers in a live electronic bidding • The end result of such interaction among a network of suppliers was procurement cost savings of about 15% for the buyers • The company was founded in 1995 and was on the verge of breaking even in 1998 • It was expecting to receive commissions and fees of nearly $6 million for arranging procurement of ~$200 million worth of industrial components and parts

4. The Move to B2B Commerce

5. 2003$1.3 Trillion Business-to-Consumer Business-to-Business 2002$843B 2001$499B 1999$109B 1998$43B 2000$251B B2B is Huge... Source: Forrester Research, Inc.

6. Highly Fragmented • Most product categories are highly fragmented, with numerous suppliers each offering different level of quality, service and pricing options • Buyers incur significant cost in the actual purchase process • A buyer must invest internal resources to manage the process of collecting, analyzing and acting upon all the information in the market • In addition to purchase price companies spend over 10% in additional procurement costs • On the suppliers side, there are significant costs in using the manufacturing reps • These commissions range from 4% to 7% of purchase price

7. How Does FreeMarkets Online Create Value for its Customers? • Consulting/Purchase outsourcing • Putting together specs, drawings, lot sizes, documentation and RFQs • Identifying potential savings opportunities • Identifying and qualifying suppliers • Educating and training buyers • Conducting the Competitive Bidding Event (CBE) • Providing post bid analysis and support

8. How Does FreeMarkets Online Create Value for its Customers? • Consulting/Purchase outsourcing • Distribution Intermediary

9. Industrial Buyer Manuf. Rep. Manuf. Rep. Manuf. Rep. Supplier 1 Supplier 2 Supplier 3 Traditional B2B Trading Exchanges

10. Industrial Buyer FreeMarkets Online Supplier 1 Supplier 2 Supplier 3 Internet Based B2B Trading Exchanges

11. How Does FreeMarkets Online Create Value for its Customers? • Consulting/Purchase outsourcing • Distribution Intermediary • Network Enabler/Software Provider

12. What are the Barriers for the buyers? • Elimination of established relationships with the suppliers and their representatives • Elimination of manufacturing reps could result in loss of convenience

13. What is the value to the suppliers? • Less value for the suppliers • Commission costs fell from 7% to 2.5% • Table 7.5 implies reduction in commission by $174M(4.5%)=$8M • Table 7.5 also shows $35M drop in revenue for the suppliers • Suppliers could benefit from lower sales, marketing and distribution costs and better utilization of capacity

14. Which suppliers benefit from this model? • Low cost, quality suppliers will benefit as they drive competition out of the market • The FreeMarkets model would be beneficial for large more efficient suppliers • It will also provide opportunities for a host of small suppliers, especially if they are located overseas

15. The Revenue Model • A hybrid of service fees and sales commissions • FreeMarkets charged monthly fee from the buyer based on the size of the market making team dedicated to the event • Winning supplier paid sales commissions; this was paid in installments as suppliers shipped products

16. Problems with the revenue model • Buyer side: • FreeMarkets invests substantially in a project • Consulting revenue is independent of the value created • Does not lead to another intensive purchasing study for the customer • Gross margin on consulting is about 22% • Doesn’t scale well • Supplier side: • FreeMarkets does not represent the supplier • FreeMarkets success depends on their ability to identify many potential suppliers • Suppliers pay commissions to the company that reduced their margins

17. Vertical vs Horizontal Focus? • Vertical: • Advantage: FreeMarkets can capitalize on its deep knowledge of supplier industries • Disadvantage: Hard to scale-up • Horizontal: • Advantage: Ability to generate multiple contracts from one buyers • Disadvantage: FreeMarkets does not bring much expertise to the transaction

18. How about licensing the technology? • Are buyers capable of using the technology by themselves? • If not, how will this hurt? • If they are, where is revenue going to come from? • How can these problems be addressed?

19. By the end of 1998… • FreeMarkets was pursuing the horizontal market expansion • In 2000, the company started licensing its software

20. The company went public in 12/99... Freemarket’s Stock Price

21. Where is FreeMarkets today? • For the three months ended in 3/31/01 • Revenue totaled $33M • Net loss totaled $43.7M • For the three months ended in 12/31/01 • Revenue totaled $44.8M • Net loss totaled $2.8M

22. E-Marketplaces: The Initial (95-99) business model • The e-marketplace concept started as a new way to procure products, particularly non-production items. E-marketplaces • Expand everyone’s market reach • Generate lower price for the buyers • Cut operational costs for buyers and suppliers • Automating the procurement process will reduce processing cost per order from as high as $150 to as low as $5 per order • Focus on liquidity • Transaction fee paid by the suppliers • Serve as a virtual distributor

23. Problems with this Business Model • Sellers resist paying a fee to the company whose main objective is to reduce the purchase price • Buyers resist paying a fee • The revenue model needs to be flexible • Sometimes the wrong party is charged • Low barriers to entry created a fragmented industry flooded with participants • Just in the chemical industry there were about 30 e-markets

24. Continuous evolution of the business model • Transaction fees (typically paid by the sellers) • Sometimes the wrong party is charged • Buyers and suppliers resist paying • Subscription fees (typically paid by the buyer) • Depends on a number of dimensions • Licensing the software

25. Evolving Market Types • Value-added independent e-markets • They are expanding their offering to include inventory management and financial services (Zoho); supply chain planning (Covisint, e2open, Converge, TheSupply)

26. Consider Instill Corp. • Instill.com focuses on the food service industry and provides an infrastructure which links together operators, i.e., restaurants, distributors and manufacturers. This e-marketplace provides value to its customers by offering not only procurement services, but also forecasting, collaboration and replenishment tools.

27. Consider eSkye.com • In the alcoholic beverage industry, eSkye has tailored an offering that provides the supply chain with real value. eSkye now links retail stores, distributors and suppliers providing visibility into a supply chain where little data existed. eSkye adds value by automating the ordering process for the retailer while providing product flow information to distributors and suppliers.

28. Evolving Market Types • Private e-Markets • Valuechain.Dell.com (Dell), eHub (Cisco) • IBM, Sun Microsystems and Wal-Mart • These companies use the marketplace to improve supply chain collaboration • Providing suppliers with demand information and production data

29. Evolving Market Types • Consortia-based e-markets…. • Covisint (automotive); Trade-Ranger (oil); Omnexus (chemicals); e2Open and Converge (high-tech) • Objective of the consortia is • Aggregate activities and use the buying power of consortia members • Provide suppliers with standard systems that support all buyers and allows suppliers to reduce cost

30. Evolving Market Types • Content based e-markets…. • Focus on Maintenance, Repair and Operations (MRO) goods • These are components that are not part of the finished product or the manufacturing process but are essential for the business • Examples include lighting, office supply, fasteners,…

31. E-marketplace Examples Independent VerticalExchanges (IVX) Independent Horizontal Exchanges (IHX) Consortia TradingExchanges (CTX) Private Trading Exchanges (PTX)

32. Private vs. consortium-based public markets • Owner • Single vs Co-Op • Objective • Private: (i) Share proprietary data (ii) allow for SC Collaboration • Consortia: (i) Buying/selling commodities (ii) Finding new suppliers • Participants • Private: Selected group of suppliers • Consortia: Open Market • Buyer Cost • Private: Building and maintaining the site • Consortia: Subscription fee; licensing fee

33. Private vs. consortium-based public markets • Supplier Cost • Private: No fee • Consortia: Subscription fee; Transaction fee • Challenges • Private: Initial investment • Consortia: (i) Many have recently collapsed; (ii) preferred suppliers may object because of price focus; (iii) Sharing proprietary data (iv) developing standards

34. Private vs. consortium-based public markets • Automotive Industry • Covisint was established in early 2000 by the Detroit’s big three automakers • It now also includes Renault, Nissan, Mitsubishi and Pegeot • Volkswagen established its own private e-market • Volkswagen e-market provides not only similar capabilities to that of Covisint but also real-time information on production plans so that suppliers can better utilize resources

35. Consider IBM • IBM has saved about $1.7 billion since 1993 by being able to divulge sensitive price and inventory information over a private exchange built for 25,000 suppliers and customers, says Bill Paulk, IBM's vice president of e-marketplaces. As host of the exchange, the company helped defray the cost of connecting suppliers. The payoff: On-time delivery to customers soared from about 50% to close to 90%, "which helped justify the cost," Paulk says. • E2open: A consortia based e-marketplace established in 1999

36. A Framework for eProcurement • Type of Component • Strategic Components • Part of the finished product • Not industry specific; company specific • Examples: PC motherboard and chassis • Commodity Products • Can be purchased from a large number of suppliers • Price is determined by market forces • Examples: Memory unit in a PC • Indirect Material • MRO

37. A Framework for eProcurement • Level of Risk • Uncertain Demand (Inventory risk) • Volatile market price (Price Risk) • Component availability (Shortage Risk)

38. Risk: Commodity Products • Can be purchased either • in the open market through on-line auction, or • through the use of long term contracts • Long term contracts guarantee certain level of supply but may be risky for the buyer • Inventory risk, shortage risk or price risk

39. A Framework for eProcurement • Indirect Material • Typically low risk and hence the focus is on content based hubs. • The objective is to use an MRO-hub that specializes in unifying catalogs from many suppliers • Examples: MRO.com, Grainger on-line catalogs

40. Grainger • W. W. Grainger has been selling industrial supplies for 72 years • In 1995 Grainger established Grainger.com, an on-line catalogue for more than 220,000 products from 12,000 suppliers • In 1999, Grainger experienced revenue growth of $102M through its internet channel • The MRO supply industry is growing at a rate of 3-4% a year. From 1996 to 1999 Grainger internet sales grew 32% a year and 20% in offline due to customers that were lured to Grainger from the web site

41. A Framework for eProcurement • Strategic Components • Typically high risk components that can be purchased from a small number of suppliers • The objective is to use private or consortia-based e-marketplace. • The focus is on an e-marketplace that allow collaboration with the suppliers

42. Consortia or Private? • Transaction volume • Number of suppliers • Cost of building and maintaining the site • The importance of protecting proprietary business practices • Technology and product life cycles

43. A Framework for eProcurement • Commodity Products • Products go directly into finished goods • High risk • Many potential options to choose from • Long Term Contracts • Buyer and supplier commit to certain volume (called the commitment level) • Supplier guarantees a level of supply for a committed price • Flexible, or Option Contracts • Buyer pre-pay a relatively small fraction of the product price up-front, in return for a commitment from the supplier to satisfy demand up to a certain level (called the option level) • The buyer can purchase any amount up to the option level by paying additional price for each unit purchased • Spot Purchasing

44. A Framework for eProcurement: A Portfolio Approach Option Level H L N/A Inventory Risk (Supplier) Price, Shortage Risks (Buyer) Inventory Risk (Buyer) Commitment Level L H

45. B2B Software Vendors • Oracle (Indirect and Direct) • i2 Technologies and Manugistics (Direct) • Ariba (Indirect and Direct) • Commerce One (Indirect and Direct) • Agile (Direct) • VerticalNet (Indirect)

46. E-Procurement: The reality • Companies conducting greater than 20% of procurement transactions online have reduced their transaction processing cost by nearly a third (Hackett Benchmarking) • Product savings and process cost improvements effect operating cost by 10% (Credit Suisse First Boston Technology Group)

47. E-Procurement: The reality • To capture this benefits purchasing organization needs to invest heavily in: • Changing internal procurement processes • Integrating e-marketplaces in internal systems • Purchasing B2B applications, and • Paying e-marketplace transaction fee/subscription fee Source: Forrester Research

48. Positive Aspects of Trading Exchanges (Companies who use exchanges): • Reduce costs or labor (31%) • Better access to products/vendors (24%) • Increase speed or efficiency (29%) • Access to more customers (21%) Source: AMR Research

49. Positive Aspects of Trading Exchanges (Companies who plan to use exchanges): • Reduce costs or labor (43%) • Better access to products/vendors (26%) • Increase speed or efficiency (23%) • Access to more customers (10%) Source: AMR Research

50. Negative Aspects of Trading Exchanges (Companies use exchanges): • Security trust (17%) • Start Up cost (5%) • Loss of face-to-face relationships (12%) • Lack of standards (5%) • Immature technology (5%) • Integration issues (7%) Source: AMR Research