Procurement and Outsourcing Strategies

Dr. Prashant Gupta

Purchasing / Procurement / Sourcing

Procurement:

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.

Purchasing

Acquisition of goods & services

Activities
Help decide whether to make or buy
Identify sources of supply
Select suppliers & negotiate contracts
Control vendor performance
Importance
Major cost center
Affects quality of final product

Objectives of the Purchasing Function

Help 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 Sales

Industry

All industry
Automobile
Food
Lumber (Furniture)
Paper
Petroleum
Transportation

Percent of Sales

52%
61%
60%
61%
55%
74%
63%

Benefits of Effective Sourcing Decisions

Better 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 Chain

Sourcing Processes include:

1. Supplier Assessment & Scoring
2. Supplier Selection and Contract Negotiation
3. Design Collaboration
4. Procurement
5. 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 Factors

Replenishment Lead Time

On-Time Performance
Supply Flexibility
Delivery Frequency /
Minimum Lot Size
Supply Quality
Inbound Transportation
Cost

Pricing Terms
Information Coordination
Capability
Design Collaboration Capability
Exchange Rates, Taxes, Duties
Supplier Viability

2. Supplier Selection and Contracts

Objectives:

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 Bids
Direct negotiations
Reverse Auctions

Supplier Selection and Contracts (Contd.)

Contracts for Product Availability and Supply

Chain Profits
Buyback Contracts
Revenue-Sharing Contracts
Quantity Flexibility Contracts
Contracts to Coordinate Supply Chain Costs
Contracts to Increase Agent Effort
Contracts to Induce Performance Improvement

2.1 Contracts for Product Availability

and Supply Chain Profits

Many 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 Buyer

Inventory Risk
(Supplier)

N / A*

Low Option Level

for Buyer

Price and
Shortage Risks
(Buyer)

Inventory Risk
(Buyer)

Low Base
Commitment
Level by Buyer

High Base
Commitment Level
by Buyer

3. Design Collaboration

50-70 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 Logistics

Reduces 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 Customization

Mass 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 Customization

Modular 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 Manufacturability

Part commonality
Eliminating right-hand and left-hand parts
Designing symmetrical parts
Combining parts
Using catalog parts rather than designing a
new part
Designing parts to provide access for other
parts and tools.

4. The Procurement Process

The 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
Aspects

Direct Materials

Indirect Materials

Use

Production

Maintenance, Repair, and

Support Operations (MRO)

Accounting

Cost of goods sold SG&A (Selling, General

and Administrative)

Impact on
production

Any delay will

delay production

Less direct impact

Processing cost
relative to value
of transaction

Low

High

Number of
transactions

Low

High

Differences between Procurement for

Primary and Support Activities
Aspects

Procurement for Primary

Activities

Procurement for
Support Activities

Product Assortment

Limited to large

Very Large

Number of Suppliers

Limited, Transparent

Very Large

Purchasing Turnover

Very Large, Considerable

Limited

Number of Purchase
Orders

Considerable

Very Large

Average Order Size

High

Small

Control

Depends on type of
production planning

Limited, forecastrelated or projectrelated planning

Decision Making
Unit

Engineering, Manufacturing Fragmented, varies

specialists dominant
with product or service

The Procurement Process

Focus 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 Analysis

A 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 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.

Appropriate Procurement 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 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 growth

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

Kraljics Supply Matrix

Kraljics Supply Matrix

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

Bottom right quadrant

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

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)

Bottom left quadrant:

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

Supplier Footprint

Supply Strategies have changed over the years

American automotive manufacturers

High-tech industry

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

Challenge:

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 Products

Innovative Products

Slow

Fast

Predictable

Unpredictable

Profit Margin

Low

High

Product Variety

Low

High

Average forecast error at the time

production is committed

Low

High

Average stockout rate

Low

High

Product clockspeed
Demand Characteristics

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.

Innovative products

Fashion items, cosmetics, or high tech products

Appropriate supply chain strategy is pull
Focus: high profit margins, fast clock-speed, and
unpredictable demand, responsiveness, maximizing
service level, order fulfillment

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

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

Integrated Framework
Component Forecast Accuracy
Component Supply Risk
Component Financial Impact
Component Clock-speed

Component Sourcing Strategy

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

Lead time reduction strategy

High component forecast accuracy/Low supply risk/High

financial impact/Slow clock-speed.
Low component forecast accuracy/High financial risk/Fast
clock-speed

Flexibility and lead time strategy

Low component forecast accuracy/High financial risk/Fast

clock-speed/High supply risk

Qualitative Approach to Sourcing Strategy

A Qualitative Approach for Evaluating Component

Sourcing 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.

Not have enough supply to meet demand

both supply risk and financial risk.

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

Outsourcing

Outsourcing 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 Trends
Outsourcing components have increased
progressively over the years.
Some industries have been outsourcing for a
long time.
Fashion Industry (Nike) (all manufacturing
outsourced)
Electronics Industry
Cisco (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 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
clock-speed, and if so, how?

Outsourcing Benefits and Risks

Benefits

Economies of scale

Risk pooling

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.

Reduce capital investment

Capital investment transferred to suppliers.

Suppliers higher investment shared between
customers.

Outsourcing Benefits

Focus on core competency

Buyer can focus on its core strength.

Allows buyer to differentiate from its competitors.

Increased flexibility

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:

High tech where technologies change very frequently

Fashion where products have a short life cycle

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 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 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.

Suppliers focus on cost reduction

implies slow responsiveness to design changes.

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 shrank to 8% in 1995

Behind Compaqs 10% leading share

Led to eventual sale of PC business to Lenovo

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.
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 Outsourcing

Identifying self Core Competency
Outsourcing Activities Portfolio
Evaluating Competency of Potential
Outsourcing Partners

Identifying Core Competency

Core 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 Activity

Strategic
Characteristics of
Activity

Primary

Secondary

NonCore

Primary NonCore
Activities

Secondary NonCore Activities

Core

Primary Core
Activities

Secondary Core
Activities

Outsourcing Activities Portfolio

Type of Activity

Activities

Primary Core

Production, Product Design, Production

Planning and Scheduling, Marketing, and
Customer Services

Secondary Core

Logistics, Human Resources, Maintenance

Primary NonCore

Information Technology, Finance and

Accounting, Sales, and Procurement

Secondary Non- Real Estate, Food Service, Landscaping

Core

Product Architecture
Integral Products
Modular Products

Integral Products
Made from components whose functionalities
are tightly related.
Not made from off-the-shelf components
Designed as a system taking a top-down
design approach
Evaluated based on system performance, not
based on component performance
Components in integral products perform
multiple functions

Modular Products
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

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.

Framework for Make / Buy Decisions

Dependency /
Product

Dependency
on knowledge
and capacity

Independent
for knowledge,
dependency
for capacity

Independent
for knowledge
and capacity

Modular

Outsourcing is Outsourcing is Opportunity to

risky
an opportunity reduce cost
through
outsourcing

Integral

Outsourcing is Outsourcing is Keep

very risky
an option
production
internal

Make/Buy Considerations
Reasons for Making

Lower production cost

Unsuitable suppliers
Assure adequate supply
Utilize surplus labor and make a
marginal contribution
Obtain desired quantity
Remove supplier collusion
Obtain a unique item that would
entail a prohibitive commitment from
the supplier
Maintain organizational talent
Protect proprietary design or quality
Increase/maintain size of company

Reasons for Buying

Lower acquisition cost

Preserve supplier commitment
Obtain technical or management
ability
Inadequate capacity
Reduce inventory costs
Ensure flexibility and alternate
source of supply
Reciprocity
Item is protected by patent or trade
secret
Frees management to deal with its
primary business

Outsourcing Decisions at Toyota

About 30% of components in-sourced

Engines:

Transmissions

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

Vehicle electronic systems

Designed and produced by Toyotas suppliers.

Company has dependency on both capacity and
knowledge

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.