Supply chain Management (18ME653)

MODULE 2
Syllabus:
Strategic Sourcing Outsourcing – Make Vs buy – Identifying core processes
– Market Vs Hierarchy-Make Vs buy continuum -Sourcing strategy –
Supplier Selection and Contract Negotiation. Creating a world class supply
base- Supplier Development – World Wide Sourcing.

Strategic Sourcing

 Strategic sourcing can be defined as a collective and organized

approach to supply chain management that defines the way
information is gathered and used so that an organization can leverage
its consolidated purchasing power to find the best possible values in
the marketplace.
 Strategic sourcing is one part of overall procurement management that
can help to achieve these goals- reduce costs, assure and improve the
quality of the final product and achieve a faster time to market.
 Strategic sourcing views suppliers as crucial value partners and
aims to building sustained, collaborative relations.

Why do we need Strategic

Sourcing? Increased Level of Cost
Savings
By identifying and selecting suppliers that will provide the highest value
at the right pricing will enable an organization to continuously achieve
higher cost savings.

Better Alignment of Sourcing and Business Objectives

Better alignment allows the business to achieve higher business
performance with higher efficiency and minimal supply chain risks.

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Optimization of Ideal Suppliers

An organization is equipped with information that will allow them to
match their business objectives to their ideal suppliers. This implies
highest value-creation at lowest possible cost.
Long-term Relationship Building with Suppliers
Strategic sourcing helps to create a synergy between organizations and
its suppliers. Sustained relationship with suppliers also implies that
when the suppliers are valued and considered in various sourcing
decisions; they feel motivated to optimize their performance to meet the
organizations objectives.

Outsourcing

 Sourcing does not strictly mean only looking to purchase cheap

products but the emphasis is on acquiring newly formed business
partnerships.
 Modern supply chains have evolved from simple, linear connections
between businesses and suppliers to an interconnected network
spanning continents, departments and functions.
 The key to an optimized supply chain is effective supply chain
management (SCM) and a great way to achieve such optimization is by
outsourcing SCM to the right experts.
 In information technology, an outsourcing initiative with a technology
provider can involve a range of operations, from an entirety of the IT
function to discrete, easily defined components, such as disaster
recovery, network services, software development or QA testing.

Outsourcing Services

Business process outsourcing (BPO) is an overarching term for the

outsourcing of a specific business process task, such as payroll. BPO is
often divided into two categories: back-office BPO which includes internal
business functions such as billing or purchasing, and front-office BPO

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which includes customer-related services such as marketing or tech

support.

In today’s cloud-enabled world, however IT outsourcing can also include

relationships with providers of software infrastructure and platforms-as-
a-service. In fact, cloud services account for as much as one third of
the outsourcing market, a share that is destined to grow. These services
are increasingly offered not only by traditional outsourcing providers but
by global and niche software vendors or even industrial companies
offering technology enabled services.

Outsourcing Examples

1. Nike holding only designing and branding

2. Dell holding only branding and strategy decisions

3. Toyota, Maruti-Suzuki, Honda holding only assembling

4. Voltas – only branding

5. LIC and National insurance – only sales of policies

Benefits and costs/ Role of outsourcing

 Lower costs (due to economies of scale or lower labor rates)

 Increased efficiency

 Variable capacity

 Increased focus on strategy/core competencies

 Access to skills or resources

 Increased flexibility to meet changing business and commercial

conditions
 Accelerated time to market

 Lower ongoing investment in internal infrastructure

 Access to innovation, intellectual property, and thought leadership

 Possible cash influx resulting from transfer of assets to the new provider

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Risks of outsourcing

Some of the risks of outsourcing include:

 Slower turnaround time

 Lack of business or domain knowledge

 Language and cultural barriers

 Time zone differences

 Lack of control

Outsourcing’s hidden costs

The total amount of an outsourcing contract does not accurately

represent the amount of money and other resources a company will
spend when it sends IT services out to a third party. Depending on what
is outsourced and to whom, studies show that an organization will end
up spending at least 10 percent above that figure to set up the deal and
manage it over the long haul.

Among the most significant additional expenses associated with

outsourcing are:

 The cost of benchmarking and analysis to determine whether

outsourcing is the right choice.
 The cost of investigating and selecting a vendor.

 The cost of transitioning work and knowledge to the outsourcer.

 Costs resulting from possible layoffs and their associated HR issues.

 Costs of ongoing staffing and management of the outsourcing

relationship.

Make Versus Buy: The Strategic Approach

The supply chain involves a number of firms and encompasses all

activities associated with the transformation of goods from the raw
material stage to the final stage, wherein the goods and services reach the

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end customer. While studying make versus buy decisions, we analyze

from the point of view of the focal firm or the nodal firm, which is at the
strategic center of the supply chain. The make versus buy decision
evaluates the contribution of each activity. Using the value chain
framework developed by Michael Porter, we classify all supply chain
activities as primary activities and support activities. Primary activities
consist of inbound logistics, operations, outbound logistics, sales and
service. Secondary activities involve procurement, technology
development, human resource management and firm infrastructure
management. The make versus buy decisions look at each of these
activities critically and ask the question: Should this activity be done
internally or can it be outsourced to an external party? Once the decision
to outsource has been taken, the firm has to choose among competing
suppliers and also decide on the nature of the relationship it would like
to establish with the supplier firm. Traditionally, firms believed that
everything should be done internally unless there is a compelling logic in
favor of outsourcing. Thus, all outsourcing-related decisions had to be
justified. We have come a long way from the days of the Ford Motor
Company, where vertical integration was the norm. Now, perhaps, we are
on the other extreme with our discussion of virtual corporations, where
a firm starts with the assumption that all activities must be outsourced
unless there is a compelling logic to justify keeping activities in-house.
Michael Dell, the CEO of Dell Computers, has stated that if his
company was vertically integrated, it would need five times as many
employees and would suffer from a drag effect. Apart from primary
activities in the value chain, even support activities that were usually
done in-house are outsourced in big way now. Rather than taking
extreme positions, we need to build up managerial logic to understand
these issues. Hence, we first look at a few cases where firms have made
these decisions in recent years and then bring out a conceptual
framework that can help firms in their make versus buy decisions.

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In India, Bharti AIRTEL has decided to focus on customer delight and

brand building and leave network management and a host of other
services to its outsourcing partners.

When Reliance put up its refinery in Jamnagar, it realized that the

volume of logistics had increased significantly and therefore decided to
build internal competence. Thus, Reliance Logistics came into being, and
today, not only does it manage its own logistics activities but also
provides services to the food division of ITC.

Factors Influencing Make or Buy Decisions:

1. Volume of Production If the volume of production is high, it favors

the make decision and low volume favors buy decisions.
2. Cost Analysis: Break Even Analysis

3. Utilization of Production Capacity: The organization, which has

created large production capacity, favors the decision to make
4. Integration of Production System: The vertical integration favors
the make decision whereas horizontal integration favors buy decision
5. Availability of Manpower: Availability of skilled and competent
manpower favors makes decision where as scarce manpower prefers
buy decisions.
6. Secrecy or Protection of Patent Right: This condition favors the make
decision
7. Fixed Cost :A lower fixed cost favors the decision to make and
higher fixed cost the make decision
8. Availability of competent suppliers or vendors

9. Quality and reliability of vendors.

Identifying Core Processes

As exemplified by Bharti Airtel, the decision to identify selected

processes as core processes and focus on improving those can have a
significant impact on the performance of a firm. The identification of core

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processes is a crucial decision. If this is driven by short-term benefits

such as re-engineering of balance sheets and improved return on
investments, then the long-term business sustainability is endangered.
Instead of becoming the best in the chosen category (represented by core
processes), the firm runs the risk of ending up a s a mere hollow
corporation. The mere decision to focus the resources on core activities
to match capabilities with the best-in-class performance is not enough;
firms must strive to be the best in the world in that specific area.

In these areas they can invest in people, equipment’s and R&D.

Such a focus will also help the firm in attracting the best talent from
that field. Many corporations have realized that they can never hope to
attract the best talent in IT; hence, they have decided to depend on
their outside partners for the IT support required for business
application.

Thus, the first step for a firm is to develop the capability to

distinguish between core activities and commodity activities. Even among
core activities, it has to keep certain activities in-house, and for all
outsourced critical activities, it has to maintain some knowledge so that
it can manage an effective relationship with its outsourcing partner. The
two ways through which one can identify a firm’s core processes are the
business process route and the product architecture route.

The Business Process Route

For any firm, three core and high-level business processes include
customer relationship, product innovation and supply chain
management. Customer relationship focuses on acquiring new
customers and building relationships with existing customers. Product
innovation focuses on developing new products and services, while
supply chain management focuses on fulfillment of customer orders. It is
possible to un-bundle the three business processes and a firm can afford
to outsource two of these business processes. Some researchers have

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argued that a firm must identify and ensure that it builds core
capabilities in-house in at least one of these areas. Firms like HP and
high-end pharmaceutical firms focus on product innovations. Firms like
Nike and Benetton focus on brand building and customer relationships.
Firms like Wal-Mart and Dell Computers focus on supply chain
management capabilities. Of course, within the identified core business
process, firms can examine each of the activity and probably outsource
those activities that are of the commodity type.

For example, within supply chain management, firms might outsource

the warehousing or transportation functions.

In the case of Microsoft, it decided that customer relationship

management and software design are its core processes, while design and
manufacturing is not core to its business. Bharti decided that customer
relationship was core and network management was not.

Core processes retained within the company must be strategic from the
business point of view. Firms must realize that value within the chain
gets distributed to the chain partners on the basis of the unique
capabilities that they bring to the table. A firm has to ensure that it has
a relatively higher bargaining power within the chain. A firm has to make
sure that in- house business processes give it enough strategic power in
the chain and do not allow other chain partners to dictate the terms of
value exchange in the chain. In the PC business, the power within the
chain went to Intel and Microsoft. So, even though IBM was at a strategic
point in product development, it lost its power and became a peripheral
player in the chain.

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The Product Architecture Route

In the product architecture approach, the focus is on sub-systems and

components and the make or buy decisions are made at that level. A
product like a car can be divided into sub- systems such as engine,
chassis and transmission. The engine sub-system can be divided into
components such as power cylinder, fuel system and engine electronics.
In a product, first the sub-systems are classified as strategic and non-
strategic. A sub-system is strategic if it involves technologies that change
rapidly, if it requires specialized skills and technologies and if it can
significantly impact the performance of the product on attributes that are
considered important by the customer.

By keeping theses strategic sub-systems internal, a firm can ensure that

it can offer differentiated products and can avoid being commoditized.
Further, within a sub-system, the same kind of analysis has to be done
for all major components. All those components where the firm is
technologically ahead of potential suppliers or can hope to achieve a
leadership position with some investments are kept internal to the firm.
In case the suppliers have a huge technological lead, which will be
impossible to bridge in the foreseeable future, or if the time and
investments required for catching up may not be worth the effort, then
the component should be outsourced and the supplier should be treated
as a strategic partner (see Figure 3.1 for a diagrammatic view of the
overall framework). Of course, if a firm finds that for all the components
the suppliers have a lead and it has no hope of catching up in the near
future, then the firm has become a hollow corporation and will see a
decline in its fortunes over a period of time. Tata Motors realized that in
diesel engine technology it was far behind its suppliers and will never be
in a position to catch up with them. So it decided to buy diesel engines
from Fiat and treat Fiat as a strategic partner. Cummins discovered that
pistons were part of a strategic sub-system but that its suppliers were far

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ahead in the relevant technologies and therefore decided to buy pistons

rather than make them internally. Honda might treat engine technology a
strategic sub-system, while Nissan might treat transmission as a
strategic sub-system. Of course, once Tata Motors decided to source the
design of diesel engine sub-systems from the supplier, it ensured that in
the other systems kept in-house, it maintained the position of a leader.

Figure 3.1: The Strategic Outsourcing Process

Even when one outsources a strategic sub-system or component, one

should retain the knowledge of its architecture in-house. Ravi
Venkatesan, Chairman, Microsoft Corporation (India) Pvt Ltd, defines
architecture knowledge as follows: Architecture knowledge is the
intimately detailed and specialized power of translation required to
capture customer requirements and reproduce them in the language of
sub-system performance specification. It is based on many detailed
understandings of the linkages between user requirements, system

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parameters and component specifications; it is unique to each company,

intuitively developed in countless conversations by a team of strategists,
designers and marketing people.

A firm might not produce the engine, but it may control its design and
manufacturing by remaining the expert in architectural knowledge.
Cummins realized that it must keep architectural knowledge, that is, the
ability to develop good piston specifications, to meet engine power
requirements. In the case of Bharti, its network engagement team of 50
people allows it to keep all relevant architectural knowledge in-house.

Virtual corporations outsource all supply chain activities to one party or a

combination of parties and just focus on brand building. Even if a firm
outsources supply chain management, it still has to keep the
architectural knowledge of the impact of internal and external
environments on market demand and supply risks. Webvan realized that
poor understanding of supply chain issues made its business unviable.
Similarly, many e-retailers could not deliver goods during the Christmas
period because they had not anticipated that their logistics partners were
likely to face resource constraints during that rush season, which led to
much customer dissatisfaction during that period.

Market versus Hierarchy

The make versus buy decision is also known as the market versus
hierarchy decision in economics literature. The key issue here is to
coordinate the chain so as to provide a bundle of goods and services at
the lowest cost for a given level of service required by the customer. If a
firm decides to make the relevant component in-house, it may not have
the necessary economies of scale and might have to use internal
hierarchy for coordination. In the hierarchical form, a firm has greater
control over coordination but there may not be enough motivation for the
internal supplier to work on innovations to reduce cost and improve

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service over a period of time. The costs involved in control and

coordination of internal supply is termed agency costs in economics.
When a firm uses market mechanisms to procure the necessary inputs,
it may be able to take advantage of economies of scale and also choose
the supplier that supplies goods and services at lower prices. In this case,
the supplier has enough motivation to innovate and the firm, as a buyer,
has the flexibility of changing the supplier, which is not an option
available to the firm that chooses to make inputs internally. However,
there are costs incurred in the control and coordination of the external
supplier and are termed as transaction costs in economics. Costs related
to economies of scale are tangible in nature but the bulk of agency and
transaction costs are intangible in nature. We first look at each of the
three issues, economies of scale, agency costs and transaction costs, in
detail and finally study the overall framework of the decision- making
process. Initially, the focus will be purely on the make versus buy
decision, where we assume that the firm has an arm’s-length relationship
with the firm from where it is buying and that it is managing coordination
and relationship with the supplier firm only through a formal contract. At
a later stage, we will look at the entire continuum, where several
intermediate types of relationships are possible between the pure make
versus buy situations.

Economies of Scale

Economies of scale are cost advantages reaped by companies when

production becomes efficient. Companies can achieve economies of scale
by increasing production and lowering costs. For example, Wal-Mart’s
“everyday low prices” are due to its huge buying prices. Even Amazon’s
“festival of festivals” also improves the economies of scale.

Firms that specialize in production of input can usually achieve higher

economies of scale vis-à-vis vertically integrated firms. A vertically
integrated firm produces only for its internal needs, while an external

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supplier firm can aggregate demands of many potential buyers and,

thereby, enjoy huge economies of scale. Economies of scale can be
achieved in manufacturing or logistics activities. There are four major
sources of economies of scale:

1. Higher volume allows a firm to spread its fixed cost over a larger
volume of operations
2. Higher volume allows a firm to choose more efficient technologies

3. Pooling of buffer capacities and inventories

4. Learning curve effect.

• Higher volume allows a firm to spread its fixed cost over a larger
volume of operations: Any manufacturing or logistics process will
involve investments in fixed costs. A firm with higher volume is able to
spread its fixed costs over a higher output and thus has lower cost of
operations. For example, the cost of a truck trip from Mumbai to
Bangalore is more or less fixed because major costs like driver cost, bulk
of fuel cost and administrative cost are independent of the load carried by
the truck. Similarly, when a firm sets up its manufacturing unit, the
set-up cost is the same, irrespective of the volume of production. So a
firm with bigger batch sizes will have lower costs of operation.

• Higher volume allows a firm to choose more efficient

technologies: Higher volume allows a firm to invest in technologies that
are capital intensive but result in lower fixed and variable costs per unit
of output. In the semiconductor industry, capital-intensive technologies
capable of handling wafers of diameter 300 millimeters allow firms to
obtain twice as many chips per wafer compared to older technologies,
which could handle wafers only with diameters up to200 millimeters.
This allows a semiconductor manufacturing firm, willing to invest in more
capital-intensive technologies, to bring down the cost per chip.
Increasingly, firms manufacturing semiconductors are using foundries

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from Taiwan, providing advantages of lower costs because of their higher

scale of operations. Recently, Motorola decided to outsource the
manufacturing of chips to third parties. Similarly, a transport firm that
can transport 40 tons per trip in a Volvo truck will have lower costs
per ton of material compared to a transport firm that requires four trucks
of 10-ton capacity each to transport the same volume of goods. The same
will be true in warehousing also, where larger warehouses can invest in
IT, which will reduce its costs per unit of operations, while small
warehousing firms will not find such investments viable.

• Pooling of buffer capacities and inventories: If firms keep their

activities in-house, they have to keep buffer capacities and inventories
to take care of the uncertainties in demand. A supplier, on the other
hand, is able to pool uncertainties over a larger number of customers
and as a result needs much lower levels of buffer capacity and safety
inventory. A supplier can also ensure utilization of high capacity by
pooling demand across customers who have different demand profiles.

For example, a logistics firm that transports Maruti cars from Gurgaon to
Bangalore carries Kurlon’s mattresses to their Delhi warehouse on the
return trip. Consequently, it is able to offer lower transport costs to
Maruti as well as to Kurlon. Similarly, a contract manufacturer can
improve capacity utilization if it can work with two different companies
having seasonal demands in different seasons: one with seasonal demand
in the winter and the other with seasonal demand in the summer.

• Learning curve effect: The learning curve captures the impact of

cumulative production on the average cost of production. The
management and the workers are able to improve their performance
based on experience gained through the cumulative production of a firm.
In several industries, it is found that with doubling of cumulative
production the average cost declines by10 to 20 per cent.

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The pressure faced by firms due to steadily rising costs is forcing them to
review their earlier decisions, and increasingly, firms are availing the
advantages of third-party companies that provide manufacturing and
logistics services. A supplier who is providing services to a largerset of
customers will always have lower costs. Firms are turning to contract
manufacturers whenever they think that the manufacturing process
does not provide sources of competitive advantage. Within the
electronics industry, a bulk of manufacturing has shifted to electronics
manufacturing service providers like Flextronics, Solectron and Celestica.
Similarly, very few firms own transportation- and warehousing-related
asset, and depend on transport and ware housing firms for their logistics
operations. Many firms are outsourcing their IT operations to firms like
IBM and Wipro, which have strong economies of scale. Then there is also
the case of Indo Nissin Foods Ltd, the manufacturer of Top Ramen
noodles, which has outsourced its distribution operations to Marico.

However, if a firm has large volumes and a reasonably stable demand,

internal manufacturing is likely to offer more or less similar costs of
production. Hence, almost all automobile companies assemble vehicles
internally, unlike the electronic goods manufacturers or white goods
manufacturers. Wal-Mart has huge volumes and finds it more economical
to own a fleet of vehicles. In general, the marginal benefit of a “buy”
decision starts coming down if a firm has large volumes of operation. So a
multi-product firm may benefit from vertically integrated operations.

Third parties will offer services at a lower cost, provided there is enough
competition in the supply market. If there are not enough suppliers, then
the supplier may use its monopolistic power and may not pass on the
benefits of scale to the customers.

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Agency Cost

Bharti used to manage customer billing operations through its internal IT

department. The important question here is, “How does one ensure that
the interest of the IT department and that of the marketing departments
are aligned, and how does one make sure that the IT department is
putting its best effort and is not slackening?” This issue is known as
the agency problem in economics literature. The IT department is known
as the agent and the marketing department as the principal. A firm with
its own fleet of trucks faces a similar problem of motivating the transport
department, where the internal transport department is the agent and
the marketing department is the principal. In a hierarchical firm, there is
greater control over coordination, but there may not be enough
motivation for the internal supplier to work on innovations to reduce
costs and improve service over a period of time. The cost involved in
control and coordination of internal supply is termed agency cost in
economics.

There is significant time and effort involved in the control and

coordination of internal activities. If one decides to manufacture the
necessary inputs within the firm, then the firm has to worry about agency
issues. It is quite common that managers and workers of internal supply
units sometimes knowingly do not act in the best interests of the firms.
Thus, the top management incurs agency costs associated with in-
house supply. In-house divisions within a firm are usually treated as
cost centres and are usually insulated from competitive pressures as
they have captive internal markets. Further, most large firms have
common overheads and joint costs, which are allocated to different units,
so it is usually difficult to measure individual divisions’ contributions to
overall profitability. The absence of market competition along with
problems involved in measuring divisional performance make it difficult
for the top management to evaluate the current performance of input
supply operations with respect to its best achievable performance.

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Transaction Cost

There are costs involved in using market mechanisms, which can be

avoided if those relevant activities are brought inside the firm. These
costs are known as transaction costs. The transaction costs comprise
the following:

• Search and information costs: Costs involved in locating and

evaluating the right supplier.

• Bargaining and contracting costs: A firm has to first negotiate the

terms of exchange and finally prepare the contract so that it is assured
that the supplier will provide the required good sand services as per the
agreed terms and conditions.

• Policing and enforcement costs: A firm has to constantly monitor

the supplier so as to ensure that the supplier sticks to the terms and
conditions of the contract. Firms might also have to legally enforce the
contract if the supplier does not follow the contract. Bharti has put in
elaborate mechanisms for monitoring the SLAs with IBM and Ericsson.

• Cost incurred because of loss of control: The use of market

mechanisms may result in under investment in relationship-specific
assets, which, in turn, increase the cost for buyers.

Further, there may be additional costs that firms may have to incur
because of poor coordination. There is also the risk of leakage of strategic
information that will hurt the buyer firm in long run. The cost incurred
because of loss of control is a major component of transaction costs in
several situations of market exchange. If it were possible to write a
perfect contract and enforce it, one may not have to worry about costs
incurred because of loss of control. Unfortunately, we live in a world of
incomplete contracts and hence discuss the reasons and the implications
of the same in the following section.

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Incomplete Contracts

In theory, it is possible to write a complete contract that stipulates each

party’s responsibilities and rights for each and every contingency that
could conceivably arise during the transactions. Unfortunately, in
practice, it is impossible to write a complete contract. The reasons why
contracts are not complete are as follows:

• Bounded rationality: Managers have a limited capacity to process

information; hence, when dealing with complex situations, they are
unlikely to seek and process all the information available. For example,
it will be difficult for managers of Bharti and IBM to think through all
possible scenarios related to regulatory change, technology and market
conditions. Therefore, both parties will, at best, identify major
scenarios and include the relevant conditions in the contract, but will
find it difficult to think through all possible scenarios.

• Difficulties in specifying or measuring performance: Even if

managers are willing to seek and process comprehensive sets of
information, it will still not be possible to write a complete contract if
one cannot specify and measure performance. For example, when
buying an advertising service or consultancy service, service performance
is not easy to specify at the time of writing the contract. Even if the
quality requirements are specified in the contract, certain aspects of
quality cannot be measured easily. In several situations, quality is
ensured through process controls and cannot be easily checked at the
delivery stage. In the pharmaceutical industry, the temperature
maintained during the transit stage affects the effectiveness of drugs, and
this aspect of quality cannot be checked at the receipt stage. When
hiring a management graduate, companies accord a higher importance
to the reputation of the college because it is difficult to judge a candidate,
straight out of college, for a managerial job. Firms assume that reputed
management colleges have process controls in place to ensure quality in

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the graduate. Several attributes in a physical product can be measured

only through destructive testing. So there is a possibility of opportunistic
behaviour by the external supplier, which will have an adverse impact on
the long-term performance of the firm.

• Asymmetry of information: There may be asymmetry of information

at the time of writing of the contract. For example, certain information
about future changes, either in technology or the supply market, may
result in lower costs, but the supplier may not provide the relevant
information and may take advantage of it while fixing either the price or
other conditions in the contract. For example, Bharti has better
information about future markets and IBM has better information about
future technologies, and each may hide this information from the other
so as to ensure more favourable terms.

Even if it is possible to write a complete contract, in some emerging

economies like India, where legal infrastructure is weak, it takes an
enormous amount of time to get a legal remedy. In some countries like
China, the contract may not be enforceable. So, in effect, we have to work
with incomplete contracts.

With the unfeasibility of a complete contract that specifies the

consequences of every possible contingency, the reputation of the
supplier plays an important role. Since the supplier firm has to
maintain its reputation, it might resist from behaving opportunistically
in an unforeseen contingency. Of course, reputed firms will usually
charge a premium, and this premium, charged by a reputed supplier
firm, can be included in transaction costs.

The inability to write a complete contract results in a significant increase

in the cost of transacting business through market exchange and
includes the following situations:

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• Presence of relationship-specific assets

• Poor coordination affecting supply chain performance

• Leakage of strategic information resulting in adverse supply chain
performance

The Make-Versus-Buy Continuum

We started out by exploring two extreme positions:

(a) Make an input or buy an input using the market and (b) vertical
integration versus market, where the buyer has an arm’s-length
relationship with the suppliers. There are several alternative ways in
which the exchange can be organized. In this section, we discuss two
important alternatives:

(a) Tapered integration, where a firm both makes and buys a given input.

(b) Collaborative relationship, which could be a formal contractual

relation or a long-term informal relationship, based on trust. In some
cases, it can lead to alliances or joint ventures

Tapered Integration:

Tapered integration represents a mixture of market and vertical

integration. A firm makes part of the requirement in-house and procures
the rest from the market. Firms like Pizza Corner and Madura Garments
fall in this category, wherein they own some retail outlets and depend
on franchisee or other models for the rest of their sales. Keeping part of
the manufacturing in-house allows firms to have a better understanding
of the industry cost structures, and this helps them in negotiating better
deals with suppliers. Firms are able to keep up the pressure on their
internal supply group to innovate and work on cost reductions by
showing them benchmark numbers from markets. Firms can also keep
the pressure on the supplier by saying that if they do not improve the
complete manufacturing will be shifted in-house, as they have the
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capability for it. As this helps avoid a potential hold-up situation, the firm
is less vulnerable on this front. Though at first glance it looks like as if
tapered integration allows a firm the best of both worlds, if not managed
properly, the firm might end up getting the worst of both worlds. By
distributing production between internal and external supply groups, a
firm may not have economies of scale at both places. Further, the
coordination and monitoring activities might increase costs significantly

Collaborative Relationship:

In a collaborative relationship, the supplier is an extension of the

firm. The firm treats its suppliers as strategic partners and usually a
supplier is assured of business for a reasonably long period of time. The
firm does not indulge in competitive bidding every year and does not
change its supplier to get the small price reduction offered by a
competing supplier. Information is shared freely across firms, and the
supplier is willing to invest in relationship-specific assets. Usually, the
supplier gets involved early at the product design stage and the price paid
to the supplier is based on the actual costs incurred. One major concern
in collaborative relationships is ensuring that the supplier keeps working
on innovations. Just like the internal supplier, the partner in a
collaborative relationship is assured of business, and this may result in
complacency on the part of the supplier. Firms should periodically
benchmark the partner’s costs with the market so as to ensure that the
supplier remains competitive. Dell Computers benchmarks all its
partners on cost and technology leadership. Only if the supplier
maintains leadership on both these fronts does Dell continue with the
same partner

Sourcing Strategy: Portfolio Approach

Firms buy a large number of components and services and, of

course, not all of them should be handled in same way. The popular
portfolio approach developed by Kraljic (see Figure 3.3) classifies items

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based on the importance of the item in terms of value of purchase (high

versus low) and associated supply risk in the supply market. Supply risk
captures two dimensions: number of suppliers in the market and the
demand–supply gap in the supply market. If an item has very few
suppliers who have monopoly in the market and supply is less than the
demand, the buyer faces a significant supply risk. In supply markets
where there are large numbers of players and there is surplus capacity in
the market, the items bought will be classified as low-supply-risk
category items. Packaging material and transport service markets come
in this category and represent low-risk items. Diesel engines, diesel fuel
systems and proprietary technology items have few suppliers, so they
represent the high-risk-supply category. For example, Bosch has a
market share of 81 per cent in the fuel-injection equipment market, so
obviously it comes under the high-risk category. Similarly, oil and steel
in the early part of the 21st century represented the high- risk category
because demand outstripped supply. There was a strong demand for steel
and fuel in India and China and, as a result, demand outstripped supply.
Because of the supply uncertainty created by the disturbances in Iraq,
the supply risk for oil increased significantly after the interventions by
the United States of America in Iraq. Classifying items on their
purchasing value is a straightforward issue because it just needs internal
data and growth projections at the firm level. Supply risk, on the other
hand, represents a more sophisticated analysis because the focus is on
the supply markets, and in the case of many commodities, the supply
markets are global in nature. So firms should either develop adequate
capability in this area or should take help from experts for carrying out
this exercise.

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Like everything else, purchasing expenditure per item also follows the 80–
20 rule, that is, 20 per cent of the items represent about 80 per cent of
the value of purchase. Similarly, the bargaining power of buyers and
suppliers depends on the demand–supply conditions in the supply
markets and hence are different for different items. Typically, managers
end up spending equal a mounts of time and effort on all items and all
suppliers. Because each supplier has to go through supplier certification,
if there are large numbers of items and distinct components the
purchasing manager may not be focusing on items where opportunities
may be high or supply risks are significant.

To understand this issue better, see Figure 3.4, which has aggregate data
from the portfolio analysis carried out by a couple of Indian firms. As
can be seen in Figure 3.4, 4–10 per cent of parts accounted for about
70–80 per cent of the purchase value. On supply-risk dimensions,82–90
per cent of the items represent low-supply-risk situations. What is most
striking is the low-value, low-risk quadrant. Items in this quadrant
account for 80–85 per cent of the items and 15–25 per cent of the
purchase value. The explicit data on purchase orders are not presented in
the study, but it is very likely that the low-value, low-risk quadrant will
account for the largest number of purchase orders and, therefore, will
take up the bulk of the purchasing manager’s time. We obviously need a
different sourcing strategy for each quadrant .As shown in Figure 3.3, the
four quadrants are named as follows: routine products, leverage
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products, strategic products and bottleneck products. We take each

category and discuss the sourcing strategy.

• Routine products: This quadrant represents significant opportunity.

The focus is on reducing the number of parts and the number of
suppliers. The aim is to reduce administrative and logistics complexity.
The time saved here is used to focus on strategic suppliers and
bottleneck suppliers. The focus is on moving to system buying rather
than component buying. A large number of items and suppliers come in
this quarter, which represents a non-critical, low-valued supply.
Unfortunately, managers end up spending much energy in this quarter.
Ideally, the purchasing department should not waste its energy on small
items. Rather, it should aggregate components into systems and start
sourcing the systems. This issue is discussed in greater detail in the
section titled “Reconfiguration of the Supply Base”.
• Leverage products: This quadrant consists of high-value, standard
products. These items provide an opportunity for leveraging buying power
in low-supply-risk situations. In these supply markets, there are a large
number of suppliers and switching costs are low. So firms should be
aggressive in their attempts to encourage competitive bidding in order
to leverage their position. Most of the benefits obtained by firms in
reverse auctions have been in this category.

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A firm can reduce the number of suppliers and focus on operational-level

integration so that apart from purchasing costs inventory and
administrative efforts can also be reduced.

• Strategic products: This quadrant represents high-value products

with high supply risks. As shown in Figure 3.4, this quadrant usually
accounts for less than 5 per cent of the items and for almost 40 per cent
of purchase value. Items in this quadrant are treated as strategic items,
and a firm must work towards establishing collaborative, long-term
relationships with suppliers in this quadrant. Firms must create
opportunities for mutual cost reduction by working together on all
aspects, including product design. Because fewer parts and suppliers are
involved, firms can invest in building collaborative relationships. The top
management of firms should get actively involved in devising a strategy
for this category of items.

• Bottleneck products: These items represent relatively low value, but

a firm is vulnerable on this front because of the supply risk inherent in
this market. Since a firm is likely to be buying relatively smaller value, it
is also unlikely to have much clout with suppliers. Here, the focus is on
securing supply, and a firm should actively keep looking at alternative
sources of supply.

If possible, the firm should also look at substitutes that are from low-
risk supply markets. For example, in the diesel fuel system, there may
not be too many suppliers of the required capability and competence. A
firm might try and develop a better understanding of supplier priorities
and their planning systems so that it can align its buying plan with the
suppliers’ operating plans. For example, some steel producers produce
certain grades of steel only once in a year. If an interested firm knew of
their internal processes, it might be in a better position to obtain reliable
supply. If required, the firm should also be willing to pay a premium for
a reliable source of supply.

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In doing the above-mentioned analysis, firms seem to focus on items

involved in direct purchases or those that affect the cost of goods sold.
But firms buy a huge quantity of indirect goods and services, such as
travel, advertising, IT and human-resources-related purchases, which
have rarely come under the radar of sourcing executives. In the United
States of America, direct purchases account for 47 per cent of the firm’s
expenses and indirect purchases account for 24 per cent of its
expenses. Firms like American Express and Chase Manhattan Bank
have managed to reduce costs by 10–15 per cent in their purchase of
indirect goods and services.

Ideas of portfolio analysis are equally applicable for indirect purchases.

Typically, they are handled by the marketing, human resources and IT
departments, who do not have the necessary skills of sourcing and end
up paying premium prices without getting anything substantial in return
in terms of higher services.

Reconfiguration of the Supply Base

Most Indian companies work with a large number of vendors. In

the past, a number of items were reserved for the small-scale sector and
this forced Indian corporations to source material from many small
players. Most of these small firms had very little motivation to innovate.
Further, purchasing managers preferred to work with a large number of
suppliers so that as a buyer the firm could play one supplier against
another at the bidding stage. If we take the example of freight, typically,
Indian firms work with a large number of transporters. Toyota Kirloskar
has just one strategic supplier of logistics services with whom it has a
collaborative relationship. Other firms may not want to go all the way to
single sourcing, but they have to work on reconfiguring their supply base
so as to reduce the number of suppliers. Reconfiguration involves the
following two ideas:

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• Move to system buying

• Reduce the number of suppliers per item/system

Once a firm has moved to system buying, it can try and reduce the
number of suppliers for each system. Reducing the number of suppliers
does not necessarily mean sole sourcing, that is, having only one
supplier. Sole sourcing is valid for large complex systems that require
massive investments in tools. Usually, Japanese firms like to have dual
suppliers for every system and they motivate suppliers by shifting a
fraction of their business from one supplier to another, based on supplier
performance. They also encourage suppliers to compare performances
with each other. With fewer suppliers, a firm can move to electronic
information flow and then to process qualification rather than having
inspections at the receipt stage. Firms can also work with the idea of a
green channel where a supplier’s material goes directly to the assembly
line and thus the firm can reduce many non-value- added activities in the
chain.

Impact of the Internet on Sourcing Strategy:

Some years back there was the view that the Internet will
fundamentally alter the sourcing strategy of firms. A large number of
researchers and practitioners argued that with the advent of the Internet
firms can source from anywhere in the world and that old ideas of
sourcing will not be valid in the virtually connected world. During the
days of the dotcom bubble, some analysts expected the three big auto
companies GM, Ford and Chryster to save to the tune of $2,500 per
$19,000 vehicle, using Covisint, the electronic collaborative exchange. In
the post-dotcom-bubble era, firms have realized that the fundamentals
of sourcing strategy remain valid in the post-Internet era also. In this
section, we critically analyses the impact of Internet technology on
sourcing strategy.

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Ideally, firms prefer to evaluate a large number of potential

suppliers, as a broadening range of suppliers will definitely help the
firm in lowering the price at which it will buy the item. Also, a larger
number of potential suppliers will reduce the risk of opportunistic
behavior, inherent in situations involving bargaining among a few
parties that are highly dependent upon each other. Unfortunately, the
costs involved in locating and evaluating the right supplier and the
interactions are strictly the function of the number of suppliers included
in the search process. Consequently, a firm determines the optimal
number of suppliers by trading off the cost of further searches against
the expected benefit from identifying a better supplier. Since search and
evaluation costs are lower for suppliers in the geographical
neighborhood, most of the firms traditionally work with a limited
number of suppliers located in their geographical proximity. Internet
technology has changed the nature and extent of costs involved in the
search and evaluation process.

Because of advances in IT in general and the Internet in particular,

costs related to computer-aided information search and coordination
have declined, averaging 25 per cent per year. It was argued that the
optimal number of suppliers in the consideration set is bound to
increase as the Internet lowers search and evaluation costs. Further,
suppliers in the consideration set will be globally distributed and not
limited to the geographical neighborhood of the firm. Also, the Internet
fueled a lot of electronic public market exchanges and industry-
sponsored exchanges where information about suppliers can be obtained
without much effort. Further, electronic reverse auction became a
popular technology, which allowed the buyer to organize auctions where
potential suppliers all over the world could bid via the Internet and the
firm could select the most suitable supplier.

These developments raised serious discussions among scholars

and practitioners about the direction of evolution of the buyer–supplier

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relationship. There was also concern about whether we are going back to
an era in purchasing where the only thing that mattered was the price.
Over the past few years, after a detailed study of reverse auctions, it has
been found that reverse auctions work best for items such as plastic
resin, transport services and personal computers, where there are a large
number of suppliers and there is excess capacity in the system. It was
observed that reverse auctions and market exchanges worked reasonably
well for items in the low-supply-risk category in the purchase portfolio
matrix. As per the industry estimate, an average of 4 per cent of total
corporate expenditure is sourced using reverse auctions, indicating that
the goods and services to which reverse auctions can be successfully
applied to are limited. Similarly, the popularity of public market places
underwent a substantial decline after the dotcom bubble burst.

Supplier Selection and Contract Negotiation

 Before selecting suppliers, a firm must decide whether to use single

sourcing or multiple suppliers.

 Single sourcing guarantees the supplier sufficient business when the

supplier must make a significant buyer-specific investment.
 While, having multiple sources ensures a degree of competition and
also lowers risk by providing a backup should a source fail to deliver.
 The selection of suppliers is done using a variety of mechanisms,
including offline competitive bids, reverse auctions, or direct
negotiations. No matter what mechanism is used, supplier selection
should be based on the total cost of a using a supplier and not just the
purchase price.
 In general, auctions are best used when the quantifiable acquisition
cost is the primary component of total cost. If ownership or post-
ownership costs are significant, direct negotiations often lead to the
best outcome.

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 In many supply chain settings, a buyer looks to outsource a supply

chain function such as production or transportation. Potential
suppliers are first qualified and then allowed to bid on how much
they would charge to perform the function.
 When conducting an auction based primarily on unit price, it is
thus important for the buyer to specify performance expectations
along all dimensions other than price.
 From the buyer’s perspective, the purpose of an auction is to get
bidders to reveal their underlying cost structure so the buyer can
select the supplier with the lowest costs.
 A significant factor that must be accounted for when designing an
auction is the possibility of collusion among bidders.
 Second-price auctions are particularly vulnerable to collusion
(contract is assigned to the lowest bidder-but at the price quoted by
the second-lowest bidder)
 If there is collusion and all bidders but the lowest cost bidder raise
their bids, the contract goes to the lowest cost bidder, but at a higher
price. Firms must take care to ensure that no collusion occurs when
using an auction.

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Basic principles of negotiation

 Firms enter into negotiations both for supplier selection and to set the
terms of the contract with an existing supplier.
 Negotiation is likely to result in a positive outcome only if the value
the buyer places on outsourcing the supply chain function to a
supplier is at least as large as the value the supplier places on
performing the function for the buyer.
 The differences between the values of the buyer and seller is referred
to as the bargaining surplus.
 A good estimate of the bargaining surplus improves the chance of a
successful outcome.
 Suppliers of Toyota have often mention that “Toyota knows our costs
better than we do”, which leads to better negotiations.
 The key to a successful negotiation, however, is to make it a win-win
outcome that grows the surplus. It is impossible to obtain a win-win
outcome if the two parties are negotiating on a single dimension, such
as price.
 To create a win-win negotiation, the two parties must identify more
than one issue to negotiate. Identifying multiple issues allows the
opportunity to expand the pie if the two parties have different
preferences.
 This is often easier than it seems in a supply chain setting especially
if both parties focus on the total cost of ownership.

Creating a world class supply base

 Competitive edge is something all companies strive for as part of

building their so- called “world-class supply chain”
 From a high-level definition, this means having effective
interdependent relationships between people, process and technology;
and from our suppliers to our customers such that we are enabled
to increase market value and drive down end-to-end supply chain
costs.

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Core elements of effort in getting to that end state include:

 Collaborative long-term relationships built on respect and trust.

 Effective demand signals that drive sourcing and manufacturing and

enable volume adjustments as needed.
 Operations and logistics alignment with capacity managed and
leveled production schedules.
 Ability to manage mixed loads with on-time/ in-full delivery coming
into and going out of the organization.
 Ongoing collaborative operations and product delivery improvement
with cost reductions across the end-to-end chain.

Becoming world-class requires that we focus on operational excellence

and use all means at our disposal to ensure:

 Increased visibility across the supply chain

 Improved control and decision-making

 Improved product availability

 Improved alignment between organization and targets

 Increased data accuracy and user confidence

 Increased system performance

 Standardizing and harmonizing people, process and

technology Put all this together, and the value
opportunities to business become real:
 Reduce inventory between 15% and 30%

 Increase inventory turns as much as > 17.5%

Real world Results

HCL AXON has helped an ever-growing list of clients transform their

supply chain:

 For a global storage networking manufacturer, we achieved an 85%

improvement in operating cycle time by increasing supply chain
efficiency.

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 For a leading biotechnology company, we cut the time required for

demand forecasting by 50%.
 For a global life sciences company, we delivered an organization-wide,
360-degree view of the customer to support its 1200-member sales
force.
 For a leading U.S. retailer, we enabled a 78% increase in revenue,
which they achieved within four months of its Oracle implementation.
 For one of Europe’s largest soft drink companies, we delivered $49M in
cashable benefits by transforming its supply chain.
 For the world leader in information storage systems, we reduced order-
to schedule cycle times from days to minutes by improving information
exchange between warehouses and the plant.
 For the largest local authority in the European public sector, we
created more than
£400M in savings over three years, with up to £514M projected, by
overhauling the agency’s operations.

Supplier Development

 Supplier development describes a structured program to improve the

capability of suppliers.
 Buyers may seek to improve capability by sharing ideas with their
suppliers, by seconding staff, by advancing funds for investment, or by
working collaboratively to jointly develop new processes.
 Supplier development is resource intensive and usually focuses on key
long-term suppliers with whom co-operation is appropriate.

 The logic is that, through developing the supplier’s capability, both

parties will share in the benefits of better performance, better quality,
shorter cycle times and/or lower costs.

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The role of supplier development in supply chain success:

1. Earn a Competitive Advantage

2. Encourage Collaboration Between Individual Suppliers

3. Drive Innovation

4. Create Stronger Long-term Supplier Relationships

5. Resolve Performance and Quality Issues

World Wide Sourcing

 This is also termed as global sourcing.

 It is the process of sourcing goods and services from the international
market across geopolitical boundaries.
 It aims to exploit global efficiencies such as lower cost skilled labor,
cheaper raw materials and other economic factors like tax breaks and
low trade tariffs. Examples are call centers in India, clothing and
shoes manufactured in Ethiopia and Thailand.
 Some advantages of global sourcing are learning how to do business
successfully in a new market, finding and developing alternate supplier
sources to reduce costs and stimulate competition.
 The opportunity exists to locate scarce skills and resources not
available or unproductive at home thereby increasing manufacturing
capacity and other technical capabilities.
 There are also disadvantages, Monitoring costs go up and there are
hidden costs relating to the effort and time spent learning about
different cultures and time zones, especially in the beginning. There is
exposure to financial, political and legal risks, often in emerging
economies.
 In the service industries there is also a real risk in losing a grip on your
intellectual property.

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Questions
1 Explain Make v/s Buy: The Strategic Approach.
2 Why do we need Strategic Sourcing?
3 Explain the strategic Outsourcing Process.
4 Write a short note on global sourcing.
5 What is economic of scale? Explain four major sources of economies of
scale.
6 Define Transaction cost. List the costs which comprise transaction.
7 Explain Impact of the Internet on Sourcing Strategy.
8 Write a short note Supplier Selection and Contract Negotiation

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