Module-2

Strategic Sourcing Outsourcing

Make Vs. buy:

 Production units are identified mostly with their decision to make or buy. In other words, do
they wish to produce the desired product on their own or do they want to purchase it from the
foreign market.
 This decision is critical because the third-party suppliers especially in countries like Eastern
Europe, China, and other low-cost parts of the world hold out the promise of essential
beneficiaries, which the developed nations fail to offer.
 The decision of a firm to perform its activities internally or get those activities done from an
independent firm is known as the make versus buy decision. This make versus buy issue is
strategic in nature and involves the following key decisions: What activities should be carried
out by the firm and what activities should be outsourced? How to select the entities/partners to
carry out outsourced activities and what should be the nature of the relationship with those
entities? Should the relationship be transactional in nature or should it be a long-term
partnership?
 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.

Identifying Core Processes

 The identification of core 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 as 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, equipments 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 fulfilment 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. A firm
must identify and ensure that it builds core capabilities in-house in at least one of these areas.

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 (as shown in Figure, view of the overall framework)

The strategic outsourcing process (Ref: Janath shah )

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.
 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.
 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.

Economies of Scale
There are four major sources of economies of scale, which are briefly discussed here.
1. 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.
2. 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
millimetres allow firms to obtain twice as many chips per wafer compared to older
technologies, which could handle wafers only with diameters up to 200 millimetres.
This allows a semiconductor manufacturing firm, willing to invest in more capital-
intensive technologies, to bring down the cost per chip.
3. 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.
4. 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 by 10 to 20 per cent.
Agency Cost
 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.
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 goods and 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 underinvestment 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.

Incomplete Contracts
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.
 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.
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:
 Presence of relationship-specific assets
 Poor coordination affecting supply chain performance
 Leakage of strategic information resulting in adverse supply chain performance

Relationship-specific Assets

A relationship-specific asset is an investment made to support a given transaction.

In several situations, a firm will be able to improve the efficiency of transactions
and reduce costs in the process if the supplier can invest in specialized assets. These
specialized assets are known as relationship-specific assets, as they cannot be
redeployed for other customers without any significant costs. These specialized
assets could involve either physical assets or human capital.

We illustrate the idea of a relationship with several examples from different

contexts:

• Maruti Suzuki has asked several of its suppliers to locate either finishing
operations or stock points close to its Gurgaon plant.

• FMCG players typically ask the packaging material suppliers to locate their
facilities close to the buyer’s plant.

Poor Coordination

In several supply chain situations, coordinating decisions between both parties is

essential for overall performance. Because of differences in objectives and
priorities, coordination on all occasions is not guaranteed between buyers and
suppliers. The problems of coordination are illustrated with several examples:

• Soft drink firms spend enormous amounts of money on advertising campaigns,

and to ensure that the campaigns have the desired impact, they need the cooperation
of the local bottlers at the implementation stage. Coke and Pepsi have realized that
they need to coordinate retailing activities, traditionally handled by the local
bottlers. So they have decided to take greater control over bottling plants, and in
some markets they have decided to even own the bottling plants.

Leakage of Strategic Information

If one is buying from a firm that is also supplying similar inputs to competitors, a
lot of strategic and sensitive information is likely to get leaked to the competitors.
It may relate to product design or customer information or future plans. In such a
case, this problem can be avoided by making the input internally. For example, the
selection of dyes and designs for new products is regarded as critical information,
so Benetton keeps dyeing operations within the firm.

In a world of complete contracts, all the three issues discussed above can be taken
care of. But in a world of incomplete contracts, all these issues contribute to
transactions costs of market exchange. If the transactions costs are substantially
high, the firm is better off by bringing the activity in-house.
Integrative Framework of Market Versus Hierarchy
 To resolve the make versus buy issue, a firm has to look at the benefits as well
as the costs involved. Costs should not be viewed from a narrow perspective;
instead, the costs and risks associated with loss of control should also be
captured in the transaction costs involved in market exchange.
 Costs related to economies of scale, agency costs and transactions costs have
been integrated in the framework provided in Figure. If additional costs due to
poor economies of scale plus agency costs of internal control and coordination
are less than transaction costs of market exchange, the firm should settle for
the make option, else the firm should opt for market exchange.
 Capturing the true value of agency and transaction costs requires a deep
understanding of business. Though most garment firms outsource
manufacturing operations, Zara Corporation, a leading European garment
company, has decided to keep the bulk of its manufacturing facilities within
the firm.
 In the past few years, Benetton has also decided to increase internal
manufacturing capacities. Both these firms value responsiveness and want
tighter control over their operations, so they prefer internal manufacturing
capacities for a quick response to market trends.

The integrative framework of make versus buy (reference: Janath Shah)

The Make-Versus-Buy Continuum

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
capability for it.
 As this helps avoid a potential hold-up situation, the firm is less vulnerable on
this front.
 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.
 Japanese manufacturers work with a network of suppliers with whom they maintain close long-
term relationships. Japanese companies have subcontractor networks called keiretsu. This
network involves vendors, bankers and distributors. Firms within a keiretsu are linked by
informal personal relationships. As they share long-term relationships, they avoid most of the
problems associated with market exchange relationships and are willing to invest in higher
relationship-specific assets and do not worry about information asymmetry and hold-up
problems.
 This allows each firm within the keiretsu to focus on its core competence and all get the
necessary economies of scale. However, since they are assured of a market they may also suffer
from agency problems discussed in vertical integration.