Unit II

Strategic Sourcing
• In-sourcing and Out-sourcing
• Types of Purchasing Strategies
• Supplier Evaluation
• Selection and Measurement
• Creating a world class supply base
• World Wide Sourcing

2
 The Sourcing Decision in a
Supply Chain
• Purchasing, also procurement, is the process by
which companies acquire raw materials, components,
products, services, or other resources from
suppliers to execute their operations
• Sourcing – entire set of business processes
required to purchase goods and services
• Outsourcing – supply chain function being
performed by a third party

3
 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
• 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
13-4
 5

The Sourcing Decision in a Supply

Chain

• Outsourcing questions
1. Will the third party increase the supply chain
surplus relative to performing the activity in-
house?
2. To what extent do risks grow upon outsourcing?
3. Are there strategic reasons to outsource?
 In-House or Outsource
• Capacity aggregation - A third party can increase the supply
chain surplus by aggregating demand across multiple firms
and gaining production economies of scale that no single firm
can on its own.
• Inventory aggregation - A third party can increase the supply
chain surplus by aggregating inventories across a large
number of customers.
• Transportation aggregation by transportation intermediaries -
A third party may increase the surplus by aggregating the
transportation function to a higher level than any shipper can
on its own.

13-6
 In-House or Outsource
• Transportation aggregation by storage intermediaries - A third
party that stores inventory can also increase the supply chain
surplus by aggregating inbound and outbound transportation.
• Warehouse aggregation - A third party may increase the
supply chain surplus by aggregating warehousing needs over
several customers.
• Procurement aggregation - A third party increases the supply
chain surplus if it aggregates procurement for many small
players and facilitates economies of scale in production and
inbound transportation.

13-7
 In-House or Outsource
• Information aggregation - A third party may increase the
surplus by aggregating information to a higher level than can
be achieved by a firm performing the function in-house.
• Receivables aggregation - A third party may increase the
supply chain surplus if it can aggregate the receivables risk to
a higher level than the firm or it has a lower collection cost
than the firm.
• Relationship aggregation - An intermediary can increase the
supply chain surplus by decreasing the number of
relationships required between multiple buyers and sellers.

13-8
 Factors Influencing Growth of
Surplus by a Third Party
• Scale
– Large scale it is unlikely that a third party can achieve further
scale economies and increase the surplus
• Uncertainty
– If requirements are highly variable over time, third party can
increase the surplus through aggregation
• Specificity of assets
– If assets required are specific to a firm, a third party is unlikely
to increase the surplus
• Cost and quantity of available capital
– Third party may have available or lower cost capital

9
 Factors Influencing Growth of
Surplus by a Third Party
Table 15-1 Growth in Surplus by Third Party as a Function of Scale,
Uncertainty, and Specificity

Blank Blank Specificity of Assets Involved in Specificity of Assets Involved in

Function (Low) Function (High)
Firm scale Low High growth in surplus Low to medium growth in surplus

Blank High Low growth in surplus No growth in surplus unless cost

of capital is lower for third party

Demand Low Low to medium growth in surplus Low growth in surplus

uncertainty for
firm
Blank High High growth in surplus Low to medium growth in surplus

10
 Risks of Using a Third Party
1. The process is broken
2. Underestimation of the cost of coordination
3. Reduced customer/supplier contact
4. Loss of internal capability and growth in third-
party power
5. Leakage of sensitive data and information
6. Ineffective contracts
7. Loss of supply chain visibility
8. Negative reputational impact

11
 Identifying Core Processes
• Distinguish between core activities and
commodity activities.
– Microsoft launching video games;
– Microsoft focused only on software and
outsourced the hardware(Xbox) to Flextronics
• Two ways to do
– The Business Process Route
– The Product Architecture Route

12
 The Business Process Route

• Three core and high level business processes

– Customer relationship
• Nike and Benetton
– Product innovation
• High end pharmaceutical companies, technology
companies
– Supply chain management
• Walmart and Dell

13
The Product Architecture Route

14
 Designing a Sourcing Portfolio:
Tailored Sourcing
• Options with regard to whom and where to source
from
– Produce in-house or outsource to a third party
– Will the source be cost efficient or responsive
– Onshoring, near-shoring, and offshoring
• Tailor supplier portfolio based on a variety of
product and market characteristics

15
 Designing a Sourcing Portfolio:
Tailored Sourcing
• Sources must focus on different capabilities
– Cost
– Responsiveness
• Volume-
Volume-based tailored sourcing
• Product-
Product-based tailored sourcing

16
 Designing a Sourcing Portfolio:
Tailored Sourcing
Table 15.3 Factors Favoring Selection of a Responsive or Low-
Cost Source

Blank Responsive Source Low-Cost Source

Product life cycle Early phase Mature phase
Demand volatility High Low
Demand volume Low High
Product value High Low
Rate of product obsolescence High Low
Desired quality High Low to medium
Engineering/design support High Low

17
 Designing a Sourcing Portfolio:
Tailored Sourcing
Table 15.4 Factors Favoring Onshoring, Near-Shoring, or
Offshoring
Blank Onshore Near-Shore Offshore
Rate of innovation/product High Medium to High Low
variety
Demand volatility High Medium to High Low
Labor content Low Medium to High High
Volume or weight-to-value ratio High High Low

Impact of supply chain High Medium to High Low

disruption
Inventory costs High Medium to High Low
Engineering/management High High Low
support
18
 Designing a Sourcing Portfolio:
Tailored Sourcing
Table 15.5 Differences Between Direct and Indirect Materials

Blank Direct Materials Indirect Materials

Use Production Maintenance, repair, and
support operations
Accounting Cost of goods sold Selling, general, and
administrative expenses (S
G&A)
Impact on production Any delay will delay Less direct impact
production
Processing cost relative to Low High
value of transaction
Number of transactions Low High

19
 20

Product Categorization

Figure 15-1 Product Categorization by Value and Criticality

 Sharing Risk and Reward in the
Supply Chain
• Independent actions by two parties often result in
lower profits than could be achieved
• Stronger firms tend to push risk on to supply chain
partners

21
 Supplier Scoring and Assessment
• Supplier performance should be compared on
the basis of the supplier’s impact on total cost
• There are several other factors besides
purchase price that influence total cost

13-22
 Supplier Assessment Factors
• Replenishment Lead Time • Pricing Terms
• On-Time Performance • Information Coordination
• Supply Flexibility Capability
• Delivery Frequency / • Design Collaboration
Minimum Lot Size Capability
• Supply Quality • Exchange Rates, Taxes,
• Inbound Transportation Cost Duties
• Supplier Viability

13-23
 Supplier Selection and Contracts
• 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

13-24
 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 if
the supply chain coordinated actions to have a common
objective of maximizing total supply chain profits
• An approach to dealing with this problem is to design a
contract that encourages a buyer to purchase more and
increase the level of product availability
• The supplier must share in some of the buyer’s demand
uncertainty, however

13-25
 Contracts for Product Availability and Supply
Chain Profits: Buyback Contracts
• Allows a retailer to return unsold inventory up to a
specified amount at an agreed upon price
• Increases the optimal order quantity for the retailer,
resulting in higher product availability and higher profits
for both the retailer and the supplier
• Most effective for products with low variable cost, such as
music, software, books, magazines, and newspapers
• Downside is that buyback contract results in surplus
inventory that must be disposed of, which increases
supply chain costs
• Can also increase information distortion through the
supply chain because the supply chain reacts to retail
orders, not actual customer demand

13-26
 Swimsuit Example
• 2 Stages:
– a retailer who faces customer demand
– a manufacturer who produces and sells swimsuits to the
retailer.
• Retailer Information:
– Summer season sale price of a swimsuit is $125 per unit.
– Wholesale price paid by retailer to manufacturer is $80 per
unit.
– Salvage value after the summer season is $20 per unit
• Manufacturer information:
– Fixed production cost is $100,000
– Variable production cost is $35 per unit

27
 What Is the Optimal Order Quantity?
• Retailer marginal profit is the same as the marginal
profit of the manufacturer, $45.
• Retailer’s marginal profit for selling a unit during the
season, $45, is smaller than the marginal loss, $60,
associated with each unit sold at the end of the season
to discount stores.
• Optimal order quantity depends on marginal profit and
marginal loss but not on the fixed cost.
• Retailer optimal policy is to order 12,000 units for an
average profit of $470,700.
• If the retailer places this order, the manufacturer’s
profit is 12,000(80 - 35) - 100,000 = $440,000

28
 Risk Sharing
• In the sequential supply chain:
– Buyer assumes all of the risk of having more inventory than
sales
– Buyer limits his order quantity because of the huge financial risk.
– Supplier takes no risk.
– Supplier would like the buyer to order as much as possible
– Since the buyer limits his order quantity, there is a significant
increase in the likelihood of out of stock.
• If the supplier shares some of the risk with the buyer
– it may be profitable for buyer to order more
– reducing out of stock probability
– increasing profit for both the supplier and the buyer.
• Supply contracts enable this risk sharing
29
 Buy-Back Contract
Swimsuit Example
• Assume the manufacturer offers to buy unsold
swimsuits from the retailer for $55.
• Retailer has an incentive to increase its order
quantity to 14,000 units, for a profit of $513,800,
while the manufacturer’s average profit increases
to $471,900.
• Total average profit for the two parties
= $985,700 (= $513,800 + $471,900)
• Compare to sequential supply chain when total
profit = $910,700 (= $470,700 + $440,000)

30
Contracts for Product Availability and Supply Chain
Profits: Revenue Sharing Contracts

• The buyer pays a minimal amount for each

unit purchased from the supplier but shares a
fraction of the revenue for each unit sold
• Decreases the cost per unit charged to the
retailer, which effectively decreases the cost of
overstocking
• Can result in supply chain information
distortion, however, just as in the case of
buyback contracts

13-31
 Revenue Sharing Contract
Swimsuit Example
• Manufacturer agrees to decrease the
wholesale price from $80 to $60
• In return, the retailer provides 15 percent of
the product revenue to the manufacturer.
• Retailer has an incentive to increase his order
quantity to 14,000 for a profit of $504,325
• This order increase leads to increased
manufacturer’s profit of $481,375
• Supply chain total profit
= $985,700 (= $504,325+$481,375).
32
Contracts for Product Availability and Supply Chain
Profits: Quantity Flexibility Contracts

• Allows the buyer to modify the order (within

limits) as demand visibility increases closer to the
point of sale
• Better matching of supply and demand
• Increased overall supply chain profits if the
supplier has flexible capacity
• Lower levels of information distortion than either
buyback contracts or revenue sharing contracts

13-33
 Contracts to Coordinate
Supply Chain Costs
• Differences in costs at the buyer and supplier can
lead to decisions that increase total supply chain
costs
• Example: Replenishment order size placed by the
buyer. The buyer’s EOQ does not take into
account the supplier’s costs.
• A quantity discount contract may encourage the
buyer to purchase a larger quantity (which would
be lower costs for the supplier), which would
result in lower total supply chain costs
• Quantity discounts lead to information distortion
because of order batching

13-34
 Contracts to Increase Agent Effort
• There are many instances in a supply chain where
an agent acts on the behalf of a principal and the
agent’s actions affect the reward for the principal
• Example: A car dealer who sells the cars of a
manufacturer, as well as those of other
manufacturers
• Examples of contracts to increase agent effort
include two-part tariffs and threshold contracts
• Threshold contracts increase information
distortion, however
13-35
 Contracts to Induce
Performance Improvement
• A buyer may want performance improvement
from a supplier who otherwise would have little
incentive to do so
• A shared savings contract provides the supplier
with
a fraction of the savings that result from the
performance improvement
• Particularly effective where the benefit from
improvement accrues primarily to the buyer, but
where the effort for the improvement comes
primarily from the supplier
13-36