Term II: Supply Chain Management (SCM)

Session 14: Sourcing decision in Supply Chain

Rohit Gupta
Operations Management Area
IIM Ranchi
Email: rohit.gupta@iimranchi.ac.in
The Role of Sourcing in supply chain
Sourcing is the set of business processes required to purchase goods and services. It’s
about finding the balance between the quality of products and raw materials you need and
the affordability.
 Outsourcing
 Offshoring

Outsourcing occurs when a company contracts a specific process out to a third party,
finding someone who specializes in whatever needs to be done.
Offshoring happens when businesses send in-house jobs overseas.
Sourcing involves the following
 Finding quality sources of goods and services
 Negotiating contracts
 Establishing payment terms
 Market research
 Testing for quality
 Considering outsourcing for goods
 Establishing standards
The Role of Sourcing in supply chain

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 end customer.

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?

Outsourcing results in the supply chain function being performed by a third party.
Outsourcing decisions are important and tend to vary across firms and industries.
Comparative Advantage (David Ricardo, 1817)

A firm is said to have comparative advantage over another in production of a

particular good or services if she is able to produce the same at a
lower marginal cost.

This drive for lower cost raises the classical dilemma that any company
executive faces.

Make or Buy???

It eventually leads to search for outsourcing partner, contractual agreements

and associated risks.
Buy Decision
Component Supplier Final Goods Retail Product Price: p
Manufacturer (CM) w Market Quantity demanded: q

CM’s per unit Supplier’s per unit

production cost: c production cost: s
1. CM produces Work-In-Progress (WIP) and sells 1 unit of WIP to Supplier at a price: w (≥ c)
2. Supplier produces Finished Goods (FG) and 1 unit of FG requires n units of WIP
Total Demand faced by Supplier is: q
Derived Order Quantity of WIP to CM from Supplier is: nq
CM’s per unit production cost for WIP is: c
Therefore, CM’s total production cost for producing nq WIP is: cnq
CM’s revenue by selling nq WIP to Supplier is: wnq
Supplier’s own per unit production cost for FG is: s
Supplier’s own total production cost for producing q FG is: sq
Supplier therefore has incurred a total cost of (s + nw)q for producing q FG [buying nq
WIP from CM and her own production cost for q FG]
The per unit retail product price is: p
By selling q FG in the market supplier earns a total revenue of pq
Therefore, the supplier’s net profit in case of Buy decision is:  B  p  s  nwq
 Make Decision
Component Supplier Final Goods Retail Product Price: p
Manufacturer (CM) c Market Quantity demanded: q

CM’s per unit Supplier’s per unit

production cost: c production cost: s
1. Supplier procures the vendor firm CM after capital investment of an amount: K
2. CM (now another unit of the supplier firm) produces Work-In-Progress (WIP) and sells
1 unit of WIP to Supplier at a price: c
3. Supplier produces Finished Goods (FG) and 1 unit of FG requires n units of WIP

Ignoring the Capital Invested for acquiring CM and following the argument presented
previously, in this case the supplier’s profit would be given by:  M  p  s  ncq

Note: We have deliberately not accounted for the Capital Investment component in
our analysis, as of now.

The Difference in Profit Levels between Make and Buy Decision is given by:
   M   B  nw  cq  0, as w  c
Choice between Make and Buy
Case 1: ∆π = n(w – c)q < K : It is profitable for the Supplier to Buy
Case 2: ∆π = n(w – c)q = K : Supplier is indifferent between Make or Buy
Case 3: ∆π = n(w – c)q > K : It is profitable for the Supplier to Make
However, the reality would not be this simple and the aforementioned calculation is
required to be done in NPV (Net Present Value) form.

Net Present Value (NPV): It represents the profitability of any undertaking (in our case
the undertaking of the supplier is to decide whether to make the product in-house or to
outsource the same) and it is calculated as: discounted/ present values (PV) of cash
inflows minus discounted/ present values of cash outflows (including the initial cost)
over a (usually fixed and exogenously decided) period of time.

In our calculation, for the sake of simplicity, let us assume that major breakdown does
not happen and the maintenance of the machines are very low, i.e. additional outflow of
cash is approximately zero.
Then the NPV calculation for make or buy decision would look like:
N
nwi  ci qi

i 1 1  r i 1
K
Where, ‘r’ is the discount rate and ‘N’ is the number of years
over which the firm plan to remain in this business.
Let us explore a bit further:
In the previous problem, let us assume that the quantity demanded in the final
market is price dependent and is given by the relation: q = a – bp

 Buy  p  s  nwq  p  s  nwa  bp 

 Make  p  s  nc q  p  s  nc a  bp 
Let us calculate the optimal retail price (p) in each case.

From the first order condition(s) we get,

 Buy a  bs  nw
 0  pBuy
*

p 2b
 Make a  bs  nc 
 0  pMake
*

p 2b
*
Implication: As, w ≥ c, therefore, pBuy  pMake
*
 qBuy
*
 qMake
*

Note: This above phenomena is due to price-setting ‘ability’ of the supplier and that
stems from her bargaining power in the market.
The supplier will have that if the market is either an oligopoly or a monopoly.
Problem: Choice of Outsourcing Partner

A US based firm has decided to outsource part of her operation to another country. 4 companies
from 4 different countries had placed their bid for the outsourcing activity. The management of the
firm has the following data available.

Costa Weight of
Selection Criterion Mexico Panama Peru
Rica each factor
Trust 1 2 2 1 0.4
Quality 7 10 9 10 0.2
Religious Attitude 3 3 3 5 0.1
Individualism 5 2 4 8 0.1
Time Orientation 4 6 7 3 0.1
Uncertainty Avoidance 3 2 4 2 0.1

The country-wise ratings are on a 1 – 10 scale, where 1: Lowest Risk and 10: Highest Risk
The firm’s internally decided weight for each component is also given. Calculate which country poses
minimum risk for the purpose of outsourcing.
Answer

Criterion Mexico Panama Costa Rica Peru

Trust 1x0.4=0.4 2x0.4=0.8 2x0.4=0.8 1x0.4=0.4

Quality 7x0.2=1.4 10x0.2=2.0 9x0.2=1.8 10x0.2=2.0
Religious Attitude 3x0.1=0.3 3x0.1=0.3 3x0.1=0.3 5x0.1=0.5
Individualism 5x0.1=0.5 2x0.1=0.2 4x0.1=0.4 8x0.1=0.8
Time Orientation 4x0.1=0.4 6x0.1=0.6 7x0.1=0.7 3x0.1=0.3
Uncertainty Avoidance 3x0.1=0.3 2x0.1=0.2 4x0.1=0.4 2x0.1=0.2
Total Risk 3.3 4.1 4.4 4.2
Problem: (an extension): Range of Weight

Just before placing the final order to the Mexico based firm, an emergency meeting was
called as the company executives were not agreeing to the weight assigned to “Trust”.
As a result the selection criterion table looked like this:

Costa Weight of
Selection Criterion Mexico Panama Peru
Rica each factor
Trust 1 2 2 1 w
Quality 7 10 9 10 0.2
Religious Attitude 3 3 3 5 0.1
Individualism 5 2 4 8 0.1
Time Orientation 4 6 7 3 0.1
Uncertainty Avoidance 3 2 4 2 0.1

For what range of w, if any, Mexico is still going to win the outsourcing contract?
Answer
Criterion Mexico Panama Costa Rica Peru

Trust 1xw=w 2 x w = 2w 2 x w = 2w 1xw=w

Quality 7x0.2=1.4 10x0.2=2.0 9x0.2=1.8 10x0.2=2.0
Religious Attitude 3x0.1=0.3 3x0.1=0.3 3x0.1=0.3 5x0.1=0.5
Individualism 5x0.1=0.5 2x0.1=0.2 4x0.1=0.4 8x0.1=0.8
Time Orientation 4x0.1=0.4 6x0.1=0.6 7x0.1=0.7 3x0.1=0.3
Uncertainty Avoidance 3x0.1=0.3 2x0.1=0.2 4x0.1=0.4 2x0.1=0.2
Total Risk 2.9 + w 3.3 + 2w 3.6 + 2w 3.8 + w

Mexico can win the contract if the following criteria are fulfilled:
1. 2.9 + w ≤ 3.3 + 2w => w ≥ - 0.4
2. 2.9 + w ≤ 3.6 + 2w => w ≥ - 0.7
3. 2.9 + w ≤ 3.8 + w => holds for any Real value of w
Therefore, the required weight range is given by: w ≥ - 0.4
 Vendor Selection by AHP Technique

The Analytic Hierarchy Process (AHP) is a mathematical theory for measurement and
decision making that was developed by Dr. Thomas L. Saaty during the mid-1970's.

AHP Steps to a Decision

Step1: Problem Definition and Research

Step2: Eliminating Infeasible Alternatives
Step3: Structuring a Model
Step4: Making Judgements
Step5: Synthesizing
Step6: Examining and Verifying the Decision
Step7: Documenting the Decision
 Identification of Relevant Criteria

Relevant Criteria for Manufacturing Industries

 Price of product (PP)

 Transportation ease and cost (TC)
 Quality certification of the Vendor (QC)
 Quality of product (based on rejection rate) (QP)
 Goodwill of the Vendor (GW)
 Reliability of the Vendor (RV)
 Experience of the vendor in the same field (EV)
 Lead time (LT)
Criterion Intensity of Importance Criterion
ExI VSI SI MI EI MI SI VSI ExI
TC
QC
QP
PP GW
RV
EV
LT
QC
QP
GW
TC
RV
EV
LT
QP
GW
QC RV
EV
LT
GW
RV
QP
EV
LT
RV
GW EV
LT
EV
RV
LT
EV LT
How to complete the questionnaire
Tick the most appropriate box according to your opinion on how important one criterion
over another. If your preference is between two levels of importance, e.g. between
Strong Importance and Very Strong Importance, please tick the intermediate box
between them.

Intensity of
Values Definition
Influence
EI 1 Equal Importance
Moderate importance for
MI 3
one over other
SI 5 Strong Importance

VSI 7 Very Strong Importance

ExI 9 Extreme Importance

Examples
Each row has a single paired comparison for you to make. As stated above, between two criteria “EI” means
that both criteria are of Equal Importance. If you think, for example,
Case 1: the importance of Price of product(PP) over Transportation ease and cost (TC) is Strong
Importance, your answer should be placed on the left side subject to the degree of relative importance, and
then you would tick as follows:

Criterion Intensity of Importance Criterion

ExI VSI SI MI EI MI SI VSI ExI
PP √ TC

Tick  or X means: the importance of PP over the criterion TC is a Strong Importance.

Case 2: If, however, you think the importance of TC over the criterion PP is an Extreme Influence, then you
should tick on right side as follows:

Criterion Intensity of Importance Criterion

ExI VSI SI MI EI MI SI VSI ExI
PP √ TC

Case 3: If the importance is the same, tick on Equal Importance.

Criterion Intensity of Importance Criterion
ExI VSI SI MI EI MI SI VSI ExI
PP √ TC
 Checking for Consistency

 Consistency Ratio (CR) is used to measure how consistent the

judgments have been relative to large samples of purely random
judgments.
 AHP evaluations are based on the assumption that the decision maker
is rational, i.e., if A is preferred to B and B is preferred to C, then A is
preferred to C.
 If the CR is greater than 0.1 the judgments are untrustworthy because
they are too close for comfort to randomness and the exercise is
valueless or must be repeated.
Consistency Ratio (CR)

𝐶𝐼
𝐶𝑅 =
𝑅𝐼

𝜆𝑚𝑎𝑥 − 𝑛
𝐶𝐼 =
𝑛−1

CI: Consistency Index; RI: Random Index

n 1 2 3 4 5 6 7 8 9 10

RI 0 0 0.58 0.9 1.12 1.24 1.32 1.41 1.45 1.49

Where n is the number of criteria or factors