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Outsourcing: Make versus Buy

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 Learning Objectives

How do firms take “make-versus-buy” decisions?

What is the underlying theoretical logic for “make-versus-buy” decisions?
What are the costs and benefits of outsourcing?
What should be the nature of the relationship with vendor firms?
How can a firm design its sourcing strategy based on the purchase-portfolio matrix?
How has the internet affected the sourcing decisions of a firm?

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Videos
https://www.youtube.com/watch?v=ClegdV8Gw4I Introduction
https://www.youtube.com/watch?v=YgkPaDhsjUQ Explanation
https://www.youtube.com/watch?v=nxOguVpobyg Reasons Why Companies Outsource
https://www.youtube.com/watch?v=YgkPaDhsjUQ Buy it!!!
https://www.youtube.com/watch?v=ncli94xodm8 Make it!!!
https://www.youtube.com/watch?v=-ZpHiMTwOdM Move it!!!
https://www.youtube.com/watch?v=DvEh04LNJ_I DHL International Supply Chain
https://www.youtube.com/watch?v=JZu_gxi3sbs Fedex and UPS Documentary
https://www.youtube.com/watch?v=90a2qHYqMoU Pros and Cons of Outsourcing

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Case Study
Darden’s Supply Chain yields a competitive edge..
Darden Restaurants, Inc.

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 Make versus Buy: The Strategic
Approach

Make vs Buy represents two extremes along the

continuum of possibilities.
How to select the entities/partners to carry
Once a firm has decided to buy a certain set of
out outsourced activities and what should
activities/ items, not all items are sourced using the be the nature of relationship with those
same approach entities?
What activities should be carried out by the firm
and what activities should be outsourced? Should the relationship be transactional in
Core competence of the firm – In house nature or should it be a long term
partnership?
Core processes of the firm – In house
Others – Outsource

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Make or Buy Decision:
oA choice between producing a component or
service in-house or purchasing it from an
outside source.
Outsourcing:
oTransferring a firm’s activities that have
traditionally been internal to external
suppliers.
oThe vendor performing the outsourced
service is an expert in that particular specialty.
oThis leaves the outsourcing firm to focus on
its key success factors and its core
competencies.
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What Activities Can be Outsourced?
Business Process Route

Identify high-level business process of importance

• Customer relationship: acquiring new customers and maintaining/building good relations with the existing ones. E.g.,
Nike and Benetton
• Product and service innovation: Developing new products/services. E.g., HP and Pharmaceutical Industry
• Supply Chain Management: Fulfilment of Customer Orders. E.g., Dell and Wal-Mart

Outsource activities which are of commodity type. E.g., Warehousing or Transportation

At least one of the Core processes retained within firm must provide strategic power to the firm
within the chain

A firm must ensure that it has higher bargaining power within the chain.

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 What Activities Can be Outsourced?...
Product Architecture Route
◦ The focus here is on sub-systems and components and the make/buy decisions are
made at that level.
◦ A sub-system is strategic if it involves:
◦ Technologies that change rapidly
◦ If it requires specialized skills and technologies, and
◦ If it has significant impact on the performance of the important product attributes
◦ Ability to offer differentiated product
◦ Technological leadership
Identification of strategic subsystems, components
◦ Even for outsourced subsystem firm must keep architecture knowledge in-house
◦ E.g., e-retailers are sometimes not able to deliver products on time due to their
dependency on their logistics partners, especially during festive seasons

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 Virtual Corporations:
https://www.youtube.com/watch?v=FknAHSZapls
Virtual corporations outsource all
supply chain activities to either
one party or a combination of
parties and just focus on brand
building
Is virtual corporation a hollow
corporation (?)
Name few Virtual Firms……………
Advantages of a Virtual Firm:
• Specialized management
expertise
• Low capital investment
• Flexibility, and
• Speed
However, managing a virtual
company is highly dynamic and
demanding
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 Strategic Outsourcing Process

https://www.supplychaindigital.com/top-10/top-10-outsourcing-companies-world : Top 10 Outsourcing Companies

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 Economies
of Scale

Make or Buy
Decisions
Market
Incomplete Agency
Contracts vs Cost
Hierarchy

Transaction
Cost
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https://www.youtube.com/watch?v=7qeehDLYa8g
https://www.youtube.com/watch?v=7qeehDLYa8g :: Outsourcing:
Outsourcing: Is
Is itit good
good or
or bad?
bad?
Market versus Hierarchy: The Economic Perspective

1. Economies of Scale
• Higher volume allows a firm to spread its fixed cost over larger volume of operations
• Higher volume allows a firm to choose more efficient technologies
• Pooling of buffer capacities and inventories

Due to steadily rising costs, the firms are more and more availing 3P services for manufacturing and Logistics

e.g., Outsourcing of IT operations to IBM and Wipro

Indo Nissin Foods Ltd. (Top Ramen) o/s distribution operations to Marico

Outsourcing of warehouses and transportation is also very common

If a firm has larger demand – can have internal manufacturing

e.g., Wal-Mart would prefer its own fleet of vehicles for transportation

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Market versus Hierarchy: The Economic
Perspective…

2. Agency Cost
• Cost of Control and Coordination of internal supply
• Usually termed as Cost Centers, insulated from competitive pressures

3. Transaction Cost
• Search and Information cost
• Bargaining and contracting cost
• Policing and enforcement cost
• Cost incurred because of loss of control

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 Market versus Hierarchy: The Economic
Perspective…

4. Incomplete Contracts
In practice, it is impossible to write complete contracts

Reasons why contracts are not complete:

 Bounded rationality
 Difficulties in specifying /measuring performance
 Asymmetry of information

Inability to write complete contract increases transaction cost in following

situations:
 Presence of relationship-specific assets: Results in Hold-up problem for suppliers
 Poor coordination affecting supply chain performance: O/s slows down the speed in non-routine operations, results in increased
transaction costs
 Leakage of strategic information resulting in adverse supply chain performance. E.g., Textile industry

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 Relationship-specific Assets: Illustrations

Microsoft expected its

Maruti Suzuki has
introduction of Xbox Marico would like all Wal-Mart has made
asked several of its Bharti would preferred
360 to be a huge its dealers to work RFID mandatory for its
suppliers to locate Ericsson to build
success and has asked with MIDAS top 100 suppliers. All
either finishing network capacity on
its contract (Distributor supply from 2005
operations or stock the basis of its
manufacturers to build application software onwards is supposed
points close to its demand projections.
additional capacity for developed by Marico). to be RFID tagged.
Gurgaon plant.
the same.

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 Integrative Framework Of Make Versus Buy
Integrative Framework Of Make Versus Buy

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Six Sourcing Strategies
Having decided what to outsource, managers have six strategies to consider:

Many Few Vertical Joint Keiretsu Virtual

Suppliers Suppliers Integration Ventures Networks Companies

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Vertical Integration
Vertical Integration Examples of Vertical Integration
Raw Material (suppliers) Tree Harvesting

Backward Integration Chipmakers Pulp making

Current Transformation Pepsi Apple International Paper

Forward Integration Bottling Retail Stores End-user Paper Conversion

Finished Goods (Customers)

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There are several alternate ways in which the exchange can be organized:
Two important alternatives:
Tapered integration, where a firm both makes and buys a given input.
◦ It’s a mixture of market & vertical integration.
◦ Firms like Pizza corner & Madura garments fall in this category , wherein they own some
retail outlets & depend on franchisee or other models for the rest of their sales.
◦ This helps them to better understand the costing and the pricing
◦ Helps them negotiating better deals with suppliers.
◦ Able to keep up the pressure on internal supply group to innovate.
◦ Pressure on market supplier as well.
◦ Looks as if it allows a firm the best of both worlds, if not managed properly, might end up
getting the worst of both.
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 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.

Firms should
Usually the periodically
supplier gets benchmark the
The supplier is an Firm doesn’t Major concern is
Doesn’t change its involved early at partner’s costs and
extension of the indulge in ensuring supplier
supplier for a small the product design technology with
firm. Can be competitive works on
price reduction. stage & price paid the market so as to
strategic partners. bidding every year. innovation.
is based on actual ensure the supplier
cost incurred. remains
competitive.

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 Concept Of Keiretsu

Japanese companies have subcontractor networks called keiretsu.

This involves vendors, bankers & distributors.
Firms within a keiretsu are linked by informal personal relationships.
They share long term relations, so they avoid most of the problems associated with
market exchange relationship, are willing to invest in higher relationship-specific assets.
This allows keiretsu to focus on its core competence & all get the necessary economies of
scale.

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Supply Chain Risk
In this age of increasing specialization, low communication cost, and fast transportation,
companies are making less and buying more.
Which clearly indicates more reliance on supply chains and hence, more risks.
In any supply chain, vendor reliability and quality may be challenging. But the new model of a
tight, fast, low-inventory supply chain, operating across political and cultural boundaries, adds a
new dimension to risk.
As organization go global, shipping time (lead time) may increase logistics may be more
reliable, and tariffs and quotas may block companies from doing business.
In addition, international supply chains complicate information flows and increase
political/currency risks.
http://sourcinginnovation.com/wordpress/2007/02/14/five-types-of-supply-risk-and-how-to-m
itigate-them/

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 Supply Chain Risks and Tactics
RISK RISK REDUCTION TACTICS EXAMPLE
Supplier failure to Use multiple suppliers; effective contracts McDonald’s planned its supply chain 6 years before
deliver with penalties, subcontractors on retainer, its opening in Russia. Every plant – bakery, meat,
preplanning chicken, fish, lettuce – is closely monitored to ensure
strong links
Supplier Quality Careful supplier selection, training, Darden Restaurants has placed extensive controls,
Failures certification and monitoring including 3rd party audits, on supplier processes and
logistics to ensure constant monitoring and
reduction of risks
Outsourcing Take over production; provide or perform Tyson took over chicken farm production in China to
the service yourself mitigate product quality and safety concerns related
to using independent farmers.
Logistics delays or Multiple/redundant transportation modes Walmart, with its own trucking fleet and numerous
damage and warehouses; secure packaging; effective distribution centers located throughout US, finds
contracts with penalties alternative origins and delivery routes bypassing
problem areas
Distribution Careful selection, monitoring, and effective Toyota trains its dealers around the world, invoking
contracts with penalties principles of the Toyota Production System to help
dealers improve customer service, used-car logistics,
and body and paint operations.
 Supply Chain Risks and Tactics…
RISK RISK REDUCTION TACTICS EXAMPLE
Information Loss Redundant databases; secure IT systems; Boeing utilizes a start state-of-the-art international
or distortion training of supply chain partners on the communication system that transmits engineering,
proper interpretations and uses of scheduling and logistics data to Boeing facilities and
information suppliers worldwide.
Political Political risk insurance; cross country Hard Rock Café reduces political risk by franchising
diversification; franchising and licensing and licensing, rather than owning, when the political
and cultural barriers seem significant
Economic Hedging to combat exchange rate risk; Honda and Nissan are moving more manufacturing
purchasing contracts that address price out of Japan as the exchange rate for the Yen makes
fluctuations Japanese-made autos more expensive
Natural Insurance; alternate sourcing; cross-country Toyota, after its experience with fires, earthquakes
catastrophes diversification and tsunamis, now attempts to have at least 2
suppliers, each in a different geographical region, for
each component
Theft, vandalism, Insurance; patent protection; security Domestic Port Radiation Initiative: The US
and terrorism measures including RFID and GPS; government has set up radiation portal monitors that
diversification scan nearly all imported containers for radiation
Cross sourcing
It represents a hybrid technique where two suppliers each provide a
different component, but they have a capability of producing each
other’s component. i.e., each acting as a backup source.

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Sourcing Strategy: Portfolio Analysis

The portfolio approach developed by Kraljic classifies items based on the importance of the
item in terms of value of purchase ( high versus low) & associated supply risk in the supply
market.
Supply risk captures 2 dimensions:
1. No of suppliers in the market.
2. The demand supply gap in the supply market.
If an item has very few suppliers who have monopoly……the buyer faces a significant supply
risk.
In supply markets where there are large no of players & there is surplus capacity in the
market, the items bought will be low supply risk category.
Diesel engine , diesel fuel & proprietary technologies have few suppliers.

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Sourcing Strategy: Portfolio Analysis

Low High
Supply Risk

Low High

Purchasing Value

Source: Purchasing and Business Strategy

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Purchase Portfolio
Analysis

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Routine: Significant opportunity, focuses on reducing the no of parts & no of
suppliers, reduce administrative & logistics complexity. Focus on moving to
system buying rather than component buying.
Leverage: High value, standard products. Large no of suppliers & switching cost
are low. Focus should be on operations level integration so that not only
purchasing but administrative efforts can also be reduced.
Strategic: High value products with high supply risks, strategic items, firm
should look for collaborative , long term relationships with suppliers, should
create opportunities for mutual cost reduction.
Bottleneck: Low value, focus on securing supply, & should keep looking at
alternative sources of supply, even look at substitutes.

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 Routine

Routine products are products which are readily available (low purchasing risk) and have a low impact on the
financial result of a company.
 Examples of routine products are computers, paper clips, staples, cleaning, etc. The purchasing of routine
products is mainly an administrative process.
The organizational costs of purchasing these goods often exceed the costs of the goods themselves.
Many purchasing departments pay a lot of their attention to the purchasing of routine products, as there are
so many routine products and a lot of suppliers are involved. The pay off however is low.
Professional purchasing departments try to minimize the effort and time they spend on the purchasing of
these routine products (Van Weele, 1997).
Professional suppliers therefore try to minimize the effort their customers have to do: they take care of the
process for their customers.

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 Leverage

Leverage products are products which are readily available and which have a big impact on the
financial result of the buyer. Buyers pay lots of attention to the purchasing of leverage products, as the
financial risk is high. Because leverage products are readily available, the purchasing department
“scans” the market.
The competition between the many suppliers will lead to a situation where some suppliers start
discounting their product. A discount for the customer on a leverage product will result into
substantial savings (in absolute terms). For the suppliers this behavior of the customer is
uncomfortable. The traditional behavior of the supplier is to “push” the product as much as possible.
As all suppliers of the leverage product will do this, the job of the purchasing department of the
customer is made even easier.

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Strategic :

Strategic products are products with a high

financial risk and a high purchasing risk for
the customer

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 Bottleneck :
Bottleneck products are products with a low financial risk
and a high purchasing risk: there are not many suppliers
the customer can go to. Customers are vulnerable. Spare
parts are typical bottleneck products.
The power of the relationship lies with the supplier.
Customers will try to look for substitutes: this will lower
their purchasing risk. The security of supply is a key issue
for the customers.
 How should the supplier differentiate his customers?

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Portfolio Analysis of Indian
Firms

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 Sourcing strategy Based on Purchase Portfolio
Classification

Classify outsourced items/processes using

portfolio matrix
Design strategy for each quadrant
◦ Focus on direct as well as indirect goods and services
◦ Sourcing of Indirect material account for significant part of cost of goods sold

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 Impact of Internet on Sourcing Strategy

Advances in information technology in general, and the internet in particular, costs related to computer-
aided information search and coordination have declined, averaging 25% per year.
Initial reactions by practitioner/researcher community:
◦ Internet would fundamentally change sourcing practices.
◦ Optimal number of suppliers in the consideration set increases with lower search and evaluation
cost
◦ Suppliers in the consideration set would be globally distributed and not limited to the geographical
neighbourhood of firm.
◦ Internet fuelled a lot of electronic public-market exchanges and industry-sponsored exchanges
where information about suppliers can be obtained without much effort.
Current understanding on the part of practitioner/researcher community:
◦ Basic logic underlying the sourcing strategy using the purchase portfolio matrix is not going to
change because of the internet.
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◦ Internet is an enabler in implementing the sourcing strategy based on the purchase portfolio matrix.
Reverse Auction
What is Reverse Auction
Unlike a typical auction, the roles of the buyers and sellers are reversed
in reverse auction. Firms use this approach to identify suppliers willing to
supply specific items like steel or service like freight at the lowest bid
price. Suppliers bid electronically for a contract over a window of about
30-60 minutes.
At the bidding stage, all suppliers have access to information about the
lowest bid in real time, and since the amount in an auction is usually
large, the supplier is under tremendous pressure to reduce his bid and
usually ends up bidding a lower amount than what he would have bid
during normal circumstances.

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Reverse Auction
Best Practices in Reverse
Auction
Use reverse auction for items under the low supply-risk market category in
the purchase portfolio matrix, as for these items usually there are a large
number of suppliers and there is surplus capacity in the market; hence, there is
enough incentive for suppliers to reduce their bids during reverse auctions
Specifications must be clearly stated in the RFQ (Request for Quotation)
document: RFQs must be detailed and take care of all the issues including
delivery lead times, treatment of urgent orders, warranty etc.
Firms must have a robust supplier qualification process
Firms must ensure that the purchase lots in a reverse auction are large
enough to motivate suppliers.

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Strategic Outsourcing :
The Case of Bharti Airtel

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Strategic Outsourcing: Network Design and
Installation

Bharti will pay vendors according to Erlangs of installed capacity

Payment will be made when capacity is up and running and has been used
by customers
◦ After a certain period, unused capacity will be
redeployed or payment will be made to the vendor
Adjustments to price per erlang function of demand density will be made
according to a pre-agreed formula
Bharti will build passive infrastructure

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Strategic Outsourcing: Network
Management

Vendors will establish NOCs (Network Operating Centers) to

monitor activity
SLAs are to guarantee quality for Bharti’s customers.
Representative metrics:
Blocked calls in peak/non-peak hours
Dropped calls in peak/non-peak hours
Voice quality

Financial rewards and penalties

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Strategic Outsourcing: IT Outsourcing

On-demand agreement with IBM for 10 years

IBM will be paid a share of Bharti’s revenues
◦ IBM modeled its revenues on a forecast of customers and employees

Adjustment for scale (IBM share will fall with growth)

SLAs (Service Level Agreements) stipulate penalties as a
function of the criticality of the system to Bharti’s business
Governing body to cope with IT evolution

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Bharti Airtel’s Experience of Strategic Outsourcing

Bharti management pleased

Predictable cost model
Developed new managerial capabilities

Former employees satisfied with transfer

Vendors better-off
Equipment vendors pleased with the end of beauty contests.
IBM used Bharti as an example in public forums

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Best Practices in Strategic Outsourcing
Ensuring goal congruence
Goal congruence ensures that control costs are low
Building professional contract management group
Developing a greatly enhanced strategic and operations information systems
Developing feedback systems to leverage and share knowledge and innovations in
both directions
Creating a mutual three-level contact system
Top management level : Break bottlenecks and ensure responsiveness
Champions on both side of the relationships
Numerous operating level personnel who develop the personal relationships and knowledge
exchanges
Shift the buyer outlook to managing “what “( results) is desired rather than managing
“how” the result is produced

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Summary-I
Traditionally, firms started with the assumption that everything should be done
internally unless there is a compelling logic for outsourcing an activity. Now, a
large number of firms want to be virtual corporations where they start with the
assumption that activity must be outsourced unless there is a compelling logic
that justifies keeping activities in-house.
Since outsourcing is a strategic decision which cannot be altered in the short run,
firms must look, not at the immediate costs, but at the long-term supply chain
costs and risks in making this decision.
Firms can identify core activities from a strategic perspective either through the
business process route or by the product architecture route. When a firm decides
to outsource some core process/sub-systems, it must keep the necessary
architecture knowledge in-house.

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Summary-II
A firm has to look at the benefits as well as the costs involved in their make-
versus-buy decisions. If additional costs due to poor economies of scale plus
agency costs of internal control and coordination exceed transaction costs of
market exchange, the firm should opt for make.
Pure Make and pure Buy are two extreme ends of the make-versus-buy
continuum. There are many ways of managing outsourced activities— tapered
integration and collaborative partnerships, are two among several hybrid ways in
which outsourced relationships can be managed.
Not all items are sourced using same the approach. Purchase portfolio matrix is
one popular approach for classifying items into four categories: routine items,
leverage items, strategic items and bottleneck items. Purchase portfolio classifies
items based on the importance of the item in terms value of purchase and the
supply risk associated with the item in the supply market.

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Summary-III
Firms should try and reconfigure their supply base
and use new technologies like internet and e-
commerce in implementing sourcing strategies
based on the purchase portfolio matrix based.

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