Outsourcing
• An “easy way” to increase profits
• Nike, Cisco, Apple outsource most of their
manufacturing
– Each could focus on research, marketing
– Each has gotten into trouble
• 2001 – Nike reported unexpected profit shortfalls due
to inventory problems
• 2000 – Cisco had to write down billions in obsolete
inventory
• 1999 – Apple was unable to meet customer demand
for new products
Outsourcing Benefits and Risks
• Benefits
– Economies of scale reduce manufacturing costs
– Risk pooling – demand uncertainties are
transferred
– Reduced capital investment
– Focus on core competencies
– Increased flexibility
• Risks
– Loss of competitive knowledge
– Conflicting objectives
• Flexibility vs. long-term, stable commitments, etc.
• Consider the IBM PC example.
A Framework for Outsourcing
• Reasons for outsourcing
– Dependency on capacity
– Dependency on knowledge
• Product architecture
– Integral products – components are tightly
related
• Designed as a system
• Not off-the-shelf components
• Evaluated based on system performance
– Modular products –independent components
A Framework for Outsourcing
(Fine & Whitney)
Product
Dependent: Indep:
knowledge, knowledge
capacity
Dep:
capacity
Modular Outsourcing Outsourcing
risky
opportunity
Indep.:
knowledge
capacity
Outsourcin
g can
reduce cost
Integral Outsourcing Outsourcing Keep
very risky
option
internal
The Move to B2B Commerce
B2B is Huge...
2003
$1.3 Trillion
Business-to-Consumer
Business-to-Business
2002
$843B
1998
$43B
1999
$109B
2000
$251B
Source: Forrester Research, Inc.
2001
$499B
FreeMarkets Online
• FreeMarkets is an online market making
firm that enabled industrial buyers to link
up with their potential suppliers in a live
electronic bidding
• The end result of such interaction among
a network of suppliers was procurement
cost savings of about 15% for the buyers
• The company was founded in 1995 and
was on the verge of breaking even in 1998
– It was expecting to receive commissions and
fees of nearly $6 million for arranging
procurement of ~$200 million worth of
industrial components and parts
The company went public in
12/99...
Freemarket’s Stock Price
Where is FreeMarkets
today?
• For the three months ended in
3/31/01
– Revenue totaled $33M
– Net loss totaled $43.7M
• For the three months ended in
12/31/01
– Revenue totaled $44.8M
– Net loss totaled $2.8M
Highly Fragmented
• Most product categories are highly fragmented,
with numerous suppliers each offering different
level of quality, service and pricing options
• Buyers incur significant cost in the actual
purchase process
– A buyer must invest internal resources to manage the
process of collecting, analyzing and acting upon all the
information in the market
– In addition to purchase price companies spend over
10% in additional procurement costs
• On the suppliers side, there are significant costs
in using the manufacturing reps
– These commissions range from 4% to 7% of purchase
price
How Does FreeMarkets Online Create
Value for its Customers?
• Consulting/Purchase outsourcing
– Putting together specs, drawings, lot
sizes, documentation and RFQs
– Identifying potential savings
opportunities
– Identifying and qualifying suppliers
– Educating and training buyers
– Conducting the Competitive Bidding
Event (CBE)
– Providing post bid analysis and support
How Does FreeMarkets Online Create
Value for its Customers?
• Consulting/Purchase outsourcing
• Distribution Intermediary
Traditional B2B Trading
Exchanges
Industrial Buyer
Manuf. Rep.
Supplier 1
Manuf. Rep.
Supplier 2
Manuf. Rep.
Supplier 3
Internet Based B2B Trading
Exchanges
Industrial Buyer
FreeMarkets Online
Supplier 1
Supplier 2
Supplier 3
How Does FreeMarkets Online Create
Value for its Customers?
• Consulting/Purchase outsourcing
• Distribution Intermediary
• Network Enabler/Software Provider
What are the Barriers for the
buyers?
• Elimination of established
relationships with the suppliers and
their representatives
• Elimination of manufacturing reps
could result in loss of convenience
What is the value to the
suppliers?
• Less value for the suppliers
– Commission costs fell from 7% to 2.5%
– Table 7.5 implies reduction in
commission by $174M(4.5%)=$8M
– Table 7.5 also shows $35M drop in
revenue for the suppliers
• Suppliers could benefit from lower
sales, marketing and distribution
costs and better utilization of
capacity
The Revenue Model
• A hybrid of service fees and sales
commissions
– FreeMarkets charged monthly fee from
the buyer based on the size of the
market making team dedicated to the
event
– Winning supplier paid sales
commissions; this was paid in
installments as suppliers shipped
products
Problems with the revenue
model
• Buyer side:
– FreeMarkets invests substantially in a project
– Consulting revenue is independent of the value created
– Does not lead to another intensive purchasing study for
the customer
– Gross margin on consulting is about 22%
– Doesn’t scale well
• Supplier side:
– FreeMarkets does not represent the supplier
– FreeMarkets success depends on their ability to identify
many potential suppliers
– Suppliers pay commissions to the company that reduced
their margins
Vertical vs Horizontal Focus?
• Vertical:
– Advantage: FreeMarkets can capitalize
on its deep knowledge of supplier
industries
– Disadvantage: Hard to scale-up
• Horizontal:
– Advantage: Ability to generate multiple
contracts from one buyers
– Disadvantage: FreeMarkets does not
bring much expertise to the transaction
How about licensing the
technology?
• Are buyers capable of using the
technology by themselves?
• If not, how will this hurt?
• If they are, where is revenue going
to come from?
• How can these problems be
addressed?
By the end of 1998…
• FreeMarkets was pursuing the
horizontal market expansion
• In 2000, the company started
licensing its software
E-Marketplaces: The Initial
(95-99) business model
• The e-marketplace concept started as a
new way to procure products, particularly
non-production items. E-marketplaces
– Expand everyone’s market reach
– Generate lower price for the buyers
– Cut operational costs for buyers and suppliers
• Automating the procurement process will
reduce processing cost per order from as
high as $150 to as low as $5 per order
– Focus on liquidity
– Transaction fee paid by the suppliers
– Serve as a virtual distributor
Problems with this Business
Model
• Sellers resist paying a fee to the company
whose main objective is to reduce the
purchase price
• Buyers resist paying a fee
• The revenue model needs to be flexible
– Sometimes the wrong party is charged
• Low barriers to entry created a
fragmented industry flooded with
participants
– Just in the chemical industry there were about
30 e-markets
Continuous evolution of the
business model
• Transaction fees (typically paid by
the sellers)
– Sometimes the wrong party is charged
– Buyers and suppliers resist paying
• Subscription fees (typically paid by
the buyer)
– Depends on a number of dimensions
• Licensing the software
Evolving Market Types
• Value-added independent e-markets
– They are expanding their offering to
include inventory management and
financial services (Zoho); supply chain
planning (Covisint, e2open, Converge,
TheSupply)
A Framework for
eProcurement
• Type of Component
– Strategic Components
• Part of the finished product
• Not industry specific; company specific
• Examples: PC motherboard and chassis
– Commodity Products
• Can be purchased from a large number of suppliers
• Price is determined by market forces
• Examples: Memory unit in a PC
– Indirect Material
• MRO
A Framework for
eProcurement
• Level of Risk
– Uncertain Demand (Inventory risk)
– Volatile market price (Price Risk)
– Component availability (Shortage Risk)
Risk: Commodity Products
• Can be purchased either
– in the open market through on-line
auction, or
– through the use of long term contracts
• Long term contracts guarantee
certain level of supply but may be
risky for the buyer
– Inventory risk, shortage risk or price
risk
A Framework for
eProcurement
• Indirect Material
– Typically low risk and hence the focus is
on content based hubs.
– The objective is to use an MRO-hub that
specializes in unifying catalogs from
many suppliers
– Examples: MRO.com, Grainger on-line
catalogs
Grainger
• W. W. Grainger has been selling industrial
supplies for 72 years
• In 1995 Grainger established
Grainger.com, an on-line catalogue for
more than 220,000 products from 12,000
suppliers
• In 1999, Grainger experienced revenue
growth of $102M through its internet
channel
• The MRO supply industry is growing at a
rate of 3-4% a year. From 1996 to 1999
Grainger internet sales grew 32% a year
and 20% in offline due to customers that
were lured to Grainger from the web site
A Framework for
eProcurement
• Strategic Components
– Typically high risk components that can
be purchased from a small number of
suppliers
– The objective is to use private or
consortia-based e-marketplace.
– The focus is on an e-marketplace that
allow collaboration with the suppliers
Consortia or Private?
• Transaction volume
• Number of suppliers
• Cost of building and maintaining the
site
• The importance of protecting
proprietary business practices
• Technology and product life cycles
A Framework for
eProcurement
• Commodity Products
– Products go directly into finished goods
• High risk
– Many potential options to choose from
– Long Term Contracts
• Buyer and supplier commit to certain volume (called the
commitment level)
• Supplier guarantees a level of supply for a committed price
– Flexible, or Option Contracts
• Buyer pre-pay a relatively small fraction of the product
price up-front, in return for a commitment from the
supplier to satisfy demand up to a certain level (called the
option level)
• The buyer can purchase any amount up to the option level
by paying additional price for each unit purchased
– Spot Purchasing
A Framework for eProcurement:
Portfolio Approach
A
Option Level
H
Inventory
Risk
N/A
(Supplier)
L
L
Price, Shortage
Risks
Inventory
Risk
(Buyer)
(Buyer)
Commitment
Level
H
B2B Software Vendors
• Oracle (Indirect and Direct)
• i2 Technologies and Manugistics
(Direct)
• Ariba (Indirect and Direct)
• Commerce One (Indirect and Direct)
• Agile (Direct)
• VerticalNet (Indirect)
E-Procurement: The reality
• Companies conducting greater than
20% of procurement transactions
online have reduced their transaction
processing cost by nearly a third
(Hackett Benchmarking)
• Product savings and process cost
improvements effect operating cost
by 10% (Credit Suisse First Boston
Technology Group)
E-Procurement: The reality
• To capture this benefits purchasing
organization needs to invest heavily
in:
– Changing internal procurement
processes
– Integrating e-marketplaces in internal
systems
– Purchasing B2B applications, and
– Paying e-marketplace transaction
Source: Forrester Research
fee/subscription fee
Positive Aspects of Trading Exchanges
(Companies who use exchanges):
• Reduce costs or labor (31%)
• Better access to products/vendors
(24%)
• Increase speed or efficiency (29%)
• Access to more customers (21%)
Source: AMR Research
Positive Aspects of Trading Exchanges
(Companies who plan to use
exchanges):
• Reduce costs or labor (43%)
• Better access to products/vendors
(26%)
• Increase speed or efficiency (23%)
• Access to more customers (10%)
•
Source: AMR Research
Negative Aspects of Trading Exchanges
(Companies use exchanges):
• Security trust (17%)
• Start Up cost (5%)
• Loss of face-to-face relationships
(12%)
• Lack of standards (5%)
• Immature technology (5%)
• Integration issues (7%)
• Source: AMR Research
Negative Aspects of Trading Exchanges
(Companies who plan to use
exchanges):
• Security trust (16%)
• Start Up cost (15%)
• Loss of face-to-face relationships
(11%)
• Lack of standards (6%)
• Immature technology (6%)
• Integration issues (4%)
• Pricing pressure (6%)
Source: AMR Research