Procurement and Outsourcing
Strategies
Designing & Managing the Supply Chain
Chapter 7
Shen Qianru
qr_shen@pusan.ac.kr
Outline
 Case: FreeMarkets Online, Inc.
 Introduction
 Outsourcing Benefits and Risks
 A Framework for Buy/Make Decisions
 E-Procurement
 A Framework for E-Procurement
 Summary
Case: FreeMarkets Online, Inc.
 FreeMarkets OnLine is an electronic markets
company which provides interactive bidding among
competing suppliers generated price savings
 It created a fair and open exchange software which
is necessary for Competitive Bidding Event(CBE)
 The company were successful at developing
reasonable expertise and market knowledge, to lead
the art and science of making markets for custom
products, where each buyer in the market has his
own set of objectives and issues
Case: FreeMarkets Online, Inc.
 The market
Concentrate in the middle- components that were not
commodities, but for which competitive supply markets
exists
No-tooling
Custom components
Low-tooling
Custom components
Transferable-tooling
custom components
Fasteners
Service center metals
Specialty chemicals
Electronic components
Machines parts
Metal fabrications
Corrugated packaging
Printed circuit boards
Stampings
Castings
Plastic moldings
Case: FreeMarkets Online, Inc.
 The sales model
Direct sales model, which consisted of high bandwidth
“client developers” networking into and establishing
relationships with senior level purchasing, operations,
and finance executives at large targeted corporations
 The market-making process
Phase 1: Identify savings opportunities
Phase 2: Prepare total-cost RFQ(Request for Quoting)
Phase 3: Identify, screen, and support suppliers
Phase 4: Conduct on-line competitive bidding events
Phase 4: Provide post-bid analysis and award support
Case: FreeMarkets Online, Inc.
 The revenue model
A price model that was a hybrid of service fees and sales
commissions
 Going forward to scale
Horizontal market expansion or vertical market
dominance?
Technology and user support subscription licensing?
Networked purchasing information systems?
Introduction
What is procurement and outsourcing?
 Procurement is the acquisition of goods and/or services
at the best possible total cost of ownership, in the right
quantity and quality, at the right time, in the right place
and from the right source for the direct benefit or use of
corporations, or individuals, generally via a contract.
 Outsourcing is subcontracting a process, such as product
design or manufacturing, to a third-party company.
-Wikipedia
Introduction
 Consider the successful short life-cycle products
company-Nike, Apple, Cisco, etc. who rely heavily on
outsourcing, particularly for manufacturing.
 In 2001,Nike reported an unexpected profit shortfall due to inventory
buildup in some products shortages for others as well as late deliveries
 In 1999, Apple’s ability to satisfy customer demand was significantly
reduced due to shortages in the G4 chip supplied by Motorola
 In 2000, Cisco was forced to announce a $2.25billion write-down for
obsolete inventory because of a significant reduction in demand for
telecommunication infrastructure to which Cisco was not able to respond
effectively.
What went wrong?
Outsourcing Benefits and Risks
 Motivations for outsourcing
• Economies of scale
Reduce manufacturing costs through the aggregation of orders
from many different buyers.
• Risk pooling
Buyers transfers demand uncertainty to the CEM(Contract
Equipment Manufacturers)
CEM aggregates demand from many buying companies thus
reduces uncertainty and component inventory levels
• Reduce capital investment
Buyers transfers capital investment to the CEM. CEM can make
this investment by sharing between many of its customers.
Outsourcing Benefits and Risks
 Motivations for outsourcing
• Focus on core competency
The buyer can focus on its core strength(special talent, skills,
knowledge sets)
• Increase flexibility
I.
II.
Ability to better react to changes in customer demand
Ability to use the supplier’s technical knowledge to accelerate
product development cycle time
III. Ability to gain access to new technologies and innovation
Outsourcing Benefits and Risks
 IBM personal computer example(chapter 6) and
Cisco case
 Two substantial risks associated with outsourcing
• Loss of competitive knowledge
I.
II.
May open up opportunities for competitors
Lose ability to introduce new designs based on their own
agenda rather than the supplier’s agenda
III. Manufacture of various components to different suppliers may
prevent development of new insights, innovations, and
solutions.
• Conflicting objectives
Buyers: Increase flexibility
Suppliers: Long time, firm, stable commitment from the buyer;
focus on cost reduction
A Framework for Buy/Make Decisions
 Reasons for outsourcing
• Dependency on capacity
The firm has the knowledge and the skills
• Dependency on knowledge
The company doesn’t have the people, skills, and knowledges
required to produce the component
 Integral/modular product
• Toyota’s example
Engine: Has both the knowledge and the capacity->100% internal
production
Transmission: Has the knowledge and designs but depends on
suppliers’ capacity->70% outsourcing
Vehicle Electronic Systems: Dependency on both capacity and
knowledge->100% outsourcing
The more strategically important the component is, the
smaller the dependency on knowledge or capacity
A Framework for Buy/Make Decisions
 Integral/modular product
• Modular product (e.g. personal computer)
Components are independent of each other,interchangeable
Standard interfaces are used
Component can be designed or upgraded with little or no regard
to other component
Customer preference determines the product configuration
• Integral product (e.g. motherboard)
Not made from off-the shelf components
Designed as a system by taking a top-down design approach
Evaluated based on system performance
Components in integral products perform multiple functions
A Framework for Buy/Make Decisions
A Framework for make/buy decisions
Product
Dependency on
knowledge and capacity
Independent for
knowledge, dependency
for capacity
Independent for
knowledge and capacity
Modular
Outsourcing is risky
Outsourcing is an
Opportunity
Opportunity to reduce
cost through outsourcing
Integral
Outsourcing is very risky
Outsourcing is an
Option
Keep production internal
E-Procurement
 Many manufacturer were desperately looking to outs
ource their procurement functions
Highly complex, significant expertise, costly
 The value proposition offered to buyers by e-markets
• Serving as an intermediary between buyers and suppliers
• Identifying saving opportunities
• Increasing the number of suppliers involved in the bidding
event
• Identifying, qualifying, and supporting suppliers
• Conducting the bidding event
E-Procurement
 Four types of e-market
• Value-added independent (public) e-market
Offering additional services(inventory management, supply
chain planning, financial services)
• Private e-market
A way to improve supply chain collaboration by providing
demand information and production data; Consolidate
purchasing power across the entire corporation
• Consortia-based e-market
Established by a number of companies within the same
industry, to provide suppliers with a standard system that
supports all the consortia’s buyers.
• Content-based e-market
focuses on maintenance, repair, operation goods;
focuses on industry-specific products
E-Procurement
Private marketplace
Public/consortia marketplace
Owner
A single buyer
Independent owner of a group of
companies from the same industry
Objectives
1.Share proprietary data
2.Allow for logistics and supply chain collaboration
1.Buying and selling commodities by
focusing on price
2.Finding new suppliers
3.Buying and selling excess inventory
Participants
Selected group of suppliers
Open market
Buyer cost
Building and maintaining the site
1.Subscription fee
2.Licensing fee
3.Transaction fee
Supplier cost
No fee
1.Transaction fee
2.Subscription fee
Main problems
1.Intitial investment
1.Recent collapse of many
marketplaces
2.Objections by referred suppliers
because of price focus
3.Sharing of proprietary information
4.Data normalization and uploading
2.Data normalization and uploading
A Framework for E-Procurement

Types of Goods Purchased by the Firm
• Strategic components: components that are part of the finished goods
and are not only industry specific but also company specific
• Commodity products: components that can be purchased from a
variety of vendors and whose price is determined by market forces
• Indirect materials: maintenance, repair and operations ;components
that are not part of the finished products, manufacturing process

Level of Risk
• Uncertain demand: inventory risk
• Volatile market price: price risk
• Component availability: shortage risk

Framework for E-Procurement
• Indirect material: risk is typically low->content-based
• Strategic components: high-risk components->private or consortia based
• Commodity products: high risk, while variety of potential options to
choose from
A Framework for E-Procurement

Base commitment level: long-term contract which is commitment level of
supply

Option level: a commitment from the supplier to satisfy demand up to a
certain level

Spot purchasing: buyers look for additional supply in the open market

Portfolio approach (appropriate trade-offs between risk and cost for
commodity products)
High
Option
Level
Low
Inventory
Risk
(supplier)
Price and
shortage
risks (buyer)
Low
N/A*
Inventory
risk (buyer)
High
Base commitment level
*For a given situation, either the option level or the base commitment
level may be high, but not both
Summary
 Benefits and risks of outsourcing
 Framework for making buy/make decisions
 E-markets and their impact on business strategies
 E-procurement and its framework