Chapter 7: Procurement And
Outsourcing Strategies
1. CASE: FreeMarkets Online, Inc.
2. Procurement And Outsourcing
Strategies
Prepared by Hoon Lee
Date on 8th June, 2007
* 참고) Shin, Sang-hoon 학생 자료를 참고하여 작성되었음.
1
CASE: FreeMarkets OnLine, Inc.
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Introduction
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Glen Meakem and Sam kinney are cofounders.
They focus on how to position their company,
both with clients and the capital markets.
January 1998, their revenues were sufficient to
cover its $300,000 monthly burn rate.
1997 revenues of almost $1.8 million and was
aiming for over 200% growth in 1998 to $6 million.
They needed to lay out a clear and compelling
strategy that would create the most value.

To raise a large amount of growth capital and provide
investor liquidity through an IPO.
* 참고) IPO (Initial Public Offering): 기업공개, 유가증권시장이나 코스닥시장에 상장한다는 의미
2
CASE: FreeMarkets OnLine, Inc.
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Founding
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Be founded in Pittsburgh in 1995 by three
entrepreneurs.
Advantage of the city’s unique blend of industrial
and high-technology infrastructure.
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Close to major manufacturing centers, a hub airport.
A strong local skill base in both software and
manufacturing.
Having purchased the interests of the third
founder, for all practical purposes.
* 참고) Pittsburgh: 세계적인 제철공업 지대, 원자력·알루미늄·기계·유리 등의 각종 공업도 활발, 피츠버그대
학교·카네기공과대학교
3
CASE: FreeMarkets OnLine, Inc.

Founding
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End of 1993, Meakem had stumbled on a very big
opportunity. Having worked on purchasing studies
for clients in McKinsey’s Houston office.
He knew that …
Industrial buyers faced tough challenges sorting through
the variety of supplier.
 The average skill level of buyers in a wide range
manufacturing companies was low and make decisions
was very limited
 Identifying truly high-quality suppliers while also
estabilishing fair market prices was extremely difficult.
-> Industrial buyers were unaware of the savings
opportunities still lurking beneath their decisions.
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4
CASE: FreeMarkets OnLine, Inc.

Founding
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Meakem’s experience about “Silent auctions”
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A group of suppliers would be assembled in a hotel
ballroom surrounded by flip charts.
Prices dropped as suppliers participated in this openprice discovery process.
The logistical difficulties of bringing together all of the
suppliers made these events difficult to replicate
Meakem’s experience about “The Logic of
Electronic Markets” is issued of Harvard Business
Review on May-June 1989.
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Electronic markets offer cross-company electronic
connections, Just as single-source sales channels do.
and therefore give customers the same convenience.
5
CASE: FreeMarkets OnLine, Inc.

Founding
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Meakem’s experience about “The Logic of…
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Customers have electronic connections to their
suppliers, they can also choose which suppliers they
want to use.
From the customers’ perspective, electronic markets are
more desirable than single-source sales channels
If the technology exists to create electronic markets and
customers want them -> It’s just time matter
He left McKinsey to join a Fortune 50 company’s
corporate business development group, He
began working on purchasing improvement
projects.
6
CASE: FreeMarkets OnLine, Inc.
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Founding
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The Interactive bidding system was fielded in
September 1994. – Interactive bidding among
competing suppliers generated price savings.
Some Important groundwork had to be put in
place.
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First, The Bidding was only as good as the product
specifications. The Supplier need a precise
understanding of the components or materials.
Second, The Results depend upon having the right
suppliers involved.
When these “lower-tech” issues were not addressed,
electronic markets failed.
Makern concluded that he would have to make
7
CASE: FreeMarkets OnLine, Inc.
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Founding
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Meakem set up shop in his basement.
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It’s an interesting challenge.
Early entrepreneurial ventures start with very little – no
team, no cash, no market, no technology, no product,
no customers, and no business model
Fortunately, I did have four critical assets : an idea,
experience, my Rolodex of contacts from my previous
experiences, and about $75,000 of savings.
My wife Diane, two children under three years of age,
was very supportive.
8
CASE: FreeMarkets OnLine, Inc.
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Founding
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Sam Kinney had several years experience at
Booz-Allen, McKinsey and Lucas Aerospace.
Sam Kinney described the genesis of the firm:
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Glen and I had been colleagues at McKinsey after
graduated.
Glen and I left McKinsey after two years.
When Glen came up with the electronic bidding idea, I
jumped up.
We knew each other and liked working together and had
similar entrepreneurial aspirations.
9
CASE: FreeMarkets OnLine, Inc.
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Founding
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Meakem explained how they arrived at the name :
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You have to balance multiple objectives.
The name must evoke in potential clients and investors
a sense of what the business does.
We also felt that with the pace of Internet start-ups,
there would be a land gram for good names in this field.
They settled on FreeMarkets Online to satisfy.
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First, It seemed to portray the essence of what the
business would do.
Second, It appeared to be available for trademark
registration.
Third, It would signal to investors through “Online”
10
CASE: FreeMarkets OnLine, Inc.
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Software Development
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Creating bidding system became the most timeconsuming early challenge.
By mid 1995, Internet was just beginning to be
recognized as a powerful new medium.
Netscape’s IPO is one of milestone events.
Internet service providers were in the throes of
upgrading 28.8 modem speed and meeting
demand.
11
CASE: FreeMarkets OnLine, Inc.
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Software Development
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FreeMarkets wanted the system to be fast, allowing realtime interaction.
That presented some technical challenges.
According to Vincent Rago, vice president of Information
Technology :
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Our needs have always been one step ahead of the
development tools.
We have had to solve problems before ready-made solutions.
Despite the lack of tools, BidWare®, BidServer® software
was tested by October 1995 .
November 1995, the S/W conducted a live bid for about
$3.2 million worth of injection-molded plastic appliance
parts.
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Bidding for air-conditioning equipment with 12 suppliers.
Buyer saved more than $400,000.
* 참고) CBE (Competitive Bidding Event)
12
CASE: FreeMarkets OnLine, Inc.
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Software Development
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The first CBE was also a resounding confirmation
of the company’s ability to design, build, and ship
user-friendly commercial software.
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The need for software to be self-trainable and easy to
use for “normal” people.
We can understand a market need, then design, build,
and test complex, wide-area-networked, client-server
applications by using early version of BidWare®.
In what has been a capital-constrained environment,
our S/W development team has not wasted any money
13
CASE: FreeMarkets OnLine, Inc.
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Software Development
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Addressing the issue of how to successfully build
software, Vincent Rago offered this perspective :
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Money is not the key issue in software development.
Focus by the development team on a real set of
customer needs, including high-level market or
business needs, detailed functionality, and usability.
14
CASE: FreeMarkets OnLine, Inc.
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The Market
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According to Kinney there ware many reasons
why buyers should find value in a service that
helps assemble suppliers into electronic bidding
sessions :
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Many supply industries are very fragmented.
In some of these industries the productivity variance
between suppliers in the top quartile and the bottom
quartile is simply enormous.
In the face of this fragmentation and variation, buyers
are left with an information problem.
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CASE: FreeMarkets OnLine, Inc.
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The Market
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CASE: FreeMarkets OnLine, Inc.
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The Organization
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CASE: FreeMarkets OnLine, Inc.
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The Market-Making Process
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Phase1 :
Phase2 :
Phase3 :
Phase4 :
events
Phase5 :
support
Indentify savings opportunities
Prepare total-cost RFQ
Identify, screen, and support suppliers
Conduct on-line competitive bidding
Provide post-bid analysis and award
18
CASE: FreeMarkets OnLine, Inc.
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The Revenue Model
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“The revenue-generation model is at the heart of
our new business development process”
A hybrid of service fees and sales commissions
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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
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CASE: FreeMarkets OnLine, Inc.
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The Revenue Model
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Problems with the revenue model
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Buyer side:
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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:
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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
20
CASE: FreeMarkets OnLine, Inc.
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A Successful Start
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CASE: FreeMarkets OnLine, Inc.
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A Successful Start
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CASE: FreeMarkets OnLine, Inc.
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A Successful Start
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A Successful Start
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Going Forward To Scale
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Horizontal market expansion or vertical market
dominance?
Technology and user support subscription
licensing?
Networked purchasing information Systems?
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Procurement And Outsourcing
Strategies
26
Procurement And Outsourcing Strategies
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7.1 Introduction
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In the 90s, outsourcing was the focus of many
industrial manufacturing.
Executive were focused on stock value, so that
press the organization to increase profits.
On easy way is outsourcing.
The instance of Nike
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The largest supplier of athletic shoes in the world.
Focuses mainly on research and development Marketing, sales, and distribution.
This strategy allowed to grow in the 90s at an annual
rate of about 20%.
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Procurement And Outsourcing Strategies
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7.1 Introduction
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The instance of Cisco
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Specializing in enterprise network solution.
“Global virtual manufacturing strategy”
Manufacturing plants all over the world
 Close arrangement with major suppliers
-> Cisco’s single-enterprise system
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Building dynamic replenishment system to help reduce
supplier inventory.
The instance of Apple
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Outsource most of its manufacturing activities. Almost
70%
Focus its internal resources on its own disk operation
system and the supporting macro software to give Apple
products their unique look and feel
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Procurement And Outsourcing Strategies
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7.1 Introduction
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Unfortunately …
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Nike in 2001
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Apple in 1999
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Shortage in the G4 chip supplied by Motorola
Cisco in 2000
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Unexpected profit shortfall.
Shortages for others as well as late deliveries
Focus on obsolete inventory in 2000
Cisco was not able to respond effectively against demand
of telecommunication infrastructure.
Solutions …
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Short life-cycle products, where technologies change
rapidly and uncertainty in customer demand.
-> buy/make decision process, procurement process
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Procurement And Outsourcing Strategies
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7.2 Outsourcing Benefits And Risks
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Some of the motivations for outsourcing are …
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Economies of scale
Risk Pooling
Reduce capital investment
Focus on core competency
Increase flexibility
The instance of IBM
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Outsourced microprocessor to Intel.
Outsourced operating system to Microsoft.
By 1985, number one supplier of PC
Compaq was competitor
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Procurement And Outsourcing Strategies
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7.2 Outsourcing Benefits And Risks
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Substantial risk associated with outsourcing
Loss of competitive knowledge
Conflicting objectives
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Procurement And Outsourcing Strategies
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7.3 A Framework for Buy/Make Decisions
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Dependency on capacity
Dependency on Knowledge
Toyota Example
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30% of its car components design and make
Having both knowledge and capacity to product its
engines - 100% of engines are produced internally
For transmissions, having knowledge and designs depending on its suppliers’ capacities, since 70%
outsourcing
Vehicle electronic systems are designed and produced
by outsourcing
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Procurement And Outsourcing Strategies
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7.3 A Framework for Buy/Make Decisions
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Distinguishing between integral and modular
products by Ulrich and Swaminathan
Modular products:
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Components are independent of each other
Components are interchangeable
Standard interfaces are used
A component can be designed or upgraded with little or
no regard to other components
Customer preference determines that product
configuration
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Procurement And Outsourcing Strategies
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7.3 A Framework for Buy/Make Decisions
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Integral product
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Integral products are not made from off-the-shelf
components
Integral products are designed as a system by taking a
top-down design approach
Integral products are evaluated based on system
performance, not based on component performance
Components in integral products perform multiple
fuctions
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Procurement And Outsourcing Strategies
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7.4 E-Procurement
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The start-up e-market:
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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
Problems with this Business Model
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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
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Procurement And Outsourcing Strategies
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7.4 E-Procurement
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Continuous evolution of the business model
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Transaction fees (typically paid by the sellers)
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Subscription fees (typically paid by the buyer)
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Sometimes the wrong party is charged
Buyers and suppliers resist paying
Depends on a number of dimensions
Licensing the software
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Procurement And Outsourcing Strategies
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7.4 E-Procurement
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Evolution
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Value-added independent (public e-markets)
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Private e-markets
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Ex) Dell, Sun, Wal-Mart,etc.
Consortia-based e-markets
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By offering additional services (inventory management,
supply chain planning and financing services.
Estabilised by a number of companies within the same
industry
Content-based e-markets
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Focus on maintenance, repair, portions
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Procurement And Outsourcing Strategies
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7.4 E-Procurement
38
Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Strategic Components
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Commodity Products
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Part of the finished product
Not industry specific; company specific
Examples: PC motherboard and chassis
Can be purchased from a large number of suppliers
Price is determined by market forces
Examples: Memory unit in a PC
Indirect Material
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MRO
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Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Level of Risk
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Uncertain Demand (Inventory risk)
Volatile market price (Price Risk)
Component availability (Shortage Risk)
Risk: Commodity Products
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Can be purchased either
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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
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Inventory risk, shortage risk or price risk
40
Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Indirect Material
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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
Strategic Components
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Typically high risk components that can be purchased from a
small number of suppliers
The objective is to use private or consortia-based emarketplace.
The focus is on an e-marketplace that allow collaboration with
the suppliers
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Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Consortia or Private?
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Transaction volume
Number of suppliers
Cost of building and maintaining the site
The importance of protecting proprietary business
practices
Technology and product life cycles
42
Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Commodity Products
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Products go directly into finished goods
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Many potential options to choose from
Long Term Contracts
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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
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High risk
Buyer pre-pay a relatively small fraction of the product price upfront, 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
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Procurement And Outsourcing Strategies
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7.5 A framework for E-Procurement Type of
Component
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Portfolio approach
Option Level
H
Inventory
Risk
N/A
(Supplier)
L
L
Price, Shortage
Risks
Inventory
Risk
(Buyer)
(Buyer)
Commitment
Level
H
44