Procurement and
Outsourcing
Phil Simchi-Levi
Kaminsky
David
kaminsky@ieor.berkeley.edu
Philip Kaminsky
Edith Simchi-Levi
Lecture Outline
1) FreeMarkets Online
2) B2B Strategies
3) B2B Pitfalls
4) Outsourcing
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
The Move to B2B
Commerce
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
B2B is Huge...
2003
$1.3 Trillion
Business-to-Consumer
Business-to-Business
2002
$843B
1998
$43B
1999
$109B
2001
$499B
2000
$251B
McGraw-Hill/Irwin
Source:
Forrester Research, Inc.
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How Does FreeMarkets Online
Create Value for its Customers?
Consulting/Purchase outsourcing
 Distribution Intermediary

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Traditional B2B Trading
Exchanges
Industrial Buyer
Manuf. Rep.
Supplier 1
McGraw-Hill/Irwin
Manuf. Rep.
Supplier 2
Manuf. Rep.
Supplier 3
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Internet Based B2B
Trading Exchanges
Industrial Buyer
FreeMarkets Online
Supplier 1
McGraw-Hill/Irwin
Supplier 2
Supplier 3
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How Does FreeMarkets Online
Create Value for its Customers?
Consulting/Purchase outsourcing
 Distribution Intermediary
 Network Enabler/Software Provider

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Which suppliers benefit
from this model?

Low cost, quality suppliers will benefit as
they drive competition out of the market
– The FreeMarkets model would be beneficial for
large more efficient suppliers

It will also provide opportunities for a host of
small suppliers, especially if they are located
overseas
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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?

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
By the end of 1998…
FreeMarkets was pursuing the horizontal
market expansion
 In 2000, the company started licensing its
software

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
The company went public
in 12/99...
Freemarket’s Stock Price
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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 emarkets
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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)
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider Instill Corp.

Instill.com focuses on the food service
industry and provides an infrastructure
which links together operators, i.e.,
restaurants, distributors and manufacturers.
This e-marketplace provides value to its
customers by offering not only procurement
services, but also forecasting, collaboration
and replenishment tools.
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider eSkye.com

In the alcoholic beverage industry, eSkye
has tailored an offering that provides the
supply chain with real value. eSkye now
links retail stores, distributors and suppliers
providing visibility into a supply chain where
little data existed. eSkye adds value by
automating the ordering process for the
retailer while providing product flow
information to distributors and suppliers.
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types

Private e-Markets
– Valuechain.Dell.com (Dell), eHub (Cisco)
– IBM, Sun Microsystems and Wal-Mart

These companies use the marketplace to
improve supply chain collaboration
– Providing suppliers with demand information
and production data
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types

Consortia-based e-markets….
– Covisint (automotive); Trade-Ranger (oil);
Omnexus (chemicals); e2Open and Converge
(high-tech)

Objective of the consortia is
– Aggregate activities and use the buying power
of consortia members
– Provide suppliers with standard systems that
support all buyers and allows suppliers to
reduce cost
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types
–Content based e-markets….
Focus
on Maintenance, Repair and
Operations (MRO) goods
–These are components that are not part of
the finished product or the manufacturing
process but are essential for the business
–Examples include lighting, office supply,
fasteners,…
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
E-marketplace Examples
Independent Vertical
Exchanges (IVX)
Consortia Trading
Exchanges (CTX)
McGraw-Hill/Irwin
Independent Horizontal
Exchanges (IHX)
Private Trading
Exchanges (PTX)
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortiumbased public markets

Owner
– Single vs Co-Op

Objective
– Private: (i) Share proprietary data (ii) allow for SC Collaboration
– Consortia: (i) Buying/selling commodities (ii) Finding new suppliers

Participants
– Private: Selected group of suppliers
– Consortia: Open Market

Buyer Cost
– Private: Building and maintaining the site
– Consortia: Subscription fee; licensing fee
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortiumbased public markets

Supplier Cost
– Private: No fee
– Consortia: Subscription fee; Transaction fee

Challenges
– Private: Initial investment
– Consortia: (i) Many have recently collapsed; (ii)
preferred suppliers may object because of price
focus; (iii) Sharing proprietary data (iv)
developing standards
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortiumbased public markets

Automotive Industry
– Covisint was established in early 2000 by the Detroit’s
big three automakers
– It now also includes Renault, Nissan, Mitsubishi and
Pegeot

Volkswagen established its own private e-market
– Volkswagen e-market provides not only similar
capabilities to that of Covisint but also real-time
information on production plans so that suppliers can
better utilize resources
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider IBM


IBM has saved about $1.7 billion since 1993 by
being able to divulge sensitive price and inventory
information over a private exchange built for
25,000 suppliers and customers, says Bill Paulk,
IBM's vice president of e-marketplaces. As host of
the exchange, the company helped defray the cost
of connecting suppliers. The payoff: On-time
delivery to customers soared from about 50% to
close to 90%, "which helped justify the cost,"
Paulk says.
E2open: A consortia based e-marketplace
established in 1999
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for
eProcurement

Level of Risk
– Uncertain Demand (Inventory risk)
– Volatile market price (Price Risk)
– Component availability (Shortage Risk)
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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 34% 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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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 consortiabased e-marketplace.
– The focus is on an e-marketplace that allow
collaboration with the suppliers
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement:
A Portfolio Approach
Option Level
H
Inventory
Risk
N/A
(Supplier)
L
L
McGraw-Hill/Irwin
Price, Shortage
Risks
Inventory
Risk
(Buyer)
(Buyer)
Commitment
Level
H
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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)

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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)

McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
fee/subscription fee
Source: Forrester Research
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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.
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for Outsourcing
(Fine & Whitney)
Product
Dependent:
knowledge,
capacity
Modular
Outsourcing
risky
Indep:
knowledge
Dep: capacity
Outsourcing
oportunity
Integral
Outsourcing
very risky
Outsourcing
option
McGraw-Hill/Irwin
Indep.:
knowledge
capacity
Outsourcing
can reduce
cost
Keep internal
© 2003 Simchi-Levi, Kaminsky, Simchi-Levi