1 Chapter 7: Procurement And Outsourcing Strategies CASE: FreeMarkets Online, Inc. Procurement And Outsourcing Strategies Prepared by Hoon Lee Date

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Chapter 7: Procurement And Outsourcing Strategies

1. CASE: FreeMarkets Online, Inc.2. Procurement And Outsourcing Strate

gies

Prepared by Hoon LeeDate on 8th June, 2007

* 참고 ) Shin, Sang-hoon 학생 자료를 참고하여 작성되었음 .

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CASE: FreeMarkets OnLine, Inc. Introduction

Glen Meakem and Sam kinney are cofounders. They focus on how to position their company, both wi

th 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 aimin

g for over 200% growth in 1998 to $6 million. They needed to lay out a clear and compelling strateg

y that would create the most value. To raise a large amount of growth capital and provide invest

or liquidity through an IPO.

* 참고 ) IPO (Initial Public Offering): 기업공개 , 유가증권시장이나 코스닥시장에 상장한다는 의미

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CASE: FreeMarkets OnLine, Inc. Founding

Be founded in Pittsburgh in 1995 by three entrepreneurs.

Advantage of the city’s unique blend of industrial and high-technology infrastructure.

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 , 피츠버그대학교 · 카네기공과대학교

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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 manufacturi

ng companies was low and make decisions was very limited Identifying truly high-quality suppliers while also estabilishin

g fair market prices was extremely difficult.-> Industrial buyers were unaware of the savings opportunities

still lurking beneath their decisions.

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Meakem’s experience about “Silent auctions” A group of suppliers would be assembled in a hotel ballroom

surrounded by flip charts. Prices dropped as suppliers participated in this open-price di

scovery process. The logistical difficulties of bringing together all of the suppli

ers 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.

Electronic markets offer cross-company electronic connections, Just as single-source sales channels do. and therefore give customers the same convenience.

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Meakem’s experience about “The Logic of… Customers have electronic connections to their suppliers, th

ey can also choose which suppliers they want to use. From the customers’ perspective, electronic markets are mo

re desirable than single-source sales channels If the technology exists to create electronic markets and cus

tomers want them -> It’s just time matter He left McKinsey to join a Fortune 50 company’s corp

orate business development group, He began working on purchasing improvement projects.

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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. First, The Bidding was only as good as the product specificat

ions. 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

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Meakem set up shop in his basement. It’s an interesting challenge. Early entrepreneurial ventures start with very little – no tea

m, 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.

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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: 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.

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Meakem explained how they arrived at the name : You have to balance multiple objectives. The name must evoke in potential clients and investors a se

nse of what the business does. We also felt that with the pace of Internet start-ups, there w

ould be a land gram for good names in this field. They settled on FreeMarkets Online to satisfy.

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”

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CASE: FreeMarkets OnLine, Inc. Software Development

Creating bidding system became the most time-consuming 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.

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FreeMarkets wanted the system to be fast, allowing real-time interaction.

That presented some technical challenges. According to Vincent Rago, vice president of Information Technol

ogy : Our needs have always been one step ahead of the development to

ols. 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.

Bidding for air-conditioning equipment with 12 suppliers. Buyer saved more than $400,000.

* 참고 ) CBE (Competitive Bidding Event)

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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.

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

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Addressing the issue of how to successfully build software, Vincent Rago offered this perspective :

Money is not the key issue in software development. Focus by the development team on a real set of customer n

eeds, including high-level market or business needs, detailed functionality, and usability.

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CASE: FreeMarkets OnLine, Inc. The Market

According to Kinney there ware many reasons why buyers should find value in a service that helps assemble suppliers into electronic bidding sessions :

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. The Market

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CASE: FreeMarkets OnLine, Inc. The Organization

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CASE: FreeMarkets OnLine, Inc. The Market-Making Process

Phase1 : Indentify savings opportunities Phase2 : Prepare total-cost RFQ Phase3 : Identify, screen, and support suppliers Phase4 : Conduct on-line competitive bidding events Phase5 : Provide post-bid analysis and award suppor

t

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CASE: FreeMarkets OnLine, Inc. The Revenue Model

“The revenue-generation model is at the heart of our new business development process”

A hybrid of service fees and sales commissions FreeMarkets charged monthly fee from the buyer based on t

he size of the market making team dedicated to the event Winning supplier paid sales commissions; this was paid in i

nstallments as suppliers shipped products

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CASE: FreeMarkets OnLine, Inc. The Revenue Model

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 cu

stomer 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

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CASE: FreeMarkets OnLine, Inc. A Successful Start

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A Successful Start

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Going Forward To Scale 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

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Procurement And Outsourcing Strategies 7.1 Introduction

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

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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The instance of Cisco 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

Building dynamic replenishment system to help reduce supplier inventory.

The instance of Apple 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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Unfortunately … Nike in 2001

Unexpected profit shortfall. Shortages for others as well as late deliveries

Apple in 1999 Shortage in the G4 chip supplied by Motorola

Cisco in 2000 Focus on obsolete inventory in 2000 Cisco was not able to respond effectively against

demand of telecommunication infrastructure. Solutions …

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 7.2 Outsourcing Benefits And Risks

Some of the motivations for outsourcing are … Economies of scale Risk Pooling Reduce capital investment Focus on core competency Increase flexibility

The instance of IBM 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 7.2 Outsourcing Benefits And Risks

Substantial risk associated with outsourcing Loss of competitive knowledge Conflicting objectives

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Procurement And Outsourcing Strategies 7.3 A Framework for Buy/Make

Decisions Dependency on capacity Dependency on Knowledge Toyota Example

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 7.3 A Framework for Buy/Make Decisions

Distinguishing between integral and modular products by Ulrich and Swaminathan

Modular products: Components are independent of each other Components are interchangeable Standard interfaces are used A component can be designed or upgraded with little or no r

egard to other components Customer preference determines that product configuration

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Procurement And Outsourcing Strategies 7.3 A Framework for Buy/Make Decisions

Integral product Integral products are not made from off-the-shelf component

s Integral products are designed as a system by taking a top-d

own design approach Integral products are evaluated based on system performan

ce, not based on component performance Components in integral products perform multiple fuctions

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Procurement And Outsourcing Strategies 7.4 E-Procurement

The start-up e-market: 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 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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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

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Evolution Value-added independent (public e-markets)

By offering additional services (inventory management, supply chain planning and financing services.

Private e-markets Ex) Dell, Sun, Wal-Mart,etc.

Consortia-based e-markets Estabilised by a number of companies within the same industr

y Content-based e-markets

Focus on maintenance, repair, portions

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Procurement And Outsourcing Strategies 7.5 A framework for E-Procurement

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

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Type of Component 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

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Procurement And Outsourcing Strategies 7.5 A framework for E-Procurement Type of Component

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 cata

logs from many suppliers Examples: MRO.com, Grainger on-line catalogs

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 collaborationcollaboration with the

suppliers

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Type of Component 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

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Type of Component 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

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Type of Component Portfolio approach

Inventory Risk

(Supplier)

Inventory Risk

(Buyer)

Price, Shortage Risks

(Buyer)

N/A

Commitment Level

Option Level

L H

H

L

Documents

1 Chapter 7: Procurement And Outsourcing Strategies CASE: FreeMarkets Online, Inc. Procurement And Outsourcing Strategies Prepared by Hoon Lee Date