Chapter 7 - Insourcing / Outsourcing

Bozarth and Handfield, Chapter 7 (3/3/03)

Chapter 7 Outline:

Purchasing

Introduction

Dell Computer Corporation

Cisco Systems

Why Purchasing is Critical

The Changing Global Competitive Landscape

Financial Impact

Performance Impact

The Sourcing Decision

Advantages and Disadvantages of Insourcing and Outsourcing

Total cost analysis

Boxed Example 7.1: Total cost analysis at ABC Company

Sourcing Strategies

Honda of America

The Purchasing Process

Needs Identification

Description

Supplier Identification and Evaluation

Supplier Selection

Purchase Order Preparation

Follow-Up and Expediting

Receipt and Inspection

Invoice Clearance and Payment

Records Maintenance

1

Elizabeth A. Morgan, 01/03/-1,

Au: I’ve inserted “of Insourcing” in these subheadings because the following section has identical subheads (and readers could easily become confused).


Supplier Evaluation Systems

Boxed Example 7.2: Supplier Evaluation at Electra Company

Trends In Purchasing Management

Long-term Contracts and Consolidation

Supply Base Reduction

Global Purchasing

Supplier Performance Measurement

Supplier Technology

Information Technology

Professionalism in Purchasing

Chapter Summary

Discussion Questions

Exercises

2


Au: This is a long section that could benefit by being broken up into a few subsections. The numbered sentence-style themes are too long for second-level headings; consider shortening them and combining related themes under one heading. (See my queries in this section for specific suggestions.)


Chapter 7:

Purchasing

Introduction

One of the most important decisions facing any business is the question of whether to

produce some product or service internally or to purchase it from an outside supply chain

partner. In this chapter, we will discuss some of the important considerations

surrounding sourcing decisions, and how firms should go about managing the purchasing

process. But to start, let’s consider the very different experiences of Dell Computers and

CISCO Systems.

Dell Computer Corporation1

At first glance, Dell Computer would seem to be in a tenuous position. “Dell Computer

has no proprietary technology,” writes Charles Fine. “In fact, the company's position in

the supply chain has it squeezed between Intel and Microsoft upstream, two of the

computer industry's most powerful players, and a downstream market populated by

millions of well-informed consumers who can choose from dozens of computer

companies that assemble almost indistinguishable personal computers."

Yet Dell Computer has not only survived, but thrived. As of May 2000 Dell had a

market capitalization of nearly $130 Billion and a gross profit margin of over 20%. Dell

1 From: Book Excerpt: The Primacy of Chains, Charles Fine, Supply Chain Management Review, Spring, 1999. Pp. 79-91)

3


accomplished this feat primarily through superior supply chain management, including

effective purchasing of products and services. Dell buys state-of-the-art technologies and

logistics services, but internally handles its purchasing, order management, and assembly

activities. The company’s strategic reliance on superior supply chain partners, coupled

with its own core competencies, has made Dell a leader in a highly competitive industry.

Cisco Systems2

Perhaps no company underscored the unlimited potential of the New Economy more than

Cisco Systems, Inc. Cisco was poised to become the world’s first trillion-dollar

enterprise, wielding a market cap greater than that of General Electric in pursuit of annual

revenue growth projected at 30 to 40 percent.

Two of the things that gave Cisco its glow were its development of a virtual

supply chain with limitless capacity and its ability to provide extraordinarily high

reliability to its customers. Another apparent strength was its approach to manufacturing:

It didn’t build most of what it sold. John Chambers, president and CEO, once explained,

“Our approach is something we call ‘global virtual manufacturing.’ First, we’ve

established manufacturing plants all over the world. We’ve also developed close

arrangements with CEMs [contract equipment manufacturers]. So when we work

together with our CEMs – and if we do job right – the customers can’t tell the difference

between my own plants and my CEM’s in Taiwan and elsewhere.”

But in early 2000, shortages of memory and optical components began

paralyzing one path of production. For the first time, Cisco’s supply chain began to

2 This section is on Cisco is quoted nearly verbatim from “Why Cisco fell: Outsourcing and its perils”, Lakeman, Boy, and Frev. http:/www.strategy-business.com/strategy/01306/page1.html

4


Au: OK to use the word strategic in this context?


experience the kind of growing pains that affected its earnings. When the

telecommunications infrastructure experienced a severe downturn, customer orders began

to dry up … and Cisco neglected to turn off its supply chain. Orders went out, parts

began to pile up. Its raw-parts inventory ballooned more than 300 percent from the third

quarter to the fourth quarter of 2000. Cisco’s problems culminated in a $2.25 billion

write-down. In short, Cisco simply wasn’t able to use outsourcing to scale up or down as

quickly as it thought it could.

This chapter is divided into two distinct, yet related, parts. In the first half of this

chapter, we will discuss the various issues surrounding sourcing decisions, including the

insourcing versus outsourcing debate, and various sourcing strategies. We will examine

how total cost analysis can be used to augment the strategic analysis of sourcing

opportunities.

The second half is devoted to the purchasing process itself. Purchasing includes

all those activities associated with identifying needs, locating and selecting suppliers,

negotiating terms, and following up to ensure supplier performance. Purchasing links a

company with its upstream supply chain partners. We take a look at the various activities

that make up the purchasing process, including product description, supplier evaluation

and selection activities. Finally, we discuss major trends that will affect purchasing

management in the years to come.3

3 Adapted from Monczka, R., Trent, R., and Handfield, R., Purchasing and Supply Chain Management, Southwestern College Publishing, Cincinnati, OH: 1997.

5


Why Purchasing is Critical

Purchasing has always been an important, if under-appreciated, function in many

businesses. As the cases of Dell and Cisco illustrate, however, several trends have

worked together to push purchasing into the limelight. These include the changing global

competitive landscape, the financial impact of purchasing, and purchasing’s impact on

such performance dimensions as quality, delivery, and technology utilization.

The Changing Global Competitive Landscape

Firms do not just compete against global competitors, but against their competitors'

supply chains. Companies that were content to purchase services and goods from local

suppliers are now seeking to build relationships with world-class suppliers, regardless of

their location. Managers have come to realize that “to compete globally, you need to

purchase globally.”

To keep up with global competition and tap into the abilities of world-class

suppliers, many companies are putting in place global purchasing systems. GM is a

case in point. Harold Kutner is GM's vice president and group executive in charge of

world-wide purchasing. Every Friday morning at 6:30 am (Detroit time), Kutner

"presides over a global video conference in which dozens of purchasing executives share

information and coordinate strategy."4 In addition, a few years back a GM purchasing

team completed a 12-day mission to Thailand, Taiwan, South Korea and Japan. The

4 "General Motors Drives Some Hard Bargains with Asian Suppliers", WSJ, 4/2/99.

6


Au: Consider deleting this subheading and the two that follow. The subsections that carry them are very short—too short, really, for a second-level heading.


Au: Consider moving this heading as specified above.


purpose of the trip was to evaluate 12 tool makers as potential sources of stamping dies,

but GM also developed valuable contacts at the same time.

Advances in information systems have served as a catalyst for global purchasing

efforts. Electronic "blueprints" can now be shared instantaneously with engineers and

suppliers around the world. Purchasing requirements for dozens of sites can be

consolidated into one large order, giving the organization maximum buyer power.

Companies can share anticipated requirements with key suppliers around the clock,

allowing suppliers to plan their activities accordingly.

Financial Impact

If you were to look at the financial statements of an average organization, how much

would you guess the company spends on purchased goods and services? In

manufacturing, the figure is astonishingly high: the average manufacturer spends

approximately 56 cents out of every dollar of revenues on goods and services (see Table

7.1). For some services, such as retailing or wholesaling, the figure can be even higher.

Table 7.1: Materials to sales ratios for different industries

Industry Materials to sales ratio

Food 65.4

Textiles 60.5

Furniture and fixtures 47.2

Chemicals 51.5

Rubber & plastics 50.1

7


Au: This two-column table could be made into a bar graph that would communicate the information better and provide visual relief at the same time. Could you include figures for some familiar service industries?


Stone/clay/glass 47.5

Primary metals 64.0

Fabricated metal 50.5

Machinery 47.8

Electrical equipment 43.1

Transportation equipment 60.0

Annual Survey of Manufacturers: 1985, U.S. Bureau of the Census, Government Printing

Office, Washington, D.C., 1987, p. 1-8.

When much of the firm’s revenue is spent on materials and services, purchasing

represents a major opportunity to increase profitability. Consider the following financial

information for Lowe's, a service firm in the home improvements retailing sector. Table

7.2 shows earnings for the company for the quarter ending January, 1999, as well as key

balance statement figures.

8


Au: I’m not clear on what Lowe’s does—it provides home improvement services to individual customers, or it sells home improvement supplies in retail stores? Please clarify. (If the latter, try “home improvement store.”)


Au: Is Lowe’s a hypothetical or a real company? If a real company, be careful; you’re presenting a less than rosy picture of the company’s finances, which could cause permissions problems.


Au: Please add a sourceline for this table. Permission to reprint may be required.


Table 7.2: Selected financial data for Lowe's Company (all figures in $000s)

Earnings & Expenses (Quarter ending January, 1999)

Sales $2,915,664

Merchandise costs $2,096,331

Pre-tax earning $168,253

Selected balance sheet items

Merchandise Inventory $2,104,845

Total assets $6,344,651

From the figures, we can see that the pre-tax profit margin for Lowe's is

($168,253/ $2,915,664) = 5.8%. This means that every dollar of sales generates a little

less than 6 cents in pre-tax profit. Furthermore, the quarterly return on assets (ROA) is

($168,253/ $6,344,651) = 2.7%. What can Lowe's do to improve these figures?

Note that every dollar saved in purchasing at Lowe's increases pre-tax profit by a

dollar. According to the above figures, Lowe's would have to generate about $17 in sales

to make the same improvement to the bottom line that saving one dollar in purchasing

costs would have. This profit leverage effect is particularly important for low margin

businesses, such as retailing. Also note that if Lowe's was able to cut its merchandise

costs, this would not only affect profits, but would also reduce the amount of money tied

up in inventory. The impact would be a higher ROA figure. To illustrate these points,

let's see what would happen if Lowe's was able to cut merchandise costs by just 3%:

9


Au: So you’re talking about a store?


Earnings & Expenses (Quarterly)

Sales $2,915,664


minus 3% savings: - $62,890

$2,033,441

Pre-tax earnings $168,253

plus 3% savings: + $62,890

$231,143




$2,041,955



$6,281,761

Pre-tax profits would increase 37%, and the new pre-tax profit margin for Lowe's

would be ($231,143 / $2,915,664) = 7.9%. Lowe's would have to increase sales by

10


($62,890 / 5.8%) = $1.1 billion to have the same impact. In addition, the new quarterly

ROA is ($231,143 / $6,281,761) = 3.7%.

Performance Impact

Purchasing also has a major effect on performance in such diverse areas as quality,

delivery and the ability of companies to exploit new technologies. Suppose, for example,

that Springfield Hospital has two dialysis machines, each with a special valve that must

be replaced every week. As a result, Springfield uses about 50 valves per year. The

hospital has two alternative sources for the valves. The cost, quality and delivery lead

times for these two suppliers are shown below:

Supplier A Supplier B

Cost per valve $10 $2

% Good 99.8% 95%

Delivery lead time Overnight delivery 1 day to 3 weeks

Defective valves cannot be identified until they are installed. Failures cause an

interruption in the treatment of patients, which lead to rescheduling nightmares, a

reduction in the effective capacity of the dialysis machines and may even result in a

medical emergency. The quality of the medical service will clearly fall if Springfield

goes with Supplier B.

Suppose now that Springfield management has estimated that the cost of a failed

valve is about $1000 per incident. Furthermore, if Springfield goes with Supplier A, then

11


Au: Good to see this service example. Hypothetical or real hospital? Hypothetical or real costs? (If hypothetical name and/or costs, I wouldn’t add a photo.)


they will be able to get by with one valve as a "back up", since overnight delivery is

guaranteed. But if Springfield uses Supplier B, they will need three "back up" valves

(about three weeks worth) to protect themselves against Supplier B's unreliable delivery

patterns.

Even before we calculate all of the costs associated with each supplier, we can see

that sourcing valves through Supplier B has the potential to seriously disrupt Springfield's

operations. These concerns are reflected in the following cost estimates:

Yearly Costs Supplier A Supplier B

Valve costs 50 * $10 = $500 50 * $2 = $100

Failure costs 0.2% of all valves fail: 5% of all valves fail:

0.2% * 50 valves *$1000 5% * 50 valves *

$1000

= $100 = $2500

Back-up

Inventory 1 valve * $10 = $10 3 valves * $2 = $6

Total Cost: $610 $1,106

Purchasing can also help an organization incorporate state-of-the-art technologies

into its products and services. When Chrysler introduced the Neon automobile, they

realized that suppliers would furnish 70% of the value of the car. In order to bring the car

out on schedule, the team invited 25 makers of key parts such as seats, tires, and

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suspension components to send engineers to Chrysler’s engineering facility.5 What was

the result of this effort? The car cost less to produce and included all of the proposed

design features.

The Sourcing Decision

Before we get into a detailed discussion of the purchasing process, it makes sense to first

talk about the sourcing decision. At its most basic level, sourcing decisions address

which products and services will be provided in-house (known as insourcing) and which

will be provided by a firm’s supply chain partners (outsourcing). The sourcing decision

is also known as the make-or-buy decision.

Quite simply, sourcing decisions are critical to operations and supply chain

managers (including those in purchasing) because it tells them what they will and will not

be responsible for. Suppose, for example, that a company decides to insource a product

or service. In this case, operations and supply chain managers must determine the

capacity and resources they need, the most appropriate manufacturing or service

processes to use, and the information systems they need to coordinate operations. But if

the company decides to outsource the product or service, the emphasis shifts to the

purchasing activities associated with identifying the most qualified suppliers and

managing the buyer-supplier relationship.

Advantages and Disadvantages of Insourcing and Outsourcing

5 Woodruff, David, “Chrysler’s Neon: Is this the Small Car Detroit Couldn’t Build?”, Business Week, May 3, 1993, pp. 116-126.

13


Table 7.3 summarizes the advantages and disadvantages of insourcing and outsourcing.

Insourcing gives a company a high degree of control over its operations, which is

particularly desirable if the company owns proprietary designs or processes. Insourcing

can also lower manufacturing costs, but only if a company enjoys the business volume

necessary to achieve economies of scale. Unlike many smaller pharmaceutical firms, for

instance, Merck is large enough to afford a sales force dedicated exclusively to selling

only Merck products. Finally, insourcing encourages the development of core

competencies. As we saw in Chapter 2, a major part of any business strategy

development effort is identifying and building core competencies—organizational

strengths or abilities, developed over a long period, that customers find valuable and

competitors find difficult or even impossible to copy. Products or processes that could

evolve into core competencies are prime candidates for insourcing.

On the downside, insourcing can be risky because it decreases a firm's strategic

flexibility. The semiconductor industry is a good example of the risks of insourcing. In

1995, at least a dozen new semiconductor plants were under construction in the United

States, including three for Intel and two for Motorola. At the time the average cost of a

chip fabrication plant was about $1.5 billion, and was expected to rise to $3 billion by

1999. To make matters worse, some of the associated manufacturing technologies had

life cycles as short as six months, after which they were expected to be superseded by

newer technologies. As a result, semiconductor manufacturers faced the very real risk of

investing in old process technologies just as newer ones emerged. To justify plant

14


Au: OK “expected to be,” or did the six-month life cycle become apparent only later?


Au: When you’re revising this chapter, please identify the key terms and put them in boldface where they are defined. I’d also list them at the end of the chapter.


Au: OK, or do you mean only that insourcing preserves core competencies?


Au: This paragraph really isn’t developed well enough to stand on its own; suggest you combine it with the one that follows.


expansions under these conditions, managers had to show that investing in new capacity

would bring a quick payback6.

Finally, if suppliers can provide a product or service more effectively than the

company itself, managers must decide whether to commit scarce resources to upgrading

their processes or to outsource the product or service. Attempting to catch up to suppliers

technologically can be an expensive proposition, which could restrict a firm’s ability to

invest in other projects, or even threaten its financial viability.

Outsourcing typically increases a firm's flexibility and access to state-of-the-art

products and processes. As markets or technologies change, many firms find changing

supply chain partners easier than changing internal processes. In addition to increasing a

firm's strategic flexibility and access to new technologies, outsourcing improves its cash

flow. With outsourcing, less investment is required up front in the resources needed to

provide a product or service. The benefits can be significant. By using contract

manufacturers, Dell Computer supported $3 billion in annual revenues with only $60

million of fixed assets7.

Of course, outsourcing has its risks. Suppliers may misstate their capabilities:

their process technology may be obsolete, or their performance may not meet the buyer’s

expectations. Consider the experience of Apple Computer. When demand for a new line

of Macintosh computers increased dramatically during the 1990s, Apple accumulated an

order backlog of more than $1 billion. The company could not obtain timely delivery of

critical parts, including modems and custom chips, because many of them had been

custom-designed and outsourced from a single supplier. Apple’s inability to deliver the

6 Source: Adapted from Erin Anderson and Barton J. Weitz, "Make-or-Buy Decisions: Vertical Integration and Marketing Productivity," Sloan Management Review, Spring, 1986, pp. 14-15.7 Shawn Tully, “You’ll Never Guess Who Really Makes...,” Fortune, 3 October 1994, 124.

15


Au: OK “technologically”?


Au: OK instead of “play catch-up,” which is a little vague and informal for a textbook?


highly valued product alienated many customers, who were not willing to wait for the

new computers8.

Control is also an issue in outsourcing. Buying firms may need to create costly

safeguards to regulate the quality, availability, confidentiality, or performance of

outsourced goods or services. At the extreme, they may lose key skills and technologies

that are part of their core competencies. To counteract such threats, many companies

oversee key design, operations, and supply chain activities and keep current on what

customers want and how their products or services meet those demands9. Table 7.3

summarizes the advantages and disadvantages of insourcing and outsourcing.

Table 7.3: Advantages and disadvantages of Insourcing and Outsourcing

INSOURCING

Advantages Disadvantages

• High degree of control. • Reduces strategic flexibility.

• Ability to oversee the entire process. • Requires high investment.

• Economies of scale and/or scope. • Potential suppliers may offer superior

products and services.

OUTSOURCING

Advantages Disadvantages

High strategic flexibility. • Possibility of choosing a bad supplier

Low investment risk. • Loss of control over the process

8 “Is Spindler a Survivor?,” Business Week, 2 October 1995, 62.9 “The Internet Age”, Business Week, October 4, 1999, pp. 103-104.

16


Au: Each table should be placed on a separate page. When possible, please double-space tables.


Au: Could you add a transitional sentence or two tying this section to the next one?


Improved cash flow. • & core technologies

• Access to state-of-the-art • "Hollowing out" of the corporation

products and services.

Table 74 looks at the debate from another angle: What factors will influence the

decision to insource or outsource? As the table suggests, insourcing will generally be

more favorable in situations where environmental uncertainty is low (thereby reducing

the risk of investing in capacity), supplier markets are not well developed, and the

product or service being considered is not directly related the buying firm’s core

competencies. In contrast, outsourcing becomes more attractive as competition in

supplier markets increases, the product or service is not seen as strategically critical, and

environmental uncertainty makes internal investment a risky prospect. Given this, it

makes sense that a lot of high tech companies, facing short product life cycles and

uncertain market conditions, outsource more often than firms in more stable industries.

Table 7.4: Factors That Affect the Decision to Insource or Outsource

Factor FavorsInsourcing

FavorsOutsourcing

Environmental uncertainty High Low

Competition in the supplier market Low High

Ability to monitor supplier’s performance High Low

Relationship of product / service to buying firm’s core competencies.

High Low

17


Au: Again, whose performance, the supplier’s? If so, wouldn’t high monitoring ability favor outsourcing?


Au: By “competition in the supplier market,” do you mean competition for suppliers’ services (from the buyer’s point of view) or competition among suppliers for buyers’ business?


Au: Wouldn’t environmental uncertainty—the potential for unforeseen change?--recommend outsourcing rather than investment in insourcing? Or am I reading this incorrectly?


Au: I think you need to walk readers through this table in the text; I had a hard time following it (see the queries on the individual items).


Total Cost Analysis

Ultimately, managers must understand the cost issues associated with insourcing versus

outsourcing. Determining the actual cost of a product or service is a complicated task

requiring both good judgment and the application of sound quantitative techniques. In

this section we will first examine the direct and indirect costs managers must consider in

making such decisions. Then we will run through a simple cost analysis.

Table 7.5: Insourcing and outsourcing costs

Insourcing Outsourcing

Direct Costs Direct materialDirect laborFreight costsVariable overhead

Price (from invoice)Freight costs

Indirect Costs SupervisionAdministative support SuppliesMaintenance costsEquipment depreciationUtilitiesBuilding leaseFixed overhead

PurchasingReceivingQuality Control

18


Au: Cf. page 21, which lists “inbound freight, receiving, and inventory costs, as well as administrative costs.” (Please reconcile.)


Au: OK? Utilities are listed on the line above.


Au: Freight costs for direct materials? (If so, place this item immediately following direct material?)


Au: By “company,” do you mean the buyer or the supplier? If the buyer, wouldn’t low capabilities favor outsourcing?


Table 7.5 identifies the major cost categories associated with insourcing and

outsourcing decisions. As the table shows, these costs are typically divided into direct

and indirect costs. Direct costs are those costs that are tied directly to the production of a

good or service, such as materials costs, labor costs, and variable overhead. If, for

example, a product requires 1.3 square feet of sheet metal, and the cost of sheet metal is

$0.90 per square foot, the direct cost of the sheet metal is:

$0.90 * (1.3 feet) = $1.17

Indirect costs, as the name implies, are not tied directly to production levels.

Building lease payments, depreciation of equipment, and staff salaries are classic

examples of indirect costs, which in essence represent the price of doing business. To

understand the true total cost of insourcing or outsourcing, managers must assign, or

allocate, indirect costs to individual units of production. That task is not as easy as it

may sound, however. Suppose managers are trying to decide whether to make a product

in house or outsource it. They estimate they will need to spend $600,000 just to design

the new product. If they plan to produce 200,000 units, they might assign the design cost

as follows:

$600,000 / 200,000 units = $3.00 per unit.

But what if the results of the design effort could be applied to future products?

Should part of the design cost be assigned to those future products, and if so, how? For

19


Au: I know students will have taken an intro business course, but it might be good to review direct labor and variable overhead here as well, just to jog their memories. (Please add a couple of sentences after the direct material example.)


this reason, outsourcing costs are usually easier to determine than insourcing costs. With

outsourcing, the indirect costs are included in the direct purchase price shown on the

supplier’s invoice. Generally, the only additional costs that need to be considered in the

outsourcing decision are inbound freight (a direct cost) and administrative costs

associated with managing the buyer-supplier relationship (such as purchasing and quality

control). In contrast, the bulk of insourcing costs may fall into the indirect category,

making the task of to estimating the true total cost more difficult.

In determining total costs, managers must consider the time frame of the

sourcing decision. If an insourcing arrangement is expected to be of relatively short

duration, as it might be for a product with a limited life cycle, then perhaps only direct

costs and some portion of the indirect costs should be applied. In the short run, firms are

better off recovering their direct costs and some portion of their indirect costs than risking

a significant decline in their business. However, if managers expect an insourcing

arrangement to become part of ongoing operations, they should consider all relevant costs

that might reasonably be incurred over the long term, including all indirect costs. In the

long run, a firm must recover all its costs or go out of business.

************************************************************

Boxed Example 7.1: Total cost analysis at the ABC Company

With this background, let's walk through a cost analysis of a simple sourcing decision at

the ABC company. One of ABC's Taiwanese suppliers has bid on a new line of molded

plastic parts that are currently being assembled at ABC’s facility. The supplier has bid

$0.10 per part, given a forecasted demand of 200,000 parts in year 1, 300,000 in year 2,

20


Au: I’ve rearranged the sentences in this paragraph to increase its coherence, OK?


Au: Did you mean insourcing?


Au: Cf. Table 7.4.


and 500,000 in year 3. Shipping and handling of parts from the supplier’s facility is

estimated at $0.01 per unit. Additional inventory handling charges should amount to

$0.005 per unit. Finally, purchasing costs are estimated at $20 per monthly purchase

order.

Although ABC’s facility is capable of producing the part, it is currently running at

95% capacity. Investing in another machine will cost $10,000, depreciated over the life

of the product. Direct materials can be purchased for $.05 per unit. Direct labor is

estimated at $.03 per unit plus a 50% surcharge for fringe benefits; indirect labor is

estimated at $.011 per unit plus 50% for benefits. Up-front engineering and design costs

will amount to $30,000. In addition, the comptroller has insisted that overhead (an

indirect cost) be allocated to the parts at a rate of 100% of direct labor cost.

Table 7.6: Total Cost Analysis for the Sourcing Decision at ABC

21


Au: Please check the figure for administrative costs under outsourcing; I get $20 x 12 x3 / 1,000,000 = .00072 (not .0072).


Au: OK?


INSOURCING

Operating Expenses:Direct labor $0.0300Fringe (50%) $0.0150Direct materials $0.0500

Indirect labor $0.0110Fringe (50%) $0.0055Equipment depreciation $0.0100 ($10,000 depreciated over 1 mill. units)Fixed overhead $0.0300Engineering / design $0.0300 ($30,000 over 1 million units)

TOTAL INSOURCINGCOSTS

$0.1815 (1)

OUTSOURCING

Purchase price $0.1000Shipping and handling $0.0100Inventories $0.0050Administrative costs $0.0072 ($20 X 12 X 3 / 1,000,000)

TOTAL OUTSOURCINGCOSTS

$0.1222 (2)

SAVINGS((1) - (2)) X 1,000,000 $59,300

Table 7.6 shows one possible analysis of the costs of insourcing versus

outsourcing this part; different managers might come up with a slightly different analysis.

For example, ABC’s managers might want to experiment with different allocation rates

for overhead and depreciation expense, to see how a change in the rate might affect the

decision. They might also want to consider the effect of exchange rates on the supplier’s

costs. Suppose, for example, that the outsourcing costs are based on an exchange rate of

30 Taiwanese dollars to one U.S. dollar. If the exchange rate were to fall to 25 to 1,

ABC’s outsourcing costs could rise by 20%. The point is that even a relatively simple

cost analysis requires managerial judgment and interpretation. Cost analyses are most

useful when they are considered jointly with strategic factors.

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******************************************************************

Sourcing Strategies

Once the decision has been made to outsource a product or service, firms still face some

choices. In single sourcing, the buying firm depends on a single company for all or

nearly all of a particular item or service. In multiple sourcing, the buying firm shares its

business across multiple suppliers. The advantages and disadvantages of each are shown

in Table 7.7.

In the past, very few North American organizations would have considered

voluntarily using a single supplier due to the inherent risks. This perception has changed

somewhat because of the example set by Japanese firms who have used single sourcing to

achieve continuous price, quality and delivery improvements. Today, companies must

consider both multiple sourcing and single sourcing, and the advantages and

disadvantages of each approach.

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Table 7.7: Advantages and disadvantages of multiple / single sourcing

Multiple Sourcing Single Sourcing

Advantages Disadvantages Advantages Disadvantages

Create competition Reduces supplier loyalty – suppliers may not be willing to “go the extra mile” for the purchaser

Volume leveraging – as volumes go up, cost per unit decreases as supplier spreads fixed costs over larger volume.

Knowing they have the business, suppliers can actually increase prices in the short term

Spread risk (in event of a fire, strike, etc. at one supplier)

Can increase risk in the event of a shortage – supplier may only supply preferred customers

Transportation economics – fewer shipments and lower per unit transportation costs

Increased supply risk – if a disaster occurs, the buyer can be left without a source of supply

Required if the purchased volume is too great for one supplier

May result in different product attributes with varying quality

Reduce quality variability, and have a standardized product

Buyer can become “captive” to a supplier’s technology – while other suppliers are surging ahead with newer technology that has better performance

Desired if firm wishes to meet obligations to support minority suppliers

Can actually result in increased prices over time, as suppliers are reluctant to provide cost savings ideas

Build stronger relationship with supplier, and gain access to design and engineering capabilities

Do not know if you have the “best” supplier available

Can ensure that suppliers do not become “complacent”

Suppliers can let performance slide if volume is not high enough to merit their attention

Required when supplier has a proprietary product

Dangerous strategy if the supplier has limited capacity – may “shut down” the buyer if takes on too much business

Required when volume is too small to split between two suppliers

24


Au: I presume this table is your own work and not someone else’s? If so, adding a bracketed note to that effect will keep this question from coming up again.


One way that companies can overcome the dilemma of the single sourcing /

multiple sourcing decision is through a compromise known as cross sourcing. In this

strategy, the company uses a single supplier for a certain part or service in one part of the

business, and another supplier with the same capabilities for a similar part in another area

of the business. Each supplier is then awarded new business based on their performance,

creating an incentive for them to improve. This also provides for a backup supplier in

case the primary supplier cannot provide the required volume. At Honda of America,

cross-sourcing is extensively used as part of their purchasing strategy (see boxed insert at

end of chapter).

A similar purchasing strategy is dual sourcing. This strategy is exactly what it

sounds like – two suppliers are used for the same purchased product or service.

Typically, the split of the business is 70% to Supplier A, and 30% to Supplier B. In this

manner, Supplier A is “looking over his shoulder”, knowing that if performance suffers it

will lose the business to Supplier B. Dual sourcing in some ways combines the best of

both worlds.

To cap off our discussion of the sourcing decision and sourcing strategies,

consider the purchasing efforts of Honda of America, described below. Honda has

integrated single and dual sourcing, as well as supplier development and integration, into

its sourcing efforts. Also notice how Honda has "gone global" by expanding the number

of North American suppliers.

25


Honda of America

Honda manufactures almost everywhere in the world, including Japan, the U.S.,

Germany, Mexico, the United Kingdom, and Brazil. When Honda first started building

cars in Ohio in 1982, the company would import car kits from Japan, and assemble them.

In the late 1980’s, Honda changed this philosophy to “We will build where we sell, and

buy where we build.”

Suppliers are evaluated according to the QCCD-M approach: Quality, Cost,

Delivery, (Product) Development, and Management. The last element refers to the

supplier's management attitude. Honda emphasizes that this is the most important part of

the equation: if a supplier has quality, cost, delivery, or development problems, they can

be improved through joint effort. However, if management’s attitude is not positive and

they are not willing to work in a cooperative manner with Honda, they can never become

a Honda supplier. To provide feedback to suppliers on a regular basis, suppliers receive a

“report card” that provides a “grade” on each of the areas of QCCD-M. This helps

suppliers to analyze, control, and improve their performance.

When a problem occurs with a supplier, Honda follows the “Three A” rule: That

is, go to the “Actual Place”, touch the “Actual Part, and view the “Actual Situation.”

Honda will even send in teams of experts to help the supplier improve their operations.

In addition, Honda also holds an annual supplier conference to inform, inspire, challenge,

and reward suppliers.

Nevertheless, competition in the supply base is very important. Honda believes in

using a single source for the majority of their parts purchased, yet they will dual source

by platform. An example of this strategy is as follows: Supplier A sources steering

26


Au: Should be D (QCDDM)? Please verify the hyphen before the M.


wheels for Civics, and Supplier B sources steering wheels for the Accord. Either supplier

can make either part, but each is a single source by platform. When a new model is

introduced, both suppliers may bid on the extra volume, with the best price and best

performing supplier likely to get the business.

The Purchasing Process

Now that we have described the issues surrounding sourcing decisions, let’s examine in

detail the purchasing process, which includes all the steps that must be completed when

someone within the organization requires some product, material or service. Some

people also refer to this as the purchasing cycle to emphasize the iterative nature of these

activities. These activities, or steps, are highlighted in Figure 7.1.

There are two things to keep in mind as we describe the purchasing process.

First, how much effort a company spends on these activities will differ greatly from one

situation to the next. The purchasing process leading to a $3 Billlion contract for 100 jets

is much different than that for a routine purchase of office supplies!

Second, as you look at Figure 7.1, recognize that companies can often gain a

competitive advantage by performing these activities better than their competitors. Many

organizations, for example, use information systems to automate routine purchase order

preparation, while others use sourcing management teams to improve the outcome of

supplier evaluation and selection efforts.


27


The purchasing cycle begins with the identification of a need (i.e. a requirement). In

some cases, this need may take the form of a component, raw material, sub-assembly, or

even a completely finished item. In other cases, the need may be a service, such as

consulting or building maintenance. Because purchasing is responsible for acquiring

products and services for the entire organization, the information flows between

purchasing and other areas of the organization can be extensive.

Figure 7.1: The purchasing process

28


Description

Source Identification& Evaluation

Supplier Selection


Follow-up & Expediting

Receipt & Inspection

Invoice Clearance & Payment

Records Maintenance

Is there a preferred supplier?No

Yes

OrderCycle


Internal users communicate their needs to purchasing in a variety of ways. For routine

items and services, users often use purchase requisitions or reorder point systems to

communicate their needs to purchasing. A purchase requisition is an internal document

completed by a user that informs purchasing of a specific need. Although a variety of

formats exist, at a minimum a purchase requisition should include a detailed description

of the material or service, the quantity and date required, estimated cost, and

authorization.

A reorder point system is another method to “kick-off” the purchase of routine

items. Each item in a typical reorder point system has a predetermined order point and

order quantity. When inventory is depleted to a given level, the system signals the

material control department (or the buyer in some organizations) to issue a request to the

supplier. While requisition forms and reorder point systems have traditionally been

paper-based, this is changing quickly as more firms switch to computer-based processing

for routine items and services.

Description

Whatever the good or service, purchasing must ensure that the user's needs get

communicated to potential suppliers in the most efficient and accurate way possible.

How purchasing accomplishes this will differ dramatically from one situation to the next.

A variety of methods exist for communicating the user's requirements10. Description by

market grade or industry standard might be the best choice for standard items, where

10 For more information on the purchasing process, see Monczka et. al., 1997.

29


the requirements are well understood and there is common agreement between supply

chain partners about what certain terms mean. Description by brand is used when a

product or service is proprietary, or when there is a perceived advantage to using a

particular supplier's products or services. A builder of residential communities, for

example, might tell his purchasing staff to purchase R21 insulation for walls and finish-

grade lumber for the trim and fireplace mantles. In addition, he might also specify

Georgia-Pacific's Catawba® hardboard siding, Kohler® faucets, and TruGreen-

Chemlawn® lawn treatment for all the homes. As you can see, the use of brand names,

market grades, or industry standards provides purchasing with an effective and accurate

"shortcut" for relaying user's needs to potential suppliers.

More detailed and expensive methods of description will be needed when the

items or services to be purchased are more complex, when "standards" do not exist, or

when the user's needs are harder to communicate. Three common methods include

description by specification, performance characteristics, and prototypes or samples.

In some cases, an organization may need to provide very detailed descriptions of

the physical characteristics of an item. We refer to such efforts as description by

specification. Specifications can cover such characteristics as the materials used, the

manufacturing process required, and physical dimensions of the product. Consider one

extreme example: the special heat shield tiles used on NASA’s space shuttles. Each tile

has a unique shape and location on the space shuttle. Furthermore, each shield must be

able to protect the space shuttle from heat generated by reentry into the Earth's

atmosphere. In providing a description of these tiles, NASA will almost certainly include

specifications regarding the exact dimensions of the tiles and the composite materials to

30


be used in making them. Such information might be relayed in the form of detailed

blueprints and supporting documentation. Furthermore, NASA will likely specify the

precise manufacturing steps and quality checks to be performed during the manufacture

of the tiles

In contrast, description by performance characteristics focuses attention on the

outcomes the customer wants, not on the precise configuration of the product or service.

The assumption is that the supplier will know the best way to meet the customer's needs.

A company purchasing hundreds of PCs from Dell Computer might demand 1) 24-hour

support available by computer or phone, and 2) 48-hour turn-around time on defective

units. How Dell chooses to meet these performance characteristics is their choice.

Firms often develop prototypes or samples to share with their suppliers.

Prototypes can provide critical information on the look or feel of a product or service.

Such information is often difficult to convey in drawings or written descriptions. Note

that prototypes or samples are not limited to physical products. An excellent example is a

prototype information system that a company might share with potential software

vendors. The prototype may include sample output screens and reports. Through the

prototype, the company can give its software vendors a clearer idea of how the company

expects its users to interact with the system.

Supplier Identification and Evaluation

Once a decision is reached to outsource a product or service, the firm must identify and

often evaluate external sources. The purpose of this section is to describe major areas of

31


supplier evaluation. You should recognize, however, that the amount of effort will

increase as:

The complexity of the product or service increases

The amount of money that is committed increases

The length of the proposed buyer-supplier relationship increases.

A full-blown evaluation process begins with the development of a list of potential

suppliers. This list may be generated from a variety of sources, including market

representatives, information databases, and trade journals. Some of the different criteria

that a company may use to assess potential suppliers include, but are not limited to, the

supplier’s:

Process and design capabilities

Management capability

Financial condition and cost structure

Planning and control systems

Environmental regulation compliance

Longer-term relationship potential

These criteria are worth talking about in more detail.11 Although it may not be

possible to obtain all the relevant information, data that can be obtained will help the

buying firm assess the potential for a successful match.

11 Adapted from Monczka, R., Trent, R., and Handfield, R., Purchasing and Supply Chain Management, Southwestern Publishing, 1997.

32


Process and Design Capabilities. As we discussed earlier in the book, processes

consist of the technology, equipment, people and information systems used to

manufacture a product or deliver a service. Since different process types have various

strengths and weaknesses, the buying firm must be aware of these characteristics up

front.

When the buying firm expects suppliers to perform component design and

production, it should also assess the supplier’s design capability. One way to reduce the

time required to develop new products is to use qualified suppliers who are able to

perform product design activities.

Management capability. Assessing a potential supplier’s management capability is a

complicated, but important, step. Different aspects of management capability include

management's commitment to continuous process and quality improvement, overall

professional ability and experience, ability to maintain positive relationships with its

workforce, and management’s willingness to develop a closer working relationship with

the buyer. Some questions that might be asked include:

What is the professional managerial experience?

Is there a high degree of turnover among managers?

Has management committed itself to total quality management and continuous

improvement?

33


Has management prepared the company to withstand the competitive challenges of

the next two decades?

Financial Condition and Cost Structure. An assessment of a potential partner’s

financial condition almost always occurs during the evaluation process. Selecting a

supplier who is in poor financial condition presents a number of risks. First, there is the

risk that the organization will go out of business, disrupting the flow of goods and

information in a supply chain. Second, suppliers who are in poor financial condition may

not have the resources to invest in required personnel, equipment or improvement efforts.

In cases when the supplier is a publicly traded company, specific financial

information can be obtained from sources such as 10-K reports, Moody's Industrials, and

Dunn and Bradstreet. Many key financial ratios can also be calculated using income

statements and balance sheets. In technology-intensive industries, the buying firm might

also look at the company's research and development (R&D) expenditures as a percent of

sales. Moreover, the firm should track such ratios for possible "red flags" that may

signify a potential financial difficulty.

Understanding the supplier’s cost structure also helps determine the effectiveness

and efficiency of the potential partner’s operations. The cost structure includes labor

costs, material costs, manufacturing or process operating costs, and overhead costs.

Collecting this information can be a challenge during the initial evaluation

process. A potential supplier may not have a detailed understanding of its costs at the

level of detail required. Furthermore, many companies consider cost data to be

34


proprietary. Even when little or no data is available, some understanding of a potential

partner’s cost structure is a critical part of the evaluation process.

Planning and Control Systems. Planning and control systems includes those systems

that release, schedule, and control the flow of work in an organization. As we shall see in

later chapters, the sophistication of such systems can have a major impact on supply

chain performance. Among the questions the buying firm should ask:

Does the supplier have computerized systems for planning material, personnel and

capacity needs? If not, why not? If so, does the supplier use these systems?

Does the supplier track key performance measures, such as throughput time, quality

levels, and costs? Are these measures compared to performance objectives or standards?

How easy is it for customers to interact with the supplier’s planning and control

systems?

This last point is particularly important to organizations interested in effective

supply chain management. When interaction is high, information about the customer’s

needs flow easily to the supplier, and the customer can, in turn, retrieve important

information from the supplier. Consider the relationship between Wal-Mart and Proctor

and Gamble (P&G). When a Wal-Mart store sells a particular P&G item, the information

flows directly to P&G’s planning and control systems. P&G can then plan production

35


and schedule shipments accordingly. Furthermore, Wal-Mart can easily find out when a

P&G shipment will arrive at one of its distribution warehouses, thereby allowing Wal-

Mart to consolidate this shipment with others on the way to individual stores.

Environmental Regulation Compliance. The 1990s brought about a renewed

awareness of the impact that industry has on the environment. The Clean Air Act of

1990 imposes large fines on producers of ozone-depleting substances and foul-smelling

gases, and governments have introduced laws regarding recycling content in industrial

materials. As a result, a supplier's ability to comply with environmental regulations is

becoming an important criterion for supply chain alliances. This includes, but is not

limited to, the proper disposal of hazardous waste.

Longer-Term Relationship Potential. In some cases, a firm may be looking to develop

a long-term relationship with a potential supplier. Perhaps the supplier has a proprietary

technology or foreign market presence that the sourcing firm wants to tap into.

Regardless of the reason, a firm that wants to establish a longer-term relationship with a

supplier must go beyond evaluating the areas just discussed. The firm will need to ask

some additional questions12:

Has the supplier signaled a willingness or commitment to a partnership-type

arrangement?

12 Spekman, Robert E. "Strategic Supplier Selection: Understanding Long-Term Buyer Relationships,"Business Horizons, July-August, 1988., pp. 80-81.

36


Will the organization immediately revert to a negotiated stance if a problem arises?

Does the supplier have a genuine interest in joint problem solving and a win-win

agreement?

Will there be free and open exchange of needed information across the organizations?

How much future planning is the organization willing to share with us?

Is the need for confidential treatment of information taken seriously?

This is not a complete list of questions that can be asked when evaluating the possibility

of a closer longer-term relationship. This list does provide, however, a framework

concerning the types of issues that are important in this area.

Supplier Selection

Final supplier selection begins once the firm completes the activities required of the

supplier evaluation process. For some items, firms may maintain a list of preferred

suppliers who receive the first opportunity for new business. A preferred supplier has

demonstrated its performance capabilities through previous purchase contracts. By

maintaining a preferred supplier list, purchasing personnel can quickly identify suppliers

with proven performance capabilities. Competitive bidding and negotiation are two

methods commonly used for final supplier selection when there is not a preferred

supplier.

Competitive Bidding. Competitive bidding in private industry entails a request for bids

from suppliers with whom the buyer is willing to do business. This process is typically

37


Au: I’ve run in this heading and the next, like the third-level headings in the preceding section.


initiated when the purchasing manager sends a request for quotation (RFQ) form to

qualified suppliers. Purchasers often evaluate the resulting bids based on price. If the

lowest bidder does not receive the purchase contract, the buyer has an obligation to

inform that supplier why it did not receive the contract. Competitive bidding is most

effective when13:

The buying firm can provide qualified suppliers with clear descriptions of the items

or services to be purchased.

Volume is high enough to justify the cost and effort.

The firm does not have a preferred supplier.

Buying firms use competitive bidding when price is a dominant criterion and the

required items or services have straightforward specifications. In addition, government

agencies often require competitive bidding. If major non-price variables exist, then the

buyer and seller usually enter into direct negotiation. Competitive bidding can also be

used to identify a short list of suppliers with whom the firm will begin detailed purchase

contract negotiation.

Negotiation. Negotiation is a more costly, interactive approach to final supplier

selection. Face-to-face negotiation is best when:

The item may be a new and/or technically complex item with only vague

specifications.

13 Dobler, Lee, and Burt, Purchasing and Materials Management, 1990, Irwin:Homewood, Illinois, p. 204.

38


The purchase requires agreement about a wide range of performance factors.

The buyer requires the supplier to participate in the development effort.

The supplier cannot determine risks and costs without additional input from the

buyer.

One thing is certain--the process that firms use to select suppliers can vary widely

depending on the required item and the relationship that a firm has with its suppliers. For

some items, a buyer may know which supplier to use before the development of final

specifications even occurs. For standard items, the competitive bid process will remain

an efficient method to purchase relatively straightforward requirements. The bid process

can also reduce the list of potential suppliers before a buyer begins time-consuming and

costly negotiation.


Once performance of the contract begins, the buyer must periodically signal to the

supplier that delivery of the product or service is required. The most common way of

doing this by releasing Purchase Orders (P.O.s)

More and more, POs are released through electronic data interchange (EDI), the

instantaneous electronic transfer of purchase documents between the buyer and seller.

By eliminating the time associated with the flow of physical documents between supply

chain partners, EDI can reduce the time it takes suppliers to respond to customers needs.

This, in turn, leads to shorter order lead times, lower inventory, and better coordination

39


between the supply chain partners. Not surprisingly, as Table 7.8 shows, the use of EDI

has increased significantly over the last several years. 14

Table 7.8: Transmitting material requests to suppliers through EDI

• 74 percent of firms currently have EDI capability with some part of their supply base.

• In 1997, firms using EDI had electronic linkage with 60 percent of their total supply

base (versus 18 percent in 1993). This 60 percent of the total supply base will

represent 70 percent of total purchase dollars.

Almost 65 percent of total purchasing transactions (purchase orders, amendments,

shipping notices or schedules) are linked directly with suppliers through EDI in 1997

Source: 1998 Executive Purchasing and Materials Management Seminar,

Michigan State University, East Lansing, Michigan

Follow-up and Expediting

Someone (typically Purchasing) must monitor the status of open purchase orders. There

may be times when a purchaser has to expedite an order or work with a supplier to avoid

14MSU Purchasing and Materials Management Executive Seminar, Michigan State University, 1996. This study used data collected by researchers at The Eli Broad Graduate School of Management at Michigan State University and Lehigh University from the MSU Executive Purchasing and Materials Management Seminar. Data were collected by having seminar participants complete a questionnaire prior to attending the seminar. The respondents were primarily from large manufacturing firms.

40


a delay in a shipment. A company can minimize order follow-up by selecting only the

best suppliers and developing internally stable forecasting and ordering systems.

In proactive follow-up, managers track orders and stay in touch with suppliers, to

ensure that they are making good progress on the open purchase order. This can help

prevent problems before they occur. On the other hand, reactive follow-up occurs when

an order doesn’t show up, and the buyer must discover what happened, if the shipment

left the supplier’s plant, and why it hasn’t arrived. This type of follow-up typically

results in expediting the shipment, usually at substantial additional costs.

Receipt and Inspection

When the order for a physical good arrives at the buyer’s location, it is received and

inspected to ensure that the right quantity was shipped, and that it was not damaged in-

transit. Assuming that the delivery occurred on-time, it will be entered into the

company’s inventory database, and become part of the company’s working inventory.

In cases when the supplier is performing a service, the buying company must

ensure that the service is being delivered according to the Statement of Work issued in

the Purchase Order. That may mean checking with the actual users within the

organization who requested the service in the first place, and ensuring that all is going as

planned. Deviations from the Statement of Work must be noted and passed on to the

supplying organization.

41


Invoice Clearance and Payment

Once the item or service is delivered, the buying firm will issue an authorization for

payment to the supplier. Payment is then made through the organizations’ “Accounts

Payable” department. This is increasingly being accomplished through electronic means.

Suppliers are more often being paid through electronic funds transfer (EFT), which

automatically sends a payment from the buying organizations’ bank account to the

suppliers’ bank account. More and more organizations are moving to integrated systems

where all purchase orders, receipts, and payments are made electronically. This form of

business is generally referred to as electronic commerce.

Records Maintenance

After the product or service has been delivered and the supplier paid, a record of critical

events associated with the purchase is entered into a supplier performance database. The

supplier performance database accumulates critical performance data over an extended

period of time, helping purchasing identify trends or patterns in supplier performance.

These data are often used in future negotiations and dealings with the supplier in

question. In the next section, we discuss how such performance evaluation systems

function.

42


Supplier Evaluation Systems

The purchasing process does not end with the receipt of an ordered item or the selection

of a supplier. Buyers need some way to identify areas requiring attention and to track

supplier performance improvement over time. A supplier evaluation system supports the

continuous management and improvement of suppliers.

Monitoring supplier progress is especially critical if the supplier is developing a

new product or process technology. The buyer must be sure that a supplier can meet

timing targets throughout each phase of the development process. Without a

measurement system, a buyer has little insight into supplier performance over time, and

would lack the quantitative data necessary to support future purchase decisions.

A major issue when evaluating supplier performance is the frequency of

evaluation and feedback. For example, should a buyer receive a daily, weekly,

monthly, or quarterly supplier quality performance report? While most firms recognize

the need to notify suppliers immediately when a problem exists, there is little consensus

about the frequency for conducting routine or scheduled supplier evaluation. For many

firms, this overall evaluation may occur only 1-2 times a year.

In some cases, companies use supplier evaluation systems to develop an overall

summary score of a given supplier’s performance. Scoring systems can provide the

buyer with quick, summary information on suppliers. The buyer (and sometimes the

supplier) can quickly see how the supplier stacks up against other suppliers. Such scores

can serve as input into future negotiations and purchasing decisions. The following

example provides an illustration of how the supplier evaluation process takes place, using

a weighted-point evaluation system.

43


***********************************************************************

Boxed Example 7.2: Supplier Evaluation at Electra Company

The Electra Company has decided to re-evaluate the performance of three of its suppliers

of integrated circuit boards (ICBs). In the past, the company has shared all business

equally with the suppliers, and has amassed a significant amount of information on their

performance history. It must now award a large contract for 500,000 ICBs to be

delivered over the next year for a new product they are building. Table 7.9 summarizes

the performance of its three major suppliers with regard to price, quality, and delivery.

Table 7.9: Summary data for three possible suppliers

Criteria Aardvark

Electronics Beverly Hills Inc.

Conan the

Electrician

Price $4 / unit $5 / unit $2 / unit

Quality 5% defects 1% defects 10% defects

Delivery 95% on-time 80% on-time 60% on-time

The process begins by developing a weight for each of the criteria used. The sum

of the weights must equal 1. In this case, the sourcing team assigned to evaluating

suppliers for the new contract has decided that Quality is the most important criteria,

followed closely followed by Delivery and Price. Thus, the team assigns the following

set of performance weights, based on a consensus among the group (note that the exact

criteria and weights may vary, depending on the product or service being purchased).

44


Au: This single subheading can’t stand alone; you can delete it or add another subheading to balance it. (Since this section is very short, I’d suggest deleting it.)


Price = 0.3

Quality = 0.4

Delivery = 0.3

Total = 1.0

Next, the sourcing team evaluates each supplier’s performance on each of the criteria,

using the following scale:

5 = Excellent. Performance greatly exceeds our expectations.

4 = Good. Performance clearly meets our expectations.

3 = Average. Performance barely satisfies our expectations.

2 = Fair. Performance falls just below our expectations.

1 = Poor. Performance falls well below our expectations.

Based on the product design team's specifications, the Electra sourcing team has

determined that the minimum allowable performance for ICBs is $4.80 per unit, 4%

defects, and 90% on-time delivery. Thus, they proceed to assign performance scores for

each criterion, as shown in Table 7.10. Finally, they calculate a weighted performance

score for price, quality, and delivery, by multiplying the weight for each criteria weight

by each supplier's respective performance score (e.g. the weighted price performance

score for Aardvark is (.3 X 4 = 1.2). Finally, the total score for each supplier is

calculated by adding up the price, delivery, and quality scores (e.g. Total Score for

Beverly Hills = 0.9 + 2.0 + 0.6 = 3.5).

45


Table 7.10: Weighted performance for three possible suppliers

Criteria (Weight) Aardvark

Electronics Beverly Hills Inc.

Conan the

Electrician

Price (.3) $4 / unit

(4)

Price Score = 1.2

$5 / unit

(3)

Price Score = 0.9

$2 / unit

(5)

Price Score = 1.5

Quality (.4) 4% defects

(3)

Quality Score = 1.2

1% defects

(5)

Quality Score = 2.0

10% defects

(1)

Quality Score = 0.4

Delivery (.3) 95% ontime

(4)

Delivery Score =

1.2

80% ontime

(2)

Delivery Score =

0.6

60% ontime

(1)

Delivery Score =

0.3

Total Score Total = 3.6 Total = 3.5 Total = 2.2

Based on the results in Table 7.10, the Electra team must now decide on which

source to use. Conan the Electrician is clearly out of the running. While this supplier has

the lowest price by far, their delivery and quality record is abysmal. This leaves

Aardvark and Beverly Hills. Aardvark has a lower price, but needs to improve its

quality. Beverly Hills has excellent quality, but they have a problem delivering on-time,

and must also find a way to reduce their prices. Because the final scores for the two

suppliers are so close, the result of this decision might be one of the following outcomes:

Award the contract to Aardvark, after a detailed negotiation in which they are asked

to provide details on how they will improve their quality.

46


Award the contract to Beverly Hills after a detailed negotiation in which they are

asked to reduce their price and explain how they will improve delivery performance.

Award a dual source contract, in which 50% of the business goes to each of the two

suppliers. The contract might state that future volumes will be assigned according to

which supplier improves their performance most quickly.

***********************************************************************

Clearly, supplier evaluation requires a significant amount of judgment in

awarding points and assigning weights. However, the process of identifying key criteria

and assigning numerical scores to performance allows purchasers to be more objective

and comprehensive in their decision-making. Furthermore, conscientious purchasers will

make every effort to back up their ratings with hard data.

Trends in Purchasing Management

Our chapter would not be complete without a look ahead to the trends affecting

purchasing management. The trends and changes we describe here are based on survey

data collected annually at Michigan State University from firms worldwide. As the

findings suggest, the changes occurring within purchasing are as dramatic as those in any

business area.

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Au: The two boxed examples in this section both have to do with purchasing strategy—a term that hasn’t been used much, but which underlies much of the chapter. In fact, the chapter headings emphasize the routine and practical—e.g., the sequence of steps in the purchasing process—rather than the conceptual (strategy). (Try to locate the discussion of dual versus single sourcing by looking at the chapter outline; it isn’t there.) In revising, consider developing a separate section on strategy, preferably at the front of the chapter. Such a section could emphasize strategic choices—for instance, Honda chooses to work with local suppliers, while Chrysler prefers global oursourcing; both are successful auto makers. Likewise with dual / single / multiple sourcing.


Long term Contracts and Consolidation

A steady increase in the use of longer-term contracts (2 or more years) has occurred since

1990. The percentage of longer-term contracts to total contracts has increased from

approximately 24 percent in 1990 to 40 percent of total contracts currently. Additionally,

the dollar value of purchases represented by longer-term contracts has increased from 34

percent to 45 percent of total purchase dollars. Within the next several years, at least half

of all contracts should be longer-term, representing two-thirds of the total value of all

purchases.

The pressure to reduce costs has had a major influence on the growth of longer-

term agreements. The use of longer-term agreements can reduce dramatically the costs

associated with maintaining a relationship between a buyer and supplier.

Supplier reduction efforts often precede the development of longer-term purchase

agreements with the remaining suppliers. This way, firms can establish long-term

relationships with a few, high performing suppliers. Also, longer-term purchase

agreements are often a prerequisite to activities requiring closer interaction and

cooperation between a buyer and supplier. As purchasers pursue activities that require

closer relationships, such as early supplier involvement and EDI, expect the use of

longer-term agreements to increase.

The use of longer-term contracts is paralleled by an increase in the number of

purchase consolidation efforts. Purchase consolidation is the pooling of purchasing

requirements by multiple areas in a company, or even across companies. By

consolidating their needs, businesses can achieve higher overall purchasing volumes and

leverage their purchasing efforts. Consolidation provided tremendous cost savings

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Au: This subheading and the ones that follow don’t fit the specs for a second-level heading; they’re really too long for that treatment, anyway. Yet the section is quite long—about ten pages—and that’s a long way for a reader to go without some visual relief. I’d suggest shortening these sentence-style headings so they will work as second-level headings. For instance, “Long-Term Contracts,” “Purchase Consolidation,” and so on. Consider deleting the numbers; these trends seem general enough that their order of importance might be subject to debate. In addition, consider combining related trends under a single heading, especially for the shorter subsections. From a design point of view, second-level headings should carry a minimum of several paragraphs of text; from an editorial point of view, integration of ideas is preferable to a choppy, bit-by-bit presentation. (See my queries on later subheads.)


opportunities throughout the 1990s and beyond. In fact, most firms have achieved only a

moderate level of consolidation, even when opportunities for consolidation exist.

Supply Base Reduction

In 1990, the average buyer in an organization was responsible for 126 suppliers. By the

late 1990s, buyers regularly did business with about 46 suppliers, representing a decline

of 63 percent from 1990 levels. Note that a reduction in the number of suppliers a firm

maintains is often just a reduction in the total number of first tier suppliers (see Chapter

1). A trend within the automotive industry, for example, has been to rely on larger

suppliers to design and build entire subsystems, such as the automobile’s electrical

system. Instead of dozens of smaller suppliers providing components for the subsystem,

the purchaser uses one major supplier, who then uses dozens of suppliers to help build the

system.

Global Purchasing

In the US, purchases from foreign sources increased from 9 percent in 1990 to 14 percent

of total purchases in the late 1990s. Cost reduction pressures along with a need to gain

worldwide access to process and product technologies continue to push this trend. These

factors will help ensure that a gradual increase in total purchases from international

sources will continue.

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Supplier Performance Measurement

By the late 1990s, more than one half of all firms surveyed had defined minimum levels

of acceptable supplier performance, up from one-third of firms in 1990. These levels,

often established as part of the performance benchmarking process, are meant to reflect

best-in-class or world-class performance standards. The growth in acceptable supplier

performance levels is consistent with the growing number of firms maintaining formal

supplier performance measurement systems. The number of firms using formalized

systems to measure supplier performance has increased dramatically, from 47 percent in

1990 to more than 80 percent in the late 1990s. As we have discussed, without these

systems it becomes difficult to make supplier selection decisions, determine where to

commit supplier development resources, and track supplier improvement efforts.

Supplier Technology

Firms forecast a 20-30 percent average increase in their reliance on product and process

technology bought from suppliers. There are four major reasons behind this trend. First,

more firms are focusing on their core competencies, thereby leading them to off-load

non-critical activities to suppliers. Second, there is growing worldwide competition with

accompanying cost and quality pressures. Tapping into the best suppliers helps firms

meet these cost and quality requirements. Third, nearly every organization is feeling

pressure to innovate rapidly and continuously upgrade their performance in critical areas.

Suppliers' design and technical expertise can help meet these needs.

A fourth reason is that many companies now view time-related capabilities as

critical to their success. For instance, in some industries the ability to take new products

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Au: The year 2000 will come and go before this book is published. Can you update this projection? See also trend 11.


Au: Trends 10 and 11 might be consolidated under one heading.


from concept to customer in the shortest possible time will rival the highest perceived

product quality and the lowest product price in importance.

Firms responding to a recent Michigan State survey expected to reduce

development times by 40 to 45 percent over the next several years. To achieve this,

purchasing must pursue activities that support development time reduction, such as early

supplier involvement with computer design interfaces.

Information Technology

Within the next several years, firms expect to establish electronic linkages with more than

60 percent of their supply base, compared with 20-25 percent today. Furthermore, 65

percent of total purchase transactions (purchase orders, amendments, shipping notices or

schedules) should link directly with suppliers through EDI.

Perhaps a more important trend is the emergence of Internet-based business-to-

business exchanges (B2Bs). B2Bs are on-line trading communities that put hundreds or

even thousands of potential buyers and suppliers in touch with one another, and automate

the flow of information between the trading parties. A major advantage of B2Bs over

EDI is that B2Bs take advantage of standardized Internet protocals to make data

interchange much simpler than ever before. This allows even small companies to

participate. Public B2Bs are open to any company that meets certain criteria and is

willing to pay the fees necessary to join and/or transact with other parties. An excellent

example of a public B2B is Ariba (www.Ariba.com). Private B2Bs, in contrast, limit the

trading partners to only a selected group.

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Professionalism in Purchasing

In the future, purchasing professionals will perform fewer day-to-day buying activities,

and spend more time on strategic activities such as supplier evaluation and selection, new

product development, and insourcing / outsourcing decisions. To illustrate, many

organizations now issue credit cards to selected users. These cards allow the user

purchase what they require directly from approved sources. The credit card company

issues reports, performs billing, and assumes many responsibilities performed previously

by purchasing.

Information technology will further reduce the clerical burden placed on

purchasing professionals. By relying on information systems, users can order directly

what they require through their computer terminal. Also, production planning and

control systems will generate orders automatically, based on production requirements.

These systems will use EDI to forward component requirements immediately to

suppliers, reducing the need for managerial oversight.

Another development that will reduce the clerical work assumed by purchasing is

the use of suppliers to manage inventory at the customer's site. This is a classic example

of an out-sourced activity that was previously performed by purchasing or materials

management professionals.

These changes concern some purchasing professionals. If, for many years, an

individual’s primary responsibility has been to place purchase orders routinely, what

happens when job requirements shift or even disappear? The purchasing group at a large

Midwest chemical company is currently in transition from “order placing”

responsibilities to more strategic activities.

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Table 7.11 summarizes the major changes that are occurring in the area of purchasing

management.

Table 7.11: Trends in purchasing management

Area of Purchasing Traditionally. . . … In the Future

1. Contract length Competitive bidding, renewed annually or semi-annually.

Long-term contracts (more than 2 years) with performance improvement clauses.

2. Purchase consolidation Products and services purchased by individual business units.

Purchases consolidated across business units to leverage volumes and purchasing efforts.

3. Number of suppliers Suppliers switched often, many suppliers used for each purchased product or service.

Firms more likely to single-source or dual-source products or services, to improve performance and reduce costs.

4. Location of suppliers Primarily domestic, or even local.

Global sourcing by the best suppliers in the world

5. Top management's perception of purchasing

Purchasing seen as a “nuisance” or non-value-added activity.

Purchasing seen as a way to harness suppliers' capabilities, especially in new product development.

6. Importance of time Long cycle times tolerated; little involvement of suppliers in new product development process.

Cycle time a critical order-winner; suppliers cooperate in new product development to reduce product development time.

7. Improving supplier’s capabilities

Suppliers expected to improve … or else!

Buying organizations improving supplier performance through supplier development programs

8. Supplier performance measurement

Random or nonexistent monitoring of supplier’s quality, delivery, and price over time

Detailed, formal performance measurement systems to track price, delivery, quality, and other measures.

9. Supplier performance standards.

Low standards if any Increasing levels of performance expected.

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10. Reliance on supplier product and process technology.

Little to none. Suppliers expected to deliver exactly what was asked and no more.

Suppliers active in new product/process development.

11. Electronic information systems linking buyers and suppliers.

Little or none. Increasing use of EDI, B2Bs, CAD/CAM, and web to link supply chain partners.

12. Purchasing responsibilities

Primarily clerical – processing purchase orders.

Increased use of technology for routine activities; more time spent on managing relationships with key suppliers.

Chapter Summary

Purchasing can contribute significantly to profitability, quality performance, speed of

product development, and technological innovation within a firm. Furthermore, executives

have come to recognize the important role purchasing plays in importing value in the form

of supplier’s capabilities into the organization.

However, satisfying internal organizational needs is only part of the buyer's task.

There is an external dimension which makes the task even more complex. The size of the

supply base, as well as the availability of local suppliers, can limit the number of options

available to a buyer. Contemporary supply chain responsibilities require that the purchasing

professional act as an initiator and facilitator of strategic supply chain relationships. The

increasingly critical task domain of the purchasing field has finally led to management

recognition and appreciation of the field’s potential for contributing to long term

competitive advantage.

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Au: Discussion questions here?


Discussion Questions

1. What are some of the pros and cons of outsourcing? Why do you think many firms

are experiencing an increase in their levels of outsourcing?

2. Describe the problems associated with the allocation of indirect costs to a product or

service. How does this complicate total cost analyses of sourcing decisions?

3. Someone says to you, “All purchasing does is place orders for goods. What’s the

big deal?” Is this true? What is the big deal?

4. What is a preferred supplier? What are the advantages and disadvantages of using

preferred suppliers?

5. Under what conditions might a company prefer to negotiate rather than use

competitive bidding to select a supplier?

6. In the chapter, we suggested that advanced information systems will automate some

of the more routine purchasing activities. What are the implications for purchasing

professionals? Is this a good time to join the purchasing profession? Explain.

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Exercises

Dulaney’s Department Stores has posted the following yearly earnings and expenses:

Earnings & Expenses (Year ending January, 2004)

Sales $50,000,000


Pre-tax earning 5,000,000




1. What is Dulaney’s current profit margin? Its current yearly ROA?

2. How much would Dulaney’s pre-tax earnings increase if merchandise costs were cut

by 10%? What would the impact be on the yearly ROA?

3. How much sales would Dulaney have to generate in order to have the same effect on

pre-tax earnings as a 10% decrease in merchandise costs?

4. What would the yearly ROA be after a 10% cut in merchandise costs?

5. Looking back at Boxed Example 7.2, suppose Conan the Electrician has implemented

a Total Quality Management (TQM) program, and as a result has brought defect levels

down to just 1%, the same as Beverly Hills Inc. Recalculate the weighted performance

score for Conan the Electrician using the weights provided in the boxed example. Should

Electra change their preferred supplier, based on these results?

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Flynn Industries has outsourced the delivery of its products, and now wants to develop a

tool to help it evaluate its transportation carriers. The first table shows the rating values

associated with different levels of price, quality, and delivery performance, as well as

criteria weights that reflect the relative importance of these dimensions. To illustrate how

the ratings work, suppose a carrier has a damage level of 0.82%. This would fall between

0.75% and 1.0%, thereby garnering a rating of 2. The second table shows actual average

performance levels for three carriers.

6. Calculate the weighted average performance for each carrier. Who is “best”?

7. How would the results change if the weights for price, quality, and delivery shifted to

0.6, 0.2 and 0.2 respectively?

8. Based on the results in Problem 1, should Flynn Industries single source or not?

What might stop them from single sourcing?

Rating Values:Suppliers are rated on a scale of 1-5, depending on their specific performance levels

Criterion(weight) 1 2 3 4 5

Price 0.20) > $2.50/lb $2.01-$2.50/lb $1.51-$2.00/lb $1.00-$1.50/lb < $1.00/lbQuality (0.20)

Damage > 1%

Damage 0.75-1.0%

Damage 0.5-0.74%

Damage 0.25-0.49%

Damage < 0.25%

Delivery (0.60)

< 82% on-time 82-84% on-time 85-90% on-time 91-95% on-time > 95% on-time

Carrier A Carrier B Carrier C

Price $1.98/lb Price $2.02/lb $98.00/100lbs

Quality 0.35% damaged Quality 0.26% damaged 0.86% damaged

Delivery 93% on-time Delivery 98% on-time 83% on-time

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Documents

Chapter 7 - Insourcing / Outsourcing