UNIT 2 STRATEGIC SOURCING

2.1 OUTSOURCING

Introduction to Outsourcing

Outsourcing results in the supply chain function being performed by a third party. Outsourcing is
one of the most important issues facing a firm, and actions across industries tend to be varied.
Benefits of outsourcing

 lower costs (due to economies of scale or lower labor rates)

 increased efficiency
 variable capacity
 increased focus on strategy/core competencies
 access to skills or resources
 increased flexibility to meet changing business and commercial conditions
 accelerated time to market
 lower ongoing investment in internal infrastructure
 access to innovation, intellectual property, and thought leadership
 possible cash influx resulting from transfer of assets to the new provider

Risks of outsourcing

 slower turnaround time

 lack of business or domain knowledge
 language and cultural barriers
 time zone differences
 lack of control
2.2 Make Vs Buy

Production units are identified mostly with their decision to make or buy. In other words, do they
wish to produce the desired product on their own or do they want to purchase it from the foreign
market. This decision is critical because the third-party suppliers especially in countries like
Eastern Europe, China, and other low-cost parts of the world hold out the promise of essential
beneficiaries, which the developed nations fail to offer.

The Make Vs Buy decision of a nation depends on three pillars.

These pillars are:

 Business strategy
 Risks
 Economic factors

Business Strategy

The first pillar in the Make Vs Buy decision is the business strategy adopted by a nation.
Business strategy strategically engages the importance of the company whose product or service
is being considered for outsourcing, in addition to the process, technologies or skills needed to
design the product or deliver that particular service. These factors should be carefully
considered, not just on the basis of current competitive environment but also by anticipating the
changing competitive environment in future. So, as a rule, it’s advisable to select the in-house
skills and abilities when a product or a function plays a very important role in improving the
company’s performance or is considered a core operation. Perhaps, if we consider a time-
sensitive product or a product, which is prone to consequent design changes, third-party
producing would likely be a mistake. In simple worlds, companies must opt for outsourcing in
the following scenarios:

 Remove the processes, which are intensive on the balance sheet, e.g., capital or labor.
 Minimize the costs.
 Achieve flexibility for adjusting output in comeback to changing demand.
  Phase out management of paperwork, documents or training.
 Monitor fewer workers.
 Have access to new process or network tools and technologies.
 Leverage external expertise.

In fact, if a product relies on proprietary technology or intellectual property or if a product or an

operation is critical for the company’s performance, it is recommended to select in-house skills
& abilities rather than outsourcing.

Obviously, outsourcing is worth considering under some situations. If a product or function has
essentially become a commodity or is derived from factors other than unique or differentiating
capabilities and as such, moving production or management to a third party does not give rise to
significant risk to the company’s strategy, outsourcing would be the perfect solution.

Risks

The second pillar under the Make Vs Buy strategy is risks involved with any decision. The major
risk factors involved in making a product in the home country or purchasing it from foreign
countries are quality, reliability, and predictability of outsourced solutions or services. Along
with these, there are risks inherent in the process of labeling and selecting the right supplier and
structuring a workable ongoing relationship.

When we have numerous suppliers, a single failure in the supply chain may not be deadly. Even
when the suppliers are making parts of an item instead of that completely furnished item, there
will be errors in manufacturing. These errors should be identified before the products are
assembled so that the faulty item cannot be delivered to the consumer directly.

We know outsourcing opens up a broad array of new risks. We need to be attentive of any
potential pitfalls with producers and examine outsourcing partners on the basis of their
importance to the company.

Operations in outsourcing that lead to failure of service could be overwhelming, for example, an
IT network, a payroll processing system or element manufacturing, as compared to risks or
problems like a glitch in a training program or a long-term product development plan, which is
much lesser. It is very important to acknowledge the risks that are related to the location of an
external supplier. Apart from judging the source country’s political stability, companies require
to examine the safety and lead times of shipment schedule. Along with this, they have to label
and examine potential secondary carriers or routes or search for other producers as a backup in a
different area that supplies incremental volume during peaks in demand or disruptions of the
primary source of supply. When we merge the outsourced manufacturing of products or
outsourced processes that demand distinct skills or assets, making it difficult or expensive to re-
source, the supply chain management becomes a highly complex function.

In fact, these risks through which a producer may exploit a customer’s highly reliable
relationship by increasing prices or charging better terms (referred as hold up risks) can be easily
handled with some external solutions. This is a very important decision to make. One has to go
through all the available options and select the best one out of them before making any
commitments to the supplier because outsourcing agreements can be difficult to amend or break.

Economic Factors

The third pillar in the Make Vs Buy strategy is the economic factors residing in the country that
needs to decide if to buy a product or make it on its own. The various economic factors comprise
the effect of outsourcing on capital expenditures, return on invested capital and return on assets,
along with the probable savings gained by outsourcing. To study the importance of pricing
mechanisms, let’s consider those companies that base their decision on if they need to outsource
solely on approximate calculations of the in house as compared to the external costs related to
the outsourced function, for example, the cost of each item produced or the price of running an
HR department or an IT network instead on the total costs. The net prices that need to be taken
care of comprise the layouts for handling the outsource supplier, exclusively as the outsourced
process changes. These changes prove to be very essential.

For example, customizing some software on a third-party information technology network can
compute a large surcharge to the outsourcing deal. Tackling the customization in-house, i.e.,
within the home country, where the IT department can work closely, their work can be easily
monitored and more productively with end-users to satisfy their demands can be obtained, tend
to be less costly. Along with this, the home country needs to choose the outsourcing partners
very cautiously. In case the outsourcing partners are not selected properly, the companies often
attempt to protect themselves from failures or delays by replicating in-house some of the effort
that was originally farmed out. This leads to multiple prices for the same project and potential
costs are mostly neglected when the outsourcing deal is made.

The costs that are often neglected in outsourcing manufacturing operations are as follows:

 Transportation and handling charges.

 Expanded, extended inventories.
 Administrative bills like the supplier management and quality control rates.
 Casted complexity and its effect on lean flows.
 Minimal return on invested capital.
 Production dependability and quality control.

Taking all these costs into consideration, depending on a one-time quote to measure the
competitiveness of an external producer is mostly not enough. Enterprises can be saved from this
mistake by factoring into the outsourcing equation the economic effects of comparative wage
prices, labor productivity, tools and staff utilization, the biasness of both the labor base and
functional processes, the potential for process and product innovation and relative purchasing
power.

Finally, we can say that for a successful outsourcing relationship, the basic factors include the
sharing of savings from productivity progress, so that both sides have an inducement to merge.
After establishing a sober formal relationship, it is very essential to search for the right balance
between fully transparent supplier functions and micromanagement or the perception of it.

After the outsourcing decisions are made and suppliers have been chosen, it is crucial to be on
the same front on a fair and balanced pricing mechanism, productivity progress and cost
minimization expectations and the necessary scale of responsiveness to design, service or
delivery changes.
SUPPLIER SELECTION; APPRAISAL AND EVALUATION

Supplier Assessment Methods

There are two main approaches used in selecting suppliers:

 Supplier appraisal – used to select potential / new suppliers

 Vendor rating – used to assess already performing suppliers.

Supplier appraisal can be undertaken by a combination of the following:

 Desk research using published or unpublished data already in existence e.g. company’s
reports, balanced sheet, strike records etc

Field research to obtain further data of a prospective supplier by a visit to their working
environment

Supplier appraisal

This is the assessment of the potential suppliers so as to be used as on of the company’s

suppliers. Thus, the concern is with the selection of the next suppliers. The main techniques used
in supplier appraisal are:

I. Desk research:

This is where an analysis of the supplier’s document is done. The documents include:

Balance sheet, profit and loss account, organization chart etc. This analysis is done by use of
statistical tools and ratio analysis. This enables the buyer to make an informed judgment on the
potential of the supplier to be.

II. Field research / Capacity survey:

 Effectiveness of production systems.

 Quality assurance systems
 Cost control systems
 Appropriateness of the equipments
 Attitudes and stability of management.
 Competence of technical staff
 Morale of workforce which indicates quality of service expected.
 Employee relations – in accordance of strikes, communication between managers and
subordinates, past major customers and reputation of the organization
 How the company handles environmental and human rights issues.
Once the new suppliers have been selected, constant monitoring and feedback is required to
either improve their performance or eliminate the non-performing ones.

Vendor Rating

It is the assessment of already performing suppliers so as to improve their performance or

replace them. The two techniques used in vendor rating are:

 Subjective supplier rating method.

 Objective supplier rating method.
Subjective supplier rating method:

A purchasing officer is appointed to observe on how well or badly the suppliers are performing
and then judge each supplier. It is subjective because different individuals have different value
judgments.

Advantages:

1. It is cheap to carry out as only one observer is used and there are no records kept.
2. Is a good method to eliminate obvious shortcomings.
Disadvantages

1. Not factual therefore personal liker and dislikes may be used by the observer.
2. Not accurate
3. It is susceptible to bribery thus the company may receive low quality items
4. No records are kept in case they may be needed for future reference.
Objective supplier rating method:

Marks are allotted to each of the factors that determine a good supplier each time a supplier
performs. These factors include: Right price, right time, right quality, right quantity, service
given to the buyer, cost reduction effort, management capability.

The marks are the compiled at the end of a given period and used to come up with a conclusion
in respect to each supplier.

Advantages:

1. The method is more accurate than subjective.

2. Avoids complaints / disputes as it is based on facts
3. Minimizes incidences of bribery
4. Ensures high quality goods are delivered.
5. Reference in form of records is kept in case the procurement / purchasing officer leaves
office.
Disadvantages:
1. Record keeping can be expensive.
2. The method is time consuming.

THE TEN CS OF EFFECTIVE SUPPLIER EVALUATION

Many of the aspects of supplier appraisal are neatly summarized by carter as the ‘Ten Cs of
Supplier Evaluating’

 Competency of the supplier to undertake the task required

 Capacity of the supplier to meet the purchaser’s total needs
 Commitment to the supplier to the customer in the term of quality, cost driving and
service
 Control system in relation to inventory, cost, budget, people and information
 Cash resources and financial stability ensuring that the selected supplier is financially
sound and is able to continue in business into the foreseeable future
 Cost commensurate with quality and services
 Consistency the ability of the supplier to deliver consistently and, where possible,
improve levels of quality and service.
 Culture
 Clean-i.e. environment
 Communication –the role of information technology
2.3 Negotiation

2.3.1 Definition and objective of negotiation

Negotiation refers to the process of conferring, discussing or bargaining to reach an agreement in
business transactions. This makes negotiation a process of planning, reviewing and analyzing
used by both buyers and sellers to reach acceptable agreement or compromise. Thus, in
purchasing negotiation must be used only as decision making process for it to achieve its full
value. In successful negotiations, both sides win something – i.e. it is a win – win negotiation
approach.

2.3.2 Styles and approaches of negotiation

These can be classified as adversarial and partnership

Adversarial negotiation: Also referred to as disruptive or win – lose negotiation approach.

 Parties have competing goals

 Involves use of threats
 In case of deadlock, negotiation is terminated
 The approach is rigid
 The attitude is that of we must win, they must lose.

Partnership negotiation: Also referred to as win- win negotiation.

 Common goals emphasized upon.

 Negotiation is friendly and based on openness
 In case of a deadlock, negotiation results to further problem solving
 The approach is flexible
 The attitude is we both must win.

2.3.3 Phases / Stages of negotiation

Preparation stage: Activities performed during the preparation stage include:

 Gathering facts about suppliers

 Setting objectives
 Determining bargaining strengths
 Planning strategies
 Preparing for alternative courses of action
 Choosing the negotiating team
 Choosing the venue

Introduction Stage
  Involves setting agenda, rules and procedures and create a conducive environment.

Discussion stage / Debating stage

 Avoid interruptions
 Avoid arguments
 Avoid destructive debates
 Regularly summarize issues to avoid later confusion
 Watch and interpret body language.

Bargaining Stage

 It involves setting terms on which to settle – e.g. price reduction by so much percent will
result in order increase by so much percent.
 Ploys can appropriately be used at this stage.

Agreement stage / Conclusion of negotiations

 It is important to record full details of the negotiation .The minutes of the meeting can be
used to serve this purpose.

Post – Negotiation Stage:

 It involves making a draft document which should be sent to the other party for approval.
 Ensure that there is commitment of all relevant employees in order to make the
agreement work
 Prepare official contract based on draft agreement
 Evaluate the performance.

2.3.4 Elements of an effective negotiation

 Substance issues are satisfactorily resolved

 Working relationship are preserved or even enhanced
 The negotiation produces a wise agreement – i.e. one that is satisfactory to both sides.
 The negotiation is efficient – i.e. it is no more time consuming or costly than necessary
 The negotiation is harmonious – i.e. it fosters rather than inhibit good interpersonal
relationships.

2.4 Supplier development

The goal of supplier management and supplier development is a world class supply base.
Supplier management involves

- Supplier performance measurement

- Supply base optimization
- Buyers accepting some responsibility for supplier performance

Supplier management is a pre-requisite to supplier development.

Definition of Supplier development:

“Supplier development is defined as a buyer firm infusing

- Suggestions and ideas

- Human resources
- Training
- Financial capital
- Technology

Into a supplier to improve his capabilities and improve his performance in order to meet the
buyer firm’s short term and long term supply needs”.

Steps involved in Supplier development:

Step 1: Identitify candidates for supplier development

-Is the supplier essential? or
-Does this supplier meet minimum requirements and show great potential? And
-Is this product or service a source or potential source for competitive advantage?

Step 2: Meet with supplier’s top management

Stages in supplier development:

This involves supplier performance measurement and supplier evaluation.

Supplier evaluation is an event to pre-qualify suppliers, to award contracts, to pursue

improvement opportunities. Supplier performance measurement is a continuous process.

The quantitative variables used in performance measurement are as follows:

1. Cost reductions
2. Quality performance
3. Delivery performance
4. Contract deficiency notices (CDNs)
5. New product development support
6. Technical ability
7. Commitment to R & D
 8. Trust levels
9. Problem resolution ability
10. Responsiveness

The above said variables are then recorded and reported using techniques such as categorical
system, weighted point system, Cost Index.

Categorical system

Weighted average of scores across a number of categories is called weighted point system.

Cost Index:

Quantifies the total cost of doing a business with a supplier.

SPI = Total purchase price + Non performance costs

-----------------------------------------------------
Total purchase price

Non performance costs are generally per incident standard costs for late delievery, order shipped
incomplete, quality problems, a line shut down, lost customer sale, inspection and return costs,
etc

Next in process in supply base optimization

Supply base optimization

Optimization is a continuous process. First step is to eliminate marginal and perhaps very low
volume suppliers. The prime motive is to create a world class supply base.

Advantages:
- Reduced cost
- Having a world class supply base
- Suppliers that generate fewer problems
- Buyers redirect their time to value adding activities
- Access to suppliers’ engineering, design and other capabilities

Risks of a reduced supply base:

- Absence of competition may generate complacency and price increases

- Risk of supply disruption

2.5 Worldwide sourcing

The world has grown a good deal smaller, figuratively, in the last 50 years, with the increased
speed of transportation and communication. The internet has accelerated the trend to global
supply, making it easier for source selection and reducing communication problems.
International agreements aimed at relaxing trade barriers and promoting free trade have also
provided opportunities for firms to expand their supply bases to participate in global sourcing.

Why source worldwide?

Firms expand their supply base to include foreign suppliers for many reasons. However, the
primary reason for using an international supplier is that better value is perceived to be available
from that source than from a domestic supplier.

The specific factor that makes the international buy look attractive will vary. Let us explore some
of these reasons that may cause an international supplier to be selected as the preferred source.

1. Unavailability of items domestically: The first and oldest reason for international trade has
been that domestic sources were not available.

2. Cost/price benefits: The ability of an offshore supplier to deliver product or service at a lower
overall cost than domestic suppliers. Cost differentials between countries arise possibly because
of lower labour rates, different productivity levels, willingness to accept a lower profit margin,
exchange rate differences, lower-cost inputs for materials and government subsidies.

3. Government pressures: It makes good economic and political sense to consider the
alternatives of buying from suppliers in customer countries. Many multinational firms also
accept that they have a social responsibility to buy products from suppliers in nations in which
they operate plants, as a means of developing those nations. Additionally, many nations insist as
a condition of sale of a major product to their country that the seller must agree to buy a
specified value of goods in that country.

4. Quality: While the quality level of the international sources generally is no higher than from
domestic suppliers, on some items it is more consistent. This is due to several factors, such as
newer, better capital equipment; better quality control systems; and perhaps the offshore
supplier’s success in motivating its workforce to accept responsibility for doing it right the first
time (the zero-defects concept).

5. Access to product and process technology: Gaining access to the most current technology
leaves many companies with little choice except to pursue worldwide sourcing.

6. Access to the only source available: Economic recessions, mergers and government
environmental regulations often result in suppliers exiting certain lines of business due to higher
costs, loss of business volume, or both. A loss of supplier capability and availability often leave
domestic buyers with no viable supply alternative except international sources.

7. React to buying patterns of competitors: This is probably the least mentioned reason for
worldwide sourcing because most firms do not want to admit that they are reacting to the
practices of competitors. Imitating the action of competitors is the ‘fashion and fear’ motive. A
buyer may try to duplicate the factors that provide an advantage to a competitor, which may
mean sourcing from the same suppliers or regions of the world that a competitor uses.

In order to gain access to the lowest costs, cutting-edge technology and best capabilities,
organisations must scan the global landscape in search of the best suppliers. By aligning
technology roadmaps with leading-edge suppliers, designers can ensure that their products and
services will truly be world class, not just the best in the region. Although the exact reasons each
firm sources internationally will vary, they surely include some of those discussed here. Without
access to worldwide sources of supply, firms may not remain competitive. A domestic firm that
buys a portion of its material requirements worldwide is better than a domestic firm that is no
longer in business as a result of its inability to meet global competition.

Potential challenges for worldwide sourcing

Global supply for many firms is a competitive necessity. However, managing international
supply networks presents a number of challenges and firms with little or no international
experience often face obstacles or barriers when beginning global sourcing. The potential
problem areas include:

1. Source location and evaluation: The key to effective supply is selecting responsive and
responsible suppliers. Internationally, this is sometimes difficult as obtaining relevant evaluation
data is both expensive and time-consuming.
2. Lead-time and delivery: Improvements in transportation and communications have reduced
the lead-time for international procurement. However, there are four areas where the buyer
should anticipate additional lead time:

a. Establishing credit for first-time international buyers often involves obtaining a letter of credit.

b. Even with improvements in transportation, the buyer may still experience delays, particularly
with inland carriers in the foreign country.

c. Delays in customs are also possible.

d. The time goods are in port, for both outbound and arriving, also depends on the number of
ships in line for unloading and hours of port operations.

3. Expediting: Because of distance, expediting an offshore firm’s production/shipment is more

difficult.

4. Political and labour problems: Depending on the country in which the supplier is located, the
risk of supply interruption due to governmental problems, e.g., change in government or trade
disputes — may be quite high.

5. Hidden costs: When comparing an offshore with a domestic source, it is easy to ignore some
of the costs in the offshore procurement. Examples include foreign exchange premiums, finance
charges, foreign taxes, import tariffs, extra safety stock due to longer lead times, business travel,
marine insurance, customs documentation charges, needs for translator, etc. The buyers must
compare total cost of ownership before opting for an international supplier.

6. Currency fluctuations: Most significant world exchange rates float freely and sometimes
change rather rapidly due to economic, political and psychological factors, making the prices
significantly higher or lower than at the time the agreement was originally signed.

7. Payment methods: The method of payment often differs substantially in international buying
than in domestic buying.

8. Quality: Misunderstandings in the quality specifications and interpretations of drawings and

specifications can be quite costly due to distances and lead times involved.

9. Warranties and claims: In the event of rejection for quality reasons, return and replacement
of items is complex and time-consuming due to distances and transportation costs.

10. Tariffs and duties: The buyer must know which tariff schedule(s) applies and how the duties
are computed. The cost of non-compliance with import regulations can be staggering.

11. Administration costs: Global supply requires additional documentation, mainly for duty and
customs, logistics activities, payment and financial charges.
12. Legal issues: If potential legal problems are a risk in domestic buying, they are several times
greater in international buying. Buyers must also consider carefully the laws under which an
international contract is governed.

13. Logistics and transportation: The trend towards integrated logistics on the domestic side is
mirrored by a similar move in global supply. Global buyers must deal with more complex
shipping terms than domestic buyers with respect to shipping costs, risks and responsibilities of
buyer, seller and shipper.

14. Language: Different language, dialects or terminology may result in miscommunication.

Words mean different thing in different cultures. Difficulties arise in connection with
interpretation with domestic contracts is much increased in international contracts.

15. Communications: Global supply can involve problems with communication. These relate to
time zone differences, working days and problems with the communication network itself.

16. Cultural and social customs: The nature and customs of individuals and business
organisations from different cultures can raise a surprising number of obstacles to successful
business relations. Problems caused by cultural misunderstandings can lead to higher supply
chain costs, e.g., pace of negotiation, relationship, time orientation, values and decision-making
style.

17. Ethics: Are transaction bribes or facilitating payments allowed in the foreign countries?
What is considered ethical in one culture may not be ethical in another. The intention of filling
commitments, the implications of giftgiving and even the legal systems differ widely. Ethical
issues also include those of buying from overseas suppliers that operate sweatshops, employing
child labour and offering barely subsistence-level pay.

Finally, resistance to change from an established, routine procedure or shifting from a long-
standing supplier, are also major barriers. Buyers are sometimes reluctant to shift business from
domestic sources to unknown foreign sources. Home market nationalism can still be an issue.

2.6 Identify core processes , Market Vs Hierarchy