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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
Risks of outsourcing
Cost savings
Pricing
Resources & technology
Ability to meet deadlines
Minimal supervision
Limit liabilities
Trustworthiness
Who will lead the team
Service level agreement
Communication
Supply chain surplus is the difference between the value of a product for the customer and the
total cost of all supply chain activities involved in bringing the product to the customer. Third
parties increase the supply chain surplus if they either increase value for the customer or
decrease the supply chain cost relative to a firm performing the task in-house. Third parties can
increase the supply chain surplus effectively if they are able to aggregate supply chain assets or
flows to a higher level than a firm itself can. The various mechanisms that third parties can use to
grow the surplus are as follows:
1. Capacity aggregation. A third party can increase the supply chain surplus by aggregating
demand across multiple firms and gaining production economies of scale that no single firm can
on its own. This is the most common reason for outsourcing production in a supply chain. One of
the reasons that Dell (and every other PC manufacturer) outsources design and production of the
processors in its PCs to Intel is that Intel supplies many computer manufacturers and gains
economies of scale that are not available to Dell if it designs and produces its own processors.
The growth in surplus from outsourcing is highest when the needs of the firm are significantly
lower than the volumes required to gain economies of scale.
2. Inventory aggregation. A third party can increase the supply chain surplus by aggregating
inventories across a large number of customers. W.W. Grainger and McMaster-Carr are MRO
suppliers that provide value primarily by aggregating inventory for hundreds of thousands of
customers. Aggregation allows them to significantly lower overall uncertainty and improve
economies of scale in purchasing and transportation. As a result, these MRO distributors carry
significantly less safety and cycle inventory than would be required if each customer decided to
carry inventory on its own.
3. Transportation aggregation by storage intermediaries. A third party that stores inventory can
also increase the supply chain surplus by aggregating inbound and outbound transportation.
Storage intermediaries such as W.W. Grainger and McMaster-Carr stock products from more
than a thousand manufacturers each and sell to hundreds of thousands of customers. On the
inbound side, they are able to aggregate shipments from several manufacturers onto a single
truck. This results in a lower transportation cost than could be achieved by each manufacturer
independently. On the outbound side, they aggregate packages for customers at a common
destination, resulting in a significantly lower transportation cost than can be achieved by each
customer separately.
4. Warehousing aggregation. A third party may increase the supply chain surplus by
aggregating warehousing needs over several customers. The growth in surplus is achieved in
terms of lower real estate costs and lower processing costs within the warehouse.
7. Lower costs and higher quality. A third party can increase the supply chain surplus if it
provides lower cost or higher quality relative to the firm.
Process is broken
Reduced customer contact
reduced supplier contact
growth in third party power
leakage of information
Ineffective contract
Loss of supply chain visibility
Negative reputational impact
2.2 Make Vs Buy
Introduction
Outsourcing is closely related to make or buy decision. The corporations made decisions on
what to make internally and what to buy from outside in order to maximize the profit margins.
As a result of this, the organizational functions were divided into segments and some of those
functions were outsourced to expert companies, who can do the same job for much less cost.
Make or buy decision is always a valid concept in business. No organization should attempt to
make something by their own, when they stand the opportunity to buy the same for much less
price.
This is why most of the electronic items manufactured and software systems developed in the
Asia, on behalf of the organizations in the USA and Europe.
Four factors to be considered
When you are supposed to make a make-or-buy decision, there are four numbers you need to be
aware of. Your decision will be based on the values of these four numbers. Let's have a look at
the numbers now. They are quite self-explanatory.
The volume
The fixed cost of making
Per-unit direct cost when making
Per-unit cost when buying
Now, there are two formulas that use the above numbers. They are 'Cost to Buy' and 'Cost to
Make'. The higher value loses and the decision maker can go ahead with the less costly solution.
Cost to Buy (CTB) = Volume x Per-unit cost when buying
Cost to Make (CTM) = Fixed costs + (Per-unit direct cost x volume)
Cost concerns
Desire to expand the manufacturing focus
Need of direct control over the product
Intellectual property concerns
Quality control concerns
Supplier unreliability
Lack of competent suppliers
Volume too small to get a supplier attracted
Reduction of logistic costs (shipping etc.)
To maintain a backup source
Political and environment reasons
Organizational pride
Reasons for Buying
Following are some of the reasons companies may consider when it comes to buying from a
supplier:
Lack of technical experience
Supplier's expertise on the technical areas and the domain
Cost considerations
Need of small volume
Insufficient capacity to produce in-house
Brand preferences
Strategic partnerships
The Process
The make or buy decision can be in many scales. If the decision is small in nature and has less
impact on the business, then even one person can make the decision. The person can consider
the pros and cons between making and buying and finally arrive at a decision.
When it comes to larger and high impact decisions, usually organizations follow a standard
method to arrive at a decision. This method can be divided into four main stages as below.
1. Preparation
Team creation and appointment of the team leader
Identifying the product requirements and analysis
Team briefing and aspect/area destitution
2. Data Collection
3. Data Analysis
4. Feedback
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.
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.
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:
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.
Supplier scoring and assessment is the process used to rate supplier performance. Suppliers
should be compared based on their impact on the supply chain surplus and total cost.
Factors : lead time, reliability, quality, and design Capability and price charged by a supplier.
Supplier selection uses the output from supplier scoring and assessment to identify the
appropriate supplier(s). A supply contract is then negotiated with the supplier. A good contract
should account for all factors that affect supply chain performance and should be designed to
increase supply chain profits in a way that benefits both the supplier and the buyer.
Design collaboration allows the supplier and the manufacturer to work together when designing
components for the final product. Design collaboration also ensures that any design changes are
communicated effectively to all parties involved with designing and manufacturing the product.
Once the product has been designed,
procurement is the process whereby the supplier sends product in response to orders placed by
the buyer. The goal of procurement is to enable orders to be placed and delivered on schedule at
the lowest possible overall cost.
Finally, the role of sourcing planning and analysis is to analyze spending across various
suppliers and component categories to identify opportunities for decreasing the total cost.
Supplier selection
Before selecting suppliers, a firm must decide whether to use single sourcing or multiple
suppliers. The selection of suppliers is done using a variety of mechanisms, including offline
competitive bids, reverse auctions, or direct negotiations. No matter what mechanism is used,
supplier selection should be based on the total cost of using a supplier and not just the purchase
price.
Some of the auction mechanisms that are often used in practice are as follows:
• Sealed-bid first-price auctions require each potential supplier to submit a sealed bid for the
contract by a specified time. These bids are then opened and the contract is assigned to the
lowest bidder.
• In English auctions, the auctioneer starts with a price and suppliers can make bids as long as
each successive bid is lower than the previous bid. The supplier with the last (lowest) bid
receives the contract. The difference in this case is that all suppliers get to see the current lowest
bid as the auction unfolds.
• In Dutch auctions, the auctioneer starts with a low price and then raises it slowly until one of
the suppliers agrees to the contract at that price.
• In second-price (Vickrey) auctions, each potential supplier submits a bid. The contract is
assigned to the lowest bidder but at the price quoted by the second-lowest bidder.
In multiunit Dutch auctions, the buyer starts by announcing a low price and then raises it slowly
until a supplier is willing to provide one unit of the goods or services. The price is raised slowly
until suppliers have committed to all units of goods or services desired by the buyer. In this
auction, each unit is supplied at a different price.
In a multiunit English auction,the buyer starts at a high price and bidders announce the quantity
they are willing to supply. If the total quantity that suppliers are willing to supply exceeds the
desired quantity, the buyer lowers the price until the quantity for which suppliers bid equals the
desired quantity. All suppliers then get to supply at this price. This auction is also referred to as
the uniform-price auction.
Suppliers in either auction can raise the final price by colluding and forming a bidding ring that
assigns only one bidder to enter the auction process for the entire ring. After the initial auction,
the ring then has a separate auction to divide up the quantity it has been assigned among its
members.
Supplier Assessment Methods
There are two main approaches used in selecting suppliers:
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
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.
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:
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:
Introduction Stage
Involves setting agenda, rules and procedures and create a conducive environment.
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.
It is important to record full details of the negotiation .The minutes of the meeting can be
used to serve this purpose.
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.
2.3.5 Contracts
1. How will the contract affect the firm’s profits and total supply chain profits?
2. Will the incentives in the contract introduce any information distortion?
3. How will the contract influence supplier performance along key performance measures?
Ideally, a contract should be structured to increase the firm’s profits and supply chain profits,
discourage information distortion, and offer incentives to the supplier to improve performance
along key dimensions. Many shortcomings in supply chain performance occur because the buyer
and supplier are different entities, each trying to optimize its own profits.
Three contracts that increase overall profits by making the supplier share some of the buyer’s
demand uncertainty are as follows:
3. Quantity flexibility contracts: Under quantity flexibility contracts, the manufacturer allows the
retailer to change the quantity ordered (within limits) after observing demand.
The goal of supplier management and supplier development is a world class supply base.
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”.
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:
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
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
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.
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.
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.
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.
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.
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.
Global sourcing comprises both shared services and outsourcing solutions that can be
implemented domestic and offshore.
Factors:
Material costs
Transportation costs
Quantitative aspects:
- Logistics
- Economics
- Quality
Qualitative aspects
- Political
- Legal
- Cultural
- Bureaucratic
- Environmental
- Ethical nature
- Distance – the distance between the buyer and selling firm is significant in terms of time
zones and physical location
- Quality issues – the buying firm must spend the necessary time to correctly specify and
articulate quality expectations
- Pipeline inventory – this will always occur when a third party is involved