Business, Operations and Supply Chain Strategy (MS 911) Supply Chain Strategy: Determining organisational boundaries - vertical integration and outsourcing

Teaching schedule, topics 7-12 TopicLecture 7Introduction to supply chain strategy 8Determining organisational boundaries: vertical integration and outsourcing 9Drivers of supply chain performance 10Dynamics of vertical supply networks: demand fluctuations and the bullwhip effect 11International issues in supply chain strategy 12Risk management in supply networks; including the design and management of sustainable supply chains 2

Required reading for this lecture Required reading for this lecture on vertical integration and outsourcing: Hayes, Pisano, Upton & Wheelwright (2005), Operations, Strategy, and Technology – Pursuing the Competitive Edge, chapter 4 Chartered Institute of Purchasing and Supply (2009), Coursebook for the Unit on Strategic Supply Chain Management, 2 nd edition, chapters 14 and 19 3

There are two possible perspectives on the boundaries of the (business) organisation: external perspective: the supply chain internal perspective: the value chain The boundaries of the business organisation 4

production of raw materials by raw material producers storage of raw materials by raw material producers consumption of finished goods by final customers transportation of finished goods to Distribution Centres transportation of raw materials to factory 1 storage of raw materials at factory 1 fabrication of raw materials into components storage of finished goods at factory 2 storage of finished goods at Distribution Centres storage of components at factory 1 assembly of components into finished goods transportation of components from factory 1 to factory 2 storage of components at factory 2 C Transportation of finished goods from Distribution Centres to retailers storage of finished goods at retailers transportation of finished goods from retailers to final customers External perspective: the supply chain 5

C Stages of the supply chain 6 production of raw materials fabrication of components assembly of finished goods distribution of finished goods retailing of finished goods

Position of a focal firm in the supply network CCCC production of raw materials fabrication of components assembly of finished goods distribution & retailing of finished goods 7

The supply network of the industry CCCC production of raw materials fabrication of components assembly of finished goods distribution & retailing of finished goods 8

Vertical integration (VI) Vertical integration occurs when a firm buys one or more other firms: either at the next downstream stage (‘forward integration’ ); or at the next upstream stage (‘backward integration’ ); or both. 9

production of raw materials by raw material producers storage of raw materials by raw material producers consumption of finished goods by final customers transportation of finished goods to Distribution Centres transportation of raw materials to factory 1 storage of raw materials at factory 1 fabrication of raw materials into components storage of finished goods at factory 2 storage of finished goods at Distribution Centres storage of components at factory 1 assembly of components into finished goods transportation of components from factory 1 to factory 2 storage of components at factory 2 C Transportation of finished goods from Distribution Centres to retailers storage of finished goods at retailers transportation of finished goods from retailers to final customers Backward integration 10

CCCC production of raw materials fabrication of components assembly of finished goods distribution & retailing of finished goods 11 Backward integration

production of raw materials by raw material producers storage of raw materials by raw material producers consumption of finished goods by final customers transportation of finished goods to Distribution Centres transportation of raw materials to factory 1 storage of raw materials at factory 1 fabrication of raw materials into components storage of finished goods at factory 2 storage of finished goods at Distribution Centres storage of components at factory 1 assembly of components into finished goods transportation of components from factory 1 to factory 2 storage of components at factory 2 C Transportation of finished goods from Distribution Centres to retailers storage of finished goods at retailers transportation of finished goods from retailers to final customers Forward integration 12

CCCC production of raw materials fabrication of components assembly of finished goods distribution & retailing of finished goods 13 Forward integration

In comparison with downstream operations, upstream operations tend to deal with: more standardised products narrower product lines more automated technology more capital-intensive, and less labour-intensive, processes higher breakeven points higher variability of profits Upstream operations will tend to prioritise resource utilisation, whereas downstream operations will tend to prioritise customer service objectives. 14 Upstream versus downstream

Direction – upstream or downstream or both? Extent – how many adjacent stages should be bought? Balance – should the firm buy up all of its suppliers, or only some and still rely for some materials on others? Or should the firm buy up all of it customers, or only some and still sell some products to others? 15 Decisions in Vertical Integration

Horizontal integration CCCC production of raw materials fabrication of components assembly of finished goods distribution & retailing of finished goods 16

Internal perspective: the value chain The value chain depicts the firm as a collection of value- creating (or value-adding) activities. Porter distinguishes between: five ‘primary’ activities dealing with the flow of (to-be) transformed resources; four ‘support’ activities for the development of the appropriate transforming resources. Value-adding activities, together with the resources needed for them, are organised in the form of business processes. Operations (production) processes are business processes that are mainly concerned with the production of goods or the provision of services to external customers. 17

Diagram of the value chain Primary activities Support activities Human resource management Technology development Procurement Inbound logistics Production operations Outbound logistics Marketing & sales Service Firm infrastructure (e.g. finance, accounting, legal) 18 Margin

Vertical dis-integration refers to the outsourcing of primary (production and distribution) activities. Example: outsourcing by UK manufacturers of production activities to China. Outsourcing (1) 19

Vertical dis-integration Primary activities Support activities Human resource management Technology development Procurement Inbound logistics Production operations Outbound logistics Marketing & sales Service Firm infrastructure (e.g. finance, accounting, legal) 20 Margin

Business Process Outsourcing refers mainly to the outsourcing of support and primary non-production activities; including: IT services (ITO), HR, Finance & Accounting, and Indirect Procurement. Example: outsourcing of IT services to Eastern Europe. Outsourcing (2a) 21

Outsourcing of IT services Primary activities Support activities Human resource management Technology development Procurement Inbound logistics Production operations Outbound logistics Marketing & sales Service Firm infrastructure (e.g. finance, accounting, legal) 22 Margin

Business Process Outsourcing refers mainly to the outsourcing of support and primary non-production activities; including: IT services (ITO), HR, Finance & Accounting, and Indirect Procurement. Example: outsourcing of IT services to Eastern Europe. Marketing & Sales and Service activities. Example: outsourcing of call centre facilities to India. Outsourcing (2b) 23

Outsourcing of call centres Primary activities Support activities Human resource management Technology development Procurement Inbound logistics Production operations Outbound logistics Marketing & sales Service Firm infrastructure (e.g. finance, accounting, legal) 24 Margin

Options for BPO Management consultants One-to-one relationship, with supplier staff on client site Used for customised products, with uncertain business or technical requirements Fee-for-service outsourcing One-to-one or one-to-some relationship, with some supplier staff on client site and other supplier staff on supplier site Used for customised products, with stable business or technical requirements Netsourcing One-to-many relationship; supplier staff is not on client site Used for standard products, with stable business or technical requirements 25

Transaction Costs Economics (TCE) Transaction Costs Economics (TCE) was developed by the economist Oliver Williamson. According to TCE, the firm should buy in those activities for which the sum of production and transaction costs is lower if provided by an external supplier than if provided by the firm itself. Resource-Based View (RBV) Capabilities-Based View 26 Theoretical frameworks to analyse VI and outsourcing decisions

Factors influencing outsourcing decisions Constraints on resources and limits to capabilities Coordination requirements Importance of tacit knowledge Strategic control and risks Threat of ‘hold-up’ (or ‘lock-in’) Protecting intellectual property 27

Lower costs because of: Specialisation, leading to higher productivity Economies of scale Market discipline, leading to high- powered incentives for suppliers Potential disadvantages Potential advantages Higher costs because of: Transaction costs, particularly those relating to transaction-specific investments (TSIs) Increased flexibility and control Reduced flexibility and control Particularly if there are TSIs Openness to externally- generated innovation Loss of internally-generated innovation through learning by doing 28 Potential advantages and disadvantages of outsourcing

Long-term contracts Partnership relationships Minority equity investments Joint ventures etc. To be effective, all of these arrangements rely on the development of mutual trust between the actors. 29 Possible alternatives to full VI or outsourcing