Procurement and Outsourcing David Simchi-Levi Philip Kaminsky Edith Simchi-Levi Phil Kaminsky kaminsky@ieor.berkeley.edu

Lecture Outline 1) FreeMarkets Online 2) B2B Strategies 3) B2B Pitfalls 4) Outsourcing

FreeMarkets Online FreeMarkets is an online market making firm that enabled industrial buyers to link up with their potential suppliers in a live electronic bidding The end result of such interaction among a network of suppliers was procurement cost savings of about 15% for the buyers The company was founded in 1995 and was on the verge of breaking even in 1998 It was expecting to receive commissions and fees of nearly $6 million for arranging procurement of ~$200 million worth of industrial components and parts

The Move to B2B Commerce

B2B is Huge... Business-to-Consumer 2003 $1.3 Trillion Business-to-Business 2002 $843B 2001 $499B 1999 $109B 1998 $43B 2000 $251B Source: Forrester Research, Inc.

Highly Fragmented Most product categories are highly fragmented, with numerous suppliers each offering different level of quality, service and pricing options Buyers incur significant cost in the actual purchase process A buyer must invest internal resources to manage the process of collecting, analyzing and acting upon all the information in the market In addition to purchase price companies spend over 10% in additional procurement costs On the suppliers side, there are significant costs in using the manufacturing reps These commissions range from 4% to 7% of purchase price

How Does FreeMarkets Online Create Value for its Customers? Consulting/Purchase outsourcing Putting together specs, drawings, lot sizes, documentation and RFQs Identifying potential savings opportunities Identifying and qualifying suppliers Educating and training buyers Conducting the Competitive Bidding Event (CBE) Providing post bid analysis and support

How Does FreeMarkets Online Create Value for its Customers? Consulting/Purchase outsourcing Distribution Intermediary

Traditional B2B Trading Exchanges Industrial Buyer Manuf. Rep. Supplier 1 Supplier 2 Supplier 3

Internet Based B2B Trading Exchanges Industrial Buyer FreeMarkets Online Supplier 1 Supplier 2 Supplier 3

How Does FreeMarkets Online Create Value for its Customers? Consulting/Purchase outsourcing Distribution Intermediary Network Enabler/Software Provider

What are the Barriers for the buyers? Elimination of established relationships with the suppliers and their representatives Elimination of manufacturing reps could result in loss of convenience

What is the value to the suppliers? Less value for the suppliers Commission costs fell from 7% to 2.5% Table 7.5 implies reduction in commission by $174M(4.5%)=$8M Table 7.5 also shows $35M drop in revenue for the suppliers Suppliers could benefit from lower sales, marketing and distribution costs and better utilization of capacity

Which suppliers benefit from this model? Low cost, quality suppliers will benefit as they drive competition out of the market The FreeMarkets model would be beneficial for large more efficient suppliers It will also provide opportunities for a host of small suppliers, especially if they are located overseas

The Revenue Model A hybrid of service fees and sales commissions FreeMarkets charged monthly fee from the buyer based on the size of the market making team dedicated to the event Winning supplier paid sales commissions; this was paid in installments as suppliers shipped products

Problems with the revenue model Buyer side: FreeMarkets invests substantially in a project Consulting revenue is independent of the value created Does not lead to another intensive purchasing study for the customer Gross margin on consulting is about 22% Doesn’t scale well Supplier side: FreeMarkets does not represent the supplier FreeMarkets success depends on their ability to identify many potential suppliers Suppliers pay commissions to the company that reduced their margins

Vertical vs Horizontal Focus? Advantage: FreeMarkets can capitalize on its deep knowledge of supplier industries Disadvantage: Hard to scale-up Horizontal: Advantage: Ability to generate multiple contracts from one buyers Disadvantage: FreeMarkets does not bring much expertise to the transaction

How about licensing the technology? Are buyers capable of using the technology by themselves? If not, how will this hurt? If they are, where is revenue going to come from? How can these problems be addressed?

By the end of 1998… FreeMarkets was pursuing the horizontal market expansion In 2000, the company started licensing its software

The company went public in 12/99... Freemarket’s Stock Price

Where is FreeMarkets today? For the three months ended in 3/31/01 Revenue totaled $33M Net loss totaled $43.7M For the three months ended in 12/31/01 Revenue totaled $44.8M Net loss totaled $2.8M

E-Marketplaces: The Initial (95-99) business model The e-marketplace concept started as a new way to procure products, particularly non-production items. E-marketplaces Expand everyone’s market reach Generate lower price for the buyers Cut operational costs for buyers and suppliers Automating the procurement process will reduce processing cost per order from as high as $150 to as low as $5 per order Focus on liquidity Transaction fee paid by the suppliers Serve as a virtual distributor

Problems with this Business Model Sellers resist paying a fee to the company whose main objective is to reduce the purchase price Buyers resist paying a fee The revenue model needs to be flexible Sometimes the wrong party is charged Low barriers to entry created a fragmented industry flooded with participants Just in the chemical industry there were about 30 e-markets

Continuous evolution of the business model Transaction fees (typically paid by the sellers) Sometimes the wrong party is charged Buyers and suppliers resist paying Subscription fees (typically paid by the buyer) Depends on a number of dimensions Licensing the software

Evolving Market Types Value-added independent e-markets They are expanding their offering to include inventory management and financial services (Zoho); supply chain planning (Covisint, e2open, Converge, TheSupply)

Consider Instill Corp. Instill.com focuses on the food service industry and provides an infrastructure which links together operators, i.e., restaurants, distributors and manufacturers. This e-marketplace provides value to its customers by offering not only procurement services, but also forecasting, collaboration and replenishment tools.

Consider eSkye.com In the alcoholic beverage industry, eSkye has tailored an offering that provides the supply chain with real value. eSkye now links retail stores, distributors and suppliers providing visibility into a supply chain where little data existed. eSkye adds value by automating the ordering process for the retailer while providing product flow information to distributors and suppliers.

Evolving Market Types Private e-Markets Valuechain.Dell.com (Dell), eHub (Cisco) IBM, Sun Microsystems and Wal-Mart These companies use the marketplace to improve supply chain collaboration Providing suppliers with demand information and production data

Evolving Market Types Consortia-based e-markets…. Covisint (automotive); Trade-Ranger (oil); Omnexus (chemicals); e2Open and Converge (high-tech) Objective of the consortia is Aggregate activities and use the buying power of consortia members Provide suppliers with standard systems that support all buyers and allows suppliers to reduce cost

Evolving Market Types Content based e-markets…. Focus on Maintenance, Repair and Operations (MRO) goods These are components that are not part of the finished product or the manufacturing process but are essential for the business Examples include lighting, office supply, fasteners,…

E-marketplace Examples Independent Vertical Exchanges (IVX) Independent Horizontal Exchanges (IHX) Consortia Trading Exchanges (CTX) Private Trading Exchanges (PTX)

Private vs. consortium-based public markets Owner Single vs Co-Op Objective Private: (i) Share proprietary data (ii) allow for SC Collaboration Consortia: (i) Buying/selling commodities (ii) Finding new suppliers Participants Private: Selected group of suppliers Consortia: Open Market Buyer Cost Private: Building and maintaining the site Consortia: Subscription fee; licensing fee

Private vs. consortium-based public markets Supplier Cost Private: No fee Consortia: Subscription fee; Transaction fee Challenges Private: Initial investment Consortia: (i) Many have recently collapsed; (ii) preferred suppliers may object because of price focus; (iii) Sharing proprietary data (iv) developing standards

Private vs. consortium-based public markets Automotive Industry Covisint was established in early 2000 by the Detroit’s big three automakers It now also includes Renault, Nissan, Mitsubishi and Pegeot Volkswagen established its own private e-market Volkswagen e-market provides not only similar capabilities to that of Covisint but also real-time information on production plans so that suppliers can better utilize resources

Consider IBM IBM has saved about $1.7 billion since 1993 by being able to divulge sensitive price and inventory information over a private exchange built for 25,000 suppliers and customers, says Bill Paulk, IBM's vice president of e-marketplaces. As host of the exchange, the company helped defray the cost of connecting suppliers. The payoff: On-time delivery to customers soared from about 50% to close to 90%, "which helped justify the cost," Paulk says. E2open: A consortia based e-marketplace established in 1999

A Framework for eProcurement Type of Component Strategic Components Part of the finished product Not industry specific; company specific Examples: PC motherboard and chassis Commodity Products Can be purchased from a large number of suppliers Price is determined by market forces Examples: Memory unit in a PC Indirect Material MRO

A Framework for eProcurement Level of Risk Uncertain Demand (Inventory risk) Volatile market price (Price Risk) Component availability (Shortage Risk)

Risk: Commodity Products Can be purchased either in the open market through on-line auction, or through the use of long term contracts Long term contracts guarantee certain level of supply but may be risky for the buyer Inventory risk, shortage risk or price risk

A Framework for eProcurement Indirect Material Typically low risk and hence the focus is on content based hubs. The objective is to use an MRO-hub that specializes in unifying catalogs from many suppliers Examples: MRO.com, Grainger on-line catalogs

Grainger W. W. Grainger has been selling industrial supplies for 72 years In 1995 Grainger established Grainger.com, an on-line catalogue for more than 220,000 products from 12,000 suppliers In 1999, Grainger experienced revenue growth of $102M through its internet channel The MRO supply industry is growing at a rate of 3-4% a year. From 1996 to 1999 Grainger internet sales grew 32% a year and 20% in offline due to customers that were lured to Grainger from the web site

A Framework for eProcurement Strategic Components Typically high risk components that can be purchased from a small number of suppliers The objective is to use private or consortia-based e-marketplace. The focus is on an e-marketplace that allow collaboration with the suppliers

Consortia or Private? Transaction volume Number of suppliers Cost of building and maintaining the site The importance of protecting proprietary business practices Technology and product life cycles

A Framework for eProcurement Commodity Products Products go directly into finished goods High risk Many potential options to choose from Long Term Contracts Buyer and supplier commit to certain volume (called the commitment level) Supplier guarantees a level of supply for a committed price Flexible, or Option Contracts Buyer pre-pay a relatively small fraction of the product price up-front, in return for a commitment from the supplier to satisfy demand up to a certain level (called the option level) The buyer can purchase any amount up to the option level by paying additional price for each unit purchased Spot Purchasing

A Framework for eProcurement: A Portfolio Approach Option Level H L N/A Inventory Risk (Supplier) Price, Shortage Risks (Buyer) Inventory Risk (Buyer) Commitment Level L H

B2B Software Vendors Oracle (Indirect and Direct) i2 Technologies and Manugistics (Direct) Ariba (Indirect and Direct) Commerce One (Indirect and Direct) Agile (Direct) VerticalNet (Indirect)

E-Procurement: The reality Companies conducting greater than 20% of procurement transactions online have reduced their transaction processing cost by nearly a third (Hackett Benchmarking) Product savings and process cost improvements effect operating cost by 10% (Credit Suisse First Boston Technology Group)

E-Procurement: The reality To capture this benefits purchasing organization needs to invest heavily in: Changing internal procurement processes Integrating e-marketplaces in internal systems Purchasing B2B applications, and Paying e-marketplace transaction fee/subscription fee Source: Forrester Research

Positive Aspects of Trading Exchanges (Companies who use exchanges): Reduce costs or labor (31%) Better access to products/vendors (24%) Increase speed or efficiency (29%) Access to more customers (21%) Source: AMR Research

Reduce costs or labor (43%) Better access to products/vendors (26%) Positive Aspects of Trading Exchanges (Companies who plan to use exchanges): Reduce costs or labor (43%) Better access to products/vendors (26%) Increase speed or efficiency (23%) Access to more customers (10%) Source: AMR Research

Negative Aspects of Trading Exchanges (Companies use exchanges): Security trust (17%) Start Up cost (5%) Loss of face-to-face relationships (12%) Lack of standards (5%) Immature technology (5%) Integration issues (7%) Source: AMR Research

Loss of face-to-face relationships (11%) Lack of standards (6%) Negative Aspects of Trading Exchanges (Companies who plan to use exchanges): Security trust (16%) Start Up cost (15%) Loss of face-to-face relationships (11%) Lack of standards (6%) Immature technology (6%) Integration issues (4%) Pricing pressure (6%) Source: AMR Research

Outsourcing An “easy way” to increase profits Nike, Cisco, Apple outsource most of their manufacturing Each could focus on research, marketing Each has gotten into trouble 2001 – Nike reported unexpected profit shortfalls due to inventory problems 2000 – Cisco had to write down billions in obsolete inventory 1999 – Apple was unable to meet customer demand for new products

Outsourcing Benefits and Risks Economies of scale reduce manufacturing costs Risk pooling – demand uncertainties are transferred Reduced capital investment Focus on core competencies Increased flexibility Risks Loss of competitive knowledge Conflicting objectives Flexibility vs. long-term, stable commitments, etc. Consider the IBM PC example.

A Framework for Outsourcing Reasons for outsourcing Dependency on capacity Dependency on knowledge Product architecture Integral products – components are tightly related Designed as a system Not off-the-shelf components Evaluated based on system performance Modular products –independent components

A Framework for Outsourcing (Fine & Whitney) Product Dependent: knowledge, capacity Indep: knowledge Dep: capacity Indep.: knowledge capacity Modular Outsourcing risky Outsourcing oportunity Outsourcing can reduce cost Integral Outsourcing very risky Outsourcing option Keep internal