LOG 408: Global Logistics Management Lecture 3: Outsourcing and Procurement

Key Points of Last Lesson Rapid growth of international trade in recent decades Measuring logistics performance of countries (LPI & LSCI) What is globalization, is it good or not? The positions of countries in globalization, as well as its drivers The role of multinational companies in global trade, and the impact of their overseas investments Directional imbalances in freight volumes and solutions

Trends in the manufacturing sector due to globalization Global competition Global sourcing Global value chains resulting in increasing complexity and competition Global access to knowledge and new technologies SCM expertise and innovation play more roles for business success

Outsourcing The transfer of to a third party of the management & delivery of a process previously performed by the company itself It can happen within same country Offshore outsourcing: Outsourcing to firms in faraway countries, often lower cost locations Most prominent outsourcing locations: China (manufacturing) and India (service) e.g., Volvo Trucks (India)

Some observations on outsourcing Outsourcing components have increased progressively over the years Some industries have been outsourcing for an extended time Fashion Industry (e.g., Nike) (all manufacturing outsourced) Firms outsource to reduce cost, not only manufacturing, inventory, and transportation cost, but also capital costs Electronics Industry Cisco (major suppliers across the world) Apple (over 70% of components outsourced)

Supplier Footprint Supply Strategies have changed over the years American automotive manufacturers 1980s: Suppliers either in the US or in Germany. 1990s: Suppliers in Mexico, Spain, and Portugal. 2000s: Suppliers in China High-tech industry 1980s: Sourcing in the US 1990s: Singapore and Malaysia 2000s: Taiwan and mainland China Challenge: Strategy should depend on the type of product or component purchased

It Covers not just Manufacturing but Product Design, Too… Taiwanese companies now design and manufacture most laptop sold around the world (e.g., Quanta, Compal) Brands such as Hewlett-Packard and PalmOne collaborate with Asian suppliers on the design of their PDAs.

Questions/Issues with Outsourcing Why do many technology companies outsource manufacturing, and even innovation, to Asian manufacturers? What are the risks involved? Should outsourcing strategies depend on product characteristics, such as product clockspeed, and if so how? What should be considered in the buy /make decision process?

Discussion Watch a Video on outsourcing and discuss author’s proposition: Outsourcing is bad for business (http://www.youtube.com/watch?v=V7fsEIp2r_8) The author’s reasoning: Cost Risk Core competency Are they valid?

Outsourcing Benefits (1) Economies of scale & risk pooling Aggregation of multiple orders reduces costs, both in purchasing and in manufacturing e.g., Dell outsources design and production of processors in its PCs to Intel. Intel supplies many computer manufacturers and gains economies of scale that are not available to Dell if it designs and produces its own processors. Demand uncertainty transferred to the suppliers Suppliers reduce uncertainty through the risk-pooling effect Reduce capital investment Suppliers’ higher investment shared among customers.

Outsourcing Benefits (2) Focus on core competency Buyer can focus on its core strength Allows buyer to differentiate from its competitors Increased flexibility The ability to better react to changes in customer demand The ability to use the supplier’s technical knowledge to accelerate product development cycle time The ability to gain access to new technologies and innovation. Critical in certain industries: High tech where technologies change very frequently Fashion where products have a short life cycle

Outsourcing Risks Underestimating the cost/effort of coordination. Reduced customer/supplier contact. e.g., Boise Cascade outsourced all its outbound distribution to 3rd parties and lost considerable contact with its customer base. Solution: BC in-sourced distribution in the local area while letting much of its distribution be handled by 3rd parties. Loss of internal capability and growth of 3rd party power. e.g., computer industry in the mid 1980’s. Conflicting objectives between suppliers and buyers Leakage of sensitive data and information.

Example of Outsourcing Problems IBM in PC industry market entry in 1981 Outsourced many components to obtain market quickly 40% market share by 1985 beating Apple as the top PC manufacturer Other competitors like Compaq used the same suppliers IBM tried to regain market by introducing the PS/2 line with the OS/2 system Suppliers and competitors did not follow IBM market share shrunk to 8% in 1995 Behind Compaq’s 10% leading share Led to eventual sale of PC business to Lenovo

A Framework for Make/Buy Decisions How can the firm decide on which component to manufacture and which to outsource? Focus on core competencies How can the firm identify what is in the core? What is outside the core? The Fine/Whitney framework. Reasons for outsourcing: Dependency on capacity – has the knowledge but decides to outsource Dependency on knowledge – doesn’t have the knowledge (people or skills) to produce the product

Outsourcing Decisions at Toyota About 30% of components in-sourced Engines: Company has knowledge and capacity, all are produced internally Transmissions Company has the knowledge, designs all components, but depends on its suppliers’ capacities, 70% outsourced Vehicle electronic systems Designed and produced by Toyota’s suppliers, it has dependency on both capacity and knowledge Toyota varies its outsourcing practice by the strategic role of the components and subsystems The more strategically important the component, the smaller its dependency on knowledge or capacity of suppliers.

Product architecture – integral and modular products Components are independent of each other Components are interchangeable Standard interfaces are used A component can be designed or upgraded without regard to other components Customer preference determines the product configuration Integral products Not made from off the shelf components Designed as a system (top-down design approach) Evaluated based on system, rather than component, performance Components perform multiple functions

A Framework for Make/Buy Decisions based on internal ability Product Dependency on knowledge and capacity Independent for knowledge, dependent for capacity Independent for knowledge and capacity Modular Outsourcing is risky Outsourcing is an opportunity Opportunity to reduce cost through outsourcing Integral Outsourcing is very risky Outsourcing is an option Keep production internal 3-17

More external factors to consider on the make /buy decision Important criteria: Importance of the component to the customer. Component clockspeed. Competitive position. Capable supplier base. Architecture. For example, component is important to the customer, clockspeed is fast, firm has competitive advantage => keep manufacturing in-house, independent of number of suppliers and the component architecture

Examples of Decisions Criteria Example 1 Example 2 Example 3 Example 4 Customer Importance Important Not important Clockspeed High Slow Competitive Position Competitive Advantage No advantage Capable Suppliers X Key variable to decide strategy Architecture DECISION Inhouse Outsource Inhouse, Acquire suppliers, Partnership Outsource with modular, Inhouse or joint development with integral 3-19

Overview of Sourcing Decision In-house or outsource? If outsourcing, then select the suppliers. How many and who? What is process and criteria for selection? Procurement – the process in which the supplier sends product in response to customer orders.

Criteria for evaluating and selecting outsourcees Minimum requirements: Reliability of delivery on time Quality certifications Conformance to agreed specifications Delivery lead time Financial capability Performance track record Price or cost reduction Senior management attitude Responsiveness to demand uncertainty Record of corporate social responsibility

Procurement Strategies Impact of procurement on business performance 2005 profit margins for Pfizer (24%), Dell (5%), Boeing (2.8%). Reducing procurement cost by exactly 1% of revenue would have translated directly into bottom line, i.e., net profit. To achieve the same impact on net profit through higher sales Pfizer would need to increase its revenue by 4.17 (0.01/0.24) % Dell by 20% and Boeing by 35.7% The smaller the profit margins, the more important it is to focus on reducing procurement costs.

Fisher’s functional vs. innovative products

Functional and Innovative Products Functional Products Diapers, soup, milk, tiers Focus: efficiency, cost reduction, and supply chain planning. Innovative products Fashion items, cosmetics, or high tech products Focus: high profit margins, fast clockspeed, and unpredictable demand, responsiveness, maximizing service level, order fulfillment

Procurement Strategy Functional Products Focus should be on minimizing total landed cost unit cost transportation cost inventory holding cost handling cost duties and taxation cost of financing Sourcing from low-cost countries, e.g., mainland China and Taiwan is appropriate Innovative Products Focus should be on reducing lead times and on supply flexibility. Sourcing close to the market area Short lead time may be achieved using air shipments

Questions to think What are the most frequently reported problems in outsourcing? How would you argue with the youtube video on “outsourcing is bad”? Discuss the appropriate sourcing strategy for a component with low customer importance, fast clockspeed, and no competitive advantage. Should it be made in-house or outsourced?