1. Procurement and Outsourcing
David Simchi-Levi
Philip Kaminsky
Edith Simchi-Levi
Phil Kaminsky

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

3. 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

4. The Move to B2B Commerce

5. 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.

6. 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

7. 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

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

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

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

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

12. 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

13. 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

14. 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

15. 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

16. 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

17. 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

18. 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?

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

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

21. 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

22. 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

23. 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

24. 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

25. 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)

26. 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.

27. 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.

28. 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

29. 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

30. 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,…

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

32. 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

33. 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

34. 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

35. 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

36. 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

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

38. 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

39. 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

40. 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

41. 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

42. 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

43. 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

44. 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

45. 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)

46. 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)

47. 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

48. 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

49. 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

50. 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

51. 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

52. 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

53. 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.

54. 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

55. 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