Chapter 7: Procurement And Outsourcing Strategies

Chapter 7: Procurement And Outsourcing Strategies
CASE: FreeMarkets Online, Inc. Procurement And Outsourcing Strategies Prepared by Hoon Lee Date on 8th June, 2007 * 참고) Shin, Sang-hoon 학생 자료를 참고하여 작성되었음.

CASE: FreeMarkets OnLine, Inc.
Introduction Glen Meakem and Sam kinney are cofounders. They focus on how to position their company, both with clients and the capital markets. January 1998, their revenues were sufficient to cover its $300,000 monthly burn rate. 1997 revenues of almost $1.8 million and was aiming for over 200% growth in 1998 to $6 million. They needed to lay out a clear and compelling strategy that would create the most value. To raise a large amount of growth capital and provide investor liquidity through an IPO. * 참고) IPO (Initial Public Offering): 기업공개, 유가증권시장이나 코스닥시장에 상장한다는 의미

Founding Be founded in Pittsburgh in 1995 by three entrepreneurs. Advantage of the city’s unique blend of industrial and high-technology infrastructure. Close to major manufacturing centers, a hub airport. A strong local skill base in both software and manufacturing. Having purchased the interests of the third founder, for all practical purposes. * 참고) Pittsburgh: 세계적인 제철공업 지대, 원자력·알루미늄·기계·유리 등의 각종 공업도 활발, 피츠버그대학교·카네기공과대학교

Founding End of 1993, Meakem had stumbled on a very big opportunity. Having worked on purchasing studies for clients in McKinsey’s Houston office. He knew that … Industrial buyers faced tough challenges sorting through the variety of supplier. The average skill level of buyers in a wide range manufacturing companies was low and make decisions was very limited Identifying truly high-quality suppliers while also estabilishing fair market prices was extremely difficult. -> Industrial buyers were unaware of the savings opportunities still lurking beneath their decisions.

Founding Meakem’s experience about “Silent auctions” A group of suppliers would be assembled in a hotel ballroom surrounded by flip charts. Prices dropped as suppliers participated in this open-price discovery process. The logistical difficulties of bringing together all of the suppliers made these events difficult to replicate Meakem’s experience about “The Logic of Electronic Markets” is issued of Harvard Business Review on May-June 1989. Electronic markets offer cross-company electronic connections, Just as single-source sales channels do. and therefore give customers the same convenience.

Founding Meakem’s experience about “The Logic of… Customers have electronic connections to their suppliers, they can also choose which suppliers they want to use. From the customers’ perspective, electronic markets are more desirable than single-source sales channels If the technology exists to create electronic markets and customers want them -> It’s just time matter He left McKinsey to join a Fortune 50 company’s corporate business development group, He began working on purchasing improvement projects.

Founding The Interactive bidding system was fielded in September – Interactive bidding among competing suppliers generated price savings. Some Important groundwork had to be put in place. First, The Bidding was only as good as the product specifications. The Supplier need a precise understanding of the components or materials. Second, The Results depend upon having the right suppliers involved. When these “lower-tech” issues were not addressed, electronic markets failed. Makern concluded that he would have to make

Founding Meakem set up shop in his basement. It’s an interesting challenge. Early entrepreneurial ventures start with very little – no team, no cash, no market, no technology, no product, no customers, and no business model Fortunately, I did have four critical assets : an idea, experience, my Rolodex of contacts from my previous experiences, and about $75,000 of savings. My wife Diane, two children under three years of age, was very supportive.

Founding Sam Kinney had several years experience at Booz-Allen, McKinsey and Lucas Aerospace. Sam Kinney described the genesis of the firm: Glen and I had been colleagues at McKinsey after graduated. Glen and I left McKinsey after two years. When Glen came up with the electronic bidding idea, I jumped up. We knew each other and liked working together and had similar entrepreneurial aspirations.

Founding Meakem explained how they arrived at the name : You have to balance multiple objectives. The name must evoke in potential clients and investors a sense of what the business does. We also felt that with the pace of Internet start-ups, there would be a land gram for good names in this field. They settled on FreeMarkets Online to satisfy. First, It seemed to portray the essence of what the business would do. Second, It appeared to be available for trademark registration. Third, It would signal to investors through “Online”

Software Development Creating bidding system became the most time-consuming early challenge. By mid 1995, Internet was just beginning to be recognized as a powerful new medium. Netscape’s IPO is one of milestone events. Internet service providers were in the throes of upgrading 28.8 modem speed and meeting demand.

Software Development FreeMarkets wanted the system to be fast, allowing real-time interaction. That presented some technical challenges. According to Vincent Rago, vice president of Information Technology : Our needs have always been one step ahead of the development tools. We have had to solve problems before ready-made solutions. Despite the lack of tools, BidWare®, BidServer® software was tested by October November 1995, the S/W conducted a live bid for about $3.2 million worth of injection-molded plastic appliance parts. Bidding for air-conditioning equipment with 12 suppliers. Buyer saved more than $400,000. * 참고) CBE (Competitive Bidding Event)

Software Development The first CBE was also a resounding confirmation of the company’s ability to design, build, and ship user-friendly commercial software. The need for software to be self-trainable and easy to use for “normal” people. We can understand a market need, then design, build, and test complex, wide-area-networked, client-server applications by using early version of BidWare®. In what has been a capital-constrained environment, our S/W development team has not wasted any money

Software Development Addressing the issue of how to successfully build software, Vincent Rago offered this perspective : Money is not the key issue in software development. Focus by the development team on a real set of customer needs, including high-level market or business needs, detailed functionality, and usability.

The Market According to Kinney there ware many reasons why buyers should find value in a service that helps assemble suppliers into electronic bidding sessions : Many supply industries are very fragmented. In some of these industries the productivity variance between suppliers in the top quartile and the bottom quartile is simply enormous. In the face of this fragmentation and variation, buyers are left with an information problem.

The Market

The Organization

The Market-Making Process Phase1 : Indentify savings opportunities Phase2 : Prepare total-cost RFQ Phase3 : Identify, screen, and support suppliers Phase4 : Conduct on-line competitive bidding events Phase5 : Provide post-bid analysis and award support

The Revenue Model “The revenue-generation model is at the heart of our new business development process” 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

The Revenue Model 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

A Successful Start

Going Forward To Scale Horizontal market expansion or vertical market dominance? Technology and user support subscription licensing? Networked purchasing information Systems?

Procurement And Outsourcing Strategies

7.1 Introduction In the 90s, outsourcing was the focus of many industrial manufacturing. Executive were focused on stock value, so that press the organization to increase profits. On easy way is outsourcing. The instance of Nike The largest supplier of athletic shoes in the world. Focuses mainly on research and development - Marketing, sales, and distribution. This strategy allowed to grow in the 90s at an annual rate of about 20%.

7.1 Introduction The instance of Cisco Specializing in enterprise network solution. “Global virtual manufacturing strategy” Manufacturing plants all over the world Close arrangement with major suppliers -> Cisco’s single-enterprise system Building dynamic replenishment system to help reduce supplier inventory. The instance of Apple Outsource most of its manufacturing activities. Almost 70% Focus its internal resources on its own disk operation system and the supporting macro software to give Apple products their unique look and feel

7.1 Introduction Unfortunately … Nike in 2001 Unexpected profit shortfall. Shortages for others as well as late deliveries Apple in 1999 Shortage in the G4 chip supplied by Motorola Cisco in 2000 Focus on obsolete inventory in 2000 Cisco was not able to respond effectively against demand of telecommunication infrastructure. Solutions … Short life-cycle products, where technologies change rapidly and uncertainty in customer demand. -> buy/make decision process, procurement process

7.2 Outsourcing Benefits And Risks Some of the motivations for outsourcing are … Economies of scale Risk Pooling Reduce capital investment Focus on core competency Increase flexibility The instance of IBM Outsourced microprocessor to Intel. Outsourced operating system to Microsoft. By 1985, number one supplier of PC Compaq was competitor

7.2 Outsourcing Benefits And Risks Substantial risk associated with outsourcing Loss of competitive knowledge Conflicting objectives

7.3 A Framework for Buy/Make Decisions Dependency on capacity Dependency on Knowledge Toyota Example 30% of its car components design and make Having both knowledge and capacity to product its engines - 100% of engines are produced internally For transmissions, having knowledge and designs - depending on its suppliers’ capacities, since 70% outsourcing Vehicle electronic systems are designed and produced by outsourcing

7.3 A Framework for Buy/Make Decisions Distinguishing between integral and modular products by Ulrich and Swaminathan Modular products: Components are independent of each other Components are interchangeable Standard interfaces are used A component can be designed or upgraded with little or no regard to other components Customer preference determines that product configuration

7.3 A Framework for Buy/Make Decisions Integral product Integral products are not made from off-the-shelf components Integral products are designed as a system by taking a top-down design approach Integral products are evaluated based on system performance, not based on component performance Components in integral products perform multiple fuctions

7.4 E-Procurement The start-up e-market: Serving as an intermediary between buyers and suppliers Identifying saving opportunities Increasing the number of suppliers involved in the bidding event Identifying, qualifying, and supporting suppliers Conducting the bidding event 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

7.4 E-Procurement 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

7.4 E-Procurement Evolution Value-added independent (public e-markets) By offering additional services (inventory management, supply chain planning and financing services. Private e-markets Ex) Dell, Sun, Wal-Mart,etc. Consortia-based e-markets Estabilised by a number of companies within the same industry Content-based e-markets Focus on maintenance, repair, portions

7.4 E-Procurement

7.5 A framework for E-Procurement 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

7.5 A framework for E-Procurement Type of Component 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

7.5 A framework for E-Procurement Type of Component 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 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

7.5 A framework for E-Procurement Type of Component 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

7.5 A framework for E-Procurement Type of Component 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

7.5 A framework for E-Procurement Type of Component Portfolio approach Inventory Risk (Supplier) (Buyer) Price, Shortage Risks N/A Commitment Level Option Level L H H L

Chapter 7: Procurement And Outsourcing Strategies

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