Operations Strategy

Session 7&8: Strategic Sourcing

Dr. Partha Priya Datta
IIM Calcutta
 General Rationale for Outsourcing and
Offshoring
Outsource
Pro Con
• Operational and strategic focus • Strategic risks:
• Cost and risk pooling efficiencies: • Dependence/Loss of control
•Scale economies • Leakage of proprietary skills/
•Risk pooling information;
• Operational and financial flexibility • Incentive problems (hold up, dual
• Access to technology/innovation marginalization)
• Market competition/discipline • Transaction costs
• No “learning by doing/owning”

Pro Con
• Cost reductions • Transportation costs
• Proximity to local or new markets • Lead times
• Domestic labor market constraints • Risks
Offshore • Operational hedge • Quality, including health,
• Foreign trade barriers environmental and CSR
• Currency, IP, political,
competitive
• Domestic trade barriers
• Global operations’ complexity and
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social implications
 Strategic Sourcing
A strategic framework
1. Is outsourcing feasible?
No
 Is a stable supply base with necessary capabilities available?
 Is outsourcing politically viable?
Yes
Yes 2. Is outsourcing necessary?
 Are internal financial and operational capabilities insufficient?
No
3. Is outsourcing in line with strategic priorities and risks? No
 Is this activity “non-core”?
 Is the risk of outsourcing it tolerable?
Yes
4. Is outsourcing desirable given our value proposition? No
 Can external suppliers do it better? (TCO & NPV)
Yes
5. Do we have the ability to manage suppliers and ongoing risk?
 Can we contract on detailed requirements?
 Can we coordinate incentives and operational flows?

Easy Difficult Impossible

Market Buy Long Term Relationships Vertical Integration

 Sourcing Strategy
What is it?
= Deciding on appropriate supply relationships for each activity.

Three step approach:

1. Identify the activity and its requirements;
2. Make-or-buy decision: which activities are internal or not?
3. SRM: define, contract and manage the supplier relationship

Distinguish:
• Strategic buyers: lead cross-functional sourcing teams that
develop sourcing strategy
– CPO, global commodity managers, commodity business plan
• Tactical buyers: execute transactional purchase order
processes
 Sourcing Strategy
Why it is important ?
• Purchasing, sourcing, procurement is the biggest single cost for most firms
– Accounts for 60% of the average company’s total cost
• Great potential for bottom-line improvement.
– E.g., 20% profit margin and purchasing is 85% of COGS.
• Price = $100, COGS = $80, Purchasing = .85*$80 = $68
• Say purchasing improves 10%
• Then margin becomes $20+$6.8, which is a 34% increase
• And even greater leverage on net income!

• Sourcing must be strategic:

1. Cost containment is fundamental
– Control prices and prevent wasteful spending
2. If well practiced, it can also drive innovation, quality, flexibility or
responsiveness
– Need talent and mindset beyond transactional purchasing
– Need to integrate with overall operations strategy
Sourcing Strategy: What Can Be Sourced ?

• Design of part of all of a product or service

• Manufacturing or delivery of a complete product or
service
• Manufacturing or delivery of some or all of the
components or modules of a product or service
• Extraction and processing of raw materials
• Processing equipment for both manufacturing and
services
• Logistics and supply chain services
• IT and other services
 Sourcing Strategy Questions
• How many suppliers should the company engage in
total and for a given part or commodity?
• What role should each supply play?
• Should overseas sourcing be used, and if so, how
much?
• How should supplier relationships be structured and
managed?
 Choosing the Right Number of Suppliers: Value
to Reducing the Supply Base
• Lower cost and effort to manage relationships overall
• Greater potential to coordinate designs
• Increased capability to synchronize schedules
• Increased capability to evaluate suppliers on multiple criteria,
not just cost
• Capabilities of procuring modules rather than parts
• Ease of tracking performance
• Ease of exchanging information
 Choosing the Right Number of Suppliers:
Disadvantages to Multi-tier Supply Chains
• Lack of visibility over inventory leading to:
– More stockouts as information is late to arrive from lower levels of the
supply chain
– More inventory throughout the supply chain as each tier buffers
against uncertainty
• Increased cost of quality
• Greater demand volatility
• Diminished new product or service performance:
– Increased cycles times
– Less effective optimization of integral designs
 Choosing the Right Number of Suppliers: Per
Item Outsourced Depends On -
• Uniqueness of sourced item or equipment
• Viability and reliability of suppliers
• Stability of the technology associated with the item being
sourced
• Significance of the buying company’s business to the total
business of the supplier
• Branding implications of sourcing decision
• Competitiveness of market
Structuring Supplier Relationships: Types of Supplier Relationships
Structuring Supplier Relationships: Choosing the
Right Type of Relationship
 Structuring Supplier Relationships: Incentives
and Contracts
• To improve flexibility
– e.g., minimum guarantees for certain volumes
– e.g., vendor managed inventories
• To optimize inventory and stockout trade-offs
– e.g., supplier allows returns
– e.g., revenue sharing
 Simple Contracts
• Fixed Price
• Cost Plus
• Transaction based
Performance-pay (pay at risk) incentives can be tied to any of the
contracts

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 Structured Contracts:
Sourcing & business unit Manufacturing & financial
executives executives

Structured contracts

Buyers Collaboration technology Suppliers

Designs Forecasts Capacity Transactions

The supply chain sees: By dramatically increasing the

 Decreased cycle times speed of information flow.
 Reduced inventory
 Integrated work flows By aligning business objectives
 Greater supply chain and investments, using information
throughput about uncertainty, and allocating risk
to the parties best able to manage it.

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 Structured Contracts
define a supply service agreement
AVAILABILITY AND RESPONSIVENESS PRICE

1 How many can I buy? Quantities guaranteed available w/i 3 month LT $400 per unit
2
Q1’06 1000 units per month 3
Q2’06 1000 units per month
2 When can I get them?
Q3’061 2000 units per month
Q4’06 3000 units per month
3 At what price?
Add’l quantities guaranteed available w/i 1 month $425 per unit
2
Q1’06 400 units per month 3
Q2’06 400 units per month
Q3’061 800 units per month
Q4’06 1000 units per month

NON-PERFORMANCE

1% of unit price earmarked by Supplier for every day late, applied at

4 What if . . . ? end of 6 months towards AOS corrective action at buyer’s discretion

BUYER LIABILITY (COMMITMENT) PRICE

Quantities buyers commits to buy $400 per unit

5 My commitment ? Q1’06 100 unit per month
Q2’06 100 unit per month
Q3’06 400 units per month
Q4’06 400 units per month

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