Strategic Outsourcing

Dr. Dawei Lu

Key Learning Points

• Critical roles of purchasing in SCM
• Operational purchasing activities
• Purchasing performance measures
• Kraljic Purchasing Portfolio
• Customer evaluation tool
• Supplier selection process and criteria
• Supplier selection tools, and case exercise
• Negotiation skills and game

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W hatisS trategicO utsourcing

Outsourcing used to be viewed as a tactic

for reducing the cost of back-room functions
such as payroll and IT.
But things started to change in 1990s when
companies began outsourcing more
strategically significant functions such as
manufacturing and logistics and even
product design.

O utsourcingcanbedefined as:
T hecapability and processtoobtainthe
supply ofaproductorserviceexternalto
theorganisationthathasstrategic
significance

 The key objec tives ofou ts ou rc ing are

– To red u c e totalS C c os t
– to enabl
e bu s ines s to foc u s on its c ore
c om petenc es ;
– and to free m anagers to foc u s on m ore s trategi
c,
highervalu e-ad d ing ac tivities .

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 Discuss the following questions:
What is the difference between
outsourcingand supply
How to distinguish outsourcingand
subcontracting
What is the connection between
outsourcingand verticalintegration

InsourceorO utsource?
T heverticalIntegrationdecision

E xc es s c apac ity m ay be u s ed to s u pply

otherc om panies

Raw
m aterial C om ponent A s s em bly W holes aler Retailer
s u pplier m aker O peration

N arrow E xtentofVerticalIntegration

W id e E xtentofVerticalIntegration

Upstream D irec tion ofVerticalIntegration Downstream

A d apted from N igelS lac k, 2 0 0 6

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 S ourcingA lternatives

O ffs hore O ffs hore

Local or Global Decision

Global

M anu fac tu ring O u ts ou rc ing

L oc alP rod u c tion/ O ns hore

L oc al

Ins ou rc ing O u ts ou rc ing

M ake Buy
Make or Buy decision

T ypesofO utsourcing
Business process outsourcing (BPO)
– Marketing / call centre outsourcing
– R & D process outsourcing
– Engineering process outsourcing (EPO)
– HR and recruitment process outsourcing
– Knowledge process outsourcing (KPO)
Business function outsourcing
– Financial auditing
– IT services
– Logistics services
Facility and man power outsourcing
– Capital equipment leasing
– Free length experts hiring

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Functions mostly outsourced:
• Resource intensive – high labour or capital costs
• Relatively discrete – can be isolated or standardised
• Require specialist knowledge that internally not available
• Fluctuating in capacity utilisation
• Subject to quickly changing or uncertain market
• Subject to rapidly changing technology
• Requiring expensive investment

What not to outsource:

Activities that are regarded as core competences

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Com petitiveP ositionofN ations
Criteria R ussia
• Vast talent pool from top
Culture Russian military conglomerates
with solid experience (av. 5-15
years) in sophisticated
environments
• Low labor costs
• Russian work ethic and culture
T alent are European and very similar
to that of US
• Communication cost: * 8,000-
Infrastructu 12,000 $/month
re • Stable power grid based on
multiple technologies.
Practically unlimited supply of
oil.
• Democratic government with
Geopolitical political stability
Factors • No outside enemies
• Direct flight to Moscow from
most US cities: 8-10 hours
Income tax applies
Business •
• Total customs duty exemption
Incentives •
•
No VAT for IT services export
No import duty on IT
equipment
China
• Largest, mostly untapped pool of
IT talent in the world
• Lowest labor costs, but major
ethics questions
• Significant differences between
Asian (and specifically Chinese)
culture and business
environment and business
culture of US/Europe
• Communication cost: ~$10,000-
15,000$/month
• Modernized power grid in major
cities only
• Primitive economic
infrastructure
• Precarious business environment
due to communist government,
particularly in regard to IT sector
• International tensions due to
relationships with Taiwan, Tibet,
'rogue states' and internal
human rights situation
• No direct flights from East coast
USA. Flights from West and
Midwest take 12-14 hours
• Software policy 2000 offered
some limited tax and VAT
exemptions
• 15% customs duty on technology
imports
• Very limited exemption
India YourCountry
• Large pool of IT talent
• Competition for talent increased
significantly and will only
intensify
• Presently low labor costs
• Cultural environment differs
significantly from US/Europe
• Communication costs $15,000 -
20,000/month
• Very frequent power outages
and other infrastructure
problems
• Stability of political system
varies, but is weakened by
internal religious divisions and
nuclear conflict over Kashmir
• Active conflict with Pakistan over
Kashmir with mutual threats of
nuclear war; 'live' exchanges of
cross-border fire commonplace
• No direct flight from the US; 22
hours flight time
Income tax holiday till 2010
•
• Customs duty exemption
•
•
No VAT for foreign entities
No import duty on IT equipment
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 S hiftinValue-A dding

‘Value-added’ shifts from OEMs to suppliers (Binder and Clegg 2010)

Key Outsourcing Decision Factor:

CoreCom petencies

The bedrock knowledge and skills on

which the organisation is based
To give competitive advantage, they
must have:
– high uniqueness
– low substitutability
– transportability between market

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 Du P ontCaseS tudy:
How toM akeO utsourcingDecision

• W hatare the fac tors D u P ontu s ed to m ake

d ec isions ?
• O n whatbas is the ou tc om e ofthe fac tors
were c ons id ered (c os t, tec hnology and
etc . )
• H ow wou ld the trad e-offs and c onflicting
fac tors are m anaged ?
• C reate a toolto fac ilitate the proc es s es .

O utsourcingDecision-m akingT ool

Factors W eight S cores T otal
Focusing on core competences 0.35 5 1.75
Cost saving 0.20 2 0.40
Making use of external technology 0.20 4 0.80
Achieving flexibility 0.15 0 0
Release capital 0.10 -3 -0.3
Final Decision Index: 2.65
Likert Scale: 5 4 3 2 1 0 -1 -2 -3 -4 -5
For Neutral Against

Decision: 3 to 4: Weak ‘For’; 4 to 5: Strong ‘For’;

-1 to 1: Neutral
-3 to -4: Weak ‘Against’; -4 to -5: Strong ‘Against’

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Options for Sourcing Technology
Q u inn (1 995)

POTENTIAL CONTRACT RELATIONSHIPS

Fu ll
owners hip
P artial
owners hip
Control Need

Joint
d evelopm ent

Retainer

L ong-term
c ontrac t
C alloption

S hort-term
c ontrac t

Flexibility Need

Benefits of Outsourcing
Focus on and further developing core
competences
Further differentiated competitive edge
Reduce cost
Increased business flexibility
Improved supply chain responsiveness
Raise the entry barrier through focused
investment
Enhanced ROI or ROE through down sizing the
fixed asset.

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Reasons to Review Outsourcing
Restructuring the supply bass
Capital circumstance no longer the same
Shift on “what we are good at”
Change to world capabilities
More pressure on cost control
Resources no-longer available internally
Customer demand changed

R isksof Outsourcing
Negative impact on company’s personnel
Loss control over key strategic design task, sub-system or
component, resulting in negative impact on the company’s
competitiveness.
Creating tomorrow’s competition
Severe business disruption due to failed supply from single sourced
suppliers.
Tactical, short term approach to outsourcing may inhibits
continuous improvement and long term investment
Intellectual property right risks
Foreign currency exchange risk if involves overseas suppliers

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 GroupExercise:How toM ake
O utsourcingDecision

• Take D E L L C om pu teras a c as e
• C ons id erboth oftheir
Manufacturing Operation and
Design Function
• C reate a proc es s toolthatc an help
m anagers to m ake rational
d ec isions on whetherto ou ts ou rc e

T oolsforO utsourcingDecisionM aking

The decision logic of outsourcing

Is ac tivity No D oes No Is No Is s ignificant No Explore

s trategic c om pany c om pany’ s operations outsourcin
im portanc e? have operations perform anc e g this
s pec ialised perform anc im provem ent activity
knowled ge? e s u perior? likely?

Yes Yes Yes Yes

Explore keeping this activity in house

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Source: www. emeraldinsight.com

Source: www. roymogg.com

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Source: www.telecomcircle.com

Abbetti’s Technology Sourcing Matrix

Im portanc e to bu s ines s
High Medium Low

High Continue to License /joint

invest Consolidate venture,
C om petitive P os ition

Maintain Keep pace reduce

capability investment

Neutral Invest and

Partnership Outsourcing
develop

Initiate R & D Sell/license

Examine for
Weak Partnership Design out
investment ,
find co-maker Find supplier

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 CASE STUDY

OUTSOURCING AND SUBCONTRACTING AT

DU PONT EUROPE
(Case written by Luis Vivanco, Carlos Cordon and Thomas E. Vollmann)

“When possible we don’t subcontract the manufacturing of

polymers. It makes sense for its manufacturing to be an in-house
activity as it represents our core competence.”

“If it’s a core competence you keep it. If it’s generic you have the
option to go outside.”

Quotes from senior managers from two

different business units at Du Pont

When asked about their decisions to outsource, managers at Du Pont seemed to have a clear
idea about the decision criteria. Most of the time it revolved around what the managers
considered to be the “core competence” of the business. In the latter part of 1996, however,
the initiatives taken by different business units seemed to be inconsistent with each other.
Something that was done in-house in one site was performed by a third party in another.
Bernie Margel, Director of Sourcing for Du Pont, wanted to define a set of guidelines which
could be used by the business units to make outsourcing decisions. Although she agreed in
principle that it was necessary for Du Pont to maintain its core competencies, she wondered if
there was a clear and consistent interpretation of what defined a core competence.
Furthermore, she questioned how factors such as potential economies of scale, and future
industry and environmental developments, as well as the development of capabilities to stay
as an industry leader, were factors in the decision to outsource.

Du Pont de Nemours Europe

In 1996, Du Pont de Nemours was one of the largest producers of polymers in the world. It
had manufacturing and commercial operations throughout Europe, with its 1argest
manufacturing facilities concentrated in the Benelux region. Its products were

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high performance polymers used to build plastic components for a wide variety of industries
such as consumer electronics and automotive. Broadly speaking, manufacturing these
products consisted of two major steps: resins creation, a chemical process through which the
polymer was created from petroleum components, and compounding, a physical extrusion
process through which the polymer was converted into small pellets for its use by the clients.
Du Pont was also involved in the recycling of polymers.

Differentiating Factors in the Polymers Industry

The polymers made by Du Pont were considered high performance products. The
characteristics of a polymer resin defined its potential use. The most important characteristics
were elasticity, shock resistance, rigidity and corrosion resistance. Many of these products
were protected by Du Pont patents.

Du Pont had an outstanding record of product research and innovation. Some of the
manufacturing processes were proprietary and developed by Du Pont. Process research and
development was focused on manufacturing a given product at a competitive price. In
particular, Du Pont processes were very efficient at making the products in very high
volumes. Often the same products could be made through other processes, although in a less
efficient manner.

Outsourcing and Subcontracting Initiatives

As of the 1980s, Du Pont created, compounded and recycled polymers. It also designed and
constructed its own facilities.

With respect to the compounding of polymers, Du Pont defined its investment and
subcontracting actions based on the assessment of the following factors:

• Economies of scale: Du Pont invested in compounding machinery if the expected asset

utilization justified the investment. Otherwise, Du Pont outsourced.

• Process economies: Often there were savings in performing the compounding operation
just after the chemical process. Depending on the amount of these savings, Du Pont

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 considered investing in compounding machinery.

• Market expansion for new applications: Growth in plastics was driven by the substitution
of metal parts by plastics. In some cases, Du Pont would be involved in downstream
manufacturing to promote the adoption of plastics.

• Proprietary knowledge: Nature of the activity.

In the late 1980s the company placed an emphasis on looking at what activities could be
obtained from external sources in order to focus investments only on those activities
considered part of Du Pont’s core competencies. Under the new philosophy, the decision
between new investment and outsourcing relied on one question: is the process/product a core
competence of Du Pont?

In the early l990s, outsourcing subcontracting activities in polymers could be classified in the
following three categories: products, processes and plant construction. Product and process
outsourcing and subcontracting activities represented more than 10% of the total sales of Du
Pont, potentially having an important impact on the bottom line.

Product outsourcing and Subcontracting

Du Pond decided to allocate production of a product to an outside company under the
following circumstances:

Lot size. A competitive survey showed that Du Pont was not competitive for small lots in
certain products. Therefore, if the size of the order placed by the customer was too small and
the product was not proprietary, the sales force would guide the customer to companies
which could provide the product, but Du Pont would take no responsibility for its quality. Du
Pont did, however, have the capacity to produce small lots in some cases, for key customers
who refused to take products that were not manufactured by Du Pont.

Product uniqueness and sales volume potential. A product was also acquired if Du Pont
lacked the assets to manufacture it efficiently and the expected sales volume did not justify
developing the expertise. To service key customers in this case, Du Pont made sure that the

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quality controls used by the subcontractor were the same as if Du Pont was making the
product internally.

Swing capacity. Du Pont sales were subject to annual seasonality. Du Pont’s equipment
required over 90% utilization to meet the internal financial targets. As a consequence, the
company only invested in new equipment if the expected utilization was higher than 50%.
This resulted in periodic subcontracting during peak periods. Logically, in these cases the
third party product was more expensive than Du Pont’s because they could not obtain such a
high assets utilization, nor did they have Du Pont’s proprietary process expertise.

In some cases, Du Pont demanded that suppliers keep separate facilities for the production of
Du Pont’s products for confidentiality. For these suppliers, Du Pont often represented 25 to
30% of their total sales. Most of these suppliers hired temporary workers to adjust to the
fluctuations in demand. Often, Du Pont provided engineering and quality support and
performed quality audits.

Move Towards Standardization

With the objective of reducing cost, Du Pont was in the process of standardizing the
compounding machinery. This would simplify maintenance and training and would allow a
reduction in spare parts inventory.

With the existing variety of machines, 70 to 80% of the products could be extruded in-house,
which represented more than 90% of the volume. Theoretically, the new equipment would
allow any product to be made by any machine. This would allow greater flexibility. In 1996,
only 25 to 30% of production was made to order while the remaining was made to stock. It
was expected that production to order would increase substantially in the future.

Process Outsourcing and Subcontracting

Some processes were considered outside of the company’s core competencies. As a
consequence, these processes were outsourced. Two instances of process outsourcing were a
recycling operation and special compounds.

Du Pont was the owner of a plant in Bowden, England, for recycling operations. Apart from
the plant manager, only an engineer and a secretary were hired by Du Pont directly. The plant

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was run by an outside company who was paid for operating the facility. The company had a
contract which could be terminated with 12 months notice. Du Pont provided the raw
materials and the two companies agreed on yields, quality and performance measures, as well
as annual cost improvement targets. Du Pont did not consider plastic recycling a core
competence, however, Du Pont did want to be the owner of the assets because of the
possibility that future regulators would not allow a company to manufacture chemical
products if it did not have recycling capabilities.

In the case of some special compounds, Du Pont did not have the adequate machines to carry
out the compounding operation efficiently. From a machinery point of view, factories were
equipped with different machines that had different characteristics and, depending on the
physical and chemical properties of the product, certain machines were more efficient than
others. To reach the optimal level of efficiency, a detailed knowledge of the product’s
chemical characteristics was necessary. Du Pont was concerned that some of that knowledge
could go to competitors and, as a consequence, preferred to outsource only when necessary.
By 1996, compounding outsourced represented slightly above 10% of total production.

In one particular instance, Du Pont had a long lasting relationship with a compounding
company that had the capabilities to compound certain products more efficiently. In fact, the
first European compounds were made by this company in 1970. The relationship included
integrated systems between the two companies, quick response to R&D requests and
openness to investing in unique compounding equipment at Du Pont’s request. Until recently,
Du Pont had not had the equipment to compound these products.

However, in recent years, Du Pont had decided that compounding was a core competence. As
a consequence, the company had started to invest in developing the specific compounding
capabilities which were unique to their compounding partner.

By contrast, in the US operations compounding was outsourced most of the time. The reason
was that union agreements in the US demanded that employees of a chemical company, such
as Du Pont, all be paid under the same guidelines. As salaries in the chemical industry were
substantially higher than those paid in a compounding company, it made economical sense to
outsource as much compounding as possible. This was not the case in Europe as Du Pont

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could compound polymers at 60% of the purchasing cost of other companies.

Plant Construction Outsourcing and Subcontracting

At one time, Du Pont had the resources to design and to build its own plants. This capability
had been developed initially to keep control over the process design knowledge and due to a
lack of external expertise in building polymer manufacturing facilities. By the late l980s,
however, outside contractors were used to build new facilities and, in general, to perform any
necessary construction. At first, many subcontractors were used and were chosen through
competitive bidding.

Du Pont soon realized how difficult it was to transfer best-practices from one project to
another if too many companies were used for their construction needs. Consequently, the
number of subcontractors was reduced and closer relationships were developed with them.
An exception was made for small projects in which small, usually local, subcontractors were
hired.

Du Pont believed that using well qualified contractors assured access to the latest engineering
technology. Contractors in charge of building a facility worked closely with Du Pont on the
plant design, having access to highly proprietary information. This presented Du Pont with a
number of issues.

• Continuing to develop core competencies. With the design of the manufacturing

processes not being 100% internal anymore, Du Pont was concerned about how to keep
people with expertise designing and constructing plants. By allowing others to actually
build the facilities, Du Pont migrated its core competence from building to project
management. Du Pont management believed, however, that they had acquired world-
class competencies in project management and were capable of delivering projects at a
total project cost of 80% of other companies.

• Assuring that proprietary knowledge does not reach competitors. As part of the
confidentiality agreements, Du Pont agreed with their subcontractors, usually large
companies who also worked with Du Pont’s competitors, that people working on a
project with Du Pont could not work on a similar project with a competitor within 5 to

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 10 years, depending on the nature of the project. Recognizing the difficulty of
completely preventing information from going to competitors, Du Pont hoped that by
the time it happened they would already be in the next step.

• Keeping cost down. There were inherent savings in outsourcing construction. These
savings could be maintained and maximized if the right set of incentives for the
supplier was used. The initial budget for the process was made independently by the
contractor, by Du Pont and by an independent project analyst (IPA) to ensure that the
bid submitted by the contractor was realistic. A pay-per-performance clause was
included to avoid complacency in either resource use or quality. Most important,
contracts required that the facility be delivered and running at a specified time with
specified yields.

Implications of the Outsourcing and Subcontracting Practices.

As Du Pont would see it, the subcontractors core competence in these three areas of
outsourcing/subcontracting was either manufacturing or construction, not product
development, sales or technical support. The lack of expertise in this areas would prevent the
subcontractors from becoming competitors of Du Pont. The confidentiality agreements,
whose terms and conditions were defined on a case-by-case basis depending on the nature
and history of the relationship, would be a further deterrent for taking advantage of Du Pont’s
knowledge. This allowed Du Pont to concentrate financial and management resources on the
company-defined core competencies.

Bernie Margel realized the importance of consistency in outsourcing decision and in the
criteria to follow. What were the steps that had to be taken to make this possible?

Question:

1. What was Du Pont’s business and market environment? What could be their
business strategy?
2. Can you identify Do Pont’s competitive edges and core competencies?
3. What were the criteria Do Pond used for its outsourcing decision? Were they
rationale? Were they fit to their business strategy?
4. What steps had to be taken to ensure the consistency in outsourcing decision?
(What are the possible problems if the outsourcing decision is not consistent?)