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Chapter 08: Sourcing

Sourcing Purchasing Procurement Outsourcing

Sourcing is the stage that comes Purchasing is Procurement is an end-to-end Outsourcing is an
before any purchases are made the process of process that covers everything agreement in which
and can be considered a sub- buying goods such as planning purchases, the responsibility of
process of the procurement and services sourcing, negotiating pricing, in-house performed
process. and making making the purchases, activities are
Sourcing includes finding payment to handling inventory control transferred to a third
sources of supply, guaranteeing supplier for and storage- all activities that party.
continuity in supply, ensuring goods or are required in order to get the
alternative sources of supply and services. product and services from the
gathering knowledge of supplier to its final
procurable resources. destination.

Benefits of Effective Sourcing Decisions***

1. Identifying the right source can result in an activity performed at higher quality and lower
cost.
2. Better economies of scale can be achieved if orders with in a firm are aggregated.
3. Reduction in the overall cost of purchasing, especially for items for which a large number
of low value transections occur.
4. Design collaboration can result in products that are easier to manufacture and distribute,
resulting in lower overall costs, especially for components that contribute a significant
amount to product cost and value.
5. Good procurement processes can facilitate coordination with suppliers and improve
forecasting and planning. Better coordination lowers inventories and improves the
matching of supply and demand.
6. Appropriate supplier contracts can allow for the sharing of risk, resulting in higher profits
for both the supplier and buyer.
7. Firms can achieve a lower purchase price by increasing competition through the use of
auctions.
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In-house or Outsource Decision

• The decision to outsource is based on the growth in supply chain surplus provided by the
third party and the increase in risk incurred by using a third party. A firm should consider
outsourcing if the growth in surplus is large with a small increase in risk.
• Performing the function in house is preferable if the growth in surplus provided by the third
party is small or the increase in risk incurred by using a third party is large.

Reasons for Making

An organization makes its own materials, components, services, and/or equipment in-house for
many reasons.

1. Protect proprietary technology: Firms may choose not to reveal the technology by asking
suppliers to make it, even if it is patented. An advantage of not revealing the technology is
to be able to surprise competitors and bring new products to market ahead of competition
allowing the firm to charge a price premium.
2. No competent supplier: If existing suppliers do not have the technology or capability to
produce a component the firm may be forced to make all item in-house at least for the short
term. The firm may use supplier development strategies to work with a new or existing
supplier to produce the component in the future as a long term strategy.
3. Better quality control: If the firm is so experienced and efficient in manufacturing the
component that suppliers are unable to meet its exact specifications and requirements, the
make option allows for the most direct control over the design, manufacturing process,
labor, and other inputs to ensure that high quality components are built.
4. Use existing idle capacity: if a firm has excess idle capacity, it can use the excess capacity
to make some of its components. This strategy is valuable for firms that produce seasonal
products. It avoids layoff of skilled workers and, when business picks tip, the capacity is
readily available to ruled demand.
5. Control of lead time, transportation, and warehousing costs: The make option provides
better control of lead time and logistical costs since management controls all phases of the
design, manufacturing, and delivery processes.
6. Lower cost: If technology, capacity, and managerial and labor skills are available, the
make option maybe more economical if large quantities of the component are needed on a
continuing basis. Although the make option has a higher fixed cost due to initial capital
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investment, it has a lower variable cost per unit because it does not include supplier profit
margins.

Rationales for Outsourcing

Strategic reasons 1. To improve company focus,

for outsourcing 2. To gain access to world-class capabilities,
3. To gain access to resources that are not available internally,
4. To accelerate reengineering benefits,
5. To improve customer satisfaction,
6. To increase flexibility and
7. To share risks.

Tactical reasons 1. To reduce control costs and operating costs,

for outsourcing 2. To free up internal resources,
3. To receive an important cash infusion, to improve performance,
and
4. To be able to manage functions that are out of control.

All these reasons underlie one overall objective: to improve the overall performance of the
outsourcing firm, or from another perspective, to enhance the value of an organization's
offerings to its customers.

Strategic decision for outsourcing: How will you decide on make, buy, and collaborative
decision? Explain by a model.

Strategic decision for outsourcing identifies the two most important factors that should be
considered while thinking about outsourcing.

• Strategic importance of the competence.

• Level of competitiveness relative to suppliers

Based on these two factors there are four options available:

1. Maintain / invest (opportunistically): When competencies are not strategic but provide
important advantages, a firm should keep in-house as long these advantages are (integrally)
real.
2. In-house / invest: When competencies are strategic and world-class, a firm should focus
on investments in technology and people; maximize scale, and stay on leading edge.
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3. Collaborate/ maintain control: When competencies are strategic but insufficient to
compete effectively, a firm should explore alternatives such as partnership, alliance, joint-
venture, licensing, etc.
4. Outsource: When competencies have no competitive advantage, a firm should go for
outsourcing.

How Do Third Parties Increase the Supply Chain Surplus?

Third parties increase the supply chain surplus if they either increase value for the customer or
decrease the supply chain cost relative to a firm performing the task in-house.

Three important factors that affect the increase in surplus that a third party provides: scale,
uncertainty, and the specificity of assets.

1. Capacity aggregation gives economies of scale: A third party may increase in the surplus
by aggregating demand across multiple firms and gaining production economies of scale
that no single firm can on its own. The growth in surplus from outsourcing is highest when
the needs of the firm are significantly lower than the volumes required to gain economies.
2. Inventory aggregation reduces uncertainty: A third party may increase in the surplus
by aggregating inventories across a large number of customers. Aggregation allows to
significantly lower overall uncertainty and improve economies of scale in purchasing and
transportation. The third party performing inventory aggregation adds most to the supply
chain surplus when demand from customers is fragmented and uncertain.
3. Transportation aggregation by transportation intermediaries: The transportation
intermediary aggregates shipments across multiple shippers, thus lowering the cost of each
shipment below what could be achieved by the shipper alone, especially when the shipper's
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transportation flows are highly unbalanced, with the quantity coming into a region very
different from the quantity leaving the region.
4. Transportation aggregation by storage intermediaries: A third party that stores
inventory may increase in the surplus by aggregating in-bound and outbound
transportation, and is most effective if the intermediary stocks products from many
suppliers and serves many customers, each ordering in small quantities.
5. Warehousing aggregation: A third party may increase in the surplus by aggregating
warehousing needs over several firms in terms of lower real estate cost and lower
processing cost. Savings through warehousing aggregation arise if a supplier's warehousing
needs are small or if its needs fluctuate over time
6. Procurement aggregation: A third party may increase in the surplus by aggregating
procurement for many small players and facilitates economies of scale in ordering,
production and inbound transportation. Procurement aggregation is most effective across
many small buyers.
7. Information aggregation: A third party may increase in the surplus by aggregating
information to a higher level than can be achieved by a firm performing the function in-
house. All retailers aggregate information on products from many manufacturers in a single
location. This information aggregation reduces search costs for customers.
Information aggregation increases the surplus if both buyers and sellers are fragmented and
buying is sporadic (occasional/ infrequent).
8. Receivables aggregation: A third party may increase in the surplus by aggregating the
receivables risk to a higher level than the firm or it has a lower collection cost than the firm.
Receivables aggregation is likely to increase the supply chain surplus if retail outlets are
small and numerous and each outlet stocks products from many manufacturers that are all
served by the same distributor.
9. Relationship Aggregation: A third party can decrease the number of relationship require
between multiple buyers and sellers. Relationship aggregation increases supply chain
surplus by increasing the size of each transection and decreasing their number, and is most
effective when many buyers sporadically purchase small amounts at a time, but each orders
often has products from multiple suppliers.
10. Lower costs and higher quality: A third party can increase the supply chain surplus if it
provides lower cost or higher quality relative to the firm. If these benefits come from
specialization and learning, they are likely to be sustainable over the longer term.
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A firm gains the most by outsourcing to a third party if its needs are small, highly
uncertain and shared by other firms sourcing from the same third party.

Risk of Using Third Party

1. The process is broken: The biggest problems arise when a firm outsources supply chain
functions simply because it has lost control of the process. Introducing a third party in to a
broken supply chain process only makes it worse and harder to control.
2. The cost of coordination: A common mistake when outsourcing is to underestimate the
cost of the effort required to coordinate activities across multiple entities performing supply
chain tasks.
3. Reduction of customer/supplier contact: A firm may lose customer/supplier contact by
introducing an intermediary. The loss of customer contact is particularly significant for
firms that sell directly to consumers but decide to use a third party to either collect incoming
orders or deliver outgoing product.
4. Loss of internal capability and growth in third-party power: A firm should choose to
keep supply chain function in house if outsourcing will significantly increase the third
party’s power.
5. Leakage of sensitive data and information: Using third party required a firm to share
demand information and, in some cases, intellectual property. If third part also serves
competitors, leakage is always a danger.
6. Ineffective contracts: Contracts with performance metrics that distort the third party's
incentives often significantly reduce any gains from outsourcing.
7. Loss of supply chain visibility: Introducing third parties reduces the visibility of supply
chain operations, making it harder for the firm to respond quickly to local customer and
market demands.
8. Negative reputational impact: Actions regarding labor or the environment taken by the
third party may have significant negative impact on the reputation of the firm.

3PL and 4PL

3PL: A third party logistics (3PL) provider performs one or more of the logistics activities of
a firm, relating to the flow of product, information, and funds, by using their own resources,
such as warehouse facilities, and their network of freight transportation providers to help the
firm ship or store their products appropriately, that could be performed by the firm itself.

3PL companies tend to specialize in:

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• Inbound and outbound freight • Distribution
• Customs • Order fulfillment
• Freight consolidation • Cross-docking
• Warehousing • Inventory management

Most 3PLs started out by focusing on one of the functions in the supply chain. For example,
UPS started out as a small package carrier.

4PL: A 4PL company does not stop at outsourcing logistics services but also outsources the
management of said services.

• A fourth-party logistics provider essentially takes third-party logistics a step further by

managing resources, technology, infrastructure, and even manage external 3PLs to design,
build and provide supply chain solutions for businesses.
• A fourth-party logistics provider (4PL) integrates the resources of producers, retailers and
third-party logistics providers in view to build a system-wide improvement in supply chain
management. They are non- asset based meaning that they mainly provide organizational
expertise, have no way of transportation or warehousing, but rather use the transportation
and warehousing services of a 3PL company.
• 4PL organization acts as a single interface between the client and multiple logistics service
providers.
• 4PL manages other 3PLs, truckers, forwarders, custom brokers, and others essentially
taking responsibility of a complete process for the customer.
• 4PL example: Deloitte provides 4PL services.

Sources of Information****

o Current suppliers
o Preferred suppliers
o Sales representatives
o Information databases
o Experience
o Trade journals
o Trade directories
o Trade fairs, exhibitions and conferences
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o Second-party or indirect information
o Internal sources
o Internet searches
o Online market exchanges, auction sites and supplier/buyer forums
o Formal requests for information (RFI)
o Informal networking and information exchange with colleagues and other purchasing
professionals
Supplier Scoring and Assessment*** (Marks 2.5)
Supplier performance should be compared on the basis of the supplier’s impact on total cost.
There are several other factors besides purchase price that influence total cost.

• Replenishment lead time: Replenishment lead time dictates the amount of inventory
required.
• On-time performance: On time performance affects the variability of the lead time and
hence the safety stock
• Supply flexibility: Less flexible the supplier, more lead-time variability it will display as
order quantities change.
• Delivery frequency/minimum lot size: affect the size of each replenishment lot ordered
by a firm - cycle and safety inventory.
• Supply quality: Quality affects the lead time taken by the supplier to fulfill order and also
the variability of this lead time because follow-up orders often need to be fulfilled to replace
defective products.
• Inbound transportation cost: The distance, mode of transportation, and delivery
frequency affect the inbound transportation cost.
• Pricing terms: Allowable time delay before payment has to be made and any quantity
discounts offered by the supplier- affects the working capital required.
• Information coordination capability: Information coordination capability affects the
ability of a firm to match supply and demand- reduces bull whip effect.
• Design collaboration capability: As a large part of product cost is fixed at design,
collaboration capability of a supplier is significant
• Exchange rates, taxes, and duties: Significant for a firm with a global manufacturing and
supply base.
• Supplier viability: Supplier should be around to fulfill the promises it makes.
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The Weighted-Criteria Evaluation system*** (Marks 4)

1. Select mutually acceptable performance dimensions mutually acceptable to both customer

& supplier such as quality, responsiveness, delivery, cost, etc.

2. Monitor and collect performance data.

3. Assign weight based on their relative importance to the company objectives. Weights must
equal one.
4. Evaluate each performance dimensions and rate from 0-100.

5. Evaluate each of the performance measures on a rating between 0(fails to meet any
intended purpose or performance) and 100 (exceptional in meeting intended purpose or
performance).

6. Multiply the dimension ratings by their respective importance weights and then sum to get
an overall weighted score.
7. Classify suppliers based on their overall score:
i. Unacceptable (less than 50): Supplier is not used and dropped from further business.

ii. Conditional (between 50 and 70): Supplier needs development work to improve
performance but may be dropped if performance continues to lag.
iii. Certified (between 70 and 90): Supplier meets intended purpose or performance.

iv. Preferred (greater than 90): Supplier will be considered for involvement in new product
development and opportunities for more business.

8. Audit and perform ongoing certification review.

Supplier Selection- Auctions and Negotiations

Supplier selection can be performed through:

• Competitive bids: A competitive bid is a price submitted by a vendor or service provider

to a requesting firm for products or services to win a contract.
• Reverse auctions: A reverse auction is a type of auction in which sellers bid for the
prices at which they are willing to sell their goods and services.
Direct negotiations: Negotiation results in a positive outcome only if the value the firm
places on outsourcing the supply chain function to the supplier is at least as large as the
value the supplier places on performing the function for the firm. The difference between
the values of the firm and supplier is referred to as the bargaining surplus. The goal of
each negotiating party is to capture as much of the bargaining surplus as possible.
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Types of Auction:

1. Sealed-bid first-price auctions:

Sealed-bid first price auction requires each potential supplier to submit a sealed bid for the
contract by a specified time. Contract is assigned to the lowest bidder.
2. English auctions:
The firm (auctioneer) starts with a price and suppliers can make bids as long as each
successive bid is lower than the previous bid. The supplier with the lowest bid receives the
contract.
3. Dutch auctions:
The firm (auctioneer) starts with a low price and then raises it slowly until one of the
suppliers agrees to the contract at that price.
4. Second-price (Vickery) auctions:
Each potential supplier submits a bid. The contract is assigned to the lowest bidder but at
the price quoted by the second lowest bidder.

Strategic Components of Supply Contract

Supply Contract can include the following:

o Pricing and volume discounts.
o Minimum and maximum purchase quantities.
o Delivery lead times.
o Product or material quality.
o Product return policies.

Different Types of Supply Contracts

1. Supply Contracts for Strategic Components

a) Make to Order Supply Chain Contracts

In make to order contracts, the manufacturer produce end product once the buyer places the
order, creating additional wait time for the buyer to receive the product, allowing for more
flexible customization.

Two Stage Sequential Supply Chain: A buyer and a supplier who want to optimize own
profit.
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Buyer’s activities Supplier’s activities

o Generating a forecast Reacting to the order placed by

o Determining how many units to order from the supplier the buyer according to Make-To-
o Placing an order to the supplier so as to optimize his own profit Order (MTO) policy.
o Purchase based on forecast of customer demand.

Risk Sharing: In the sequential supply chain,

o Buyer assumes all of the risk of having more inventory than sales.
o Buyer limits his order quantity because of the huge financial risk.
o Supplier takes no risk.
o Supplier would like the buyer to order as much as possible
o Since the buyer limits his order quantity, there is a significant increase in the likelihood of
out of stock.
If the supplier shares some of the risk with the buyer it may be profitable for buyer to order
more, may reduce out of stock probability and increase profit for both the supplier and the
buyer. Supply contracts enable this risk sharing.

i. Buy Back Contracts:

• In buy back contracts, the supplier agrees to buy back unsold goods from the buyer for
some agreed-upon price higher than the salvage value.
• This gives the buyer incentive to order more units, since the risk associated with unsold
unit is decreased.
• On the other hand, the supplier’s risk clearly increases.
• The contract is designed to increase in buyer’s order quantity, decrease the likelihood of
out of stock as well as compensate the supplier for the higher risk.

Limitations:

 Buy Back Contracts require suppliers to have an effective reverse logistics system and
may increase logistics costs.
 Retailers have an incentive to push the products not under the buyback contract.
- Retailer’s risk is much higher for the products not under the buyback
contract.
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ii. Revenue Sharing Contracts: In revenue sharing contracts, buyer transfers a portion of the
revenue to the supplier from each unit sold to the end customer, in return gets a discount
on the wholesale price from supplier.

Limitation:

 Revenue sharing contracts require suppliers to monitor the buyer’s revenue and thus
increases administrative cost.
 Buyers have an incentive to push competing products with higher profit margins.
- Similar products from competing suppliers with whom the buyer has no
revenue sharing agreement.

iii. Quantity-Flexibility Contracts: Quantity-Flexibility Contracts are contracts in which the

supplier provides full refund for returned (unsold) items as long as the number of returns is
no larger than a certain quantity.

iv. Sales Rebate Contracts: Sale rebates contracts provide a direct incentive to the retailer to
increase sales by means of a rebate paid by the supplier for any item sold above a certain
quantity.

v. Global Optimization: The various contracts described above raise an important question:

What is the best strategy for the entire supply chain?

• An unbiased decision maker would treat both supplier and retailer as one entity and transfer
of money between the parties is ignored, and maximize supply chain profit. However,
unbiased decision maker does not usually exist.
• The global optimization requires the firm to surrender decision-making power to an
unbiased decision maker
• However, carefully designed supply contracts help firms to achieve global optimization
without the need for an unbiased decision maker, by allowing buyer and suppliers to share
risk, the potential benefit, and achieve the exact same profit as much as global optimization.
• Global optimization does not provide a mechanism to allocate supply chain profit between
the partners. Supply contracts allocate this profit among supply chain members.
• Effective supply contracts allocate profit to each partner in a way that no partner can
improve his profit by deciding to deviate from the optimal set of decisions.
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b) Make to Stock Supply Chain Contracts

In make to stock supply chain contracts products are manufactured based on demand forecasts.

i. Pay Back Contracts

• In Pay Back contract, buyer agrees to pay some agreed-upon price for any unit produced
by the manufacturer but not purchased.
• This gives manufacturer incentive to produce more units, since the risk associated with
unused capacity is decreased.
• On the other hand, buyer’s risk clearly increases.
• The contract is designed to increase in production quantities and compensate the
buyer/distributor for the increase in risk.
ii. Cost Sharing Contracts
• In cost sharing contract, buyer shares some of the production cost with the manufacturer,
in return for a discount on the wholesale price. This reduces effective production cost for
the manufacturer and gives incentive to produce more units.
• Limitations: Cost-sharing contract requires manufacturer to share production cost
information with distributor, that manufacturer are reluctant to do.
• How this contract implemented in practice?
Through an agreement between the two parties in which
- The distributor purchases one or more components that the manufacturer needs.
- The components remain on the distributor books but are shipped to the manufacturer
facility for the production of the finished good.
2. Contracts with Asymmetric Information

There is an implicit assumption is that, buyer and supplier share the same forecast. It is easy
to see, however, that when the supplier needs to build capacity based on forecast received
from manufacturer, the buyer has an incentive to inflate its forecasts.

How to design contracts such that the information shared is credible? The following two
contracts achieve credible information sharing:

a. Capacity Reservation Contracts

In capacity reservation contracts, buyer pays to reserve a certain level of capacity at the
supplier. The reservation price is a menu of prices designed by the suppliers to motivate the
buyer to reveal its true forecast for different capacity reservations provided by supplier.
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Thereby, by choosing the amount of capacity to reserve with the supplier, the buyer signals
true forecast.

b. Advance purchase contracts

• In advance purchase contract, the ssupplier charges special price before building capacity.
• When demand is realized, price charged is different
• Buyer’s commitment to paying the special price reveals the buyer’s true forecast.

3. Contracts for Non-Strategic Components

Traditionally buyers have focused on long-term contracts for many of their purchasing needs.
However recent trend is towards more flexible contracts. In this case,

o Products can be purchased from variety of suppliers

o Market conditions dictate the price
o Buyers need to be able to choose suppliers and change them as needed
o A flexible contract offers buyers option of buying later at a different price than
current, also offers effective hedging strategies against shortages
i. Long-Term Contracts
• Also called forward or fixed commitment contracts
• Long-term contracts specify a fixed amount of supply to be delivered at some point in the
future.
• The supplier and the buyer agree on both the price and the quantity to be delivered to the
buyer.
• The buyer bears no financial risk while taking huge inventory risks due to:

 Uncertainty in demand
 Inability to adjust order quantities.
ii. Flexible, or option, Contract
• The buyer pre-pays a relatively small fraction of the product price up-front, in return for a
commitment from the supplier to reserve capacity up to a certain level.
• The initial payment is the reservation price or premium.
• If the buyer does not exercise the option, the initial payment is lost.
• The buyer can purchase any amount of supply up to the option level by:

– Paying an additional price (execution price or exercise price) agreed to at the

time the contract is signed.
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• The total price (reservation plus execution price) typically higher than the unit price in a
long-term contract
• A flexible, or option contract
- Provides buyer with flexibility to adjust order quantities depending on realized demand and
- Reduces buyer’s inventory risks
- Shifts risks from buyer to supplier as supplier is now exposed to customer demand
uncertainty.
• A related strategy is used in practice to share risks between suppliers and buyers through
flexible contracts. In these contracts,

– A fixed amount of supply is determined when the contract is signed

– Amount to be delivered (and paid for) can differ by no more than a given
percentage determined upon signing the contract.

iii. Spot Purchase

• Buyers look for additional supply in the open market.
• Firms may use an independent e-markets or private e-markets to select suppliers.
• The focus is on

- Using the marketplace to find new suppliers

- Forcing competition to reduce product price.

iv. Portfolio Contract
• The buyer signs multiple contracts at the same time in order to ooptimize their expected
profit and reduce their risk.
• The contracts differ in price and level of flexibility, thus allowing the buyer to hedge against
inventory, shortage and spot price risk.
• This approach is particularly meaningful for commodity products since a a large pool of
suppliers and each with a different type of contract.

Appropriate Mix of Contracts: To find an effective contract, the buyer needs to identify the
appropriate mix of low price yet low flexibility (long term) contracts, reasonable price but
better flexibility (option) contract, or unknown price and quantity supply but no commitment
(spot market).

- How much to commit to a long-term contract? Base commitment level.

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- How much capacity to buy from companies selling option contracts? Option level.
- How much supply should be left uncommitted? Additional supplies in spot market
if demand is high

Risk Trade-Off in Portfolio Contracts:

• If demand is much higher than anticipated (i.e. base commitment level + option level <
demand), firm must use spot market for additional supply.
• Typically the worst time to buy in the spot market as prices are high due to shortages.
• The buyer can select a trade-off level between price risk, shortage risk, and inventory risk
by carefully selecting the level of long-term commitment and the option level.

For the low option level,

- The higher the initial contract commitment, the smaller the price risk but the higher
the inventory risk taken by the buyer.
- The smaller the level of the base commitment, the higher the price and shortage
risks due to the likelihood of using the spot market.

For the low level of base commitment,

- The higher the option level, the higher the risk assumed by the supplier since the
buyer may exercise only a small fraction of the option level.

Option Level High Inventory Risk N/A

(Supplier)
Low Price and shortage Inventory Risk
risks (Buyer) (Buyer)
Low High
Base Commitment Level