CH 3 - Sourcing Decision in A Supply Chain

Supply Chain and Logistic Management
Sourcing Decision in a Supply Chain

0| Supply chain and logistic management
© Dr. Saeed
Learning Objectives
§ Understand the role of sourcing in a supply chain
§ Discuss factors that affect the decision to outsource a supply chain function
§ Identify dimensions of supplier performance that affect total cost
§ Structure successful auctions and negotiations
§ Describe the impact of risk sharing on supplier performance and information

distortion
§ Design a tailored supplier portfolio

© Dr. Saeed
The Role of Sourcing in a Supply Chain
§ Sourcing is the set of business processes required to purchase goods and

services
- Outsourcing
- Offshoring

© Dr. Saeed
§ Outsourcing questions
- Will the third party increase the supply chain surplus relative to performing
the activity in-house?
- To what extent do risks grow upon outsourcing?
- Are there strategic reasons to outsource?

© Dr. Saeed

© Dr. Saeed
Supplier Scoring and Assessment
§ 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
- such as lead time, reliability, quality, and design capability

© Dr. Saeed
Supplier Selection and Contract Negotiations
§ Identify one or more appropriate suppliers
§ Contract should account for all factors that affect supply chain performance
§ Should be designed to increase supply chain profits in a way that benefits both
the supplier and the buyer

© Dr. Saeed
Design Collaboration
§ 50 and 70 % of the spending at a manufacturer comes from procurement
§ About 80 % of the cost of a purchased part is fixed during the design stage
§ Design collaboration with suppliers can result in reduced cost, improved quality,
and decreased time to market
§ Design for logistics, design for manufacturability
§ Modular, adjustable, dimensional customization

© Dr. Saeed
Procurement
§ A supplier sends product in response to orders placed by the buyer
§ Orders placed and delivered on schedule at the lowest possible overall cost

© Dr. Saeed
Sourcing Planning and Analysis
§ Analyze spending across various suppliers and component categories
§ Identify opportunities for decreasing the total cost

© Dr. Saeed
Cost of Goods Sold
§ Cost of goods sold (COGS) represents well over 50 percent of sales for most
major manufacturers
§ Purchased parts a much higher fraction than in the past
§ Companies have reduced vertical integration and outsourced
Cost of goods sold (COGS) refers to the direct costs of producing the goods sold
by a company. This amount includes the cost of the materials and labor directly
used to create the good. It excludes indirect expenses, such as distribution costs
and sales force costs.
Vertical integration is a strategy whereby a company owns or controls its

suppliers, distributors, or retail locations to control its value or supply chain.
10 | Supply chain and logistic management

© Dr. Saeed
Class Activity
- Identify pros and cons of vertical integration
- Identify pros and cons of outsourcing, offshoring, and near shoring

© Dr. Saeed
Benefits of Effective Sourcing Decisions
§ Identifying the right source can result in an activity performed at higher quality and
lower cost
§ Better economies of scale can be achieved if orders within a firm are aggregated
§ More efficient procurement transactions can significantly reduce the overall cost of
purchasing
§ Design collaboration can result in products that are easier to manufacture and
distribute, resulting in lower overall costs
§ Good procurement processes can facilitate coordination with the supplier and
improve forecasting and planning. Better coordination lowers inventories and
improves the matching of supply and demand
§ Appropriate sharing of risk and benefits can result in higher profits for both the
supplier and the buyer
© Dr. Saeed
In-House or Outsource?
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. Supply
chain surplus can grow using
1. Capacity aggregation
2. Inventory aggregation
3. Transportation aggregation by transportation intermediaries
4. Transportation aggregation by storage intermediaries
5. Warehousing aggregation
6. Procurement aggregation
7. Information aggregation
8. Receivables aggregation
9. Relationship aggregation
10. Lower costs and higher quality

© Dr. Saeed
Factors Influencing Growth of Surplus by a Third Party
Specificity of Assets Involved in Function

Low High
High growth in
Firm scale Low Low to medium growth in surplus
surplus
Low growth in No growth in surplus unless cost of

High
surplus capital is lower for third party
Demand
Low to medium
uncertainty Low Low growth in surplus
growth in surplus
for firm
High growth in
High Low to medium growth in surplus
surplus

© Dr. Saeed
Factors Influencing Growth of Surplus by a Third Party
§ Scale
- Large scale it is unlikely that a third party can achieve further scale
economies and increase the surplus
§ Uncertainty
- If requirements are highly variable over time, third party can increase the
surplus through aggregation across other customers
§ Specificity of assets
- If assets required are specific to a firm, a third party is unlikely to increase the
surplus

© Dr. Saeed
Risks of Using a Third Party
1. The process is broken
2. Underestimation of the cost of coordination
3. Reduced customer/supplier contact
4. Loss of internal capability and growth in third-party power
5. Leakage of sensitive data and information
6. Loss of supply chain visibility
7. Negative reputational impact

© Dr. Saeed
Total Cost of Ownership (TCO)
TCO includes all supply chain costs of sourcing a good or service from a particular
supplier and can be considered in three “buckets”—acquisition costs, ownership
costs, and post-ownership costs
§ Acquisition costs include all costs associated with the purchase of material from a
supplier until it reaches the buyer and is ready for use
§ Ownership costs include all costs associated with the purchased part from when it
arrives from the supplier to when the finished product is sold to the customer
§ Post-ownership costs include all costs incurred by the firm after the finished product has
reached the end customer
The importance of taking the TCO perspective has helped several companies make better
decisions, whereas in other cases, a focus on the purchase price has ended up increasing
the total cost
© Dr. Saeed
Total Cost of Ownership

© Dr. Saeed
Supplier Selection – Auctions and Negotiations
§ Supplier selection can be performed through variety of mechanisms, including

offline competitive bids, reverse auctions, or direct negotiations
§ No matter what mechanism is used, supplier selection should be based on the

total cost of using a supplier and not just the purchase price.
§ Commonly used mechanisms for auctions are:
- Sealed-bid first-price auctions
- English auctions
- Dutch auctions
- Second-price (Vickery) auctions

© Dr. Saeed
Auctions and Negotiations - Basic Principles of Negotiation
§ Firms enter into negotiations both for supplier selection and to set the terms of
the contract with an existing supplier. When the total cost of ownership has
multiple components besides the cost of acquisition, negotiations generally
result in a better outcome compared with the use of auction
§ The goal of each negotiating party is to capture as much of the bargaining

surplus as possible
- Have a clear idea of your own value and as good an estimate of the third
party’s value as possible
- Look for a fair outcome based on equally or equitably dividing the bargaining
surplus
- A win-win outcome
© Dr. Saeed
Auctions and Negotiations - Basic Principles of Negotiation
§ Firms enter into negotiations both for supplier selection and to set the terms of
the contract with an existing supplier. When the total cost of ownership has
multiple components besides the cost of acquisition, negotiations generally
result in a better outcome compared with the use of auction
§ The goal of each negotiating party is to capture as much of the bargaining

surplus as possible
- Have a clear idea of your own value and as good an estimate of the third
party’s value as possible
- Look for a fair outcome based on equally or equitably dividing the bargaining
surplus
- A win-win outcome
© Dr. Saeed
Sharing Risk to grow Supply chain profits
§ Independent actions taken by two parties in a supply chain often result in

profits that are lower than those that could be achieved if the supply chain were
to coordinate its actions
§ The absence of risk sharing in a supply chain results in locally optimal decisions
that decrease the total supply chain profits
§ Following three approaches to risk sharing increase overall supply chain profits
by making the supplier share some of the buyer’s demand uncertainty;
- Buyback or returns contracts
- Revenue-sharing contracts
- Quantity flexibility contracts

© Dr. Saeed
Sharing Risk to grow Supply chain profits - Buyback Contracts
§ Buyback Contracts allow a retailer to return unsold inventory up to a specified amount at an agreed
upon price
§ In some instances, manufacturers use holding-cost subsidies or price protection to share risk and
encourage retailers to order more
§ Holding-cost subsidies
- With holding-cost subsidies, manufacturers pay retailers a certain amount for every unit held in
inventory over a given period
§ Price support
- In the high-tech industry, in which products lose value rapidly, manufacturers share the risk of
product becoming obsolete by providing price support to retailers
- Many manufacturers guarantee that in the event that they drop prices, they will also lower prices
for all inventories that the retailer is currently carrying and compensate the retailer accordingly.
The retailer thus increases the level of product availability in the presence of price support

© Dr. Saeed
Sharing Risk to grow Supply chain profits - Revenue Sharing Contracts
In revenue-sharing contracts, the manufacturer charges the retailer a lower wholesale
price (compared with the case without risk sharing), but shares a fraction of the retailer’s
revenue
§ One advantage of revenue-sharing contracts over buyback contracts is that no product

needs to be returned, thus eliminating the cost of returns

© Dr. Saeed
Sharing Risk to grow Supply chain profits - Quantity Flexibility Contracts
Under quantity flexibility contracts, the manufacturer allows the retailer to change the
quantity ordered (within limits) after observing demand
§ If a retailer orders O units, the manufacturer commits to providing up to Q = (1 + a) O

units, whereas the retailer is committed to buying at least q = (1 – b) O units. Both a and
b are between 0 and 1
§ Retailer can purchase anywhere between q and Q, depending on the demand it observes
§ In these contracts the manufacturer shares risk by allowing the retailer to adjust its order
as better market information is received
§ Quantity flexibility contracts increase the average amount the retailer purchases and
may increase total supply chain profits when structured appropriately
§ Quantity flexibility contracts are common for components in the electronics and
computer industries

© Dr. Saeed
The Procurement Process
§ The process in which the supplier sends product in response to orders placed by
the buyer
§ Main categories of purchased goods
- Direct materials
- Indirect materials
§ Procurement process for direct materials should be designed to ensure that

components are available in the right place, in the right quantity, and at the
right time
§ Focus for indirect materials should be on reducing transaction cost

© Dr. Saeed
The Procurement Process
Direct materials are components used to make finished goods. For example,
The process
§memory, hard in whichand
drives, theCD
supplier
drives sends product
are direct in response
materials tomanufacturer.
for a PC orders placed by
Indirect materials are goods used to support the operations of a firm. PCs are
the buyer
examples of indirect materials for an automotive manufacturer.
§ Main categories of purchased goods
- Direct materials
- Indirect materials
§ Procurement process for direct materials should be designed to ensure that

components are available in the right place, in the right quantity, and at the
right time
§ Focus for indirect materials should be on reducing transaction cost

© Dr. Saeed
The Procurement Process - Difference b/w Direct and Indirect Materials
Direct Materials Indirect Materials

Use Production Maintenance, repair, and
support operations
Impact on production Any delay will delay Less direct impact

production
Processing cost relative to Low High

value of transaction
Number of transactions Low High

© Dr. Saeed
Designing a Sourcing Portfolio: Tailored Sourcing
§ Options with regard to whom and where to source from
- Produce in-house or outsource to a third party
- Will the source be cost efficient or responsive
- Onshoring, near-shoring, and offshoring
§ Tailor supplier portfolio based on a variety of product and market characteristics

© Dr. Saeed
Responsive Source Low-Cost Source

Product life cycle Early phase Mature phase
Demand volatility High Low
Demand volume Low High
Product value High Low
Rate of product obsolescence High Low
Desired quality High Low to medium
Engineering/design support High Low

© Dr. Saeed
Onshore Near-shore Offshore

Rate of innovation/product variety High Medium to High Low
Demand volatility High Medium to High Low
Labor content Low Medium to High High
Volume or weight-to-value ratio High High Low
Impact of supply chain disruption High Medium to High Low
Inventory costs High Medium to High Low
Engineering/management support High High Low

© Dr. Saeed
Making Sourcing Decisions in Practice (1/3)
1. Use multifunction teams
- Effective strategies for sourcing result from multifunctional collaboration within the firm
- A sourcing strategy from the purchasing group is likely to be relatively narrow and focus
on purchase price
- A strategy developed with the collaboration of purchasing, manufacturing, engineering,

and planning is much more likely to identify the correct drivers of total cost
2. Ensure appropriate coordination across regions and business units
- Coordination of purchasing across all regions and business units allows a firm to
maximize economies of scale in purchasing and also to reduce transaction costs
- Better supply chain coordination and design collaboration, however, may require strong
involvement at the business-unit level to be effective

© Dr. Saeed
3. Always evaluate the total cost of ownership
- An effective sourcing strategy should not make price reduction its sole objective
- All factors that influence the total cost of ownership should be identified and used in
selecting suppliers
- Supplier performance along all relevant dimensions should be measured, and its
impact on total cost should be quantified
- Focusing on the total cost of ownership also allows a buyer to better identify
opportunities for better collaboration in design, planning, and fulfillment.

© Dr. Saeed
4. Build long-term relationships with key suppliers
- A basic principle of good sourcing is that a buyer and supplier working together can
generate more opportunities for savings than the two parties working independently
- Solid cooperation is likely to result only when the two parties have a long-term
relationship and a degree of trust
- A long-term relationship encourages the supplier to expend greater effort on issues

that are important to a particular buyer. This includes investment in buyer-specific
technology and design collaboration
- Long-term relationships should be nurtured with suppliers of critical and strategic

direct materials

© Dr. Saeed
Dr. Amad Saeed
Riphah International University, Lahore

Riphah School of Business and Management
phone: +92 (0)42-

email: amad.saeed@riphah.edu.pk
web: www.lahore.riphah.edu.pk

© Dr. Saeed

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Supply Chain and Logistic Management

Sourcing Decision in a Supply Chain

§ Understand the role of sourcing in a supply chain

§ Identify dimensions of supplier performance that affect total cost

§ Structure successful auctions and negotiations

§ Describe the impact of risk sharing on supplier performance and information

§ Design a tailored supplier portfolio

1| Supply chain and logistic management

§ Sourcing is the set of business processes required to purchase goods and

2| Supply chain and logistic management

- To what extent do risks grow upon outsourcing?

- Are there strategic reasons to outsource?

3| Supply chain and logistic management

4| Supply chain and logistic management

§ Supplier performance should be compared on the basis of the supplier’s impact

- such as lead time, reliability, quality, and design capability

5| Supply chain and logistic management

§ Identify one or more appropriate suppliers

6| Supply chain and logistic management

§ 50 and 70 % of the spending at a manufacturer comes from procurement

§ Design for logistics, design for manufacturability

§ Modular, adjustable, dimensional customization

7| Supply chain and logistic management

§ A supplier sends product in response to orders placed by the buyer

8| Supply chain and logistic management

§ Analyze spending across various suppliers and component categories

§ Identify opportunities for decreasing the total cost

9| Supply chain and logistic management

§ Purchased parts a much higher fraction than in the past

§ Companies have reduced vertical integration and outsourced

Vertical integration is a strategy whereby a company owns or controls its

10 | Supply chain and logistic management

- Identify pros and cons of vertical integration

- Identify pros and cons of outsourcing, offshoring, and near shoring

11 | Supply chain and logistic management

13 | Supply chain and logistic management

Specificity of Assets Involved in Function

Low growth in No growth in surplus unless cost of

14 | Supply chain and logistic management

15 | Supply chain and logistic management

1. The process is broken

2. Underestimation of the cost of coordination

3. Reduced customer/supplier contact

4. Loss of internal capability and growth in third-party power

5. Leakage of sensitive data and information

6. Loss of supply chain visibility

7. Negative reputational impact

16 | Supply chain and logistic management

18 | Supply chain and logistic management

§ Supplier selection can be performed through variety of mechanisms, including

§ No matter what mechanism is used, supplier selection should be based on the

§ Commonly used mechanisms for auctions are:

- Sealed-bid first-price auctions

- Second-price (Vickery) auctions

21 | Supply chain and logistic management

§ The goal of each negotiating party is to capture as much of the bargaining

§ The goal of each negotiating party is to capture as much of the bargaining

§ Independent actions taken by two parties in a supply chain often result in

- Buyback or returns contracts

- Quantity flexibility contracts

25 | Supply chain and logistic management

26 | Supply chain and logistic management

§ One advantage of revenue-sharing contracts over buyback contracts is that no product