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Procurement and Outsourcing
Phil Kaminskykaminsky@ieor.berkeley.edu
David Simchi-Levi
Philip Kaminsky
Edith Simchi-Levi
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Lecture Outline
1) FreeMarkets Online
2) B2B Strategies
3) B2B Pitfalls
4) Outsourcing
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
FreeMarkets Online
FreeMarkets is an online market making firm that enabled industrial buyers to link up with their potential suppliers in a live electronic bidding
The end result of such interaction among a network of suppliers was procurement cost savings of about 15% for the buyers
The company was founded in 1995 and was on the verge of breaking even in 1998– It was expecting to receive commissions and fees of
nearly $6 million for arranging procurement of ~$200 million worth of industrial components and parts
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
The Move to B2B Commerce
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
2003$1.3 Trillion
2003$1.3 Trillion
2002$843B2002
$843B
2001$499B2001
$499B
2000$251B2000
$251B
1998$43B1998$43B
Business-to-Business
Source: Forrester Research, Inc.
1999$109B1999
$109B
Business-to-Consumer
B2B is Huge...
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Highly Fragmented
Most product categories are highly fragmented, with numerous suppliers each offering different level of quality, service and pricing options
Buyers incur significant cost in the actual purchase process– A buyer must invest internal resources to manage the process of
collecting, analyzing and acting upon all the information in the market
– In addition to purchase price companies spend over 10% in additional procurement costs
On the suppliers side, there are significant costs in using the manufacturing reps– These commissions range from 4% to 7% of purchase price
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How Does FreeMarkets Online Create Value for its Customers?
Consulting/Purchase outsourcing– Putting together specs, drawings, lot sizes,
documentation and RFQs– Identifying potential savings opportunities– Identifying and qualifying suppliers– Educating and training buyers– Conducting the Competitive Bidding Event
(CBE)– Providing post bid analysis and support
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How Does FreeMarkets Online Create Value for its Customers?
Consulting/Purchase outsourcing Distribution Intermediary
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Traditional B2B Trading Exchanges
Industrial Buyer
Manuf. Rep. Manuf. Rep. Manuf. Rep.
Supplier 1 Supplier 2 Supplier 3
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Internet Based B2B Trading Exchanges
Industrial Buyer
FreeMarkets Online
Supplier 1 Supplier 2 Supplier 3
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How Does FreeMarkets Online Create Value for its Customers?
Consulting/Purchase outsourcing Distribution Intermediary Network Enabler/Software Provider
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
What are the Barriers for the buyers?
Elimination of established relationships with the suppliers and their representatives
Elimination of manufacturing reps could result in loss of convenience
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
What is the value to the suppliers?
Less value for the suppliers– Commission costs fell from 7% to 2.5%– Table 7.5 implies reduction in commission by
$174M(4.5%)=$8M– Table 7.5 also shows $35M drop in revenue for
the suppliers Suppliers could benefit from lower sales,
marketing and distribution costs and better utilization of capacity
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Which suppliers benefit from this model?
Low cost, quality suppliers will benefit as they drive competition out of the market– The FreeMarkets model would be beneficial for
large more efficient suppliers It will also provide opportunities for a host of
small suppliers, especially if they are located overseas
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
The Revenue Model
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Vertical vs Horizontal Focus?
Vertical:– Advantage: FreeMarkets can capitalize on its
deep knowledge of supplier industries– Disadvantage: Hard to scale-up
Horizontal:– Advantage: Ability to generate multiple
contracts from one buyers– Disadvantage: FreeMarkets does not bring
much expertise to the transaction
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
How about licensing the technology?
Are buyers capable of using the technology by themselves?
If not, how will this hurt? If they are, where is revenue going to come
from? How can these problems be addressed?
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
By the end of 1998…
FreeMarkets was pursuing the horizontal market expansion
In 2000, the company started licensing its software
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
The company went public in 12/99...
Freemarket’s Stock Price
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Where is FreeMarkets today?
For the three months ended in 3/31/01– Revenue totaled $33M– Net loss totaled $43.7M
For the three months ended in 12/31/01– Revenue totaled $44.8M– Net loss totaled $2.8M
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
E-Marketplaces: The Initial (95-99) business model
The e-marketplace concept started as a new way to procure products, particularly non-production items. E-marketplaces – Expand everyone’s market reach– Generate lower price for the buyers– Cut operational costs for buyers and suppliers
Automating the procurement process will reduce processing cost per order from as high as $150 to as low as $5 per order– Focus on liquidity– Transaction fee paid by the suppliers– Serve as a virtual distributor
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types
Value-added independent e-markets– They are expanding their offering to include
inventory management and financial services (Zoho); supply chain planning (Covisint, e2open, Converge, TheSupply)
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider Instill Corp.
Instill.com focuses on the food service industry and provides an infrastructure which links together operators, i.e., restaurants, distributors and manufacturers. This e-marketplace provides value to its customers by offering not only procurement services, but also forecasting, collaboration and replenishment tools.
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider eSkye.com
In the alcoholic beverage industry, eSkye has tailored an offering that provides the supply chain with real value. eSkye now links retail stores, distributors and suppliers providing visibility into a supply chain where little data existed. eSkye adds value by automating the ordering process for the retailer while providing product flow information to distributors and suppliers.
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types
Private e-Markets– Valuechain.Dell.com (Dell), eHub (Cisco)– IBM, Sun Microsystems and Wal-Mart
These companies use the marketplace to improve supply chain collaboration – Providing suppliers with demand information
and production data
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types
Consortia-based e-markets…. – Covisint (automotive); Trade-Ranger (oil);
Omnexus (chemicals); e2Open and Converge (high-tech)
Objective of the consortia is– Aggregate activities and use the buying power
of consortia members– Provide suppliers with standard systems that
support all buyers and allows suppliers to reduce cost
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Evolving Market Types
–Content based e-markets…. Focus on Maintenance, Repair and
Operations (MRO) goods–These are components that are not part of
the finished product or the manufacturing process but are essential for the business
–Examples include lighting, office supply, fasteners,…
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
E-marketplace Examples
Private TradingExchanges (PTX)
Independent VerticalExchanges (IVX)
Independent HorizontalExchanges (IHX)
Consortia TradingExchanges (CTX)
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortium-based public markets
Owner– Single vs Co-Op
Objective– Private: (i) Share proprietary data (ii) allow for SC Collaboration– Consortia: (i) Buying/selling commodities (ii) Finding new suppliers
Participants– Private: Selected group of suppliers– Consortia: Open Market
Buyer Cost– Private: Building and maintaining the site– Consortia: Subscription fee; licensing fee
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortium-based public markets
Supplier Cost– Private: No fee– Consortia: Subscription fee; Transaction fee
Challenges– Private: Initial investment– Consortia: (i) Many have recently collapsed; (ii)
preferred suppliers may object because of price focus; (iii) Sharing proprietary data (iv) developing standards
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Private vs. consortium-based public markets
Automotive Industry– Covisint was established in early 2000 by the Detroit’s
big three automakers– It now also includes Renault, Nissan, Mitsubishi and
Pegeot Volkswagen established its own private e-market
– Volkswagen e-market provides not only similar capabilities to that of Covisint but also real-time information on production plans so that suppliers can better utilize resources
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Consider IBM
IBM has saved about $1.7 billion since 1993 by being able to divulge sensitive price and inventory information over a private exchange built for 25,000 suppliers and customers, says Bill Paulk, IBM's vice president of e-marketplaces. As host of the exchange, the company helped defray the cost of connecting suppliers. The payoff: On-time delivery to customers soared from about 50% to close to 90%, "which helped justify the cost," Paulk says.
E2open: A consortia based e-marketplace established in 1999
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement
Level of Risk– Uncertain Demand (Inventory risk)– Volatile market price (Price Risk)– Component availability (Shortage Risk)
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Grainger
W. W. Grainger has been selling industrial supplies for 72 years
In 1995 Grainger established Grainger.com, an on-line catalogue for more than 220,000 products from 12,000 suppliers
In 1999, Grainger experienced revenue growth of $102M through its internet channel
The MRO supply industry is growing at a rate of 3-4% a year. From 1996 to 1999 Grainger internet sales grew 32% a year and 20% in offline due to customers that were lured to Grainger from the web site
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement
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
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for eProcurement: A Portfolio Approach
Inventory Risk
(Supplier)
Inventory Risk
(Buyer)
Price, Shortage Risks
(Buyer)
N/A
Commitment Level
Option Level
L H
H
L
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
B2B Software Vendors
Oracle (Indirect and Direct) i2 Technologies and Manugistics (Direct) Ariba (Indirect and Direct) Commerce One (Indirect and Direct) Agile (Direct) VerticalNet (Indirect)
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
E-Procurement: The reality
Companies conducting greater than 20% of procurement transactions online have reduced their transaction processing cost by nearly a third (Hackett Benchmarking)
Product savings and process cost improvements effect operating cost by 10% (Credit Suisse First Boston Technology Group)
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
E-Procurement: The reality
To capture this benefits purchasing organization needs to invest heavily in:– Changing internal procurement processes– Integrating e-marketplaces in internal systems– Purchasing B2B applications, and– Paying e-marketplace transaction
fee/subscription fee
Source: Forrester Research
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Positive Aspects of Trading Exchanges (Companies who use exchanges):
Reduce costs or labor (31%) Better access to products/vendors (24%) Increase speed or efficiency (29%) Access to more customers (21%)
Source: AMR Research
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Positive Aspects of Trading Exchanges (Companies who plan to use
exchanges):
Reduce costs or labor (43%) Better access to products/vendors (26%) Increase speed or efficiency (23%) Access to more customers (10%)
Source: AMR Research
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Negative Aspects of Trading Exchanges (Companies use exchanges):
Security trust (17%) Start Up cost (5%) Loss of face-to-face relationships (12%) Lack of standards (5%) Immature technology (5%) Integration issues (7%)
Source: AMR Research
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Negative Aspects of Trading Exchanges (Companies who plan to
use exchanges):
Security trust (16%) Start Up cost (15%) Loss of face-to-face relationships (11%) Lack of standards (6%) Immature technology (6%) Integration issues (4%) Pricing pressure (6%) Source: AMR Research
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Outsourcing
An “easy way” to increase profits Nike, Cisco, Apple outsource most of their
manufacturing– Each could focus on research, marketing– Each has gotten into trouble
2001 – Nike reported unexpected profit shortfalls due to inventory problems
2000 – Cisco had to write down billions in obsolete inventory 1999 – Apple was unable to meet customer demand for new
products
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
Outsourcing Benefits and Risks
Benefits– Economies of scale reduce manufacturing costs– Risk pooling – demand uncertainties are transferred– Reduced capital investment– Focus on core competencies– Increased flexibility
Risks– Loss of competitive knowledge – Conflicting objectives
Flexibility vs. long-term, stable commitments, etc. Consider the IBM PC example.
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for Outsourcing
Reasons for outsourcing– Dependency on capacity– Dependency on knowledge
Product architecture– Integral products – components are tightly related
Designed as a system Not off-the-shelf components Evaluated based on system performance
– Modular products –independent components
McGraw-Hill/Irwin © 2003 Simchi-Levi, Kaminsky, Simchi-Levi
A Framework for Outsourcing (Fine & Whitney)
Product Dependent:knowledge, capacity
Indep:
knowledgeDep: capacity
Indep.:
knowledgecapacity
Modular Outsourcing risky
Outsourcing oportunity
Outsourcing can reduce cost
Integral Outsourcing very risky
Outsourcing option
Keep internal
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