Outsourcing: Make versus Buy

3
Learning Objectives
How do firms take make-versus-buy decisions?
What is the underlying theoretical logic for make-versus-buy decisions?
What are the costs and benefits of outsourcing?
What should be the nature of the relationship with vendor firms?
How can a firm design its sourcing strategy based on the purchase-portfolio matrix?
How has the internet affected the sourcing decisions of a firm?
Make versus Buy: The Strategic Approach
Make vs Buy represents two extremes along the continuum of possibilities.
Once a firm has decided to buy a certain set of activities/ items, not all items are sourced
using the same approach
What activities should be carried out by the firm and what activities should be outsourced?
Core competence of the firm In house
Core processes of the firm In house
Others - Outsource
How to select the entities/partners to carry out outsourced activities and what should be
the nature of relationship with those entities?
Should the relationship be transactional in nature or should it be a long term partnership?
What Activities Can be Outsourced?
Business Process Route
Identify high-level business process of importance
Customer relationship: acquiring new customers and maintaining/building
good relations with the existing ones. E.g., Nike and Benetton
Product and service innovation: Developing new products/services. E.g., HP
and Pharmaceutical Industry
Supply Chain Management: Fulfilment of Customer Orders. E.g., Dell and
Wal-Mart
Outsource activities which are of commodity type. E.g., Warehousing or Transportation
At least one of the Core processes retained within firm must provide strategic power to the
firm within the chain
A firm must ensure that it has higher bargaining power within the chain.
What Activities Can be Outsourced?...
Product Architecture Route
The focus here is on sub-systems and components and the make/buy decisions are made at
that level.
A sub-system is strategic if it involves:
Technologies that change rapidly
If it requires specialized skills and technologies, and
If it has significant impact on the performance of the important product attributes
Ability to offer differentiated product
Technological leadership
Identification of strategic subsystems, components
Even for outsourced subsystem firm must keep architecture knowledge in-house
E.g., e-retailers are sometimes not able to deliver products on time due to their dependency
on their logistics partners, especially during festive seasons
Virtual Corporations
Virtual corporations outsource all supply chain activities to either one party or a combination
of parties and just focus on brand building
Is virtual corporation a hollow corporation (?)
Strategic Outsourcing Process
Make or Buy
Decisions
Market
vs
Hierarchy
Economies
of Scale
Agency
Cost
Transaction
Cost
Incomplete
Contracts
Market versus Hierarchy: The Economic Perspective
1. Economies of Scale
Higher volume allows a firm to spread its fixed cost over larger volume of operations
Higher volume allows a firm to choose more efficient technologies
Pooling of buffer capacities and inventories
Due to steadily rising costs, the firms are more and more availing 3P services for
manufacturing and Logistics
e.g., Outsourcing of IT operations to IBM and Wipro
Indo Nissin Foods Ltd. (Top Ramen) o/s distribution operations to Marico
Outsourcing of warehouses and transportation is also very common
If a firm has larger demand can have internal manufacturing
e.g., Wal-Mart would prefer its own fleet of vehicles for transportation
Market versus Hierarchy: The Economic Perspective
2. Agency Cost
Cost of Control and Coordination of internal supply
Usually termed as Cost Centers, insulated from competitive pressures
3. Transaction Cost
Search and Information cost
Bargaining and contracting cost
Policing and enforcement cost
Cost incurred because of loss of control
Market versus Hierarchy: The Economic Perspective
4. Incomplete Contracts
In practice, it is impossible to write complete contracts
Reasons why contracts are not complete:
Bounded rationality
Difficulties in specifying /measuring performance
Asymmetry of information
Inability to write complete contract increases transaction cost in following situations:
Presence of relationship-specific assets: Results in Hold-up problem for suppliers
Poor coordination affecting supply chain performance: O/s slows down the speed in non-
routine operations, results in increased transaction costs
Leakage of strategic information resulting in adverse supply chain performance. E.g.,
Textile industry
Relationship-specific Assets: Illustrations
Maruti Suzuki has
asked several of
its suppliers to
locate either
finishing
operations or
stock points close
to its Gurgaon
plant.
Bharti would
preferred
Ericsson to build
network capacity
on the basis of its
demand
projections.
Microsoft
expected its
introduction of
Xbox 360 to be a
huge success and
has asked its
contract
manufacturers to
build additional
capacity for the
same.
Marico would like
all its dealers to
work with MIDAS
(Distributor
application
software
developed by
Marico).
Wal-Mart has
made RFID
mandatory for its
top 100 suppliers.
All supply from
2005 onwards is
supposed to be
RFID tagged.
Integrative
Framework
Of Make
Versus Buy
Two extreme positions in Make-versus buy continuum:
Make an input or buy an input using the market
Vertical integration versus market, where, buyer has an
arms length relationship with the suppliers.
The Make-versus-buy Continuum
The Make-versus-buy Continuum
There are several alternate ways in which the exchange can be organized:
Two important alternatives:
1. Tapered integration, where a firm both makes and buys a given input.
Its a mixture of market & vertical integration.
Firms like Pizza corner & Madura garments fall in this category , wherein they own
some retail outlets & depend on franchisee or other models for the rest of their sales.
This helps them to better understand the costing and the pricing
Helps them negotiating better deals with suppliers.
Able to keep up the pressure on internal supply group to innovate.
Pressure on market supplier as well.
Looks as if it allows a firm the best of both worlds, if not managed properly, might end
up getting the worst of both.
2. Collaborative relationship- which could be a formal contractual relation or a
long-term informal relationship, based on trust. In some cases, it can lead to
alliances or joint ventures.
The supplier is an extension of the firm. Can be strategic partners.
Firm doesnt indulge in competitive bidding every year.
Doesnt change its supplier for a small price reduction.
Usually the supplier gets involved early at the product design stage & price
paid is based on actual cost incurred.
Major concern is ensuring supplier works on innovation.
Firms should periodically benchmark the partners costs and technology with
the market so as to ensure the supplier remains competitive.
Concept Of Keiretsu
Japanese companies have subcontractor networks called keiretsu.
This involves vendors, bankers & distributors.
Firms within a keiretsu are linked by informal personal relationships.
They share long term relations, so they avoid most of the problems associated
with market exchange relationship, are willing to invest in higher relationship-
specific assets.
This allows keiretsu to focus on its core competence & all get the necessary
economies of scale.
The portfolio approach developed by Kraljic classifies items based on the
importance of the item in terms of value of purchase ( high versus low) &
associated supply risk in the supply market.
Supply risk captures 2 dimensions:
1. No of suppliers in the market.
2. The demand supply gap in the supply market.
If an item has very few suppliers who have monopolythe buyer faces a
significant supply risk.
In supply markets where there are large no of players & there is surplus capacity in
the market, the items bought will be low supply risk category.
Diesel engine , diesel fuel & proprietary technologies have few suppliers.
Sourcing Strategy: Portfolio Analysis
Sourcing Strategy: Portfolio Analysis
Supply Risk
L
o
w
H
i
g
h
Purchasing Value
Low High
Source: Purchasing and Business Strategy
Purchase Portfolio Analysis
Routine: Significant opportunity, focuses on reducing the no of parts & no of suppliers, reduce
administrative & logistics complexity. Focus on moving to system buying rather than component
buying.
Leverage: High value, standard products. Large no of suppliers & switching cost are low. Focus
should be on operations level integration so that not only purchasing but administrative efforts
can also be reduced.
Strategic: High value products with high supply risks, strategic items, firm should look for
collaborative , long term relationships with suppliers, should create opportunities for mutual cost
reduction.
Bottleneck: Low value, focus on securing supply, & should keep looking at alternative sources of
supply, even look at substitutes.
Routine products are products which are readily available (low purchasing risk) and have a low
impact on the financial result of a company.
Examples of routine products are computers, paper clips, staples, cleaning, etc. The
purchasing of routine products is mainly an administrative process.
The organizational costs of purchasing these goods often exceed the costs of the goods
themselves.
Many purchasing departments pay a lot of their attention to the purchasing of routine
products, as there are so many routine products and a lot of suppliers are involved. The pay off
however is low. Professional purchasing departments try to minimize the effort and time they
spend on the
purchasing of these routine products (Van Weele, 1997). Professional suppliers therefore try to
minimize the effort their customers have to do: they take care of the process for their customers.
Routine
Leverage products are products which are readily available and which have a big impact on the
financial result of the buyer. Buyers pay lots of attention to the purchasing of leverage products,
as the financial risk is high. Because leverage products are readily available, the purchasing
department scans the market.
The competition between the many suppliers will lead to a situation where some suppliers
start discounting their product. A discount for the customer on a leverage product will result into
substantial savings (in absolute terms). For the suppliers this behavior of the customer is
uncomfortable. The traditional behavior of the supplier is to push the product as much as
possible.
As all suppliers of the leverage product will do this, the job of the purchasing department of the
customer is made even easier.
Leverage
Strategic products are products with a high financial risk and a
high purchasing risk for the customer
Strategic :
Bottleneck products are products with a low financial risk and a high purchasing risk: there are
not many suppliers the customer can go to. Customers are vulnerable. Spare parts are typical
bottleneck products.
The power of the relationship lies with the supplier. Customers will try to look for substitutes:
this will lower their purchasing risk. The security of supply is a key issue for the customers.
How should the supplier differentiate his customers?
Bottleneck :
Portfolio Analysis of Indian Firms
Sourcing strategy Based on Purchase Portfolio
Classification
Classify outsourced items/processes using portfolio matrix
Design strategy for each quadrant
Focus on direct as well as indirect goods and services
Sourcing of Indirect material account for significant part of cost of goods sold
Impact of Internet on Sourcing Strategy
Advances in information technology in general, and the internet in particular, costs related
to computer-aided information search and coordination have declined, averaging 25% per
year.
Initial reactions by practitioner/researcher community:
Internet would fundamentally change sourcing practices.
Optimal number of suppliers in the consideration set increases with lower search and evaluation cost
Suppliers in the consideration set would be globally distributed and not limited to the geographical
neighbourhood of firm.
Internet fuelled a lot of electronic public-market exchanges and industry-sponsored exchanges where
information about suppliers can be obtained without much effort.
Current understanding on the part of practitioner/researcher community:
Basic logic underlying the sourcing strategy using the purchase portfolio matrix is not going to change
because of the internet.
Internet is an enabler in implementing the sourcing strategy based on the purchase portfolio matrix.
Reverse Auction
What is Reverse Auction
Unlike a typical auction, the roles of the buyers and sellers are reversed in reverse auction.
Firms use this approach to identify suppliers willing to supply specific items like steel or service
like freight at the lowest bid price. Suppliers bid electronically for a contract over a window of
about 30-60 minutes.
At the bidding stage, all suppliers have access to information about the lowest bid in real time,
and since the amount in an auction is usually large, the supplier is under tremendous pressure
to reduce his bid and usually ends up bidding a lower amount than what he would have bid
during normal circumstances.
Reverse Auction
Best Practices in Reverse Auction
Use reverse auction for items under the low supply-risk market category in the
purchase portfolio matrix, as for these items usually there are a large number of
suppliers and there is surplus capacity in the market; hence, there is enough
incentive for suppliers to reduce their bids during reverse auctions
Specifications must be clearly stated in the RFQ (Request for Quotation) document:
RFQs must be detailed and take care of all the issues including delivery lead times,
treatment of urgent orders, warranty etc.
Firms must have a robust supplier qualification process
Firms must ensure that the purchase lots in a reverse auction are large enough to
motivate suppliers.
Strategic Outsourcing : The Case of
Bharti Airtel
Strategic Outsourcing: Network Design
and Installation
Bharti will pay vendors according to Erlangs of installed capacity
Payment will be made when capacity is up and running and has been used by
customers
After a certain period, unused capacity will be redeployed or payment will be made to the
vendor
Adjustments to price per erlang function of demand density will be made according to a
pre-agreed formula
Bharti will build passive infrastructure
Strategic Outsourcing: Network Management
Vendors will establish NOCs (Network Operating Centers) to monitor activity
SLAs are to guarantee quality for Bhartis customers. Representative metrics:
Blocked calls in peak/non-peak hours
Dropped calls in peak/non-peak hours
Voice quality
Financial rewards and penalties
Strategic Outsourcing: IT Outsourcing
On-demand agreement with IBM for 10 years
IBM will be paid a share of Bhartis revenues
IBM modeled its revenues on a forecast of customers and employees
Adjustment for scale (IBM share will fall with growth)
SLAs (Service Level Agreements) stipulate penalties as a function of the criticality of the
system to Bhartis business
Governing body to cope with IT evolution
Bharti Airtels Experience of
Strategic Outsourcing
Bharti management pleased
Predictable cost model
Developed new managerial capabilities
Former employees satisfied with transfer
Vendors better-off
Equipment vendors pleased with the end of beauty contests.
IBM used Bharti as an example in public forums
Best Practices in Strategic Outsourcing
Ensuring goal congruence
Goal congruence ensures that control costs are low
Building professional contract management group
Developing a greatly enhanced strategic and operations information systems
Developing feedback systems to leverage and share knowledge and innovations in both
directions
Creating a mutual three-level contact system
Top management level : Break bottlenecks and ensure responsiveness
Champions on both side of the relationships
Numerous operating level personnel who develop the personal relationships and knowledge
exchanges
Shift the buyer outlook to managing what ( results) is desired rather than managing
how the result is produced
Summary-I
Traditionally, firms started with the assumption that everything should be done internally
unless there is a compelling logic for outsourcing an activity. Now, a large number of firms want
to be virtual corporations where they start with the assumption that activity must be
outsourced unless there is a compelling logic that justifies keeping activities in-house.
Since outsourcing is a strategic decision which cannot be altered in the short run, firms must
look, not at the immediate costs, but at the long-term supply chain costs and risks in making
this decision.
Firms can identify core activities from a strategic perspective either through the business
process route or by the product architecture route. When a firm decides to outsource some
core process/sub-systems, it must keep the necessary architecture knowledge in-house.
A firm has to look at the benefits as well as the costs involved in their make-versus-buy
decisions. If additional costs due to poor economies of scale plus agency costs of internal
control and coordination exceed transaction costs of market exchange, the firm should opt for
make.
Summary-II
Pure Make and pure Buy are two extreme ends of the make-versus-buy continuum. There are
many ways of managing outsourced activitiestapered integration and collaborative
partnerships, are two among several hybrid ways in which outsourced relationships can be
managed.
Not all items are sourced using same the approach. Purchase portfolio matrix is one popular
approach for classifying items into four categories: routine items, leverage items, strategic
items and bottleneck items. Purchase portfolio classifies items based on the importance of the
item in terms value of purchase and the supply risk associated with the item in the supply
market.
Firms should try and reconfigure their supply base and use new technologies like internet and
e-commerce in implementing sourcing strategies based on the purchase portfolio matrix based.