Module 2

Strategic Sourcing
2.0 Introduction
Strategic sourcing can be defined as a collective and organized approach to supply chain
management that defines the way information is gathered and used so that an organization can
leverage its consolidated purchasing power to find the best possible values in the marketplace.
Strategic sourcing is one part of overall procurement management that can help to achieve these
goals- reduce costs, assure and improve the quality of the final product and achieve a faster time
to market. Strategic sourcing views suppliers as crucial value partners and aims to building
sustained, collaborative relations

• Why do we need Strategic Sourcing?

– Increased Level of Cost Savings

– Better Alignment of Sourcing and Business Objectives

– Optimization of Ideal Suppliers

– Long-term Relationship Building with Suppliers

2.1 Outsourcing
• Sourcing does not strictly mean only looking to purchase cheap products but the
emphasis is on acquiring newly formed business partnerships.

• Modern supply chains have evolved from simple, linear connections between businesses
and suppliers to an interconnected.

• The key to an optimized supply chain is effective supply chain management(SCM) and a
great way to achieve such optimization is by outsourcing SCM to the right experts.

• In information technology, an outsourcing initiative with a technology provider can

involve a range of operations, from an entirety of the IT function to discrete, easily
defined components, such as disaster recovery, network services, software development
or QA testing.

2.1.1 Outsourcing Services

• Business process outsourcing (BPO) is the outsourcing of a specific business process
task, such as payroll (employees).

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 • BPO is often divided into two categories:
- Back-office BPO: which includes internal business functions such as billing or v
purchasing?
- Front-office BPO: which includes customer-related services such as marketing or
tech support.

• In today’s cloud-enabled world, however IT outsourcing can also include relationships

with providers of software infrastructure and platforms-as-a-service

• These services are increasingly offered not only by traditional outsourcing providers but
by global and niche software vendors or even industrial companies offering technology
enabled services.

• Outsourcing Examples
1. Nike holding only designing and branding

2. Dell holding only branding and strategy decisions

3. Toyota, Maruti-Suzuki, Honda holding only assembling

4. Voltas – only branding

5. LIC and National insurance – only sales of policies

Benefits and costs/ Role of outsourcing

 Lower costs (due to economies of scale or lower labor rates)
 Increased efficiency
 Variable capacity
 Increased focus on strategy/core competencies
 Access to skills or resources
 Increased flexibility to meet changing business and commercial conditions
 Accelerated time to market
 Lower ongoing investment in internal infrastructure

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2.2. Make Versus Buy: The Strategic Approach
The make versus buy decision evaluates the contribution of each activity. Using the value chain
framework developed by Michael Porter, we classify all supply chain activities as primary
activities and support activities.

 Primary activities consist of inbound logistics, operations, outbound logistics, sales and
service.
 Secondary activities involve procurement, technology development, human resource
management and firm infrastructure management.

The make versus buy decisions look at each of these activities critically and ask the question:
Should this activity be done internally or can it be outsourced to an external party?

Example

i. In India, Bharti AIRTEL has decided to focus on customer delight and brand building
and leave network management and a host of other services to its outsourcing
partners.

ii. When Reliance put up its refinery in Jamnagar, it realized that the volume of logistics
had increased significantly and therefore decided to build internal competence. Thus,
Reliance Logistics came into being, and today, not only does it manage its own
logistics activities but also provides services to the food division of ITC.

2.2.1 Factors Influencing Make or Buy Decisions:

1. Volume of Production If the volume of production is high, it favors the make decision
and low volume favors buy decisions.

2. Cost Analysis: Break Even Analysis

3. Utilization of Production Capacity: The organization, which has created large

production capacity, favors the decision to make

4. Integration of Production System: The vertical integration favors the make decision
whereas horizontal integration favors buy decision

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 5. Availability of Manpower: Availability of skilled and competent manpower favors
makes decision where as scarce manpower prefers buy decisions.

6. Secrecy or Protection of Patent Right: This condition favors the make decision

7. Fixed Cost :A lower fixed cost favors the decision to make and higher fixed cost the
make decision

8. Availability of competent suppliers or vendors

9. Quality and reliability of vendors.

2.3 Identifying Core Processes

As exemplified by Bharti Airtel, the decision to identify selected processes as core processes
and focus on improving those can have a significant impact on the performance of a firm.
The identification of core processes is a crucial decision.

The two ways through which one can identify a firm’s core processes are the business
process route and the product architecture route.

i. The Business Process Route:

For any firm, three core and high-level business processes include

- customer relationship,

- product innovation and

- supply chain management.

• Customer relationship focuses on acquiring new customers and building relationships

with existing customers.

• Product innovation focuses on developing new products and services,

• while supply chain management focuses on fulfillment of customer orders.

It is possible to un-bundle the three business processes and a firm can afford to outsource two of
these business processes. Some researchers have argued that a firm must identify and ensure that
it builds core capabilities in-house in at least one of these areas.

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Examples

 Firms like HP and high-end pharmaceutical firms focus on product innovations.

Firms like Nike and Benetton focus on brand building and customer relationships.
Firms like Wal-Mart and Dell Computers focus on supply chain management
capabilities.
 In the case of Microsoft, it decided that customer relationship management and
software design are its core processes, while supply and manufacturing is not core to
its business.

ii. The Product Architecture Route

In the product architecture approach, the focus is on sub-systems and components and
the make or buy decisions are made at that level.
- A product like a car can be divided into sub systems such as engine, chassis and
transmission.
- The engine sub-system can be divided into components such as power cylinder,
fuel system and engine electronics.
In a product, first the sub-systems are classified as strategic and non-strategic. A sub-
system is strategic if it involves technologies that change rapidly, if it requires
specialized skills and technologies and if it can significantly impact the performance
of the product on attributes that are considered important by the customer.
Tata Motors decided to source the design of diesel engine sub-systems from the
supplier, it ensured that in the other systems kept in-house, it maintained the position
of a leader.

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2.4 Market versus Hierarchy
If a firm decides to make the relevant component in-house, it may not have the necessary
economies of scale and might have to use internal hierarchy for coordination. In the hierarchical
form, a firm has greater control over coordination but there may not be enough motivation for
the internal supplier to work on innovations to reduce cost and improve service over a period of
time.

When a firm uses market mechanisms to procure the necessary inputs, it may be able to take
advantage of economies of scale and also choose the supplier that supplies goods and services at
lower prices. In this case, the supplier has enough motivation to innovate and the firm, as a
buyer, has the flexibility of changing the supplier, which is not an option available to the firm
that chooses to make inputs internally.

2.4.1 Economics of scale

Economies of scale are cost advantages gained by companies when production becomes
efficient. Companies can achieve economies of scale by increasing production and lowering
costs. For example, Wal-Mart’s “everyday low prices” are due to its huge buying prices. Even
Amazon’s “festival of festivals” also improves the economies of scale.

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There are four major sources of economies of scale:

i. Higher volume allows a firm to spread its fixed cost over a larger volume of
operations
ii. Higher volume allows a firm to choose more efficient technologies
iii. Pooling of buffer capacities and inventories
iv. Learning curve effect.

2.4.2 Agency Cost

Bharti used to manage customer billing operations through its internal IT department. The
important question here is, “How does one ensure that the interest of the IT department and
that of the marketing departments are aligned, and how does one make sure that the IT
department is putting its best effort and is not slackening?” This issue is known as the agency
problem in economics literature.

There is significant time and effort involved in the control and coordination of internal
activities. If one decides to manufacture the necessary inputs within the firm, then the firm
has to worry about agency issues. It is quite common that managers and workers of internal
supply units sometimes knowingly do not act in the best interests of the firms. Thus, the top
management incurs agency costs associated with in-house supply.

2.4.3 Transaction Cost

There are costs involved in using market mechanisms, which can be avoided if those relevant
activities are brought inside the firm. These costs are known as transaction costs.

The transaction costs comprise the following:

• Search and information costs: Costs involved in locating and evaluating the right
supplier.

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• Bargaining and contracting costs: A firm has to first negotiate the terms of exchange and
finally prepare the contract so that it is assured that the supplier will provide the required
good sand services as per the agreed terms and conditions.

• Policing and enforcement costs: A firm has to constantly monitor the supplier so as to
ensure that the supplier sticks to the terms and conditions of the contract. Firms might also
have to legally enforce the contract if the supplier does not follow the contract. Bharti has put
in elaborate mechanisms for monitoring the SLAs with IBM and Ericsson.

• Cost incurred because of loss of control: The use of market mechanisms may result in
under investment in relationship-specific assets, which, in turn, increase the cost for buyers.

2.4.4 Incomplete Contracts

In theory, it is possible to write a complete contract that stipulates each party’s
responsibilities and rights for each and every contingency that could conceivably arise during
the transactions. Unfortunately, in practice, it is impossible to write a complete contract.

 Bounded rationality: Managers have a limited capacity to process information;

hence, when dealing with complex situations, they are unlikely to seek and process all
the information available.

- For example, it will be difficult for managers of Bharti and IBM to think through all
possible scenarios related to regulatory change, technology and market conditions. Therefore,
both parties will, at best, identify major scenarios

 Difficulties in specifying or measuring performance: Even if managers are willing

to seek and process comprehensive sets of information, it will still not be possible to
write a complete contract if one cannot specify and measure performance.

- For example, when buying an advertising service or consultancy service, service

performance is not easy to specify at the time of writing the contract. Even if the quality
requirements are specified in the contract, certain aspects of quality cannot be measured
easily. In several situations, quality is ensured through process controls and cannot be easily
checked at the delivery stage. In the pharmaceutical industry, the temperature maintained
during the transit stage affects the effectiveness of drugs, and this aspect of quality cannot be
checked at the receipt stage.

 Asymmetry of information: There may be asymmetry of information at the time of

writing of the contract.

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 For example, certain information about future changes, either in technology or the supply
market, may result in lower costs, but the supplier may not provide the relevant
information and may take advantage of it while fixing either the price or other conditions
in the contract. For example, Bharti has better information about future markets and IBM
has better information about future technologies, and each may hide this information
from the other so as to ensure more favorable terms.

2.5 The Make-Versus-Buy Continuum

It started out by exploring two extreme positions:

(a) Make an input or buy an input using the market and (b) vertical integration versus market,
where the buyer has an arm’s-length relationship with the suppliers. There are several alternative
ways in which the exchange can be organized. In this section, we discuss two important
alternatives:

i. Tapered integration, where a firm both makes and buys a given input.

ii 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

i. Tapered Integration
Tapered integration represents a mixture of market and vertical integration. A firm
makes part of the requirement in-house and procures the rest from the market.
Eg. Firms like Pizza Corner and Madura Garments fall in this category, wherein they
own some retail outlets and depend on franchisee or other models for the rest of their
sales. Keeping part of the manufacturing in-house allows firms to have a better
understanding of the industry cost structures, and this helps them in negotiating better
deals with suppliers

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 ii. Collaborative Relationship
In a collaborative relationship, the supplier is an extension of the firm. The firm treats
its suppliers as strategic partners and usually a supplier is assured of business for a
reasonably long period of time. The firm does not indulge in competitive bidding
every year and does not change its supplier to get the small price reduction offered by
a competing supplier.
Firms should periodically benchmark the partner’s costs with the market so as to
ensure that the supplier remains competitive.

2.6 Sourcing Strategy: Portfolio Approach

Firms buy a large number of components and services and, of course, not all of them should be
handled in same way. The popular portfolio approach developed by Kraljic. Supply risk captures
two dimensions: number of suppliers in the market and the demand–supply gap in the supply market. If
an item has very few suppliers who have monopoly in the market and supply is less than the demand,
the buyer faces a significant supply risk.

Classifying items on their purchasing value is a straightforward issue because it just needs
internal data and growth projections at the firm level.

As shown in Figure 3.3, the four quadrants are named as follows: routine products, leverage
products, strategic products and bottleneck products. We take each category and discuss the
sourcing strategy.

• Routine products:

This quadrant represents significant opportunity. The focus is on reducing the number of parts
and the number of suppliers. The aim is to reduce administrative and logistics complexity. The

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time saved here is used to focus on strategic suppliers and bottleneck suppliers. The focus is on
moving to system buying rather than component buying.

A large number of items and suppliers come in this quarter, which represents a non-critical, low-
valued supply.

• Leverage products:

This quadrant consists of high-value, standard products. These items provide an opportunity for
leveraging buying power in low-supply-risk situations. In these supply markets, there are a large
number of suppliers and switching costs are low. So firms should be aggressive in their attempts
to encourage competitive bidding in order to leverage their position.

A firm can reduce the number of suppliers and focus on operational-level integration so that
apart from purchasing costs inventory and administrative efforts can also be reduced.

• Strategic products:

This quadrant represents high-value products with high supply risks. This quadrant usually
accounts for less than 5 per cent of the items and for almost 40 per cent of purchase value. Items
in this quadrant are treated as strategic items, and a firm must work towards establishing
collaborative, long-term relationships with suppliers in this quadrant.

Firms must create opportunities for mutual cost reduction by working together on all aspects,
including product design. Because fewer parts and suppliers are involved, firms can invest in
building collaborative relationships. The top management of firms should get actively involved
in devising a strategy for this category of items.

• Bottleneck products:

These items represent relatively low value, but a firm is vulnerable on this front because of the
supply risk inherent in this market. Since a firm is likely to be buying relatively smaller value, it
is also unlikely to have much clout with suppliers. Here, the focus is on securing supply, and a
firm should actively keep looking at alternative sources of supply.

If possible, the firm should also look at substitutes that are from low-risk supply markets. For
example, in the diesel fuel system, there may not be too many suppliers of the required capability
and competence. A firm might try and develop a better understanding of supplier priorities and
their planning systems so that it can align its buying plan with the suppliers’ operating plans.

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2.7 Supplier Selection and Contract Negotiation

2.7.1 Supplier Selection :

Before selecting suppliers, a firm must decide whether to use single sourcing or multiple
suppliers. Single sourcing guarantees the supplier sufficient business when the supplier must
make a significant buyer-specific investment. While, having multiple sources ensures a degree of
competition and also lowers risk by providing a backup should a source fail to deliver.

The selection of suppliers is done using a 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 a using a supplier and not just the purchase price. In
general, auctions are best used when the quantifiable acquisition cost is the primary component
of total cost. If ownership or post-ownership costs are significant, direct negotiations often lead
to the best outcome.

In many supply chain settings, a buyer looks to outsource a supply chain function such as
production or transportation. Potential suppliers are first qualified and then allowed to bid on
how much they would charge to perform the function. When conducting an auction based
primarily on unit price, it is thus important for the buyer to specify performance expectations
along all dimensions other than price.

From the buyer’s perspective, the purpose of an auction is to get bidders to reveal their
underlying cost structure so the buyer can select the supplier with the least costs. A significant
factor that must be accounted for when designing an auction is the possibility of collusion among bidders.

Second-price auctions are particularly vulnerable to collusion (contract is assigned to the lowest
bidder-but at the price quoted by the second-lowest bidder)

If there is collusion and all bidders but the lowest cost bidder raise their bids, the contract goes to
the lowest cost bidder, but at a higher price. Firms must take care to ensure that no collusion
occurs when using an auction

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2.7.2 Contract Negotiation :
Basic principles of negotiation

 Firms enter into negotiations both for supplier selection and to set the terms of the
contract with an existing supplier.
 Negotiation is likely to result in a positive outcome only if the value the buyer places
on outsourcing the supply chain function to a supplier is at least as large as the value
the supplier places on performing the function for the buyer.
 The differences between the values of the buyer and seller is referred to as the
bargaining surplus.
 A good estimate of the bargaining surplus improves the chance of a successful
outcome.
 Suppliers of Toyota have often mention that “Toyota knows our costs better than we
do”, which leads to better negotiations.
 The key to a successful negotiation, however, is to make it a win-win outcome that
grows the surplus. It is impossible to obtain a win-win outcome if the two parties are
negotiating on a single dimension, such as price.
 To create a win-win negotiation, the two parties must identify more than one issue to
negotiate. Identifying multiple issues allows the opportunity to expand the pie if the
two parties have different preferences.

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  This is often easier than it seems in a supply chain setting especially if both parties
focus on the total cost of ownership.
 Competitive edge is something all companies strive for as part of building their so
called “world-class supply chain”
 From a high-level definition, this means having effective interdependent relationships
between people, process and technology; and from our suppliers to our customers
such that we are enabled to increase market value and drive down end-to-end supply
chain costs.

Core elements of effort in getting to that end state include:

 Collaborative long-term relationships built on respect and trust.
 Effective demand signals that drive sourcing and manufacturing and enable
volume adjustments as needed.
 Operations and logistics alignment with capacity managed and leveled production
schedules.
 Ability to manage mixed loads with on-time/ in-full delivery coming into and
going out of the organization.
 Ongoing collaborative operations and product delivery improvement with cost
reductions across the end-to-end chain.

 Becoming world-class requires that we focus on operational excellence and use all means
at our disposal to ensure:
> Increased visibility across the supply chain
> Improved control and decision-making
> Improved product availability
> Improved alignment between organization and targets
> Increased data accuracy and user confidence
> Increased system performance
> Standardizing and harmonizing people, process and technology

Real world Results

HCL AXON has helped an ever-growing list of clients transform their supply chain:

For a global storage networking manufacturer, we achieved an 85% improvement in operating

cycle time by increasing supply chain efficiency.

> For a leading biotechnology company, we cut the time required for demand forecasting by
50%.
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 > For a global life sciences company, we delivered an organization-wide, 360-degree view of
the customer to support its 1200-member sales force.

> For a leading U.S. retailer, we enabled a 78% increase in revenue, which they achieved within
four months of its Oracle implementation.

> For one of Europe’s largest soft drink companies, we delivered $49M in cashable benefits by
transforming its supply chain.

Supplier Development

 Supplier development describes a structured program to improve the capability of

suppliers.

 Buyers may seek to improve capability by sharing ideas with their suppliers, by
seconding staff, by advancing funds for investment, or by working collaboratively to
jointly develop new processes.

 Supplier development is resource intensive and usually focuses on key long-term

suppliers with whom co-operation is appropriate.

 The logic is that, through developing the supplier’s capability, both parties will share in
the benefits of better performance, better quality, shorter cycle times and/or lower costs.

The role of supplier development in supply chain success:

1. Earn a Competitive Advantage

2. Encourage Collaboration Between Individual Suppliers

3. Drive Innovation

4. Create Stronger Long-term Supplier Relationships

5. Resolve Performance and Quality Issues

World Wide Sourcing

> This is also termed as global sourcing.

> It is the process of sourcing goods and services from the international market across
geopolitical boundaries.

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> It aims to exploit global efficiencies such as lower cost skilled labor, cheaper raw materials and
other economic factors like tax breaks and low trade tariffs. Examples are call centers in India,
clothing and shoes manufactured in Ethiopia and Thailand.

> Some advantages of global sourcing are learning how to do business successfully in a new
market, finding and developing alternate supplier sources to reduce costs and stimulate
competition.

> The opportunity exists to locate scarce skills and resources not available or unproductive at
home thereby increasing manufacturing capacity and other technical capabilities.

> There are also disadvantages, Monitoring costs go up and there are hidden costs relating to the
effort and time spent learning about different cultures and time zones, especially in the
beginning. There is exposure to financial, political and legal risks, often in emerging economies.

> In the service industries there is also a real risk in losing a grip on your intellectual property.

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