procurement and outsourcing phil kaminsky [email protected] david simchi-levi philip...

Procurement and Outsourcing

Phil [email protected]

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


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


The Move to B2B Commerce


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...


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


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



Consulting/Purchase outsourcing Distribution Intermediary


Traditional B2B Trading Exchanges

Industrial Buyer

Manuf. Rep. Manuf. Rep. Manuf. Rep.

Supplier 1 Supplier 2 Supplier 3


Internet Based B2B Trading Exchanges

Industrial Buyer

FreeMarkets Online

Supplier 1 Supplier 2 Supplier 3



Consulting/Purchase outsourcing Distribution Intermediary Network Enabler/Software Provider


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


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


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


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


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


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


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?


By the end of 1998…

FreeMarkets was pursuing the horizontal market expansion

In 2000, the company started licensing its software


The company went public in 12/99...

Freemarket’s Stock Price


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


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


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


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


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)


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.


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.



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



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



–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,…


E-marketplace Examples

Private TradingExchanges (PTX)

Independent VerticalExchanges (IVX)

Independent HorizontalExchanges (IHX)

Consortia TradingExchanges (CTX)


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



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



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


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


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



Level of Risk– Uncertain Demand (Inventory risk)– Volatile market price (Price Risk)– Component availability (Shortage Risk)


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



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


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



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


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



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


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


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)


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)


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


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


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%)



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%)



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


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


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.


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


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

procurement and outsourcing phil kaminsky [email protected] david simchi-levi philip...

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